All traders, experienced and new to the field, hold theories about the market. Through reading, trading, listening or watching they have discovered how they believe the markets operate. A problem arises when a particular theory is implemented by a trader, but the facts do not indicate that theory should be used. Consciously or subconsciously it is quite easy to discard the facts that don't fit into the theory and only focus on the ones that do. The mind has a natural tendency to find order, to attribute movements in the market to some larger picture that is easier to understand than the chaos of day-to-day fluctuations. This is fine, looking at the big picture can do well for us in our trading, but only if we are objective and not manipulating facts to fit a theory.
How This Problem Develops
Most traders are bombarded by information and opinions on a continual basis, whether it is friends telling them about a stock they just bought, the news mentioning a particular correlation between two assets that has been in effect for the last week or other similar stories. Any information can quickly be converted into a market theory in a trader's mind. The stock pick mentioned by a friend becomes a way to make money, and even after researching the company and finding some disconcerting issues with the stock, the person buys the stock on the advice of her friend anyway.
In the other example, a trader hears of a correlation on the news relating to the U.S. dollar and the stock market. The trader begins to trade this correlation not really understanding it, believing the theory spoken about on the news will work all the time. It likely will work some of the time, but ultimately the trader could end up losing money.
This is how the problem works on an introductory level, but even experienced traders get pulled into this. We hear a tip, theory or strategy and implement it even if we are unsure what it is we are doing, or even in the face of conflicting evidence. Luckily, any trader can overcome this tendency, and will need to in order to be truly successful. (Find out more about the role the media plays in your investment decisions in Financial Media 4-1-1 For Investors.)
The Problem Advances in Complexity
The types of problems faced above can slip up any trader, no matter how experienced. Everyone makes mistakes, and that is fine, but eventually, as traders become more experienced, they realize they need to form their own theories about the market. They create a trading plan and trade according to a certain set of models of how the markets work, and then strategies are created to capitalize on these market models.
The model may be that money can be made by capitalizing on trends or it may be that markets always retrace, and strategies to capture trends or turning points are implemented respectively. Another model may be that markets move back and forth on a micro scale, so the trader adopts scalping techniques to make a living.
These models and the strategies contained within those models can be become fairly complex and result in an extension of the original problem mentioned in the section above.
Take for instance a simple trendline strategy where two or more price points touch the trendline. The trader likes this strategy and has found that it has worked well for making money if he goes long as prices bounce off the upward-sloping trendline, or short the market when prices break below the trendline. Then there comes a time where the trendline does not seem to fit the data adequately. The market has been choppy and prices are not pulling back to the trendline, then prices break through the trendline, but quickly move back above it. The trader keeps drawing new trendlines and keeps losing money as the market continues its whipsawing pattern.
The problem is that the trader is forcing a strategy on the market. The market is no longer moving in a trend, but is now ranging. The trader is trying to use a favorite method for trading even when the market is indicating this type of strategy should not be used. Basically the price data is being manipulated to fit the trendline, even though the price data indicates no trend is currently present.
Does It Get Worse?
Unfortunately this problem can get very complex, and while the examples above have focused on technical aspects, many traders also use fundamental analysis in their trading. A trader may use a technical strategy that indicates he should be long the market, but because he heard an analyst earlier that afternoon saying the economy was headed for a downturn soon, the trader hesitated on the trade and missed the opportunity. With so many theories and strategies a trader can easily face information overload. In an attempt to avoid this they must strive to focus on one strategy or theory and apply it to the market constantly. (For more on analyst expectations, be sure to read Analyst Forecasts Spell Disaster For Some Stocks.)
Another example may be that a long-term trader trading on fundamentals believes the economy has ended its decline and will soon head higher. This trader buys stock because she wants to apply the theory now and get into the market. However, with additional research, she may have found money was not flowing into the market yet and stocks were still heading lower, indicating the turn in the economy was still a ways away. The trader has looked only at information that will allow her to make the trade, and has discarded information that would indicate she should wait or not implement a particular strategy yet. (Learn more about money flow in The Basics of Money Flow.)
Overcoming the Problem
The examples and branches of this problem are created by several factors, which can be avoided by taking some time to set down some guidelines.
- Create a detailed plan of how you will trade.
Among other things it should clearly define when a particular strategy or theory will be used. It will explain what factors need to be present in order to implement the strategy or if other factors are present the strategy will not be implemented. No trader should be left guessing what to do. Each trade should be the product of the plan that takes all contingencies into account.
- Have strategies for different market environments (ranging, trending, etc) or don't trade when the environment does not fit your strategy.
- Trade inside a vacuum.
It is often said that any prediction made about the market will come true ... eventually. Thus, no matter what anyone else says, it is ultimately you who determines when you enter or exit, and why. Tips from a friend or TV analysts don't provide you with exit or risk management rules. In other words, they can afford to be right whenever it happens, but you cannot afford to be wrong for a long period of time. Trade your own ideas and try to filter, as much as possible, outside influences once you have created a plan.
- Monitor and Track.
A trader needs to know what is working and what isn't. Keep track of trades and why you made them. If something isn't working, ask yourself whether the plan itself is faulty or just your implementation. Keep track of trades that were made based on tips or were "mistake" trades. Even if money was made on a tip or a mistake, make sure to keep it separate from results created by the plan.
- Let the facts dictate what theory or strategy to use, instead of manipulating facts to suit a theory.
It can be very easy to fall into the trap of trying to manipulate data or inputs to accommodate a theory or strategy. Fortunately, traders can overcome this problems by creating a detailed plan about how and when we will trade in the markets, by filtering outside opinion, keeping trading records of reasons and results for trades, and letting facts dictate what theory or strategy to use.