Sunday, November 18, 2012

The Trader's Mind X - The transition to success

So now that you understand the differences in psychological makeup of a new trader versus a successful trader, let's see how to transition your mind from the former to the latter.

Replace lust with caution and skepticism
The very first step is to limit the number of trades you take. When traders say that overtrading is a very common trading error, thats only half-correct. Many of the ills of trading poorly show up as overtrading. By limiting the number of trades you can make, you prevent the amount of damage you can do to your account in one sitting. But more important, your mind needs to shift from getting into this move to getting into the biggest move of the day. Since there are only one or two big moves in the first couple of hours and perhaps another in the last hour and half, your approach switches to looking for quality trades and large swing trades.

What this means for your account is that despite a low win rate, you can still be a profitable trader if your wins are at least twice as large as your losses. Your goal as a new trader should be to exclusively focus on large moves. If you are unsure the move is going to be large, its ok not to take the trade. Don't worry if you stand aside and the move ends up being big. That is part of trading. Learn to let it go. Similarly, you will be stopped out a couple of times and the very next move will be large (or not). That's ok. You are in the process of learning to judge exactly where the large move is. With experience it will come naturally (but not without sufficient screen time).

Replace fear with discipline
Once your discrimination and judgement get better, your larger wins and smaller losses will make you a better selector of trades however, your trade management needs to be extremely disciplined. Note that as long as you are trading in a trend (HH and HL or LL and LH) with volatility (decent size swings and bars) and near support (TL/ema/swingpoint), your chances of success should be slightly greater than 50% at the very least. Add good pattern and signal bar and your win rate should be around 60% or even more. Your decision to enter the trade is all the processing your mind needs to make. Once you set a stop and target, do not change them. Your mind is vulnerable when in a trade and susceptible to errors of judgement. You should simply let the math work for you and let the market either fill your target or take your stop out. If your setups are truly 60%, you will accumulate winnings in the long run.

Replace desperation with acceptance
Many professionally successful people who come to trading believe rightly that perseverance is a virtue and its their dogged persistence that made them successful. Realize that in trading, perseverance is inapplicable and desperation is probably what you will slip into. Learn to accept that today is a losing day and stop trading. Take a trading buddy's help if you wish. Disclose your losing trades and let them tell you to stop. Soon, you will be able to stop on your own. Similarly, do not be overconfident on successive wins and end up taking untested setups. Many traders have their large losing days right after their large winning days. If you are susceptible to these, just take a day off or only take one trade the next day after a big winning or losing day, win or lose.

Refine your method continuously
Over time, you can make slight changes to the above rules and fine tune your setups. For example, you should always keep track of the success rate of your individual setups and your average win or loss per setup. That way, passing a lower expectancy setup or taking a good setup with a questionable signal bar become easier. Always keep your trading goals in mind when you refine your methods. For example, you should prefer to refine your system for higher probability than to get a better price since adding a contract to a higher probability trade is a better way to make more money than getting an extra couple of ticks on existing size.

Over time, your approach and mental state will shift to that of a successful trader. However, this is not easy and will be a constant struggle. Even after you have been winning for a while, its possible to have slip ups and lapse into your old habits. You should always be on guard and protect your mind from harmful habits as long as you are a trader.

Friday, November 16, 2012

The Trader's Mind IX - The consistent trader

The consistently profitable trader replaces eagerness and impatience with patience and caution. The simplest thing you can do psychologically for your account is to prevent getting into bad trades in the first place.

Never be eager to trade but when your setup shows up, act without hesitation. This seems counter-intuitive, but this is how many predators work. You may have seen shows on discovery channel where a camouflaged fish stays without moving until a prey comes close enough and then it jumps suddenly and eats it. That's basically what the trader tries to be: patient but alert.  With some exceptions, its usually better to miss a trade than to take a trade and be stopped out.

