Tips for Improving Your Trading Psychology, Part III

4. BIAS IS FOR THE NEWS MEDIA, NOT TRADERS

One of the items you should have on your trading checklist is whether your transaction is an investment or a trade. It's difficult to overemphasize the importance of knowing this before you hit the buy button on your platform.

If you choose to buy a stock and deem it a trade on your checklist, then keep it as such until you close it out. Never, never, never let a trade turn into an investment. When you do, it leads you into falling in love with a stock and that, in turn, leads to stubbornness and bias.

When you are biased, your mind slips into rooting for a stock and ignoring price action. Cheering as if you were holding a beer and wearing a giant foam finger is living in Fantasyland. Price action is reality.

In this day and age of extreme market volatility, bias can absolutely level your account. Here's how it can happen:

Say Trady McTrader believes KLM Corporation has good support at $40/share with favorable moving averages. His research shows it could hit its upper band at $42 and plans a stop-loss at $39.50 in case his technical analysis should be proven wrong. That's a 4:1 risk/reward ratio. He buys 500 shares, risking less than 2% of his trading capital. To this point Trady has done everything right.

A few days later KLM has moved up to $41.92/share and he's already pleased with his acumen. He also hears a news report that KLM is set to expand into new markets in the coming five years. The market Cupid just shot an arrow straight into his heart. He's now thinking of abandoning his initial upper target and letting it roll a bit longer. In fact, McTrader buys another 500 shares, this time on margin. Now his average price is almost $41/share.

Well, as it turns out, savvier traders already modeled KLM's expected growth into the price of the stock and it actually went down the next day. And the next. And the next. All the way down near his initial stop of $39.50, which he never raised despite his average price having risen. He's now around $1500 in the red. Trady's spirits are low but he's convinced himself that KLM will rally and he will more than break even. He now commits the cardinal sin of short-term trading: he takes off his initial stop-loss.

After a few days of gyration in KLM, weak S&P technicals bring all stocks down violently. KLM falls down to $36 that week and Trady is too depressed to even look at the charts. He couldn't sleep a wink and, as he tossed and turned, he decided he would sell at the market price the next day. The pain of a $5000 paper loss was too much and he finally capitulated and got out with a small bounce to $36.50. But he did not take notice that the technicals of both KLM and the S&P both improved and he misses a huge wave that brings KLM up to $47 within the next two months.

Trady McTrader tried to serve two masters by trading and investing at the same time. As such, he had neither the conviction of a long-term investor nor the nimbleness of a short-term trader. His mind became addled with stress and confusion and his decision-making suffered.

Every trader has had a moment like this to a varying degree. I know I have. I'm reasonably sure a similar thought-process occurred in the mind of the rogue trader fellow who lost $2 billion for UBS recently. Whether it's the loss of a few hundred dollars or a few hundred-thousand, many traders with great potential never recover from such mistakes.

Now you can see the importance of having a clear and consistent mind from the time you enter a trade to the time you exit. A savvy short-term trader understands that his mind will play tricks on him every moment his money is tied up in a trade. To him a stock is just a piece of paper, unworthy of love. Love your wife and kids more by not having to explain why you lost a large sum of hard-earned cash because your infatuation with a stock led you to ignore your stop-loss.