Intergrity, Honesty, Responsibility

The successful traders/investors I have met in my travels all share these three qualities: Integrity, honesty, responsibility. In this blog, I’ll first explain what I mean by the terms and then proceed to give examples on how their lack stops us from achieving our dreams.

  • Integrity: I see three levels of integrity. The first is keeping promises to others; the second is living our lives in alignment with our professed values and beliefs (we ‘walk our talk’); and the third is keeping promises to ourselves. (Landmark Forum)
  • Honesty: The refusal to pretend that facts are other than as they are (Ayn Rand: the refusal to fake reality)
  • Responsibility: The ability to personally respond (Fritz Perls). We are accountable for the responses we have to life’s situations. For example: we are not responsible for an accident caused by the negligence of another party but we are responsible for the way we respond to the consequences of the accident.

In my role as mentor, I see a wide diversity of personalities. Yet despite variances in human nature, those who succeeded all evidenced the three traits. Those who ultimately fail – those that surrender without completing the course – are the ones who never acquire one or all of them.

For example: I have one student who has the ability to be making money now. Yet, he is merely breaking even. Given the time and effort put in, the breakeven result would be, for another, an excellent result. But in his case, given his talent and feel for the market, the results could be much better.

When we examine the metrics, the reason for the mediocre results is clear: he takes profits much smaller than his losses. The cause for this is not hard to find: he trades two timeframes – FX for swing trades, ES for day trades. Whenever the market moves rapidly in his favour in the swing trade, he grabs the money rationalizing that he may as well put some money in his pocket. He figures that should the market correct, he can reinstate the position.

You can imagine the result. The very best trades do not retrace and as a result the profits he took and what he ought to have taken are wide apart.

To deny the facts, he focuses on the occasions that the early grab gave a better result. What he ought to be doing is focusing on the whole spectrum of trades. He chooses not to on the basis that ‘things are different now’.

Because, because ……we can rationalize away just about anything.

Actually in his case, I am optimistic that he’ll see the light. He is bright, intelligent and has a great feel for the market. I think it is only a question of time before the penny drops. The fact that he is breaking even rather than losing is testimony to his ability.

Another student may not share the same result. In this case, the program has always been a struggle. The student has been seeking success for over 5 years after leaving his job as a bank dealer. Having him change his ways has been a hard- fought victory, won inch by inch. We are now at the stage where he has to write out his trading plan.

Normally writing out the trading rules, takes no more than a month; some do it in a week. In his case, we have been at it for 3 months and there is still no plan in sight. I understand the source of the barrier. As long as the plan is not written down, failure to achieve his goals can be laid at the feet of ‘something out there’: it’s the market’s fault, I am having girl-friend problems, it’s Ray’s fault, he ……

Once the plan is down in black and white, then he perceives that long-term success rests squarely on his shoulders. And right now, he is playing the avoidance game.

How do we tell if we lack integrity, honesty and responsibility? It’s a question of self-awareness of the consequences of our actions. Dr. George Lianos once said to me: “If you repeat a behaviour, then no matter how valid the reasons for each individual occurrence, focus on the fact that you are repeating the behaviour – that is the reality”. Once we identify the behaviour, then we act to change it.

Trauma of Loss/Roadmap S&P

I hope you all have kept safe. Tonight I write on two topics. I touch on the trauma of wipeout and I look at the S&P’s roadmap for the coming week.

TRAUMA OF LOSS:

Many sent me this link: http://www.youtube.com/watch?v=2qlPW4wSzM8 (you may need to copy and paste)

It also appeared in a number of blogs: e.g. Dr. Brett Steenbarger’s “Traderfeed”: http://traderfeed.blogspot.com/

Watching it re-ignited some deep-set memories, memories of the many failures and of repeated lessons unlearned. I am full of admiration for the traders who learned from one dramatic failure; my journey took 7 years of losses and rehashing the same mistakes before I turned things around. Watching the video brought up the thought that ‘but for the grace of God and the patience and support of Chrisy (my wife) go I today’.

