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Improving Your Trading Plan

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Studies within the field of Behavioural Finance have shown that due to human bias, …

Studies within the field of Behavioural Finance have shown that due to human bias,
market participants do not always act rationally. This creates opportunities in the market for traders to profit from the inefficiencies created by these biases. However, Behavioural Finance also shows that these same biases cause traders to act in ways that could have negative impacts on their personal trading results. The perception of fund managers does change when they have been trained on Behavioural Finance (Nikiforow, 2010). Training sharpens the awareness of loss aversion and limits the affinity for conformity. Nikiforow suggests that what is needed is to incorporate these approaches into the investment process (Nikiforow, 2010). This paper reviews some of the common behavioural biases and how they can impact trading. It then covers the general content and structure of a trading plan and recommends areas where traders can incorporate behavioural bias awareness into their plans using rules and checkpoints.

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  • 1. IMPROVING YOUR TRADING PLAN 1Improving Your Trading Plan: Making it Easier to Cut Your Losses, Let Your Profits RunBenjamin S. CheeksInternational School of Management, Paris
  • 2. IMPROVING YOUR TRADING PLAN 2AbstractStudies within the field of Behavioural Finance have shown that due to human bias,market participants do not always act rationally. This creates opportunities in the market fortraders to profit from the inefficiencies created by these biases. However, Behavioural Financealso shows that these same biases cause traders to act in ways that could have negative impactson their personal trading results. The perception of fund managers does change when they havebeen trained on Behavioural Finance (Nikiforow, 2010). Training sharpens the awareness of lossaversion and limits the affinity for conformity. Nikiforow suggests that what is needed is toincorporate these approaches into the investment process (Nikiforow, 2010). This paper reviewssome of the common behavioural biases and how they can impact trading. It then covers thegeneral content and structure of a trading plan and recommends areas where traders canincorporate behavioural bias awareness into their plans using rules and checkpoints.Keywords: Trading Plans, Behavioural Finance, Behavioural Economics, Behavioural Bias
  • 3. IMPROVING YOUR TRADING PLAN 3Improving Your Trading Plan: Making it Easier to Cut Your Losses, Let Your Profits RunThis paper defines a trader as an investor that engages in the transfer of financial assetswith the purpose of profiting from short-term trends. It is the goal of every trader to beat themarket. If not, they would all invest in index funds. According to Modern Portfolio Theory aninvestor should put together a portfolio of diversified stock. Modern Portfolio Theory states todo exactly that and the Efficient Market Hypothesis states that efficient markets areunpredictable and traders cannot consistently beat them.Modern Portfolio Theory has had such an impact on the financial world that in 1990Harry Markowitz received the Nobel Peace Prize in Economics in recognition of the ModernPortfolio Theory. With such heavyweights against them, why is it that traders still try? Lo andMacKinlay suggest a reason. They explain how $1 invested in US Treasury bills betweenJanuary 1926 and December 1996 would have been worth $14 at the end of the period. Had the$1 been invested in the S&P500 during the same period, it would be worth $1370. However, aninvestor with perfect foresight to switch their investment on a monthly basis to the higheryielding asset for that month would have turned the $1 into $2,303,981,824 (Lo & MacKinlay,1998). Even a modest ability to forecast trend could be handsomely rewarded.While Modern Portfolio Theory and Efficient Markets Hypothesis are still hotly debatedtopics, the most profound attaches focus on the assumption that all investors act rationally. If wetook a moment to reflect on the past investment decisions we have made, Im sure we could thinkof at least one example where we did not act in the most rational manner. The first noted studyregarding financial behaviour was published in 1979 by Kahneman and Tversky. They calledtheir theory Prospect Theory. With Prospect Theory, it was demonstrated empirically that whendeciding among alternatives that involve risk, people do not always act rationally. Prospect
