Five questions to ask before each trade

Successful trading and investing is largely about asking the right questions. Many of the most serious mistakes we make come from blindly accepting our ideas and perceptions at face value. I would like to offer you a short checklist of questions that will challenge you to think more deeply and to work out your process more thoroughly.

1. Do I understand this idea?
Every investment or trading decision rests on an idea. On one extreme, perhaps the signal to buy or sell something is generated by an algorithm (a set of rules); even in this case, the algorithm is built on an idea that something should happen in the market after a set of conditions are fulfilled. On the other hand, maybe you are trading off a hunch or a gut feel.

Ideas can come from many places: are you following someone on social media? Is your idea based on fundamental, macro, or technical ideas? I think the key questions to ask are do you really, fully, understand the idea and were it comes from? (For instance, many people trade-off of dimly understood beliefs about fundamentals. If you are taking a 2 day trade based on “fundamentals”, you probably have a logical disconnect.) Also, is your idea reproducible?

Is this an idea you can execute, in some form, over and over? Good investment and trading programs are built around consistency, and, for this to happen, the idea must be something you can repeat. (We should also ask if the idea has a statistical edge, but that’s a rabbit hole we can explore another day.)checklist-154274_640

2. Do I understand how the market should move if I am right?
This is important, and not as simple as it seems. You think something is going up so you buy, but when should the market move? How long is it ok if the market is flat? What if it goes down a little bit, or a lot? What would be strongest confirmation of your idea? What might mean the idea has become consensus and is now vulnerable to reversal–when is good, too good?

Another variation of this question is asking if your position will properly capture the market move. In some cases, this is simple: you think the Nasdaq futures should go up beyond the high of the day in the 30 minutes, so you buy Nasdaq futures–simple. But what if you think volatility is going to increase in stocks and you’re trading the VIX futures, or a leveraged ETP, or options on one of the above? Do you truly understand how those products will respond to market movements? What if you think Delta Airlines should do better than its competitors? Is buying DAL the right play there?

3. Do I understand my risk?
No, not do you know where your stop is; I mean do you really, truly understand your risk? What is the worst that can happen, and what is the probability of that worst case outcome? (As I wrote in my book, we have terrible intuition about very rare and very serious risks–this is one reason that risk management is so difficult.) Once we’ve accepted that worst-case risk, we should then begin to think about less serious risks. Do not just assume that your risk is your stop; think deeper.

4. What might I be missing?
This is hard one, because the question you’re asking is what do you not know, and what do you not know that you don’t know! Many people find it challenging to think along these lines, but this is one way that we grow as traders and investors. Always ask what you don’t know. Always be learning.

5. What mistakes might I be making?
More and more, the investment literature focuses on cognitive mistakes. There are important lessons here, but, to me, one of the most important is that things are “wrong” with the way we perceive patterns, risk, and probability. These errors are fundamental part of human perception and cognition, and you aren’t going to change them–you cannot fix most cognitive biases, so how do you work with them? How do you minimize their ability to harm you? Asking these questions can help you protect yourself from some serious and dangerous errors.

These questions will not solve every problem you have, but they can point you in the right direction and help you work toward solutions to some of your most serious challenges.

Read more from Adam at his blog on financial markets, risk and life at http://adamhgrimes.com. Twitter: @AdamHGrimes

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