The most important question you need to ask

I spent an hour a week ago talking with a very experienced stock trader. This guy has made a lot of money, but he’s made it while fighting a strongly bearish bias–he’s been almost exactly wrong, for a long time. He’s been wrong, and he’s stayed wrong. Though he’s made money (a testimony to his trading skill), he knows he could have done much better without this bias, but he’s been unable to shake it. The more stocks go up, the more certain he is that the day of reckoning is just around the corner, the more support he finds in cycles, numerology, fundamentals, and indicators, and the more bearish he gets. As we were talking, I found myself asking one question over and over, and trying to get him to ask himself the same question: how will you know when you are wrong?

121313_1953_ReaderQuest1.jpgIt is human nature to have biases. We naturally form opinions, and traders have to act on those opinions–you have to risk your money (or someone else’s) based on your “opinion”, so we logically look for supporting factors. This can get a little bit crazy because you can always find justification: there’s some Elliot wave count you can coerce, some confluence of Fibonacci ratios, some indicator, some pattern, some cycle, some pattern in numerology, some fundamental justification, some projected political or macro event, some shift in balance of trade–there is always something!

Many people don’t realize this, but it is always possible to find justification for being long, short, or flat any market at any time. This is why we have to narrow our scope and define our trading strategies clearly–it’s always possible to find justification to do whatever you want. It’s impossible to overstate the importance of that point, so please read it a few times! You can always, at any point in time, find justification for executing whatever trade you want.

Karl Popper was one of the greatest thinkers of the 20th century–scientist, philosopher, and philosopher of science. At the risk of oversimplifying, one of his most important ideas provides the foundation for modern scientific thought: ideas can never be proved, only disproved. We need to focus not on finding things that support our ideas, but we should look for pieces of information that contradict. An idea is only meaningful insomuch as it can be disproved.

In other words, if you can’t clearly say what could prove you wrong, you don’t have a trading idea–you have faith. Faith may very well have its place in human experience, but it has no place in financial markets. We manage risk based on the hard realities of being right and wrong within a vanishingly narrow sliver of a probabilistic edge. We must be brutally honest with ourselves and with our trading ideas, because the market is brutal.

So, every time you put risk on in the market, ask your question this question: how will I know I am wrong? What could  happen that will show me my idea was wrong? It’s not an exaggeration to say that is the most important question in trading, and it’s one that is often overlooked. If you don’t have an answer, you don’t have any business pulling the trigger on that trade.

AdamHGrimes

Adam Grimes has over two decades of experience in the industry as a trader, analyst and system developer. The author of a best-selling trading book, he has traded for his own account, for a top prop firm, and spent several years at the New York Mercantile Exchange. He focuses on the intersection of quantitative analysis and discretionary trading, and has a talent for teaching and helping traders find their own way in the market.

This Post Has 16 Comments

  1. Rich

    Totally agree! Great post as usual.

  2. Passion

    Its called a stop location identified in advance. U cant kno ur risk if u dont

    1. Adam Grimes

      That’s part of the answer… but only for certain types of trading. I have a post coming up on how trading ‘sayings’ can be dangerous because they don’t apply to so many types of market activity.

      But, yes, if you’re that kind of trader then a stop location is absolutely critical (but that still doesn’t address the issue of managing a bias).

  3. thorgood

    don’t make big bets..so if you do go wrong, it won’t destroy you. experience and history are the best teachers..if you’d paid your dues and paid attention, you can teach yourself a lot. filter out the noise, and don’t get distracted. question everything and everyone. be paranoid. assume it’s a lie until proven otherwise. remember, no one has your back. listen to your gut. never push yourself into an idea or a trade if it doesn’t feel right even if all around you believe it. be aware of useless market chatter via the media-but don’t let it influence you. and most of all, love what you do. you can’t be successful navigating in a sea of fear or second guessing. cheers,Carol

    1. Adam Grimes

      You forgot one: be careful of trading platitudes. They sound good, but they only apply to certain kinds of trading. People tend to apply them blindly to all types of trading, and that causes much confusion, especially for developing traders.

      😉

  4. thorgood

    by the way, your friend was wrong and he made a lot of money? one wonders what the definition of wrong is, then..slightly less right? or maybe it’s the old better to be lucky and not right then just plain old right. hahaha

    1. Adam Grimes

      I think it’s clear from the post, isn’t it? Also, I don’t think his results were driven by luck–it’s trading skill. Chances are he could have done a lot better without his bias forcing him to fight a rising market.

  5. Sodepop88

    how will I know if my opinion on a stock is wrong? Isn’t the answer always simple and usually the same? That is, the price goes down in the time frame that I thought It would go up? Give me another example, what am I missing here?

    1. Adam Grimes

      Dont underestimate the possibility of a subtle, longer-term bias to affect your decisions in the short-term. Are you more likely to look for longs or shorts? To trade more or less aggressively? To look to reenter? To use wider or closer stops? All of these things can be affected by a longer-term bias.

      Furthermore, we need to be careful and remember that people trade and invest in many different ways. What you said might be true for a trader who enters based on a pattern with a clearly defined stop, but not everyone trades like this. How do you manage a bias driven by, for instance, fundamental valuations when market direction contradicts? How much contradiction is ok? When do you change your bias? Those are the types of questions to consider.

  6. Markus Fernandez-Kennedy

    I read from somewhere in your work that as soon as you put a trade on you should regularly try to identify whether the trade is wrong. This sage advice has made its way on to a yellow sticky note above my screens and has served me very well to date. Thank you for the great post and your clear and cogent advice.

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