We all make winning and losing trades—simply because of probability. Some, but few, traders are skilled in predicting market direction. However, most traders—including professional money managers—have a difficult time outperforming the market averages. Studies have shown that most individual investors fail to understand this simple principle and tend to believe that their results are better than their actual results. In other words, they believe they do better than the market averages when in fact they perform far worse.
Trade Selection
If we have no special skills when selecting our trades, then we must develop some skills that give us a trading edge. With no edge, we can expect to win about half the time. When we add in the cost of trading (i.e., commissions) we must do one of two things as traders:
earn a profit well over 50% of the time;be certain that we do not lose more money from losing trades than we earn from winning trades.
To meet that goal, we must practice good risk management and be certain that our losses are limited to acceptable levels. However, that is not the only thing we can do to achieve success as a trader. The way we think—the trader mindset—contributes a great deal to the success or failure of almost every trader.
The Trader Mindset or the Psychology of Trading
The work of Dr. Brett Steenbarger offers insight into the psychology of trading. The following are his thoughts from an article in Forbes on how traders respond to losing money:
Key to Success for the Options Trader
Find strategies that you understand well. Use them when you believe market conditions are appropriate (i.e., covered call writing and naked put selling work well in a slightly bullish environment; iron condors work well when market volatility has been high but is steadily decreasing). Track the results. Figure out how well the market environment that you anticipated became reality. Over time, you will discover which strategies work well—not only because the strategy itself was viable—but more importantly because you adopted it at the right time. Develop the discipline to take those inevitable losses. Know when enough is enough and exit winning trades when the remaining potential profit has become too small to justify the risk of earning the last few nickels on a trade.
Keys to Success for the Technical Analyst
Learn how to read charts. This takes time and is never something you can learn overnight. Even though there is no guarantee of success, any edge helps. If you get a buy signal, then it is okay to get along—even when you know the signal may be wrong. But your success comes from cutting losses and from studying all the signals. Learn which ones work often and which are no better than break even. Study the results and gain an additional edge by knowing which ones work for you.
General Keys Anyone Can Use
Do not trade just to trade. When your results are poor, take a break from trading, but not from analyzing your results. When your strategies do not work, carefully figure out whether it is time to sit on the sidelines or adopt another strategy. but do not just guess at what to do. Have a sound reason for every trade.