The video is a stark reminder that success in this game rests on the trinity: ‘Plan x Risk Management x Psychology’. Note that multiplication signs: a zero in any factor results in failure.

S&P ROADMAP

Speaking of plan let’s have a look at a roadmap for the S&P for the week and possibly next week:

Figure 1 shows the S&P basis cash with an 18-day Swing (the monthly trend), a completed Ray Wave Count and a Market Profile Structure. The first question is: what is the trend of the 18-day?

figure-01-18d-swing-mktp-rwc.jpg

FIGURE 1 S&P 18-day

To answer that, let’s turn to the 12-M (the yearly trend). The 12-Month has triggered a possible Upthrust change in trend from up to down (See Figure 2). To complete the signal I need a monthly bearish bar close below 1455. Right now that looks the case but only an end of month bearish close will confirm. In the meantime, if we assume the start of a bear market, how should the 18-d unfold?

figure-02-uothrust-cit.jpg

FIGURE 2 12-M S&P

Normal technical analysis theory suggests that breakouts are retested. I have found that the retest zone is generally (in a downtrend) between the upper boundary of the Primary Buy Zone (1406 basis cash) to the Maximum Extension (1360) (see Nature of Trends for definitions). There is also 13-w resistance (13-w breakdown point at 1370/1371). This is a pretty wide zone but does serve as a starting point (See Figure 3).

figure-01-18d-swing-mktp-rwc.jpg

FIGURE 3 18d Breakdown Points

Figure 4 shows a projection of a likely termination zone for the first wave down assuming a 3-wave structure. I consider the old wave-5 as the new wave-(2). A 69% retracement is equivocal on whether we see a 5-wave or 3-wave 1st move. We do know that a 3-wave move will not exceed 1.618 wave-(1). This provides a target to 1238 basis cash. I’ll assume the more conservative 3-wave target until the market says different.

figure-4-wave-3.jpg

FIGURE 4 Wave-(3) Target

Figure 5 shows the 80-min Ray Wave Count. For this count to be correct, the market needs to hold below 1334.20. Wave-2 was simple; Wave-4 will be complex and the structure as at the close on Tuesday 01-22-2008 has qualified as a complex wave-4. If so, wave-5 ought to begin tonight.

figure-5-wave-5.jpg

FIGURE 5 80-Min S&P

Wave-5 will be either the longest or the shortest wave. If the shortest wave, we’ll probably see it end at 1276 to 1248 with the most likely level to be 1258 to 1276. 1258 is the maximum extension of wave-4; 1276 is the minimum projection for wave-5.

This is the preferred scenario. If correct, I expect to see a rally of 1.97% to 2.22% (with a lesser probability of 2.66% to 2.83%) off yesterday’s close. This figure ties in with a wave-(4) around 1324 to 1350. I’ll consider the alternate count (wave 5 is the longest if the need arises).

To summarise: if we do get a wave-5 terminating around 1258 to 1276, we can expect a rally to 1324 to 1350 with the preferred target being 1335 to 1345. This is an area where I’d look to go short IF VOLATILITY has returned to normal. For the moment, I’ll abstain from trading the US stock indices.

[The 1.97% to 2.83% was taken off a study done by the Quantifiable Edges site:

http://quantifiableedges.blogspot.com/2008/01/time-cbi-indicate-bounce-could-be-near.html

(Thanks Brett Steenbarger [http://traderfeed.blogspot.com/)] for the heads up to the excellent Quantifiable Edges site)]

That’s the roadmap for the coming week in the S&P. It’s only a roadmap and I am sure that there will be detours as reality pans out. But by having a roadmap, each detour will provide information to make a more accurate picture against which to take a low risk trade when the current rally ends.

Volatility and the Trader

I was told when I first began trading that ‘volatility is the life blood of a speculator’. Like all trading truisms, this has an element of truth. Imagine trying to eek out a living when ranges are tiny and market direction flat.

