How self-knowledge can make you a better trader

We all have our demons to deal with when spread-betting the financial markets. In fact, I would say that along with sport, trading can uncover your innermost qualities more directly than probably any other activity. The hard part comes in recognising and acknowledging your strengths and your weaknesses.

Successful traders invariably have a keen understanding of themselves and how their personalities affect how they operate in the highly emotional and often fast-moving world of spread-betting.

I have found that one of the most common failings among traders is inertia – the fear of pulling the trigger on a trade, especially when it goes against prevailing opinion. The vast majority of traders become more and more bearish as markets fall, and more and more bullish when they rally. After all, if all you read in the press and on financial websites is unrelenting gloom as they report the latest market falls, who can resist the siren call of the herd? It seems crazy to bet against them. But, if we want to make serious profits consistently, we must do just that (at carefully chosen times, of course).

Why you need to bet against the herd

It is the herding impulse that drives mass movements. History is replete with examples.

The lone voice expressing a contrary opinion is drowned out and receives little, if any, publicity (often until after their death, when their forecasts usually prove correct).

For example, the US dollar plunged this summer as the market’s attention focused on the weak US economy, and the Fed’s quantitative easing (QE) money-printing programme. Just about every commentator I read this summer took it as a given that the dollar would remain weak for a long time and would face a major crisis. That is herding behaviour par excellence.

Of course, the argument was very logical – who could argue against that proposition? But I was getting more and more bullish as the market fell! And, as we all know now, the dollar did bottom in early November and has rallied almost 10% as I write. So much for the opinions of the herd! 

What they forgot is that the other side of the trade (the euro) was in even greater danger than the dollar. If a trader had sold the EUR/USD near its high at 1.42, they would be sitting on a profit of £1,200 for every £1 bet, all within the month of November (see chart below). At the high, the overwhelming body of opinion was bearish the dollar. The various sentiment measures (covered in an earlier post) give an accurate indication of this one-sidedness.

Euro v US dollar

Experience tells us that of the euro bulls who rode the market to its peak, not many took profits there. After all, the ‘fundamentals’ hadn’t changed. If anything, the economic data coming out of the US was still pretty dreadful.

Are you cut out for trading? Take a personality test

But to sell short in a rising market takes a lot of confidence. Most traders act as if frozen in the headlamps and wait for the market to ‘confirm’ their view. Confirmation usually takes two parts: a growing consensus of opinion with their own, and the market steaming in that direction.

However, the best trades are usually the ones where you get in early in a new trend (after all, you have more time to profit then). The herd still believes in the old trend – there is no credible leader to challenge the old order.

So, how can you tell if you have what it takes to trade boldly (but not rashly!)? There are in fact, several very good websites where you can discover your trading strengths and weaknesses. I would encourage all traders to take their own trader test.

Two of the better ones I have found are www.marketpsych.com and www.tharptradertest.com. You can pay for enhanced reports, but I’ve found that the free tests are perfectly adequate.

In terms of Personality Factors, the tests give readings of:

Conscientiousness – ability to plan trades with self-control
Emotionality – stress sensitivity – do you get angry at the markets?
Extroversion – tendency to optimism
Openness – to new experiences, ability to expand your horizons, accept new ideas
Agreeableness – concerned with cooperation and harmony
Confidence bias – a key indicator, as too much can be dangerous!
Over-optimism – do you overestimate your abilities?
Risk aversion – describes itself
Emotional vulnerability – do you suffer from ‘analysis paralysis’?
Impulse control – do you have high self-discipline? Can you delay gratification?
Instant gratification – do you take small profits rather than larger ones that take more time to work?
Intellectualism – too much leads to over-thinking a trade, and hence paralysis
Herding – do you follow the crowd, or are you more of a contrarian?

You can see that there is lot to go into when you look inside yourself! What I would suggest is that you look upon the results not with a confrontational attitude (!), but with an open mind. You may be surprised by some, but do look at yourself as honestly as you can. When you do, you are well on the road to being a better trader, as you are more in control of yourself.

To help us keep on the straight and narrow, I have come up with two very simple money management tools: the 3% rule and the break-even rule. Using these rules will automatically impose a high degree of discipline on your trading, so all you have to do is search out the high-probability trades – and that takes patience. Find out if you have it in your trader test!