Monday, January 11, 2016

Psychology Plays a Key Role

Managing emotions and psychology is big part of trading.  There is an entire segment of the industry and numerous books devoted to the psychological aspects of trading.

I’ve come to believe that the true underlying purpose of having a trading plan and accepting randomness are really just tools to help mitigate the impact of emotions while trading.

Common emotions are typically Fear, Greed and Over-confidence.

Fear of Losing

  • Was the trade avoided even though all of the plan criteria were met?  Was the trade avoided because recent transactions were losers (see Accepting Randomness)?
  • Was the stop-loss moved closer (and not in accordance with the plan rules) to minimize the potential loss?

Fear of Being Wrong

  • Was the stop-loss increased to avoid exiting a trade that is currently losing?

Greed / Over-confidence

  • Was the target increased (and not in accordance with the plan rules)?
  • Were trades entered when the plan criteria are not met because I did not want to miss out on potential profits?
  • Was the trade size increased prematurely (and not in accordance with plan rules)?

If I start to make any of the mistakes above it’s a clear signal that I need to take a step back and review the trading plan.

Accepting Randomness (aka Winning By Losing)

Consistently profitable Forex traders do not win 100% of their trades.

The above statement may seem obvious.  However, when I reflect on the thoughts and emotions I felt before, during and after trades I now realize how easy it is to lose perspective.

Why did the transaction not work?   Should I have waited for a different indicator to enter?  What’s wrong with my plan?

The truth is the losing transaction was simply a losing transaction.  All trading approaches have their share of losing transactions.

For example, if my Forex trading plan is based on a strategy that is 60% successful, I know that on average 4 out of every 10 transactions will be losers.  However, I don’t know when the 4 losers will appear.  For example all three series below have 6 winners (W) and 4 losers (L):

I admit that it can be quite difficult to accept but an individual loss is simply just one of the L’s in the series.

Losing trades are part of the plan.  I need the four L’s to achieve the 6 W’s.  The outcome of each individual transaction is unknown.  What matters is the plan has overall positive expectancy, meaning over time, if I follow my plan consistently, the combination of wins and the risk versus reward result in a positive return.  The wins compensate for the losses.

It is easy to lose this perspective, especially in the heat of the moment after either a win or a loss.  To be a successful Forex trader I need to lose.

Tuesday, December 29, 2015

There is no magical secret system

Stop searching.  I highly doubt there is a special combination of indicators and rules that anyone can simply buy on the internet and run-off to large profits.
If such a system existed the cost would be astronomical and so many traders would use it that the affect on the market would eliminate the much of the system’s benefits.

If such a system existed why is it even available for purchase?

If someone discovered a magical system, why would they need or want my $250 a month?

Would big investment banks or trading firms not scoop it up, keep it a secret and use it to profit?

Similarly, the common approach of continuously searching for the proper indicators to add to stock charts is also dangerous.  This never-ending chart tweak is really a magical secret system search in disguise.  

When I first started out, I was constantly adding, removing and tweaking the indicators on the chart.  Each time a trade lost I would think “maybe if I used a 20 period average instead of 50?”,  “what if I set this to 75 instead?” , “I should not enter when the ADX is blah blah blah”.

This does not mean technical indicators are useless and should be completely avoided.  Indicators can be an important aspect of technical, chart based trading.   However, it is important to understand how they work and to use them for the proper purpose and context.  

I'm starting to believe that the two key benefits of using technical indicators are:

  • Helps visualize what previously happened with supply and demand
    • Individuals respond in unique ways to information.  
    • Some people prefer numbers while others prefer graphical images
    • A picture is worth a thousand words

  • Supports decision making using non-subjective criteria
    • Incorporating rules based on technical indicators can help take the emotion out of trades.
    • “I will exit the trade if the closing price on this bar is below the 10 period SMA” This is not subjective.  The price either closes above, equal to or less than the SMA value.   Clear rules can help mitigate fear and greed when in a trade.  Traders can focus on discipline and following simple, clear rules instead of hanging on and hoping for more profit or less losses.