“Why Economists Don’t Make Good Traders” and other Nuggets

My ideas for educational feature topics usually come from readers’ suggestions or from tidbits I have gleaned from many years of studying and trading futures markets and stocks. I also get educational topic ideas from discussing markets with my peers in the newsletter and trading advisory services industry. For this educational feature, I don’t have any one topic that I will focus upon, but instead will give you a few more trading “nuggets.”

Why Economists Don’t Make Good Traders

Are you a little surprised at the headline of this nugget? When I first started in this fascinating business I was a reporter right out of college, working on the floor of the Chicago Mercantile Exchange. Just before my very first trip onto the trading floor, I suspected I’d find that floor traders were a bunch of academics (or economists) in pinstripe suits, conducting business quietly with their noses stuck into a notebook full of trading statistics and charts. Wrong! Instead, I found that floor traders were more like construction workers than academics, in that they were “regular” guys or gals, many of which did not conduct business quietly, and who read the sports page first–and even told a salty joke here and there.

Actually, I found that a bit refreshing because my background is rooted in a blue-collar-type work ethic. (I was also a construction worker before and during my college days.) Anyway, my point is that successful floor traders (and other traders) are good at what they do not because of their extensive studies of economics or business principles or related text books. Stock and futures traders are successful because of their trading experience and their realization that markets are a reflection of human nature–which tends to repeat itself.

Let me provide an analogy with the famous “Old Faithful” geyser at Yellowstone Park. An academic (economist) may study what makes the geyser work and all the physical elements involved in producing the big shot of water and steam. However, all the trader really cares about is one important thing: When the geyser will produce its next big plume of steam. Most economists tend to be “behind the curve” when it comes to pegging economic conditions and market moves. Traders are forced to be right out there on the cutting edge of market trends and trend changes. (And yes, that “edge” can be very sharp!)

Baseball and Trading Futures: Both are a Big Boy’s Game

Trading futures is not a game for the faint of heart. I read a story on the ODJ newswire the other day that succinctly put the specter of losing trades into perspective. The greatest baseball hitters in the world do not even bat .400. In other words, the best baseball sluggers are successful about 3 out of 10 times they step up to the plate. The same is true with futures trading. The very best traders in the world lose on well more than half of all the trades they make. The key is limiting losses on the more numerous losing trades and maximizing profits on the fewer winning traders. Some individuals’ egos cannot accept the fact that more losing trades than winning trades are a part of trading futures.

Barry Bonds, Hank Aaron, Willie Mays and Mark McGwire all suffered hitting slumps–and more than just one. I’m sure they didn’t like those slumps, but they persevered and eventually broke out of them. Futures and stock traders will also almost certainly experience periods of poorer trading performance. And, of course, there are the many men whose dream was to make it to “The Show” in the Major Leagues, but did not have the skills required. Those men who did not make it to “The Bigs” were not “losers.” They were the ones who at least gave their dreams their best shot. And then they went on to pursue other things and found their successful niche in life. I believe the same is true in the very challenging fields of trading futures and stocks.

Some People Never Learn

I am going to describe to you a CNBC TV interview that I saw aired a while back, and then I want you to figure out what’s wrong with the analyst’s approach.

The interview was with a stock analyst/advisor. He was asked by the CNBC reporter to provide his stock picks that he saw as good bets to perform well in the next year or two. The analyst went on to describe several stocks. He went into detail about how one stock had been beaten down too far the past few months, and that another stock was a bargain at its current low price level and was sure to rise from the depths. Still another stock had been “underperforming” but was likely going to kick into higher gear once some kinks were worked out and the economy picks back up. He described a couple more stocks that were also “due for rebounds.”

What’s wrong with this investment approach? The stock analyst is a bottom-picker! So-called bargain hunters for beaten-down or cheap stocks only have slightly better odds for success than bottom-fishers in futures markets. When a stock or futures market price is low, there is a reason why it is so low: The collective marketplace has determined the price to be a fair price at that given moment.

Chase Manhatten Technical Analyst Tirone: “You Need Game Plan”

All successful traders have one common, yet very important ingredient in their trading methodologies: a game plan.

“When it comes to planning, many traders can be compared to the German army during World War II–in that the invasion of Britain was planned but never executed, while the Battle of Britain was executed, but never planned,” said John C. Tirone, senior technical analyst for Chase Manhattan Bank in New York, and a trader for 30 years. “Many traders and investors go through their sometimes very short investing lives planning trades they never execute and executing trades they never plan.”

Tirone was speaking at the Technical Analysis Group (TAG XVIII) meeting in New Orleans, held last week and sponsored by Dow Jones Telerate.

