A few nights ago I decided to sharpen my knives. As many of my readers know, I spent some time in a professional kitchen, and there was a time when I did this knife sharpening routine several times a week, and often every day. But now I cook casually at home… so this only happens once a year and usually after I find a blade to be annoyingly dull.
I find work like this to be very calming and centering. The hands know what to do, and the mind mostly shuts off. There’s a hypnotic grace to the ritual—to the rhythm of body and hands, and metal on stone. As I worked, I thought a bit about trading and the work we’re doing to help people learn how to be traders.
I take each knife out of the block, and there’s a little lesson here: I own probably 100 knives, and there was a time when it seemed I tried to use a different knife for every task. Now, I just have at hand what is in the block, and it’s a bit of a motley assortment: I have my stainless Solingen steel blades that were the workhorses when I did my apprenticeship, a couple cheap (but wickedly sharp) American blades, and a handful of pre-World War II Sabatiers that are old carbon steel and will rust if not cared for properly (but how perfectly they fit my hand!)
I don’t have a magazine cover-ready photogenic block of shiny, consistent handles. They’re not all the same brand. Some are old. Many are banged up in different ways. But I know them. They work for my hand. They are my knives. And I’ll often cook a meal with just a single knife in hand.
In trading, most of us begin looking for the perfect, magical system, the indicator or ratio that will show us exactly what the market will do. We have systems and screens that layer complexity upon complexity. We think these things will make us profitable. The more experienced trader knows that he or she IS a trader, and that the trading methodology is ultimately just a tool. There’s value in refining and perfecting the tool, but it’s ultimately the hand that holds that tool that determines success.
How do you think you start to sharpen a knife? It might surprise you. The first thing I do is draw a sink full of warm water and drop the sharpening stone in so it soaks up water. Then I begin by cleaning each knife—a sprinkle of scouring powder and a vigorous rub with a wet sponge. I think about the things that come naturally to you after you’ve done this a while. If you want to scour a blade and not cut yourself, you must lay the blade flat on the counter and scrub it there. Hold it in the air, and you risk a very bad cut. These little details matter.
And so it is in the markets. The little, tiny refinements that seem natural, almost insignificant, can make all the difference between winning and losing. The beginner might search for traders in adverse market conditions while the experienced trader has the patience to wait. The beginner might adjust stops too frequently while the experienced trader just waits. The experienced trader might naturally see things in patterns and relationships that can’t even be explained easily to anyone else, and all of this is natural. Mastery is the assimilation of many small skills at a very deep and natural level.
Next, you look at the knife.
This seems obvious, but you don’t just pick it up and start sharpening it! You look at it. Has the blade taken a curve that you need to (carefully!) bend out? Is the edge chipped? Is the tip ok?Handle cracked? Any corrosion around the rivets or on the bolster? Any place that needs to be cleaned again? Any scratches from bones that you might want to polish out with some fine sandpaper? How dull is the blade? Any folding damage to the edge?
First, you look. You can’t know what to do unless you look.
Too many developing traders just rush to put on that first trade. The basics are not complicated, and that’s one reason they are hard. When you are sharpening a knife, of course you look at it first! (But how many people don’t do that…) When you are learning to trade, of course you must think of what your goals are, what your risk tolerance is. Of course you must think about whether your trading plan actually has an edge at all. These are obvious things, but a beginner, left naturally to him or herself, will almost never think of these obvious things. The important things are hidden in plain sight.
Then you put the knife on the stone and sharpen. If you watched, you’d think you could do this too. You just see a guy scrubbing a blade across a sharpening stone, but there’s a lot you don’t see. I did this for 10 years without really knowing what I was doing, and then another 10 really working to learn it.
You don’t see, at first, that the angle I hold the blade is exactly consistent. It’s held in hands of flesh and bone, but the blade won’t get sharp unless each stroke is machine-like in its consistent precision. You don’t see that I’m carefully gauging the pressure on different parts of the blade so the stone works evenly. You might not see that I give a few extra strokes and pressure on some dull spots I saw when I was looking at the blade.
I’m pretty sure you won’t see that the carbon steel blades get a slightly different angle than the stainless. And you might not notice that I sharpen most of them with two bevels to support the cutting edge better. You probably don’t notice that I move my whole body from the legs because I’ve found if I pull with my arms I change the angle on the stone ever-so-slightly over the stroke.
The little things matter so much. Anyone can buy an index fund and just forget about it for years, so anyone can be successful in the market. But if you’re going to be trading actively, there are hundreds of small refinements that, collectively, determine your success. You won’t learn them easily and you won’t master them quickly, but, until you do master them, any success you have will be fleeting, at best.
After what seems like a very short time, the rhythmic sound of steel on wet stone, I flip the blade over and do the other side. I’m careful to work consistently to shape the blade evenly on both sides. I think about the connection here—this blade is becoming useful because of what I’m removing. It’s an irreparable process; every stroke takes something away from the blade (I wonder briefly if the blade hates the stone that makes it beautiful and useful)—something that can never be returned.
