Specialty Skills

Breaking Bad Trading Habits, Is the Switch Cost Too High?

Dr. Woody Johnson

Change is one of the ironic constants of the Universe. In other words, the one thing that doesn’t change is the fact that everything changes. As time proceeds, even if you aren’t paying attention you will notice that everything must change and nothing stays the same; the young become the old, and mysteries do unfold. Yes, nothing and no one stays the same. And of course, this notion is paradoxical because there are those who are afraid of change to the point that they continue to do the same ineffective thing and expect a different result.

Free Trading WorkshopPeople begin to operate within a set of parameters and despite their effusive vocalizations to the contrary, they still adhere to unwanted bad habits. For instance, they continue to talk about the importance of having an operational plan and specific plans for each trade and they don’t construct either plan. Or, despite admonitions about the critical importance of documenting their trades they don’t use a journal. And of course, there are those who repeat the same rule violations over and over while whining throughout the process. Yes, even though the notion of change is ubiquitous, folks are still stuck in a rut…or 2…or 5! But, it doesn’t stop there because there are individuals who after sincere introspection and self-reflection have identified an area or areas of their trading and they go about making a change in their trading process. They may even go as far as to put a plan together with goals, objectives and timetables with specific structures to support them in making that change, reaching those goals and turning the corner in their trading. However, even those traders who are toiling away in quiet desperation because they know that their trading is in trouble can’t maintain focus and follow-through. They “still” wander from the path and find themselves, despite the effort, back in that same rut. In other words, they couldn’t afford the “switch” cost.

Have you ever had a “brand” of computer, indicator or trading strategy that you enjoyed; but then came across another that boasted of faster response, more accurate identification or significantly better results; and you “switched?” But, later you found that not only was there a learning curve with this new item, it may have been faster but it lacked some important functions; or it was more accurate but left out some crucial data; or it produced better results only in some ways and they were sporadic? Those differences were “switch costs.” Another concept that is both similar and pertinent to the conversation is “opportunity costs,” which are both the financial and implicit cost associated with an opportunity, such as an economic investment. Investopedia defines “opportunity cost” as:

1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% – 2%). In other words, “it’s what a person sacrifices when they choose one option over another.”(1)

Now, the important point here is that when you endeavor to change your trading approach, strategies or habits there are switch costs associated with those as well. For example, identifying that you must allow your winners to run because you have been prematurely exiting trades before they have reached targets due to the fear associated with the potential loss if the price action retraces and hits your stop. This “switch” is designed to address the cost of engaging in this rule violation which is the money left on the table by not allowing the winner to run, which in some cases could be considerable. So there is incentive to change. You institute an intervention designed to support you in remaining steadfast when this situation rears its head. For instance, you tell yourself that you’ll take a deep breath and “make” yourself stay in the trade. Then, at the appointed time in the trade the price action surges past break-even for a few ticks and despite the “promise” you made, you liquidate for a small profit. Yes, despite your best efforts you did it again! So, what is the force, motivator or gain that turns out to be the “switch cost?” It is what you are telling yourself about the trade which harbors a conscious or unconscious belief that is driving the fear. This underlying belief that sounds suspiciously like, “I’ll never go broke by taking a profit” assuages your distress about leaving money on the table. Now, although this statement is not false, it wrongly infuses the mindset that it is “better” to take the small profit than to risk a loss. One thing for sure is that it feels emotionally safer and temporarily relieves the anxiety associated with the potential loss because the emotional fallout associated with the loss is often immensely more distressing than the emotional toll caused by the rule violation; that is, leaving money on the table…which by-the-way only lasts until you realize just how much money was left this time.

So, here’s the deal, you must identify the “switch costs” associated with the change that you want to make. This is done by routing out the “secondary gains” connected to that and, therefore, maintaining the status quo. Once you do that you’ll be able to “weather” the discomfort associated with making the change, in part by keeping your focus on the “reason” why the change is necessary. This is what we teach in “Mastering the Mental Game” Online, On-location and XLT courses. Ask your Online Trading Academy representative for more information. Also, get my book; “From Pain to Profit: Secrets of the Peak Performance Trader.”

Happy Trading

Dr. Woody Johnson – wjohnson@tradingacademy.com

1. http://www.investopedia.com/terms/o/opportunitycost.asp

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.