Mental Accounting Errors set up Failure

Mar 18, 2007: 5:42 PM CST

Quick: What if I gave you $1,000 to invest however you wanted right now? It’s your money now – free. Would you put it on a speculative option play and try to double it within a week?

Now, ask yourself, would you be likely to make the same speculative decision if forced to use your own money to make a trade? Probably not. The answers to these questions help illustrate the main point of “Mental Accounting.”

Strictly speaking, we value earned money (especially if we had to work hard for it) more carefully than free money or ‘windfall’ profits. As such, we are more likely to take chances and speculate with free money, and we are more likely to preserve earned money. This, of course, makes intuitive sense but how does this affect your decisions in the market and how does it set you up for possible failure?

When you get a windfall profit you did not anticipate from a trade, you are elated and think you are a pro and want to put that money right back to work to make even more profits. It doesn’t take long before violating your money and risk management rules lead to that windfall profit dissapating like the dust in the wind.

On the flipside, when you only have a small amount of money to invest (especially if you worked hard at a job you didn’t enjoy), you are much more likely to guard that money with your life. This means (in the trading world) that you are more likely to wait for confirmation before entering, which not only may lead to missed profits, but missed opportunities. It only takes a few losses when trading with “scared money” for you to develop a heightened sense of fear before trading away your hard-earned dollars.

Going further, if you carefully research a company and charts before putting on a trade (with scared money), you enter when you are totally certain of reward and profit, yet the price goes against you. What do you do? You are losing money now, and it’s money you really can’t afford to lose. My guess is that you hold on to the position, knowing (hoping) that the price will reverse and you will still make a profit. However, the stock goes further against you. Do you sell?

Probably not. Now you hope to exit for break-even and at least get your hard-earned money back. Finally, you can’t take the pain of loss any longer and you sell. It doesn’t matter what the stock does next – you violated your discipline to cut losers short because you couldn’t afford to have a loss.

Valuing money differently leads to overtrading and excessive risk on one hand, and undertrading and holding on to losers too long on the other hand.

If you are interested in the academics behind Mental Accounting, a great resource is at www.behaviouralfinance.net

Next, I will discuss how to view money in the market and steps to reduce mental accounting errors.

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Five Ways to Increase Possibilities for Profit

Mar 17, 2007: 11:20 AM CST

While there are various ways to increase your potential for profit in the market, I am submitting five categories to begin altering your trading behavior to increase potential profits.

  1. Hold your trades longer than usual
  2. Increase position size (concentrate capital) in fewer stocks
  3. Decrease position size but trade highly volatile stocks (those with high beta, like Google (GOOG)
  4. Decrease normal position size, but trade more opportunities in more stocks
  5. Increase your market knowledge and education, or get with a trading coach or mentor

Let’s take them individually and discuss strategies for each:

        Hold trades longer than usual

My bias is scalping and day-trading. The targets for the patterns I identify are anywhere from 15 cents to a dollar. I usually hold trades from 15 minutes to a few hours. If I played on larger time frames consistently and held my position using the same patterns, I would be holding for days or weeks and playing for five to ten dollars sometimes. Of course, my stops would be larger and my losses larger and outside my comfort zone, but if I worked on overcoming this, I would enjoy the benefits of taking dollars out of the market consistently, instead of cents.

Also, by studying the dynamics of trend behavior and longer-term pricing action, you can find key spots to position yourself and hold trades for weeks (or even months) for dynamically increased profit. You can’t change overnight, so start by increasing your holding times slowly and incrementally take on more risk and profit. Of course, longer time frames require reduced share size, especially when making the transition.

        Increase position size in fewer stocks/trades

If you are accustomed to trading a balanced portfolio, or swing trading more than five to ten stocks, or trend trading dozens of stocks, it might be helpful to study your results and see if certain patterns are making money consistently, while others are not. then consider eliminating underperforming strategies for entry/exit. Focusing your efforts on three to five (or less) stocks at a time will decrease your decisions and increase your ability to monitor these positions. For day-traders, it might be helpful to hold only two positions maximum at a time, or just hold one concentrated position but monitor it closely.

        Trade highly volatile stocks with reduced share size

Remember, part of money management involves studying the beta or volatility of stocks. You do not want to concentrate a large position for a large time in a highly volatile stock, because your P/L statements – and emotional stability – will also be highly volatile. Google (GOOG) has been known to move $20 or more in a day (not to mention the $50 or greater overnight gaps). Research in Motion (RIMM) has been known to move $5 to $10 in a day.

If you are a scalper/day trader who normally trades 1,000 shares for 20 cents ($200 profit), then a $2 move in a volatile stock will result in the same profit with 100 shares – both actions could occur withing an amazingly short period of time – 10 minutes to 20 minutes. Reducing position size yet playing for the same target can reduce commission too, but make sure you have a strong stomach and wider stops before playing highly volatile stocks

        Trade smaller positions in more stocks

This is an interesting rule and one that speaks of diversification and hedging. I once attempted a swing trading strategy that attempted to find the strongest stocks in the strongest sectors and then offset risk (hedge yourself) by going short the weakest stocks in the weakest sectors. The strategy did not work for my risk-tolerance preferences, but the idea of hedging positions and taking more positions with decreased capital per position is appealing for longer-term investors more than traders. Traders capitalize on short-term price inefficiencies and must actively manage trades, and holding more than five to ten positions at a time can be extremely challenging for active investors or traders.

This is where “Edge” plays a major role. The difference between “The House” and gamblers in a casino is the concept of edge. If we assume the House wins 55% of the time and the gambler wins 45%, and the win/loss amount is slightly even, then two divergent strategies emerge:

The Gambler – with odds against him – should take concentrated bets fewer times, because if he plays all night, he will lose all his money because the more cards he is dealt, the more money he loses.

