THE HUMAN BRAIN
YOUR SYSTEM/METHODOLOGY OPERATION PROFITS/LOSSES
YOU – TRADE WHAT YOU SEE, NOT WHAT YOU THINK/FEEL COMMITMENT
DISCIPLINE MONEY MANAGEMENT
RISK CONTROL THE THREE SIMPLE RULES
SYSTEM PARAMETERS
As soon as an idea is accepted it is time to reject it.
Holbrook Jackson
Anyone who has ever traded knows the truth of this formula.
So here come the simple rules. If your trading approach lets profits run and cuts losses short and if it achieves a 50 per cent hit rate then overall you will win. This is clearly so. For each profit there will be a loss, but as profits are allowed to run they will average a larger sum than the losses, which are always kept small.
The purpose of analysis (technical or fundamental) is not to analyze markets, it is to build your system/trading approach. This is not to den- igrate Technical Analysis because building your system is an essential step to success. The reason I know that you need a system is because of that formula on the previous page. A system does produce simple trad- ing rules. Anything else is going to be more complicated. I might sum- marize this as:
If Simple Trading Rules + Human Brain = Chaos and Confusion ThenComplex Trading Rules + Human Brain = ?
That question mark is not pleasant – I have lived it during the first part of my trading career.
Systems
So the trader has a clear goal: to produce a system which will, overall, give an edge. A 50 per cent hit rate is a good target, but you can get away with less than that and still win, if profits run enough. This is where the analysis comes in – to produce that system. Neither letting profits run, nor cutting losses short is that simple (see Chapter 9) but they can be learnt. So this need not be a big problem.
Personally I do not like statistical type indicators and for my own trading I have developed systems based on Peter Steidlmayer’s Market Profile. The concepts of “Value,” “Minus Development,” and “Accep- tance” are like a breath of fresh air after some of the rubbish I have wasted my time on over the last decade. These important concepts are dealt with exhaustively in this book.
A quick word about “random” systems, or more correctly “random- entry” systems. I have often heard it said that random systems work – i.e. just toss a coin to decide on entry criteria. I have not tested this the-
Section 1 ã The underlying philosophy
ory, but there would seem a logical flaw. I would accept that a random- entry system with no stops would most likely win 50 per cent of the time. But this would achieve nothing because the profits and losses would probably become equivalent over time – and commissions would probably kill you. Once you start to use stops it is likely (guar- anteed) that your hit rate would drop from 50 per cent. Forgetting the psychological problems of trading a system taking loads of losses, the arithmetic may still kill you.
For my own systems I accept the “logic of the stop.” The key is to keep losses small, therefore the key item is the relationship between the entry point and the stop. This is where Minus Development (MD) comes in – my stops are always placed beyond MD. I want to avoid excessive phi- losophy within this chapter but it is often (usually?) what is not there that is important rather than what is. This is illustrated by Sherlock Holmes and “the dog that didn’t bark.” Great musicians say that it is the spaces between the notes which are crucial, not the notes themselves.
MD is the absence of development. Steidlmayer’s work is the making of Chaos into Order. The bell curve does this. Development takes place when the market spends some time at certain price levels. MD occurs when the market spends little or no time at a particular price – it occurs when that price level is rejected.
The stop level controls your risk. It is the ratio between risk and reward which governs how successful your system allows you to be.
However again I digress, the important point to realize is that it is not difficult to produce a system that will give you a winning edge.
The human brain
But that is only stage 1. The difficult bit is using it! This is where the human brain comes in.
In the excellent article by Tony Plummer (see Appendix 2) mention is made of the “triune” brain. Briefly this comprises three parts, what we might call the instinctive, emotional and thoughtful parts. Once we introduce the human brain to any equation we introduce all three parts.
The thoughtful part is useful within the trading context. However the
System parameters – simple trading rules and the human brain
other parts are not always so. Trading is a highly charged business.
Money, lots of it, is involved. There is risk of loss and potentially large rewards. Most traders overtrade, immediately putting themselves under substantial psychological pressure. This is not surprising because if you overtrade you are likely to be wiped out – it is a logical certainty. All this brings the instinctive and emotional parts of the brain into action, often fren- zied action. This is not helpful for trad- ing. They make you do the wrong thing at the wrong time, they make you join the herd, they shake you out of good positions, they do every- thing they can to guarantee that you lose.
The human brain has its part to play – that is in designing the system and then monitoring its performance. But whilst the system is active it should be left alone. But that is what, ultimately, is so difficult.
At the start of this chapter I said that I wanted to explain the trading process, explain what analysis is really for, and show how to win in the markets. Let me end by summarizing these three. The trading process is to adopt a low risk strategy. Losses must be kept low (1 per cent or 2 per cent of capital is a good guideline) and profits must be allowed to run (otherwise you will never cover your losses). A good system will do this whilst still giving you a 50 per cent plus hit rate – yes, you are still going to lose around half the time! Not easy for those who have a deep felt respect for their hard earned cash.
Analysis is for the purpose of developing your system, end of story.
You win by learning how to control your emotions and instincts so that you can follow your system – that takes experience but I believe that the process can be short circuited if you know what the problems are – but then I am an optimist.
Section 1 ã The underlying philosophy
Trading is a highly charged business. Money, lots of it, is
involved.
SUMMARY
■ The basic equation is that:
Simple Trading Rules + the Human Brain = Chaos and Confusion This is primarily due to the workings of the triune brain.
■ More complex rules become extremely difficult to operate, especially for novices.
■ The logic of the stop determines the risk/reward of your approach.
System parameters – simple trading rules and the human brain
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