While trading methods are as varied and different assnowflakes, successful traders seem to share a set of attitude traits andmoney management techniques.. Ninety percent of market books
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Chapter
Ten years ago you would find, if you looked, perhaps one or two books
written about the psychology of trading Today there are nearly a dozen
on the market I think this is partly a function of the fact that almosteverything that can be said about trading methods has been said I say
“almost” because I am constantly peppering my editor with proposals formore books!
There is perhaps another reason Traders are finally coming to the tion that a trading method—no matter how good—does not in itself lead toconsistent success in the market
realiza-When you were a teenager, your mother or father probably accused you atone time or another of having an attitude
Traders have an attitude also, although probably not of the kind yourparents meant While trading methods are as varied and different assnowflakes, successful traders seem to share a set of attitude traits andmoney management techniques In this chapter and Chapter 16, “MoneyManagement Simplified,” I delineate and discuss these common traits andtechniques
Much has been written about the power of positive thinking fromNapoleon Hill’s classic Think and Grow Rich, to psycho-cybernetics, to the
“Seth Material” and Abraham My own belief is that our consciousness is anactive agent in the unfolding universe, not the passive onlooker of most ofWestern philosophy Imagine and visualize success in some concrete form orimage You may find the universe coming to you
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The Trading Pyramid
As I have mentioned previously, there are three components to a trading gram: trading method, money management, and psychology or attitude Thevast majority of traders spend almost all of their efforts affecting a tradingmethod Ninety percent of market books are still trading method tomes Infact, most successful traders will tell you, of the three components, the tradingmethod is the least important
pro-You are well advised to allocate significant thought and effort to attitudeand money management (See Figure 17.1.) How much you order their relativeimportance determines your trading pyramid The diagram on the left is thecorrect pyramid—or at least some similar shape The diagram on the right is theincorrect pyramid—giving too much emphasis to the trading method and toolittle to money management and attitude
“1” is Money Mangement, “2” is Psychology, “3” is Trading Method.Most traders place their trading method at the base as the most impor-tant and substantial Money management is in the middle and psychology oftrading gets little attention at the top To my way of thinking money manage-ment must be the base, then psychology, and a trading method as a finishingtouch An argument could certainly be made that psychology of trading should
be the base Top traders share more attitude characteristics than anything else
Fear and Greed, Greed and Fear
Fear and greed are the base emotions that drive every market They are tive to humans and unless you use an automated computer program to trade,your goal can only be to control them and not to eliminate them
instinc-Since economic booms, busts, and bubbles keep recurring, year after year,century after century, it is clear evolution is not going to transfer the skillslearned in one generation to another and, as Santayana warned, we seemed
FIGURE 17.1 The Trading Pyramid
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doomed to repeat the past People have short memories, and fear and greed keepreturning; a hedge fund bubble was followed by the dot.com bubble, in turnfollowed by the real estate bubble in less than a decade A second hedge fundbubble may not be far away
We tend to get greedy when we are making money and overstay ourwelcome; we tend to become fearful when we are losing and again overstayour welcome These emotions cause us to mentally freeze and delay makingcritical decisions that would be in our own best, rational interest Making adecision implies change and there is nothing more difficult for a human being.One successful trade can cause overconfidence and lead to what I call theKing Kong Syndrome—the warm, good-all-over feeling that we can do nowrong A large losing trade can cause enormous self-doubt, leading us to makerevolutionary changes in our trading program when, in fact, a little time awayfrom the market and a few evolutionary adjustments would put us back on track.The late Pete Rednor, office manager at Peavey and Company where Iapprenticed as a commodity trader in the early 1970s, would wait for a trader toget the King Kong Syndrome When the trader next placed an order, Pete would
go to a telephone in the back office and place the identical order—but inreverse He usually won, and when the trader lost it all and stopped trading,Pete lamented the loss of a trading system
The key is containing the emotions of fear and greed within a relativelyslight area To do that, you must in turn be able to anticipate the onset of fear orgreed, and find methods for controlling them before they impact trading deci-sions Biofeedback works for some people; mediation for others Yoga, vigorousexercise, sedentary hobbies, and reading are other psychological health remedies.Never be afraid of the markets but always respect them Never be hesitant
to simply walk away for a few hours or a few days The markets will not goaway; they are happy to wait for you to return Never trade when you are emo-tionally distraught I had trouble dealing with missing a good trade opportunityfor many years Eventually I had the experience to see that good trades arealways going to be available
It is common for new FOREX traders to be literally mesmerized by themovement of the prices as seen on charts The short-term charts—1-minute, 5-minute, and 15-minute—move quickly up and down and carry your emotionsright along with them
Profiling Performance
Good records of your trading will help you build profiles you can review fromtime to time Often a marked change in profiles will be a leading indicator of about of fear or greed Monitor your trading results on a weekly basis Use the
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biofeedback form of Chapter 15, “The Plan! The Plan!” and again discussed inChapter 16, “Money Management Simplified.”