Once in a trade, a winning trader simply follows fixed trade management rules. For example, price either fills a fixed target or stops the trader out. There should be little discretion here, since your judgement, which was strongest before you got into a trade is now at its weakest. Every tick against a weak trader makes him panic and want to get out for breakeven or tiny profit. Every tick in his favor makes him push the target further out. The consistent trader does neither. Its not that he is any superior, its just that he uses mathematics to ensure that his odds of reaching a profit are higher than his odds of being stopped out and over time, he accumulates winnings regardless of what happens on this individual trade. The individual trade does not matter and losses are part of trading. Do not try to use your judgement now, its at its weakest. Use well tested trade management rules.

After a win, a poor trader is jubilant and will trade larger size and weaker setups (trading the house money). After a losing trade he is in dispair and curiously may do the exact same thing: trade larger and weaker setups to "make the money back." This is a well travelled shortcut to a blown account.

A consistent trader does no such thing. He simply tries to go back to pre-trade mode where he is patient yet alert.

A winning trader also knows when to stop for the day. Its utterly important not to have large losing days and too many losing trades in a day. Your mind cannot after a point control your emotions because you may not even realize you are in a state of desperation. A winning trader stops trading at a well defined daily loss limit.

Eventually, the winning days become larger than the losing days and a trader becomes profitable. For some traders this is a sudden change but for most its gradual and occurs with improvement in their trading skill.

Thursday, November 15, 2012

The Trader's mind VIII - The basics of emotions

What exactly are emotions and why do we feel them?
Emotions are a form of self-communication. When our ancestors were primitive creatures facing an uncertain world, the mind would sense imminent danger and opportunity and activate the physical changes need for immediate action.

Obvious examples are when a predator is sensed, the body needs to quickly switch to fight-or-flight mode. Similarly, when food or mating opportunities are sighted, the mind becomes alert and eager.

Practically all your emotions and behavior stem from millions of years of survival adaptation. In the ancient world, reacting to good or bad situations immediately and appropriately meant life instead of death. Modern humans rarely face such challenges and have developed some degree of control over their emotions. Occasionally, the limbic system keeps escalating emotion and may be hard for you to control it.

Emotions are about expectancy and preparedness. Events that you are well aware are likely to happen and are prepared for do not cause strong emotional reaction. For example, if someone close to you dies suddenly, you may feel shock and dispair and cry for days. On the other hand, if they were terminally ill for a couple of years, their death may actually bring you closure and relief instead. Similarly, if you do not win the lottery, you don't really go into an emotional fit because you never expected to win. But when you win, you are delighted.

Events that you are unprepared for can cause your body to go into "just do something" mode. For example, countries where there are fire-prevention drills see systematic evacuation on a fire alarm while those without may see stampedes.

What does this mean to me as a trader?
When you are watching the market, your mind is in a mode similar to the mind looking for mating opportunities. You'll probably hit on every potential trade till one works. Once you are in a trade, you watch anxiously for prey or potential danger. This compels you to exit trades early with no loss than to stand your ground and be stopped out. When you are stopped out, your mind acts like a parent gazelle whose calf has been attacked by wolves.. Your mind goes into "just do something" crisis mode. This is also called classic tilt mode, when a couple of losses force the trader to abandon all risk management and trade management rules and just try to get his money back.

Lets call these three emotions lust, fear and desperation. Of these desperation is the hardest to control. Your mind is in a state where its willing to go to great lengths and take severe risks to get back its precious young. You will do the most damage to your account in this state. Fear prevents you from following through with your trading plan and you will end up with small winners and large losers and you will be a net loser over the long term. Lust traps you into poor trade after poor trade and your account will bleed slowly from a thousand cuts.

So how do I address this in my trading plan?
Once you understand the forces driving you, you can work on managing them. One way to manage this is to try to observe yourself and see how you act. The very act of observation will change the observed (the observer effect).

Desperation: When you are in desperation, you are unlikely to be able to observe yourself and think rationally. Having someone else observe you will often help with a reality check. This could be a mentor or trading buddy. Its important you disclose all your trades to your observer or it wont have the full effect. Your trading buddy can watch out for signs of poor emotional state and support you with feedback. Having a maximum trade count per day and a maximum loss limit will greatly protect your account from an untimely demise.

