Trading and the second marshmallow

By John Piper

¬†One of the difficulties with trading is that the rules change as you progress. The novice must learn to cut losses and not much else matters at this stage. Once that rule is ingrained, it is down to running profits. But if you try and run profits at the ‘cut losses’ stage you will have a lot of problems.

Another of the difficulties is that many traders break the rules and win! But this can be disastrous, because the market is bound to catch you out if you follow the wrong rules. Trading has a logic of its own. If you allow losses to run, the logic is you will be wiped out. Over many different trades the market will exploit any weaknesses in either the trader or his/her system. Statistically a few ‘bad’ traders will do well for a while – but not in the long run.

1. Reduce position size to the point where you are comfortable.

It may seem odd that reducing position size is my number one idea for making more money, but it is so. Many traders put themselves under excess pressure, by doing so they are prone to make bad decisions and they lose money. So reduce position size and make more money!

2. Consider using option strategies – don’t limit your options!

Options have a lot of plus points, and have a part to play in your strategy.

3. Find a trading mentor.

Trading is a very difficult business. Not least because it is a zero sum game. NO, cancel that – it is a negative sum game, because every time you enter the game you pay commission, not to mention all the other expenses involved, price feeds, computers, software, etc, etc. With futures, the amount every winner wins is paid for by all the losers, but all participants pay commissions and the other costs. So in aggregate it’s a negative pot. It’s no surprise so many lose.

If you need help with your trading, find someone who has experience to help you. Ideally a local trader – many are prepared to help because trading is a fairly dry business with little meaningful human contact. Otherwise you may need to find a professional who is willing to help but he may well expect to charge a fee. I do this myself, but your best bet is to try and find someone who is local to you.

4. Use stops which have some meaning.

Not all traders use stops and by not using stops everything becomes a lot simpler because you get wiped out fairly quickly. Actually that is not totally true but it is true for some, if not many. But if you are using an approach which does utilize stops then try and ensure your stops have some significance, otherwise you tend to be throwing money away.

5. Understand the logic of your trading approach.

Every approach to the market involves risk. As a trader, you must control risk, just as a tightrope walker learns to live with imbalance. Understand the logic of your approach and the risks you are taking, because that risk will come home to roost. In one sense the market is a generator of random sequences, especially if you follow a precise algorithm. If you or your approach has a weakness the market will find it in one of those random sequences.

6. Let profits run – wait for the second marshmallow!

Unless you let your profits run you will never cover your losses, let alone come out on top. You must also cut your losses. Most traders learn to cut losses quite easily but have trouble learning to run profits. This is not surprising. Cutting losses is an active function requiring careful monitoring of what is happening – it requires action. Running profits, in contrast, requires inaction, and doing nothing can be tough. In modern society we are used to quick gratification. We want our goodies and we want them now. The same goes for trading profits: once you see them, you want them – but you cannot have them if you want to let profits run.

The book Emotional Intelligence describes an experiment in which a child is left in a room with a marshmallow and told that if he does not eat it, he will receive a second marhshmallow. Apparently this simple test is a far better guide to success than any number of intelligence tests. It is also exactly what traders must do if they want to let profits run, so don’t eat that marshmallow and you will get two!

7. Be selective

There are so many keys to success but I feel this is the one that separates those who make lots of money from those who just get by.

8. Don’t predict.

Market action is not predictable. A trader does not predict action – he takes calculated risks. He risks a little to make a lot.

9. Don’t panic.

This is critical. Panic is mother to losses. Part of this is not putting yourself under undue pressure. The more relaxed you are, the less likely you are to panic.

10. Be humble – big egos cost a lot to run!

A person who is full of himself has no room for anything else: he will not listen, or learn. A trader who is not humble may not listen to the market and will get wiped out. I suspect we have all heard stories of macho traders who take on the market and get turned into mincemeat. I believe humility is an essential for trading success.