Finding the trades
While there are many parts of trading business that are essential to trader’s success, the core area is undoubtedly finding and executing the trades. There are two parts of our every day trading process that are designed with that purpose in mind: Analysis System and Entry System.
Analysis System is designed to understand the current market conditions. It helps identifying what we can do on the market. It does not tell us when to trade, but it should certainly tell us when NOT to trade. To me, the essence of market analysis is to identify trading pairs where there is a higher chance of the price going in one direction over the other. When such trading pairs are found, the Entry System comes to action.
Entry System is designed to look for specific entry patterns in the direction identified by our market analysis. Main question that a good Entry System should ask is “Where do I put my Stop Loss order?” No matter what entry parameters we use, what targets we set, there is only one variable we have control over, and that is the amount of money we are willing to pay the market to find whether our trade is going to work or not (see the article in Issue 3). There is always a certain point in any market, beyond which it is not feasible to hold a losing trade. Thus, finding this stop point is the most important task of the Entry System. Without good Stop Loss, there should be no entry in the first place.
After identifying a good technical place for the Stop Loss, we will see whether the price is too far away from it, preventing us from having a good Risk/Reward ratio. When we see that Stop Loss can be placed in a good location, which is not too far away from the current price, we are ready to look for the entry itself.
At this point we already know:
- The market bias, or the path of least resistance in which we want to trade, that was identified by our Analysis System;
- A good Stop Loss price, beyond which it is not feasible to hold the losing position;
- We also decided that the distance to our Stop Loss leaves enough room on the other side (that is, profit side), so that our target can be placed with a good Risk/Reward ratio (ideally the potential reward should be at least 3 times the predefined risk).
All that remains at this point is to find the entry trigger, defined in our Entry System. For some it can be a certain indicator signal – I personally prefer to use Price Action patterns.
Executing the trades
After both the Analysis System and Entry System processes are finished, we should be able to take a trade right at that moment, since we know everything we need to do that. Unfortunately, often it is not the case, as we start to think and hesitate, trying to find the best trade of the day or making sure that it is “truly” the right signal. More often than not such hesitation leads to consulting the information that we do not use in our trading system, and therefore do not know how to use properly. The result is almost universally losses, frustration and subsequent psychological breakdown, leading to even more trading errors.
Even though our trading process should give crystal clear signals what to do or not do right this moment, at the same time we are always facing a certain amount of subjectivity on the market, as we can never predict the price precisely. We are building certain expectations where the price will go, and such expectations should never be made rigid.
It is very important not to have any attachment to our market expectations, as it is one of the main reasons leading to frustration and consequently psychological problems.
Think about it as a weather forecast. While modern technology increased the precision greatly, the weather can still be unpredictable, especially in some parts of the world. When you read the forecast, you build certain expectations for your day, possibly you are planning your weekend according to that forecast. Now, you may be planning a family lunch in the park on Sunday and your expectation, according to the weather forecast, is for a sunny day. After you made all the preparations on Sunday morning, it suddenly starts to rain, and does not look like it is going to stop.
What are your reactions to this situation? Are you going to be upset because you have to change your plans completely? Are you somewhat angry at the forecast stations, since they obviously made such a big mistake? Or are you going to quickly adjust your plans and spend a pleasant day with your family at home?
I am using this example because the way we treat such life situations will be the way we treat our market analysis. If we are not able to stay flexible in simple life situations and adjust the plans, we are not going to be able to stay flexible on the market, where the real money is at risk. Just like the attachment to our plans for the weekend leads to anger and frustration, so will our attachment to market analysis, and even more so.
When you expect the market to break the resistance and go higher, but it doesn’t, how do you feel? What if you already opened a position on the break and now watching the price go against you? Not only you are watching your loss growing, but more importantly, you are dealing with being wrong. The market went against your expectations, making you wrong. Or did it?
In modern life there are not many things that cause psychological pain for most people more than losing money and being wrong. You will find a lot of discussion in various resources about the necessity of accepting the risk and being ready to lose money (I prefer to think of it not as “losing” but as simple expenses of doing business or tuition fee if you are only starting the education). While acceptance of monetary risk is extremely important, another risk in our trading is being wrong, and I think it causes much more grief than the loss of money itself.
