Sunday, 20 April 2014

The Four Types of Trades

First, I encourage you to remember that the market can go up, down, or sideways, in any time frame, and it is out of our control. We all know that.

But there are things within our control. Trading what, when, and how much are within our control. Our P&L is at the intersection of what is within our control and not.

In order to navigate this busy intersection, it’s helpful to think of four possible types of trades or trade outcomes.

Type One:
The first type of trade is when you execute on your edge, your thesis, or your plan and the outcome is positive – you make money. The trade is in synch with the market – or as one of my clients says, “The market cooperated”. Everyone’s favorite type!

Type Two:
The second type of trade is where you execute on your edge, your thesis, stick to your plan and the outcome is negative, you lose money. For whatever reason, the market did not cooperate. We know there will always be a number of these type two trades. Good traders not only know this, they accept it as part of the business.

Type Three:
The third type of trade is when you do the wrong thing – you veer from your edge, forget your thesis, or ignore your plan and the outcome is negative – losing money. This is the trade we look back on after the fact and say, “Why did I do that again”! And often you can see pretty clearly, after the fact, what you ignored or minimized during the trade, when you were caught up in trading your P&L more than the market.

Many traders experience this type of trade, but the better traders have much fewer. The better traders learn from their type three trades. They learn about the market and they learn about themselves.

Type Four:
The fourth type of trade is when you do the wrong thing, ignore your plan, but the outcome is positive. Examples of a type four trade include an impulse trade that pays off, or doubling down on a loser, or holding a loser far too long (incurring opportunity costs along the way) until it finally turns into a winner. Type four trades are an example of getting rewarded for the wrong behavior. Type four trades have the potential to be the most dangerous type of trade with respect to your mind.

Type four trades are an example of variable, or random intermittent reinforcement, getting rewarded randomly. Psychologists have long known behaviors rewarded with random intermittent rewards are among the most difficult behaviors to extinguish.

A great example of this is the obsessive or addictive behavior seen when some people play the slot machines in a casino. On the behavioral level they are responding to a variable intermittent schedule of reinforcement. On a biological level, the brain’s neurological reward circuits involving biochemicals such as dopamine are very active; creating a neuro-behavioral system that is difficult to break.

High performing traders don’t want to reinforce bad habits. I know this from working with many elite high performing traders and portfolio managers. The best traders learn to do more of what works and less of what doesn’t. That’s how they become great and remain great.

The place to start is by tracking all your trades and categorizing them into these types.
Extracted  article from

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