  • 4. IMPROVING YOUR TRADING PLAN 4Theory and similar studies inspired by it have more recently been branded Behavioural Finance.In 2002, just 12 years after Markowitz, Kahneman won the Nobel Peace Prize in Economics forhis work in Behavioural Finance. Finally the traders had a heavyweight on their side. However,in a twist of fate befitting a Greek tragedy, it is the same biases that create the opportunities inthe markets that prevent the traders from taking advantage of them. This paper reviews a briefbackground of Modern Portfolio Theory, Efficient Markets Hypothesis, and Behavioural Financeand proposes improvement that traders can make to their trading plan to attempt to overcometheir own behavioural biases.Modern Portfolio Theory and Efficient Markets HypothesisModern Portfolio TheoryMarkowitz introduced the Modern Portfolio Theory (MPT) in a series of paperspublished in the 1950s while working at the University of Chicago. The theory is an attempt toquantify the concept of investment risk.In short, the theory states that when considering the addition of an asset to a portfolio, theinvestor should consider how the value of that asset changes in relationship to the other assets inthe portfolio under certain conditions. In order to do this, one must calculate the expected returnof an asset as well the standard deviation of that return. Simply put, expected return can becalculated using the weighted average expected return of a series of outcomes. Variance isdefined as a measure of the dispersion of a set of data points around their mean value withstandard deviation being the square root of the variance.As an example, assume that over a certain time frame, an investor has expectations abouthow the value of the US dollar will change against a basket of currencies and how that changewill impact the price of gold. Historically speaking, there has been a negative correlation
  • 5. IMPROVING YOUR TRADING PLAN 5between gold and the value of the US dollar. In other words, when the US dollar decreases invalue, gold tends to increase in value.Let’s assume that the investor has the following expected outcome for gold based uponthe US dollar.Scenario Probability Effect on Gold Weighted AverageUS$ up 5% 25% -0.5% -0.1%US$ flat 25% 0.0% 0.0%US$ down 5% 25% 15.0% 3.8%US$ down 10% 25% 20.5% 5.3%Expected Return 8.9%Standard Deviation 9.2%In this example, the investor believes there is a 25% probability of any of the fourscenarios taking place with each having a different effect on gold prices. Using the formulaproposed by Markowitz (Markowitz, 1952, p. 83), we can determine that the expected return is8.9% and the standard deviation is 9.2%.When considering a second investment to add to the portfolio, Markowitz suggestsfinding an investment that is not correlated to the others. Continuing this example, withMarkowitz words in mind, the investor chooses an S&P500 index fund believing that the overallUS Market is positively correlated to changes in the value of the US dollar. The investor has thefollowing expected outcome for the S&P500 based upon changes in the value of the US dollar.Scenario Probability Effect on S&P500 Weight AverageUS$ up 5% 25% 27.5% 6.9%US$ flat 25% 15.5% 3.9%US$ down 5% 25% -2.0% -0.5%US$ down 10% 25% -5.5% -1.4%Expected Return 8.9%Standard Deviation 13.4%Both investments have the same expected return of 8.9%, but the S&P500 index has amuch greater standard deviation. Common sense might suggest to some investors that this is a
  • 6. IMPROVING YOUR TRADING PLAN 6more risky investment and by adding to the portfolio, it will increase the overall portfolio risk.However, the following table shows that this is not true.Gold Effect S&P500 Effect50% 50% Combined Weighted Average-0.3% 13.8% 13.5% 3.4%0.0% 7.8% 7.8% 1.9%7.5% -1.0% 6.5% 1.6%10.3% -2.8% 7.5% 1.9%Expected Return 8.9%Standard Deviation 2.7%A portfolio equally weighted between gold and the S&P500 will yield the same returnwith a much lower standard deviation of 2.7%. This according to Markowitz will have a muchhigher appeal to an investor as investors do desire expected return with the lowest variance.Note that assigning different weights to the investment rather than a 50/50 split will alsohave an impact on the standard deviation. One should not assume that an equal weighting ofeach asset is preferred.Using this very basic example, one can see how it is possible through trial and error usingMPT to theoretically put together a portfolio that would provide maximum expected return withthe lowest variance. Studies reveal that with as few as 40 well-chosen stocks, an investor caneliminate all but market risk; also called systematic risk (Statman, 1987). This risk cannot bediversified away.Assumptions of MPT.There are several assumptions inherent in MPT. At least two of these are explicit. Thefirst is that investors wish to maximize their return with the least variance. As discussed later inthe paper, this assumption does not always hold true for a variety of reasons. The secondexplicitly stated assumption is that risk can be defined by variance or standard deviation.
