Trading is really pretty simple. You try to complicate things, but the fact is, not matter what product you're trading, the market can only move in one of three directions: up, down, or sideways. So there are really only three types of trading days: Days to make money, days to lose less money and days to do nothing.
You know from the minute you wake up in the morning-just from the vibe of the market, world events, the way reactions to those events are playing out and your own intuitive feelings-what kind of a day it's going to be for your portfolio. You know whether it's a day you should be making money, a day you should be losing money or a day when the best thing you can do is to do nothing.
And because you know that, you need to let the market dictate what you're going to do on any given day rather than push forward with your own emotionally-driven plan. You should not start the day with a personal agenda. Instead, your mentality needs to be, I have a portfolio on, so is today a day to press my bets and make money? Is it a day to limit my losses because the world is acting in a way that is inconsistent with my core thesis? Or is this a day to just sit back, be parient and do nothing?
When you make mistakes it's usually because you are trying to fight the market and make it do what you want it to do. Maybe it's a day to limit your losses and instead you're trying to make money because you're down on the month or the year. Or it's a day to make money but you're afraid to size up your position because if you're wrong you'll be giving back a large chunk of your profits.
Whether you had a big drawn down in your account the previous week or you've already booked a large profit, there always going to be some fear creeping into your mind and impacting your decisions. You simply have to learn to recognize your fear and compartmentalize it so that you can continue to make optimal decisions base on the oportunities the market is presenting at the moment. If you do that, you won't panic when the market is going against you, because you will have trained yourself to just exit the trade. Your inner dialogue should be, "I got the trade wrong. I lost money. So what?It's nothing personal. It's just the market-sometimes I will be right and other times I will be wrong."
The single most important factor for profitable trading is to be net profitable. The way you do that is to make more money when you are right than you lose when you are wrong, and a huge part of that process is knowing when it's time to get out of the trade. The equation you should use for losing less is this:
H + W + P = E
Hoping + Wishing + Praying = Exit The Trade
When you find yourself doing one of the following:
- Hoping the trade gets back to the price you got long or short from
- Wishing you had waited longer to get into it, or
- Praying that some market event will move your position and bail you out of a loss that is getting bigger and bigger
It means that you have become emotional about your trade and you need to start to exit the position. I don't really care if you start by taking 10% of it off or 100% all at once. The point is that you need to push buttons and stop the bleeding-not tomorrow or the next day, but right now.
Of the many factors that may cause you to fight the market or fail to take advantage of the opportunities it is presenting, one of the most influential is how and when you get paid. As you know, portfolio managers at hedge funds don't get a regular paycheck like most emplyee. Sure, you may get a nominal salary or draw each month, but you get your real paycheck(the performance-based bonus) once a year, and that is typically a month or two the books close on December 31. So while you know how much money is in your trading account at any given time, that money only exists on a screen-it's not in your personal bank account, and until the books close at the end of the year, it's vulnerable to loss. I have found that this creates an interesting psychological phenomenon that impacts your risk-taking behavior throughout the year.
You are human, and your trading behavior is often affected by how and when you get paid. For example, from mid-November through December, you tend to be more risk averse, whether or not the opportunity in the market warrants it, simply because you don't want to lose what you've already made during the year. And in January you are risk averse, as well, because the last thing you want to do is start the year "in a hole." So in the middle of the year, say from March to September or October, you're likely to be more comfortable putting on risk, and tend to assess your trades more objectively and confidently than you would at either the end or the beginning of the calenda year.
The amazing aspect of this phenomenon is that the fund itself has created it by determining when you get paid for your performance. My suggestion for how to correct this is for the fund to vary the beginning and ending of each PM's calendar year. This would allow each PM at a particular fund to be comfortable with taking risk at different times, thereby avoiding their PMs all becoming comfortable or uncomfortable at the smae time. It would also act as a natural internal risk management tool by diversifying the risk taking of the fund, creating an internal hedge against hedge trading, and disconnecting any PM correlations that might normally exist simply because of the calendar month.
Assuming that isn't going to happen anytime soon, perhaps the biggest problem I see created by the risk averse November-to-January and risk-seeking March-to-October mentality is that noone ever knows when a great trading opportunity is going to appear. It could be on December 12 or even the first week in January, so you have to be psychologically prepared to take advantage of the opportunity no matter when it occurs. Maybe on January 5 there's an unexpected news announcement by the European Central Bank. In this situation, you may be assessing the risk/reward ratio correctly, but if you are being conservative that week because it's early in the calendar year, you won't put on the appropriate-size position given your level of conviction.
Plain and Simple, you want to strike to avoid basing your risk-taking decisions on what time of year it is or whether your portfolio is up or down. You don't want to thonk, " I really need to make money this week because it's already November and I haven't make money this year, and if I don't put up decent numbers the firm may cut my capital or my investors may put in redemption notice". You also don't want to think, " It's December, my fund or pad is way up, and I want to hang onto that money." Whether you are the principal or the PM or both, you need to realize that those reasons are personal to you and your business and that the market does not behave differently base on your current profit or loss. I understand that the pressure you are under is that you do need to make money to make good on professional commitments, achieve personal goals or support a lifestyle, just like the rest of us-but unlike the rest of us, you are also locked into an artificially created time frame for doing that. Nevertheless, when it comes to making a trading decision, you have to set your personal issues aside and go back to the basic of trading.
Book Title:
Trading Psychology Playbook