But there are times when markets become ‘too volatile’: the meaning of ‘too volatile’ is personal and varies from individual to individual. The important thing is to have some measure of ‘too volatile’. My definition is two consecutive days of ranges greater than an ATR of mean + 3 standard deviations. The definition is instrument specific so that I can have, say the ES being too volatile while BPJY may not be.

Once I see a ‘too volatile’ reading in an instrument, I cut all positions (usually profitable ones; losing trades have probably been stopped out). The reason I do this is twofold:

  1. Quantitatively, my setups are validated by price action that is ‘normal’. When markets get too volatile, the population has been too small to date to draw meaningful conclusions. So in accordance with my first philosophical rule for trading (preservation of capital), I take myself out of the market.
  2. Qualitatively, my psyche is comfortable with only so much volatility. Beyond a certain point, I know I am likely to think the dollar value of the tic fluctuation rather than dwell on the info the market is providing. I can become accustomed to increasing volatility if the increase is gradual. But too rapid an increase places my in a zone of discomfort.

The message I am pushing here is take care if you are feeling uncomfortable with the ranges and market movement.

In line with the theme of this post, let’s turn to the ES.

To identify the boundaries for this structure (in Market Profile Terms – distribution) are off the 13-w swing low prior to the sideways price action (development). I notice that although the swing low occurred June 14 2006, the directional move did not start until July 18 2006. I prefer to anchor the July low to start my retracement levels.

The Primary Buy Zone lies within 1272 to 1229 (basis the CSI perpetual contract). The current difference between the CSI-p and ESH8 is about 5 points (ES is lower than CSI-p by 5). This makes the Primary Buy Zone 1267 to 1225.

01-22-2008-sp-18d.jpg

FIGURE 1 S&P Primary Buy Zone

Last night we edged into the Primary Buy Zone. This is an area where I usually par my position size to no more than 1/3 the initial size.

In addition, the last time the market reacted so strongly, Greenspan came in and cut rates prompting a 5% rally. Now this does not mean Bernanke will cut rates today but he might. Whether or not he does, will only provide more fuel to a market that is volatile.

All in all this is a good time to put some $ in your pocket. Oh sure, the market may head lower but then again it may not. I’ll part with this story: A student was long gold and sitting on some very nice profits. He was looking to exit at the Primary Sell Zone. The market got to within about a dollar of the minimum price.

To say he was excited …well that would be putting it mildly.  As he pointed out, the weekly bar looked good (opening near the lows and closing near the highs). Based on it, there was every reason to believe that the profit levels would be reached. However I did warn him that the daily’s painted a weaker picture and that he should establish some level beyond which he would cut the position.

He decided to place a breakeven stop but I could tell that he did not feel his stop would get hit. Well it did. The market opened lower on the Monday and proceeded South.

The point of the story is this. If you have profits in the ES, Gold etc, identify a level beyond which you will cut the position: Nothing feels worse than letting large profits turn into losses. When I say ‘identify’, I mean treat the loss as having occurred – feel it – rather than just give lip service to the level.

Reviewing Decisions

My assessment last night on what the FED was likely to do was off the mark. I assessed a 67% probability that it would cut the Fed Fund Rate by .25 and the Discount Rate by .50. Instead it cut both by .25.

I always do a post analysis assessment especially if it proves off the mark. I review the decision components to see what I may have done differently, being careful to avoid hindsight bias.

The Decision Tree I constructed rated the probability of rates being raised and remaining unchanged as being so low that I did not spend much time on them. I focused instead on the various scenarios (branches) for a cut in the rates. I pruned the scenarios to three:

  • a) One of the rates would remain unchanged and the other cut by .25
  • b) Both would be cut by .25
  • c) One of the rates would be cut by .25 and the other by .50

The inputs to the branches were:

  1. The state of the US economy;
  2. The need to protect the US $ and
  3. Bernanke’s view of the cause of the 1929 depression.