  • 7. IMPROVING YOUR TRADING PLAN 7An implicit assumption of the MPT is that investors have an accurate conception ofpossible returns. This assumption leads one to the Efficient Markets Hypothesis.Efficient Markets HypothesisThe work of Markowitz was furthered by Eugene Fama. Fama is known for developingthe Efficient Markets Hypothesis (EMH) (Fama, 1965). He showed that price movements wereconsistent with an “efficient” market and furthered defined an efficient market as one in whichprices “fully reflect” available information (Fama, 1970).One cannot describe the EMH without mentioning the old economic joke of the $100 bill.It describes an economist and his colleague strolling down the street when they spot a $100 billlying on the ground. As his colleague reaches to pick it, the economist says, “Don’t bother, if itwere real someone else would have already grabbed it” (Lo, 2004, p. 16). In other words, anefficient market reacts almost instantaneously to new data; therefore are no arbitrageopportunities.The theory was later refined to include weak from, semi-strong form, and strong formefficiency (Fama, 1970). The three versions of the hypothesis broke the available data into threedifferent subsets. The weak form tests the hypothesis where the information set is historicalprices and volume information. The semi-strong includes other publically available informationsuch as earning announcements, stock splits, dividend payments, etc. Finally the strong formtests include data not available to the public such as insider information or monopolisticinformation.
  • 8. IMPROVING YOUR TRADING PLAN 8Behavioural FinanceBehavioural Finance is the primary competing doctrine to the MPT and EMH. Themodern day roots of Behavioural Finance can be traced back to the work of Kahneman andTversky (Kahneman & Tversky, 1979).Advocates of Behavioural Finance argue that investor behaviour is not always rational asassumed by the EMH. Specific behavioural biases lead investors to make decisions that could beundesirable to their economic outcome. Some of the most studied are loss aversion,overconfidence, regret, overreactions, and herding.Loss AversionPeople weigh losses twice as much as gains of similar magnitude (Tversky andKahneman, 1992). Loss aversion and related theories (i.e. disposition effect) have been used toexplain why investors engage in irrational behaviour. The relationship between Prospect Theoryand investor behaviour is consistent with selling winners too early and holding onto losers fortoo long (Shefrin & Statman, 1985). Many assert that not only do investors avoid risk in order tominimize losses, but they may assume additional risk in order to avoid sure losses (De Bondt,Muradoglu, Shefrin, & Staikouras. 2008) and Neilson (2002). One could easily speculate that itis this propensity towards more risk that causes some investors to double down or invest more intheir loser in hopes that they will more quickly return to profitability through dollar costaveraging. Extreme and well-known examples of this behaviour are Nick Leeson the trader thatbrought down Barings Bank and Jérôme Kerviel who nearly did the same to Societe General.Loss aversion is reference or frame dependent. Koszegi & Rabin state “How a person assesses
  • 9. IMPROVING YOUR TRADING PLAN 9the outcome of a choice is often determined as much by its contrast with a reference point as byintrinsic taste for the outcome itself” They go on to add:Equating the reference point with expectations rather than the status quo is also importantfor understanding financial risk: while an unexpected monetary windfall in the lab maybe assessed as a gain, a salary of $50,000 to an employee who expected $60,000 will notbe assessed as a large gain relative to status-quo wealth, but rather as a loss relative toexpectations of wealth (Koszegi & Rabin, 2006, p. 1134).This can be applied in the financial world to the loss a fund manager feels when his fundreturns 20% on a year where the benchmark index gained 25%.This point has also been supported in small scale classroom projects. In one suchexample, a paper trading account is established for each student. The paper trading accountallows the student to simulate trading while keeping track of paper profits and losses. Thestudents have two months to trade in a variety of markets to see who can generate the highestreturn at the end. Early in the allotted trading time, one of the students established a sizeablelead over his classmates. This had the effect of establishing a new reference point to otherstudents. In class discussions following the trading exercise, the majority of studentsacknowledge the big lead and admitted that it caused them to make more risky trading decisionsor invest in more speculative instruments such as futures in order to catch the winner. Inaddition to the paper trading account the experiment also included in-class trading where thestudents were assigned to groups and had to make a group decision as to how to invest. Due tothe limited time trading, examples in this exercise are minimal, but anecdotal data showed thatregardless of the indicators and trend, groups that were trailing by a large margin took more risk.Examples of such risk taking were allocating large amounts of capital to one trade or placing
