BarroMetrics Views: The Rubber Meets the Road II
In today’s blog, we’ll be having a look at Diffusion and Acceptance.
Let’s place both tools in context. Traders know that to succeed over the long term, our trading results need to produce, over the long-term, a positive expectancy return. One way of doing this is to ensure that our losses are less than our profits. But, newbie traders, tend to produce the reverse results. (See for example, attached study by FXCM).
The question is why?
We already know the answer - our reptilian brain sees loss as a threat, thus causing the fight, flight or freeze (3Fs) response. Once invoked, the 3Fs’ predominant desire is to alleviate our anxiety - we do this by immediately exiting the trade, by adding to our losing positions or denying the losses. But, the appropriate response, the one that, over the long run, leads to optimal decisions, is to do our best to interpret the incoming data and to act on it.
That’s the problem. Let’s turn to the solutions.
I have suggested that one way of overcoming the 3Fs is to become aware of their commencement by knowing our biological responses that signal the beginning of the 3Fs. Here the REPS exercise is useful.
Two other solutions, more long-term, are Acceptance and Diffusion.
Acceptance is being comfortable with discomfort.
No one likes to lose money; no one likes ‘leaving money on the table’ (taking say 40 pips when 300 pips proved to be available) etc. But, we can ‘not like’ something and still accept it. If we don’t, when we refuse to accept reality, we’ll let the memory of the event affect our next trade.
Remember Paul? He has a day-trading system that has a 40-pip profit target. He achieved that today, but in doing so left, 160-pips on the table. So, on the next trade, he ‘forgot’ to apply the target rules. As a result, he goes for 50-pips, and the market goes to 47 pips and reverses. Had he followed the system, he’d have his 40 pips, but because he was influenced by the previous trade, he ended up taking a loss.
In this case, Acceptance means knowing, believing and acting on the assumptions behind the system:
“a momentum system with a high win rate and low-pip profit target (low relative to the average true range).”
It means accepting that there will be times when we’ll leave pips on the table, just as there will be times taking the 40-pips is the best we could have done. Because we won’t know until after the event which is going to occur, we place our faith in the system’s logic and its backtest results.