When does too much of a good thing become a bad thing? When does something helpful actually turn harmful? I believe the stock market is the greatest opportunity available today. Where else can the average person invest in new emerging trends and the innovations of geniuses? But the question I pose today is, when does trading become harmful and actually an impediment to financial success? Let's take a look at two traders to see how too much of a good thing can turn into a financial nightmare.
Trader A and Trader B both start out with $100,000 accounts. They both decide to track their equity curves over an 18 week period. Trader A begins with a winning trade of 10% but then loses 8% on each of his next two trades. His account is down $6,896, or 6.9%, after three weeks.
Trader B is a little more talented. He cuts his losses at 5% and has a bigger winner than Trader A. He's off to a good start and is up over 1% after three weeks.
Our stock market aficionados take two different paths. Trader A realizes that he has been trading poorly, and the market is showing signs of weakness. He decides to sit out for the next few weeks until a strong uptrend develops. His account remains unchanged. He is still down 6.9% and close to $7,000.
Trader B takes a different course of action. He believes he has to trade every day. Emboldened by his recent success, he continues to trade. After a few losses, he doesn't get worried. He's cutting his losses at 5% and not in a serious drawdown yet. However, as the losses start to pile up, he gets agitated and his ego gets involved. He just can't accept that his account is down in value. He reasons if he could just get one big winner, he can return to equity highs. The market, however, has different plans. Trading in a relentless market, he digs himself an even bigger hole. His account, and most importantly his psyche, are both severely damaged by the time we get to week 11.
You may be thinking. This example makes no sense. Who could possibly have a string of ten losing trades or in this case ten losing weeks in a row? I beg to differ. There are many episodes in history of a long string of losses playing out in games of chance. In 1913, a game of roulette at the Monte Carlo casino saw black hit 26 times in a row. Fortunes were lost as gamblers bet on red, believing it was likely to hit on the next spin. I've had weeks like Trade B did, and sometimes it can happen on both the long and short side. For instance, after experiencing a few longs being stopped out, a trader may reason it is time to go short. He puts on a short position and what do you know, a short selling rally ensues which forces him to buy back his position. Now, he thinks the bulls are in charge and decides to start buying again just for the cycle to continue. I tore up my account in a whipsaw environment like this in my second year of trading.
Now, the market has its' ebbs and flows, and it starts to trend upward in our example. Trader A decides to take some trades. He's still cutting his losses at 8% and taking profits at 20%. While he is still not trading a 3:1 risk to reward ratio like we'd prefer, he is up over 23% over the last seven weeks.
Trader B recognizes market conditions are now in his favor. He buckles down and plans to take advantage of a hot market. He's pretty good at cutting his losses at 5% and usually takes profits at 20%. Trading at a 4:1 reward to risk ratio allows him to make pretty good progress. He's up over 40% over the last seven weeks of our experiment.
But it's not only about the last seven weeks. So who came out ahead?
Trader B is really frustrated. He spent so much time screening and trying to find trades. He's had a phenomenal last few months but is down since he started tracking his equity curve. If only he could make some more trades, then he'd be back at new highs!!!!
Trader A knows he's not perfect, and there are things he can improve on. But he's happy to see his account making progress.
There's a lot of things Trader A can do to improve. However, by sidestepping a difficult period in the market, he drastically outperforms Trader B. Trader B looks like he has potential. He clearly has talent as exemplified by his ability to return 40% in such a short period of time. However, his inability to step away from the market and constant need to trade does him in.
I've been lucky enough to learn from some of the top traders in the world. When looking at their equity curves, one thing always stands out to me: they go flat. When the market gets difficult, they move to cash. They don't try to short. They don't bottom fish. They don't day trade. They go flat. Doing this is what makes them great. Take a look at Trader A and Trader B's equity curves. You can see the genius of Trader A in knowing when to take a step back. While Trader B's chart looks like a roller coaster, Trader A's is calm. What's interesting to note is that these equity curves most accurately describe both traders' mindsets: A is calm, steady, and collected, while B is emotional, volatile, and unhinged.
Even if we give Trader B a few weeks of wins, it doesn't matter if the trend of his account is still down. Sure, he gets a win here and there, but his refusal to go to cash during a market correction does him in.
Just for fun, let's say Trader B learns his lesson. He now understands the power of sitting out. What would his account look like if he just took a vacation while the market corrects? Maybe he decides not to trade. Maybe he takes a trip to Hawaii. Maybe he decides to take up ballroom dancing. It doesn't really matter. The key is, he's not trading in a correcting market and has given up his need to overtrade.
Wow, what a difference less trading can do! Sometimes, less really is more. The change is evident in his equity curve. In fact, he's probably less stressed out as well being that he didn't put pressure on himself to try and fight a down trending market. And it's all right there in his new and improved equity curve! Look at that straight line from week 4 to 12. Have you ever seen anything so beautiful?
Don't beat yourself up if you are an over trader like Trader B. Many suffer from this disease. I myself have struggled with this. But it is crucial to understand the dangers that overtrading present to a trader, both psychologically and financially. This is tale of two different scenarios. One which is the epitome of a winner and one which is a warning. Those who feel the need to trade every day pay a heavy price, literally.
If you are having difficulty with your trading, scale back. Trade a drastically reduced position size or go to cash. And if the market is not acting right, or is in a downtrend, step away. Sometimes people who come from other professions get confused. In sales, more sales leads to more money. In football, more touchdowns often leads to more wins. But in trading, does more trading lead to more money? The truth is actually far different. In fact, there is such a phenomenon as too much of a good thing becoming something bad. The conclusion is simple: too much trading kills the trader.
Risk right. Sit tight.
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