Financial risk taking: An introduction to the psychology of trading and behavioural finance

Having a general understanding of the role and function of emotions is a valid area of study for traders because scientific studies have acknowledged that emotions are indispensable to th[r]

Financial Risk Taking: An Introduction to the Psychology of Trading andBehavioural Finance

Mike Elvin

Single Stock Futures: A Trader’s Guide

Patrick L Young and Charles Sidey

Uncertainty and Expectation: Strategies for the Trading of Risk

International Commodity Trading

Ephraim Clark, Jean-Baptiste Lesourd and Ren´e Thi´eblemont

Dynamic Technical Analysis

Technical Market Indicators: Analysis and Performance

Richard J Bauer and Julie R Dahlquist

Trading to Win: The Psychology of Mastering the Markets

FINANCIAL RISK TAKING

An Introduction to the Psychology of Trading and Behavioural Finance

Mike Elvin

West Sussex PO19 8SQ, England Telephone ( +44) 1243 779777 Email (for orders and customer service enquiries): cs-books@wiley.co.uk

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Library of Congress Cataloging-in-Publication Data

Elvin, Mike.

Financial risk taking : an introduction to the psychology of trading and

behavioural finance / Mike Elvin.

p cm.

Includes bibliographical references and index.

ISBN 0-470-85026-4 (alk paper)

1 Stocks – Psychological aspects 2 Speculation – Psychological aspects.

3 Investments – Psychological aspects I Title.

HG6041.E48 2004

332.6
01
9 – dc22

2004002789

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN 0-470-85026-4

Typeset in 10/12pt Times by Laserwords Private Limited, Chennai, India

Printed and bound in Great Britain by MPG Limited, Bodmin, Cornwall

This book is printed on acid-free paper responsibly manufactured from sustainable forestry

in which at least two trees are planted for each one used for paper production.

List of Figures

has been greatly enriched.

To traders everywhere, who have had the courage, determination, and vision to walk upon a unique path.

Part A: The Tactical Model of Trading Competence 47Part B: The Strategic Model of Trading Competence 59

6 Emotions, Emotional Intelligence, and the Trader 151

7 Martial Arts and Budo Zen – Controlling Fear and Self-Sabotage 179

8 Standards and Criteria for Trading Competence 219

My trading career stumbled last Friday I sabotaged myself in an old, familiarway: with too much risk, after too little sleep, layering risk upon risk after thatfirst, losing trade For months my miniature hedge fund had been doing well.Then, 90 hours ago, I gave away weeks of painstaking profit in an afternoon ofexhausted madness

I have my excuses, of course I have been under strain The trades will turnout to be correct But I should have remembered what is in these pages.This is an interesting book, an unusual and lateral response to the trader’scondition You will not find much in here about how or when to trade, and yetyou will find everything The way you view this book will determine whetheryou join the 10% of successful traders or the 90% who lose

That is because the author, Dr Mike Elvin, is a trader and a psychologist He hashad his own, terrible lessons at the home-trader’s keyboard, with the professionalbackground to analyse them On page 75 you will find a chart revealing that heknows how to trade, doubling his account equity in three months But first youwill discover his old moments of frozen terror, sweating and shaking as he directshis mouse to enter an order The honesty of the book, in contrast to most guruliterature, is one of its strengths

The main strength is the subject matter You are the most important variable

in the trading equation Not you, the set of technical indicators, or you, thefundamentalist with an insight into economies and companies I mean you, thethinking, feeling human being A good trader can make any strategy work, and

a poor one will lose money over time regardless of method A good trader, like

a good parent, employee or lover, needs self-knowledge above all

One of life’s challenges is to live in the present, and this book will help you

to live in the trading present Absorb what Dr Elvin has to say and there is a

chance, albeit a small one, that you will succeed The risk that you will destroyyourself is still great because you are human, and human nature never changes.But the survival guide is in your hands.

Tim RaymentYorkshire, EnglandJanuary 2004

Contrarian Investment Strategies

Psychology is the reason for both the consistently superior performance of themethods the financial academics cannot explain, as well as the consistently poorerresults of those approaches that fail Yet, psychology is not only misunderstood,but ruled out at source (sic) by most of the current generation of financial scholars.The study of investor behavior in markets is still in an embryonic stage.Although we can statistically trace pattern after pattern of investor behavior,

we know little of the dynamics of the complex interactions of cognitive, group,and other psychological forces that underlie them

Psychology offers the marketplace the opportunity to gain a much clearerunderstanding of what causes predictable behavior The marketplace in turn offersthe various branches of psychology a major laboratory to pinpoint patterns ofbehavior unlikely to be as statistically documented in such depth anywhere else

David Dreman, (2002, p 397)

My heart felt thanks and gratitude to Tom Williams, Director of Genie Software

and author of The Undeclared Secrets That Drive the Stock Market, who through

his friendship, guidance, and mentorship, inspired and encouraged me to achievewhat I could Also, for his practical support and introductions to traders duringthe years of research and writing of this book

My gratitude to Dr Richard McCall, who tutored me in the way of tradingdiscipline and for allowing me to paraphrase the contents of his personal lecturesand writings

To Professor Keith Oatley, Head of Psychology at Toronto University, for hisadvice regarding research in the complex field of emotions, for permission to use

some of the contents of his book Understanding Emotions, and for his friendship

over the years

My thanks to Professor Jennifer Jenkins of Toronto University for allowing me

to paraphrase some of her work which was jointly written with Professor Oatley

I thank Professor Fenton O’Creevy, Head of the Business School at The OpenUniversity, who allowed me to interview him in depth and for kindly forwarding

a number of recent research papers to me

My thanks to Mark Douglas, author of The Disciplined Trader and Trading

in the Zone, for reading my draft manuscript and making excellent suggestions.

