Let’s see if you can tell what the trader in the following scenario did wrong.
An excited trader sees a good play setting up on an intraday chart. All the pieces seem to be falling into place, an intraday pullback with good volume characteristics, at support, a tight intraday stop, etc. And all the market indicators are coming alive after an afternoon of sideway consolidation on an exceptionally positive market day. Then… BAM! The entry price gets triggered. The trader executes and gets filled. After a brief pop, the stock abrutly falls back, giving up its short-lived gain, and is now hovering around the entry price. “What happen?” the trader thinks.
With its late afternoon rise now totally evaporated, the market is clearly weakening. His stop now is just a tick away, the trader starts examining the stock, looking for clues as to why this perfect setup is going south. After checking for any news item (there is no news), the trader checks the daily chart. “Yes. The daily chart looks good. Really good,” he observes. “I’ll just move the stop down under the day’s low. Yeah. It shouldn’t break that!” Ten minutes later, the new stop is violated as the perfect setup heads down to south, taking his with it. Frustrated, the trader cashes out and can’t believe how much was just lost.
Where did this trader go wrong? Was it that the trader ignored the developing market weakness? Not exactly. The trader made three deadly mistakes of:
- Switching Time Frames. Having picked and played the setup on a completely intraday basis with an intraday entry point and a tight intraday stop, switching to a daily chart and adjusting the stop based on the daily completely altered the original play, skewing the original risk/reward ratio against the trader.
- Planning the trade and failing to trade the plan. Sticking to the original plan – whatever the timeframe – is absolutely essential. Failure to trade the plan puts you at the mercy of the market and erodes the self-confidence necessary to trade effectively.
- Rationalizing. The psychological root of the other two mistakes, rationalizing a change of time frames or plans is a form of denial – a denial of the reality of what’s really happening.
If you ever hope to approach the market with intelligence, planning each one of your trades is an absolute must. Most losing traders are flying by the seat of their pants, without any knowledge of how to even construct a trade plan. However, planning your trade and then failing to trade your plan is a greater crime. Because most people tend to be overly optimistic by nature, they have a hard time bringing closure to any event that will leave them with a loss / or pain. When the time to act arrives, many can’t summon the resolve and courage to cut their losses. So instead, they begin a process or rationalizing. This process of talking one’s self out of correct action eventually winds up taking the trader completely out of the game.
How to eliminate the Sin of Rationalizing
Eliminating or keeping the process of rationalizing in check can be done using the following two steps:
First the trader must realize they are rationalizing. Key signs that you are talking yourself out of an action are
- Asking “why” a stock is acting a certain why. The reason behind a stock’s behavior should have no bearing on a trader’s planned course of action. If the plan was to exit DBS on a drop below $20, finding out why the stock has dropped has no value. The trader’s correct course of action is to exit first, ask questions second.
- Checking for news. Saying abreast of news on a particular stock is not a bad thing. However, when the real purpose behind checking the news is to postpone an action that was planned, it is nothing more than an exercise in escapism.
- Thinking in terms of “maybe”. Whenever a trader starts using the word maybe when called into action by a stop or a target, uncertainty has been given the upper hand. It is nearly always better to adhere to a trading plan that has been put in place in advance, than opting to change in midstream.
Once a trader has spotted the signs of rationalization, the only approptiate action appears below
Exit the position!!!
This may sound harsh but my many years of experience have convinced me that rationalization leads to harm more often than it lead to good. If you find existing the entire position difficult to do, then at least lightening the load by selling half should be done. In short, if you are trying to find a reason to stay in a position, it is obvious no reason is apparent. Searching for a reason means you don’t have one. And a trader who’s in a stock without a firm reason will be a losing trader.