To buy or not to buy?

To buy, or not to buy? That is the question. Much like Stockguy22, I find my trading account much fatter now than it was at the beginning of the year. So what should I do with my early windfall? Should I look for a sweet ride like he did? Granted, my account is certainly not big enough to tempt me with a new Lamborghini, but check out these wheels! Decision, decisions, decisions. Of course I jest, as I have about as much intention of buying that monstrosity as Frank does of buying the Gallardo, but I wanted to write a post mirroring his to further illustrate the point he made about the importance of focusing on your approach to trading and not worrying about the size (or lack of) of your account. One of the biggest mistakes a trader can make is to become overly fixated on dollars instead of paying attention to the trading process and letting the results take care of themselves. This classic mistake often compounds itself by leading traders into making other common errors such as overtrading, taking subpar setups or exiting trades poorly in an effort to reach arbitrary dollar based goals. The best way to avoid this trap is to focus on the trading process instead of on gains and losses. Of course, the results of trades are important and should not be ignored, but they should not be used as a means of “taking score”. In fact, the best way to grade your trading is by judging how well you execute your trading stategy. If you do this correctly, the results will follow.

Take a look at the report card below. These are my results for the first quarter of 2011. These are the areas I focus on when taking trades. Notice that there is no grade for money made. That is the last thing I look at when judging whether I have traded well. For each trade I take, I grade myself on the four criteria that I have found are most important to my trading. Much like being back in school, I give myself a grade from four to zero which corresponds to the letter grades A,B,C,D and F. It is important to be honest with yourself when grading a trade and to not let the final result of the trade affect what grade you assess to it. For instance, just because you lost the full amount you risked on a trade does not mean that you did not earn straight A's, what is important is that you correctly determined and executed that particular trade. Conversely, just because you made a boatload of money doesn't mean that you deserve good grades on it as you could have made several mistakes such as chasing it or doubling down when it wasn't part of the original plan.

The first “subject” I grade myself on is Strategy. This is kind of a catchall for several tasks, the most important of which is choosing the correct setup for a particular trade and my ability to stick to the plan. Some of the questions I ask myself when determining my grade are: Did I choose the correct instrument for this particular setup? (should I have used common shares or options, and if options did I choose the correct structure.) Does my risk/reward structure match the probability of the trade succeeding. The most important part of this grade is my ability to stick to the plan and not modify it while I am in the middle of the play. This is important enough to warrant its own grade, but it is not typically a mistake I make, so I prefer to keep it as part of my overall strategy grade. As you can see on my report card, I graded out at 3.51, barely an A. I did a good job of sticking to the setups that work well for me, but need to develop new strategies in order to diversify my ability to attack different market scenarios.

The second “subject” I grade myself on is Sizing. This is often overlooked, but critical to trading success. Many traders take on too much size on their trades which forces them to trade nervously and freak out every time a stock corrects. On the other end of the spectrum, undersizing a trade can lead to a trader not taking profits or stopping out at the proper levels because the change in dollar amount is not big enough. My grade on sizing was 3.45, which would work out to a high B. The most common mistake I make on sizing is to take too small of a position on certain option strategies. I typically make this mistake when buying out of the money options. Because out of the money options often expire worthless, I tend to reduce my size on these plays, but I often go too far in this respect as I almost never hold to expiry and have had reasonable success in my timing.

The third “subject” I grade myself on is Entries. This grade reflects my ability to correctly time the entry of my trade using proper analysis of support/resistance levels, candlesticks and moving averages. It is also based on my ability to follow the guidelines for entry that each of my setups require. This includes properly recogizing technical patterns and incorporating multiple time frames when judging my entry. Some of the mistakes that earn poor grades are: chasing a breakout, jumping in before a candle confirms my entry on both breakouts and support plays, and taking a trade while it is in the middle of its range. While there are of course a million mistakes one can make in their entries, these are the ones I will typically make. My grade on my entries was 3.82, my highest mark for the quarter. This is typically the strongest component of my trading because I have rigorous rules I must follow for entering a trade.

The fourth and final “subject” I grade is my Exits. This in my opinion is the hardest and perhaps the most important component of trading. Afterall, you don't make or lose money when you enter a trade, that happens on your exit. This grade reflects not only my ability to honor the stops set in place when I first enter a trade but my ability to stick to my exit stategy as well. The most common and most dangerous mistake a trader can make is to allow a trade to fall below the stop loss, but a more insidious mistake often made by a trader is the early exit. This mistake is often seen as a positive because the trader is happy to be profitable in a trade, but more often than not, these early exits erode gains more consistently than losing trades do. As we can see on the report card, I earned a 3.27, my worst grade. This was due to a couple of bad trades in which I let a stock run through my stop as well as a few trades in which I scaled out before my targets were hit.

My overall grade for the first quarter was barely an A at 3.51. This is reflected in my returns as I was able to book 25% returns on my account over the first 3 months of 2011. However, there is definitely room for improvement. Had I graded higher on my exits, I likely would have booked about 40% returns in that period as I let two trades run below my stops and trailed my stop too closely on a third trade. These 3 mistakes alone held back my total returns by 10%! This is why it is important to review your performance on every trade you make. While you cannot control the success of your trades, you can control your performance, and traders should strive for behavioral consistency throughout each of their trades. Breaking your rules even once can lead to a huge drop in overall performance.

If you are looking to improve your trading(and really, who isn't?), a good place to start would be to implement a review process similar to the one I just positted. Honest self reflection will allow you to better understand both your weaknesses and strengths and is an important step towards improving your trade results. If you are truly interested in improving your trades I would highly recommend you join a trading group like the one we have at stockguy22.com. We have an incredible group of traders in our virtual trading floor that are practically printing money on a day to day basis. In fact, many of their gains blow away the results stockguy22 and myself have had over the last few months. As an added bonus, we are now offering four free hours of one on one mentoring to anyone that joins our site this month. If you are currently looking for ways to improve your trading, this is the perfect opportunity. Join today and help me help you!

 

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Posted in Commentary, General Trading