Also, for sharing with me his personal thoughts regarding trading, life in general,and his generosity of spirit

My thanks to Richard Smitten, author of Jesse Livermore: The World’s Greatest Trader for reading a draft copy of my book and allowing me to interview him on

more than one occasion regarding his personal understanding of Jesse Livermoreand the relationships in his life

I am grateful to Michael Feeny, Senior Trader at Sumitomo Mitsui BankingCorporation, City of London, for reading a draft of my book, making helpfulcomments, and for assisting me to understand the trading culture in invest-ment banking

My thanks to James Montier, Head of Strategy at Dresdner Kleinwort stein, for sharing his insights with me on behavioural finance and giving me

Wasser-a number of reseWasser-arch pWasser-apers he wrote since his book BehWasser-aviourWasser-al FinWasser-ance

was written

My thanks to Daniel Goleman, author of Emotional Intelligence, for giving me

permission to paraphrase from his books

To Peter Schaapveld, Consultant Forensic and Clinical Psychologist, for ing a draft of the book and offering helpful comments

read-My sincere thanks to Paul Gould, Webmaster of Trade2Win, and to Alan Rich,Group Moderator and Market Trainer, for reading draft chapters of my book Thecomments were used to good effect

My thanks to Symon Price at Mental Health Concerns & Issues for sending

me many useful research documents and website links

My gratitude to Helen Quenet, Webmaster of ThePitTrader, for reading draftchapters of my book, giving me charting data, and inviting me to take part

in seminars

My sincere thanks to E Hirsch, J Joachim, T Greenwood, and E Ford, forreading the draft manuscript and making helpful comments as fellow traders.Also to Roy Didlock of TraderGuide Systems for offering useful charts andcomments

My sincere thanks to “Kappa” and 37 other home traders, who gave me able data on trading styles and personality, but who wished to remain anonymous

valu-My sincere gratitude for the support given to me by Chris Swain and RachaelWilkie (editor) at John Wiley & Sons (publishers) It took longer than we thought!

My thanks to Dr Alex Elder for allowing me to paraphrase some of his work

My gratitude to Mr K of the FSA for permission to publish his commentsregarding training

My sincere thanks to Lewis Borsellino for allowing me to interview himbetween the 9th and 18th holes, and helping me to understand the nature ofopen outcry trading at the Chicago Mercantile Exchange

Also, my sincere thanks to Girma Mesfin, who has given me encouragementand support over the years of writing this book and who has shown me byexample that perseverance will eventually result in success

My sincere thanks to Sonia Stevens and Sue Bradbury, both of whom typed asignificant amount of this book and who make a tremendous effort to ensure alldocuments were completed quickly

And finally, to my friend and trading colleague, Tim Rayment, a very talentedtrader and award winning journalist, who gave me helpful comments on themanuscript and spent a considerable amount of time writing the Foreword to thisbook I am indebted for this kindness

Mike Elvin 2004

For the purposes of this book, “risk” is defined as the coexistence of dangerand opportunity; where there is uncertainty in relation to future outcome Theseductive blend of danger and opportunity has a powerful allure and the challenge

of day trading is fraught with dangers, not normally associated with traditionalemployment If you have one, two or three degrees, diplomas, MBAs, whatever,you have no advantage over an astute corner shop newspaper vendor or a streetflower salesman In fact, a hypothesis has been suggested to the contrary; thatpeople with professional qualifications need to “unlearn” their cognitive schema

to engage the venture unencumbered by predispositions

The substance of the book has been drawn from two sources: first, from my sonal experience of changing professions in my late thirties from a relatively safecareer of managing mental health services in London, England, to that of a stockindex futures trader; second, from the large volumes of academic research papersand related literature in the fields of experimental psychology, occupational andperformance psychology, economics, day trading, and business administration

per-I hold formal qualifications and training in these fields and have confidence tomake valid inferences from training, research and personal experience

The purpose of this book is to present a synthesis of contributions to thepsychology of financial risk taking (I will use the term “trading” as synonymouswith “financial risk taking”) by numerous authors from the above fields It willintroduce the neophyte trader or speculator to a world of personal growth andlearning which is as much of a requirement for competence as is a thoroughunderstanding of market technical analysis.

When I embarked upon my training as a derivatives trader, I read many books

by “experts” and I discovered that old concepts were being rebranded with tatious new names Many authors led me to believe that they had “invented” newanalytical systems or “discovered” scientific axioms, but I have now come tounderstand that many systems are combinations of moving averages of varyingdegrees of complexity There will always be exceptions to this

osten-During my novice years of trading, I read Jack Schwager, Market Wizards and The New Market Wizards, which I highly recommend I met numerous other

“experts” and “wizards” in England who did not quite have the pedigree ofSchwager’s “Wizards”, but nevertheless presented me with a model or paradigmfor learning I did not understand the difference between going “long” or “short”

in the market, which will give the reader an idea as to the amount and quality oftraining that I needed to achieve competence

ALCHEMY AND WIZARDS

I met my first tutor through a highly complimentary article in a respected nationalnewspaper The man seemed highly intelligent, had a few endearing idiosyn-crasies, and called himself “Chief Wizard” I parted with ¤9000 for two weeks’tuition and software Following this course, I discovered that the course contentwas seriously lacking and the software was archaic

Whatever reason leads us to train to become traders, there is then the task offinding suitable courses taught by tutors with the personal attributes of integrity,quality and ability In the USA there are numerous courses taught by recognisedtraders and there are numerous sources where candidates can access opinions andviews of previous attendees In the UK, trading as a full-time endeavour has onlyrecently become a reality and many candidates have been hoodwinked by charis-matic tutors of questionable ability Essential attributes such as qualifications,experience, and proven trading ability have largely been ignored by candidates,mainly as a result of lack of information and general knowledge

I refer the reader to Box 1.1 where there is an outline of a course taught in the

UK by a tutor calling himself Chief Wizard I could be accused of inappropriatelyusing this book as a vehicle to “get even” since I was one of many people to beduped by this man It is a known fact that post-course complaints often betraytheir underlying motives of subtle revenge towards the disappointing training andtutor I have no such motives My intentions are two-fold; first, to raise general

awareness of courses taught in the UK and second, to allow the reader to assessthe quality of this course on a continuum from unsatisfactory to satisfactory Inother words, it is not my intention to bring Chief Wizard (CW) to his knees; it

is my intention to bring the investing public to their senses! The course outlined

in Box 1.1 was not written by myself, but was written by a student of ChiefWizard who had the intention of sending the document to trading standards andlaw enforcement agencies The document highlights many pertinent issues Ihave preserved the document as much as possible in its original form, save forcorrecting grammatical errors and clarifying convoluted points

Box 1.1 Derivative’s Trading Course of 1998 Sold and Taught by

‘‘The Chief Wizard’’

Last spring I attended a two-week course in derivatives trading run by theChief Wizard (CW) The course fee was £5000 and one was also required topurchase software at a cost of £1865 It had since become clear to me thatthe software itself is out of date and significantly defective, and what littleinformation was gained during the course is almost of no value

With the software, the buyer receives a book entitled “The UndeclaredSecrets of the Stock Market”, by the respected veteran trader and marketanalyst Tom Williams Most of the relevant information presented by CW inhis course is in fact contained in this book CW tells his students that thebook is fraught with deliberate errors in order to wrong foot those in theknow After much build up, he eventually leads his students page by pagethrough the book in order to correct those errors For the most part, thesecorrections involve replacing the words “selling” with “buying” and “buying”with “selling” Clearly CW and Williams disagree on whether activities withinthe market should be referred to by the actions of the outside small time trader

or the inside professional In fact, the terminology is of little real consequence

so long as one is consistent By changing some but not all of these terms, CWhas taken a book that has been written with internal consistency, and has made

it inconsistent Other changes had little or no effect on the overall meaningpresented by Williams

CW insisted that his instructions should be followed blindly without tion At the same time he gives us no hard and fast rules as to what to do (this

ques-of course would be impossible) Half way through the second week someonepointed out that they still did not know what a futures contract was, and yetthey were expected to trade in these instruments CW became irritated andeventually angry He repeatedly insisted that it was his job to keep peoplefollowing the intended path, and those of us with awkward questions weretrying to stray from “the path” It seems incredible that CW refused to explain

a futures contract

CW considers himself to be a great teacher, using radical methods to preparehis students for a deadly war or game During CW’s course, students wererequired to memorize various lists of facts and market occurrences and to

be able to reproduce these on command Amazingly, many people actuallybelieved that they were learning something of value by being put under press-ure like this In my view, anyone spending £500 per day on such a courseshould be prepared to memorize a dozen or more such lists between the firstand second day or else stay at home and save their money CW dragged thisrepetitive and puerile process out for two weeks

Good teaching involves bringing the student to an understanding of thematerial being learned CW deals only in indoctrination, by forcing people tomemorize lists of words when they have little or no idea of the underlyingmeaning of those words In the end, students were left with the ability to fireoff lists at speed without really knowing how to recognize these concepts inthe real world of derivatives trading

More than half of CW’s course time was taken up by CW talking abouthimself He is a blatant racist with a deep-seated hatred of the German people

On one occasion, he stated to the class that he could not allow “Negroes” toattend because they were intellectually inferior and would hold up the rest

of the class This was not so with Asian blacks, however, and one of thetwo Asians attending this course was made an example of by being tied upthen gagged by CW The travesty was meant to be a joke and a salutaryexperience for all others who did not pay attention to CW In addition tothese highly offensive actions and statements, he stated that any race capable

of the Holocaust must necessarily be irredeemable and “rotten to the core”

He takes the silence from the group as tacit agreement He does not seem torecognize that no one is willing to object, because they have spent severalthousand pounds and this more than any thing convinces them that CW musthold the key to substantial wealth

At other times, he discusses his recent victories in the markets, his politics,how he enjoys spending his wealth, how he metaphorically owns a wheelbar-row to transport his money, the admiration he attracts, his personal strugglefor wealth, military training (this seems to hold a suspicious fascination forhim), memories of previous lives, the conspiracy behind the death of PrincessDiana, his own yachting experiences (including his focus and calm while sail-ing solo in the English channel during the 1987 hurricane), the shooting ofJohn Kennedy, the selling-out of British industries to foreign interests, and hispersonal abilities to auto-induce out-of-body experiences

During one of the days, I kept a time line outlining the topics under sion Out of over seven hours of classroom time, just under two minutes weredevoted topics related to futures trading Even this time was taken to answer, in

discus-a grudging discus-and pdiscus-atronizing wdiscus-ay, the queries rdiscus-aised by three different students

(one answer took four seconds) CW’s interests in the aforementioned topicstook up the rest of the time.

CW employed classic techniques to maintain credibility in the eyes of most

of his students First and foremost, he offered them the hope of attaining greatwealth This made him valuable in the minds of the listeners Additionally hewould express great concern for the welfare of his students (no such concernhas been forthcoming since the end of the course) He would act in a graveand serious manner and then suddenly became friendly and easygoing Hewould relate stories of his childhood, speaking of deep-rooted fears in anemotional manner This would endear him to many of the listeners, creatingsympathy He also allowed himself to be overcome with emotion on at leasttwo occasions – again with many students this had the effect of creating abond of trust The tactics employed were (frighteningly) not unlike that of acult leader

CW created the illusion that his students were learning information at anaccelerated rate Often he would discuss a recent victory on the market, andthen take the group through a laborious calculation to determine the profit from

a fractured fill He ran through at least four such calculations The mathematicswould not be beyond a reasonably able 13-year-old, but because of the tediousnature of the calculation and the amount of paper used people felt as if theyhad been working hard Following such a calculation, he would remind us that

we could not do this sort of trading anyway, but that we should understandthe “complex” calculations involved

At no time during the course was a computer made available to observetechnical charts or actual market movement In fact, technical charts were notused to teach any of the ideas presented Occasionally CW would produce aphotocopied sheet showing a trade he himself had accomplished Always thesetrades were carried out using “higher level methods” which we were not privy

to We could not see any evidence of the concepts we had learned in the charts.There are several people who have benefited from the course CW himselftook in almost 2 million pounds sterling in course fees alone His personalfriends have made money by selling computers and data feeds to his prospec-tive students CW’s broker, another personal friend, is clearly doing very wellfrom the commissions generated by fledgling traders, regardless of the successrate of such trades There is little evidence to show that these traders are doinganything other than losing money, despite months of paper trading using ideaslearned from CW The implications are obvious

During the course, my group was presented with many blatant lies Some

of these are as follows:

1 As part of the course, CW sold a software package for £1865 called ume Spread Analysis (VSA Version 4.3.4) developed by Tom Williams,

Vol-a respected Vol-author Vol-and retired trVol-ader A new version hVol-ad simultVol-aneouslybeen released by Tom Williams’ company called VSA Professional (Ver-sion 5) CW deliberately lied by saying VSA 5 was purposely sabotagedwith errors in order to wrong foot the professional trader This wastold to us so that we would continue to believe that we possessed thebest available version of VSA, namely VSA 4.3.4 – an obsolete soft-ware package.

