Trading psychology is predicated on first having a profitable methodology
(Forex FX 4X, Trading Mindset and Trading Psychology, Guest Post)
The following is a guest article from Hanover who I would like to thank for this excellent trading psychology post.
A mountain of literature has been written about trading psychology, and that oft-heard ‘d-word’: discipline.
Contrariwise, I’ve always been impressed by Gil Blake’s succinct, no-nonsense summation of the art of trading (as quoted in his interview in Jack Schwager’s New Market Wizards):
“[i]There are five basic steps to becoming a successful trader. First, focus on trading vehicles, strategies, and time horizons that suit your personality. Second, identify nonrandom price behavior, while recognizing that markets are random most of the time. Third, absolutely convince yourself that what you have found is statistically valid. Fourth, set up trading rules. Fifth, follow the rules.”1
Given this elegant, step-by-step formula, the entire literature of trading psychology ultimately resolves itself in those three final words, namely following the rules. But this is unconditionally predicated by the previous steps: establishing definitive rules — for entries, exits and trade size — that are based around non-random price behavior; and absolute statistical confidence that these rules deliver a winning ‘edge’. Anything less is mere guesswork.
It’s my view that there’s no ready substitute for this. Without total confidence in our method, maintaining any kind of discipline over the long term is going to be near impossible; we have no logical platform for dealing with the occasional sequences of losses that will inevitably occur. And how can we otherwise know whether these losses are a most likely a temporary aberration, or whether shifting market conditions necessitate that our method is in need of review, and possible overhaul?
The order of the steps is also significant: until we have our methodology in place, discipline is effectively irrelevant, as we have no rules to remain disciplined to.
Assuming that we’re willing to take demo (or ‘paper’) trading seriously, it can be helpful in allowing us to test our method objectively, providing us with confidence that our edge continues to operate successfully in real time, and under current (even if simulated) market conditions. It’s my view that folk who denigrate the value of demo trading — on the grounds that it doesn’t test emotional mettle — underrate the importance of first building a sound trading methodology.
Over the years I’ve had the privilege of communicating with a few successful veteran traders. And despite differences in their approach (one was clearly a ‘discretionary’ trader, for example), all described trading as a mundane, rote exercise: following the same well-worn steps routinely to deliver the same average result. A recipe of pragmatism and simplicity.
According to trading psychologist and author Dr Brett Steenbarger, “trading affects psychology as much as psychology affects trading”2. The lack of a proven profitable method can cause aspiring traders to make emotionally-based trading decisions. Consequently, they attribute their failure to their obvious lapses in discipline, when, unbeknown to them, this is actually masking their lack of trading knowledge and experience. That highlights another good reason why it’s important to have an unambiguous trading methodology: it makes it easier to pinpoint whether any shortcoming lies with the implementation, or in the methodology itself.
It’s my view that many folk attempt to circumvent psychological problems by seeking measured, textbook answers, when emotions are ultimately existential in their nature, and hence the only real solution is (as Dr Susan Jeffers might say) to “feel the fear and do it anyway”3. The only way to overcome fear of water is not to study swimming, but to take the plunge oneself.
Many trading-related problems can be alleviated, or even defeated, by applying a little self-honesty and common sense: if, for example, exits are our Achilles heel, then we can simply use automation (TP, trailing stop, and/or an EA) to manage our trades, and walk away from the computer. (And moreover, the only possible justification for micromanaging a trade is statistical proof that newly acquired information has invalidated the original trade parameters). As another example, demo trading can also help to demonstrate that a problem is rooted in a fear of being wrong, as distinct from a fear of losing money. Again, simple common sense.
As a final point, we can sabotage our trading by over leveraging ourselves not only mathematically, but also emotionally. If trading full lots makes us sweat bullets, then we must step down to mini-lots; it’s a case of knowing our personal pain threshold (which is generally lower than most folk think!), and staying well within it. We must know the worst-case risk before entering a trade; if we feel remotely uncomfortable, then we either downsize accordingly, or don’t take the trade. As the maxim says: “scared money never wins”.
We can make trading psychology as simple or as complex as we want to. But we must not fool ourselves: only after proving that we have a real methodological edge should we ever start to look at emotions as the primary cause of any trading failure. If we don’t know how to trade profitably, then no amount of discipline, positive thinking or psychotherapy is going to suddenly make us a winner.
1 also http://www.scribd.com/davidn_105/d/7…of-Consistency
3 Feel the Fear and Do It Anyway is the title of Dr Jeffers’ best-selling book: