Mistakes That Stand Between You And Your...

The Illusion Of Control- This Little Trading Mistake

The market can and should be thought of as an independent entity - it will do what it wants and when it wants to do it. As a trader, once you have entered into the market, you have little control over how that market then behaves.

This is where psychology takes over. Many novice traders feel that by being intrinsically involved in the selection and entry into a particular stock they are in control of how the trading market will behave - this is a trading fundamental error to make.

The Lottery Principle and How it Relates to Trading

To help understand this concept, a similar example can be witnessed in individuals who play a national lottery with the jackpot totalling many millions of dollars. Many individuals who play the lottery pick numbers that are important to them - for example, birthdays of loved ones or an anniversary. Picking these numbers gives them a sense of control and power that somehow these numbers are better than any other and more likely to win. In reality, the numbers chosen are no more significant than any other combination. It is the fact that they have linked an important emotional attachment to certain numbers that gives the player a sense of control - it has nothing to do with increasing the likelihood of winning.

When entering into a position (detailed by your own trading system) you are in absolute control of your market entry. You may therefore feel that you have a certain control or power over the market you are trading and in which direction it will go. However, once you are in a trade you have absolutely no control over the direction the market takes - it will do what it wants! That's why trading money management is so important. Compare this to the lottery and the principle may make more sense - you may have absolute control over the numbers that you chose but you have absolutely no control over the winning numbers that come out.

Entry and Trading Money Management

While the entry (See also trading stops) is undoubtedly a very important part of any trading system, it does not actually determine how much money you will make (or lose) on a trade. What actually matters is the amount of money that you put on a trade in the first place. The following example may clarify this point.

Example 1

You are interested in buying stock XYZ. Your trading system tells you to buy the stock at $10.Your exit signal is generated when the stock hits $12. Let us consider two scenarios where you invested 1) $1000 and 2) $5000.

1. For $1000 you will be able to purchase 100 shares at $10. You will sell these shares at $1200 when they hit $12. This results in a profit of $200 on the initial investment.

2. For $5000 you will be able to purchase 500 shares at $10. You will sell these shares at $6000 when they hit $12. This results in a profit of $1000 on the initial investment.

As can be seen, it is not the entry that determines how much you will make (this should be determined by your trading system) it is actually the amount of money that you put on the trade in the first place.

However, a word of warning! The above example may suggest that the more money you place on a trade, the more money you will get out of it. This is true only if the trade goes in your favour. If the trade goes against you, you will obviously lose more money. (see trading profits)

Therefore, another key question to ask yourself is how much money you should invest in the first place to avoid excessive losses and this will be answered in later chapters. (See also: How To Maximize Your Trading Profits)

Summary

The key to being a successful trader and not the worse trader in the world, is to realise that you can't control the markets. You must have the discipline to follow your trading system (see trading exits) to the letter to tell you when to get in and out of a trade and to know how much money to invest in a trade without risking excessive losses. Backtesting your trades, discipline, and money management are the two most effective weapons in your arsenal to becoming a successful trader.