Saturday, August 15, 2009

Complexity

One observation I have made over my years of trading, coaching, and conducting seminars is that there seems to be a conception among many retail traders that trading and trading plans need to be complex. I couldn't disagree more. I have found that using simple, basic methods, one can be quite successful. I have often said, and reiterate here, that good trading is simple, but that does not mean it is easy. Doing the simple things can be difficult. Difficult because we tend to have fights with ourselves. We may have some specific entry strategy, for example, but fail to make the entry because we decided to wait for more confirmation and by the time we see enough confirmation to satisfy ourselves, we have missed the trade.

Several years ago, a couple who had attended a series of my seminars asked if they could spend some time with us on Hawaii while we were over there so they could see exactly what I did in my own trading. These folks had a great knowledge base and knew quite a number of strategies. I spent the better part of a day one Sunday with them, looking for some candidates to trade the next day. During that time we found 4 or 5 candidates upon which we agreed and discussed entry the next day provided they did not reverse direction. We also agreed to meet the next morning and walk the beach. Since Hawaii is so far west, the markets open quite early and around 4:30 A.M. Hawaii time, I placed three of the trades we had discussed. Later in the morning we met and as we walked the beach, I asked these folks which trades they had entered. I was shocked when they responded: "None of them." After having spent the greater part of a day trying to help them find some entries, I was really curious why they hadn't entered even one. They told me they were looking for more confirmation. By the time we got back from our walk, they had gotten the confirmation, but with a strong market, it happened that they missed all the trades. Fortunately, I was able to close all of mine within a few days for a nice profit.

The principle I had tried to show them was to find an entry with an adequate potential reward to risk ratio and an exit that would take them out with a small loss if the position moved against them soon after entry. By the time they had what they considered to be confirmation, the reward side of the reward to risk equation was much less than we had seen on Sunday and the exit or potential loss was much greater than it had been had they entered as we had discussed. The entry concept was simple, but, for them it certainly wasn't easy.

Clearly, these people believed that by waiting for what they considered to be confirmation they thought they would be entering a "safer" trade. Tain't necessarily so. Could they have entered after seeing their confirmation and still seen the trade turn immediately against them? Of course that could happen. No one can know the future and some general market or stock specific news could have triggered a reversal. What then would have been their situation? If they were using the disciplined exit they had already pre-determined on Sunday, the loss would be greater since the stock had to move to achieve the "confirmation" they required. In this situation, the complexity was the addition of a requirement of confirmation after they had already seen an entry that would work.

These folks are not alone. I have often seen retail traders jump from strategy to strategy each time they are exposed to something new evidently believing that there is some secret holy grail of trading. If there is, it isn't jumping from strategy to strategy.

Anyone who believes that added complexity can bring the answer might want to review the Long-Term Capital Management debacle. Long-Term Capital Management was managed by sophisticated and bright professionals; it had two Nobel Prize winners on its advisory staff and a complex plan using modern finance theory. In spite of the complexity, it not only failed, but nearly brought down the U.S. if not the world financial system (years before the current bailout issues).

The answer, I believe, is in learning how to cut losses and let profits run. Though I have discussed these critical concepts in "Trade Your Way to Wealth" and "Smart Investors Money Machine" as well as in numerous articles over the years, a subscriber recently suggested that I keep tossing the notion out as a "tease" and further suggested that it would be helpful if I could give some guidelines on how to do those things. I agree. I am currently preparing a short series of articles that should begin around the end of the month in which I will try to do exactly that -- try to give some guidance on how a trader might go about cutting losses and letting profits run. Again, the concepts are quite simple, but as with so many things in trading, not necessarily easy.

by Bill Kraft, Editor
Copyright 2009, Makin' Hay, Inc.
All Rights Reserved


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To comment on Bill's article click on the "comments" link below.

5 comments:

Anonymous said...

As I understand it, LTCM actually cornered a number of smaller national markets, thereby making themselves unable to unload.
Yours,

Tony Scott said...

Mr. Kraft,
I love your articles, and recognize many of the faults you discuss in myself. I, like many, may tend to "overthink" things, and as a result, miss a trade that I had ferreted out as a good one.

In this upcoming series of articles, perhaps you might show us a few of your actual trades, how you sorted possibilities to find them, and what your specific thought process was regarding entry and exit to "cut losses and let profits run". Also, if any part of your methodology involves judging supply and demand at certain levels to see how strong they are (and therefore how much support or resistance is present--HOW do YOU do it?

Thanks, and keep up the good work.
Tony Scott
P.S. I've read and enjoyed "Trade Your Way to Wealth".

Nona said...

To your point: Dennis Gartman says that all great traders have a simple technical system. Not one of the traders' systems is complex. Not one!

I look forward to your further articles on this subject.

It seems to me that if one gets the overall trend right AND gets the trend right on one's choice of stock(s), some 80% of the work is done. After that, if a particular stock is selected, it's a matter of following the guidelines you recommend: figuring out an entry point that has a clear, near exit point.

That piece of insight from our tutoring session, i.e., picking entries with clear, near exit points on stocks that are trending in a particular direction, has been worth the price of admission.

And then you threw in all that other useful help and information!

~ GemmaStar

Bill Kraft, MarketFN.com said...

Thanks, Tony. I hope everyone recognizes that I'm not immune from some of the faults I have discussed over time. That is one of the reasons I've been able to identify some of them. Awareness just makes them a little easier to avoid. As the most recent article suggests, I have found that simplicity takes the prize, at least for me. As the series of articles takes shape, I suspect that you will be surprised how simple my own sorting process really is. Thanks for the kind words about "Trade Your Way to Wealth." I hope you check out "Smart Investors Money Machine" as well.
Bill Kraft

Bill Kraft, MarketFN.com said...

Thanks, Gemma Star. As far as I am concerned you hit the nail on the head. I definitely enjoyed our coaching sessions and I'm really glad that you have been able to find some ways to improve your trades.
Bill Kraft