March Madness's Trading Secret
March Madness – aka the NCAA college basketball tournament – is known for its fabulous upsets and its infamous chokes: like Gonzaga choking against UCLA in the Sweet Sixteen last week, losing in the final 10 seconds of the game after leading all game long. We've all seen it happen, and some of us have even participated first hand – whether it's basketball, football, baseball, or even an individual sport like golf – you're ahead, the game's in the bag, the champagne is on ice, and then ... things start to unravel. Sometimes a team regains its composure, sometimes it chokes.
If you're a trader, you're all too familiar with that gut-wrenching feeling.
Just like a Final Four NCAA basketball team that follows its game plan, once you have a method for trading, your next job is to follow it. So, if the zone defense is working, the players stick with the zone. If your method tells you to stay with the trade, you stay with the trade. But, then, things happen – someone breaks the zone by dribbling into the paint and dishing off to his teammate who scores. Does that mean the team immediately switches to a man-to-man defense? Not if the coach says to stick with zone "d." You stick with the one that brung ya to the Big Dance.
It's the same with trading. So you take a loss, does that mean you change your method? No. You stick with it, but there's one thing more to learn to be a successful trader and to get to the Final Four: that is, once you've got your trading method in place and know how to follow it, you have to learn to accept your gains. Don't limit them, let them play out. In this last piece in our series on the Six Secrets of a Successful Trader, Bob Prechter describes how easy it is for a trader to lose the nerve to make a big profit. (That's a polite way of saying CHOKE.)
Bob Prechter's Six Secrets of a Successful Trader
1. Find a method. 2. Be disciplined. 3. Get experience. 4. Accept responsibility. 5. Accommodate losses. 6. Accept huge gains.
Requirement No. 6 is "accept gains." This one doesn't sound like a problem.
Bob Prechter: You've got a point! And when I advocate having the mental fortitude to accept huge gains, the comment usually gets a hearty laugh. Which merely goes to show how little most people think it is actually a problem. But to win the game, you have to understand why you are in it. I have seen this problem stymie lifelong traders, people who have gained or lost one point for a living for so long that they cannot make the big money when it comes, even when they say they know what is happening.
The big moves in markets come only once or twice a year. Those are the ones that will pay you for all the work, fear, sweat and aggravation of the previous 11 months or even 11 years. Don't miss them for reasons other than those required by your objectively defined method. Stay with a position during those rare times when it is hugely successful. Most people can't do it. Even though their method is telling them, "Don't sell yet," they can't stand it. If they get double their usual profit, they get out, and they're thankful.
O.K., so No. 6 is a derivative of Requirement No. 1, get a method. But what's wrong with a 100% return?
Bob Prechter: What's wrong with it is that it may not make up for all your 15% losses. Let me give you an example of what can happen when you focus on how much money you're making instead of how it is you make it. Let's say for a full year, you trade futures contracts, making $1,000 here, losing $1,500 there, making $3,000 here and losing $2,000 there. Once again, you enter a trade because your method told you to do so. Within a week, you're up $4,000.
Your friend/partner/acquaintance/broker/advisor calls you and, looking out only for your welfare, tells you to take your profit. You have guts, though, and you wait. The following week, your position is up $8,000, the best gain you have ever experienced. "Get out!" says your friend. You sweat, still hoping for further gains. The next Monday, your contract opens limit against you. Your friend calls and says, "I told you so. You got greedy. But, hey, you're still way up on the trade. Get out tomorrow." The next day, on the opening, you exit the trade, taking a $5,000 profit. It's your biggest profit of the year, and you click your heels, smiling gratefully, proud of yourself.
Then, day after day, for the next six months, you watch the market continue to go in the direction of your original trade. You try to find another entry point and continue to miss. At the end of six months, your method finally, quietly, calmly says, "Get out." You check the figures and realize that your initial entry, if held, would have netted $450,000. You gave up on a trade that was going to deliver 4,000%.
And the problem was?
Bob Prechter: Simply that you had allowed yourself unconsciously to define your "normal" range of profit and loss. You looked at a job requiring the services of a Paul Bunyan and decided that you were just a Wee Willie Winkie. Who were you to shoot for such huge gains? Why should you deserve more than your best trade of the year? You then abandoned both method and discipline. In other words, it comes down to a question of self-esteem and personal limits. But perhaps more often, it is simply that you have substituted an unconscious, undisciplined observation – that the market had some kind of permanent "normal range" of fluctuation – and then superseded your method with that false idea. This is requirement No. 1 again, but it is such a common method of failing that I include it explicitly.
Some people – probably even a lot of people – are simply unable to accept the fact that they can earn a windfall just sitting around watching a monitor and guessing that a line on the screen is headed up instead of down.
Bob Prechter: But it's NOT a windfall. That's my point. There's no easy money on Wall Street. You earned it. By taking all those losses correctly and with the required discipline, you earned the big trade.
Doesn't the IRS categorize capital gains as "unearned income"?
Bob Prechter: Yes, but that's baloney. It's hard to make money in the market. You deserve your losses, don't you? Well, you richly deserve every dime you can make, too. Don't ever forget that.
Editor's Note: This last installment of Bob Prechter's six requirements to become a successful trader is a good way to remind all current and future traders what the point of trading is – to earn money. But to do that, you must also study the markets that you want to trade. EWI offers specialized market forecasting services (previously reserved mostly for professional traders) that are affordable for private investors and traders. Please read below for more information.
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