  • 10. IMPROVING YOUR TRADING PLAN 10contrarian bets in the hopes that the other teams guessed incorrectly. In contract to this, thegroup that was leading or within striking distance of the lead stuck closer to the trading rules andasset allocation (personal account, April, 2011).Psychological Accounting and Decisions FramingTversky and Kahneman provide another example of how behaviour can be influenced bychanging how the outcome is framed. They provide an example of a gambler at a racetrack toexplain:For another example, consider a person who has spent an afternoon at the race track, hasalready lost $140, and is considering a $10 bet on a 15:1 long shot in the last race. Thisdecision can be framed in two ways, which corresponds to two natural reference points.If the status quo is the reference point, the outcomes of the bet are framed as a gain of$140 and a loss of $10. On the other hand, it may be more natural to view the presentstate as a loss of $140, for the betting day, and accordingly frame the last bet as a chanceto return to the reference point or to increase the loss to $150. Prospect theory impliesthat the latter frame will produce more risk seeking than the former. Hence, people whodo not adjust their reference point as they lose are expected to take bets that they wouldnormally find unacceptable. This analysis is supported by the observation that bets onlong shots are most popular on the last race of the day (Tversky and Kahneman, 1981, p.456).Read the example above again mentally substituting stock market for race track, trade forbet, and high risk investment for 15:1 long shot and you have an investing scenario to whichmany traders can relate.
  • 11. IMPROVING YOUR TRADING PLAN 11Overconfidence.In order to overcome the anxiety that such a situation creates, people tend to ignore theuncertainty; resulting in overconfidence in their decision. Overconfidence keeps us fromrealizing how little we know about a certain situation and how much and what additionalinformation we need to understand the risks associated with our actions. From an investmentpoint of view it has been shown that overconfidence leads investors to attribute too much of theirsuccess to ability and their failures to bad luck and will trade more frequently than “rational”investors and by doing so lower their returns (Gervais & Odean, 2001).Regret and Regret Aversion.As previously stated, people have anxiety related to decision of risk. This is because iftheir decision proves to be worse than it may otherwise have been, the person experiences regret(Bell, 1982). Regret aversion is also used to explain why traders hold losing positions longerthan they should (Shefrin & Statman, 1985). Traders are prone to letting their losses ride inhopes that they will eventually break-even. They call this the “disposition effect”. To the trader,realising the loss is proof that their judgement was incorrect thus regretting it was made.Holding the stock gives the hope that the decision will eventually prove to be correct.Overreaction.There is data consistent with the hypothesis that market participants have the tendency tooverreact (De Bondt & Thaler, 1987). Investors tend to overweight recent information andunderweight older data. To demonstrate this phenomenon, De Bondt & Thaler used monthlydata from the NYSE from 1926 to 1982 to construct two portfolios that consisted of stocks withhigh abnormal positive and negative returns. Analysing this data, they find that extreme changesin stock price are followed by significant stock price changes in the opposite direction. Similar