Too many little lessons here for trading and to learning to trade… to many to list! But think about that the next time the market hurts you. Taken correctly, the lesson the market just gave you can make you better. Does the blade hate the stone?
Then I do something you might think odd: I wash the blade in the water and I touch the edge. I know I can’t really see what I’m looking for, but the fingers feel easily: I stroke the blade just the right way to check for symmetry up and down the edge, and, critically, to feel for a little, tiny, folded burr. That almost-microscopic wire burr tells me I have worked the metal to the point it lost its structural integrity and is ready to take the sharpest edge it can hold. When I look carefully, I can see it in the right light, but I’m amazed at what the fingers can sense when you trust the sense of touch. That wire burr will come off soon, but the failure of the metal tells me I’m almost where I need to be.
If we look the wrong way, we’ll never see what is important; the fingers can see what the eye cannot. In trading, using the right statistics to understand our results show us things that are hidden if we only look at individual trades. We must use the right tools to see. Also, if you tried to cut with the blade at this point, you’d think it a failure. It’s not what you would consider sharp, but success is just around the corner…
Next, I flip the stone over and run a few light strokes over the harder side of the stone. Not minutes or hours, just maybe 20 strokes on each side of the blade. I know what this has done. I’ve ripped the wire burr off the edge and left a brilliant, keen edge. I am amazed how little time and pressure it takes to accomplish this if you know what you’re doing.
Last, most people would probably hone the blade on a piece of leather. This is, in fact, how you finish a razor blade—polishing to mirror smoothness, but I’ve discovered over the years I want something different from my blades in the kitchen. I want tiny, almost imperceptible teeth on the cutting edge, and the way to get those is to draw the blade a few times through a piece of end grain wood. This allows the blade to find easier purchase on something like a tomato skin, and it only takes 3 or 4 strokes through my old broken piece of a bamboo chopstick to finish the edge.
Don’t get me wrong… it’s razor sharp. You can, in fact, easily shave hair off your arm with it, but I don’t want a razor edge. I want the right edge for the kind of work I will do with the tool.
Many of us get in the markets, not so much for the wrong reasons, but for reasons we don’t understand. A classic example would be someone who wants the excitement of trading. You can certainly have excitement. You can create a system and approach that will fulfill your dreams in the market—and you will. But are those the right dreams? Are you perfectly aligned with your goals, objectives, and skills? Are you a coherent whole? When you get where you’re going, is it where you want to be?
After this knife is done, can you guess what comes next? That’s right: repeat. And again. And again. Though there’s a certain amount of hard-won skill in doing this, it’s really just routine. It only becomes useful when it’s repeated again and again, until all the knives are sharpened. Then I’ll take care of my tools, flatten the stone, let it dry, and put it away until it’s time to do this again.
I know this was a different kind of blog post. It asks a bit more of you, the Reader, but there are some important lessons that can help you shape who you are as a trader and move on to the next steps in your trading journey.
This is a followup to my recent blog post on strings of losses in trading systems. I ended that blog with a promise to consider how the probabilities affected our behavior, and I’ve been swamped with requests to write this post! This is a good topic, and one that obviously generates some interest, so let’s dig in.
Trading is hard. We know this. We also have a pretty good idea why it’s so hard. There are many reasons, but, to my way of thinking, they center around two areas:
Objective edges in markets are very small. The only way to apply them is over large samples and with consistency.
Human psychology interacts with the market environment in some weird ways that make all this harder than it has to be.
As for the second point, I think there are many reasons why our psychology is so poorly tuned for trading, but two reasons jump out:
Evolution probably favored cognitive development of paranoia, pattern recognition even when patterns are false, and immediate action. There was probably no evolutionary advantage to being able to understand probability and randomness, so it’s not part of our natural cognitive framework.
Financial markets evolve and have evolved out of the competitive actions of many market participants. This creates an environment in which our normal actions will naturally be turned against us by “the market” (which is nothing more than the sum of all the actions of all market participants.)
I made those bullet points, but I they hold some of the deepest truths I’ve learned in over two decades of trading. I’d submit that both of those points are worth your careful consideration, but let’s look at a few practical ways that our brains can “misfire” and cause us to do the wrong thing in the markets.
String of losses
This was the topic of that previous blog, and we can summarize it very easily: random data has more runs (in trading, of both good and bad things) than we expect. Because runs “feel” wrong to us, we tend to make some mistakes.
First, a string of winners can easily lead to overconfidence and to taking too much risk on the next trade. Traders can feel euphoric and invincible, or, at the very least, have an inflated opinion of their own skill when really it’s nothing more than a natural, lucky run.
A strong of losses can cause just the opposite. In addition, many trading educators do not properly understand randomness and tell developing traders to spend a lot of time in trade review and to look to modify trading plans after runs of wins and losses.
You can’t remind yourself often enough that all of this is highly random and noisy. If you understand your win rate and have some idea about the stability of your system (a legitimate point that was raised in the comments to my previous post) you can make some informed decisions about what you should do.