“Experience has proven that success follows the wise trader/investor who identifies an effective strategy, and has the discipline necessary to carry it out,” said Tirone. He said there are two key elements that distinguish the successful trader from the unfortunate majority: strategy and discipline.

Tirone said many traders take positions “based on impulse, hunch, or what they read from a newsletter–instead of reason–and then wait to get lucky. They have not learned or probably even thought about the fact that even the very best traders consider themselves fortunate to be right on most trades, or even to make significant profits during most years.”

“If the trader will take the time to plan his trades properly, he can possibly have the odds on his side in the long run, which is something few gamblers could ever attempt to achieve. Over the long term, those traders/investors that are still operating in the markets–and who have followed a carefully thought out and well-defined plan in a disciplined manner–expect to have favorable results,” said Tirone.

The basic elements of a trading plan should provide the reason for logically entering and exiting a position, whether it proves profitable or not. “Once a position is entered, the price can only take three paths: rise, fall or remain unchanged . . .”

“The heart of a game plan must indicate, unequivocally, how the trader is to exit from a trade he has entered.” Likewise, this critical area consists of three parts: 1) accepting losses if a position shows adversity; 2) a plan for accepting profits; and 3) a plan for exiting a trade if the price, over time, is negligible or does not meet expectations.

What Are The “Big Boys” Up To? How use the Commitment of Traders Report in your Trading

I have discussed in past articles how volume and open interest can be used to help identify and confirm market situations and trading opportunities. I’ll take open interest one step further in this column by examining the Commitments of Traders (C.O.T.) report, issued by the Commodity Futures Trading Commission (CFTC).

The C.O.T. report is released weekly–every Friday afternoon. There is also a C.O.T. report that includes options on futures issued at the same time. The report that includes options is not as closely followed as the report that covers only futures. Reason: The combined futures and options report has less history.

The C.O.T. reports provide a breakdown of each Tuesday’s open interest for markets in which 20 or more traders or hedgers hold positions equal to, or above, reporting levels established by the CFTC.

The C.O.T. report breaks down by open interest large trader positions into “Commercial” and “Non-Commercial” categories. Commercial traders are required to register with the CFTC by showing a related cash business for which futures are used as a hedge. The Non-Commercial category is comprised of large speculators–namely the commodity funds. The balance of open interest is qualified under the “Non-reportable” classification that includes both small commercial hedgers and small speculators.

What is most important for the individual trader (you) to examine in the reports is the actual positions of the categories of traders–specifically the net position changes from the prior report. To derive the net trader position for each category, subtract the short contracts from the long contracts. A positive result indicates a net-long position (more longs than shorts). A negative result indicates a net-short position (more shorts than longs).

Now, if I’ve got many of you lost at this point, DON’T WORRY. I’ve got some suggestions later on that allow you to look at some examples of reports on other websites. What I’m trying to do at this point is familiarize you with the general basis of the report, related terminology and how traders use the C.O.T. report. This stuff will sink in–it just takes a little while.

My friend, Steve Briese, is one of the world’s foremost experts on C.O.T. data. He publishes the “Bullish Review,” which comes out right after each C.O.T. report. It is from conversations with Steve through the years and reading some of his material that I have learned about the C.O.T. report and its value to traders.

The most important aspect of the C.O.T. report for most traders is the change in net positions of the commercial hedgers. Why? Because studies show that commercials hold a superior record to other trading groups in forecasting significant market moves. The large commercials are generally believed to have the best fundamental supply and demand information on their markets, and thus position their trades accordingly. Along with the advantage of having the best fundamental supply and demand information on their markets, large commercials also trade large size, which in itself moves markets in their favor.

It’s important here to note that whether a particular trader group is net long or net short is not important to analyzing the C.O.T. report. For example, commercials in silver are the producers and they have never been net long, because they hedge their sales. In gold, however, the commercial mix is more heavily weighted toward fabricators who buy long contracts as a hedge against future inventory needs. So, again you need to look at the net change in positions from the previous report or several of the recent reports.

Individual traders that consider positioning themselves on the same side of the market as large commercials, when the large commercials become one-sided in their market view, is the best way to utilize the C.O.T. report.

Some traders do like to take the opposite sides of the trades on which the small trader (non­reportable positions) in the C.O.T. reports are shown taking. This is because most small speculative traders of futures markets are usually under-capitalized and/or on the wrong side of the market.

Also, some traders will also follow the coat-tails of the large speculators, thinking the large specs must be good traders or they would not be in the large trader category.

Briese says that contrary to what some believe, divergences from seasonal open interest averages in C.O.T. report data are not reliable trading indicators. This is even true with agricultural markets, where one would suspect that hedging is a seasonal consideration

Behavioral Patterns That Sabotage Traders - Part I

Although I do not maintain a private practice of counseling/coaching for traders, it is perhaps inevitable that traders would contact me for assistance after reading my book on The Psychology of Trading. Once in a while I take on a project of working with a group of traders because of the opportunity to push the envelope and use psychology to improve their trading performance. In the past few years, I would guesstimate that I have gathered personality questionnaire data and assisted over one hundred traders.

