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The Seduction of Leverage: Rule: Do Not Overtrade!
The Seduction of Leverage: Rule: Do Not Overtrade!
Thompson
I must have bumped into this time worn dictrum a thousand times before I began to understand more
fully the implications of this rule relative to actions taken in speculative markets.
Of course, early in my studies I decided this rule was simply common sense and too basic to waste any
further time or effort on, So I vowed to never overtrade and simple as that I was through with this rule.
(Well, maybe I was through with this rule but it was NOT through with me.)
First, I did not stop to carefully define and identify the nature of this great ogre called Overtrading.
Being so blinded, I failed to fully master the technique of How not to overtrade! It is not enough to
empirically discover or intellectually agree that overtrading or any other trading sin is financially harmful,
a trader must acquire the technique of translating this rule into action. A similar analogy can be applied to
successful speculation, as it is not merely the' ability to analyze something, it is the further ability to
translate that information into a practical and profitable technique of entry and exit.
A trading rule like a pearl of a precious necklace can only be strung and truly called yours after you have
acquired a thorough understanding of its definition, its implications for action and can integrate this
information into your trading operations. Only then can this rule be of great practical value.
Close-up on Overtrading
Let's examine in greater detail this superb trading rule: Thou Shall Not Overtrade! First, recognize that
the cardinal sins of overtrading and the failure to limit your losses (using a stop loss order) probably slay
more novices than all other influences combined. Secondly, realize that overtrading is in some part
stimulated by the phenomena of leverage. We might define leverage in the markets as the right to control
the disposition of an investment or speculative vehicle whose current total value is some multiple of the
amount of capital required to secure such right. Now the virtues of leverage we shall let alone, for the ad
copy of the trade reminds us incessantly of the "tremendous profits" we shall all accrue as a result of the
beneficence of leverage. This view is of course one dimensional and it's the flip side of leverage that we
should know intimately. The low margins (high leverage) which typically exist on the options and futures
exchanges are surely not established to optimize your return on investment, but rather as an inducement
to draw a greater number of participants and enhance liquidity.
The affectations of leverage on the mind and subsequent actions of the typical trader are without a doubt
both extraordinary and pervasive. Treated improperly leverage can be financially disabling and often
fatal. The two general effects of leverage tend to be either overtrading relative to time or overtrading
relative to capital.
Disadvantages of Daytrading
The disadvantages of the "day trader" are enormous. First, he has to deal with a third person, his broker,
as he can not act instantaneously and directly as the floor person can. Therefore, there is an inherent time
lag which increases his overhead. Even if the disadvantages of time lag were somewhat equalized by
technology he would still have to overcome the potential for much higher operating expenses. He has to
maintain the cost and repair/maintenance of a quote machine, the possible costs of a microprocessor and
an array of software and data expenses. He might even be paying for the cost of a private office. And of
course, his commission costs alone put him at a great disadvantage to the professional on the floor, who
pays a fraction of his commission costs.
Unlike his competition on the floor, he has the further handicap of not being able to judge the quality of
the buying or selling on the floor. Is the market rallying because the professional traders are establishing
long positions or is it mostly short covering by retail houses who sold short early in the day? This
information may be valuable to the scalper.
Lastly, the "daytrader" fails to realize that the real opportunities for a legitimate intra-day trade are less
frequent than one supposes, as accumulation/distribution and the technical condition is not poised in such
an ideal manner every day or even every week. The daytrader feels compelled to overtrade to justify his
very daily presence before the quote machine. Many also perversely rationalize daytrading as a more
conservative approach as they are not exposed to the risk inherent in holding a position overnight. This
fear is bred by ignorance of the characteristics of price activity and the small probabilities for consistent
gains over time actually make this strategy a high risk approach in the long run.
The solution to this problem is to simply stop attempting to trade in the same arena as the professional
scalpers unless you can somehow overcome the disadvantages mentioned herein. Meanwhile, study the
characteristics of price action more and make an effort to change the time horizons of your trading
activities.
relieve the trauma of recent losses; or because once one has entered the position the tension of making
the exit decision is so great that you exit just to relive this condition of anxiety.
Like premature entry the solution to the above problem is of course to first recognize whether the
problem exists, then if so, to focus greater attention on overcoming your weaknesses and understanding
the characteristics of trend activity. Realize that in order to maximize your profits you must end this habit
of premature exiting. Study how you can more carefully define and fine tune the trend you attempted to
trade so that you can stay with it to its culmination. In the attempt to optimize the distance between entry
and exit, you must optimize your understanding of what occurs at each stage of price activity. From the
end of a downmove, through a period of accumulation and trend reversal, into the stage of mark up in
prices, through the distribution process, and trend reversal then full circle into the markdown in prices.
As in correcting premature entry you must better qualify your rules for exiting to maximize profits.
judgment. He is not pressured to live or die by the daily fluctuations of the tape. He is interested only in
net results over long periods of time. A professional interested in longevity can never risk no more than a
small (10% or less) portion of his capital on any one venture. Firstly he knows his judgment falls apart
when his capital is endangered by disproportionate risk and secondly if he is wrong (and his state of mind
increases this probability) he will have a harder time recovering from his great setbacks or he may never
recover. He is playing a game of survival and it is much harder to recover from a 30% or 50% loss than
from a series of 15% losses. Prudence in the area of not overtrading relative to his capital insures his
longevity. In this arena the small capitalized trader can trade with the same composure and presence of
mind that a very large professional trades with. Dickson Watts, a renowned cotton speculator from the
19th century, stated that "The fundamental principle that lies at the base of all speculation is this: Act so
as to keep the mind clear, its judgment trustworthy."
It is upon this principle that all of your actions must be directed, and it is upon this principle that you
should seek to avoid overtrading both relative to time and capital. Armed with the mental advantages
aforementioned you have removed yourself from the masses of the crowd and are beginning to act
rationally, decisively, professionally.