Risk & Mind Management / Trading Foundations

I shall be writing two articles for Market Analyst in my quest to identify why only 10% to 20% of traders achieve success. It is almost a cliche that trading success is a function of:

Winning Psychology (60%) x Risk Management (30%) x A Written Plan (10%)

This formula had been known for quite some time. In other words, the road maps (the Habits of Success) required to succeed have been clearly laid out for all to see. And given the tremendous advancement in understanding how our brain works and the role of emotion, I would have expected that the ratio of successful traders to unsuccessful traders would have improved since I started trading over 30 years ago. But, looking at the figures, the ratio remains the same - 80% to 90% are long-term losers. And this, despite the fact we went through one of the most sustained bull markets in stocks, gold, and crude oil. That environment should be conducive to trading success, but this has not proven to be the case.

So, the question must be asked: why?

One answer lies in the unrealistic expectations of each generation of newbies.

Relatively few (if any) budding doctors, lawyers, architects would believe that by attending one paid seminar, and/or reading one book and/or attending a series of free previews, they will acquire the knowledge to succeed. But this is not the case with trading. 

The fact that we are bombarded by hyperbolic claims of easy, quick and meteoric success, suggests that the ads work i.e. the purveyors sell enough products to make it worthwhile. On the other side of the equation, the relatively fewer realistic ads would suggest that genuine vendors are less successful.

But this factor is not the complete answer; I have met many genuine committed budding traders who have failed. So again, the question is why is this so?

I think it is partly because trading is a probability game, and because it is a probability game, on any one trade, a raw novice can beat an experienced trader i.e. the novice will make money in the trade while a master will lose money in the same trade.

This aspect exists only in trading: If I took Mike Tyson or Tiger Woods or Nadal, I would have no chance of beating them in their chosen sport. As a result of this quirk of nature, the mental paradigms, which would be difficult to overcome, become even more formidable. It does not help that the paradigms are unconscious and that the trading environment is surrounded by two additional barriers to success:

1.There is no formalised educational structure in trading. The gamut ranges from someone like Dr. Brett Steenbarger (who devotes his considerable expertise freely and for no charge to assist the retail trader) to the scam artists who falsify results to prove that their trading systems will have a 90% return and will turn $1 into $1M in 3 months or less.  As a result, the environment inadvertently strengthens the unconscious barriers to success.

2. The low barrier to entry. In sports, to compete with the best in the world, you need to attain a certain level of competence - not so with trading. Indeed with CFDs, you can enter the arena with as little as S$1000.00 (about US$750.00).While I am a great believer in the benefits of CFDs in the appropriate context, in this case, all it does is encourage a novice to trade when he has little chance of success.

So, we have thus far traced four reasons why the more things change, the more they stay the same:

• Human nature: wanting something for little effort

• The fact that on any one trade, a novice can beat a professional

• The lack of a formalised educational structure and

• The low barrier to entry

The biggest block to our trading success is what I call our 'default future'.

In our childhood we encounter events to which we develop strategies to enable us to be safe, and secure. In time, these strategies become automatic, unconscious responses. To the extent we come from a functional environment, is the extent to which we achieve success - the responses become our strong suits; to the extent we develop dysfunctional responses, is the extent to which we will fail. By functional, I mean with the ability to deal with reality.

But whether the responses are functional or dysfunctional, they key point is they are unconscious and automatic responses - and as such, until we become aware of them, they create a default future. In short, the responses are what we don't know, we don't know and until they become known to us, we will continue to respond in the same way, especially during times of stress.

In addition, it appears that humans are hard-wired with two traits and these two traits are formidable barriers to our success:

1.Our decision-making process falls predominantly into the Impulsive or Risk Manager mode. It's important to understand that the terms describe a mode of behaviour we tend to fall into; we need to execute our trades in the manner best suited to one of the two modes to which we belong. For more information read: Day Trade?
(http://tradingsuccess.com/blog/day-trade725.html).

2. We invariably develop two unconscious strategies; the fixed mindset and the growth mindset. We have both, but one tends to predominate. The fixed mindset says that our ability and intelligence is limited. Therefore our success is dependent on the talents we have. Since that too is limited to what we were born with, there is no point in seeking to improve and enhance it. This mindset is seen most clearly with talented individuals who do little to enhance their abilities e.g. John McEnroe.  I would venture that this mindset predominates with those that enroll for the sure win, no effort school of trading.

The other mindset is the growth mindset that believes in constant and never ending improvement. It is the basis of the recommendations in the Cambridge Handbook of Expertise and Expert Performance and in the book, Talent is Overrated. With this mindset, we believe that success lies in our actions, and it is up to us to achieve what we can with the talent we were given. 

Like our default future, these traits are unconscious responses and not something that we know, we know or that we know, we dont know. Rather like our unconscious strategies, they fall into the category of something we don't know, we don't know.

Since our default future falls into the what we dont, we dont know category, how do we identify it?

The easiest way is to observe our stated outcomes, our behaviour and our results. If our behaviour does not lead to our outcomes but we persist with the behaviour, you can bet your bottom dollar that some unconscious response is at play.