  • 12. IMPROVING YOUR TRADING PLAN 12studies in support of the overreaction hypothesis include strong evidence demonstrating theeffect of overreaction to negative events are stronger than to those of positive events (Brown &Harlow, 1988), and overreaction to be more prevalent for smaller firms than larger firms and aremore prevalent in the short window around quarterly earnings announcements (Chopra,Lakonishok, & Ritter, 1992).Herding.Human herding behaviour results from impulsive mental activity in individualsresponding to signals from the behaviour of others. They are driven to follow the herd becausethey do not have firsthand knowledge adequate to form an independent conviction, which makesthem seek wisdom in numbers (Pretchner, 2001). Relating this back to the finding of Shefrin &Statman (1984) would suggest that herding is also related to regret aversion. If the investor doesnot follow the crowd and the crowd is right, regret could ensue. Herding is different fromoverreaction in that herding can happen slowly and smoothly over a relatively extended amountof time. Continuing the theme from the animal world, it is overreaction that causes the herd tostampede and trample the weaker and slower in the herd.Adaptive Markets Hypothesis.A review of the schools of thought related to the scientific practice of financialmanagement would not be complete without a mention of the Adaptive Markets Hypothesis(AMH) (Lo, 2004). The AMH is an effort to bridge the gap between the two opposing views.Lo calls the hypothesis an “evolutionary approach to economic interactions”. He says it isheavily influenced by “evolutionary psychology” and the need for humans to maximize thesurvival of their genetic material rather than their expected utility. The AMH embraces the
  • 13. IMPROVING YOUR TRADING PLAN 13biases shown in Behavioural Economics and puts an evolutionary spin on them. One example isthat of risk preference.Until recently, U.S. markets were populated by a significant group of investors who hadnever experienced a genuine bear market—this fact has undoubtedly shaped theaggregate risk preferences of the U.S. economy, just as the experience of the last fouryears, since the bursting of the technology bubble has affected the risk preferences of thecurrent population of investors. In this context, natural selection determines whoparticipates in market interactions; those investors who experienced substantial losses inthe technology bubble are more likely to have exited the market, leaving a differentpopulation of investors today than four years ago (Lo, 1984 p. 24).As this article was written before the Global Financial Crisis, the same logic would suggest thatthe investing population today has once shifted from that of three years ago. The theory suggeststhat as the investor population changes, they begin to exploit different profit makingopportunities. It is this exploitation and the resulting scarcity that eventually destroys theseopportunities but in turn creates new ones. This is witnessed in booms and busts, bubbles andcrashes. This in turn implies that different trading strategies will perform well in some marketenvironments and not in others. Therefore, in order to achieve a consistently high level ofinvestment returns, one much adapt to the current market conditions.The Trading PlanBoth Behavioural Economics and Adaptive Markets Hypothesis allow for the possibilitythat markets do not always exhibit rational behaviour and are therefore not efficient. This createsopportunities for traders to make money by taking advantage of these inefficiencies. In order totake advantage of the opportunities that Behavioural Finance present, the investor should be
  • 14. IMPROVING YOUR TRADING PLAN 14familiar with the concepts. Psychologists argue that behavioural biases are difficult to overcomeeven with the knowledge of their existence (Pronin & Kugler, 2007). The perception of fundmanagers does change when they have been trained on Behavioural Finance (Nikiforow, 2010).Training sharpens the awareness of loss aversion. Training also limits the affinity forconformity. Nikiforow suggests that what is needed is to incorporate these approaches in theinvestment process. One way to do this is to establish a trading plan that has a mechanism thathelps to temper those behaviours that can have a negative impact on trading. Much as everygood business needs a business plan, it is also important that the investor setup a plan for trading.As the aphorism goes, “plan your trade and trade your plan”.Understandably, there is little academic research on trading plans and their make-up.Successful traders are unwilling to discuss how they execute their trades under the belief that themore people who know the strategy, the less successful it will be. In order to demonstrate howan understanding of Behavioural Finance can be incorporated into a trading plan, it is importantto discuss the general content structure of a good trading plan. The elements of the trading planthat follows draws heavily from Wilson 2003, class notes from Horn (personal account,February-April, 2011) and the author’s personal trading experience.For the sake of this paper, a trading plan is defined as a systematic method for describingthe trader’s goals and objectives for trading, markets to trade, system or systems to be used toselect trades, money management strategy, and trading routine. All of these elements will bedescribed in more detail shortly.
