A few weeks back, I kicked off the Intelligent Investor Series as part of my weekly commentaries. Th...
Make Sure You’re Trading, Not Gambling
11/04/2011 1:56 pm EST
Rob Hoffman explains that traders who fall victim to certain "gambling" habits often mismanage their risk, struggle with inconsistency, and unknowingly give up their edge in the markets.
Trading can be a lot like gambling if you let it be so. Some of the best traders in the world are also great poker players, but there’s a big difference between how you trade and how people gamble, and our guest today is Rob Hoffman, here to talk about that.
So, Rob, how can trading be gambling? We hear that a lot of people treat their trading like gambling, but it probably doesn’t have to be that way.
Yes, and let’s draw the distinction, because you’re absolutely right. There are some fantastic, really phenomenal professional gamblers who do very well in the market. I’m not talking about them today.
What I’m talking about is the average trader out there that makes references to things such as “Well, I’m taking high-risk trades, but I keep my stops really tight.”
Also, “I’m playing with house money.” That’s one I hear all the time and it just grinds my gears every time I hear that because they make these analogies to gambling almost subconsciously; they don’t even realize they’re doing it.
Let’s talk about that “house money” issue. Is it really house money, or is it money that you worked hard to earn? You pay for subscription services; you’ve read lots of books; you’ve subscribed to great trader interview sites. There are lots of tools out there that people can use to grow their knowledge. You’re paying for that.
Then, of course, the school of hard knocks, where you do take losses and drawdowns during your trading development and career.
So, by the time you finally start to see some consistent profitability, are you really playing with house money, or money that you earned? Is that money just play money, or is that money you’re going to pay your bills with, or grow your account with and be able to trade more size down the road.
It’s not really house money when you have a successful morning. That really doesn’t allow you to take higher-risk trades in the afternoon, and I see that phenomenon over and over.
For instance, I see a lot of people say “I make money in the morning, but I lose money in the afternoon.” As I sit and talk with those types of students, I often find that they do have a successful morning, and then their attitude changes. “Well, now I can double up, triple up, and take a lot more risk because it’s all house money.” They don’t treat it like their own.
It’s so important for people to understand that if you’re making money, that is your money and you need to protect it.
I find that the best professional traders, their mentality is not about how much money they can make on the next trade. It’s about protecting their money and thinking about how much money they could lose on the next trade.
See related: Tough Talk About Risk Management
So, that’s one key instance right there, and then the whole concept of risk and risk management. What I find happens with a lot of traders is that they say “Well, yes, I’m taking a lot of risky trades and I’m taking a lot of momentum-based trades. I don’t really have a science behind what I’m doing. I just see the markets shooting real fast in one direction or the other and I chase after that. But that’s okay because I’m keeping my stops tight.”
Well then of course what I see is just like a credit card statement for a person who keeps shopping, the credit card bill comes and you’ve got to pay the piper and you owe this big drawdown, this big debt.
Same thing with these traders; no individual trade is blowing them out, but at the end of the month, it’s death by 1000 cuts because you’ve still got to pay your commissions and all those little losses add up to big losses.
What has to happen there is the mindset has to change. Learn that no, it’s not acceptable just because I’m keeping my stops tight to take a bunch of high-risk trades.
The focus really has to be how can I minimize losses from the very beginning, and keeping stops tight may be perfectly fine, but keeping stops tight on higher-probability trades, and not just saying “Well, I know this is really risky and that’s my style, but I’m keeping my stops tight.”
In the end, ask yourself what is that doing to your trading account month over month, and if you’re seeing continued drawdowns, you need to have a mind shift and focus on higher-probability set-ups.
See related: The Risk/Reward Error No Trader Can Afford
And it also seems to me that if you’re guessing on your trades without having any sort of edge, that again pushes your trading into the gambling arena.
It pushes you into the gambling arena, and then you’re clearly not journaling. You probably don’t have a trading plan if you’re flying by the seat of your pants.
Two fundamental tenets that every trader should have: a trading plan and they should journal those trades, especially if they are in the more junior stages of their career, absolutely.
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