Change your Mind, upgrade your Trading
Updated: Sep 28, 2020
Often times traders, especially newcomers, think that in order to be a successful trader they must learn everything they can about technical analysis. They think that the more material they learn, the better results they can achieve. This couldn't be further from the truth.
In fact, in trading, your biggest enemy is not the market nor other traders, it's you. You are the only person holding you back from consistency and success.
Think about it this way, if two people are using the same system and only one of them is successful, then what is the only plausible explanation for that ? There must be something different in the successful trader's mind (either concious or unconcious).
In this article, I want to introduce you to some concepts that make successful traders successful and that there's a direct correlation between gambling and trading.
2. The Trader's Death Triangle
A lot of traders struggle because they get caught up in what I call the "Traders Death Triangle".
Every trader has to deal with losses (notice what you feel when you hear that word). That is inevitable. But, our minds are wired to protect us from emotional pain. Because of the way it works, we try in any possible way to justify losses. We try to rationalize by finding a set of reasons and excuses to relieve our pain. Ultimately what comes up is :
"I need to learn more in order to avoid losses."
There we are, learning about other indicators and methods in order to avoid the inavoidable. Now, what happens on that next loss after we learned a new tool ?
We will still feel emotional pain.
And we keep on finding excuses, coming up with the fact that we need to make ourselves more knowledgeable. This process goes on and on, until one day, we either blow our account or start questioning our beliefs, whether conciously or unconciously.
The problem doesn't come from learning a new tool per se, it comes from learning a new tool in order to avoid losses. It is our intention that is not aligned with the reality.
Obviously, there are traders out there that are creating a consistent income. Considering what we said, what can we assume about these traders ? Are they consistent and successful because they have more knowledge than us ? Are they in any way smarter ? Maybe, maybe not.
What is undisputable, is that they have to some degree accepted the fact that trading is just like gambling. There is no difference. The thing is, when you trade, you are gambling, but you are not the player, you are the casino. And what's so special about casinos ? Well, you probably know the saying :
"The house always wins."
3. Understanding the nature of Trading
It is hard to believe that trading is just like gambling. Since the first moment we started our trading journey, we always had the impression that trading was all about skills. That is absolutely wrong.
Why am I saying that trading does not only rely on our trading skills ? To understand that, we have to understand the nature of price movements. This is a concept that seems just so obvious to everybody, but it isn't. If it was that obvious, we wouldn't find ourselves trying to avoid losses.
So, what makes prices move in a financial market ? Other traders, of course. We are tied to others when it comes to trading. Whenever we buy or sell short any financial instrument, the only way we're going to make profits is if other people have the same conviction for the future as we do. In other words, they need to act in a way that is consistent with what we believe.
Now, it's pretty easy to assimiliate that concept. How can we predict what thousands or millions of traders on the same market are going to do ? We can't. People might not have the same convictions and beliefs as we do !
We can't expect others to believe exactly what we believe. They only thing we can do is guess what they might do (i.e. act in a way that gives us a higher probability of something happening over something else).
4. The market's perspective
What we know about the market, is that it forms patterns. Patterns imply consistency. Meaning that the same patterns repeat themselves over and over again.
Because a pattern repeats itself over and over again, we, as traders, are able to create what we call an "edge" (e.g. a trading strategy). An edge is defined as "the probability of one thing happening over another". To clarify this, whenever we see an edge, it doesn't mean that we KNOW what the market is going to do, it does only mean that we put the odds in our favor.
As an example, what you see below is an edge ("First pullback after breakout").
This is where the notions of consistency and randomness merge :
The outcome of every trade is random
The outcome of a larger series of trades is consistent
What does this tell us ? It tells us that on a micro-level (each trade), there is no way we can know what is going to happen (and we don't need to know !), but on a macro-level (overall) we know that we will be profitable (it goes without saying that the strategy must be valid, i.e. backtested).
Then, there's no reason to bother trying to predict anything. Moreover, since you don't bother trying to predict, you can focus 100% on the execution of your trades.
