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How discretion will kill you

December 11th, 2009 · 3 Comments · Strategies

Under this “dramatic headline” is a pledge to cut down discretionary trading and focus on systematic automated trading.

image credits: chego101@flickr

image credits: chego101@flickr

I think many traders (and I include myself) suffer from “bad” discretionary trading: entering a trade without a proper trading plan or system, only based on “gut feelings”.

I am no exception and have recently experienced being in trades that do not turn out as expected. I personally feel a bit lost in these situations and wish I had a better plan…

Without a proper plan, the management of the open trade is subject to all sorts of emotional influences, mostly greed and fear
I recently went to a motorbike track riding school. The instructor was demonstrating that all our instinctive “survival” behaviours when faced with a “situation” almost always make things worse. I believe the same equally applies to managing an open trade: without discipline and a plan, you are most likely to take all the wrong decisions.

And despite reading about how a trade plan is important, how cutting your losses short and letting your winners run is the way to trade, you still make these same mistakes, knowing full well that you are making them but still thinking that “it might work” (doubling down, letting losers run, etc.
And as John Mayard Keynes said:

The market can stay irrational longer than you can stay solvent

Discretionary trading is an intuitive approach with no reference to the past (as opposed to a back-test that provides you with a frame of reference). Your decisions are based on interpretation of events – which is mostly subjective and dependent on your emotional state (i.e. most likely affected by your current loss or gain). Unless you are Paul Tudor Jones and able to decipher the markets and make the right calls, discretionary trading is a very hard art to master.

Now, this is not saying that automated trading does not offer its own psychological pitfalls including:

  • skipping trades/overriding signals
  • not being able to live through large drawdowns and stopping trading the system
  • search for “holy grail” and curve-fitting in back-test

This is not saying that great discretionary traders do not exist either; but having a tried and tested system that you trust will give you the comfort of a reference, which should in turn give you an incentive to stay displined and follow it.
Now, finding a good system to trade is not easy so let’s get to work! ;-)

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3 Comments so far ↓

  • B7

    I agree 100%. Our emotions are the #1 reason that traders lose money in the markets. If a trader follows a simple trend following system for example, the chances of making money are quite high. However, when we make decisions with our emotions (which virtually everyone does), our chances of losing money are greater than 90%.

    That’s a great point that you make about riding a motorbike. (I love motorcycles!) It’s interesting to see the similarities between things that seem unrelated (fast bikes and markets) but are actually similar. We experience the exact same emotions! The visceral rush of acceleration, danger and the speed of pavement moving by just inches from our body. We get the same rush from the excitement of winning (also known as greed) and the danger of losing (fear).

    Our emotions have been refined over hundreds of millions of years to protect us and help us survive in our environment. But the environments of riding a motorcycle and trading the markets are completely new to human beings. They have been around for just a few thousand years at most, in the case of markets. And, in the case of motorcycles (first designed by Germans, who make the best cars!), 125 years ago.

    That means that we have not learned how to succeed in the markets (or on a motorcycle) on an emotional level. We can only use our intellect to overcome the limitations of our evolution and our emotions. I think that the best way to do so is to eliminate our emotions. This can be accomplished by trading with a system that is based on rules, automated, and not discretionary.

  • NH

    I have one question: do we need them (ones who do discretion trading?)
    Since the cost of information technology is low, it become so easy to implement some kind of system to find some trading edges – and there are possibilities that those system by different people are similar, even identical. Just like two people can both buy tradestation, and decided to design a system using moving average cross over, and they optimize there system for the same market – they get the same result.
    Ok, the example might be too simpified. But I would like to hear from your opinion. Thank you.

  • Milktrader

    The topic of emotions and trading is interesting. There is the view that you shouldn’t have emotions when trading, but I don’t agree with that view. There is a field of research in psychology now that suggests that emotions clue us in on conditions before our other sense pick up on the clues.

    Clearly emotions can have a major bad impact on our trading. But I feel it has more to do with how well we know ourselves and less to do with the emotions themselves.

    On discipline and emotions. I don’t think it works. If you need to control your emotions with rules and such, then you need to work on your belief system first so you don’t experience the emotions that are getting you in trouble.

    System trading has a huge startup cost and I’m still paying it myself. It’s easy to get frustrated and revert to old ways. It’s okay if you do. Big deal. You always do the best you can. Your actions are simply a reflection of who you are as a trader. Take note and move forward.

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