  • 15. IMPROVING YOUR TRADING PLAN 15Goals and objectives.In this section, the trader should define the following: What am I aiming to achieve? Isit to replace full-time income or earn a specific amount of money or return? Is it a hobby?• How many hours per day will I allocate to trading?• What will my trading hours be? As highlighted in Fortune Magazine, night trading isbecoming the new “day trading”. Many brokers are offering extended trading hoursas late as 8pm. For those interested in stocks, the Asian markets open around 7.30pmUS Eastern Time. There are also commodities and futures market that trade 20 to 24hours per day.Markets to trade.What market or markets will you trade? Will you focus on equities or futures? Will youcombine equities with options? Will you trade futures options? Will you trade the US markets,the Australian market, one of the European markets or a combination of several of the above?Trading system.The trading system is the central part of the trading plan. The investopedia definition oftrading system is as follows:A trading system is simply a group of specific rules, or parameters, that determine entryand exit points for a given equity. These points, known as signals, are often marked on achart in real time and prompt the immediate execution of a trade(http://www.investopedia.com).I would add that it should also include how trading orders will be placed. The trading system isthe heart beat of the trading plan. Entire books have been written as to how to develop the besttrading system. While the design of the trading system is one of personal preference and
  • 16. IMPROVING YOUR TRADING PLAN 16experience, one thing that most traders will agree upon, it is critical to thoroughly backtest thetrading system before trading with real money.Selecting trades - technical and fundamental analysis.In order to define the rules, the trader must first determine how to analyse tradingopportunities. There are two analytical models used to determine which investment to buy and atwhat price. These are fundamental and technical analysis. Each method has its own underlyingphilosophy and methods, both have the same ultimate goals; to determine market direction,anticipate future direction, and provide price targets for entry and exit.Technical analysis relies on historical price and volume information. By charting thesepoints and matching patterns, technical traders attempt to predict future price changes.Functional analysis relies on information from such sources as financial statements and companyreports. Fundamental analysis may also consider macroeconomic data such as interest rates,inflation, and GDP. Functional traders attempt to profit by buying investments that areunderpriced under the assumption that the right price will eventually be realised.For those investors that cannot decide between the two, research shows that while each ofthe analytical models can work well, models that integrate the two have superior explanatorypower (Bettman, Sault, Schultz, 2009). Others suggest selecting stocks with sound fundamentalswhile using technical trading rules to determine when to enter and exit trades using observedsignals (Coe & Laosethakul, 2010).Entry and exit points - buy and sell signals.Entry points occur when a buy signal or set of buy signals have been triggered. For atechnical trader, a buy signal may be that the price of equity has crossed its 20 day movingaverage or the combination of the aforementioned crossover with volume for that day that
  • 17. IMPROVING YOUR TRADING PLAN 17exceeds the average of the last 15 days. For fundamental traders, an entry point may be when aprice per earning target has been reached along with a current ratio on balance sheet of 2.5.Regardless of the type of analysis being used or the nature of the buy signals, they all have thesame purpose: to alert the trader that a change in trend has occurred and the stock price ismoving up. The opposite is true for sell signals and exit points.Order placement.Order placement is made up of the rules that a trader follows before, during, andimmediately after entering the trading order. For examples, many traders will always entermarket orders, while others will enter limit orders a few cents above the current bid price to seeif a seller will accept. Also, some traders will not place orders before midday on a Mondaymorning under the belief that the market needs a few hours to set direction.Stop-loss orders.Many traders also enter a stop-loss order immediately following a buy order. This stop-loss order will instruct the broker to sell the security when it drops to a certain price. Somebrokers have software that will allow the stop-loss order to be entered simultaneously to theinitial buy order. When entering stop-loss orders, the trader must determine the rule for settingthe loss limit. The rules will vary with investor and risk tolerance. Some traders set the stop-lossorder at 10% for all purchases. Other traders vary the stop-loss dependent upon the stock’saverage trading range for a set period. Regardless of the method, a stop-loss order is one of themost important tools that a trader has for managing losses.
  • 18. IMPROVING YOUR TRADING PLAN 18Trading timeframe.Your trading timeframe determines how long you will hold an investment. Some buyand hold investors will hold onto investments for years while some day traders may only hold aninvestment for a few minutes.Other considerations.Other considerations when developing a trading plan include choosing the right broker.When choosing a broker, some key things to consider are commissions, level of service, andspeed of trade. All of these items have a cost. Commissions are the easiest to quantify andnaturally get the most attention. However if your low cost broker cannot provide access to thedata you need, either real time or historical, the cost you pay to access this data elsewhere couldoutweigh the savings in commission. The importance of speed will vary dependent upon howquickly the trader needs their ideas implemented. A day trader measures speed in fractions of asecond. On the other hand, a fundamental trader making weekly trades may find several secondsacceptable. For some traders, speed may not be as important as the ability to place limit ordersrather than market orders. Those limited by their broker to market orders absorb the full bid-askspread. This can add up to several dollars per trade and several thousand dollars per yeardependent upon your trading.Money management.In this section, the trader should define the following:• How much capital will I trade with?• How much capital will be allocated to any one trade?• How will position size be determined?• How will I control the downside? How will I set stop-loss values?
