51 R U L E # 9
Don’t
services, the evolution of communication is also growing at a phenomenal rate. At the time of this writing, any individual with reasonable means lo- cated in a developed area has instant access to almost any other indi- vidual, source of information, or market center anywhere in the world instantaneously via the Internet, cell phone, or television. I live and work in downtown Chicago, but if I wanted to I could have complete access to everything I have now from a sailboat in the Caribbean or a mountaintop in India; and so could you. As traders we are no longer limited by distance or connectivity to any market or information base. If we perceive that an op- portunity exists in an area somewhere on the other side of the world from our home, we can choose from an almost unlimited number of ways to ex- ploit that opportunity and an equally unlimited information flow to manage that opportunity.
A key to cutting our losses is selecting which opportunities are the best profit potential for us personally and if the truth were told, we re- ally need only one market. The fact that we can actively participate globally at any moment contributes at least in part to the problem of overtrading.
Many traders make the mistake of thinking that the term overtrading can only mean excessive trading in a particular market. Although that is one aspect of it and needs to be addressed as part of your loss-control strategy, it would be far more accurate to rephrase this rule as “Don’t overcommit.” It really doesn’t matter precisely what that means for you directly, but as a serious student of lasting trade success, you must make choices about how to allocate your limited resources. No one has unlim- ited capital and no one has unlimited mental or emotional resources. Yes, you must have controls on your behavior to prevent excessive trading within one market, but you must also narrow your focus down to a spe- cific number of markets and the reasons you trade them. It is unreason- able to think you will perform equally well in all markets across all opportunities.
Without a solid understanding of each particular market and how each is structured, you will run the risk of having losses you cannot ex- plain to yourself. Worse yet, because you cannot easily find the cause of your lack of profitability in one particular market, you will most likely continue to have losses in that market. Many traders have com- plained of net losing years or flat years while showing closed profits in one market against closed losses in another. The common complaint goes something like, “If only I hadn’t traded in crude oil! I made six fig- ures in the S&Ps!”
Learning to stop overtrading requires a willingness to limit your op- portunity base while simultaneously maximizing your effectiveness in the markets you will trade. It does no long-term good for your trading account
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to have significant gains in one market offset by losses in another. Addi- tionally, overtrading is a symptom of a trader’s impatience with the oppor- tunity he has selected or frustration over the results he has achieved. No long-term successful trader ever complains about opportunity or how long it takes to develop. Such a trader has learned that certain times are better for executing than others, and that no matter what, it will take some amount of time to see results. If nothing is happening today, then nothing is happening today. The market that trader is working in simply doesn’t have a lot to offer at this particular time. The wise trader is not concerned with that issue because he knows how to trade that market and he doesn’t have his focus degraded by trying to put effort into seven different places which he can’t exploit as effectively as he can one.
Because we as traders have so many choices and so much information available to us, we are tempted to think all perceivedopportunities will re- main actualopportunities for us personally, simply because we have ac- cess to something we ordinarily may have never known about before. We think that access to information is a de facto source of opportunity, when in reality our own ability to manage opportunity and information flow is the real key to our long-term success. One aspect of making the rule “Don’t overtrade” work for you directly is to narrow your focus to the best possi- ble market opportunities for you personally and limit your information flow to only the critical information needed to exploit that number of mar- ket opportunities.
As an example, if you cannot understand why China is the fourth- largest economy in the world today but won’t revalue their currency to re- duce their trade surplus, then buying a China-based mutual fund for your long-term IRA stock account may not be a good move, even though that fund meets your basic criteria for risk/reward ratio and has four confirm- ing technical indicators that you have come to trust well. Letting that trade go because you don’t have time to understand global economics well enough to know when it will be time to liquidate that trade might save you a significant amount of capital should you miss something along the way.
The fact that you can follow the Hang Sang index in real time and get Eng- lish-translation market commentary twice a day from Hong Kong does not mean you will be able to put it together well enough to effectively trade that opportunity from your home in the United States. It is tempting to think you can, but you might be overtrading your limited resources if you can’t. A 40% loss in something you don’t understand rips the bottom out of two solid years in a “beat the S&P 500” trade you found. I am not saying it is a bad idea to consider globalizing your opportunity base. I am saying it is a bad idea to spread yourself too thin just because you can.