The House, with odds in its favor, wants the gamblers to play as much as possible – they many hands dealt because at the end of the night, it will take in more money than it lost, and it plays out its edge over many opportunities to demonstrate the edge.

Finding more opportunities to demonstrate your edge should result in more profits to you – provided you have a demonstrated and tested edge.

        Expand your knowledge or seek help from trading professionals

The markets are dynamic and there is so much to learn from so many people (websites, blogsites, books, seminars, coaching, training, simulation). Each step you increase your knowledge alerts you to more possibilities in the market and decreases the randomness and uncertainty factor you perceive as you trade. If you feel like you are hitting a plateau, there are various coaches – both psychological and educational – to help you reach that new level of success. Expanding knowledge also means testing your strategy or gathering more data on yourself and your strategies. Through increased knowledge, fear and anxiety should decrease as confidence in yourself and your abilities increase.

Obviously, you cannot try all these strategies at once, and some are designed for active traders while others are designed for investors or longer-term traders. These can be guides for helping increase your risk and profits, but you must determine if any of these strategies can be helpful for you. Before changing your strategy dramatically, always be open to new possibilities of how to better pull profits out of the market with increased confidence.

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Questions Regarding Risk-Taking

Mar 17, 2007: 10:48 AM CST

You can increase your risk-taking ability and overcome fears by analyzing your actions and asking empowering questions, as explored earlier.

Here are a few questions which can further help with your analysis and motivate you to make a difference once you understand more about what keeps you from taking risk.  These questions are designed to take place when analyzing your trading decisions and chosen entry and exit points.

  • Exactly how much were you influenced by your emotional reactions?  Did it make a major difference in your decision?
  • Did you stay with the trade with confidence, or did you exit prematurely once you had a profit because of anxiety?
  • Did you add to your position (increasing risk and potential reward) and hold it through an extended uptrend you anticipated?  Did you add at all when you should have?
  • If the stock declined below your purchase point (but not stop-loss point), did you stick to your analysis and hold the trade (take heat) or did you cut your loss quickly?
  • Were you trying to call a top or bottom or were you fully open to price action?

If you are not getting the results you envision, you must devise some form of analysis to study your behavior, results, and your reaction to the market opportunities you are trading.  Documenting your trades and analyzing more than just “profit or loss” can give you great insights into ways to increase your risk-taking behavior and profitability.

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Explanation in the Comment Thread

Mar 16, 2007: 12:11 AM CST

I wanted to draw attention to a conversation taking place between Jordan and I in the Comments section of the post “March 14th Analysis”

In it, Jordan asks me to clarify points concerning momentum divergences and the “Impulse Buy” pattern which illustrates the “Momentum precedes price” example.

I also wanted to note a new chart of McDonalds (60 minute) in line form and bar form which highlights the Impulse Buy pattern and Momentum divergence.

Although I trade other patterns, I find this set-up to be most profitable and most comfortable for me to execute consistently.

The simple explanation is that after a downtrend (reverse the terms for uptrend), momentum and selling decline and a base forms (you should expect a longer base to form than in this example). Equilibrium is achieved between buyers and sellers. Eventually, new information enters the arena and throws participants off balance, which creates (in this case) a strong upside momentum thrust.  The problem is that you cannot anticipate this momentum thrust, and divergences are often good only for small targets (and represent countertrend plays).

I look to enter a position following this momentum thrust (and the retracement against it) when price nears a key moving average. I then play for the most recent swing high. I repeat the pattern once price corrects back to the moving average and play again for the newly formed swing high. Stops are placed a short distance below the moving average which allows me to enter with a tight stop (but not too tight).

Another point to note (which I have not illustrated on the chart) is that the new momentum low on the left side of the chart corrects up to the moving average (when the bars turn green) and you would be wise to play this new momentum low short for an equal swing or at least a retest of the most recent swing low.  Entry would be around $44.25 and the exit target would be $43.  Risk would be about 25 cents at $44.50 (slightly above the declining 20 period moving average).

I plan to explore this idea in a further post. For the meantime, feel free to jump in and participate with us in this discussion – or at least scan it briefly.

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March 15 Educational 15 minute chart

Mar 15, 2007: 6:50 PM CST

Today was a consolidation day, and one with very choppy action that whipsawed many traders, myself included. It was difficult to find direction today, and I suppose the story will be similar tomorrow as it is Options Expiration Friday. It is actually a “Quadruple Witching” Expiration Day, so my recommendation is to take the day off and enjoy a nice, three day weekend after all this wild market action recently.  Andy Swan suggests the same, yet goes a step further to predict a possible bearish mauling (strong market decline) next week.  I don’t know if I would go that far.

I wanted to post a quick chart of the DIA 15 minute chart over the last few days and note some educational momentum divergences forming in the creeping action we have experienced.

The most striking point to me – again – is the volume spikes on March 14th during the afternoon. The Big Picture hints that this might constitute a “Key Reversal Day”. I admit it is worth a thought. It is certainly comforting for the bulls to see possible capitulatory selling action here.

Notice the two divergences (black lines on the bottom pane 3/10 MACD indicator). Keep in mind that momentum readings are voided in a range bound environment which we have at the moment. Momentum is winding down to a market equilibrium point, and a directional bias will soon be established.

Take time to do some research and be careful should you decide to scalp or trade on Friday. Odds favor consolidation and choppy market action due to the uncertainty of the “big boys” unwinding futures contracts and options adjustments as necessary. This will take precedence unless some major news or fundamental action occurs. Have a great long weekend.

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