  • 19. IMPROVING YOUR TRADING PLAN 19• How will I measure my performance?• How will I draw an income or pay myself?Trading routine.It is important to establish daily, weekly, quarterly, and yearly routines. Routines arebeneficial to help bring order and discipline to the trading plan. The daily routine would includetasks such as reviewing open positions and researching new stocks. Weekly reviews of tradeperformance are also important. In addition to trading performance, the quarterly and yearlyreviews should include a "review" of the entire trading plan. Required adjustments should bemade at this time.Measurement and feedback.Key measures for system evaluation consist of the total number of trades, the averageprofit per trade, largest winning trade, profit factor (gross profit/gross losses), maximumdrawdown, percent profitable trades, and maximum consecutive losers. Professor Horn refers tothe last three as personal evaluations as they have the ability to challenge the resolve of anytrader (personal account, February-April, 2011).Incorporating Behavioural Bias into the Trading PlanHow can we incorporate this new found knowledge of behavioural biases in the tradingplan? The first recommendation is to add a section to the trading plan called the Belief System.Belief system.People have a difficult time recognizing bias within themselves (Ehrlinger, Gilovich, &Ross, 2005). However, introspection can help us to understand the causes of our behaviour andhelp predict future actions (Jones & Nisbet, 1972, as cited in Pronin et al, 2007). Then again,unconscious cues such as behaviour biases can also mislead (Pronin et al, 2007).
  • 20. IMPROVING YOUR TRADING PLAN 20Heeding this warning I recommend that the trader reflect on their trading in terms of pastactions or behaviours rather than solely as introspection. For example, instead of asking yourselfhow you would respond to a 20% drawdown of trading capital, ask how in the past aconsiderable loss of capital affected your behaviour and emotions. It is important to look atspecific situations.Another good tool to overcome bias blind site is the use of analogy. Analogy allows usto by-pass conscious processes. Asking what analogy you would use to describe the stockmarket can provide some interesting insight.Some key questions to answer in the belief section are:What analogy would I use to describe the stock market? The answer to this question can providekey unconscious thoughts about the market. For example, someone describes the stock marketas a casino in Las Vegas implies that they feel the stock market is a gamble and controlled bychance. Someone defining the stock market as a game implies there are winners and losers and aset of rules by which to play.Key questions to ask include:• What are my strengths and weaknesses?• How have I used my strengths in the past during trading?• How have my weaknesses hurt my trading and how can I overcome them?• How have I demonstrated the self-discipline required to follow my plan? In whatcircumstances do I not show discipline? How can I prevent it from impacting mytrading?• How have I reacted to a large loss of capital in the past? What impact did this haveon my friends and family?
  • 21. IMPROVING YOUR TRADING PLAN 21Trading diary.The second section that I recommend adding to your plan is a Trading Diary. Themeasures discussed previously will show the trader what did occur, not what failed to occur. Forthis you will become dependent upon your trading diary. In the diary, the trader will detail theirthoughts and emotions when making trades. Litvak and Lerner (2009) describe four ways inwhich emotional bias is demonstrated. Reviewing these when making decisions is instrumentalin determining if there is bias in the decision. The first is whether or not the judgment lackscorrespondence with your criteria. In this context as the criteria has been defined in the tradingplan the question to answer is – does the decision fit your trading plan? These second to detectbehavioural bias is to determine if the judgement is based upon bad information. The thirdquestion to answer is whether or not the decision is influenced by the failure to use goodinformation. Is the trader looking only at data that supports the decision while missing goodinformation to the contrary? The last method of detecting bias is to ask if the decisioncorresponds to the judgement of others. A trend trader would need to be able to show a trend hasformed that supports the decision. However, a contrarian trader would want to confirm that thetrader does not follow the prevailing pattern. By recording this information and reviewing it aspart of the trading routine, a trader can gain a deeper insight into their trading and more easilydetect patterns of bias that are having an impact on trades.Including behavioural bias considerations in the trading plan.This section of the paper highlights tools and behaviours that an investor can incorporateinto a trading plan in an attempt to overcome or to raise awareness of behavioural biases thatmay have negative impacts. Some of these tools will be rules that are easily defined and easy toimplement within the strategy; assuming the trader can recognize and overcome the bias. Others
