This article originally appeared in FutureSource’s Fast Break Newsletter, where Craig Turner is a regular contributor on various futures trading topics.
For many traders, the Psychology of Trading can be the greatest hurdle they need to overcome in order to be successful. At Daniels Trading, one of our primary goals is to help self-directed online and broker assisted traders overcome this common issue, and get them on their way to achieving the results they are looking for. While there are many factors that go into the Psychology of Trading, we feel these three are the most common and important to trading success.
1. Losing open positions are losing real money.
Some traders convince themselves their position is not a loss until they liquidate. Unfortunately, in a mark to market world, a losing position needs to be treated as a loss in the traders mind. Traders often hold onto a position far longer than they should because they think the market will come back. They think they are not actually losing money until they get out. However, the market does not have to come back to the original price.
Another common event is the market goes against traders to the degree that they get out of their trades because they have reached their threshold of market pain, before the market does come back to their entry. Does that mean you have to get out of a position because it is going against you? No, but you need to confront that fact that the market has not gone in your direction.
How can traders avoid this problem?
All traders should evaluate all of their positions at the end of the day or first thing in the morning. We look at all of our losing positions and we pretend we are flat. We then ask ourselves, if we were not in this position, would we get in now at this price based on what the market is telling us. We will evaluate the market from Technical and Fundamental aspects, and we will even play “Devil’s Advocate” on why not to get in. If the final answer is “no”, we exit our losing position. If the final answer is “yes”, we stick with the position and review it again in 24 hours.
Why does this work?
This process works because it helps traders to emotionally detach from their open positions. Traders stay in positions too long because they are too emotionally invested in the trades. Any trader who is too emotionally invested will not be able to evaluate the markets and his account properly. In order to emotionally detach, you have to look at the market as if you are not in the position at all. Once you clear your head and look at the market as you don’t have a position, you will be able to evaluate it honestly and effectively.
This process also works because the trader is checking the status of the trade at least once a day. This makes sure the trade does not get away from the trader. You can’t just stick your head in the sand and hope the position comes back. Hope is not part of the equation. This process forces the trader to confront the current market conditions.
2. Open, positive trades are not profitable until the trade is closed.
Some might say this is contradictory to the first rule. It is and it needs to be. Too many traders think that losses don’t count until they liquidate, and they count “their winnings” before they exit a trade. I’ve talked to traders that said they “gave back profits” because they did not get out in time. The fact is, they did not “give back” anything. There are no profits until you exit.
Why the difference in thinking and attitude towards winners and losers?
If traders can accept that winners are not profits until they liquidate, they are more likely to take profits and not let the position turn against them. If traders can accept that a losing trade is losing real money now, they are more likely to get out of a bad trade and preserve trading capital. There are two sayings in trading that relate to this. The first is “your first loss is your best loss”. The second is “no one ever went broke taking a profit”. Those two sayings relate directly to the Psychology of Trading.
How should traders get in the habit of taking profits?
Traders need to have a stop in place and trail it manually from day to day at the very least. Some will also use a limit order for a profit target. I prefer moving the stop each day to lock in profits on a profitable trade. If you are up 30 cents on corn, and you put your stop 10 cents below the last trade, you know you are locking in 20 cents or $1000. The most important thing is not exactly how you manage your profit targets, but that you actually have a plan in place with orders in the market.
We also evaluate winning positions every day, just like we do with losing positions. We ask ourselves two things. The first is, if this trade went against us starting tomorrow, how much would we want to profit and still feel good about the trade. That price becomes our stop loss. The second thing we do is say, “if we were not in this market now, would we get in at this level?” If the answer is “yes”, we might think about adding on a position. If the answer is “no” we make sure we have that stop in place to take profits in case the market turns against us.
3. Understanding Leverage is Key to Trading Success.
Leverage can change how traders normally approach the markets. They see the leverage and how much it can work for them positively but never fully explore the downside. Using leverage properly can turn good trades into great trades, but trading with leverage makes risk management even more important. Leverage plays a direct role in Greed and Fear, which are two of the strongest elements in the Psychology of Trading. Using leverage appropriately will reduce the roll Greed and Fear play in your trading. Here are two rules to live by concerning Leverage:
Margin is not a Guideline for Leverage
Actually, margin is the level that tells traders they are overleveraged and in risk of blowing out their accounts. If you constantly find yourself on Margin Call or trading right at the margin levels, the powers of Greed and Fear will eventually overtake your trading. Constantly living on the edge takes it toll, as any trader who has been overleveraged for an extended period of time will tell you.
Know your Account Leverage Ratio
Account Leverage Ratio is the Total Contract Values divided by the Net Liquidity in your account. Let’s say you have a $10,000 account and long Gold from $1300/oz. Gold is a 100oz contact, so the total contract value is 100oz X $1300/oz = $130,000. Take the total contract value ($130,000) and divide it by your net liquidity ($10,000). $130,000/$10,000 is 13:1.
Your $10K acct long 1 contract of gold is leveraged 13:1. Even more importantly, if Gold declines by $50 to $1250, that is a $5000 move. Your account is now at $5000 ($10,000 – $5000) and the total contract value is $125,000. Your account leverage ratio is now $125,000 / $5000 = 25:1. A less than 5% move in gold has resulted in a doubling your account leverage. Traders need to know how much a market can reasonably move against them or in their favor, and how that changes the leverage they are using.
If gold trades trade up $50 from $1300 to $1350, the trader will have $15,000 in their account for a $135,000 contract. The account is now only leveraged 9:1. A less than 5% move in Gold has reduced the leverage ratio significantly.
While there is no magic number for how leveraged your account is, you should always be aware of the leverage you are using. Conservative traders should try to keep the leverage between 5:1 to 10:1. Aggressive traders should try not to get beyond 20:1 as a general rule. Once you get to 25:1 or greater, the account will be heavily leveraged and at serious risk of blowing out on any significant market move. Understanding the leverage will help traders make better decisions when entering and exiting trades.
Putting It all together
Traders who can limit losses, take profits and understand leverage, greatly improve their chances of success. These aspects of trading are more mental than people realize. If you can attack these common issues with the understanding they are rooted in the Psychology of Trading, you will be better armed to trade the markets more effectively and with better control of the leverage you are using.