Dear Diary: Why is it that individual traders routinely get the shaft?

This is a question I wrote in my trading journal nearly 15 years ago. Although a diary is typically associated with a teenage girl who has just discovered her true love in third period French, it is actually a very important tool of self-discovery for the trader. This is especially important for individual traders.

Like hungry cats turned loose on a rat farm, individual traders, unlike fund managers, are unsupervised and have the freedom to act unchecked in any way that they choose. Unfortunately, this kind of freedom reinforces bad habits. The biggest mistake these traders make is a common yet fatal affliction that plagues nearly all traders—they are trading to make money. Trading to make money? Isn’t that what we as traders are supposed to be doing? You would think so. However, look at it this way; traders certainly place their orders with the idea of making money. But what are most traders doing? They are losing some serious cash. So if trading to make money doesn’t work, what perspective should we be trading from? What mental shift is required to stop us from nibbling like sparrows and defecating like elephants?

My Worst Trade Ever
It is with these thoughts in mind that I recall my worst trade ever—the trade that beat me upside the head with a 2 x 4, snapping me awake to the realities of trading. It was this trade that made me realize that I had to adjust my mental perspective so that I could do this for a living. In the early 90s my wife and I were recent transplants to Roseville, Minnesota. We moved there from Austin, Texas in September. To say that we were unprepared for the coming brutal winter is like saying China seems to have a slight appetite for copper and cement. Of course we should have known we were in trouble when we saw a sign at Target advertising a sale on fleece underwear. Ah, hindsight.

We started that winter in an apartment where we had to park our cars outside. By the time February rolled around it took us about 30 minutes to get psyched up enough to venture outside in weather sporting wind chills of 70 degrees below zero. And that was just to find out whether our cars would start—most of the time they did not. About the time we had exhausted the rental supply at Blockbuster, we decided it was time to take action. We needed a house with a garage—a heated garage—and we needed it now. We found one quickly and put in an offer at full price. It was accepted just as quickly and our dream of thawing out began to unfold before us.

A Stroke of Genius?
At the time I had been trading for a few years part-time and had built up a trading account to just over $150,000 trading options. My plan was to take $30,000 out of the account to use as a down payment on the house. As the closing date approached, I was struck with a brilliant idea. Why not just make a few extra trades and create the $30,000 needed for the down payment out of trading profits? That way I could keep my $150,000 trading account intact! Truly a stroke of genius.

I put on the coffee and reviewed my charts for hours that night. I looked at multiple time frames and countless indicators. The hours of study drew me to the same conclusion time and time again—the major stock market averages were approaching solid resistance levels. I therefore made the one deduction that was abundantly clear to me: To buy OEX puts aggressively the next trading day.

The next morning, primed and ready to go, I placed my order and then went to my day job. I was able to get quotes at the office, so I would periodically check to see where the markets were trading and whether or not I had been filled. Around lunch, the markets had drifted up to resistance and I was filled for 100 OEX puts at $8.00, or $80,000. The markets consolidated for a while and edged up just a little higher, driving down the price of the puts to $7.00. Unable to resist this bargain, I went ahead and bought another 100 puts, putting my entire account into this one trade. I calculated that a move of just two points in the option price would get me my house money. Needless to say Einstein would be impressed.

The next day the markets did an odd thing. They opened higher. Even more unusual, they continue to move higher through mid-morning and into lunch. And strangest of all, the markets closed at their dead highs on the day. I was a bit perplexed, but at the same time I had confidence that the trade would work out. After all, I just needed to make the $30,000 and I would be done. If the market went against me a little, then it just meant that it would take a few more days than I expected for the trade to work out.

The Pain of Loss
At this point, we all know that this story will not have a Hollywood ending, so let’s cut to the epilogue. The markets screamed higher for the next four trading days in a row. Unable to take the pain any longer, I finally called my broker and begged him to close me out. I got an unimposing 75 cents for my puts, leaving me with $15,000. In just four days I had caused $135,000 to vanish into thin air. It took a few moments for this to sink in. I had just blown out my trading account. Worse, I wasn’t going to have enough money to meet the down payment on the house. I tried to console myself with thoughts like “At least I’m not part of the first landing wave on Omaha Beach.” Or, “At least I’m only 22 and have the rest of my life ahead of me.” It didn’t work. Omaha Beach actually sounded more appealing. Of course, I did what any rational person would do in this situation—I got cash advances on my credit cards so I could buy the house, and I sure as hell never said a word to my darling wife. (I’m obviously playing the odds here that she won’t read this article.) I didn’t trade again for six months. Let’s fast forward to today.

A Different Time
Today is August 8th, 2006. I’m looking at the markets this morning to see how everything is setting up. It’s one of those “interesting trading days” as the Federal Reserve’s FOMC announcement is at 1:15 p.m. CST, just three hours away. I know most of the markets will be quiet up until that time. The night before I viewed my daily charts in various markets. I generally look at about 30 charts each evening—the stock index futures, metals, energies, grains and currencies. There were a few things that stood out to me the night before. First, the currency pair New Zealand/U.S. dollar (NZD/USD) is trading just under its 100-period exponential moving average (EMA). It’s tested this level four times now and this time I’m looking for a break out up and through that 100-EMA. The main reason for this has to do with a bullish divergence in the 14-period RSI. See Figure 1.


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Before I went to bed I placed a bid just above the 8-period EMA (about 15 pips) at 0.6238. I placed a stop at 0.6196, which is mostly a money management related stop. My target is the 1.272 percent extension of this move higher, which is 0.6380. I always like to get “in front of” my targets, so I place an order to sell at 10 pips below at 0.6370.

