It’s not my fault — I didn’t even know it was a mistake!

Mistake 1: defining a trading mistake

The greatest mistake you can make in life is to be continually fearing you will make one.

Elbert Hubbard, The Note Book, 1927

My guess is that most of you are probably inquisitive as to what constitutes a trading mistake. Given that this is a book about trading mistakes and how to avoid them, it seems only logical that the first chapter needs to define what mistakes are, and highlight some of the many mistakes that are discussed in the following pages.

Trading mistakes inevitably stem from two main sources: believing that trading is easy; and not having a well-defined plan for engaging the market. Invariably, all mistakes that traders make emanate from these two things. Much of this chapter is from an interview with leading market educator and world-renowned trading coach Dr Van Tharp, whose comments appear in bold throughout this chapter. He offers the following definition of a trading mistake:

A mistake can be defined in one of two ways:

1. First, I consider it a mistake to make the assumption that trading or investing is easy and that you don’t need to do a lot of work to be successful. In fact, if people don’t go through the five steps [outlined on page 3], then everything they do is probably a mistake. The second definition has to do with the results of the first step.

2. It is a mistake to not follow a complete set of rules and guidelines as a trader; this should be written down in your working business plan. A mistake occurs when you break any of your rules.

A great pick-up line

The romantic notion and lure of trading attracts people to the promise of profit from buying and selling anything from shares in companies, through foreign exchange, to the global commodity markets. It is one of the last great free market activities available to anyone with a computer and a telephone. The entrepreneurial spirit in all of us is kindled by the thought of actively buying and selling gold futures, currencies and a wide range of other markets. It also makes great cocktail party conversation when people enquire as to what you do: ‘Oh, not much’, you reply casually, ‘I’m a trader’. Instantly a world of fast cars, glamorous people and sailing in Monaco flashes before their eyes. Little do they realise that the reality of trading is brutally different from this glossy, shallow image portrayed in the marketing hype of many of the lesser respected promoters in this industry. It takes persistent hard work to become a consistently successful trader.

Trading is a profession like any other. Most people go through many years of schooling and training to learn their profession, but not for trading. Entry is easy—just open up a brokerage account. It is comparable to the average person walking into a hospital and telling the staff, ‘I’d like to practise brain surgery today’. If they’d allow it (as they do trading), then the results probably would be fatal to the patient just as the results in trading are usually fatal to your account if you are one of the typically ill-prepared traders. The first major mistake people make is not having the appropriate training.

There are five steps people should go through to get the training they need before engaging the market:

1. Extensive self-examination and working through psychological issues. This is an ongoing process that never truly ends, but I’m willing to say that most people have completed this step when they have solved five major psychological issues. For example, someone might say, ‘My self-esteem is low and I have a lot of anger because my father always used to criticise me and put me down. However, I’ve worked on my anger through various feeling-release techniques and now it seldom comes up’. When people have solved five issues, I think that they can handle most other things that come up and are ready to move on to step two. Not knowing your common patterns and how you might self-sabotage is a major mistake.

2. Develop a working business plan to guide you through the trading process. This should include a statement of who you are (resulting from step one); objectives; an assessment of the big picture; at least three trading systems that fit the big picture; a complete set of business systems (like how to do research, how to manage data, and so on); a worst-case contingency plan; position sizing strategies to meet objectives (these would be a subset of the systems); and a psychological management plan. Being ill-prepared for the unexpected is also a major mistake.

3. You need several non-correlated systems that fit the big picture. One of the biggest mistakes that people make is to develop one trading system and then try to fit it to all market types. You cannot do it. But you can design a really good system, perhaps even a Holy Grail-type system to fit any particular market. For example, there is a huge difference between a quiet bull market and a hugely volatile bear market, or even a hugely volatile sideways market. And all three markets probably need different systems. You need to understand how to look at market type (in a way that fits how you trade) and only trade markets in which your system works well. Trading without a system (defined below) is a mistake. Not knowing how your system will perform in each market type is a major mistake.

4. You need a great set of objectives that fit who you are and then you need a position sizing™ strategy that fits your objectives. Position sizing is that part of your strategy that tells you how much to risk throughout the course of the trade. Most people don’t realise (again a mistake) that it is through position sizing that you meet your objectives. A great system just makes it easier to meet your objectives through position sizing. Not having objectives is a mistake. Not having a position sizing algorithm designed to meet your objectives is also a mistake.

5. You need to monitor your trading to minimise the impact of mistakes. This shows that, if you’ve completed all five steps, a mistake only results from not following your rules. Not having a plan in place to monitor and correct your mistakes also is a mistake.

How much did that cost?

When all is said and done, mistakes cost us money—either through not exiting a losing trade at a predefined stop-loss point, not taking trades according to the rules of our trading system due to some arbitrary or emotional influence on our thinking, or just doing things that should never be considered as viable or sensible trading decisions in the first place. All traders need to identify the point at which they accept defeat and cut losing trades as well as a way to monitor their overall performance based on the extent of these losses.

