This is part 1 of a 4 part article which focuses on a traders ability to establish a trading methodology; please enjoy:
The desire to win
Traders desire to win. Nothing else matters to them. They believe the most crucial question is timing the entry. Exits don’t matter at all, they contend, because if they rightly time the entry could easily get out long before a retracement erases profits.
That’s the reason why there are thousands of books about Technical Analysis, Indicators, Elliott Wave Forecasting, and so on. But just a handful of books on psychology, statistical methods, and trading methodology.
The need to be right
The truth is not out there; It is in here. There are a lot of psychological problems that infest the majority of losing traders. One of the most dangerous is the need to be right. They hate to lose, so they let their loses run hoping to cover at the next market turn and cut their gains short, afraid to lose that small gain. This behaviour, together with improper position sizing is the cause of failure in most of the traders.
The law of small numbers
The second one is the firm belief in the law of small numbers. That means the majority of unsuccessful traders infer long-term statistical properties based in very short-term data. When his trading system enters in a losing streak, they decide the system doesn’t work, so they look for another system which, again, is rejected when it gets into another losing sequence and so on.
There are two problems with this approach. The first one is that the trading account is depleted continuously because the trader is discarding a system when at its worst performance, adding negative bias to his performance every time he switches that way. The second one is that the wannabe trader cannot learn from the past nor can he improve it.
Not keeping records
Traders, also, have the nasty habit of not keeping a record of their trades; therefore it is impossible for them to analyse and assess the statistical properties of their trades.
For instance, the figure below shows a typical premium-seeker style return distribution, a hit-and-run style, scalping, or mean reverting type of traders, showing a negatively skewed return distribution.
While fig 2 shows the distribution of returns of a typical premium buyer, or a trend-follower if you like.
To be aware of which type your profit distribution is, and other key features, a successful trader needs to register the actual data of trade results.
The next article will deal with diversification and its effect on drawdown and risk….
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