Know When to Hold 'Em or Fold 'Em

05/20/2013 10:00 am EST

Focus: STRATEGIES

Brian Shannon, CMT

President, AlphaTrends.net

20-year trading veteran Brian Shannon talks about the costly emotional mistakes that traders make and how to control them.

I'm here with Brian Shannon, and we're talking about the costly emotional mistakes that traders make.  What are they Brian and how can we avoid them?

There are a lot of them, and I'm not sure you can avoid them.  You can try to control them.  We're taught that we want to be unemotional traders.

Is that possible?

I don't think it's possible.

Me either.

You have to be a pretty boring person, if that's possible.  I don't know those guys and I don't strive to be that guy.  However, I think we have to recognize our emotions and have a way of knowing when they're leading us astray; getting married to a belief about a certain stock or business.

That's happened to me.

Sure, it unfortunately happened to me, as well, on several occasions, which is why I gravitate more towards technical analysis and try to be as objective about price action as possible.

You don't get caught up in the story, but rather you're concentrating what's really actually happening?

Right, I like a good story like anyone does.  I mean there have been some great stories of stocks that I've traded over the years.  Some of them have gone bankrupt and some of them are just flash-in-the-pan type things.

Well, it's a good point because over the years traders have become married to the idea that Apple is going to go up forever, for example.

Apple doesn't go up forever.  I think some people have recognized that this year.  We've seen a 25% pullback.  You know, the thing about Apple, for instance, is it's that giant.  It was the largest market cap stock.

I don't know if it still is, but it's something that everyone believes in.  We all use their products.  We have multiple products in our homes, most likely.  They get married to the belief that it's going to be something that works forever.  You know, any company has a product lifecycle and it gets reflected in the price of the stock.

Getting married to that belief and thinking that I'll average in at a 50-day moving average, a 200-day moving average.  You find out that those levels don't always hold.  Getting married to a belief is certainly a problem, which leads to compounding the problem by averaging down, by going on leverage.

Cost averaging, so when the price moves down we just keep buying more of it even though it's hurting us.

Keep buying, yeah.  That's how you can create really big holes.  You eventually run out of money or conviction, and a lot of times that happens right at the worst times when all the bad news comes out, they're downgraded and that sort of thing.

Then you get that big emotional draft lower where it flushes those people out, and you end up selling at the lows.  It hurts badly.

So it sounds like what you're saying it's no big deal to have an opinion about a stock and a story about a stock or a financial instrument, but we have to make sure we concentrate on what's really happening.  Is reality contrary to what we started to believe and is it time now to get out?

Right, the market is a discounting mechanism.  It anticipates the future fundamentals.  Look at the story and understand it.  If it starts to violate certain technical levels, a 200-day moving average or big level support, then you have to be unemotional, take your loss or cut your losses or harvest your profits, if that's the case.  You have to have some kind of discipline about selling, and I think a lot of people don't have that because they get married to that belief and just end up riding or round-tripping a stock.

Do you keep a number in mind when you're holding onto a position that if it loses more than a percentage in particular or specially, that you're just going to dump it no matter what?

It's not necessarily a percentage.  I think a percentage is a good starting point, but it's a little bit arbitrary as well.  For me, I like to look at what is the trend.  If it's in an uptrend on a daily timeframe and it's just pulled back to a level of support and it's starting to rise from there, I'll buy that first higher high in a shorter-term timeframe once that short-term timeframe trend is violated and the pattern of higher lows and higher highs.

That's an early warning sign.

Yeah, it tells me that the uptrend that I was buying for is no longer in existence so why would I hold?  I'm buying for a trend trade and if the definition of trend is broken on the timeframe that I'm engaged in the market, then it's clear cut.  There's really no reason to still be involved whether it's your initial protective stop/loss and you take a little bit of a hit or if it's getting stopped out of profits along the way.

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