2 CW’s motive for lying becomes clear when you discover he bought thefull rights to VSA 4.3.4 from T Williams CW tells all students that hepaid a seven-figure sum for the rights (e.g in excess of £ 1 000 000)

T Williams has publicly stated that this is a lie

3 CW tells students that the book “The Undeclared Secrets of the StockMarket” also contain intentional errors designed to wrong foot anyonewho obtains the book but does not study with CW

4 CW tells students that the software VSA 4.3.4 has a secret method

of initializing the moving averages – the formula needs to be enteredexactly as specified by CW If the program does not recognize the user,

it fails to function correctly

5 CW’s personal friend, John Bollinger, specifically developed BollingerBands for VSA 4.3.4

6 CW informs selected students that he has the ability to initiate body experiences at will He can teleport his mind to any location atany time Often he will travel to the home of a friend and describe tothat friend what is happening at his home

out-of-7 The practice and study of derivatives trading involves the use of tematic vincivism” a neologism coined by CW He defines this phraseas: “The practice of repeatedly examining an idea or pronouncement

“sys-to constantly assess its validity.” Any student applying this self-styledconcept to the course itself will realize by the end of the second day thatthere is little to be gained from the course The neologism “vincivism”

is synonymous with “empiricism”, but is more sonorous and quent, thus encouraging CW’s self-edification and a false belief in hisown myth

grandilo-8 The trading room at his home (called The Kremlin) is booby trappedwith CS gas canisters in case of intrusion Only bona fide wizards areallowed into the “Inner Circle”

In summary, I feel that CW has taken my money and failed to deliver on thefollowing points:

1 I paid for a course in derivatives trading and at least 85% of my time

on the course was taken up with CW’s personal opinions of unrelatedtopics, usually himself and his own achievements

2 What little information was presented to me is almost useless in thecontext of real trading.

3 The venue for the course was held on a boat moored on the riverThames near Blackfriars Bridge This was often uncomfortable, noisy,and the facilities were poor Chairs were basic and no suitabletables were provided Considering the amount CW took in fees from

my group alone (over £180 000), the use of such a cheap facility

7 The software provided is unreliable, incomplete, will not run in junction with other software, and often crashes despite running on itsown dedicated machine No course time was devoted to the use ofVSA 4.3.4 and the material provided was inadequate

con-8 I never received my own copy of the software for which I paid nearly

£3000

9 I have not received an invitation from CW since the course, despite hisinsistence that he would be inviting us down to his home to observereal time trading

10 The course literature promises a receipt for course fees but none

was given

CW has now retired to a popular and exclusive seaside area in England andrarely offers training requiring public advertising How is it possible for so manyintelligent people to be convinced by this man and his “helpers” to undertaketraining? In Chapter 5, entitled “The Psychology of Perceptual Bias”, I explainindividual and herd phenomena such as overconfidence, the halo effect, misplacedconsistency theory, the sunk cost error, and the risky shift, all of which influence

us to make inadequate decisions These decisions create traps that impel us toremain consistent with an incorrect course of action

In the writing of this book, I freely admit that I have borrowed extensivelyfrom research and literature as outlined above, and I have made every effort tocredit the originators of the research when appropriate I have found numerousauthors who borrow from undergraduate psychology and business administra-tion courses and often the information is not relevant to trading For example,

mastering statistical testing of a null hypothesis is a standard requirement forpsychology undergraduates One author presented the two statistical tests of “chisquare” and “confidence limits” as an inference tool to ascertain trading compe-tence and consistency I believe these peripheral skills can only help if you havelearned them prior to your trading career because non-relevant learning will be

an additional and unwarranted stressor to a huge learning curve Many excellenttraders have no mathematics background In addition, I recently received a flyerfor a course on “How to make a business plan for traders” The cost for thethree days was US$3500, which is more than one year’s MBA tuition fees at theUniversity of Kingston Business School where I had been seconded The coursematerial was identical to the MBA course apart from the word “trader” liberallyapplied throughout

Throughout the ages, people have tried to fulfil their dreams and ambitionsand even the smartest of us are gullible In Amsterdam, Holland, during thesixteenth century, there was an accredited degree course in alchemy from anaccredited and respected centre of education Our own historical ancestor, DrJohn Dee, mystic, astrologer, and adviser to Queen Elizabeth I, is reputed tohave researched alchemy there No one had ever turned lead into gold and wenow know that turning lead into gold does not fit the facts of empirical quantummechanics and inorganic chemistry

Regardless of the lack of evidence, it did not change the fact that peoplebelieved it could be done This belief existed for almost a thousand years Greathalls were filled with people, all discussing how to create gold from base metals

If you could convince somebody that you had done it once, people would listen

to you and pay large amounts to learn the secrets of alchemy

If you are unable to show success at the time, there was always a good reasonwhy it did not work on this occasion Others would take what the master knewand add to it, to “improve” it; others would try to refute the ideas with ideas oftheir own; still others would keep parts of the whole concept and discard otherparts not to their liking Some would combine parts of the entire history withother parts into incomprehensible combinations that only they understood butclaimed worked The same herd mentality is at work in these modern times andthere are many “experts” who would like to sell you this dream

THE PSYCHOLOGY OF FINANCIAL RISK TAKING

The psychology of financial risk taking is a theoretical and practical disciplinethat can be used as a tool to preserve your capital If you preserve your capital,winnings will take care of themselves The psychology of trading offers an answer

to the question: “Why do traders lose most or all of their money, even when usingsystems claiming 70% efficacy?”

Clearly, trading is about the person as well as market technical analysis Theoveremphasis on mathematical charting was acknowledged by Jesse Livermore

in the early 1900s On page 61 of the book Reminiscences of a Stock Operator

(by E Lef´evre), it says:

I should say that a chart helps those who can read it, or rather who canassimilate what they read The average chart reader, however, is apt tobecome obsessed with the notion that the dips and peaks and primary andsecondary movements are all there is to stock speculation If he pusheshis confidence to its logical limit, he is bound to go broke There is anextremely able man, a former partner of a well-known Stock ExchangeHouse, who is really a trained mathematician He is a graduate of a famoustechnical school He devised charts based on a very careful and minutestudy of the behaviour of prices in many markets – stocks, bonds, grain,cotton, money, and so on He went back years and years and traced thecorrelations and seasonal movements – oh, everything He used his charts

in his stock trading for years What he really did was to take advantage

of some highly intelligent averaging They tell me he won regularly untilthe First World War knocked all precedents into a cocked hat I heard that

he and his large following lost millions before they desisted But not even

a world war can keep the Stock Market from being a bull market whenconditions are bullish, or a bear market when conditions are bearish Allthat a man needs to know to make money is to appraise conditions

I am not belittling the importance of technical analysis; I am making explicit therequirement for traders to make a study of their own behaviour I call this the

“paramouncy principle”

THE PARAMOUNCY PRINCIPLE

The “paramouncy principle” is this: that you are the most important variable

in the trading equation The psychology of trading addresses the “paramouncyprinciple” in a systematic manner Implicit in this principle is my view thatanyone with average intelligence and the ability to continue learning for manyyears, will eventually become a successful trader The ability to be persistent andflexible to new ideas is a personal trait of all the traders interviewed by JackSchwager in his seminal books

Most traders lose money because they do not have an understanding of themarkets or themselves They trade without method, strategy or discipline Theyfall prey to powerful emotion, which leads to impulsivity and behaviours moreakin to gambling than to genuine understanding They fall prey to perceptualbiases that lead to false conclusions and inappropriate actions

Education is crucial in addressing the “paramouncy principle”, yet most tradersprefer courses on technical analysis Tom Williams, originator of the WyckoffVSA model, has developed an outstanding technical system, yet he stresses the

necessity of method, the requirement of discipline, and the importance of moneymanagement Even armed with this understanding, traders still have the dauntingtask of identifying the psychological factors that lead to self-defeating behaviours.

