Trading Psychology: A Checklist Approach

The S&P 500 made significant gains in the first days of 2011, yet many market analysts and traders are bearish. The reasons vary and include worries about earnings or the economy but many feel that the market is headed for a fall. These bearish pronouncements seem to be business as usual. Last summer many of the same commentators expected a new bear market but stocks resumed their up trend after a brief decline. It can be difficult to maintain long positions in stocks when everyone seems to disagree with you, but the best traders ignore the headlines and follow their rules. Having a simple checklist to follow can improve your odds of sticking with a disciplined approach.

At any given time, a lot of the people calling for a top are probably seeking headlines rather than profits. There is no qualification test required to become a market commentator or a blogger, and anyone with an email address can use WordPress to offer market opinions. Some of the sites look sophisticated. One popular site performs a seemingly never ending array of linear regressions and proclaims that nothing ever works to their satisfaction. This site does book reviews using the Amazon free preview function, which is unfair to authors and readers.  In the end, many site visitors will believe what they read because the math looks so thorough. In reality, regression analysis is a technique that has some limited applications in the markets and should always be accompanied by several tests for trading significance. The best tests of whether or not something works in the markets is simply its profitability – if an idea makes money it is good and if it loses money it is bad. Concepts like r-squared and correlation coefficients can’t pay a trader’s mortgage. Yet, they can create subscription revenue for bloggers.

Traders need to ignore the headlines and opinions of others and focus on what the markets are actually doing. Many will find this to be among the biggest challenges they face in trading. It is natural to follow the market opinions of respected analysts. However, there is never a guarantee that any one will be right in the markets.

Bloomberg recently interviewed 88-year old Joe Granville who forecast a 4,000 point drop in the Dow Jones Industrial Average during 2012. Younger traders have probably never heard of Granville who once moved markets in a simpler time. Bloomberg summarized his record in the news article:

“Granville told newsletter readers to “Sell Everything” on Jan. 6, 1981. The Dow fell 2.4 percent the next day. He correctly forecast the bear market of 1977-78 and the burst of the Internet bubble that began in 2000. In March 2008, Granville said the Dow would end the year near 9,000, more than 27 percent below its level of 12,392.66 at the time. The gauge finished the year at 8,776.39.

His predictions proved less prescient during some of the previous bull markets. He failed to foresee the rally that started in 1982 and lasted for five years. He also called for losses in 1995 while the S&P 500 rose every year till 2000.”

Granville has had some amazing successes in a career that has spanned more than 50 years, but he has had some equally disappointing periods of performance. Followers would do best to evaluate his opinion as one of several factors influencing their own strategy. The same general idea applies to the work of any analyst since all of them are likely to have some great calls along with some bad calls.

How can traders avoid letting the news influence them? Discipline is the only answer, and a checklist could help instill discipline into the trading process.

– Follow a routine.
– Follow your indicators, and ideally trade with a set of rules.
– Follow the news, but as a hobby rather than as a trading signal.
– Research new ideas, but don’t act on them until after the research is completed.

This is a short checklist, and it describes the routine of almost any successful professional. A surgeon will follow a routine that is dictated by their schedule. In the operating room, the surgeon will follow their training (the equivalent of a trader’s indicators and rules) and use procedures that are dictated by the symptoms but they won’t really experiment with an unproven idea on a live patient. Many will talk to fellow surgeons about cases (an idea that is similar to following the news), but they will usually never second guess their own strategy. Most will also read the latest journals and attend continuing education (researching new ideas) but will only incorporate new procedures after careful evaluation and planning. Professionalism includes a number of traits, but discipline is always one of them.

Trading is a profession, even for those who only do it part time. If you are pursuing short-term gains in the markets, you are competing against full-time professionals who also have money on the line. Monetary gains are often regarded as the factor that distinguishes professionals from amateurs. In sports, professionals are paid to play. Unless you limit your market activity to paper trading, you need to think of your trading as a professional activity.

Professionals follow a schedule, and even a part-time trader needs to adopt a routine that allows them to accomplish everything they need to do in the markets. This includes checking account balances and trade confirmations, updating prices to check for required trades, and reviewing all open positions. These actions can be done once a day, and even once a week is enough for some traders, but they must be done on a schedule in order to ensure that the trades are being executed properly.

For traders, the idea of a rules-based trading strategy makes the whole concept of a market opinion into a hobby. This is an important step towards profitability. Systems can be traded with small accounts, and systems can be designed with spreadsheet software and freely available end of day quotes. The 20-day rule is an example of a simple and effective strategy that doesn’t require expensive software and can be monitored and updated in only a few minutes every day.

This strategy uses only closing prices to determine whether to buy or sell and works well with futures. It is always in the market, long when prices reach a new 20-day high and short when price falls to a new 20-day low. It can easily be set up in a spreadsheet and traded with accounts as small as $1,000 on a single Treasury note contract.

The problem with a market opinion is that it often creates a mental hurdle to trading. If I tell my friends and family that I am bullish on the S&P 500 for the next six months, they expect me to be buying stocks and holding on to them for at least the next six months. Traders need to react to the market and focus on making money rather being right. A market opinion is less important than trading profits. The problem for most traders is that once they make their opinion public, it becomes a driving factor behind their trading.

The news is interesting, but markets don’t really move higher one day because the price of oil is up. Intermarket relationships change with time and oil may in fact exert a long-term trend that influences stock prices, but no single event usually makes a market go up or down on a given day. News can be quantified and incorporated into a system.

Traders could research the idea that today’s move in oil forecasts tomorrow’s stock market. This idea is easily tested (and in my experience it is practically worthless). Intermarket relationships can be set up in trading software and simple relationships can be evaluated with a spreadsheet. Once the trader has researched the idea and quantified the results, they can incorporate the successful strategies into their trading.

Trading strategies can evolve over time, if the data shows that the new idea is worth using. The news and opinions of others can inspire testing, but disciplined traders will never place a trade based on someone else’s work. Trading psychology is important to winning and these four simple steps can help keep you on track to profit from the markets.

Michael J. Carr, CMT