The hard road to consistency VIII - The tyranny of psychology

Many traders and other professionals in the trading world tell us that poor trading is mostly a psychological issue. While there's some truth in this statement, its incomplete and inaccurate. Otherwise, all psychologists should be fantastic traders.

The reality of trading is a bit more complicated. Obviously, you first need a system and understanding of the mechanics of trading. You need good risk management and trade management practices because having the best psychological state of mind is no substitute for stops.

I have searched far and wide for psychological articles regarding trading and found many books, articles and webinars, some with deep insight. However, most psychologists are not traders and their treatment of psychological issues is academic. Most of the material is generalized rather than actionable. For example: "Its more important to enhance well being than to reduce stress while trading" or "ask yourself before taking any action, am I doing whats in my best interest?"

Most of these observations are not actionable or otherwise useful. Benefits of prescriptions not related to actual trading such as marking off your trading area, feng shui, etc. may provide marginal benefits but should be viewed as borderline superstitions.

The entire development of a trader is two stages:

1. Develop or learn a proven winning system
2. Strengthen the discipline to follow it

Developing a winning system is complicated, tedious and time consuming. You are usually better off finding a mentor and learn a proven system and adjust it to fit your personality.

Once you have a system, discipline is what enables you to follow it closely. What is discipline? Discipline is simply the ability to resist short-term temptations in favor of long-term goals. Discipline is actionable. Just follow your system's rules and nothing else!

Its most important to note that many systems work only during specific kinds of price action and you should not trade if preconditions are not met. For example, my system works very well on trending and large range days and works poorly on small range days.  Fading systems work very well on trading range days and fail on trending days. Tick and bar scalpers can trade almost any price action but their win / trade is low and therefore they would need to lease a seat on the exchange to be profitable.

The ability to sit out during price action not fit for your system is discipline. The ability to stick to your stops and your daily stop loss is discipline. The ability to resist poor behavior (chasing trades, adding to losers, shorting all the way to the top, etc) are discipline.

When you chase a trade for example, you have overruled your judgement regarding passing up the preceding signal. You can never develop confidence in your market reading if you are easily swayed by a single bar. Accept that your system cannot detect every setup and at best you can catch a high percentage of moves. For example, do not buy b22 if you passed up b21 as a poor signal. Instead, add the observation to your list of things to investigate. Given enough samples, you will be able to pick on such moves eventually. You should have always anticipated a move, not react to it in urgency.

Over time, these observations will add to your system and make it richer and you will grow as a trader.

The hard road to consistency VII – No good signal bars

One of the most frustrating things for a trader is the lack of a good signal bar in a trend. A good signal bar is any signal bar with a shaved or 1t tail on the entry side and at least a 2t body. Ideally, the signal bar is neither too small or too large compared to recent bars.

I always recommend entering on good signal bars for a couple of reasons. When the market is not ready to trend your way, a strong signal bar is unlikely to trigger (b12, b66). This will protect you from many poor trades. A second important feature of good signal bars is that they are likely to respect a fixed stop (5t/6t for ES) for any given instrument.

However, on some days, there simply is no good signal bar in the direction of the trend (b10,16,20,38,50,73) but the reverse direction will often give great looking signal bars (b12,27,30,44,53,66,76).

This is typical of channel type price action. A trader who insists on great signal bars is likely to take very few trades on a channel day – which is not necessarily a bad thing, since channels are very hard to trade for most traders.

One way around this is to valuate the strengths of a signal by 3 criteria: location, pattern and signal bar. If location and pattern are strong, take a poor signal bar with-trend. For our purposes, location is a support such as HLC of prior day, ema, trendline, breakout point (as in BT) etc. Pattern is any two or three legged pullback.

Therefore, take any two or three legged pullback to a support even on a weak bar. This enables us to take b50, b56 long for example. Note that this can only be done if the signal bar is small and you can use a price action stop (beyond signal bar) rather than a fixed stop.

The hard road to consistency VI - Your equity curve as a price chart.

If you plot your winning days as green bars and losing days as red bars, you get a chart of your account size that looks similar to the price chart such as the one shown above. What makes a price chart go up and down also makes your trading account balance go up and down. When your trading is in an uptrend, you have mostly winning days with occasional losing days. The fewer and smaller your losing days, the faster your account grows.

