The Tortoise vs. The Hare – A Trading Metaphor

Everyone knows the story of the Tortoise and the Hare, but what you might not know is that it can be a very effective metaphor to describe the differences between winning and losing traders. Like the Hare, you probably experienced a lot of excitement and success right out of the gate, as you began trading your first live account. However, because you probably did not pace yourself by being consistent in your approach, you saw your early success evaporate as time went on, just as the Hare did. The Tortoise was much slower than the Hare, but because he was consistent and unemotional, he eventually won the race as you probably know. Thus, your goal as a trader, is to trade more like the Tortoise and less like the Hare, because that is how the trading game is won…

Are you a “Tortoise” or a “Hare” in the market?

In the fable of The Tortoise and the Hare, the Hare begins the race by ridiculing the slow-moving Tortoise and then leaving him behind in the dust as he sprints off from the starting line. The Tortoise, unemotional but sure of himself, begins the race in a slow but consistent manner, pacing himself from the start. The Hare gets distracted by other animals along the way, stopping to show off his speed as he tries to impress some lady rabbits (in the Disney video version) and as we all know, stopping for a nap along the way as well. Unfortunately for the Hare, this inconsistency and emotion gets the better of him and ultimately is the reason why he loses to the much slower Tortoise, even though he started with a huge physical advantage. The Tortoise may have had a disadvantage physically, but because his mindset was more consistent and in-sync with what it took to win the race, he out-lasted the haphazard and emotional Hare, and ultimately made it across the finish line first.

This fable of the Tortoise and the Hare really does a good job of describing the primary differences between traders who consistently lose money in the market and those who consistently make money. Traders who trade with a lot of inconsistency, haphazardness and emotion, are the ones who struggle and suffer through the pain of continuously blowing out their trading accounts, these traders are trading as if they are the “Hare”. Traders who take a slower and more consistent approach, like the Tortoise, tend to do much better in the long-run and don’t experience the severe emotional and financial ups and downs as the “Hare” traders.

Anyone who has followed my blog for a while knows that I am a huge proponent of the low frequency trading model. It is a pretty well studied fact that day-traders and other high-frequency traders make far less money over the course of their trading careers than lower frequency traders who take a slower and more consistent approach, like the “Tortoise”. In fact, for most people, taking a low-frequency approach to trading and trading like the Tortoise, is really the only chance they have at making significant money in the market over the long-run.

Trading is a marathon, not a sprint

Note, in the section above I ended with talking about the “long-run”, this is a key point in this whole lesson. It is not difficult to get lucky and hit a few nice winners early in your trading career, just as the Hare got off to a good start against the Tortoise. However, what differentiates winning and losing traders is not the ability to get lucky or use up all their trading capital in the first month of live trading, but the ability to remain disciplined and patient even in the face of constant temptation to over-trade and over-leverage their account, in other words, you need to pace yourself as you trade.

The Tortoise paced himself in the race against the Rabbit, and this ultimately allowed him to beat the Rabbit, who didn’t prepare properly and who clearly under-estimated the importance of mindset over ability. The Hare blew all his energy in the early-going (trading money) and got over-confident (very common among struggling traders), so much so that he literally fell asleep halfway through the race, which ultimately led to him losing to the much slower Tortoise.

Many traders tend to focus too much on the short-term, treating their trading as if it is some all-out sprint to the finish line. When they hit upon a couple of winners, they tend to then over-estimate the role that their trading ability played and underestimate the importance of remaining consistent and not doubling up their risk on the next trade. Traders tend to do the most damage to themselves right after a big winning trade or multiple winning trades. Like the Rabbit, they become frantic and over-excited, instead of remaining calm and collected like the Tortoise. This typically results in them over-estimating their trading ability, which causes them to start cranking up their risk per trade and over-trading, also known as burning up your trading capital.

Just as the Tortoise did, you have to preserve your energy to win the trading race. In other words, you need to preserve your trading capital for high-probability setups, rather than blowing it on random gambles in the market. Furthermore, I want you to think of trading as a marathon, not a sprint, because you need to pace yourself if you want to make it through to the land of successful trading and win the “marathon”. “Sprinting” has no place in the professional trader’s trading approach; slow and steady truly does win the marathon of trading.

The Tortoise reaped the big reward

Despite the odds seemingly stacked against the Tortoise at the beginning of the race, he ultimately takes home the trophy. This is exactly the same as two traders starting out with different size trading accounts, one large, one small and the trader with small account might find after 3 years of trading he has a lot more money in his account than the trader who started with the large account. This happens all the time in the market, and it’s because it doesn’t matter how much money you have, what matter is your ability to trade and your ability to manage your emotion and your money. Consistency always wins in the end.

