One of the joys of learning to trade is wading through so many diverse opinions about the markets, how they work and how you can trade them. In this article, we’ll look at 5 common trading clichés and try to figure out which are facts and which are fantasy.
Secret price levels AKA Secrets of the “Pros” – this is one of my favorites. There are a few variations on this theme but the upshot is usually that there is a profit making “secret”. Not many people know about it but if you cross someone’s palms with silver, they’ll let you know the secret. The first thing we need to consider is what it takes to move a market. It takes trading, it takes participation. By definition, anything that is ‘secret’ won’t be known by many people. So if it’s a secret, not many people will be trading it. If not many people are trading a secret level or strategy then guess what; there’s probably not going to be a significant reaction to their actions. Another consideration is the mention of “The Pros” in the first place. Most retail traders trade ‘outright’ positions – buying to sell higher or selling to buy lower. When it comes to professional trading, this is just a part of what goes on. Institutional traders are making markets, arbitrage trading, spread trading all sorts of things, so the use of the word “Pros” is usually nothing more than a marketing hook because what retail traders do bears little relationship to what most professional traders do.
The trend is your friend – It has to be said, there’s days I don’t feel like the market is my friend at all. This is an interesting cliché. I meet a lot of day traders who continually attempt catch the top or bottom of the market and ride it to the other side. That would be really nice but what usually happens is the market goes down 2 points, they try to go long, then 3-4 points down, they try to go long again, then 6- 7 points and still trying to go long racking up losses along the way. Then the market starts moving up – and they then try to short it. I call these people permafaders, always trying to do the opposite of what the market is doing. If you haven’t ever tried just going with the flow, give it a go; if the market is moving up then go with it. Of course, the trick is to know if the market is trending in the first place but with that caveat in mind I think we can go with:
Money Management can make a bad system profitable – This one comes up very often because there’s a trading book which details a random entry system with a trailing stop. Over a 10 year period they showed it would have made money. That sounds impressive on the surface but what they actually created was a trend following system. The counter-trend random entries would quickly get stopped out and the with-trend random entries would ride the trend. So whilst the entry portion was random, the system was a trend follower.
Still not convinced? Well, let’s consider the HFT world where tens or hundreds of millions of dollars are spent on infrastructure and making sure they are as physically close to the exchange to get the lowest latency. Why on earth would HFT firms do that if they could just pay a monkey to sit in the corner tossing a coin?
Take care of your losers & your winners will take care of themselves – There are many variations on this theme but the upshot is that you should focus on managing risk rather than focusing on profits. Newer traders tend to focus primarily on profits and in many cases, they tend towards unrealistic expectations. A trader that is profit oriented will buy because she thinks the market will go up and she may be right in the long term but lose on the trade. A risk oriented trader may be of the opinion that the market is bullish but she will only enter the market at a good price. That may mean waiting for the market to come down to a certain price and only getting in if it does. The end result of behavior like that is the latter trader is consistently getting better prices on her trades and making more ticks whilst at the same time taking less risk. The former trader will often get taken out just by regular volatility because they think risk management means a certain stop size. If the market is swinging 20 cents up and down and you enter long after a 15 cent move up with a 5 cent stop then there’s a good chance you will be losing a very high percentage of your trades to that general volatility. On the other hand in a market that is swinging 20 cents, if you enter when the market has moved down 18 ticks, you are less exposed to that volatility, you got in at or close to a statistical extreme. Getting a good price, keeping your risk low and just getting the hell out of a trade when it looks bad is absolutely essential to your bottom line. Make no mistake, this is a skill. It does take experience to deal with reducing risk and in particular, recognizing when a market is moving against you with participation as opposed to just moving with regular volatility.
Risk Free Trade – This is an interesting one. Risk free trades do occasionally occur. There are times when you can buy crude futures, take physical delivery of the oil, pay for storage and then sell a later crude futures contract, deliver the physical at expiry and still make a profit after the storage costs. Fancy that? No, didn’t think so. It’s obviously not without risks. Does your insurance cover terrorist attacks for instance? The term “Risk Free Trade” is often associated with option strategies and frequently it’s a pitch about using options to turn your losing trades into winners with options. When you make money in a trade, that money came from somewhere, someone had it in their account and now it’s in yours. They obviously took risk because lost money. So is it realistic to have people risking money that you can take from them without risking money yourself? Well if it was, then wouldn’t this catch on and everyone do it? And if everyone did it and didn’t risk/lose anything, how exactly would you make any money if nobody was losing it? Most of the “no risk” option strategies out there should really be described as “unknown risk” strategies. Complex options strategies employed by amateur traders who don’t really understand them. The only way to truly trade without risk is to cheat.
In our small sample size, fantasy is a clear winner with a 3-2 advantage. I chose these particular clichés as they have been the topic of a lot of heated debate on internet trading forums. This was not done to annoy people but rather to stimulate thought on ‘facts” we may take for granted. All part of the process of developing a healthy level of cynicism as you develop as a trader.