Friday, August 24, 2012

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.


  1. In your experience,which setup is the most accurate ?

    1. Continuations in a trend are the most reliable setups and in particular, the first deep pullback in a trend is the most reliable setup.

  2. Cad,
    Can you show by examples how you would. "anticipate a move"?

    1. Moves are anticipated by understanding price action. For example, a strong breakout is likely to give a BP setup that may give a trend in the direction of the breakout while a weak breakout may fail and give two legs in the opposing direction. Once a trend sets up, every two or three legged pullback is likely to continue or at least attempt to continue the trend, etc. You can see examples of these right here in the day's chart.