The axiom "don't fight the tape" doesn't do justice to the nature of trading. Indeed, the battle we most often fight is not with the market, but with ourselves. Most investors -- including me -- can be irrational, stubborn and emotional. And as I
recently wrote, they can be woefully wrong.
Here are a few reasons why "listening to your gut" will eventually annihilate your account, along with some techniques I use in removing the human element from my trading.
It is human nature to harbor the perception of control
. I can't control the market, only my portfolio's exposure to a particular stock, sector or asset class. So the answer is to look past simple price action and focus on the cycles and trends that define any natural entity.
I won't bore you with the biology, but if you have ever glanced through a microscope slide, you are more than familiar with the symphonic randomness of nature. So I begin with the assumption that the market is simply an extension of the natural world -- an environment of chaos, uncertainty and emotion. It is also an environment over which we as individuals have little effect.
The market moves as the seasons move: in trending cycles over which we have no control. So even without a calendar, I might be able to tell you that spring is finally here. Not because it is warm on any particular day, but because I have observed a number of days in which the general trend has been toward longer, warmer and more sun-filled days.
The seasonal analogy is quite applicable to the markets. A trend doesn't change in one day, but over a period of time. When my positions are moving against me, the pain I feel is one indication that the trend is changing.
It is human nature to be overconfident in our abilities
. It might surprise you that I am always reluctant to take a position in the market ...any position. When you are in the market, even in a so-called "defensive" position, you are exposing your portfolio to risk.
One way in which I reduce portfolio risk is by maintaining a continual emphasis on diversification and asset allocation. I have met far too many individuals who think that 10 or 12 stocks (most of them tech names, no doubt) constitute a diversified portfolio. This is simply the trading equivalent of Russian Roulette. The answer is to be proactive in reducing risk.
To begin with, I diversify among individual positions. My trading unit is generally 2.5% of my overall portfolio, and I am reluctant to initially commit more than that to any one trading idea.
I also seek to hold noncorrelated asset classes. If the
is weak, most likely the entire market is weak. So to reduce my market risk, I maintain nonequity holdings in commodities, fixed income and cash.
I also spread my bets among different sectors and market capitalizations. Using sector Spiders,
Standard & Poor's Depositary Receipts
, or Webs,
World Equity Benchmark Shares
, is an easy and effective way to tailor your exposure.
Another way in which I reduce risk is by never being fully long or short the market. A "traditional" hedge fund is generally 60% long and 40% short, and while I do not always stick to these guidelines, I do make an effort to hedge my long exposure with some well-placed shorts. So if I am long
, I'll probably also be long some
, or at least short some back calendar calls -- those expiring six to nine months away -- on the Nasdaq 100 Index itself. The concept is to trade the natural volatility of the market. If derivatives and short-selling are too involved for your own trading style, you might investigate one of the "short" mutual funds now available.
I also look to reduce risk by getting paid to take positions via options strategies. If I want in a position, I won't hesitate to sell an in-the-money put and risk getting assigned the stock. Once I'm long the stock, I'll immediately look to sell calls on a portion of my holdings. If the stock subsequently rises -- and gets called away -- I will re-evaluate the fundamentals and consider getting back in.
This strategy, called "systematic writing", is especially effective for taking advantage of high volatility in core holdings, which means you can be paid very well for either selling calls or puts. Watch the
, or VIX. Very often one can sell inflated options premiums when volatility is high, especially for the back month options. Once volatility comes back to normal -- assuming volatility
come back to normal -- savvy traders can buy back these positions.
Note: In Part two later today, Hoenig shares his advice on what happens when traders look to others to validate their own opinions.
Jonathan Hoenig is portfolio manager at Capitalistpig, a Chicago-based hedge fund
http://www.capitalistpig.com. He is the author of Greed is Good, recently published by HarperCollins. At time of publication, the fund was long the Nasdaq 100 Series Trust, and short the Nasdaq 100 futures, although positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to comment on his column at