Fear: More important than entering a trade is what you do after you enter. If the trade was ill-advised and caused by chasing an unexpected large bar, you should probably just exit at the best possible price. If the trade was a legitimate setup, you need to follow your trade management with discipline. Only discipline will help you overcome fear and develop confidence. Making trade management a mechanical affair with fixed stops and targets frees your mind of fear.

Lust: Before you enter a trade and before you have encountered a losing trade for the day, your mind is best prepared to make clear judgements. If you can read the market reasonably well, take every clear setup until you hit your daily loss limit. When starting out, your read of the market will naturally need a lot of improvement and losses are routine. What you do not want to do is to react to unexpected moves. Any trade you took on an expected move is far more likely to be successful than a trade taken on unexpected moves. Tame your desire to be part of the action. Only take well defined setups. Start with one setup and add more with time.

Naturally, these are not the only emotions you face. Greed, which makes you hold well beyond your expected target is another great killer. Hope, which persuades you to loosen your stops prevents you from developing any kind of discipline. All of these need to be understood and addressed.

In summary, realize that your emotions are telling you that an event occurred that you did not expect and were unprepared for. Learn from the event and incorporate it into your trading plan rather than reacting to it immediately by trading. Use understanding, preparation and discipline to tame your emotions.

Wednesday, November 14, 2012

The Trader's Mind VII - The Chase

So far we have seen inherent character issues of a trader that work very well in the outside world but sets up the trader for failure in the trading world. These are character issues built over years and are hard to shake. However, with careful planning of rules and discipline, a trader can avoid triggering them. For example, entering only on or after the breakout beyond the signal bar, we can prevent a trader's bargain hunting behavior from causing losses.

In this post we look at a complementary part of the trader's mind, his reactivity to the market. When a trader is watching the market and is expecting a big move up, he is disciplined and waits for a good signal or pattern. Bar after bar forms and the trader chooses to pass up since they do not meet his criteria. Suddenly out of the blue a large breakout bar occurs and the trader is caught unprepared, he simply cannot stand idly by as the market apparently is shooting up. He gives in and buys way above where he would have bought if the bar was acceptable. The market promptly stops him out in a deep intra bar pullback and either fails or resumes its march up.

This is a familiar scene many traders have played over and over.  When the market moves in a way you did not expect and you feel forced to act, you are likely to make a mistake. Even if you are not stopped out, if the bar starts pulling back, your confidence will be weak because this is not a trade you have taken many times and is not a natural setup and management for you. Your mind is very vulnerable to making several mistakes at this point. One way to handle this is to realize that a weak breakout will fail and a strong breakout is likely to break into a trend and the first pullback in the trend is a far better entry.

Another classical reactivity is to a prolonged channel. You see a heavily overlapped or other poor setup in a channel and take a trade and are stopped out. You enter again and again, trying to get it right this time and lose several times before you can finally enter it just right. This leads to a phyrric victory, since your gain from the winning trade is unlikely to be larger than the accumulated losses. Traders often "persist" since they know that the direction is right, they just need to figure how to enter the channel correctly. Unless you want to fade counter-trend entry bars and scalp, the only reasonable way to enter a channel is to wait for a an attempted break of the channel or wait for the channel to break into a trend.

Realize that being right about direction is insufficient. Trading chatrooms are full of traders predicting an up or down move accurately, without being able to find a good place to enter with a tight stop. Entering with a wide stop may allow you to enter nearly anywhere but such trading carries the risk of large drawdowns and is unsuitable for new traders. Patience and the willingness to sit out until your setup appears is paramount to consistency.

In the world outside trading, persistence and chasing your dreams may be great characteristics. For trading, patience and discipline are far more important.

