Does a Good Result Justify a Poor Trade Decision?
The Psychology of Trading
Trading is all about making decisions. We look at the available information, analyze it in a variety of ways, and then decide whether it represents an opportunity for a profitable trade. For example:
- Technical analysts look at charts, seeking a pattern that they know -- from past experience -- is worth an investment.
- Fundamental traders look at earnings data, cash flow, revenue etc. Based on the growth (or lack thereof), traders initiate a long or short position in the stock.
- Option traders can use either of the above methods and then choose an appropriate option strategy. In addition, we can use implied volatility (IV) of the options to make the trade/no trade decision.
- Option traders often hedge a bullish/bearish/neutral bias by trading spread positions. Spreads come with limited profits, but more importantly, they come with reduced risk and an increased probability of earning a profit.
Traders measure success or failure by how much money is earned or lost. That makes it tempting to declare that every profitable trade was based on good decision making and that every trade that lost money was the result of a mistake. That is very faulty reasoning.
It is important to recognize the role that our decisions make in the process. In other words, when earning a profit you want to know whether that profit was the result of being lucky (i.e., something that was against the odds of happening did, in fact, happen) -- or whether you made a good decision -- based on the information available at the time that a decision had to be made.
Even the best, well-thought-out, intelligent trade decisions will result in an occasional loss. When that loss is the result of bad luck, it should be disappointing, but not discouraging. For example, if your position is bullish and a devastating news event occurs (major assassination, terrorist bombing, or any other market-disrupting event), you will lose money.
That is the result of bad luck and not a bad decision on your part.
Similarly, and most importantly, when the bull market is moving stocks higher day after day, carrying your stocks higher along with all the other stocks, don't make the mistake of believing that you are a market genius just because your individual stocks are also moving higher.
Here is the truth:
Earning a profit from a single trade does not suggest that the investor made a good decision -- only that in this instance, it was a winning decision.
This is an important concept because traders frequently find themselves in very similar situations. For example:
- A trader who wants to follow technical analysis earns a profit on his/her first trade. That person then makes a big mistake in believing that he/she discovered a great way to invest. Much more data is needed before such conclusions can be drawn.
- Over the past few years, 80% of the time that the implied volatility of at-the-money XYZ options rose to 65 or higher -- on the day prior to an earnings announcement -- buyers of an at-the-money straddle lost money. However, 75% of the time that the implied volatility was between 45 and 50, ATM straddle buyers earned a profit. These statistics are good enough to warrant making a trade (position size must be suitable for your personal risk tolerance).
- The buy/sell recommendations of a specific options guru have been wrong more than 75% of the time. (This occurs more frequently than you would believe.) A good case could be made for doing the opposite of any new trade recommendations.
Any of the above could represent the main reason why you initiate a trade. However,you cannot judge whether doing so is a good decision until you have collected data from a number of trades and find that the premise for making that decision is valid. It may have been valid in the past, but that does not mean it will be valid going forward.
If you hold onto a risky position where the probability is high that you will lose more money than you can afford to lose, and when you refuse to make a risk-reducing adjustment, and when your plan is hoping that all will turn out well in the end -- that is bad risk management because hope is not a strategy.
That plan represents a series of poor decisions, regardless of the final outcome of the trade.
Quoting renowned investor Howard Marks: "One of the first things I learned at Wharton was that you can't necessarily tell the quality of a decision from the outcome. Given the unpredictability of future events and, especially, the presence of randomness in the world, a lot of well-reasoned decisions produce losses, and plenty of poor decisions are profitable. Thus one good year or a few big winners may tell us nothing about an investor's skill. We have to see a lot of outcomes and a long history — and especially a history that includes some tough years — before we can say whether an investor has skill or not."
Hat tip to Bob Bryan for blogging about Howard Marks' comment.