Learn How to Trade – Introduction

Trading is not gambling, although some of the Game Theory mathematics that applies to gambling can be of some use in trading. Non-professional gamblers will generally not make good traders unless they approach trading differently than gambling. Professional gamblers sometimes approach gambling with a careful study of the game they are playing and Game Theory mathematics to get consistent results; these gamblers can be good traders. Trading may trigger some of the same addictive reactions that gambling does in some people but not for me. I hate to gamble but I love to trade. I view most forms of gambling as a waste of money but I view trading like a great game of golf. When I go to Las Vegas I see a lot of people putting their money on bets without really knowing much about what they are doing. They are untrained in the proper techniques that are needed to win at what they are playing. The casinos take their money without much difficulty. If one of these Las Vegas gamblers turns to science and becomes skilled at it then they will be permanently thrown out of the casinos. People who approach trading the way they lose money in Las Vegas are just throwing their money away. Being a trader is being a skilled professional.

However, trading is like being a skilled sports professional rather than a typical skilled craftsperson. A skilled craftsperson gets it right nearly every time in that his success rate is near 100%. If you play a professional sport you would not expect to achieve such high success rates, just having a winning season is often cause for much satisfaction. Once you know how to trade you can expect to achieve 57-59% winners. However, learning how to trade is learning how to accept your losses as well, which are 41-43% of your trades. Losing 41-43% of the time is not always easy because the losses are not always distributed evenly. There are times when you will have nine losers in a row and you still need to keep your cool and be confident that you know how to trade the next trade. You need to trade with careful risk management so that when you have a string of sequential losers you don’t blow out your account. We will discuss proper risk management many times in this how to trade series because it is very important to your ultimate success. Most people who are unfamiliar with risk management strategies such as the Kelly Strategy will risk too much. Forty PH.D’s were asked to play a gambling game where they would be guaranteed to win 60% of the time but at the end of 100 rounds only two had more then they started with because of poor risk management. You can get everything else right and still lose money unless you manage risk correctly.

Learning how to trade is easier than many highly skilled professions but you will need to do your homework before you trade real money. Paper trade first and only after you have mastered paper trading should you slowly transition to real money (mixing some paper and some real). Paper trading today is done in an electronic simulation environment, not with real paper.

When you trade you must do what needs to be done even though you may not want to do it. Human instincts are often wrong and you must learn to resist these feelings that will lose you money. The way probability works is important to trading but is different than your natural instincts will lead you to believe. The Gambler’s fallacy, also known as the fallacy of the maturity of chances is the belief that your odds improve when an unusual series of losses occur or that your odds of winning rises when you have a losing streak. Some slot machine players will prefer slot machines that have not paid out in a while in the belief that the chance of a payout has now improved. Let’s look at a coin flip example: if you are flipping a coin and you get “heads” four times in a row then your chances of getting “tails” on the next coin toss has improved. However, each coin toss is an independent event that is ignorant of every previous coin toss. Since the coin does not remember the previous string of heads it is not biased in the next toss. If fifty different people toss a coin in the air eight different times then the probability of at least one person getting all heads or tails is 32.44%. That person with all heads (or tails) probably had difficulty accepting the outcome but it is no less probable that the person who had exactly 25 heads and 25 tails which were evenly distributed.

Another example of how human intuition is wrong is the Monte Hall paradox and Bertrand’s box paradox. You are in a game show, and you’re given the choice of three doors: Behind one door is $1,000; behind the others, $1. You pick door No. 1, and the host (who knows the right answer) opens door No. 3, which has $1. He then says to you, “Do you want to pick door No. 2?” Should you switch your choice from Door No. 1 to Door No. 2? Most people would say no because their chance has not seemingly changed and Door No. 2 does not seem to offer any improvement in their chance of winning. People are more inclined to stay with their choice once made. Staying with your choice leaves you with a 1/3 chance of winning but changing to door No.2 increases your chances to 2/3. It is surprising and not at all intuitive but it has been shown to be true (hence the term “paradox”). As a trader you should learn what is true and re-train yourself to these truths while avoiding use of your natural human instinct. Why something works in trading is unimportant, that is an academic exercise for the curious; the fact that it works is all you need to know.

For many people it is hard to exit a losing trade and accept defeat. People who have been reasonably successful in their life would rather hang in there and work that defeat into a victory. This is a recipe for disaster in trading. After several disasters the aspiring trader then over reacts and starts exiting to soon.

They want to exit a trade if there is any loss showing at all because the pain of past disasters puts them in a panic. Knowing how to trade means limiting your losers and giving your winners room to run (we will discuss this more later).For this discussion “being long” means to own a stock, bond, or whatever. If you are “short” then you have sold it after borrowing it from your broker such that you can only profit on it if it drops in price.