For example, you would have a screaming pointer of a response at play if your goal is to attain consistent trading success, and yet you continually breach your trading rules. I have chosen this example because it allows me to bring in the two human traits:

1.The Impulse/Risk Manager decision-making process and

2. The Fixed/Growth Mindset.

But before I get into that, let me bring in one more important variable. Denise Shull rightly promotes the idea that as long as we are executing our trades (as contrasted with a computer executing our rules), we must allow for some form of discretion. In some quarters, this may be seen as a breach of rules, but she likens it to a coach giving his team the play and having the quarter-back make the on-the-field decisions. A good example of this took place for me on FOMC night.

I had decided to sell the ES if:

• I saw volume at 896 and

• The volume occurred no earlier than 10minutes after the rate decision was announced.
  

Well, right on the button, strong selling volume came in and at 899, I decided that the strength of the volume meant that at 896, we would see the volume that would trigger the sell signal. So, I took the trade and got filled at 898.75. If I had been proven wrong, I would have exited the shorts.

Denise is right, if we do not allow some room for our discretion, we are doomed to not following our rules in situations which not following is the correct thing to do.

This brings me to the next point. My dominant decision-making process is that of a Risk-Manager, which is why I have better trading results as an 18day swing trader than a day-trader. But there are times (usually in the execution of a trade) that I act more like an Impulsive decision-maker,  and I am OK with that - as long as I exit the position, if the market fails to do what I was looking for.

So, if you are someone who is not following your rules, check to see your decision-making style. If your style is the Impulse mode, then make sure you do some pre-planning as this will help your intuition.Then just execute on your intuition BUT after executing, check the reward/ risk, trading benchmarks, etc. If the trade does not qualify, just exit. Do not anchor your entry price - just exit. In other words, the decisions (normally made by the Risk Manager) before the trade are carried out by the Impulse Trader after the trade. An example of an Impulse category would be most pit traders of old. 

An acquaintance recently told me: You know theres one simple reason why most people dont make the improvements in their lives they long for: The reason is that nothing is going to change in their lives if they dont take conscious actions to make a difference. You have  a choice: Either go after the knowledge and opportunities that will make a difference in your lifeor stay where you are.€

The problem is it is only now that we are discovering how to identify and change what we don't know, we don't know. And until we do that, until we change that to we know what we don't know, all the innovations and discoveries will not make one iota of difference.

An example

The last trades I took in the DX (US Dollar Index Futures) and the ES (e-mini S&P Index Futures) highlight the importance of being aware of our unconscious motivators.

Regular readers of my blog(www.tradingsuccess.com/blog) know that I started2009 with a whimper. I failed to recognize that my trading was in an Ebb state, and as a result, suffered the largest monthly loss since I started managing my private closed fund in 1990. Since then, I have been struggling to make a significant dent in the losses.

I had great expectations for the two trades, DX and ES.  I will focus on the DX here because the ES trade is well documented on the Video/Forum/Twitter free service.

Everything had lined up perfectly, and I was very confident that my favoured scenarios would unfold. I entered my first positions at 79.67 and a second set at 80.49. After both entries, the market immediately went my way.

But then the DX stalled.

I had been looking for a simple correction but instead, we saw a small trading range develop (see Figure 1).  The second set of positions I had added to the DX 80.49 proved to be around the middle of a congestion zone bounded by 81.97 and 79.62.

On Thursday June 25, the DX went to the Death Zone of the congestion zone mentioned above and sold off. I was faced with the prospect that:

• The DX would at least break 79.62 and if it did that, a breach of 78.83 was likely. A breach of 78.83 probably would resume the US Dollar bear market. If I did not exit and the market broke as expected, I would face  a loss or breakeven trade after the market had moved in my favour.

• Or would the Death Zone sell signal play false? If I exited the positions, would the DX go up rather than down, and would I have exited my positions prematurely? What if I exited and did not see another setup and trigger to re-enter the trade? I would lose the one chance I had to make substantial inroad into my losses€.

I have reproduced some of my journal entries to give you an insight into my state of mind. I am comfortable losing up to 20% of my capital - I do not like it but accept it as part of the trading game. When I lose more than 20%, my anxiety levels rise. I respond by cutting position size and making it a priority to bring the losses down under the 20%.

Unconsciously, I had placed great faith that these two trades would not only bring me under 20% but would also substantially reduce the losses. Then the blinking market had done this!! (Quote).

Whenever I feel great stress, I find it useful to rant in my journal - it blows off steam, and it allows me to safely fully experience what I am feeling. Once I have calmed down, I return to myself and then the markets. I realized that the loss and market information I had received on Thursday had triggered my unconscious motivator. Hence the emotional response. That awareness allowed me to deal with market information in a more centered state. 

Having made a decision, I implemented it and felt better for the way I had gone about it. If I had acted when my unconscious motivator had hijacked my emotions and reason, whatever decision I would have made, would have been wrong for me.

FIGURE 1

Charts made available through the courtesy of MarketAnalyst

In this article, I have focused on the need to start with the foundations of trading success: risk management and psychology because although more important than a set of trading rules, they usually are at best given lip service, and at worst, ignored or disseminated with out-of-date material (for example: trade without emotion!).

My advice: undoubtedly, you need a set of trading rules but start with a simple one and focus on cementing the foundations. In my next article, I will consider the Written Trading Plan.

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