Reviewing my inputs, it’s clear that I placed too much weight on (3). Given what has been said today about the FED alternative tool box, I was relatively spot on (1) and (2). But where I went wrong was thinking that given Bernanke’s theory of the causes of the 1929 slow down, he would seek to solve the liquidity problem through the Discount Rate. Instead the FED will be seeking alternative means.

What I did get right was the first part of the scenario I had crafted: what would happen if (b) took place. I reasoned that the ES would tank and that this would be followed by two inside days ahead of the CPI on Friday. This is subject to the PPI and Retail Sales not being greatly outside expectations. Once Friday is over, I’ll review the Tree again and see where improvements could have been made.

I do the reviews because I feel it’s important to review one’s decision-making processes. Making decisions that accord closely with reality is as important as reviewing your trading plan etc. Revision of decisions is an important rule for constant and never-ending improvement. And, I feel the review ought to be done not only when we get it wrong but also when we get it right. That way we may identify enabling patterns and limiting ones.

Preparing for Figures in the S&Ps

Non-Farm payrolls tonight. The forecast range is +110,000 to – 10,000 and the mean is around 85,000.00. The mean was around 65,000 to 70,000 until the ADP employment number last night. With that coming in at 189,000 (against the expected 50,000), the expectations have edged up.

In this post, I’d like to show the process by which I prepare for figure night. Figure nights have been my bane. It’s the time my ‘rat brain’ (using Dr. Janice Dorn’s label) is most likely to exert an influence. To counter this, I spend a lot of time preparing my responses to the figures; in addition, I make a commitment to adhere to the pre-figure plan. In short, it’s one of the few occasions, I don’t give my intuition a look-in; at least not until at least three or more hours have passed.

The first thing I do is the normal analysis – as if there are no figures coming out.

Right now, I am long with expectations that the market will make a new high. I intend to cover the longs on new highs and stand aside after that. I outlined the fundamental reasons why I think the next high will mark a 2-year high in the post “Fundamental or Technical Trader?’; add to this the position of the market on the Ray Wave structure and it makes holding past new highs a high risk trade

In the meantime, using a variation of the Rule of 3, I have closed out 1/3 of my open positions, brought the stop to breakeven on 1/3, and for the remaining 1/3, I have my stops in their initial location. The profits I took will cover the loss on the 1/3 initial stop so I am on a ‘no-loss of capital’ situation.

So the above is where I stand at the end of the normal analysis.

After the usual analysis, I prepare my responses to the figures. The attached Decision Tree shows the probabilities as I see them and they show scenarios that are too close to call.

The events I considered:

  1. The ADP numbers have a terrible record for forecasting the Non-Farm numbers but they were so skewed, we may see a higher number than expected.
  2. On the other hand, John Williams’s excellent site had this to say: (http://www.shadowstats.com/cgi-bin/sgs):

“Employment Numbers May Play Role. This Friday’s employment report could be used to decide or at least to try selling any forthcoming rate action or lack of same. Fundamentally, the numbers should be horrible; October help-wanted advertising sank anew, while jobless claims continued to rise.

So the first thing I decided was I wouldn’t be doing anything in the ES immediately after the Figures. If they come out within the range +100k to +10K, I’ll call it a night for the ES. If they come in at either extreme, I’ll be looking for a sell-off and then signs that the sell-off has failed.

The sign I’ll be looking for is an ‘open-gap’ down at the open, followed by a failure to close 50% of the gap in the first 60 minutes. The hourly close would need to be at least around the 50% of the hourly range and preferably at or below the lower 33%. I’d then look for an upside breakout of the hourly range.

On the breakout, I’d need to see Market Delta confirming breakout volume.

decision_tree.jpg

DECISION TREE

Our Life’s Purpose

Today’s (Monday) blog is a little late. The trip to and from Shenzen proved more taxing than I expected. Looking back I can say, the event went well, judging from the post presentation reactions.