A primary factor contributing to a trader’s demise is stress In trading, one’s

money is always on the line, often on a “tick-by-tick” basis, and it is exposed

to potential loss The uncertainty of all that could happen often makes the trader

“believe” that certain things must happen These “beliefs” often interfere withassessment and strategic/tactical planning

In this mental state or schema1 traders make substantial errors in judgementand action A major task for any trader is to preserve capital for more successfultrades This rarely is done well enough Traders often find that following exiting

a trade at a loss, the market returns to the original entry point and then becomes

a profit This frustrating fact leads to self-defeating behaviour and “if only”recriminations Traders are experts at punishing themselves, and the loss cycle(described in Chapter 3) leads to a self-fulfilling prophecy of failure

ACTION, ANALYSIS, AND THE BELIEF PARADIGM

Uncertainty regarding future price action causes anxiety and many traders reducethis anxiety by attempting to “predict” and “forecast” the future When a traderbelieves prices will rise or fall, the trader takes action Action follows belief

The word ‘paradigm’ comes from Greek para – beside, deiknynai – to show.

This book employs the common usage of the word, which means a model, theory,

perception, assumption or frame of reference The personal belief paradigm is

how we perceive, understand and interpret the world A paradigm is a theory,model, or explanation of something else

Beliefs are very powerful and seductive Most market technical analysis is biased

by a powerful impulse to confirm and strengthen belief The belief paradigm seeksonly confirmation and does not seek contrary evidence In addition to not seek-ing contrary evidence, the personal belief paradigm actively denies, discounts,ignores or distorts evidence The personal belief paradigm has a powerful mech-anism of denial This process of denial acts as a catalyst to elicit powerful emotions,such as fear Emotions in general and fear in particular, can impair perception andarrest appropriate action based on contrary evidence The implications for tradersare immense

Research (Schwager, 1989) indicates that traders are poor at price prediction,

showing only 35% to 50% accuracy One only needs to read the Sunday Times

Bartlett concluded that when we remember a verbal account, the words are never exact What happens is what

we perceive is assimilated into our own structure of meaning, that Bartlett called a “schema”, which includes a great deal of general knowledge Then when a recall is asked for, the subject takes a few significant remembered details and a general emotional attitude to the story, and from the “schema” constructs what the story must have been The research on “schema” and perceptual biases has profound implication for traders and will be covered

newspaper, or other quality broadsheets, to see that the experts have little or noexpertise in predicting prices.

Members of all professions sometimes perform poorly, but the poor mance of financial advisers is matched only by the poor judgement of theirclients David Dreman (1979) has produced research in “Contrarian InvestmentStrategy” Numerous studies show that advisers on equities consistently do worsethan the market they are in, even before making allowance for any fee The sameapplies to the managers of pension funds, unit trusts, and of the portfolios ofinsurance companies The main reason for their poor performance is that theyfollow the herd

perfor-The continued employment of investment analysts, commodity trading ers, etc., both by the general public and by large firms with money is an example

advis-of false belief paradigms in action, since these “pradvis-ofessionals” are known to be

worse than useless Of this, Professor Stuart Sutherland, in his book ity – The Enemy Within states: “It is as though a doctor were to be paid for

Irrational-prescribing drugs that were worse for the patient than ones selected at random.”There is evidence presented in Chapter 3 of this book that suggests the proba-bility of success in day trading is increased by abandoning efforts at prediction,and focusing upon recognising the predicates for action No one can predict withtotal accuracy what the price will be in the next minute, hour, day, or year,because the underlying catalysts of market actions are fluid and changing Thetrader must always be aware of evidence that refutes the reasons for being in thetrade and when this evidence is confirmed, the trader must exit the trade withoutquestion, regardless of strength of belief of what will or should happen Theprocess of analysis and refutation is counter to what happens in the psychology

of the personal belief paradigms and is something the trader must learn

Chapter 2 introduces the concepts of trading competences and competencies.

The competencies required to minimise risk, minimise dependence on predictionand minimise the influence of beliefs are examined To understand the processand influence of these factors on trading behaviour is the first step to tradingcompetence and freedom from the cycle of loss

The essence of successful trading is this: to know what to do when volumeand price spread patterns are recognised, to know with certainty that one will act

on those parameters when they do occur, and to let go of belief and prediction

in order to focus more clearly on what action is happening in the market, hereand now

REFLECTIONS

I have suffered the hardship of trading losses and the indignity of being winked by incompetent tutors charging extortionate fees for useless material.Surprising to some, it is an experience I am grateful for The experience has

hood-motivated me to provide affordable and efficacious education for traders Duringthe writing of this book, I asked myself one question – “Would this book havehelped me in taking my first steps to trading competence?” – the answer is yes.What follows is a navigational chart that will help to guide you safely throughthe treacherous waters between Scylla and Charybdis.

SUMMARY CHAPTER 1

• Risk is defined as the coexistence of danger and opportunity, where there

is uncertainty in relation to future outcome People wishing to learn tradingskills have been hoodwinked by charismatic tutors, some of whom have

no formal qualifications, little trading experience, and no proven tradingability A course taught in England is presented

• The psychology of financial risk taking is a theoretical and practical cipline that can be used as a tool to preserve your capital

dis-• The paramouncy principle is introduced The principle embraces the notionthat you are the most important variable in the trading equation JesseLivermore’s views on the overemphasis and dependence by traders oncharting are examined

• Traders lose money because they do not have an understanding of the kets or themselves, and they trade without method, strategy or discipline.They fall prey to powerful emotions and perceptual biases which lead togambling type behaviours

mar-• The concept of analysis and refutation is introduced Market technicalanalysis is biased by a powerful impulse to confirm and strengthen belief.Traders often seek only confirmation; they do not seek contrary evidence.The process of analysis and refutation makes explicit the requirement toidentify all information that would militate against your position

• Research by Dreman et al demonstrates the poor performance of financialadvisers, portfolio managers, and pension funds The public still investwith these professionals regardless of the considerable adverse evidence