Are you 20 trades in to trading a new system and you’ve had 5 losers in a row? Well, that situation would be very different than if you were 100 trades in and had a run of 5 losers, and the way you deal with it should be different.
Other mistakes might not be so much related to runs in probability, but they are worth considering:
We tend to get fear and greed wrong. Left to natural inclinations, most traders would tend to get fearful when they should “push the gas” a bit, and tend to get very aggressive when they should be more cautious. This is one reason why beginning traders often note that someone could make money just doing the exact opposite of what they do. You’re not imagining it! (And you’re also not hopeless—this is all normal.)
The extreme misfire of aggression comes when a trader goes “on tilt”. An active trader can easily destroy an account in a single day. I sat beside a trader who had traded professionally for years. One day, he had an unfortunate alignment of personal issues and market action, completely destroyed his trading account and went negative, ended up out of the business and had to sleep in a friend’s basement. There are real-life consequences to trading mistakes.
We attach significance to things that are not important and miss important things. Traders often imagine someone is hunting for their stops or that the market is out to get them. This is another way that our beautifully tuned cognitive tools hurt us in the market. It’s useful to be able to walk into a room and get a feel for whether people like you, whether it’s safe, or dangerous. When we apply that same sense to the market, we often think the government is trying to hunt our stop orders and that THEY always get us.
How to “fix” yourself
Ok, the bad news first: you can’t “fix” these things. They are such a fundamental part of how you see the world and how your brain works that you can’t change them.
But the good news is you don’t have to. Successful traders struggle with these same issues, even after decades of trading. You can be successful with these cognitive errors and biases, but you can’t let them shape your behavior.
And there, I think, are the answers: you need to understand the issues intellectually. You need to shape your behavior with a strong influence of your rational, analytic side. Do not be blind to emotion and don’t try too hard to repress it. (Indeed, there are traders who are, shall we say, impressively emotional and make their emotions part of their process in a constructive way.)
The goal is not to eliminate emotion and become a machine. The goal is to discipline your behavior, to be aware of your potential limitations and errors you will be inclined to make, and to work to apply your edge with more consistency in the market.
If you’re a beginning trader, thinking about the impact of strings of wins and losses is a pretty good place to start. Go back to that previous post and consider how likely you are to have 3 or 4 or more winning trades in a row. How will you feel after that? How should you feel? Now what if they were losers?
Investigating emotions and cognitive biases from a rational perspective might just be the first step in managing our behavior and strengthening our psychological perspective.
(I am working on the psychology module of my completely free trading course and will publish it soon. If you haven’t started the course, this is a great time to start so you can be ready for that module when I publish!)
Hey help me out please. I was reading a good blog by a smart math guy and he said that your next trade is always 50% chance of win. No matter what your overall win ratio is the next trade is always 50% chance. Like if your system is 75% wins, the next trade is only 50% win loss. Is that right? It’s confusing if it is.
Good question. Probability can be very confusing, and the short answer to your question is no, whoever wrote that is not right. (But even though it’s wrong, it might be useful.)
The best way I’ve found to think about problems like this is to turn them into something simple and physical. In this case, let’s think of colored marbles in a bag, and let’s simply it so your system has an 80% win rate. The way to model this would be with a bag with 10 marbles in it. There are 8 blue marbles (winning trades) and 2 red marbles (losing trades) in the bag. We can easily see that 8/10 (80%) of the marbles in the bag are blue winners.
Now, reach into the bag and grab a marble. Without looking at it, do you think it’s more likely to be blue or red? Obviously, it’s more likely to be blue. This, in fact, is the definition of win ratio in a trading system: any one trade, drawn at random, from the trade results has an 80% chance (in this example) of being a winner.
Now look at the marble. We don’t know before you look if it’s red or blue (and I suspect this is really the author’s point). Now put it back in the bag. I shake them up, and you reach in and take out another marble. (We are sampling with replacement here. If we do it without replacement (not putting the marble back), things get a little weird for this example.)
I think you can easily imagine two things with this little experiment:
The marble you draw always has an 80% chance of being blue. The author’s statement (assuming you didn’t misunderstand him, which is possible) is clearly false. The next trade has whatever your average win rate of the system is chance of being a winner. It is not 50%.
But… we never know what the next marble you draw will be until you open your hand and look at it.
That is probably the author’s point, and it’s a good one. The Gambler’s Fallacy is a well-know cognitive defect (we usually use the kinder word “bias”, but in this case it just makes humans stupid… let’s call it a defect so we can work around it!) that makes us think something is “due”. Go to a fair coin example for a moment. If I flip 4 heads in a row, are you somehow a little more likely to think the next flip should be tails? What if I flip 10 heads in a row?
Probability of runs of losses (vertical axis) given system win rate (horizontal)
In these examples, assuming the coin truly is fair, the next flip is always 50/50, no matter how many strings of heads or tails have come before. The coin has no memory of past flips and there is never any case in which something is “due” or more likely based on the past.