The event itself was probably one of the most taxing in recent memory; whatever could go wrong did. And for those of you that give presentations, the audience in China is unlike any other. By Western standards, they can be quite rude and aggressive. As an example, take one of the ‘crises’ that happened to me. The electrical source gave out, as did my battery, despite all efforts by the organisers to prevent the crash.

So you had all these staff, in full view of the 1000-strong audience, scurrying around trying to get power back to my notebook. In the meantime, I took questions from the audience. One participant asked:”Is this a news conference or a lecture? Why don’t you get your computer fixed and take questions later?!”

Imagine the situation, I am stressed out thinking of ways I can show chart patterns without a computer in a room where a flip chart won’t work and this xxxxx berates me for not fixing the computer!

Later that night I wondered what had allowed me to keep my cool – especially since it was merely another problem on top of many. Sure experience had a lot to do with it but as I thought about it, I realized that experience was only a small part of the answer.

The answer lies in what the Greeks called: “Our Highest Purpose”. That’s not the only handle by which it has been known. The most recent description is Jim Loehr’s “The Premise of Your Story, The Purpose of Your Life”.

However you describe it, identifying your purpose, ensuring that it’s consistent with your core values is the key to your motivation when times get tough. To identify our PURPOSE, we use the eulogy method:

“If you were present at your funeral, what would you like to hear?”

Jim suggests other questions (Power of Story, 2007, Free Press):

  • How do you want to be remembered?
  • What is the legacy you want to leave?
  • What makes my life worth living?
  • What is worth dying for?

The questions require ‘big’ answers. “Because I want a new $5M house” just doesn’t cut it.

In my case, my life purpose is clear: “I want my life to touch others – to have made a difference to as many as possible”. Trading success, as much as I love it, is but a by-product that allows me to better achieve my life’s purpose.

In a sense, our Life’s Purpose is the standard by which we measure our actions. Actions that lead to the Purpose are to be followed; actions that lead away or detract from our Purpose, we abstain or curtail.

Having a conscious Life Purpose provides us with the incentive to do whatever it takes to succeed. The key word here is ‘conscious’. An unconscious purpose means we are living someone else’s. To quote Jim Loehr (page 88): “The manipulations in our lives are numerous…..But whether external influences on us are intentional or accidental, malicious or well-meaning…simply cannot happen unless we let them happen.”

So the choice is not whether we live by a Life Purpose but whether ours is consciously chosen.

The Quality of Our Decisions Part 1

As traders, we spend much time in seeking more knowledge on the markets, knowledge that will provide us a distinction, a distinction that will lead to a greater edge.

But there is an area that most of us tend to overlook when looking for that edge; indeed usually when I introduce it in my public talks, I can see the audience glaze over and can almost hear the audience think: “Get over this quickly! I want the good stuff!” Well folks, “this is the good stuff”.

And the topic (drum roll please..): A Better Decision-making Process.

If you reflect on this, you’ll see why this is so important to trading, and to life. The quality of our trading, and life, ultimately depends on our actions and our actions are a by-product of our decisions.

So on what does a more robust decision-making process rest? Behavioural Finance? Logic? Creative Thinking?

None of the above. We need to go beyond Behavioural Finance; it does a great job for identifying the blocks to better decisions but some have taken a view that because we can never totally eliminate our blocks, we are doomed to poor decisions. The question is ‘poor’ compared to what? It’s like saying because we are not champion ‘traders’ we are doomed to being merely ‘good’ traders. So?

I consider myself not particularly talented in the trading arena – not a champion by any means; but that has not stopped me from making a better living than I probably could have made from any other profession and certainly better than one I would have earned from the law.

Similarly even if we never totally eliminate the psychological barriers to robust decision-making, this does not mean we should not try to make the best decision we can in the circumstances. And this implies seeking ways to improve the process.