The common understanding of the rule “don’t overtrade” is related to multiple executions within an existing market you currently trade in. This
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rule is designed to prevent you from exposing yourself to excessive low- probability trades. The most common symptom of breaking this rule is ex- ecuting multiple times from roughly the same area on the same side, but also taking multiple losses. Basically, you make six or seven trades from the long side, for example, and have five individual losses and a net loss on the day. To make matters worse, if you would have just sat tight on the first position for the whole day, you would have had a nice gain by the close.
Overtrading (as defined by multiple executions) is a function of not understanding your time frame properly, not following your rules to begin with, or not following your trade system properly. When the trader chooses to do something he ordinarily wouldn’t do, he is showing his emotional attachment to his results instead of maintaining a focused be- havior congruent with his discipline. Overtrading is a symptom of attach- ment, as is all consistently losing trading behavior.
To make this rule work for you, create a baseline of behavior that is consistent with your trading system and your trading plan. It really doesn’t matter what that baseline is initially, but you have to create it as an independent set of behavior controls, separate from your trading system or plan. For example, if you are using an execution system that makes a trade call about once a day, and you are using that system properly, it would be rare for you to have four executions to initiate in a single day in a single market. If you find you are executing more aggressively than the system actually tells you to, then you are overtrading. It is not a subjective or emotional set of data; it is a factual set of results that says, “You are not following the rules today.” It doesn’t matter if your system is a moving av- erage crossover signal with a 15-minute moving average convergence di- vergence (MACD) confirmation; if you aren’t following it, you actually have no system. And it doesn’t matter if your trade plan calls for you to take a break after two consecutive winning weeks and take your family to dinner with some of your profits; you aren’t going to have any profits.
The symptom of overtrading is often subtle so that by the time you are willing to admit you are doing it, the damage is done. Therefore, to make this rule work you have to choose ahead of time to put controls on your behavior beforeyou overtrade. You must write yourself a few rules that lead to preventing overtrading, not helping you recover after you have done the damage. That rule set is unique to you—it is a factor of your particular systemized approach and what it would look like if you weren’t following it.
The key to making this rule work for you is to ask yourself what it would look like if you were actually overtrading, based on the unique probabilities inherent in your trade system being compromised. Once you have that data, you must create a rule that would prevent that happening, if you follow it. In many cases, traders do not really know what their
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trade system probabilities are and therefore can’t really get the data to know what overtrading would look like. Overtrading is not as simple as
“trading too much.” If your system has a 55% probability of a winner but gets two-thirds of those trades on a Monday, you would be overtrading if you did a large number of trades on a Friday; so for you and your system, the definition of overtradingis not necessarily relative to the total trades created by that system. In this case, the rule “Don’t overtrade” might mean not trading more than twice on a Friday, but that wouldn’t apply on Mon- day. Maybe Monday’s rule would be “Don’t trade more than eight times.”
Gathering the data to exploit your system’s inherent probabilities is one thing, but putting controls on your behavior when you are outside those parameters depends on your knowing the difference. In any case, your trading plan is worthless if your systemized approach is not being followed properly. The rule “Don’t overtrade” is a call for you to get good data and then implement it into your trading plan. That includes both knowing which opportunities to trade in the first place, and being willing to admit that you may be not be exploiting those opportunities as well as you could. Both sides of the overtrading issue are about reducing risk ex- posure until you have the data to make a significant improvement to your market presence. The goal, of course, is to gather both the data and the will to follow your rules before burning through all your capital.
Following Rule #9 can boil down to answering this question as hon- estly as you can:
“How well do I know what I am doing, and am I willing to admit I don’t?” If the answer to that question is anything other than “I know ex- actly and I don’t need to change anything,” you are most likely overtrading in some form or another. You are either trading too many markets for you, trading without knowing your exact probabilities, or doing a little of both.
Reducing your exposure or knowing when to stop executing (or a little of both) depends on your willingness to control yourself. Unwillingness to control your behavior is what leads to breaking every other rule. Over- trading is the most important symptom to look for. We find out how bad we have the problem next in Part III, “Letting Profits Run.”
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PA RT I I I