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Some of you may have heard the term "Random
Reinforcement. I have read that approximately 85% of all daytraders
end up losing money and go "out of business". Some
say the percentage is even higher than that, which would not
surprise me. You would think that with all the educational material,
fast computers, seminars, chat rooms and magazine articles out
there, that the percentage of losers would not be so high.
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So why is it so? Why do so many traders end
up failing? Daytrading, as with any business venture, has a lot
of skills you must master in order to become successful. You
must master money management, executions, technical analysis,
tape reading, level 2 skills and computer skills. These can be
learned fairly easy with some study and practice. Let's take
money management for example, which is crucial for success. You
have "x' amount of dollars in your trading account. You
are willing to part with "x%" of that amount before
you will throw in the towel and quit trading as a business. For
each trade, there is "x%" that you are willing to lose
should your stop get hit. Knowing this and where you will have
to place your stop based on the particular stock you are trading,
you adjust your shares accordingly. That's pretty basic. Technical
analysis can be learned by reading and studying, much the same
way you did in school. You have a certain subject, you study
each night and you become proficient in it after applying yourself.
Most traders have been in trades where they
got creamed, not because a stop was blown, but because their
execution skills where lacking for the type of stock they were
trading. For example, trading a thinly traded stock with jumpy
levels. Tough to execute if it goes against you. But, this too
can easily be avoided by merely observing your stock on level
2 before your entry. The safety can be determined almost instantaneously.
Even after all the above mentioned skills are mastered, traders
continue to lose. Why? The reason why is because stops are blown,
and winning trades are not allowed to mature. But it's not enough
to tell someone not to blow a stop and let your profits run.
How can you stop doing something if you don't understand why
you're doing it in the first place? In order to "fix"
something, you must understand what is causing the problem. If
you were a car mechanic, in order to fix your engine, don't you
have to know what is causing the problem? Sure, you might be
able to come up with a temporary duct tape fix for it, but it
won't last. You must know the source of the problem before coming
up with a permanent solution.
The problem affecting our trading is due to
Random Reinforcement. Random Reinforcement is defined as: "Having
behaviors reinforced with positive or negative results on an
inconsistent basis". So this means that today we perform
a certain action and are rewarded for it. Same thing happens
tomorrow, but then on the third day, we perform the same action
and are punished by it, and so on, in a random fashion. This
makes effective learning, in the traditional sense, almost impossible.
Can you imagine being a great football player, and one weekend
you score 3 touchdowns and receive a lot of praise for it and
the next weekend you do the same thing and receive a beating?
When we were babies, every action was met with either negative
or positive reinforcement from our parents on a consistent basis.
When we performed some type of action, like clean our plate up,
we were rewarded positively. Every time we did something wrong,
we were punished, sometimes with a spanking. So we have been
conditioned to receive reward and punishment based upon our actions,
and it comes consistent with our actions in most of our everyday
lives. When we were in school, every time we got an "A"
on the report card we received positive reinforcement. Every
time a "D" showed up, we received negative reaction
from our parents. This was consistent. We knew this. We always
knew getting an "A" would reap benefits. We always
knew if we made the big play in sports, we would get praise,
and opposite when we did poorly. This reward/punishment always
occured on a consistent basis. The same thing happens in the
business world as well. So all throughout our lives, we are conditioned
to receive positive reaction and reward for things we do well
and opposite for things we do badly.
Animals are the same way. Take a dog for instance,
if you want to train him to perform a certain act, you will reward
him for doing it. So he becomes conditioned to do the same act
over and over because he knows he will get reward for it. The
trading world is different. It will reward and punish us on a
random, inconsistent basis. Sometimes we are rewarded with big
profits even though we did the wrong thing, and sometimes we
are punished with a loss even though we follow all the rules
and go by the book. It doesn't make much sense.
Now enters Joe Schmoe and he decides to give
trading a go at it, bringing all his life long conditioning with
him. So he starts trading, not really knowing what he's doing
at all. He can't keep a stop, much less knows what one is. But
he's been doing well, every time the market goes against his
position, he just hangs on, because the market "always"
turns around so that he can at least get out even or with a good
profit. He has been conditioned to blow stops, because up to
this point, he has not experienced any negative consequences
as a result of it. So, even though he is trading badly, he is
winning. Then one day, he blows a stop again, only this time,
the market does not come back. Ever! And he is finally forced
to take a huge loss to make the pain go away. So now he has just
been severely punished for doing something that used to reap
him big rewards. That's confusing.
