Sunday, August 13, 2006

>The Mentality of the Successful Trader

The Mentality of the Successful Trader

Successful traders thrive on instinct honed within a framework of trading rules. On occasion, a trader who fancies himself a writer will publish a list of his rules for public perusal. Such discourses, which typically postulate generic guidelines such as "Know yourself" and "Limit your losses," are useless to the novice reader because there is no way to truly appreciate the meaning of the rules except through experience. They are likewise useless to the experienced trader who already has an innate understanding of such things. Therefore, these self-help articles are just that: they only help the author himself.

What this trader turned writer hopes to accomplish is to help other traders develop a foundation for building their own sets of rules. Successful trading starts with a proper mentality, not a list of ambiguous guidelines. To begin, we must understand why most people are unsuccessful at the trading game. The short answer is that unsuccessful players are too emotionally involved. They personalize every decision and have egos which are easily offended by unprofitable trades. Many such market participants simply cannot cope with the loss of even small amounts of money.

These emotions, when roused, dominate the thought processes of the weak trader, causing mental distress. The trader beats himself up from the inside out, and all the energy consumed with regret and disdain reduces his capacity to make rational decisions on future trades.

Those that personalize the results of their decisions often practice the following poor behavioral patterns:

  • They sit on losing positions with hopes of breaking even.
  • They consciously or unconsciously enter trades in an effort to make up for previous losses rather than on the merits of the new trade.
  • Despite a compelling setup, they do not open a new trade at a worse price than that which their last trade on the same asset was exited.
  • And perhaps most perversely, they fail to execute well (or at all) on trading opportunities in which they have the highest levels of confidence. After all, they have the most to lose, egoistically speaking, in these situations!

(For a more insight on the neuroses suffered by poor traders, grab a copy of Justin Mamis' When To Sell.)

Successful traders, on the other hand, tend to be those who are most capable of handling the stress associated with a losing trade. They do not personalize the results of their decisions, and are therefore able to trade in a manner that protects their capital rather than their egos. Successful traders realize that there is no such thing as right and wrong in trading because the outcome is always uncertain. To the professional, there is only trading well or not trading well, and trading well means avoiding patterns of behavior that offer low probabilities of success.

To the dismay of individual traders the probability of success for each trade or trading system is not quantifiable. Granted, there are computerized trading systems that make fortunes via the algorithmic use of statistical analysis, but even for these systems, the success rate of each algorithm is dynamic and therefore never precisely known at any given point in time. Therefore, to trade well, one must develop a methodology of subjective judgment, and this methodology can only come from experience. Understanding the technical and fundamental forms of objective analysis are essential, but will not work well without a honed instinct. Subjective traders have a keen intuition, developed from years of experience, the desire to read voraciously, and the ability to utilize subconscious reasoning. (George Soros once revealed that he would close a trade if his preoccupation with the position made his back ache.)

Trading subjectively without personalizing results is perhaps the great quandary with which all traders struggle. After all, we all want to enjoy being right. We want to feel smart when a trade works out as hoped. But in reality, we must train ourselves to enjoy being successful while maintaining enough discipline to avoid judging ourselves by the profitability of each trade. The disciplined professional will not be unhappy with an unprofitable trade which he feels was well-executed, nor will he commend himself for the profitable, but poorly executed trade.

A well-executed trade is one implemented within the framework of one's own set of rules. Every set of trading rules must incorporate two essential components. First, they must contain strategies that reflect the nature of the trader. Markets are characteristically complex, reflecting the psyches of millions of players, and each trader must discover which approach to trading best suits him. In other words, which subset of market psychology can one profitably attack?

Second, all rule sets must contain an element of risk control. Risk is controlled both in objective terms: by not overexposing oneself to the potential for unbearably large losses, and in subjective terms: by trading within the purview of one's mental strengths so as to best choose entry and exit points (see Alexander Elder's Entries & Exits). By devising rules based on one's own strengths, a trader is able to approach the game with confidence rather than doubt. Doubt leads to duress, and it is under this circumstance that rules are abandoned, trades are executed from weakness rather than strength, and big losses are recorded.

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