Think about it, most people build their whole lives around trying to be right. They argue, they try to prove, they believe to hold the truth that others need to know. How many people do you know that will continue the argument beyond any reason, when it is clear to everyone but themselves that they are wrong?
There is a vicious cycle that is created from attachment to our expectations:
- We learn about the market and find a method of analysis that we like;
- We apply it and build some rigid expectations about the future price movement;
- We act upon our expectations, placing money at risk;
- The market goes against our position “making” us lose money AND “making” us wrong;
- Fear and anger arise and we continue learning more about the market, with only one purpose in mind: to find a method where the market will not make us wrong. To prove to the market that we are right.
In this situation a trader is personifying the market, assigning certain qualities to it that allow the market to “go against” trader’s position and to “make him wrong”. However, in reality the market is a collective entity, comprised of millions of traders just like himself, and all it does is simply follows the rules to try and balance supply and demand.
The problem here is not the loss that we experienced – after all I am yet to meet a trader who will state that it is possible to trade without losses and with no risk. The problem is our expectations being too rigid while our trading regimen is too flexible.
The thinking goes like this:
“I expect the market to break this level and go higher, so it MUST do that. If it doesn’t do that, it is making me wrong and that is unacceptable to me. I must refine my trading method so that the market follows my expectations precisely, then I will show it!”
In other words, there is no way the trader is willing to change his expectations and review his analysis – after all he believes that the market MUST follow it. However, he is very willing to change his trading rules to adjust them in such a way that the market always follows his expectations.
Now compare it with the opposite attitude:
“My current premise was not in line with the money flow on the market and so my position got stopped out. By going in the opposite direction the market is providing me with new information that I can now use to review my bias and find new trading opportunities”
This thinking will allow the trader to build a better premise, because he has been exposed to additional information about the money flow on the market. Not only will he be able to learn from a possible mistake he’s made when defining his original premise, but also he will instantly see additional opportunities that the market is now making available to him.
One attitude says “This is unacceptable, I resent the price going against my position. I will make sure this never happens again”, while the other asks “What other trading opportunities are available to me now with this new information the market provided me with?” It is not difficult to see what is more helpful to the trader’s development. The first trader is full of ego, he is looking for someone to blame other than himself. The second trader is humble and accepts full responsibility for all his actions, which empowers him greatly.
In my opinion these two attitudes separate consistently winning traders from everyone else.
The psychology and trader’s mindset are closely related to his trading method, his profit expectations and ultimately to his consistency and success. If trading system allows to trade randomly, without rigid rules to enter and support a position, it will lead to losses and frustration. If your risk management allows to overtrade, not controlling the amount of money you can allocate for trading every day or each month, sooner or later it will backfire and cause irreversible losses, when one day can lose more than was made in the past half a year.
It is up to us to create a trading system with rigid rules, and to have the discipline to follow these rules. At the same time we have to develop a high level of mental flexibility, letting go of our expectations easily and adjusting to the new information the market is providing us with.
We can also see a relation between our trading term and the amount of difficulty we will have to control our business properly. When trading intraday, the market is pouring new information on us with such a high speed that it is beyond most traders to absorb it and account for this information on the fly. It is much easier to overtrade when you watch the chart in real time and see one minute candle forming after another. Undoubtedly, there are traders who reached high degrees of success in short term trading, but I would argue that overall success rate is much higher for the followers of a longer term approach.
However, no matter how much we discuss the trading psychology and proper mindset, it is very unlikely to rewire our brain just by thinking about it. A great amount of everyday practice is necessary in order to change many beliefs we’ve been living with for years. In the next issue we will setup a practice routine that is designed to ingrain the new beliefs about the market, risk management, our expectations and trading execution. By following such routine we will be able to change how our brain operates, remove the hesitation and anxiety out of equation and develop the mindset that is most likely to lead to a consistent success in trading.