In the marble example, the next marble is 80% likely to be blue. Let’s say you get unlucky and pull out 3 red ones in a row. (That will happen if you do this long enough, by the way. There’s a little less than a 1% chance of pulling 3 reds in a row.) Is the next marble somehow more likely to be blue, or is it still exactly 80%?
I suspect this author knew the math but just tells himself the next trade is 50/50 so he doesn’t, for instance, bet more on a winner after a string of losses. Maybe so he doesn’t get frustrated and make other mistakes after a string of losses. Maybe to remind himself that strings of losses arise just out of random chance, and might not reflect something he’s doing wrong.
(This is a problem with the naive and classic “trade review” system. Why would you sit down and review your marble drawing technique after you draw three reds in a row? You just got unlucky with this run, and that’s fully to be expected given the probabilities of the bag of marbles. Many trading problems people try to “fix” are the same.)
By the way, it’s the same with winners–long strings of winners should not make you feel invincible and take on more risk. They also shouldn’t make you scared and think things like “my luck can’t last. I’m due for a loss…” Randomness can be very counter-intuitive at times, and one of the thorniest subjects is strings within random data.
Now, we should think about how this impacts behavior and trading psychology, but that’s a subject for another day!
For some of my readers, you already know what I’m going to tell you today. But I’ve learned recently, in talking to many developing traders, that a lot of people aren’t fully aware of the trading course and what it offers. I want to take a few moments today to share some thoughts with you, and to tell you about the newest module we published.
History of the course
I started the course in 2013, as a companion to my just-published book. I saw the course as a way to extend the material of the book, to help people who learned from listening or seeing rather than reading, and, frankly, as a way to combat some of the crappy courses I saw people charging thousands of dollars for.
I created a course that is fully the equal of nearly all of the paid courses out there. It covers technical/directional trading in almost academic rigor: moving from probability to market dynamics to practical/applied technical analysis. All of this is crystallized in the useful heuristic of a few chart patterns, and then we work on how to apply it: risk management, creating your trading plan, and developing the psychological skills you need to do it.
Late last year, I began a project of completely re-vamping and re-doing the course, drawing from my conversations with and the experiences of thousands of traders who worked through the course. I’ve learned a lot… and the new version is even better!
I’ve written an entire new book to support the course. (Though you don’t need the book to do the course). There are hundreds of chart exercises, and many in-depth exercises that will ask a lot of you. (One of the coolest things is the analysis of the full history of the DJIA!) This is not just a course where you watch a few videos and go on with your life—if you work the course properly, it can change your life.
What can go wrong
I don’t say that lightly; I have a lot of feedback from traders who said that the material in the course took them from struggling to consistency. Making a chance in someone’s trading like that literally can change their lives.
But I also have spoken with many traders who didn’t get what they could out of the course. Why? What went wrong?
Well, first, we tend to assume something is worth what we pay for it… and… the course is free. (You can hear someone saying “dot, dot, dot” here…) I talked to one person (an ex-floor trader) who first saw the course years ago and ignored it because it was free. Once he got into it, he’s raving about all the things it’s cleared up and all the answers it’s given him, and he asks why I don’t charge $10,000 for it.
One of the other things that can go wrong is the course asks a lot of you. I cannot make you a trader. There is nothing I can say to you, teach you, or give you that will make you into a trader. Sorry, but that’s the reality. If you are going to become a successful trader, it will depend on the work you do.
And that work is hard. That work is sometimes tedious. (Sometimes, it’s very rewarding and fun.) It takes a lot of focused work over a long time, and, especially in a world of 13 second engagement with Facebook videos, we may be losing the skill of focused attention.
What you can do
If you’ve taken the some of the course but sort of fell off the wagon, go, right now, and start again. If you went completely through the old version of the course, the new version is worth your time too. There are some brand new modules and content that was not in the course before:
An in-depth look at the history of modern technical analysis: main players, what they did, and how it all fits together. (Module 6, unit 4)
A deep look at the patterns of classical charting, using the original source material. (Module 6, unit 5). Everyone on social media brings out “head and shoulders” patterns all the time, but you’ll have a solid perspective on these patterns that most people are missing.
Trade management and specific exit techniques.
Work on cognitive biases and perceptual errors.
A new module and material on risk (will come in Module 8)
Completely revised psychology and discipline work, including units on routine and process, and how to develop the mental skills of profitable trading. (Module 9, not yet released).
I’m not going to lie—I’m excited about this course. It has been a labor of love (and oh… the labor it has been!) for several years, and I think the recent additions are significant improvements. If you haven’t seen it, I’d love for you to check it out and let me know what you think.
Just to be crystal clear: the course is, and always will be, completely free. Registration is required, but I’ll never share your email address or contact information. Also, I do have some subscription services that do a pretty good job of connecting the course to current market conditions… pointing out some actionable trade ideas… filtering markets for best patterns and trades. I’ll share those with you too, and, for some of you, these services may bring tremendous value. But there’s no obligation or need to buy anything—the course is totally, and completely, free.