Look not only for how much money you are making—you cannot winthem all—but look also to see the patterns in trade series that went well for you.Profit/Loss ratios, the currency pairs that worked the best for you, the types ofmarkets—trading or trending—that worked well How often did you move astop or profit objective? Constantly jiggling stops-loss, take-profits, and yourtrading process are an early warning sign
“Know Thyself,” the ages-old Socratic saying, is a trader’s watchword.Only you know which factors cause emotional unbalance, and which do not As
I used to tell my schoolaphobic son, “Lay low, hang loose.” I know one traderwho uses Camtasia from www.techsmith.com He webcams his entire sessionsand reviews them for his facial expressions and body language
Do not try to be totally objective—it is an unattainable goal for a humanand not even a worthy goal There are good instincts hiding in the subjectiveand you do not want to bury them in your subconscious
The Attitude Heuristic
In Chapter 13, “The FOREX Marketplace,” I suggest a heuristic for your ing method I like to keep a mental chart of my emotions; an attitude heuristic.Imagine a graph going from 0 in the middle to ⫺1 at the bottom and ⫹10 atthe top (see Figure 17.2) Greed is the top half; fear, the bottom half Sure, it isexciting to make a trade It is even more satisfying to close out a winner And it
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is a disappointment to see a trade go bad Do not expect your emotions to staybetween 4 and 6; you are human They will not At least after tracking yourselffor a few weeks you will know when you are in the danger zones, perhaps above
8 or below 2 or more importantly when you are headed toward a danger zone.Review these numbers vis-à-vis your performance You will be surprised howmuch you learn and the ways you can benefit If you can eliminate 1 out of
3 losing trades you will almost certainly be successful in the long run The linebetween winning and losing can be razor thin
TIP: Use the Biofeedback Form in Chapter 15, “The Plan! The Plan!” tochart your fear and greed
Characteristics of Successful Traders
No one has all these characteristics all of the time But having known literallyhundreds of traders, I can assure you that most of them share most of thesecharacteristics—most of the time
• Successful traders tend to have control over their emotions—they never
get too elated over a win or too despondent over a loss
• Successful traders do not think of prices as “too high” or “too low.”
Prices are numbers; zeros are zeros whether there are three of them orseven of them If the size of the trade makes you nervous, it is too large;scale down
• Successful traders do not get emotionally attached to a market or a
trade They do not anthropomorphize about the markets: “They’regoing after stops now,” or “The market is nervous,” or “The marketmust know something I don’t.” Just thinking in such terms is an error.The market is not out to get you
• Successful traders do not panic They make evolutionary changes to
their trading program, not revolutionary changes
• Successful traders do not flinch at making a decision, pulling the trigger
once everything has lined up for a trade
• Successful traders treat trading as a business, not a hobby or game—
even if it is a hobby
• Successful traders stay physically fit.
• Successful traders do not trade when they are emotionally stressed or
under duress
• Successful traders hang up the DO NOT DISTURB sign when they
are trading
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• Successful traders come prepared for all eventualities on any given
trad-ing session They come to work with a plan that includes many gencies and not just for what they hope will happen In your tradingprogram you should have predetermined responses to the following
contin-“What happens if ” situations: Prices open sharply higher or lower;the market is quiet; the market is volatile; the market makes new highs;the market makes new lows; the market opens higher and reverses; themarket opens lower and reverses
• Successful traders trade only with money they can afford to lose.
Trading FOREX is speculation, not investment It can be exciting,exhilarating—and addictive Being emotionally involved with themoney at risk is a formula for losing if ever there was one
• Successful traders spend as much time on improving their attitude and
money management as they do their trading method
• Successful traders keep a low profile and do not discuss their trading
with others
• Successful traders let the market do its thing and try to take advantage.
Unsuccessful traders attempt to impose their will on the markets
• Successful traders know the rare occasion when it is wise to let their
instincts override a decision
• Successful traders consistently review their trades.
