Most traders or investors fail because as humans we tend to accept risk in losing situations while avoiding risk in winning situations.

In trading this translates into holding onto a losing trade in order to avoid admitting our mistake while closing out a profitable trade in case it turns around and evaporates along with our self-affirmation that we got it right.

To be a successful trader you generally need to reverse this psychology and learn to cut losing trades while holding on to and working winning trades.

A common mistake made by traders is the inability to match their time, finances, personality, risk tolerance and experience to an appropriate trading style. Most people attempt to trade far too aggressively, as they believe this approach will enhance their profitability.

Probability Exercise

The stock market is driven by fear, greed, hope, ego and most of all people.

Which option (A or B) would you prefer in the following profit and loss scenarios?

In scenario 1 option B would actually be the most desirable and avoiding the interference of fear. In scenario 2 option A would be the most desirable and avoiding the interference of greed. Did you select these? The emotions involved in decision-making often interfere with our ability to make the right choice.

The success of a trader is determined by their ability to go recognise what the market is doing and not to fight it – this means working with probabilities rather than having a rigid view of the market. The role of analysis is just to identify high probability trades and then our trading rules dictate whether the trade is entered and how it is then managed according to what the market does.

Want to know more? Register here for HomeTrader’s FREE Intro Seminar.

Interference of Emotion

Trading and investing is a skill that can be learnt and as part of this two common behaviours need to be overcome, namely impulsiveness and hesitation.

Impulsiveness is demonstrated by prematurely entering a trade in the fear that we may miss out or closing out a winning trade in the fear that it may turn around.

Hesitation is demonstrated by not entering the trade in the first place in the fear that it may go wrong or not closing out a losing trade or exiting an investment on the hope that it may turn around.

By establishing a trading plan and working within a set of clear rules a trader or investor is able to overcome these adverse behaviours.

Gut Instinct

Intuitive reactions and judgements especially in shares are generally very unreliable in making money in the long run.

Try this simple test:

Company A is a Perth based mining company. In May 2003, the company celebrated its 20th anniversary of listing on the Australian Securities Exchange (ASX). The company has two operating divisions, Gold and Advanced Minerals.

Since its first gold pour in 1983, the Company has produced over 4.7 million ounces of gold.

Since 1988 the Company's gold hedging programme has generated around A$706 million of additional revenue by achieving an average realised delivery price of A$651 per ounce of gold. This compares with an average spot price over this period of A$497 per ounce.

Which of these two options would you choose*:

1. You will buy company A
2. You will sell company A

Mechanical Trading

Mechanical (or non-discretionary) trading involves using a set of precisely defined rules which are followed with discipline and consistency. Generally, these rules are developed using some form of quantitative analysis and then rigorously tested on historical data (called "backtesting") to see if they would have made money in the past.

The advantages of this approach include:

• The methodology can be quantified, tested, measured, adapted and applied to any market/instrument.
• Exact rules are defined which can then be repeated and followed without discretion or the interference of emotion.

Overriding psychological barriers and emotion in decision-making is the ultimate objective of non-discretionary trading. Always remember that trading emotionally does not work and that is why you need to stay with your trading system even though it will be your natural human reaction to go with your gut feeling.

No System = emotional responses > incorrect or ineffective choices > sabotaged profits and amplified losses

To find out more attend HomeTrader's FREE Intro Seminar.

* company A is Sons of Gwalia and collapsed in Sept 2004