Jake Bernstein – Why Traders Break the Rules

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Periodically, we like to post articles by industry veterans like Jake Bernstein, which could contribute to improve the trading discipline of our clients and readers. During volatile times like this, this could help us navigate our way through the markets.

An Article by Jake Bernstein
Why Traders Break the Rules
www.trade-futures.com

In my nearly 40 years of trading, writing, researching the markets and observing the behavior of other traders I have come to understand many things about what causes traders and investors to behave (and misbehave) in certain ways. At first blush it would appear that if a trader correctly and completely learns the rules of successful trading then the rules would be relatively simple to follow. But in reality there is a vast chasm of difference between what is ideal and what actually occurs in the life of a trader. There are many reasons for this. In fact, I could write an entire book on this subject and still have more to say about it. Here, however, in very condensed form, as some of my thoughts on the matter. They are presented in the hope that you may gain some insight into your own behavior as a trader. If you’ve made breaking the rules a habit, then read what follows – it could save your life as a trader.

When rules are Unclear: One of the major reasons that traders break rules is that many times rules are not clearly specified. Some trading systems or analytical methods are intentionally vague or subject to varying interpretations. What is especially frustrating about such methodologies is that they change their interpretations with the aid of 20/20 hindsight. Hence, a trader attempting to learn the rules may not learn anything from their errors. Lesson #1 about following the rules of successful trading is that THE RULES MUST BE OBJECTIVE or as TOTALLY MECHANICAL and CLEARLY DEFINED as possible. One way to know well in advance that you are headed for trouble is if you are taught rules that are not really rules but rather suggestions, guidelines or analytical techniques. While lack of clarity if the stock and trade of those who sell methods and market theories, it is not what you want UNLESS you have managed to become an excellent intuitive trader or UNLESS you are able to expand on the theory and create a systematic approach from its tenets.

Lack of Confidence: Perhaps one of the most frequent causes of rule breaking is lack of confidence. By lack of confidence I mean the failure to believe in the system one is using as well as the failure to believe in one’s self. Lack of confidence is a normal human response to a variety of factors. In my estimation, lack of confidence is a learned behavior. In other words, through a variety of life experiences we develop lack of confidence that may ultimately haunt us for the rest of our lives unless we take measures to thwart its destructive effects. In traders a lack of self confidence can develop after exposure to losing systems. It only takes a few losses to undermine one’s confidence as a trader. Once self confidence is gone, doubt takes over. And doubt causes a trader to break the rules of his or her system. An effective “cure” for lack of self confidence is to thoroughly familiarize yourself with a system in all of its phases. Understand its worst case scenarios as well as its best case potential. All too often traders are blind-sided by the historical results of a system and therefore pay too little attention to its downside. When the drawdown eventually comes, the trader is devastated and lack of confidence follows. This eventually (sooner rather than later) causes the trader to abandon the system, to alter it, or to “make a few little changes”. In so doing the system is no longer a system but a tool for losses and self-destruction.

Over-Confidence can also result in rule breaking. By falling into what some traders have so aptly named the “King-Kong” syndrome, you will begin to feel as if you can do no wrong. This type of behavior typically comes after a lengthy or highly profitable winning streak. The trader begins to feel as if he or she cando no wrong – as if they have the Midas touch. As a result, they are prone to break the rules since their attitude leads them to believe that everything they touch will turn into gold. Such behaviors can be seen in all walks of life – not only in the markets. Again, the best way to minimize this problem is to have a thorough working knowledge of your system. In knowing that your system has had performance limits, you will remain well grounded, thereby minimizing the possibility of over-confidence.

Information Overload: I consider this one of the most serious threats to the self discipline and self confidence of a trader. We are often too quick and too willing to give credence to the opinions of other traders and market analysts. We believe that their work is better than ours; that they know more; that they are well-connected; that they are more experienced; more astute, wealthier, etc. the more opinions we assess, the more confused we become. There will always be many explanations of the same event. The voice of what we believe to be authority can often persuade us to break the rules. Adolph Hitler brainwashed an entire nation to break the rules. Some of the most absurd ideas are “sold” to the public as fact. The more information we have the more confused we get. The more confused we get, the more tempted we are to break the rules. The cure? Close out ALL information other than what you need for your systematic trading approach.

(c) Copyright 2007 Jake Bernstein