Start today… this course can change your trading… and it can change your life.
There are so many “teachable moments” in recent market action, it’s hard to decide where to start. I think one of the clearest lessons comes from the recent implosion of short volatility products such as XIV and SVXY—good lessons here on volatility and on risk in general.
First of all, a little history: Over the past decade, we’ve seen more and more Exchange Traded Products (ETPs) that allow anyone with a stock account to trade many different things just by punching up a stock ticker. Some of these are great for diversification and international access; we can buy positions in many different stocks, both at home and abroad, with a single ticker.
Others are more problematic because they allow stock traders to trade things like commodities. If we understand the risks and different characteristics of, for instance, gold, crude oil, or the British Pound currency, we have an easy way to trade them. If we expect them to behave like a stock and think about “investing” in these things, we’re probably in trouble.
Other products are so dangerous that we could argue it’s irresponsible to make them available to the public. Some levered products fall into this category, and one of the things I’ve watched with great concern was the growing number of volatility-related products.
Many of these products appeared to have very predictable characteristics—they declined with apparently astonishing predictability. This led to a group of traders who advocated shorting these products, and to a large group of uneducated, inexperienced, and unskilled traders setting themselves up as social media gurus around this concept.
For several years, these strategies appeared to offer consistent returns. In early February (2018), the bill came due: volatility came back into the market with a vengeance as realized volatility spiked. After the close on 2/5/18, VIX futures exploded, and some of the corresponding ETFs crashed. XIV (an inverse product that “goes down when volatility goes up” (more on that in a moment)) closed that day at 97.01. A few hours later, it was trading below $5.
Similar moves occurred in other products, and many traders experienced devastating losses. As I write this, a few days later, social media is filled with talk of class action lawsuits, and “traders” talking their book, buying more, and talking about how it “has to go back up to at least the XXX day moving average.”
Let’s focus on some good things we can learn from this: 1) never trade a product you do not understand. 2) never trade a strategy you don’t understand.
Never trade a product you don’t understand. Many people had the facile and simplistic understanding that “this thing goes up when volatility goes down” or “this thing always decays so it always makes sense to short it.” Of course, it’s more complicated than that. What, exactly, did the product track? In most cases, VIX futures, but where on the curve? What are the VIX futures? What’s the VIX? How are these things tied to volatility in the market?
These are important questions. Years ago, when these products started appearing, I advised many people to exercise extreme caution trading them because you might be trading a derivative of a derivative of a derivative of a derivative, and there are many surprising ways you can lose in such a chain. Consider a simple strategy of buying a put or a call for a directional move on a stock—there are plenty of ways you can be right on your stock call and still lose money. Imagine how much worse this can be!
Sadly, there was a small army of social media idiots who set themselves up as experts in groups with witty names like “the Short Selling Academy.” With a simple message like “these products always go down so all you have to do is to short them”, they gained a following and no one stopped to think that the gurus might be trading (or not) a $2,000 account while they dispensed expert advice. Truly a case of the blind leading the blind.
For a new trader, it’s hard to know what you don’t know and hard to know who to listen to. Social media credibility can easily be built in “fake” ways, and so-called experts may, in fact, have no idea what they are talking about. What can you do?
Well, first of all, you can get a solid education in some trading and market basics. One of the core understandings—perhaps the most important—is that there’s no free lunch. If you think you’ve found a risk free opportunity or something that provides steady income with essentially no risk, you’re missing something. If there’s opportunity, there is always risk; the two are inextricably wound together. If you don’t see the risk, or if the risk seems very small, you’re missing something. Work to understand the risk.
Next, you do need to understand the mechanics of the thing you are trading. How much and in how much detail? Well, it’s your money, so you can decide. At the very least, reading the prospectus would be a good place to start. In the case of the XIV and related ETNs, the prospectus includes 16 pages on Risk. Our natural inclination might be to assume that’s a lot of CYA legalese. Some of it might be, but some of it points to real risks. An hour or so spent reading this before you risk your account might be a good idea.
As for understanding the strategy, this is perhaps even more difficult, but here’s a golden rule, which is tied to the “no free lunch” rule: if a strategy loses very rarely, those losses can be huge. In some kinds of trading (e.g., directional swing trading), we might win about as often as we lose, and wins and losses are about the same size. Consider a trend following who might lose much more frequently than he wins. In this case, his losses should be much smaller than his wins.
But strategies that rarely lose come with big problems. In the case of shorting option premium, you might almost always win. You might, in fact, win so often you think you can start calling it “income” because you just make a trade and get income. What you are missing is that your losses, when they do occur, can be many times your average win. If you haven’t structured the trade properly, a loss could be enough to wipe out your trading account or, in some cases, your entire net worth.
These are kinds of risks that short volatility strategies carry. It doesn’t matter whether you are trading them through options, futures, or an ETN on futures, except that more links in the chain lead to more complexity and more ways to lose. If you don’t understand the basic risks of being short volatility, you’re taking unacceptable risks to your trading account.