Therefore a winning trader's account shows a cumulative graph like that of b1-17. A breakeven trader is likely to have alternating winning and losing days, todays gains lost the next day such as the range between b45-59. A losing trader is likely to lose a few times (b18-25) and go on tilt (b26-29) and then stop trading or change his style.

Its obvious that for your account to grow, you need to have fewer and smaller losing days and larger and greater number of winning days. While you may not be able to control the number of winning days versus losing days in the beginning, you certainly have the power to control how large a losing day is. Limiting your maximum loss per day prevents days where you go on tilt, effectively reducing days that look like b27 to a small bear bar, meaning much faster recovery on days where price action is more suited to your style and skill level of trading.

The first thing a big losing trader needs to do is be a smaller losing trader and then change to a breakeven trader. If you take trades where your wins are twice as large as your losses, there are very few ways you can be a losing trader, for example by going on tilt and taking questionable trades. At worst you should be a breakeven trader with alternating winning and losing days.

Once you are a breakeven trader, you can stay in the game indefinitely and hone your trading skills until you slowly start seeing profit. A breakeven trader can keep detailed logs regarding setups tried, stop sizes used, win rates, confidence in the read, etc. and narrow choices to a small set of setups that work for him. Continuous focus on this small set of setups over time will slowly flip these setups from net breakeven to net wins.

The hard road to consistency V - Poor price action days

In the post Off days, I spoke about the trader not being upto his game despite the price action being conducive to his type of trading. The flip side is when the trader is focused and ready but the price action is extremely poor. Today was such a day on ES.

Of course what constitutes poor price action varies based on trading strategy. For someone who takes very few trades and swings them to the max, a small range day with overlapped TTR action on most of the day is probably the worst kind of price action. On the other hand, a tick scalper would probably love a day like this.

There was no clear signal that worked the entire day and the biggest moves on b1 and b74 arguably were not off clear signals. New traders may get chopped up losing entire weeks worth of earnings on a day like this. This is mainly due to focusing on patterns and ignoring market context.

The risk management strategy to deal with such a day is exactly the same as the off day. You need to stop trading after two losses. Occasionally, you could look for an additional PM setup if a good one sets up (it did not today).

Expert and agile traders (I'm not one) may be able to switch context and switch to fading entry bars to get 10t on quite a few trades (for example, fading the second push down by selling close of b23 or buying close of b31 with 4t risk and 8t target)

Remember that every day does not have to be a winning day. Some days are simply not meant for swinging style trading. Since I choose to not trade unless my potential reward is 2x the risk, I prefer to stay out and reduce my exposure than to take smaller rewards (There were a few 1:1 setups).

The hard road to consistency IV - Very few low risk trades

Your consistency will only improve when your outlook changes from looking eagerly to make a profit to watching cautiously to minimize risk. Letting trades go if they dont seem to match the risk to reward expectation is the basic underlying framework of any profitable trading system.

As long as you try to recognize every tradable patterns and act on them, you are likely to stay a breakeven trader or slightly better. Once you are comfortable letting trades go, you become a far better trader.

The larger your risk, the higher your chances of making a trade work, but also higher your loss if the setup were to fail. The bare minimum risk on ES is 5t.  If you are just starting out, your win rate is probably near 50%. At 50% a 1 point win such as the long above b11 versus a 5t loss actually works against you. To account for commissions and other costs, you need to take at least 6t just to breakeven.  You would really need to look for trades that give you 2x your risk.

On an average day, there may be about two to five low risk/high reward trades. Your goal should be to focus on them and not bother with the minor trades.

For example, today there were only three setups that gave 10t while respecting a 5t stop (marked with dots on chart). Technically, some other bars such as b60 and b20 may have worked but they were second entries or not clear setups.

The best risk to reward is the first deep pullback in a new move. b17L was the first deep pullback in a bull move and b69S was the first deep pullback in a bear move.

Measuring risk is also about knowing when you can trade and when you need to sit out. When bars are small (b23-60) you are usually better off sitting out until bars come back to normal. Otherwise, you risk the pattern play out just as you expected but unable to reach your target. Wait for decent sized bars and then look for setups.