Luckily for us, in recent years new discoveries have been made that lead us to think better. One discovery: the better decisions come from a synthesis of the right and left brain. Recently a discovery was made that an even process is to alternate between right and left brain activity. Since I read about the theory, I amended my decision-making process to incorporate this idea. It’s too early to report if there has been a bottom-line impact but it certainly feels more comfortable.

My previous decision-making process began with the right brain ‘stream of consciousness’ thinking. I would start with the 12-period monthly swing chart (yearly trend, 12-M) and work down to the 18-period daily swing chart (monthly trend, 18-d). The purpose of this step was to seek the critical question/questions relating to an instrument. For example in the S&P, on Monday November 19, the critical questions for me are:

  1. Whether the low at 1438.53 marks the termination of the correction.
  2. If not whether the end of the Zone marks the end of the correction (For those that have read the Nature of Trends this is the Primary Buy Zone marked by 1555.9 and 1370.6).
  3. Whether the high at 1576.1 identified a 13-w Upthrust Change in Trend Pattern or an Irregular Correction.

Using the various tools at my disposal, I would seek the answers using my Left-brain. The result of this process would be a strategy (buy/sell) and tactics (zone, entry and exit strategies). The final step would be to review the decision against my Behavioual Finance checklist to ensure I was not making some simple error in thinking e.g. anchoring an exit price.

I have just described the previous process. Recently I read “Think Better” by Tim Hurson and have adopted his model. I believe it is superior to the one I am using. I’ll deal with this in tomorrow’s post.

The Relative Importance of Your Trading Tools

I was referred to Brett Steenbarger’s blog of Nov 14 ( http://traderfeed.blogspot.com/) . As I read, it struck me that the tools we use in our trading plans are of less importance than having a plan.

Brett’s approach to the markets is very different to mine. He is a short-term trader and to gain his edge, he uses internals backed by statistical testing. I have had the honour and pleasure of meeting Brett and would say that his tools suit his personality.

I too use statistical testing but because I process sensory information visually {and to a much lesser extent kinesthetically (through feelings)}, I use tools that suit my personality: Barros Swings, the Ray Wave and the Market Profile are all used as visual mediums.

A fab example of this difference was Brett’s use of the volume at the bid (as the market moved down) as a target for identifying the end of the move up. I never thought of using volume that way. Incidentally, I also subscribe to Market Delta but what I find important is the shape of the profile at support and resistance areas.

Again last night provided an interesting example.

As you know from my blog, I went long early with a position that was half normal size. I then decided to use the breakout of the 1st hour’s opening range to enter the market for my remaining positions. But, the 30 minute volume profile on the 1st breakout (at 11:30) took the form of a bell curve. This suggested that the market would rotate back into the range and it did, all the way back from 1466 to 1459.

At 13:30 the market took out 1466 but this time the volume profile for the period took the form of a one-timeframe (trending) market. Sure I got filled 3 points worse off, 1469 rather than 1466 but I had an easy exit strategy if I was wrong about the breakout. A failed breakout with one-timeframe characteristics is likely to attempt a move in the opposite direction. This meant I could place my stops at 1457 under the start of the distribution (1459). This exit strategy was unavailable to me if the breakout took the form of a bell curve since that shape said that the probabilities favoured a rotation back into the opening range.

Score another important lesson for Pete Steidlmayer: it’s not the breakout price that is important. What is critical is how the market reaches the price (e.g. the form the breakout takes) and what the market does after reaching the price.

So, you’re probably asking what’s the central point of this posting.

It’s a simple one.

Newbies worry about some secret whiz bang, never fail, tool that will bring them untold riches. But such a tool does not exist. What is more important than the non-existent, never fail tool, is to find a tool or tools that match our personality. Unless we do that, we are likely to second guess our signals; such second guessing will lead to the slippery road of breach of discipline. So, rather than engage in a fruitless search for a non-existent super tool, focus instead on understanding your personality and find the tools that mesh with it.