For some traders, this lesson comes too late and they are already out of the game. If you got lucky and weren’t hurt in this event, double down your efforts to understand the risks (and associated probabilities of incurring the losses from those risks) of anything and everything you trade. If you were hurt, then use this as a lesson to understand why and think about how you can guard against this type of event in the future.
Risk isn’t bad. In fact, our job as traders is to take on the right kinds of risk. A kind of silly way to think about it is that risk is the fuel we put in the “trading engine” to make profits, but that silly analogy isn’t far off. We need to understand the risk and make sure we are taking the right kind of risk at the right time and in the right amounts. Mis-understood risk is the killer, so work to understand your risk.
Mistakes are a part of trading. They’re a bad part of trading, and we generally do everything we can to reduce those errors. In fact, for developing traders at certain stages, the difference between profits and losses can simply be eliminating errors.
Over the years, I’ve made every boneheaded, stupid trading mistake possible: I’ve bought instead of sold, I’ve doubled up positions instead of exiting (by buying instead of selling!), I’ve ignored stops, I’ve taken frustration trades, I’ve skipped trades because I was afraid… the list goes on and on. I will say this: many of those mistakes I made one time and took the lesson to heart. Many of those mistakes were also made very early in my trading career. But if I’d just read about them, I don’t think I would have had the powerful learning that came from the pain of doing something dumb and losing money.
Most of those mistakes are so blazingly obvious you’d probably never make them yourself. (Actually, if you trade long enough, I bet you make most of them lol.) But there was one other mistake I made for a portion of my career that is a real killer:
That mistake was to trade with money I could not afford to lose!
Now, I know there are plenty of services that tell you you can open a trading account with a small amount of money, and grow that account into an amount that will support you and your family in a lavish lifestyle. They will justify this claim by showing you upward sloping equity curves, talking about the compounding power of interest, and probably suggesting a few trades with 1,000% return will help.
They are lying to you. I don’t know any other way to say it, and it has to be said because this is one of the keys to trading with the right psychological framework.
You cannot win consistently unless you can allow yourself to lose. If you are in a tight spot financially, as I was at the time I was making this mistake, every loss will be translated into something real: “there goes my car insurance payment for the month”, “that was my house payment”, “if I lose a few more times like that I’m going to have to stop trading.”
I don’t think there’s anything magical or mystical going on here, but when we focus on something, we tend to move toward that thing. Even if our focus is a burning desire to avoid it, focusing on something tends to attract us to that thing. If we are focused on avoiding losses… well, we have lots of losses.
When you can fully accept loss, something magical does happen—you finally find yourself in a state of clarity. Many former problems “fix” themselves with astonishing clarity. You might just find yourself winning instead of losing.
From a practical perspective, I think the lesson is this: your trading account needs to be true risk capital. Especially at first, it needs to represent such a small amount of money to you that you don’t think about the finances. (This is also why I advocate a period of backtesting and then papertrading before committing any real capital.)
There are good and bad ways to work with a small amount of capital. One of the other huge errors I see from small traders is trading tiny stocks. Yes, you can buy 10,000,000 shares of that $0.001 stock, but should you? Trading is all about consistency, so think about how you can build that record of consistency. Maybe you should be buying a few shares of a larger stock, instead. Maybe you should be trading currencies, where you can trade tiny positions. Basically, you’re going to lose while you’re learning, so keep those losses small.
If you are in a bad spot financially, I’m not saying you can’t learn to trade. Yes, trading can be a significant and meaningful part of your financial picture. It can literally change your life. These things are true, but make sure you are learning with a tiny amount of money so you can learn without feeling the pressure and burden of losses.
When I look back over my career, I think this was the single biggest mistake, and it guaranteed my failure in that period of my trading: scared money never wins, for good reason. Trading with money you can’t afford to lose is a sure-fire way to lose.
Understanding this can point you toward some answer for your personal financial situation and for the future of your trading program.
This is a guest post from my friend (and a trader and author for whom I have tremendous respect) Kevin Davey. I first “found him” through his book. I read many trading books each year, most of which I end up skimming after the first few pages, and quite a few of which I stop reading in disgust. Kevin’s book was different. I read the whole thing, and kept thinking “this guy is different… this book is different…” And he is. Check out his bio and links after the story…
Its 11 PM Sunday night, and you are psyched. You are ready to go tomorrow morning. You’ve studied for a couple of months for this. You’ve read a bunch of books, watched You Tube “experts” do exactly what you’ll be doing, and you’ve even done some simulated practice at home on your own.
You know it is hard, but the video experts tell you that you can do it – you just have to overcome your mental blocks. You can accomplish anything now that you have “book smarts,” the half dozen or so books you’ve read tell you. Heck, you have heard of many people succeeding – why not you? In the back of your mind, you know the reality is many people want to do exactly what you are doing, but just can’t hack it. But in your heart, you feel you are different, somehow better.