One of the cardinal rules of good trading is to always have an exit point before you enter into a trade. Not having an exit point is another mistake. This is your worst-case risk for the trade. It’s the point at which you would say, ‘Something’s wrong with this trade and I need to get out to preserve my capital’. Your initial stop defines your initial risk, which I call 1R (where R stands for risk). If you know your initial risk, then you can express all of your results in terms of your initial risk.

Say that your initial risk is $10 per share on a $40 stock. If you make a profit of $50 per share, then you have a gain of 5R. If you have a loss of $15 per share, then you have a 1.5R loss. Losses bigger than 1R will occur when you have a sudden big move against you.

Let’s look at a few more. If the stock goes up to $140, what’s your profit in terms of R? Your profit is $100 and your initial risk is $10, so you’ve made a 10R profit. It’s quite interesting because portfolio managers like to talk about 10-baggers. A 10-bagger means a stock bought at $10 per share that goes up to $100—in other words, a stock that goes up in value 10 times. However, I think a 10R gain is much more useful to think about and much easier to attain. When our 1R was $10 per share, then the stock had to go up by $100 to get a 10R gain. But to fit the portfolio manager’s definition of a 10-bagger, it would have had to go up 10 times the price you bought it for, going from $40 per share to $400. But the $360 gain in terms of R-multiples when your initial risk was $10 would be a 36R gain!

Thus, another cardinal rule is to have profits that are many times your initial risk. When you take a trade, if you don’t think you can make at least 2R (3R is better), then you are probably making another mistake. Your profits and losses should always be stated as some multiple of your initial risk, which I call an R-multiple.

In my opinion a trading system is defined by the distribution of the R-multiples that it generates. From that distribution, you can get a mean (average) value which is the expectancy of the system. If a system has an expectancy of 0.8R, on average over many trades, you’ll make 80 per cent of your initial risk in your trading system. Having a system that doesn’t generate a positive expectancy is also another major mistake—so is not knowing the expectancy of your system.

Now that you know about R and R-multiples, you can also start thinking about mistakes in terms of R-values and that’s where we’ve been doing some research.

Analyse to understand

I’ve been asking the traders that I coach to keep track of their mistakes in terms of R. For example, if you enter the market on emotion and you make 2R, then that counts as +2R towards that mistake. If you do it again and you lose 4R, you now have −2R towards that mistake. If you do that for about a year, you’ll have a good idea about how efficient you are as a trader and what your efficiency costs you.

One of my clients was a futures trader, running a $200 million account. We estimated that over nine months he made 11 mistakes, costing him 46.5R. Thus, he made 1.2 mistakes per month, costing him 4.23R per mistake. Overall, his profit was probably 50 per cent less than it could have been because of mistakes. If he made 20 per cent profit, he probably could have made 70 per cent profit. Now can you begin to see the impact of such mistakes?

Another client was a long-term position trader, primarily trading exchange traded funds (ETFs) with wide stops. In a year of trading, he made 27 mistakes costing him 8.2R. Thus, over a year he made 2.25 mistakes per month. However, because he was trading long term with large stops and no leverage, his mistakes were not as costly. Each mistake was costing him 0.3R. During the year of trading he was up 31R (and about 30 per cent). Had he not made any mistakes, he would have been up 39.2R. His mistakes cost him 20 per cent of his profits.

What are your mistakes costing you?

Oops, sorry, my mistake

Mistakes generally fit into two main categories: one broadly relating to overall market interaction; the other relating to everyday operational mistakes. A third category, execution errors, is also discussed in chapter 19.

The first main mistake category are ‘global’ mistakes—such as not having a trading system and not having a working business plan. Most of the types of errors I’ve mentioned so far are global mistakes.

The second category includes the types of mistakes where people break specific rules. Here are some of the most common that I’ve documented:

Of course, there are many more mistakes. The more common ones are detailed in this book.

Prevention is better than cure

The good news is that mistakes can be avoided. Through appropriate training and education, including reading this book, you can learn how to avoid the mistakes that the vast majority of people make. If you take the time to learn from the experiences of the contributors to this book, you will be a long way down the road of avoiding many of these mistakes. You can also practise not making mistakes through daily positive reinforcement of a non-mistake making belief system.

I recommend that at the beginning of each day you go through a process called mental rehearsal. Ask yourself, ‘What could go wrong today that might cause me to make a mistake?’ Suppose you have nothing to do because you’ll either be in your positions or get stopped out. Thus, you might decide that the only thing you might do that would be a mistake is to override your stops. For example, you might hear some guru on the television making comments on some stock you own and decide to sell and not keep your stop.

So when you come up with that particular idea, you rehearse how to avoid it. You could turn the television off. You could watch the television without any sound if you must look at charts and prices. Or you could go through some procedure where you neutralise any comments that are said about stocks you currently own.