  • 22. IMPROVING YOUR TRADING PLAN 22will be structured as decision points that force the trader to consider the situation throughdifferent eyes, or a different frame of reference. The following tables highlight how the variousbehavioural biases can manifest themselves during trading and suggests rules or guidelines as formitigation.Loss Aversion.Table 1Rules and Guidelines for Loss AversionBehavioural Bias – Loss Aversion Rule / GuidelineHolding losers for too long (Also regretaversion)1. Set stop-loss orders. These willautomatically trigger a sale when a specificprice is reached. Do not lower the stoponce it has been set.2. Accept that losses will happen. You willnot be right on every decision.Selling winners too soon Adjust the stop-loss order up as the stock pricemoves up. This will allow the trader to realisemost of the gain.Buying riskier investments in order to make upa loss faster (also decision framing). The losscan be defined by a loss of capital or fallingshort of a reference point such as a benchmarkindex or personal investing goal.1. Only trade in those investments in yourtrading plan.2. Use the status quo as the reference pointand frame the investment as a high riskinvestment rather than framing it as achance to return to even.
  • 23. IMPROVING YOUR TRADING PLAN 23Doubling down to lower the average unit price Only place trade when your entry/exit criteriahave been met.Setting stop-loss orders too close to the buyprice. Setting the stop price within the averagetrading range of a stock could trigger a saleduring the day yet the stock end the day with again1. Stop-loss rules should be tested as a part ofthe trading system. Once these have beenset, do not change them.2. Review the average trading range for theinvestment to understand the risk of anearly stop.Overconfidence.Table 2Rules and Guidelines for OverconfidenceBehavioural Bias – Overconfidence Rule / GuidelineTrading too often Review of your trading metrics will show this.Buying high in hopes of selling higher. A good trader always has and exit plan whenmaking a trader. An overconfident traderbelieves that they can always find someone tobuy the investment at a higher price. Considerhow you will do this before making the trade.
  • 24. IMPROVING YOUR TRADING PLAN 24Overreaction.Table 3Rules and Guidelines for OverreactionBehavioural Bias – Overreaction Rule / GuidelineBuying a stock based upon recent news Only place trade unless your entry/exit criteriahave been met.Buying a stock that has moved up due tooverreactionIt is possible that due to market overreaction astock has met all entry criteria. Before buying,scan the news to determine if this is the case.If so, be aware of the fact that within a shorttime frame, the effect of overreaction is usuallyout of the price. Is your trading systemsensitive enough to monitor this?
  • 25. IMPROVING YOUR TRADING PLAN 25ConclusionContrary to the assumptions in Modern Portfolio Theory and the Efficient MarketsHypothesis, studies in Behavioural Finance show that due to human bias, market participants donot always act rationally. This creates opportunities in the market for traders to profit from theinefficiencies created by these biases. However, the same “irrationality” that affects the marketin general can also affect the individual traders. By training on Behavioural Finance, traders canincrease their awareness of times when bias may be affecting their trading. In order to limit thenegative impacts, this paper has recommended that traders train in behavioural bias and updatetheir trading plan with new rules and behavioural checkpoints.Measuring the impact of behavioural biases on traders is difficult, because researchersrarely have access to individual investor decisions. It is relatively easy to determine what atrader did. It is not as easy to determine why they did it, nor is it easy to determine what theinvestor did not do or why they did not do it. In addition, this paper only mentions a few ofthose behavioural biases that have been shown to impact traders and investors. There are manyother biases that should also be reviewed and considered.Additional research is needed with individual traders to determine how their behaviourchanges after implement behavioural bias into their trading plan. I would suggest an experimentwhere two groups were assembled and one of the groups was trained on behavioural biases andhow the manifest themselves in trading. The other group would receive no such training.Provide them basic trading rules with clear entry and exit criteria. Then during a tradingsimulation determine if the group with the behavioural bias training does a better job offollowing the trading rules.
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