The Best Trader Ever

I used to work as a mechanical engineer, so I know a little about exhaust sensors from my old days. Last night, one of the big auto parts manufacturers announced that they had patented a device that would reduce emissions significantly while at the same time increasing power when used in conjunction with hybrid engines. I was excited and yet I wanted to contain my excitement so that I could trade profitably from this news. I pulled up a list of auto parts makers and automobile manufacturers. I decided that the play on auto parts makers was too obvious, so I looked at auto manufacturers who I thought would benefit from the new advice.

I found the winner - a large foreign car maker. But what about timing my trade? Should I buy at open, intraday, or at close? I decided to go for intraday. I took the day off of work and prepared the cash to buy options. I waited for just the right moment. At 9:30 AM the market opened and the manufacturer I chose gapped up 4%. I panicked a little, afraid that I had missed the bulk of the move already. As I gazed at the minute chart, the stock began to fall back down from up 4% to up only 1.5%. At that moment, I knew that the market had not properly priced in this information. Unlike the other market participants, I knew the value of this new device would increase the demand and profitability of new cars big time. They didnââ,¬â"¢t know it, but I did. So I watched the tape, and sure enough, the stock began to surge up 3% on a single 2-minute bar and up another 2% the falling 2 minutes. The stock finally closed at 64.97, up 10%, which was a huge move for such a large company. Later that evening I found out that the CEO of the same car company appeared on CNN and said that this chip would increase sales at the company significantly and the company was poised to eat up market share due to their already large market presence in the hybrid market. What a day! I made 300% on my money after the week was done just on this one stock. I have the instincts of a tiger and the courage of a mongoose! (continued below)

The Question You Should Ask Yourself

This story is awesome isn't it? Well it's completely untrue and I made it up. Listen to the emotions, the glamour, and the storytelling. Does it get you excited to trade and to use your own instincts as well? This story, like most big trade stories you will hear is glorified, glamourized, juiced-up BS! The truth of trading is MUCH less glamorous and only half as exciting on a normal day. Remember this and never forget it. The ego desires to appear sophisticated, and daring. But the point of trading is not sophistication, or excitement. We keep score on our profit and loss statements. So, therefore the key question to ask is, "what is the most effective way to trade?" You should ask yourself this question constantly. I have found that the most effective way to trade is to trade very systematically. Like I said, the ego desires discretionary decisions in order to feel intelligent and sophisticated (and not bored!). As such, many decisions traders make are based on clouded emotion rather than profitability.

Think on Your Feet

But do you have to trade like a complete robot? I don't think so. I suggest that you first develop a very rigid system. We have already spoken about how to do this in detail in past trendwatches. Find indicators that work and then use them to develop a system. But does that mean that you have to be a slave to the system? No. There are instances where you can indeed deviate from the system. But the key question is ,"what reason do you have for deviating from the system?". If you are doing something outside of the system, it has to be based on extremely sound logic or long-term historical data. If not, you are opening the door to make emotional, and sometimes costly mistakes.

If you haven't seen the movie Maverick, there is a scene where the actor Mel Gibson is playing poker at a big time tournament. They are playing 5 card draw and Mel draws one card hoping for a royal flush. He bets all of his money without looking at this card. He flips the card over and indeed he catches the royal flush. He had a good feeling about that card. But would most professional poker players do something like this? Absolutely not! The game is won on statistics and visual and audible observations. These are quantifiable just like the observations that we make while trading. There is the rare occurrence where a player thinks his hand is better than someone else's even though that player has a relatively weak hand. Strong players often do this when they think other players are bluffing. And yet, it is rarely a case of feel. Usually, players can visually observe bluffing players and thus make decisions that deviate from the usual system. This deviation is based on quantifiable observation and therefore it is an unemotional decision.

Take Action

Like a poker player deviating from his system, traders should also deviate from their systems when there are clear, quantifiable reasons why they should. For example, I was recently trading a security and I know that this security historically emerges strongly from oversold conditions. It usually takes between 1-5 days to work. So, 2 days after I entered the trade, I was approaching my stop loss price and instead of letting it trigger and sell, I removed the stop based on the fact that this move often takes days to manifest itself. Plus it works with a high level probability. Well, it turns out that it was the right move, made for the right reason.

Here is what you should do when developing a rigid system. Write a list of every possible reason that you would exit a trade. Think of everything including news items, earnings, market conditions, industry conditions, technicals, etc. Now that you have a long list of reasons why you would exit a trade, you are better prepared when one of these many events occur. Instead of reacting with emotion (like most traders), act with purpose because you have already planned ahead. In the rare event that you must "act on the fly" do so with confidence and only if it's based on very strong logic or long-term historical data. Be disciplined, and trade well.

Price Headley is the founder and chief analyst of BigTrends.com.