5. Accepting the risk
What does it mean to accept the risk ? Many traders think that because they put a stop-loss, they automatically accept the risk. The problem is, defining a risk becomes something every trader does without even thinking about it. Think about the first things you do in the morning after you wake up. You don't do them conciously. They're so deeply anchored in you, that you do them unconciously.
Why am I defining the risk in advance ? Defining the risk is not sufficient to avoid emotional pain. Traders define a risk, but think "well this pattern is great, it's going to work out". Now, what happens when they get stopped out ? Pain.
We could define the notion of risk as follows :
"The distance I'm willing to let the market move against me, before acknowledging that my trade didn't work out."
If the outcome on a trade-to-trade basis is random, how could you, as a trader, feel emotional pain when your edge doesn't work out on a particular trade ? You shouldn't, because whenever you enter a trade, this is what you should be thinking :
"I accept to risk a certain amount of my capital, in order to see if the trade is going to work out."
Without any doubt, every trader will have to face losing streaks. We now know why streaks occur in a trader's journey, but how does the typical trader react to it ?
Let's consider the following example :
The trader has just gone through a streak of 4 losses. He just spotted an opportunity, a perfect setup that matches his strategy, every single signal is present, just as they were on all the other trades. This time, something is different.
Again, it's not about the market, but it's happening inside the trader's head.
How does he feel ? He is probably hesitating, he is fearful, he starts questioning his strategy, he doubts his skills, he is afraid of putting on that next trade !
From an objective perspective, there is no reason the trader should be afraid to put on that next trade.
The problem is when we start being fearful we cease to think objectively, instead we are trying to gather information to assure us that that trade will work out.
There's an example I really like, that illustrates the power of fear on our perception of information.
You probably recall "bagholding" a position, meaning you entered a trade without defining the risk ( or you didn't accept to take the loss) and the trade went against you.
What happened ? You were so afraid that you couldn't hit that sell button. Whenever the market gave you a few ticks, you thought "alright it's bouncing back".
You're hoping to avoid the loss (which is a psychological characteristic called "loss aversion"), this is how our brains are designed to work. This raises another fact : usually when we decide to sell our loser, the market bounces back. This is because these human characteristics are universal. In other words, you were not the only one holding on to a loser. Whenever the pain becomes intolerable, you decide to sell. So do other people.
Think about what this means. The market bounces back when you sell. What does that imply ? Other traders were seeing the price action through an objective lens. They saw everything you didn't see because your perception was clouded by fear.
That brain freeze is caused by a part of our brain called the "periaqueductal grey", which triggers automatic behaviors meant to protect our minds (or bodies in case of a physical threat) from pain.
7. The 5 beliefs
Mark Douglas is considered to be the pioneer of trading psychology. My work is partly inspired by his teachings.
He came up with the "five fundamental truths of trading". In order to become a consistent and successful trader, you have to instill these beliefs into your mind. You do not only have to accept and understand them, they have to be a part of your identity. This takes time and practice, because you probably have beliefs that are in conflict with these truths.
1. Anything can happen : Think about it that way, it only takes one trader somewhere in the world to negate the outcome of a trade.
2. You don't need to know what is going to happen next in order to make money : As we already discussed, there is not way you could predict what is going to happen and that doesn't matter because, remember, over a longer period of time, you will always be profitable.
3. There is a random distribution between wins and losses for any given set of variables that define an edge : If you have an edge that you know has a 60% win rate, you do know that you're going to make profits 60% of the time and lose money 40% of the time. What you can't know is in what sequence the wins and losses are going to occur.
4. An edge is nothing more than an indication of a higher probability of one thing happening over another : When you act on an edge, it does not assure you a profitable trade. It just tells you that the chances for a positive outcome are in your favor.
5. Every moment in the market is unique : This is an important statement. You might have two different charts that look exactly the same, but the outcome might not be the same because on each chart there are different people.
I hope that you enjoyed and got value out of this article. In further articles, I'll dive deeper into these concepts. If you have any question, suggestion or idea, do not hesitate to leave a comment below.
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