That’s a decent-sized sample, and provides me with worthwhile insights into the minds of traders and the problem patterns that interfere with their trading. Below I outline a few of the things I have learned from questionnaires and interviews with individuals who are trading for a living.

• Most trading problems are varieties of performance anxiety. Performance anxiety occurs when a performance that is usually automatic becomes the object of excessive scrutiny. This attention to the performance creates an interference effect, in which the performance can no longer flow naturally. Such performance anxiety frequently interferes with athletic performance, public speaking, sexual performance, and test taking. Whenever fears about the outcome of a performance dominate the performance, outcomes are apt to suffer.
• Performance anxiety occurs as much during times of market success as during times of market loss. It is not at all unusual to find traders who are good at taking (appropriate) losses, but who become fearful when they book a gain and take profits prematurely (i.e., prior to reaching their profit targets). Interference effects following strings of losses are no more debilitating than interference effects from pressure that traders feel when they are making money.
• Traders commonly try to replace negative self-talk with positive self-talk during trading. This is a mistake. When traders are immersed in the market and focused on the screen, they are not engaging in self-talk at all.
• Perfectionism is the most common source of performance anxiety among traders. Traders tend to be achievement-oriented and often set lofty goals for themselves. These performance goals contribute to tension when the goals are not met. In general, it makes sense to replace performance goals with process goals. Instead of setting a goal of making $250,000 a year, a trader should, for example, set a goal of following a trading plan (entries, position sizes, exits) on 90+% of all occasions.
• Perfectionism leads traders to overtrade. Overtrading is the most common source of losses among the traders I’ve interviewed. Traders overtrade when they feel internal pressures to make money that blind the trader to what is happening in the markets at the time. Trading when volatility is low, trading outside one’s trading plan or strengths, trading to make up a loss, and trading imprudently large size are examples of overtrading.
• Traders that master performance anxiety at one level of size (e.g., 5 contracts) frequently re-encounter it once they meaningfully increase their size (50 contracts). We generally calibrate our emotions by the dollar amounts we make or lose. This makes a fifty contract trade much more difficult for traders than a five contract trade, even though the setups may be identical.
• Traders often think they have worse psychological problems than they actually have. When performance anxiety patterns have interfered with trading for a considerable period of time, traders often become convinced that they have deeply-seated emotional problems that need intensive psychotherapy. Often, the self-perception that one is damaged - that one is emotionally unfit - is a larger problem than the performance anxiety itself, which is a very solvable problem.

To be sure, there are problems other than ones related to performance fears that can interfere with trading. Many of these are described in my book. The unique thing about performance anxiety is that it can afflict highly successful traders every bit as much as rookies. This is because the root of much of the anxiety - perfectionism - tends to be present in the most achievement-oriented and successful individuals. It is truly a double-edged sword.

Somewhere between the extremes of performance pressure and complacent laziness is a happy medium where traders can focus on self-improvement without sabotaging their results. Trading is like dating: You want to keep initial expectations reasonable, enjoy it while it’s happening, and learn from it once it’s over. In the second and final article in this series, I will take a look at strategies traders can use to overcome performance pressures.

Make An Honest Self Appraisal

If you are willing to accept total responsibility for your investment results, you will realize that you are the most important factor in your trading or investment success. If you have done that, you are way ahead of the crowd.

I once had a call from a gentleman in England who had been working with my home study course. He said, “I’ve been working through the course for over six months. It’s helped me realize a lot about myself, but there is one thing it hasn’t done. It hasn’t given me a positive expectancy system.” The ironic thing about that statement is that I had not attempted to give a methodology. There are several reasons for that: 1) If you want to be good, you must design something that fits you. That only is possible if you design the methodology. 2) Psychology is far more important than methodology. In fact, psychology is part of methodology. For example, when we attempt to help people develop a reasonable method that works, they resist it strongly because they have so many biases that keep them focused on the wrong aspect of trading - areas that have nothing to do with success. And it is very difficult to show them the correct direction.

As a result, the best thing you can do for yourself to increase your income from the market is to determine how you are blocking yourself. This should be done at two levels. Whenever you develop a trading business plan a great deal of that plan should have to do with introspection. Take a look at all of your beliefs. Are they useful beliefs or do they hinder you in some way? What are your strengths and weaknesses? What about you can’t you see clearly because you are part of it? You should look at doing this sort of assessment at least once each quarter.