Let me give you a couple of real life examples
that come to mind. One of my friend's, who also used to trade
in the stock market, had taken a $12,000 account up to about
$130,000 in about a two year time period. Most of that came by
playing one particular favorite stock of hers. She would usually
play 1000 to 2000 shares at a time. Trying to buy the lows and
sell the highs. If the position went against her, she would always
hang on. The stock always came back for her. She would call me
all the time and tell me of the killing she was making. I knew
eventually she would get caught up in her underwear and take
a huge hit. Then in about April of 1999, she decided to go short
2000 shares. She was sure the market was going to take a big
hit due to the upcoming Y2K deal. Well, it turned out, she shorted
almost the absolute 52 week low of that stock. She would not
cover, even with losses mounting. Why should she? After all,
the market has always come back, and it will this time. Right?
This is what she used to tell me. But no.........she was sure
the market would tank because of Y2K. Well, to make a long story
short, she ended up being forced to cover by her broker, and
ended up losing all but about $20K of her $130K fortune.
One other trader comes to mind who used to
be in one of the chat rooms I used to belong to. He came to the
room with a modest account size. Those of you who were active
in the market during the fall of 1999 will remember all the runners
we were having almost everyday. This guy started playing these
runners and was doing well. He tripled his account in about a
three week time period. He was blowing stops during this time
also, but the stocks always came back for him, thereby, rewarding
him for doing something really stupid. I even remember him bragging
about how he used to make more money per day in pre-market trading
than most people make in a week. Then one day the inevitable
happened. The runners crapped out. They went down instead of
up. And they kept going down on him. Blown stop after blown stop.
He refused to listen to reason. Why? Because he had been conditioned
that this was how you make money. Blow that stop, it will always
come back. It wasn't long before his small fortune evaporated,
and he left with less than he started out with. I did not feel
sorry for him at all.
So our actions in the market are reinforced
with positive and negative reaction on a random basis. How many
times have you been in a trade with a mental stop, only to blow
it and say to yourself, " The last time I bailed out at
my stop, only to sell out at the exact bottom and see it race
up 3 points over my entry, so I'm gonna hang on". So you
hang on, blow your stop, the stock does not bounce for you, and
you finally bail out for a huge loss. This is because you "learned"
that blowing the stop was okay. Or on the other hand, you get
into a position and see it going your way. Everything is working
according to plan, but you say to yourself, " The last time
this happened, I didn't take my profit, and the stock turned
on me, going down below my entry, and I ended up with a loss,
when I could have had a profit. So I'm gonna take my small profit
now". The stock then continues on up for another 2 points,
and you're sitting there now saying, " I sold to soon".
Wow, this trading can sure mess with the mind!
I bet you that if you could have someone stand
behind you with a 2x4 while you were trading, and beat you over
the head with it every time you blew a stop, you would quit blowing
them. Why? Because the punishment would occur on a consistent
basis, and you would "learn", that blowing a stop is
bad and painful, every time. I would personally rather lose a
little money than get whacked over the head. Obviously, this
is not practical.
Okay, Random Reinforcement is always going
to be present. We can't get rid of it and make it go away. So
knowing what it is and how it can play with our minds is the
first step. The only way to deal with a market that rewards and
punishes us on an inconsistent basis is to stick with our rules
and discipline and disassociate yourself from the money. You
must learn to feel good about your trading, not whether or not
you made or lost money, but on your ability to stick with your
rules. At the end of every trading session, you should ask your
self: "Did I stick with my rules?. Rules and discipline
are the only things constant in an inconsistent market. That
is why it's vitally important to stick with them. If you don't
you will lose in the long run. The money is merely a by-product
of your trading. If you follow proper trading discipline it will
come. Don't try to make your million over night. My basic philosophy
with regard to trading is this: I am doing what I want to do
and having fun doing it. I am making a good living for myself
and continue to improve my trading. Even if I was to hit the
lottery today, I would still trade. So why do I have to make
my million overnight if I would trade anyway? So, to put it into
a nutshell, the core reason we lose, is because we are trading
in a market that rewards and punishes us on an inconsistent basis.
By understanding this concept, we can appreciate why its so important
to stick with discipline. |