As you lie in bed Sunday night, your thoughts start to drift, right before you fall asleep. You imagine yourself at home on Monday night, after it is all over. You are sitting back in a recliner, maybe with a drink or a cigar, with a slight smile, some would say a smug expression, on your face. You’ve done what everyone said was impossible. You feel like the King Of The World!
Monday morning comes and you are nervous, but ready. You know if you fail, it will cost you emotionally, mentally and especially financially. But you enter the room, confident and self-assured as can be, and go to your workstation. You announce to no one in particular “let’s get this started!”
The orderlies roll in the heart transplant patient. He has been prepped and is ready for you to start operating…
Sounds crazy, doesn’t it? Actually, it is a pretty far-fetched scenario – someone attempting a mentally and financially (think malpractice) dangerous activity with no experience. This would never happen in the real world, right?
Well, maybe it could…
Now go back, and instead of thinking this is a new surgeon’s first day on the job, imagine it is a trader starting his or her first day of real money trading. Doesn’t sound so crazy now, does it? Maybe this even describes your start in trading – parts of it definitely ring true for me.
Both activities can be financially rewarding, for sure. And both activities are mentally and emotionally stressful. Yet one activity requires years of formalized education, years on the job experience and years of testing – a ton of work before you are allowed to be a lead surgeon. The other merely requires a pulse, a credit card, and the ability to fill out a simple application – then you can start trading!
What is wrong with this picture?
The concept is called “barriers to entry.” It is a business school / economics term that recognizes that some activities take a lot of capital and preparation to get off the ground. You can’t be a surgeon after watching some videos, you can’t open a jet airliner plant in your garage, and you can’t argue cases in front of the Supreme Court without passing the bar exam. The barriers to entry are just too high.
But you can open a trading account with no training or experience – the barriers to entry are super low. Does not mean you should, of course. And that is where the fallacy of successful trading starts. Since people can easily open an account with a few hundred dollars, they think it is an easy endeavor.
I get e-mails practically every day – people wanting to start trading with $1000, $500 or even as little as $250. People thinking they can make a nice part-time income trading for 15 minutes before they go to their “real” job. Or retirees looking to make a few easy bucks to supplement Social Security, to stave off employment at McDonald’s.
Since many brokers allow you to open an account with such small amounts, success must be possible, right?
Well, here is the reality. Trading is hard. Very hard. I always tell people “trading is the hardest way to make easy money.” I used to be in charge of Quality and Engineering for a company that made flight critical airplane parts – if our part failed, many people would likely die. Imagine the pressure and the stress of that. Yet, trading is more difficult – much more difficult.
Of course, trading is immensely appealing, especially to the younger generation, who’ve grown up in a world of a seemingly never-ending bull market. And trading also appeals to other ages too, like it always has for hundreds of years.
So, knowing all this, what is a good way forward for someone wanting to trade? Here are five steps you can take.
First, block out all the nonsense you hear about how easy trading is. Twitter seems to be a haven for young, successful, never lose traders. Except probably 99% of them are lying – most just paper trade from their parent’s basement, if they even do that. The old adage “if it sounds too good to be true” definitely holds here. My rule of thumb is that if I see signs of “trader porn” – fancy cars, bikini clad women, stacks of cash – I immediately ignore it. Real traders rarely, if ever, act that way.
Second, get educated. If you do not know which educator to trust, just read whatever you can, from whomever you can. But read with a critical mind. You’ll soon be able to distinguish fact from fiction, and you’ll learn how to ignore the b.s. so prevalent in this field.
Third, get yourself an edge – a method, strategy or approach that you have proven to yourself is successful. Think of yourself as a casino – you want the house edge working for you, not against you.
Fourth, realize that risk management is one key to your success. Risking it all because you believe you have an edge is no way to trade. Expect edges to fade away, and expect trading to always be tough, even after you have years of experience. While you are playing offense, trying to score profits, remember that defense – protecting your capital – is important, too.
Fifth, and finally, be ready to repeat steps 1 through 4 over and over again. You have to always be improving, reminding yourself to ignore the hype, constantly educating yourself, finding new edges and managing your risk. Let your guard down even for a minute, and you’ll find yourself amongst the market’s losers.
The bottom line is that trading is very, very hard. In many ways, being a successful trader is no different than being successful in any other endeavor. But with work and determination, you can be successful. Just don’t let trading’s low barrier to entry fool you.
His web site, www.kjtradingsystems.com, provides trading mentoring, trading workshops, and free trading videos and articles. Kevin is the creator of The Strategy Factory®, a unique trademarked process to develop algorithmic trading strategies.
Active in social media, Kevin has over 14,000 Twitter followers. An aerospace engineer and MBA by background, he has been an independent trader for over 25 years. Kevin continues to trade full-time and develop algorithmic trading strategies.
