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5

WHY TRADERS LOSE

the phone or clicked the mouse because of that silly $150 loss several days ago, digging themselves ever deeper into their emotional trading hole.

Everybody makes mistakes. The most successful system traders rarely have over 50 percent winning trades. In fact, good traders can be successful being right only 30 to 40 percent of the time. On the other hand, traders can be net losers and win on 60 to 70 percent of their trades if they insist on fighting the market and absorbing huge trading losses.

One thing common to most successful traders is their ability to realize quickly they are wrong and cut their losses short.

Discussions with many traders reveal that the most successful of the group have patience, are disciplined, cut losses quickly, and win the game with singles and doubles, not home runs. These same individuals divulge that their biggest hindrances to being more profitable are the tendency to take profits too quickly and the inclination to get emotionally involved in the trade and therefore not cut losses quickly enough.

While trading 10 stocks on the same system, for example, a trader noticed he was becoming heavily short in the market and decided to skip the last few entries of the day, all on the short side, due to fear of too great an exposure on the short side in a market thats "always going up." As a result, this individual trader missed the three best positions of the 10 he should have initiated on that day. The market continued its slide for the next few days in a time of heavy earnings warnings filtering into the market as the Nasdaq went through one of its famous bloody sell-offs. Had the trader followed the system he had spent so much time developing, he would have been in good shape rather that looking at what might have been.

Its a lot different with real money.

Learn to like losses. As crazy as this statement seems, there is a significant amount of truth here. Many examples exist where small losses prevented much bigger ones from entering an account. Stop-outs are there for a purpose. Even the best system certainly takes its share of losses. Live with it.

Inability to pull the trigger is a huge problem with many traders. A trader I know is fond of relating an experience he had

SYSTEM-A-DAY-SAM

when he first began trading a system in a trading room full of new traders. He had a view down a long desk with many traders examining quote and charting screens with papers scattered all over the desk. He vividly recounts looking down this row, observing one hand after another coming out, picking up the telephone, hesitating, and placing it back on the hook. The traders there simply couldnt pull the trigger, even when they knew their system was dictating a trade at the moment. If you have this psychological fault and are so afraid of losing money that you cant act, maybe this game isnt the one you should be playing.

Another guy I know brags to his friends and associates that he trades for a living but hasnt made a trade for over a year, although he gets up every day thinking that today will be the day he starts trading in a big, successful way. Once again: Imperfect action is usually superior to perfect inaction.

On the other hand, there are those who create many of their problems by overtrading. Many will double up on a system after a few successful trades. This type of activity carries with it the same problem as the greedy trader mentioned before. The actual time to do this is when the system is currently approaching its historical drawdown, not when it is approaching its best trading level of all time. Chart the performance of a system much as you would a stock or a commodity contract, noting the depth of each dip in the curve. When the system equity curve undergoes a correction and takes a few losses, thats probably the time to enter. Increase the number of contracts traded on each signal only when the current correction approaches the normal pullback previously experienced by the system equity curve.

Treat trading as a business. Its not a pastime. It is not a frivolous activity. It is not gambling. It is not the lottery (which in my opinion is nothing more than a tax on the mathematically challenged). Researched and formulated properly, a trading system can be a successful occupation. If you are not willing to take the time to thoroughly research and develop a sound theory and then implement it, you are just wasting your time and money.

It is hoped that the next several chapters will help you along your way to a happy and successful trading career.



1. Human emotions, especially fear and greed, often interfere with a successful trading career.

CHAPTER REVIEW

2. Increasing the confidence one has in a system often leads to more successful trading.

PEOPLE, PRICES,

PERSONALITIES,. AND PROBABILITIES

3. Learning to accept mistakes and losses is critical.

4. It is important to view trading as a business, not a pastime or frivolous activity

Why Technical Indicators Really Work

Those new to technical analysis frequently ask how these seemingly abstract applications can be effective in the real world of trading stocks and commodities. This is a fair question for the beginner. After all, how can lines, dots, curves, and histograms placed on a bar chart, in what seems like a random fashion, possibly have any value in predicting future price movements?