The ‘Rat Brain’ and Trading Success

Today I’m addressing Winning Psychology. If we look behind the reasons why traders fail we find one or both of these reasons:

  • The don’t know what to do and/or
  • They don’t do what they know.

Winning Psychology addresses the latter. I define Winning Psychology as a set of tools that facilitates the consistent execution of our trading plan. To understand why we need the set of tools, we need to understand our brain’s make-up. Let’s turn to that.

Paul D. MacLean, an American physician, made an exciting breakthrough for neurology with his concept of the Triune Brain. He postulated that our brain is composed of three brains:

  • The Reptilian (responsible for our survival instincts – our fight or flight response). When triggered the Reptilian’s response is action. Action, any action, is better than no action.
  • The Limbic (responsible for our emotions)
  • The Neocortex (responsible for our thinking processes).

Now if all we had to do was control our ‘fight or flight’ response, as traders we would find it easier to make money. But we need to add to the Triune Brain one more piece of essential information. Advances in Neurology have established that the best decisions are made when our emotions and reason are in sync. The idea that we should trade like emotionless robots has been shown to be impossible (at least for most of us) and even if possible, the emotionless decisions would be sub-optimal. The key to a robust decision-making process is to ensure that the Reptilian (Dr. Janice Dorn’s ‘rat brain’) does not overwhelm the Neocortex. This link between emotion and our decisions is an important finding.

When we trade, we tend to attach emotional significance to our profits and losses. Despite years of trading I still experience joy on profitable trades and sadness when I lose money. What I do is experience the pleasure and pain and move on. It’s important I do this or else I am likely to have unprocessed emotions and when that happens, I inevitably do some thing silly (like enter without pre-defining my loss) on my next trade.

The management and processing of emotions (managing the ‘rat brain’) is the key to Winning Psychology.

The best tools I know to managing the ‘rat brain are PREPARATION & REVIEW. In the preparation phase, I suggest you use some technique that will bring you to the Alpha state e.g. the Relaxation Response or some form of meditation. Once in the Alpha State, we use visualization to complete the preparation phase.

On occasions I have been asked why visualization and meditation help.

Studies have shown that visualization exercises help performance. Since trading is partially a performance activity, visualization does have a favourable impact. The meditative process is added because visualization has been shown to assist and bolster the meditative process.

The process I teach is a simple one – let’s take the entry as an example:

  • Complete your analysis and define your entry and exit strategies. You know what the market has to look like to take the trade and what it has to look like to remain and to exit. You have defined your stop loss and determined your potential core profit target. The risk/reward is one you consider worthwhile.
  • You consciously accept the loss. It’s essential here that you explore what the loss of $X would feel like if it occurred. The key is to imagine that the loss has taken place and that you feel it’s OK to take the dollar loss. By that I mean that you’ll be able to experience the sadness and then be able to move on without the loss constantly replaying. If you find that in your imagination you are unable to accept the loss, reduce your position size.

This usually works.

  • You slip into the meditative state using muscle relaxation, a meditation CD or any mediation technique (like ‘mindfulness’, ‘transcendental meditation’, Chopra’ Primordial Sound, ‘Natural Stress Relief’ etc). I would keep this aspect to around 10 minutes or so.
  • Once you feel you are relaxed (in the Alpha State), visualize every step of the entry and exit, profit and loss. Check again how you would feel if the loss occurred. See yourself experiencing the emotion resulting from the loss and moving on.

The Review Phase is similar.

  1. We review our equity and psychological journals for lessons about the markets and for insights into our personality.
  2. Then we slip into Alpha and ask: “What did I learn about the markets and/or myself”?
  3. We then visualize applying what we have learnt.
  4. Finally when we come out of meditation, we write down the applications in Step 3 anything other ideas we consciously think of.

There you have it: the Preparation and Review strategies to manage our’ rat brain’ for optimal decisions. The Preparation and Review does take time as does journal keeping, analysis etc. These processes are the price for success. On the other hand, the success we experience makes that price more than worthwhile.