TIP: After you have completed your time on a demo account and arepreparing to trade live, review this list as a self-evaluation test
Summary
FOREX trading will greatly magnify any emotional or psychological hang-ups
or concerns you bring to each trading session Trading when not in top form isasking for financial injury in the same way driving drunk is asking for physicalinjury Leverage is to FOREX what speed is to driving
The line between winning and losing can be thin Small changes candirectly affect your bottom line—in a big way
Dismiss the importance of attitude at your own peril More than any otherfactor, it is what separates the winners from the losers in FOREX and othertrading arenas
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I have divided these touches into the more specific techniques and themore general skills
Techniques
I recommend only implementing these techniques after you have your basicTrading Plan in place Then, try each one in sequence—one at a time—to see ifany of them add to the synergy of your approach
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Trending and Trading Markets
Markets have traditionally been classified as trading markets or trending kets, meaning that they move predominantly sideways or predominantly up ordown For an excellent modern look at this conventional approach I recom-mend Ed Ponsi’s FOREX Patterns and Possibilities: Strategies for Trending and Range-Bound Markets (John Wiley & Sons, 2007).
mar-This classification is useful, but it is limited and general Markets aremuch more than simply trending or trading Further, trending and trading arerelative A five-minute chart of the EUR/USD may be trading while an hourlychart may be trending (See Figure 18.1.)
Market Environments (ME)
ME is a method for more precisely quantifying the classical idea of trading sus trending markets It is enormously useful as a complement to your tradingmethod, money management, back-testing, and performance analysis It canalso be used in what is called quant in the industry—risk, portfolio, and money
ver-manager analysis
ME also teases out indicator-like information directly off charts without theneed for calculation Bar charts work perfectly Market Environments was devel-oped by Charles B Goodman and I have done further development and research.There are two primary MEs, two secondary MEs, and a single tertiary
ME Just using the two primaries can add meaningfully to your trading arsenal
Directional Movement (DM) and Volatility (V)
Directional movement is the net price change from time point A to time point B In Figure 18.2, visualize a straight line from the low price at thebeginning of the first bar of each chart to the high price of the end of the last bar
price-of each chart The former has high directional movement, the latter has lowdirectional movement This is the net price change
There are precise methods for measuring DM, but the core concept is plicity and avoiding the calculations necessary with indicators
sim-Directional Movement P(rice)2 P(rice)1With A at 0-0 divide the 90 degrees of the chart into five sections Scalethe 90 degrees to equal 100 percent and make each segment 20 percent Labelthem 1 through 5
Volatility is the gross price movement from A to B, given a specified imum price fluctuation value You may obtain a ratio with V/DM Look at a
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FIGURE 18.1 Trending and Trading Markets
Source: TradeviewForex, www.tradeviewforex.com, and MetaTrader,
www.metaquotes.net
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FIGURE 18.2 ME—Directional Movement (DM)
sampling of 50 or 100 charts to get an idea of volatility ranges, then divide thesamples into five equal segments as with DM
In the conventional classification volatility would be similar to trading,although a market may possess both high directional movement and highvolatility over a specified time period (See Figure 18.3.)
You can plot DM and V either on a 10 10 matrix (see Chapter 13, “TheFOREX Marketplace”) or use a continuum from 1 to 10 where 1 is lowest Vand lowest DM and 10 is highest V and highest DM
Every market can be defined as one of these 100 MEs or on a continuum
in ordered pairs of (DM, V) (See Figure 18.4.)
Compare this to the ME matrix in Chapter 13, “The FOREXMarketplace.” They are two different methods for visualizing the sameinformation
An ME cluster is a contiguous set of ME pairs, either on a continuum or amatrix
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Price and Time Rhythm (PR and TR)
The secondary MEs are Rhythm—Price Rhythm and Time Rhythm—andThickness
The markets often have regular price and time rhythm But you cannotsee them if you are not looking for them and do some basic counting
For time rhythm, measure the length of time (number of time units alongthe horizontal scale of a bar chart) Measure bottoms to bottoms and tops totops; make an average of each The closer the average is to each of the specificinstances, the more regular the time rhythm
For price rhythm do the same measurements of uptrends and downtrends.Keep a running record of both values and again, average them (See Figure 18.5and Figure 18.6.)
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FIGURE 18.3 ME—Volatility
FIGURE 18.4 ME—A Continuum of DM/V
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While all four of these elements can and have been precisely defined ematically, simply eyeballing a chart for rough estimates is often satisfactory Youwill be surprised how many areas on the chart you will find where price rhythmand time rhythm intersect These are strong support and resistance areas
math-A market has regular rhythm if in averaging the peaks and valleys, theaverage you derive is not far from any of the specific values
FIGURE 18.5 ME—Price Rhythm
FIGURE 18.6 ME—Time Rhythm