There are two basic reasons why these trading tools work as well as they do: (1) They work because so many people use them; and (2) they work because, in effect, they are predicting the repetitive human behavior at work in the markets.

Obviously, prices of stocks and commodities rise and fall as a direct result of the buying and selling that occurs every market day. Also obviously, the buying and selling is directed by the defined group of humans who actively trade the stock or commodity of interest. If

PEOPLE AND PRICES



increased buying causes prices to rise. The buying triggered by the buy stops thus propels the market even higher.

Lets say, for example, that 10 traders who are confident concerning the activity surrounding the breakout of a double top have placed buy orders above our theoretical double top, each for 100 shares of the stock. This results in buy orders for 1,000 shares, which could move the market a bit higher. But, what happens in our example if 200 traders each place orders at that level for 1,000 shares each? Few would argue that 200,000 buy orders at the same price level would cause the market to rise sharply.

In reality, our example of this many shares at one price is obviously an extreme. However, significant stop orders are placed every day around specific chart points of interest. Obviously, the number of shares or contracts that show up at these levels impacts directly on the markets reaction when these levels are reached. The more orders at a given level, the greater the market impact. As the number of people who believe in the double top breakout theory increase, the greater is the number of shares that accumulate at that price level, resulting in stronger market activity to the upside. Should the trades generated by our buy stop placement prove profitable, there is a high likelihood that the next time the opportunity presents itself there could be even more orders found at the point of the double top. Should our traders tell their friends, possibly more orders could show up. You get the point. The more people who use this theory, the more likely it is to work since the increased buying generated by the buy stops sends the market higher, and so forth. It becomes a self-fulfilling prophecy.

This phenomenon is expressed nearly daily in active markets. Closely observe the activity of a market when it begins to approach the high or low for the day, especially relatively early in the session. Experience has shown veteran traders that it is likely that there are stops accumulating above the days high and below the days low for the same reasons as in our hypothetical example. Knowing this, traders increase their buying activities near the high and their selling activities near the low in anticipation of increased market activity in the direction of the breakout should new highs or lows for the day be established on this move of the market. This is clearly an activity promoted by a significant number of people pursuing a strategy that has proven successful in the past.

only we were able to forecast accurately what the next collective move of the group of people trading our favorite stock was going to be, we would have a distinct advantage in planning our own trading decisions.

In the most basic format, this is what the world of technical analysis does for each and every trader who is able to master the art of technical trading. Technical indicators often can predict, with a reasonable degree of certainty or probability, what the next major move made by the trading community is likely to be.

Later on we will work extensively with such common technical analysis techniques as stochastic, Relative Strength Index, Percent R, intraday highs and lows, and other simple calculations of intraday support and resistance. As mentioned, these and other technical tools work as well as they do because so many people use them in their trading routines. This approach, seemingly rather simplistic on the surface, has a basic fundamental foundation.

Although the concept that something should work well just because people use it does seem a bit foreign when you first think about it, there is some logic behind this statement. Perhaps an example will clear this up.

One popular support and resistance trading theory revolves around the breakout of a double top formation. A double top is defined as a point on a chart that has been reached twice recently and each time has been able to turn prices back lower. The breakout theory states that, if the factors responsible for market activity are strong enough to propel the price through this level represented by the double top, the forces responsible are probably of sufficient magnitude to cause the price to climb considerably higher. Traders familiar with this theory often place buy stops slightly above this double top price. Their reason for doing so is rather fundamental from a technical analysis point of view because, if prices break through this level, their buy stops will automatically place them in a long position. If the price continues to rise as a result of the breakout, their trade will soon be in a profitable position.

Think for a moment about what has just happened in our theoretical example. First the market broke through our double top due to strength in the market. As soon as the market breaks through this price level, more buying is uncovered as the buy stops (which become market orders when the stop price is hit) are activated. As you know,



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