VISION and Trading

Yesterday I wrote that VISION, goals etc had their counterpart in out trading.

VISION is found in two components:

Our trading philosophy. Consciously or unconsciously our philosophy, Ayn Rand’s ‘sense of life’, governs our actions. So too with our trading, consciously or unconsciously, our trading philosophy governs our actions from the plans we choose to our position size to the actions we take to execute consistently our trading plan.

I adapted the statement of my philosophy when I first read it in Trader Vic – Methods of a Wall Street Master by Victor Sperandeo. The articulation there of Sperandeo’s philosophy strongly resonated with my values. So with a small amendment, I adopted it:

  • Preservations of Capital
  • Consistent Execution (leading to consistent profitability)
  • Superior Returns

You’ll see the three ideas reflected in all that I do. Our trading philosophy forms one part of our VISION.

The other component is found in the rational for a trading plan. We need a trading plan for two reasons:

  1. Before entry: it tells us when the probabilities favour our trade
  2. After entry: it tells us when the probabilities are no longer in our favour and we should quit a trade.

Both components are essential to our trading success. The key analytical insight to our success is found in the expectancy formula; the formula that tells us we can expect to make, on average, on each trade. Unless the sum is positive, we don’t have an edge i.e. we are doomed to fail in the long run. The most basic formulation of the formula finds its expression in:(Avg$Win x WinRate) – (Avg$Loss x Loss Rate) = Expected Trade Result

Where:

  • Avg$Win = Total $ profits/Total number of Winning Trade
  • WinRate = Total number of Winning Trades/Total Trades taken
  • Avg$Loss = Total $ losses/Total number of Losing Trade
  • LossRate = Total number of Losing Trades/Total Trades taken.

Most newbies focus on the Win and Loss Rate. But in my view, this is the more difficult part of the equation to control. Why this is so is best described by a story I heard about while learning Drummond Geometry (P&L Dot):

One day an ex-floor trader was told by an apprentice he had taken under his wing: ‘The 1-1 support WILL hold this decline”! The market was heading south towards what P&Lers called 1-1 support.

The ex-floor trader replied: “What are the probabilities?”

The apprentice said: “It WILL HOLD, I am certain!”

The ex-floor trader said not a word; instead, he picked up the phone and said: “Sell me 3000 Dec contracts at market”

Needless to say, the market went through the 1-1 support like knife through butter. “Remember this” said the ex-floor trader, “ we think in probabilities not certainties”.

This is a great tale. It tells us that the trading is in the realm of probabilities and as such the win/loss rate is less under our control than the Avg$Win and Avg$Loss. Both of these depend entirely on our decisions to enter and exit.

Notice that the formula explains why someone with a 90% win rate can still lose money. Let’s see why. Let’s say the Avg$Win is $10 and Avg$Loss is $100 and the win rate is 90%. The sum of the formula is:

($10 x .90) – ($100 x .10) =

(S9) – ($10) = -$1.00

So over the long term, over a large sample size, each trade we take will lose -$1.00.

Our VISION allows us to imagine a number of critical events:

  1. What does a trade need to look like – what does it have to do after entry – for me to remain in a trade?
  2. What does a trade need to look like for me to exit a trade?
  3. What does a trade have to look like for me to stop and reverse?

By visualizing the answers to these questions allows me to exit trades BEFORE my stop is hit. The technique allowed me to return 46.64 on capital (ROI) for 2007 an average dollar profit per trade of US$181.00.

By keeping detailed statistics, I am able to CANI (constant and never-ending improvement) my entry and exit. This is not to say I won’t have losses; of course, I will. My loss rate for 2007 of 50.44 attests to that. But by keeping a margin of 2:1 for my Expectancy Ratio (same formula except we divide the Avg$Win component by the Avg$Loss), I was able to return a fabulous 46.64% ROI.

In the next post, I’ll look at a trading plan and its components.