Thursday, December 27, 2007

Trading Psychology

For the last month or so, I have been reading two books about trading psychology written by Mark Douglas, "The Disciplined Trader" and "Trading in the Zone". I actually read "The Disciplined Trader" a few years ago but it didn't make much sense to me then, maybe because I was just starting to trade. I think I learned a lot more this time through. Although Douglas wrote "Disciplined" first, I would suggest reading "Trading in the Zone" first, then follow it up with "Disciplined".

One thing he said really stood out to me. It was that when you take a trade, you really need to be open to absolutely anything happening in that trade. Don't expect anything. Unless you are a huge hedge or mutual fund and have enough capital to move the market, you cannot do anything to make a trade move one way or another. You can't do anything to make the trade go the way you expect it to. But that thinking goes against our nature, because if we didn't expect a trade to go one way, why would we take the trade? One of the reasons traders have trouble cutting losses is because they had an expectation when they entered the trade, and because they only had one expectation about that trade, when something else happens that they did not anticipate, they have no idea of what to do.

This made me think about the biggest lost I ever took and the worst trading mistake I ever made. I went into a trade that I thought could not miss. This was such a great opportunity (in my mind) that I loaded up and took a large position, sure that this was the trade that could really grow my account. When the trade started out doing what I expected, it just added to my already strong feelings. Well, you can guess what happened - the trade reversed, I could not believe what started to happen because I was so sure of what I expected to happen, and I was frozen because I had no idea how to react.

That trade was a lesson and I am better about cutting losses now - not perfect, but better. I now try to really anticipate any possibility when I put a trade on, and this helps. I ask myself what I will do if the stocks does this, or if it does that. This is what I base my stop losses on - what possibilities could occur and what I would do in those cases. I have also begun to use hard stop losses more than before, instead of mental ones. This type of open-minded thinking before taking a trade helps control losses. No one likes taking a loss, but if you truly accept it as a possibility before each trade, you can avoid yourself a lot of headaches.

This type of thinking can be extended to the overall market direction as well. I find myself getting too committed to the bullish or bearish viewpoint of the market, and that limits some of the possibilities available to me. Right now, I do have an opinion of what direction the market is going, but I am trying hard not to "marry" myself to that position, even though a lot of evidence that I see seems to point that way. This way, with an open mind, I hopefully won't be caught if the market doesn't do what I think it should or will do. However, this type of thinking is easier said than done and takes time to develop. Hopefully, I become better at being open to all possibilities, in both stocks and the markets overall.

I would recommend both books for aspiring or experienced traders. Douglas presents a lot of interesting ideas that can help traders develop themselves and avoid some of the most common psychological mistakes made by all traders. Both books are good reads.

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