a great banana peel, as are hope, fear, and greed. My biggest slip-ups
occurred shortly after I got emotionally involved with positions.” – Ed
Seykota
It is said that over 90% of active traders in the financial markets don’t make
money over the long-term. There is a lot of confusion about the exact
numbers, but it’s safe to say that it’s difficult to be profitable over time.
Even investors have terrible timing on their buy and sell decisions, but why
is this the case? It typically comes down to emotions.
The majority of the errors that traders and investors make are emotional
ones because they rely on internal signals. Their emotions give birth to a
buy and sell strategy that is unproven and often unprofitable. We’ve
witnessed this as many of the wild price swings that make no sense in the
current market environment. If you want to make a quantum leap in
profitability, the first step is to stop buying or selling anything without a
solid, quantifiable, external reason for doing so.
Greed was the primary driver of the NASDAQ 5000 bubble in March of
2000, not the valuations of ‘eyeballs’ on websites. Buyers continually piled
into dot com stocks with no real intrinsic value, and held them due to the
greed of more gains and higher highs. The NASDAQ 5000 trend could have
been traded profitably with the right entry and exit signals. Simple chart
patterns and moving averages made many traders a lot of money in 2000. I
had enough money in March of 2000 to pay off my new house when I was
27 years old, and I have been hooked ever since.
The problem during this period was the traders and investors that traded
based on their personal euphoria that allowed them to hold their positions
during the parabolic tech uptrend, didn’t allow them to lock in profits and
exit their positions. Using trailing stops would have helped them exit and
keep large gains instead of riding their tech stocks all the way back down.
In March of 2009 all major stock indexes made lows that seemed
impossible just a year before. The selling escalated because of a fear of
holding equities, and sellers were willing to let go at ridiculously low
prices. Long-term trend traders should have been out of the long side of
stocks and limited losses in 2008 using any reasonable sell.
The easiest sell signal for a trader or investor to use to limit the destruction
of their capital is to exit their holdings and go to cash when the S&P 500
index tracking ETF SPY closes under its 200-day simple moving average.
For stock indexes, this one simple exit signal decreases drawdowns of
capital by about 50% in the past 15 years of backtests. It doesn’t increase
the returns in most cases, but exiting when the 200-day simple moving
average is lost will cut the down side in half.
You have the option to be in cash during market corrections, bear markets,
recessions, and market meltdowns, and you can wait to start buying again
when the indexes start closing over the 200-day. This could be the most
important signal in this book. The majority of investors and traders would
do well to go to cash when the stock market indexes are trading under the
200-day moving average, and wait for better opportunities on the upside.
An index tracking exchange traded fund like SPY, QQQ, IWM, or DIA
closing below the 200-day moving average should be your first warning
sign of danger.
Pride makes people hold what they thought was a good investment or long
side trade even though it has slipped dramatically. The only reason to buy
anything is for the possibility of it going up in price. Pride is the signal that
keeps a trader in a losing position and unwilling to admit they are wrong. It
prevents the use of stop losses and proper exit signals. A trader with too
much pride won’t even understand the need for exit signals because they are
blind to the possibility of being wrong.
Hope is another dangerous signal used by traders. A trader will buy a stock
that is falling lower day after day based on the unfounded hope that it will
go higher. Hope is not a dip buying signal. A stock index approaching the
30 RSI and above the 200-day moving average on the daily chart during a
bull market is a much better buy signal. You must have a quantifiable,
external reason to buy a dip that puts the odds in your favor based on price
action and not because you hope something good will happen.
Fear is one of the internal trade signals that completely undermine a trader’s
ability to be profitable. There are two ways to be profitable, have more wins
than losses or have big wins and small losses. A high winning percentage
system should have wins and losses equal in size to make your system
profitable. Likewise, having big wins and small losses can allow even a
small winning percentage system to make money, provided there are
enough large enough wins. Huge losses will make you unprofitable
regardless of big wins or a high winning percentage because you will give
back your profits from your winning trades, and eventually destroy your
trading capital.
Fear can signal a trader to take a small winning trade while the profits are
still there before it disappears, making it difficult to have any big wins. Exit
a trade based on a trailing stop, time stop, or because a price target is
reached rather than give into your fears. It can also make a trader miss a
valid entry signal because they are afraid of losing money.
Greed can believe in your entry signals too much and often wants to trade
with too much position size. Greed is confidence gone wrong. Each trade
signal you use should be designed to put the odds in your favor, but even a
great trade signal is not a guaranteed win, it’s just a possibility with a good
probability. Many great trading systems only have 60% win rates. The key
is how the trader manages to keep the 40% losing trades small while
maximizing the winning trades.
Greed can also blind a trader from taking the profits off the table when their
profit target is reached. Greed for gains after the risk/reward ratio has
skewed against the initial entry can lead to losses when a trend reverses.
One of the most expensive things a trader can do is not take profits at their
target as the market reverses, instead waiting for the price to recover after
it’s too late. Greed wants to trade big and stay in winning trades forever.
Your trading plan has to override your greed, control position size, and have
a strategy to take your profits when they are available.
One of the cornerstones of my teachings is that emotions are terrible trading
signals. Emotions want to buy falling knives at the beginning of market
corrections and bear markets instead of waiting for the market to find key
price support levels. Signals are created to give you a quantifiable reason to
do the opposite of what your emotions are telling you to do.
Your trading success will be largely based on your ability to approach the
markets in a systematic way using a trading plan to utilize profitable buy
and sell signals that fit your market beliefs and methodology. You need a
good external guide that you follow regardless of what your emotions are
telling you to do. Trade your signals and not your feelings, opinions, or
emotions.