As I discussed previously, you need to preserve your trading capital for the obvious trade setups, and not blow it all soon after you star trading live. The Hare expended too much energy in the early going, whereas the Tortoise stayed consistent. You need to save your money like the Tortoise so that you can stay in the game long enough to hit enough big winners so that you end the year profitable. Many traders do so much damage to their trading accounts early in the year that they have no chance of ending the year in profit. You need to try to have less trades but more certainty in the trades you do take, think about eventually becoming a “baller trader” with lower overall risk and higher rewards. This is how you make money over the long-run, it is not done by trading constantly until your money is gone. If you do this you will surely get passed up by trader who had smaller accounts but who had a better trading mindset and who understood the importance of trading with consistency.

Reptiles rule

Crocodiles and Tortoises can both teach us a lot about trading. We need to be patient and stealthy as traders, like a Croc, waiting for the easy “prey” and then acting on it with confidence. The theme is clear here; slow and steady wins the race. If you do a bit of research on both Crocodiles and Tortoises, you will see that both have been around since the time Dinosaurs walked the Earth; hundreds of millions of years ago. This clearly tells us that their slow yet consistent approach to life is one that pays off with great rewards in the long-run.

Trading with a Small Account

Every trader wants to trade a well-funded trading account (i.e. a 1,000,000 account), but very few of us actually get to do this. Most traders are stuck with trading relatively small accounts (i.e. just covering the required margin). Trading a small account requires very strict risk management (i.e. money management) because there is no buffer against mistakes or any unexpected losses. For example, if a trading account only covers its required margin by 5000, and it takes a 6000 loss, the account will become untradeable until additional money is deposited.

Trading a Small Account

Trading a small (or under capitalized) account is much more difficult than trading a large account. Large accounts are buffered against mistakes, unexpected losing streaks, and sometimes even bad traders, but small accounts have no such buffer. Large accounts can be used to trade any available market, but small accounts can only be used to trade markets with low margin requirements and small tick values. Large accounts also allow more flexible trading (e.g. multiple contracts), whereas small accounts are very limited in the trade management strategies that they can use.

In addition, trading a small account has psychological issues that make it even harder to trade the account well. For example, when a trader knows that they can only afford a single losing trade before their account becomes un tradeable (because it will no longer cover its required margin), the pressure to make a profitable trade is enormous. If the trader handles this pressure well, this might not be a problem. However, even the best traders have losing trades, and there is nothing that can be done to avoid losing trades, so this is not something that the trader has any control over, which adds to the psychological stress.

Advice for Small Accounts

With all of the disadvantages, it appears as though it is not possible to trade a small account profitably. This is not the case, and small accounts are traded profitably by many traders (including professional traders). The following advice is provided from the perspective of under capitalized accounts, but the advice actually applies to all trading accounts (even the $1,000,000 accounts).

·        Trade Using Leverage – Trading using leverage allows small account traders to trade markets that they cannot trade using cash. For example, trading individual stocks directly requires approximately 25% to 30% of the trade’s value in cash (assuming a typical margin requirement). However, trading the same underlying stock using the options or warrants markets (both highly leveraged markets), only requires approximately 15% of the trade’s value in cash. Note that leverage should not be used to increase the trade’s size (i.e. the number of shares), but should only be used to reduce the trade’s margin requirements. 

·        Trade Conservatively – Traders with well-funded accounts have the luxury of making trades with high risk (e.g. large stop losses relative to their targets). Trader with small accounts must be more cautious, and make sure that their risk to reward ratio, and their win to loss ratio are being calculated and used correctly.

·        Adhere to the One Percent Risk Rule – Trading in accordance with the one percent risk rule provides a small account with the same buffer (against mistakes, unexpected losses, etc.) as a large account. Many professional traders abide by the one percent risk rule regardless of the size of their trading accounts, because it is a very effective risk management technique.

Some traders adamantly state that under capitalized trading accounts cannot be traded successfully. This is not true. Small trading accounts may be more difficult to trade successfully, but if they are traded correctly, there is no reason why small trading accounts cannot be profitable.

By controlling the stress that is often associated with under capitalization, focusing on risk management, and correctly applying their risk management techniques (especially the one percent risk rule), small account traders can make a good living from their trading, and may be able to turn their small account into a large account.

Why Do Traders Lose in Financial Market

If you’ve been trading for a long time, you no doubt have felt that a monstrous, invisible hand sometimes reaches into your trading account and takes out money. It doesn’t seem to matter how many books you buy, how many seminars you attend or how many hours you spend analyzing price charts, you just can’t seem to prevent that invisible hand from depleting your trading account funds.

Which brings us to the question: Why do traders lose? Or maybe we should ask, “How do you stop the Hand?” Whether you are a seasoned professional or just thinking about opening your first trading account, the ability to stop the Hand is proportional to how well you understand and overcome the Five Fatal Flaws of trading. For each fatal flaw represents a finger on the invisible hand that wreaks havoc with your trading account.

Fatal Flaw No. 1 — Lack of Methodology

If you aim to be a consistently successful trader, then you must have a defined trading methodology, which is simply a clear and concise way of looking at markets. Guessing or going by gut instinct won’t work over the long run. If you don’t have a defined trading methodology, then you don’t have a way to know what constitutes a buy or sell signal. Moreover, you can’t even consistently correctly identify the trend.