The second self-appraisal you need to make is at the beginning of the day - and perhaps even hourly throughout the day. What’s going on in your life? Are you ready to face the markets? How are you feeling? Is there some sort of self-sabotage surfacing in you? For example, are you starting to get too confident? Are you starting to get too greedy? Do you in any way want to override your system? The best traders and investors are constantly doing this sort of self-assessment. If you want to make money in the market, then perhaps you should start doing the same.

Serious Money

There is an article in this week’s news section which is entitled How to Combat Over Trading. It’s an issue that I tackle often in this column because it is probably the greatest source of pain for most traders I know. K and I are often amazed by emails we get from subs who tell us that they have blown up even after BKT has had a huge run of winning trades. The reason clearly is that they over trading their account. Now this particular article tries to fix the problem by talking about the need to “visualize you plan”, “talk out your trades” and “keep a running diary”. While all those sentiments are noble I am here to tell you that they are all pure bunk.

Let’s face it, as currency traders we are in the markets because we love to trade. We don’t pore over balance sheets looking for misalignment in cashflow calculations like the credit gnomes in the bond market. Nor do we spend endless hours researching business plans like stock investors. FX is the purest speculative market there is driven first and foremost by sentiment. What is the value of a currency anyway? Some will argue that the dollar isn’t worth the paper its printed on. But we don’t care. There are no bear markets in FX. We are the ultimate “absolute return” asset class.

We are in the game because we want to PLAY. We want to match wits with the smartest people in the world and win. Trading is also very much like violin playing. If you don’t practice every day - you lose your touch. But just as violin players miss a few notes from time to time, so do we miss a few trades. The key difference of course is that the violin does not crumble into a thousand little pieces after each bad performance, but our trading account can be decimated by just one bad trade.

So how do we reconcile our desire to play with our need remain disciplined and preserve capital? Simple. We separate our money. I have multiple accounts just for that reason. For example we trade the BKT account only twice or three times a week and not surprisingly it has the best performance by far. The reason is of course because we are extremely disciplined and take only the trades that are consistent with our trading model. Next, I have an account where trade K’s calendar calls both proactively and reactively. Those of you who have been with me in live chat are familiar with some of those trades. Finally I have an account that I just trade - no real rules, lots of experimentation and needless to say a lot of stupid mistakes.

The BKT account is serious money, the procactive/reactive account is semi-serious money and the free trade account is just stupid money. The key to winning in FX is not to curtail the over trading. It is not only futile but arrogant to think that we can conquer our worst impulses. The key is not to over trade your serious money. Ironically enough the more freedom you give yourself to experiment in your stupid account, the more likely you are to stick to your trading plan in your primary account. Give it a try and let me know if it helps.

Weekly Trading Lesson: Don’t Change Time Frames To Stay In A Losing Trade

Too many times I hear about new traders opening a trade using the 5-minute chart (not my favorite approach) and when the market moves against them, they move to the 15-minute chart to justify staying in a little longer, hoping that the market will turn around. Then if the market continues to move against them, they move out to the hourly chart to look for a reason to stay in the trade. As the market continues to move against them, they shift to the daily chart to hope to find a reason to stay in the trade. The next step is to get a margin call because they have no funds left to maintain their position. Of course, the main issue here is that they were looking for a way to stay in a losing trade rather than closing it out at a small loss. Taking a loss does not mean that you do not know what you are doing. Too many new traders think that losing a trade means that they are losers or that they aren’t smart enough to trade. Nothing could be further from the truth though. Professional traders understand that if they trade, they will have losing trades. That is really the only guarantee in the field of speculation. How you handle those losing trades has as much to do with your success as a trader as any other factor. You don’t have to like losing, but you must accept the fact that all trades cannot be winning trades. You have to keep those losing trades small enough to be able to make up for them with your winning trades. Switching time frames to justify staying in a trade is not how you keep your losses small. Identify your exit point before you get into the trade and stick to it. Judge yourself from month to month rather than on every pip move in the market. Be consistent in your approach and stay in one time frame from the beginning of the trade to the end of the trade.

The pair has resumed its bullish activity for the past couple of days and is currently trading at the 1.3600 level. However, it failed to breach the 1.3715 level and has provided mixed results ever since. If the pair will indeed breach the 1.3715 level, a sharp bullish move might take place.

There is a very distinct bearish channel forming on the hourly chart, as the pair is now floating in its lower section. In addition, all oscillators on the 4-hour chart are pointing down, suggesting that the downtrend might extend. Going short might be the right strategy today.

The pair failed to break the resistance level of 1.3500 earlier today and now trades near the 1.3410 mark. The 4-hour chart is showing a bearish cross on the Slow Stochastic Oscillator and the pair’s RSI is currently floating in the overbought region. This signals downward movement may take place later today. Traders today may look to short this pair.