Trading as a Business

For those who have the intention of relying on their trading activity to generate a constant source of income, there are various aspects to consider which will have an important influence on the resulting trading performance and which will all play their part in the formation of a sound business plan.

• Trading Psychology
• Leverage
• Fund Allocation & Position Sizing
• Cash as an Asset Class

Trading Psychology

The psychology behind trading is the decisive factor for moving the stock market. A stock chart is in principle nothing more than a picture of human emotions where fear, greed, expectations and euphoria are documented. By having the discipline to use a proven trading system, you can take advantage of the psychological disorder which torments other market participants. Here are a few ways in which novice traders end up destroying their trading accounts:

• Succumbing to the herd mentality
• News Trading
• Believing in price forecasts
• Lack of self discipline

Herd Mentality

What is herd mentality?

Herd mentality (also known as mob mentality) describes a behavior in which people act the same way or adopt similar behaviors as the people around them — often ignoring their own feelings in the process. Group decisions lack the creativity and accuracy that might otherwise be found in an individual's decision making. Instead of a child being creative and choosing their own toy, or an investor being accurate and researching the market before making an investment, humans are more likely go simply go with the crowd—-even if it's not objectively the best or wisest decision. Social groups do not tend to respond well in changing environments, as individuals within that group are too preoccupied with following everyone else to make their own informed and considered opinions. This is generally true even when the group contains individuals who would otherwise make well-reasoned choices on their own. That's why groups will generally make poor decisions, while individuals can make much better ones.

News Trading

Why news trading is a bad idea

• You don’t trade the actual news. You trade peoples’ expectations and how the news are perceived.
• Price reacts to news in so many different ways and you can often see that price drops significantly after a good news release or it shoots up when the news are bad.
• Whenever you catch yourself chasing a move without a plan, then you have made a huge mistake – it’s the sign of an amateur trader.
• Furthermore, price volatility tends to rise to extreme levels when news is broadcast. This will generally result in wide quotation spreads and increases the likelihood of stops getting executed under the most unfavorable conditions.

Believing in price forecasts

• Not even the most experienced analyst can see into the future.
• Because of the numbers of traders, economists or so-called ‘trading gurus’ and the amount of forecasts, you will always find a handful of people that guessed right.
• Don’t blindly follow someone who was plain lucky.

Lack of self discipline

Here are a few examples which expose the lack of self discipline in trading:

• Widening a stop loss order when you see prices going against you. Your stop loss level is the level where you are willing to accept that your trade was wrong. Widening a stop loss orders signals that your emotional responses have taken over and that you cannot make sound trading decisions anymore.
• Not treating trading like a business. Trading is not necessarily hard or difficult, but the approach of the average trader makes it impossible to earn profits from trading. Testing different ideas, calculating and analyzing data, tweaking, continuous self-improvement, preparation and running a trade journal are all the things the regular trader does not want to hear about and that is exactly why more than 80% of all traders will never make money.
• Impatience. Trading is a long term activity and you do not have any influence on the outcome of your trades. Your only responsibility as a trader is to find a method that has a positive expectancy, religiously apply it and constantly monitor every little aspect of your performance.

Warren Buffet put it nicely when he said “The stock market is designed to transfer money from the impatient to the patient.”

Factors decisive for trading success

• Adequate Financing
• Market knowledge
• Money management
• Emotional discipline

The realities of trading

• It is impossible to predict market turns
• Losing trades are a natural part of trading
• There is no such thing as luck in the long term

As a trader these things will sometimes happen to you:

• You will buy at the high of the day
• You will sell at the low of the day
• You will get stopped out of a long trade at the day’s low and the uptrend will then resume
• You will get stopped out of a short trade at the day’s high and the downtrend will resume

And these as well…

• You will have more consecutive losing trades than you expected
• If you get stopped out 3 times in a row using tight stops and then widen your stops, that one will get hit too.
• If you get stopped out three times in a row using wide stops and then tighten your stops, that one will get hit right before a big move that you would have been in had you continued to use wide stops.

Remedies for combating emotional conflict

• Rely on your own intelligence
• Form your own opinion
• Never ask a broker what he thinks about the market
• Forget past losses or lost opportunities
• Enter the market only on clear signals
• Don’t chase after a missed move
• Beware of market consensus reports

Avoid Stress

• Take a relaxing vacation
• Get enough rest - 8 hours of uninterrupted sleep
• Get some physical exercise every day
• Maintain a well-balanced diet
• Learn how to smile
• Don’t neglect your family life
• Meditate - reduces blood pressure, increases focus and performance

Leverage

What is Leverage in Trading?

Leveraged trading, also known as margin trading, is a facility offered by many brokers, that allows the trader to amplify the value of his or her trades. That means opening positions much larger than his or her own capital would allow. This can increase the traders’ rewards, but it can also increase their risk too. To use leverage in trading, the trader need only invest a certain percentage of the whole position. This can change depending on how much leverage the broker offers, how much leverage the trader would like to implement and it also relies heavily on the regulatory authorities tasked with overseeing the online trading industry in that jurisdiction. Leverage is commonly used nowadays, especially by more experienced traders, whereas newbies should exercise caution when it comes to using leverage

Fund Allocation and Position Sizing

Why fund allocation is important?

Fund allocation refers to the amount of capital one is prepared to allocate to a trading position and also how much capital one is prepared to risk on each trade. It is generally accepted among financial professionals that the selection of individual stocks is not so relevant to the performance of a portfolio as the correct weighting of stocks, bonds, precious metals and cash. Strategic stock investments should be held for periods of at least 4 years , while cash and money market investments are ideal for the shorter term or maximum 12 months. Stock investments also depend on the age of an investor. The rule of thumb here is to subtract an investor’s age from 100 to determine the stock allocation percentage. This means that a 30 year old would be 70% invested in stocks and a 65 year old would be 35% invested in stocks. This means that the older the investor is, the more conservative his investment profile should be. In general one can say that the size of various positions within a portfolio has more influence on the overall performance than the selection of individual stocks or market timing strategies.

Position Sizing

A trading strategy which delivers a stable performance over time is of course important, however if the investor does not devote his attention to position sizing, the end result can be disappointing. Position Sizing is often overlooked by traders, however its importance should never be underestimated, especially when one takes into account the uncertainty and exuberance existing in the markets today.

Calculating maximum $ risk per trade

It is of utmost importance to define the amount of money you are prepared to risk on any one trade. It is generally recommended to limit 1% of your capital on any one trade. This theoretically means that you could make 100 consecutive losing trades before your account is dissolved.

Applying a stop loss order to every trade

Every trade should be accompanied by a stop loss order. In this way you can control how much you are prepared to risk per trade. For instance you have a buy signal for a stock now trading at $50 per share and the stop loss level is 47.50, you are risking $2.50 per share and are prepared to risk a fix amount of $200 on this transaction. You now have to calculate how many shares you are able to buy so that whatever the outcome, no more than $200 will be lost.

The formula used to calculate the position size will be:

Maximum Risk in $ Per Trade/Stop loss Price= Tolerated Position Size. In this case the number of shares to be purchased will be: $200/$2.50= 80 shares This method of position sizing is used by hedge fund managers and professional traders. Since you are only risking a small percentage of your capital on each position your trading will become less stressful and be based on your trading system and not on your emotions. In this way the odds of you being able to generate consistent positive returns will weigh in your favor over the long term.