The market always presents us with events that one would probably never imagine. We’ve recently had market volatility that is 10 standard deviations bigger than the norm. That has almost a zero probability of occurring if market volatility were normally distributed, but it is occurring. If you are not prepared to trade in this sort of climate, it could be a disaster.

Similarly, who could have imagined that the US stock market would actually close for a while because the World Trade Center was destroyed? Did you predict that one?

I recommend that everyone do a daily mental rehearsal by asking, ‘What could go wrong today to cause me to make a mistake?’ Become creative and think of everything. For everything you come up with, rehearse how you’ll perform to make sure that it doesn’t have a significant impact upon your trading.

One day you might meet that big losing trade in the markets that has your number on it. Wouldn’t it be a good idea to be prepared for it ahead of time? If you make one mistake in every 10 trades, then you are 90 per cent efficient as a trader. Increasing your efficiency from 90 per cent (that is, one mistake every 10 trades) to 98 per cent (that is, one mistake every 50 trades) could actually double your return rate or more.

First time it’s a mistake, second time it’s my fault, third time I’m an idiot

As well as being financially costly and emotionally devastating, repeating any mistake more than once is just plain stupid. But it need not be a part of your psyche if you choose to not make the mistake again, and if you choose to work through a process to review mistakes to ensure they do not recur.

Repeating the same mistake over and over again is a form of self-sabotage. And it’s one that anyone should be able to understand. At the end of each trading day, I recommend that you take a minute to review your trading and ask yourself, ‘Did I make any mistakes?’ If you didn’t, even if you lost money, then pat yourself on the back. You actually did well.

If you made a mistake, then look at the situation that led to the mistake. What happened that you need to look out for in the future? This is probably a mistake that you did not deal with in your mental rehearsal. You need to mentally rehearse the situation to make sure that you don’t repeat the mistake. Rehearsing your solution in your conscious mind several times puts it into your unconscious mind and helps you make an automatic response in the heat of the moment during the trade.

By the way, the daily debriefing and the initial mental rehearsal are two of my top tasks of trading that people should do each day. And you can probably see how valuable they are. Not doing them every trading day is another mistake—of the global variety.

Avoiding the blame game

Just like in life, trading is all about taking responsibility for every single decision and action you make. In the words of renowned trader and respected market educator Larry Williams, ‘trading is life personified’. You can get on with it, take responsibility for all your actions, and enjoy what you do, knowing that every decision you make along the way is yours to keep, and that you accept the responsibility for everything you do and everything that happens. You are 100 per cent accountable to yourself and others for all your actions. Or you can blame anyone else that happens to be even slightly associated with any of the negative outcomes that occur throughout life.

The most important trait that any trader needs is personal responsibility. It means that somehow you caused your results. For example, in our marble game, which teaches people the importance of position sizing, I use a bag of marbles to simulate a trading system. I typically use a system that is wrong about 80 per cent of the time so that we have big losing streaks but big R-multiple winners. The marbles are replaced after each trade so that the odds are always the same. My game typically has an expectancy of 0.8R and easily could have 10 consecutive losers in a game of 40 trades. Typically, you need to survive the 10 losses in a row to get the long-term expectancy, which is usually around 32R by the end of the game.

However, I usually have the same person pull out a marble (and then replace it) until that person pulls out a winning marble. Thus, any long losing streak in the game will be associated with one person. At the end of the game, I can ask of the people who went bankrupt, ‘How many of you think you went bankrupt or lost money because of this person?’ as I point to the person who was associated with the long losing streak. Many hands will go up; that’s what I call blame.

People go bankrupt when they practise poor position sizing. That’s the mistake. If you recognise this, then you are taking personal responsibility and you can fix the mistake. However, if you blame the person who pulled out the marbles, or the trading system itself, then you are not taking responsibility and you’ll probably repeat the mistake over and over again.

So people need the personal responsibility to recognise how they created their results, because it’s the only way they can be improved.

If you blame someone or something, it doesn’t fix anything: ‘It’s his fault’; ‘It’s a terrible trading system’. If you justify, it doesn’t fix anything: ‘It’s a stupid game’; ‘It doesn’t count’; ‘It doesn’t resemble real trading at all’; ‘It’s just luck and I was unlucky’. And even if you blame yourself, it doesn’t fix anything: ‘I’m a stupid idiot who keeps getting bad breaks’.

You must have the trait of always looking for how you produced your results. And when you do, then you can fix mistakes.

As a trader, you must take responsibility and accept that every action—win, lose or draw—is a result of your actions and decisions. If you can’t or won’t accept this, close this book now and go back to your day job—it’s that important.

Remember that average doesn’t cut it. It takes a lot of work to be good. You put a lot of work into learning your profession. Why do people think trading or investing should take anything less? Instead, follow the five steps that I recommended earlier.

Trading coach and author Dr Van K Tharp is widely recognised for his best-selling books, Trade Your Way to Financial Freedom and The Definitive Guide to Position Sizing, plus his outstanding Peak Performance Home Study Program—a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp, sign up for his free e-newsletter and download his trading simulation game at <www.vantharp.com>.