• Prediction of prices by traders is very poor, it is suggested that trating on developing plans using calculated probabilities and then takingaction only when the preconditions are evident, is an essential skill to belearned by traders

ing Reminiscences of a Stock Operator by Edwin Lef´evre, I noted considerable

similarities between Livermore’s emphases on money management, emotionalcontrol and intelligent battle plans and that of modern day educators Below, Ihave chosen three contemporary authors, who educate the growing numbers ofhome traders and compare their general headings for skill development againstthose of Jesse Livermore:

Jesse

Livermore

AlexanderElder

VanTharpe

LewisBorsellinoIntelligent battle

plans (timing)

Money management Money management Money management Fire

Contemporary authors advocate similar, if not identical, maxims, methods andattitudes Each has different emphases; some specialise in pit trading, others inscreen trading; a few prefer trading futures or options, while most trade stocks.This kind of variety is of benefit to students and sometimes for no immediatelyapparent reason a particular author may “connect” with a student’s needs and

a very beneficial relationship can develop between the student and the book.Jesse Livermore identified his own learning needs and the skills required to

succeed, and only published one book in 1940 entitled How to Trade in Stocks.

The book may be short but is of tremendous value from both a historical andutilitarian perspective Livermore was committed to the concept of speculation

as a disciplined business venture This discipline is reflected in his meticulousrecord keeping that enabled him to perceive price patterns His persistence inthe continued maintenance of his records eventually led him to combine a timeelement to his price patterns and the Livermore formula was created We knowmuch about Livermore’s ideas and methods through “Larry Livingston”, the

protagonist of Reminiscences of a Stock Operator, and more recently, in the biography written by R Smitten (2001) entitled Jesse Livermore: The World’s Greatest Stock Trader.

While Livermore’s original 1940 book is of tremendous importance (there arenumerous reinterpretations of this work), some might view it as crude or archaic

by today’s standards Contemporary authors have a wider remit and addressinformation technology, the new futures markets, globalisation, and personal psy-chology By analysing the competencies required in the tasks of trading, thereare immediate advantages through honing personal skills, and more generally, bydeveloping a model for learning which can be shared

Research (Kolb and Kolb, 2001) has shown that people learn best when theyuse methods and modes that suit them David Kolb developed “The LearningStyle Inventory” when he was at the Massachusetts Institute of Technology andthis has been used for more than 30 years to understand learning in professionsranging from medicine, management, to law Kolb found that people learn mostoften through one of the following modes:

• Concrete experience: Having an experience that allows them to see and

feel what it is like

• Reflection: Thinking about their own and others’ experiences.

• Model building: Coming up with a theory that makes sense of what

they observe

• Trial and error learning: Trying something out by actively experimenting

with a new approach

Learning often happens best through a combination of two or three of thesemethods Research indicates (Kolb et al., 2001) that some people rely on styles

or methods of learning that can actually hinder their learning, especially if used

too early or too much These learning methods can act as an impediment tomotivation and further learning because learning may feel boring or irrelevantand therefore drain their excitement.

It is useful here to recount some of the feedback that I have had from studentswho attended “The Chief’s” course, as referred to on page 3, Box 1.1 He hadrequested students to memorise particular patterns in the market in a nurseryrhyme fashion This rote memorisation is relevant and helpful in the context ofrehearsing an action plan However, the students never had an opportunity toapply the mnemonics to the trading screen Instead of memorising patterns thatmany students did not understand, it would have been more appropriate to applythis to screen trading After a few days, many students felt the course was irrel-evant and stopped paying attention Trainers with an academic background oftenorganise courses to fit their own preferred learning style which for academics istypically abstract and reflective However, a student, whose learning style may bemore active and concrete, needs to begin by learning some practical techniquesthat he can try immediately on the trading screen Other courses, especially inAmerica, present a specific teaching style with a fixed learning agenda This type

of learning may not suit everybody and it may assist the student to identify his orher learning styles to ensure that the cost of the course and the content will not

be wasted It may help the student to look at the Kolb Adapted Style Inventoryand the reference with an Internet link (URL) is cited at the back of this book.David Kolb did not undertake research specifically on pit or screen trading butthere are numerous authors who have contributed to this field Before identifyingthe competencies required for the trading task, I will review some influential lit-

erature of the twentieth and twenty-first centuries Mark Douglas has written The Disciplined Trader: Developing Winning Attitudes (1990) and has identified seven

steps to trading competence Although Mark Douglas has not summarised therequired skills under three major headings as the authors above, he has been verythorough in identifying the major skills required for trading competence In myopinion, Mark Douglas’ book represents a standard of excellence in authorship

in this field and I was surprised to find that he did not hold formal qualifications

in psychology, given the depth of his understanding

THE SEVEN STEPS OF TRADING SUCCESS: MARK DOUGLAS

Step 1: Staying focused on what you need to learn

Douglas stresses the importance of understanding what it is one needs to learn toachieve their goal He emphasises breaking down the goals into manageable partsand in trading stresses that there is a tremendous difference in focusing on moneyand focusing on using your trading as an exercise to identify what you need tolearn In other words, learn to trade and profits will take care of themselves

In addition, he draws the distinction that when focusing on money, the traderdoes not accept personal responsibility and often blames wins or losses on thevicissitudes of the market When focusing clearly on what is required to attaintrading competence, one fully accepts responsibility for their own learning.Douglas points out the importance of setting aside money as capital for tuitionand education His view is that the amount of money set aside for education can

be interpreted as a commitment to continuing your professional development as

a trader He states that the stronger your commitment, the faster you will learn

Step 2: Dealing with losses

Douglas outlines the importance of defining a loss before it is taken He sises the necessity for any trader to understand and completely accept the neces-sity for losses If a trader fails to do this, he will generate fear and end upgenerating the very experience that he is trying to avoid Douglas also empha-sises the necessity for traders to be flexible and open in defining what lossesmean This definition should be incorporated into the trading strategy so that yourresponse to the loss will become automatic Douglas further states, “When lossesare pre-defined and executed without hesitation, there is nothing to consider,weigh, or judge and consequently nothing to tempt you with.”

empha-Step 3: Becoming an expert at just one market behaviour

Douglas emphasises that focusing on more than one market in the early stages

of your development will create confusion and overload that will inevitably lead

to losses Douglas recommends that one particular trading pattern is identified inone market and become an expert in that To understand one system in depth,trading one market, is a difficult but possible task He advises to let go of sometrading opportunities for educational purposes After all, “what is the rush?” Ifyou are in a rush, it likely implies that you are focusing on money, not tradingskills He recommends that you do not expand on more than one market untilyou understand thoroughly its characteristics