Tuesday, November 13, 2012

The Trader's mind VI - Conviction and doubt

In the world outside trading, persistence and conviction are good traits. A persistent man is likely to solve the problem, get the date with the woman of his choice or get a job. We judge people's conviction in their positions by how well they can defend their own views. A telling example is the characterization of an election candidate as a flip-flopper resulting in their election loss. Holding fast a misinformed opinion is seen as a sign of strong ethos than switching position based on new evidence.

Your conviction or faith in your opinion endears you to your social clique. Conservatives feel comfortable hanging with other conservatives and greens with other greens. This piece of human nature is something we learn very young and use it to adopt various facets of our identity and stick to it lifelong.

I'm a Mets fan. I'm a libertarian. I'm against the death penalty and so on. The adoption of identity facets is an automatic social behavior and its function is primarily social.

When this behavior is carried to the trading world, it works against the trader from the very beginning. Trading is ultimately a non-social function as far as your account is concerned. Your losses are your own and forming an opinion and sticking to it in the face of hell or high water works against you every time.

A trader who is convinced the market has gone up too far may short the market and when it stops him out, try again on the next high and eventually short his way to the top. A seasoned trader often does not have an opinion as to the general strength or weaknesses of the market and follows the principle: "Trade what you see, not what you think."

To develop the ability to abandon a damaging view when you are wrong, adopt a rule where if you are wrong twice, you won't trade in the same direction until the price moves substantially away from the current location. Remember that you are always wrong and the market is always right.

The flip side of conviction is doubt. A trader who has a long series of losses (including consistent winning traders) are subject to losing confidence in their system, their ability to read the market and follow their own system. Such traders are subject to buyer's regret right after entering a trade, being shaken out on even the smallest pullback and tightening stops too early and thereby exiting on a loss just before the market makes a huge move in the direction of their trade.

Even when the market moves in their favor, they are unable to hold for many points. The very first pullback causes them great distress and forces them to exit at a small profit. Imagine seeing an open profit of four points and then panicing and exiting at +1 when the market pulls back. To build confidence and enable yourself to hold through pullbacks, always take a partial profit on the first push in your direction. Especially during the first hour, reversals can be abrupt and take out your stop and change your winning trade to a losing trade, which damages your confidence even more.

The partial profit enables you to hold your runner beyond the first pullback after which it gets easier since your swing stop moves into profit once the next swing point forms. Taking partial profits and sticking to your trade management rules builds confidence.

In general, you need to work on abandoning your precious opinions regarding the economy, news, the government or anything else you think may be impacting the market. These things may impact the market long-term but you have to realize that your opinions and identity relations are worthless for trading the market. You can only rely on what you see, your trade management rules and your discipline.

Monday, November 12, 2012

The Trader's mind V - The anchor

Humans do not actually have any ability to measure intrinsic value of any item. Practically all estimated values are fuzzily calculated from any claims of value the person may have encountered.

For example, if I show an object never seen before and ask what the value could be, people are likely to go blank. When pressed further, they may guess based on its size, weight, shininess and beauty.

You may have grandparents that long for the good old days when coffee was 5 cents a cup. The entire notion of paying $5 at starbucks seems absurd to them. And to actually line up to pay that ridiculous amount is quite insane in their opinion. This because your grandpa's valuation circuitry is stuck in the 1950s. A similar thing happens to all of us on smaller timescales. This is called anchoring.

When you see an item (say a pound of coffee) for sale at $5, you expect it to remain at $5. If suddenly it jumps to $10, you wont buy it right then, you wait for prices to come back down. But if the price remains at $10 for a few months, you are likely to give in and buy it for $10. Your mind is now anchored to the new price.

Anchoring is subtly employed by stores all the time. The 50% sale tells us that the fancy hat at $200 is cheap because its real value is $400. We are so lucky to get it half-off. Why, its like we just earned $200. All we have to do to earn it is to spend $200. The store has subtly anchored the value of the article to $400 in your mind. If there was no sale, you wouldn't buy it because $200 would look expensive. This is why when JC Penny decided to forego sales in favor of everyday low prices, they took a huge loss. Nobody has any reason to buy because nothing looks cheap.