I want to share a note I got from a friend and developing trader, Glenn:
A note on my trading. It is better than it has ever been. It is simpler then it has ever been. I recognize the pattern and trade it..Less thinking and more lets say brick laying type of work. Most of my losses are shorts and that is my biggest problem. I might consider not necessarily always having longs and shorts. I traded [a lot of] shares last year [doing small size on each trade] and almost broke even which is leaps of progress. I believe 2018 could be a breakout year for me…
Now, the internet is full of “you’re doing it wrong” posts. Someone will tell you a “better way” (or at least a different way) to do any and everything, often under the guise of a lifehack: how to drink water, how to put on socks, how to fold socks… you get the idea.
Furthermore, people respond much better to negativity. If I’d titled this blog “Reasons why Glenn is an idiot” (he’s not an idiot) then more people would have clicked on it—the twisted lure of clickbait. (Look for a future blog post on my 6 week and running self-imposed exile from the swamp of negativity that is Facebook. Short summary of that post: my life is better.)
But the fact is, sometimes we are doing things right, and positive reinforcement is a good thing. It’s even harder to know, as traders, when we are doing something good and right, and that’s where a little outside perspective can be helpful. Let’s look at Glenn’s note.
First, he acknowledges up front that his trading is “better than it has ever been” and, interestingly enough, is simpler than it has ever been. In a world where traders seem hellbent on adding indicators, complicating factors, ratios, and a layer of complications to trading, here is a trader reporting the progress he is making with simple, robust patterns.
The OODA loop
Second, he has closed the OODA loop. The OODA loop is a military strategic concept developed by John Boyd: Observe. Orient. Decide, and Act. Consciously thinking through the steps of this cycle can bring great clarity to the trader’s problem: Observe what is going on in the market. Orient yourself through a solid understanding of patterns and market structure. Decide what to do, and then do it (Act).
Now, in the interest of full disclosure, I know Glenn pretty well. He’s been an advisory client of mine at Waverly Advisors for a few years, and he and I have done some one on one coaching and even a few hypnosis sessions. Nowhere in those sessions did I speak the phrase “OODA loop” to him. (In fact, he’s probably saying “hmmm” the first time he reads this post lol.) But much of our work was designed, through a few gentle nudges and changes, to get him in this loop.
If you think about it, there are many places a trader can get lost, and many ways we might not see clearly. We might simply not take in the market data, and not to the homework. I stressed the Glenn the importance of showing up to work no matter how you felt about your trading. You have to immerse yourself in the flow of the data.
You also must have correct patterns and structure within which to orient yourself. This is why I hate that mindset that says “since you really only trade your beliefs and not the actual market, you can believe anything and make it work.” That’s simply a lie. Your beliefs must be aligned with the realities of the forces in the market. Glenn did a little bit of study and work to get the core of what drives the kinds of trades he wants to make.
Then, of course, the ugly problems of trading psychology really come to focus in between and around the second half of the cycle. Maybe a trader just can’t make a decision. Maybe he makes a decision, but can’t follow through. Maybe he makes a hasty decision out of frustration. Maybe he doesn’t do something when he should because he’s frozen, angry, or shocked at something the market did.
In all of these cases, it boils down to having a plan and to following that plan. I know Glenn has a plan, and I know he works on and with that plan to make it better and to make it fit him better. In fact, if the only thing he got from our work together was the necessity of having a plan, that might have been enough to get him to turn the corner.
The Plan’s the thing, to paraphrase the Bard badly… especially for the developing trader, we are lost without the plan. Without a plan, even if we do something right, we probably can’t do it again. Having a solid plan, a realistic plan, and then working with that plan is one of the keys to the kingdom.
The land of breakeven
Last, I’d like to point out that you are seeing here the brutal, real grind of a developing trader’s struggle. Glenn isn’t popping bottles of champagne and hanging out in pools with a bevy of supermodels while he waits for his helicopter to pick him up to take him to dinner… his success is incremental. So small he might miss it, if someone hadn’t pointed out to him what success looks like. The is work and grind and it’s very, very hard. Many of the traders who fail probably would have succeeded if they’d put in the hard work, and weathered the discouragement of the grind.
Success, especially at first, is quiet and subtle. Losses are smaller. They hurt less. You find yourself more focused on the next trade, and on the lessons. The nagging doubts start to go away as you focus on the process and just work the process. “Almost breaking even” is a stage of success. Nearly all traders start in the natural state of “pretty consistently losing”—this is natural. This is normal. When we move toward profitability, we spend some time in the land of breakeven first.
And that’s a good thing. I’ve had many traders say things like “I’m going to stop. I’ve been doing this for three years and I’m finally just breaking even and maybe paying for my commissions.” Don’t stop. That’s success, and your future, full success lies ahead of you… but first, you probably need to walk some steps in the land of breakeven.
I’m looking forward to Glenn’s 2018 almost as much as he is.
(If you haven’t seen my free trading course, go check it out now! These concepts, and others, are explored in-depth in a series of 9 modules, each of which is between 2-4 hours. This course provides a solid foundation for a professional approach to technically-motivated trading.)