Step 4: Learning how to execute a trading system flawlessly

Douglas defines a trading system as “what they do [trading system] is matically define, quantify and categorise past relationships in collective humanbehaviour to give you a statistically probable outcome of the future”

mathe-Douglas makes a further distinction between gambling and executing a tradingsystem in that gambling has a purely random outcome based on statistical prob-abilities, therefore you do not have to take responsibility for the outcome He

argues that because you have an element of responsibility in trading, your esteem is at stake and therefore it is much more difficult to participate Douglasadds that two main concepts need to be integrated into your mental schema, first

self-in terms of probability and second, self-in correlatself-ing the numbers or the mechanics

of your system to the behaviour He points out that traders rarely stay with asystem beyond two or three losses in a row, and it is a very common occur-rence This is where discipline becomes important, as is developing confidence

in your trading system to know that continued use with flawless executions willeventually provide profits

Step 5: Learning to think in probabilities

Douglas argues that once you have mastered the mental skill of discipline, youneed to develop your thinking along the lines of probabilities To do this Douglashas developed a series of questions that assist a trader in following the flow ofthe moment and to keep the trader focused on the here and now

1 What is the market telling me at this moment?

2 Who is paying up to get in or out?

3 How much strength is there?

4 Is momentum building?

5 Can it be measured relative to something?

6 What would have to happen to indicate momentum is changing?

7 Is the trend weakening or is this a normal retracement?

8 What would show that? If the market has displayed a fairly cal type of pattern and that pattern has been disturbed, then it is goodindication that the balance of forces has shifted

symmetri-9 Are there any places where one side would definitely gain dominanceover the other? If that point is reached, it still may take some time forthe other side to be convinced they are losers How long are you willing

to give them to stampede out of their positions?

10 If they do not stampede out of their positions, what will that tell you?

11 What did traders have to believe to form the current pattern relative to

the past? Remember that people’s beliefs do not change easily, unlessthey are extremely disappointed People are disappointed when theirexpectations are not fulfilled

12 What will disappoint the predominant force?

13 What is the likelihood of that happening?

14 What is the risk of finding out in a trade?

15 Is there enough potential for movement to make the trade worth the risk?These questions assist the trader in remembering that anything can happen Theyhelp you stay detached and keep in perspective that price movement is a function

of traders acting individually and collectively as a force, expressing their beliefs

in future value Douglas further argues that by asking yourself these questions,you are automatically keeping the focus of attention on the market and what thepossibilities are

Step 6: Learn to be objective

Douglas argues that to be objective one needs to operate out of a set of beliefsthat will allow for anything to happen as opposed to beliefs that allow the market

to express itself in a limited fashion Obviously a trader has to have some belief

or expectation about the future, or the trader would never put on a trade in thefirst place Douglas suggests that you can assess your own level of objectivity

by determining whether you have achieved the following states of behaviour

• You feel no pressure to do anything

• You have no feeling of fear

• You feel no sense of rejection

• There is no right or wrong

• You recognise that this is what the market is telling you

• This is what I do

• You can observe the market from the perspective as if you were not in aposition, even when you are

• You are not focused on money but on the structure of the market.Douglas argues that it is important to release yourself from the need to be rightand the more uncommitted your assessments are, the less potential there will be

of distortion and experiencing a painful, forced awareness

Step 7: Learning to monitor yourself

Douglas suggests that traders need to pay attention to what they are thinking andwhat market information is being focused upon Earlier in his book, he states that

a trader needs to identify personal dangers needed to function successfully in thetrading environment Once recognising the need for change, the next step will

be to identify the techniques in changing He suggests that some of the changesrequired are to neutralise commonly held beliefs about success In addition, oneneeds to learn mental skills to adapt to the constant changes in the market Also,

he suggests a number of exercises to effect change, such as self-hypnosis, positiveaffirmations, writing and structuring one’s learning process

Douglas has made a significant contribution to outlining the skills requirementsand of suggesting methods and techniques to achieve trading competence He will

be one writer that will make a significant innovation in the thinking of the first century home-based screen trader In the final chapter of this book, I outlinethe standards we hope to achieve as traders and the criteria by which we canassess our own level of competence on the continuum from novice to expert.

twenty-In this structured manner, the trader can monitor his or her own developmentand will hopefully provide a simple yet apposite tool for continued learningand survival

MIND, METHOD AND MONEY MANAGEMENT

I am grateful to Dr Alexander Elder for allowing me to reproduce some of his

work here Dr Elder has written two highly illuminating books called Trading for a Living and Come Into My Trading Room.

The three Ms of successful trading

Elder quite correctly points out that beginners focus on technical analysis Iremember my first year of full-time trading when I sat from 7.30 a.m until 8.00

or 9.00 p.m looking at a 21-inch screen searching for patterns on one-, five-, and 60-minute charts I was soon to learn that short time frame day trading isthe start of a slippery slide to bankruptcy Novices gain the impression that theyare working extremely hard and must be progressing by virtue of the amount

10-of effort they are investing in their newfound pr10-ofession Elder points out thatprofessionals operate in a three-dimensional space By this he means that theyare aware of trading psychology, their own feelings and the mass psychology ofthe markets Each trader needs to develop his own method for choosing specificstocks, options or futures as well as clear and concise rules for pulling the trigger.Money refers to how a trader manages his trading capital In my first years oftrading I asked myself why I would want to enter trading as a second careerwhen all the evidence indicated that 90% of all traders end up losing a significantamount of money or losing everything they owned While I was able to answerthis question to myself, Elder offered an interesting and additional point of view.Elder demonstrates that trading has great “Entertainment Value” for people whoare living “lives of a quiet desperation”.1 Elder depicts lives of people who aresleepwalking through life We wake up in the same bed each morning, eat thesame breakfast and drive to work down the same road We see the same dull faces

in the office and shuffle papers on our desks We drive home, watch the same TVshows, have a beer, go to sleep and repeat this routine day after day, month aftermonth, year after year There is the occasional distraction with exotic holidays buteventually one returns to the same repetitive pattern of living Discovering trading1

is like switching from a black and white TV to a colour TV with quadraphonicsound Purchasing your first stocks and shares gives one a tremendous adrenalinerush and whether the stocks make or lose money, we have felt the excitementand kick of trading and its “Entertainment Value” Elder states that trading is:

“the most exciting activity that a person can do with their clothes on Trouble is,you cannot feel excited and make money at the same time.” He further developshis thesis by saying that to become a successful trader, you have to:

• develop iron discipline (mind);

• acquire an edge over the market (method);