Anchoring is what makes markets stay in trading ranges (coffee should be $5) and trend ($10 is the new normal). Anchoring is also why pullbacks, especially deep pullbacks work very well (50% off sale). In fact, anchoring is why price action works very well in general.

For a trader, this means that he can simply imagine he's either a seller of buyer of a pound of coffee or any other item that he is familiar with and correctly guess the behavior of the crowd most of the time. If the price gets too high or too low suddenly, there will be resistance and the price will pullback. However, if it stays there for a long enough duration, it can become the new normal. Deep and sharp pullbacks are more likely to continue and slow slides are likely to eventually break a trend for this very reason.

Once you can understand how price moves, you will find price action far easier to read and understand.

Friday, November 9, 2012

The Trader's mind IV - The bargain

If the mad rush on black Friday's shopping is any lesson, humans love a bargain. Who doesn't like to get a $100 item for $80? That's 20% off! You can use the $20 to get something else.

Humans like bargains because it maximizes your purchasing power and is an inbuilt efficiency behavior. Efficiency is not limited to shopping. All things being equal, you should obviously choose a toaster that toasts quicker, a commute that is shorter and so on.

A person who can more efficiently spend his resources has higher survival ability and efficient use of our resources is therefore an inbuilt characteristic of humans.

When it comes to trading, a trader's efficient mind makes him want to buy low and sell high. Buying low is a good thing, unless you are in a down trend and the price is going further down. The bargain hunter forces the trader to enter into dangerous trading patterns such as:

  • Bottom picking -- It fell to $3 from $10, what a deal! (All kinds of counter-trend trading)
  • Adding on to a loser -- At $1 its 3 times cheaper, my profit will be 3x as big when it goes back to $10
  • Entering before a signal bar forms -- its going to be a bull bar anyway, may as well buy now to save 3t
I have personally struggled for months to break these habits before I was successful. The key element is to realize that the price is not what's important, its the difference between the entry price and the exit price and the probability that your stop is not hit in between.

Focus on probability and nothing else. Measure probability of success by taking SIM trades before you take action. You need to have a modicum of discipline to do this. Focusing on probability will automatically shift your mind in the right direction.

Thursday, November 8, 2012

The Trader's mind III - Eagerness and Dispair

Eventually, the trader settles in and realizes that trading is not easy but he can see patterns much more clearly. This is chop; this is a breakout and so on. However, in the eagerness to trade, the trader enters too early. The market stops out the trader and gives a better entry and resumes the move.

The trader may go into dispair at this point. An emotionally sensitive trader may have also reversed his position, thinking that the failure of a great setup is a very strong signal and may get stopped out a second time. If this happens enough times, the trader will find his confidence shaken and weak.

The good news is that the reason the market goes where you expect it to go is because you are now able to read the market. The bad news is that the human brain is extremely efficient at recognizing patterns and will alert you as soon as it can. This is a survival advantage. The earlier you spot a predator or prey, the better your chances of having a good meal and seeing another sunrise. Because of this, you will see the pattern a lot earlier and you eagerness will force you to act prematurely.

The right mental adjustment you need to do is to separate the pattern recognition from the action. Once a pattern is recognized, take it as directional advice and wait for a definitive signal. Some traders manage by using large stops. While this may work ok for many, I prefer precise entries since it maximizes my reward to risk (R multiple or RX). A larger RX in various kinds of price action is essential for me personally for trading large size with confidence.

Patience and the willingness to pass on a potential large move are essential for consistency. Once you are able to wait patiently and make a rational choice regarding any signal, you may take slightly lower probability trades if the RX is statistically very large such as 1PB in the first hour.

Patience -- the ability to wait for the right setup depends on detachment -- the ability to pass on a trade and miss a large profit. Combined with discipline, the ability to follow your own rules by resisting short-term temptations to meet long term goals is key trading behaviors for success.