Going Through The Ropes
I wake up to find that I’m filled, and it’s currently trading at 0.6254, up about 16 pips from my entry. I’m aware that the FOMC meeting is today so the markets could get very volatile. I move up my stop to 0.6222 and leave my target. Although I don’t trade heavily during FOMC day, I don’t mind having a few smaller positions on as long as the chart setup is clear. I find that many times prices will move up to and pause at a logical technical level on a chart just before a major economic announcement—and then the announcement will cause the chart to continue along its technical course.

The next chart that caught my attention in my nightly review was a daily chart of the CBOT’s mini-sized Dow contract (YM). In looking at the chart, (see Figure 2), I can see a very clear triple test of the 11,330 area. Last Friday, August 4th, the employment numbers came out softer than expected, and the markets exploded higher on the anticipation of a pause in the interest rate cycle. However, that strength was short lived and the markets sold off hard later in the day. Now we are hovering right under that key 11,330 level. The slow stochastic is rolling over and its looking like a sell-off is setting up.


click image for larger view

For the YM trade I don’t place an overnight order as I did with NZD/USD. I want to wait until the next morning to see where the market opens and use the pivot levels to get into a short trade. For this I will wait until after the cash market opens at 9:30 a.m. CST. Once the market opens, I go short on an early rally to the daily resistance one (R1) pivot level at 11,295. I place a stop at 11,315, which is my standard 20-point stop when using pivots. However, in this case I actually want to hold through the FOMC announcement so I don’t place a target. Because of the chart set-up I viewed the night before, I like the prospects of a downside move after the rate hike. I might be right. I might be wrong. Like pulling the handle on a slot machine, I acknowledge that I don’t know what the market is going to do next. My stops are in and there is nothing to do but wait.

The Waiting Game
It’s now 1:11 p.m. CST and the announcement is coming in four minutes. Both positions are currently moving against me. The YM is rallying into the number release—it’s up about 20 points here in the last few minutes, up to 11,275. NZD/USD is falling and is down nearly 20 pips in the last 10 minutes.

On a side note, I have been on a water kick, drinking 100 ounces of water each day with no caffeine. No coffee, tea, sodas, etc. I’ve been doing this for about three weeks now. It was tough to do initially and I felt tired frequently, but for the last week I have felt a lot more consistently energetic and I sleep better. I say this because I’m getting up from my desk just before the number is released because I have to pee.

Ok, I’m back. The rates were left unchanged. After 17 consecutive rate hikes the Fed has finally decided to step back and see what exactly it is they have done to the economy. In looking at the charts, NZD/USD is rallying hard as the dollar collapses and I’m now up over 50 pips on the position. The YM, however, is also rallying. Before the announcement I was up about 20 points and now we are at 11,305 and I’m down 10 points. My stop is still in place at 11,315. There is nothing to do here but wait.

A few minutes have gone by and the markets are now reversing. The dollar was collapsing and now it is firming and back to its highs of the day. NZD/USD is off now, trading at .6270, still decently higher from my entry. The YM is collapsing and is now down over 80 points. Ticks (a technical indicator reading) are reaching -1,000 levels now which is an extreme reading, so its time to cover. I get out at 11,204 for +101 points. (This is something I always do on my day trades. If I’m long and I get a +1,000 tick reading, then I use that as an exit signal, and vice versa.) The dollar continues to strengthen; however NZD/USD is holding up pretty good. Neither my target nor my stop has been hit so there isn’t much to do now with this trade except sit on it. If it can close higher by the end of the New York session, I will raise my stop to breakeven on the trade. Unlike the stock indexes, there aren’t any “internal” readings I can use in the forex markets such as ticks to let me know of any good spots to exit a trade. For the YM, it’s consolidating near its lows but there isn’t anything I want to do with it here. Once the FOMC announcement hits, it generally takes about 30 minutes for the markets to calm down as traders in various states of panic wind down the trades that they made “instinct.” I’m calling it a day.

A little later in the day NZD/USD sells off and come down to exactly my stop. I get stopped out for -16 pips. It of course then goes on to rally over 100 pips. But since I’m trading from the perspective that I have no clue what is going to happen next, I simply move on to the next trade.

Keeping the Cash
Ok, back to the question—if we aren’t doing this to make money, what are we supposed to being doing this for? After my blow-up trade I didn’t do any trades for six months. I spent time with other traders, and read books like Mark Douglas’s The Disciplined Trader (Prentice Hall Press, 1990) to figure out what screw was loose in my head that would allow me to get myself into the situation that I did. I knew I could make money in the markets, but keeping it seemed to be a problem—and “keeping it” is certainly a key issue for anyone hoping to do this for a living.

The net result was that I realized I had to change my perspective on what it meant to be a trader. I had already found that “trading to make money” was just courting disaster, as it automatically jump-started in me all of the bad habits losing traders have. Even if my OEX put option trade had worked out, it would have only been a matter of time before I had a blow up. What finally sank in was that when I focused on the setups and not the money, I actually made money. But when I focused on the money and not the setups, money screamed running from my account. So my change in perspective was this: Instead of trading to make money, I was now trading to acquire trading skills. This perspective shift automatically kicked in the habits that most winning traders share. Letting profits run. Looking at trading as a “series of trades” instead of placing too much emphasis on each individual trade. Cutting losers off at the knees. Realizing you never know what the market is going to do next, so to position size and use stops accordingly. We’ve all heard these rules before. We know about them. But if we are trading from the wrong perspective, we will automatically override them and will only realize it after the trade is over.

So in closing, dear diary, I thank you for being there so that I could record my state of mind during my disaster trade. Had it not been for you, I would have undoubtedly been plagued with additional disasters, and my relief sought not in a book on trading psychology but a bottle of Jack Daniels. Without you, I would never have learned to shift my perspective so that I could do this for a living.