How to overcome this fatal flaw? Answer: Write down your methodology. Define in writing what your analytical tools are and, more importantly, how you use them. It doesn’t matter whether you use the Wave Principle, Point and Figure charts, Stochastics, RSI or a combination of all of the above. What does matter is that you actually take the effort to define it (i.e., what constitutes a buy, a sell, your trailing stop and instructions on exiting a position). And the best hint I can give you regarding developing a defined trading methodology is this: If you can’t fit it on the back of a business card, it’s probably too complicated.

Fatal Flaw No. 2 — Lack of Discipline

When you have clearly outlined and identified your trading methodology, then you must have the discipline to follow your system. A Lack of Discipline in this regard is the second fatal flaw. If the way you view a price chart or evaluate a potential trade setup is different from how you did it a month ago, then you have either not identified your methodology or you lack the discipline to follow the methodology you have identified. The formula for success is to consistently apply a proven methodology. So the best advice I can give you to overcome a lack of discipline is to define a trading methodology that works best for you and follow it religiously.

Fatal Flaw No. 3 — Unrealistic Expectations

Between you and me, nothing makes me angrier than those commercials that say something like, “…5,000 properly positioned in 8000 Call Option can give you returns of over 40,000…” Advertisements like this are a disservice to the financial industry as a whole and end up costing uneducated trader a lot more than 5,000. In addition, they help to create the third fatal flaw: Unrealistic Expectations.

Yes, it is possible to experience above-average returns trading your own account. However, it’s difficult to do it without taking on above-average risk. So what is a realistic return to shoot for in your first year as a trader — 50%, 100%, 200%? Whoa, let’s rein in those unrealistic expectations. In my opinion, the goal for every trader their first year out should be not to lose money. In other words, shoot for a 0% return your first year. If you can manage that, then in year two, try to beat the Nifty or the Sensex. These goals may not be flashy but they are realistic, and if you can learn to live with them — and achieve them — you will fend off the Hand.

Fatal Flaw No. 4 — Lack of Patience

The fourth finger of the invisible hand that robs your trading account is Lack of Patience. I forget where, but I once read that markets trend only 20% of the time, and, from my experience, I would say that this is an accurate statement. So think about it, the other 80% of the time the markets are not trending in one clear direction.

That may explain why I believe that for any given time frame, there are only two or three really good trading opportunities. For example, if you’re a long-term trader, there are typically only two or three compelling tradable moves in a market during any given year. Similarly, if you are a short-term trader, there are only two or three high-quality trade setups in a given week.

All too often, because trading is inherently exciting (and anything involving money usually is exciting), it’s easy to feel like you’re missing the party if you don’t trade a lot. As a result, you start taking trade setups of lesser and lesser quality and begin to over-trade.

How do you overcome this lack of patience? The advice I have found to be most valuable is to remind yourself that every week, there is another trade-of-the-year. In other words, don’t worry about missing an opportunity today, because there will be another one tomorrow, next week and next month…I promise.

Fatal Flaw No. 5 — Lack of Money Management

The final fatal flaw to overcome as a trader is a Lack of Money Management, and this topic deserves more than just a few paragraphs, because money management encompasses risk/reward analysis, probability of success and failure, protective stops and so much more. Even so, I would like to address the subject of money management with a focus on risk as a function of portfolio size.

Now the big boys (i.e., the professional traders) tend to limit their risk on any given position to 1% – 3% of their portfolio. If we apply this rule to ourselves, then for every  Rs 50,000 we have in our trading account, we can risk only 500 – 1500 on any given trade. Stocks might be a little different, but a 50 stop in Nifty , which is one point, is simply too tight a stop. A more plausible stop might be five points or 10, in which case, depending on what percentage of your total portfolio you want to risk, you would need an account size between 150,000 and 500,000.

Simply put, I believe that many traders begin to trade either under-funded or without sufficient capital in their trading account to trade the markets they choose to trade. And that doesn’t even address the size that they trade (i.e., multiple contracts).

To overcome this fatal flaw, let me expand on the logic from the “aim small, miss small” movie line. If you have a small trading account, then trade small. You can accomplish this by trading fewer contracts, or trading Nifty contracts or even stocks in cash market. Bottom line, on your way to becoming a consistently successful trader, you must realize that one key is longevity. If your risk on any given position is relatively small, then you can weather the rough spots. Conversely, if you risk 25% of your portfolio on each trade, after four consecutive losers, you’re out altogether.

Break the Hand’s Grip

Trading successfully is not easy. It’s hard work…damn hard. And if anyone leads you to believe otherwise, run the other way, and fast. But this hard work can be rewarding, above-average gains are possible and the sense of satisfaction one feels after a few nice trades is absolutely priceless.

To get to that point, though, you must first break the fingers of the Hand that is holding you back and stealing money from your trading account. I can guarantee that if you attend to the five fatal flaws I’ve outlined, you won’t be caught red-handed stealing from your own account.