• control risks in your trading account (money management)

Mind

Elder argues that one of the most important aspects of becoming a successfultrader is to realise initially that you are a loser He compares this insight to insightsgained by alcoholics who suddenly admit that they are powerless over alcohol.Elder does not develop his thesis further by inventing a 12-step programmefor losers, or “Losers Anonymous” as he puts it He does, however, providedescriptions of typical losing behaviours

Blame

Elder argues that losing traders do not accept responsibility for themselves Theyblame the broker He recalls the story of a professor with a PhD who blamedhis broker for wiping out his one million dollar account He had shorted a stockthat his broker had recommended “It could not go any higher.” The stock wentthrough the roof and the professor hung on for another year hoping for a retrace-ment The stock continued to climb and his life savings were wiped out Blamingthe guru is another excuse that traders will use when losing Gurus are usuallyvery short lived, with a life span of approximately two years Elder suggeststhat many of the gurus are failed traders who have “jumped on the band wagonwhich is to provide clarity to clients on future movements of the stock mar-ket” These gurus also include psychologists who offer coaching and tuition fortraders Rarely does one find a training guru who qualified both as a trader and

a psychologist Blaming unexpected news is another favourite of losing traders.How many traders have you heard comment about September 11, 2001 and itsdisastrous effect on their account?

Self-sabotage

Elder points out, as have many psychologists before him, that self-destructiveness

is a pervasive human trait We are trained to control aggression against others

but our aggression needs to go somewhere We often turn our anger inwardand learn to sabotage ourselves in ways that we cannot even see ourselves Wehave a number of safeguards for social self-sabotage, such as suicide There arepsychiatric social workers to offer counselling and therapy to the potential self-saboteur, psychologists who measure risk of self-harm, and psychiatrists to giveanti-depressant/anti-psychotic medication There are no such safeguards in thefinancial markets.

Addressing self-destructive behaviours

With regard to attitudes, Elder suggests that one must admit they are a loser Thenext step will be to analyse why it is that one is a loser A losing trader is indenial and his equity is shrinking but he continues to jump into trades withoutanalysing what is going wrong He suggests that defining the difference between

a loss and a businessman’s loss is important A businessman’s risk is a small dip

in equity but a loss goes through that limit As traders we are all in the business oftrading and must take normal business risks but we cannot afford losses Moneymanagement techniques are essential to combat losses Elder agrees with many ofthe authors before him who have described trading as a battle Later in this book

I will outline the contribution of martial arts and Budo Zen to our understandingand application of discipline in trading

Elder points out that most amateurs will not admit they are trading for tainment and that financial trading is far more respectable than gambling onthe ponies A losing trader will not have the discipline to plan strategically ortactically as a general would in combat

enter-With regard to discipline, Elder suggests that many new traders expect to sit infront of their screens and make easy money day trading They skip high schooland head straight for neuro-surgery Elder points out that good traders keep goodrecords They keep them as tools of learning and discipline If you do not havegood records you cannot measure your performance or identify your learningneeds He suggests that records are kept of:

• trades;

• balance of account;

• trading diary;

• tests and self-evaluation;

• the gradual assumption of responsibility;

• constant evaluations and ratings;

• training until actions become automatic

Method

Elder proposes that meticulous record keeping is a very accurate index to thequality of any trader and his skills Regarding method, Elder focuses exclusively

on technical analysis To assist the student in developing a mental model oftechnical and fundamental analysis, I have written a brief introduction to thesedisciplines on pages 65 to 70 Elder acknowledges the vast amount of informationavailable in the market and the purpose of technical analysis is to make thisinformation manageable No trader can master all tools in technical analysis and

it is therefore essential to understand what markets you wish to trade in andthe tools which will be most effective for those markets In terms of skills,basic charting techniques are essential Elder describes a number of techniquesthat he has developed personally but also acknowledges that there are basiccharting techniques which are essential and fundamental in developing tradingcompetence Most textbooks on technical analysis will include the followingessentials:

The meaning of prices

• The open, the high, the low, the close

Bar charts, candlestick charts, and point and figure

• The meaning of an uptrend, downtrend, how to draw trend lines

• The definition of support and resistance

• False breakouts

• Open interest

• Moving averages

– Simple moving averages

– Exponential moving averages

• Trading signals

• Channels

• Entry and exit strategies

Technical analysis is very much a personal choice and dependent on the type ofmarkets you are trading Elder offers his personal view of trading methodology

I have known numerous traders to be highly successful in the market who havenever used the techniques outlined by Elder My personal choice of methodology

is using volume in relation to price spread with a number of trend following andoscillating systems Many successful traders have never used the technique I use

Money management

Mature traders will tell you that your choice of indicators depends on personalpreferences Most traders will accept that a mixture of trend following, stochastic,

volume, and other types of systems are most appropriate since the market is neverstatic, and there can never be only one indicator that is robust enough to accountfor all market activities Elder proposes that it is easy to live through modernlife having very little understanding of basic arithmetic Most of us rarely countand have ready access to calculators and digital screens on appliances Moneymanagement is synonymous with risk management While you could get awaywith few arithmetic skills in real life, you cannot have poor numeric skills andbecome a market trader.

Risk management

You do not need calculus, algebra or statistics but you must be on easy termswith adding, subtracting, multiplying and dividing In addition, you need to becomfortable with calculating percentages and fractions and round numbers inorder to count fast You need to be comfortable with the notion of probability.All competent traders are practical people who quickly calculate risks, resultsand odds Elder offers a number of easily understandable money managementtechniques He outlines the following rules:

• Limit your loss on any trade to 2% of equity in your trading account

• Never have more than 6% of your total trading account exposed to themarket at any one time This means that you could have three trades risking6% of your total account at any one time, or six trades risking only 1%each of your total trading account, or multiples thereof

• Whenever the value of your account dips 6% below its closing value atthe end of the month, stop trading for the rest of the month In other wordsstop trading as soon as your equity dips 6% below where it stood on thelast day of the previous month Close all positions and spend the rest ofthe month on the sidelines Continue to monitor the markets and undertake

a review of yourself and your trading systems

Position sizing

Position sizing is the skill to determine how much to expose in the market at anyone time on a single trade, given the current market conditions If we trade asize that is too large we will destroy our account, too small and we won’t makemoney, therefore determining an optimal level is essential

Later in the book, we will discuss the process of defining the “expected value”

of a trade These useful concepts were introduced in 1980 by psychologistsTversky, Kahneman and Wagenarr I will outline a couple of experiments thatdemonstrate our poor decision-making ability in assessing expectancy and there-fore our ability to position size