Monday, July 20, 2009

Anything Can Happen

The recent strength, seemingly from nowhere (as argued by most chartists), experienced by the market, has caused me to do a bit of introspection on the way I perceive trading opportunities. Like most traders, I seek to enter the market only when I have a discernible edge in my favor which justifies taking on risk.

How we each individually identify what constitutes a trading edge invariably differs depending on our various approaches. For directional trades I tend to rely primarily on charting and other indicators to suggest there is a high probability of the market moving a specific direction. In my experience predicting stock direction using price patterns isn't as much of a slam dunk winning approach as is touted. One other avenue I utilize in identifying tradable opportunities within the options arena is playing volatility by either buying options that seem under priced or selling those that seem overpriced.

It's important to only enter the market place when you have an edge because it allows you to trade with a reasonable expectation that in the long run you're going to be profitable. A major mistake that traders commit is becoming too confident in their ability to accurately predict which way the market is going to move. This tends to happen especially after experiencing a string of winning trades. Unfortunately becoming too confident can result in making some serious trading errors such as over leveraging oneself. Being so sure that something is going to happen- and then experiencing it not happening can be quite painful emotionally (take the failed head and shoulders pattern for example).

One of the best books I've read on trading psychology and obtaining an objective perspective is Trading in the Zone by Mark Douglas. In it he expounds on the idea that emotional pain is the byproduct of unfulfilled expectations and to become objective traders we must truly accept that anything can happen. So, emotional pain can be somewhat mitigated by having proper expectations. For example, rather than expecting (and convincing myself that I know) the market will move a certain direction- it would be more objective to merely expect movement (up, down, or sideways). Then I'll never really be disappointed, as my expectations will always be fulfilled.

The following two statements sum up my thoughts:

More confidence in my ability to predict future = more emotional and financial pain when I'm wrong
Truly believing that anything can happen = less emotional and financial pain when I'm wrong

Which route would you rather take?

4 comments:

3percenter said...

Another great post, Tyler-thanks! On a side note, I've been searching for juicy premiums on stocks with upcoming earnings. I came across SKX which seems to have had an IV spike but the options are not showing it, as compared to something like WHR. What gives?

Tyler Craig said...

Thanks-

The reason it doesn’t seem as if the high IV is showing up in SKX options is because the underlying stock is so cheap. Currently SKX sits at $11.90 and Aug 12.50 calls are at $.80 (IV of 70%), Aug 10 puts are at $.40 (IV at 80%). They're definitely trading at high vol levels, but are cheap on a dollar basis because the stock is so cheap. It’s much easier to find a potential trade on WHR b/c it’s more expensive ($56) & you have more strikes to choose from.

3percenter said...

I never even considered the underlying price as an issue. Silly me.

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I believe that the biggest problem most investors have is separating their emotions from their investment decisions.