Anyone who has ever traded with real money will know that it will soon become quite an emotional experience.  Strong emotions such as fear, greed, hope and even anger come to the fore very quickly.  But traders usually know that acting according to these emotions will damage their performance.  In many respects it is the opposite of acting on the basis of what is actually happening in the market.

This is an important issue but too many traders and authors on trading seem to propose what I consider to be an unworkable solution.  To see what I mean, let’s start with a description of what we might consider to be the perfect trader.  This does not mean a trader that wins all the time.  No, that is not going to happen.  Instead, I will think of a perfect trader as one that achieves the best possible outcome in a market.  This trader will have a plan that provides an edge and the trader follows the plan perfectly.  The trader accepts any losses and gets the maximum profit while controlling risk optimally.  So, is it an appropriate objective for you as a trader to become like this? 

Definitely not.  Because every trader has one thing in common – they are all human beings.  As a result, this ideal is unattainable.  You should never aim for something that is unachievable because you will just end up disappointed and disillusioned.  Therefore, aiming for perfection is the wrong strategy.

You cannot achieve this ideal because it requires a fully rational being.  You are not such a being.  While mainstream economic models usually assume that people are rational with full information making optimal decisions, this should always be seen as a simplification for modelling purposes rather than a description.  People are not rational when dealing with risk because they are influenced by many cognitive biases and distortions.  Successive experiments have confirmed this premise.

Among the biases are the following:

·        Loss aversion which is a well known situation where the pain that results from the loss of a certain amount is felt so keenly that it is not negated by the well being derived from a gain of a similar amount.  This engenders risk aversion whereas rational behaviour requires risk neutrality.

·        Probability Weighting Bias where people wrongly assess probabilities and give an unlikely event a high probability.  As a result, people may accept poor investments, have unfounded expectations or over-insure.  At the same time, likely outcomes are given too low a probability.

·        Narrow Framing which exists when a person makes a decision as though that decision was taken in isolation from all other decisions.  In fact this is not the case and the risks that are adopted in trading are in addition to the other risks you face in life.  However, the complexity that is associated with including all these within a single decision set means that they are excluded.

·        Reference Return which means that we tend not to see or assess returns as absolute values but relative to their context.  Thus, a trader who makes 10% on a trade when an alternative would have yielded 15% will be a lot less satisfied than making 10% when the alternative only made 5%.  This is even thought the returns the trader earned are exactly the same in both cases.

·        People act according to a Curved Value Function.  This means they are risk averse with respect to gains but are much more willing to take risks when facing a potential loss.  They ‘throw good money after bad’ and refuse fair bets.  For example it has been shown that most people would accept a guaranteed €1,000 versus a 50% chance of €2,000 or zero, even thought the expected payoff is exactly the same in both cases.  This can lead to people holding on to and extending losing trades.

The extent of our shortcomings as rational beings and traders were emphasised in the wake of the credit crunch and financial crisis.  Much attention in the literature and commentary has been paid to the idea of the ‘Black Swan’ – an ‘unforeseeable’ event that appears obvious in hindsight.  While this is essentially an explanation of the poor informational content of statistics and the unreliability of usual interpretations it also leads to questioning of the application of mainstream statistical methodologies to analysing human decision making.  This explanation concludes that while the normal distribution is relevant to much of science, the outcomes of situations where human decisions are important are not symmetrically distributed around a mean. 

An alternative approach, known as the Taleb distribution, builds on this idea.  A Taleb distribution is the term applied to a situation where there is a high probability of a small gain with a low probability of a large loss.  As such, it is much more heavily skewed relative to the normal distribution.  When this is applicable, the expected value from a series of outcomes will be negative, but this expectation is camouflaged by steady returns that give the impression that the risk is low. 

Effectively we get so used to seeing the common small gains that the probability of a rare big loss is discounted by the assumption of a symmetrical distribution.  Driving at excessive speed or without due care is an example of a Taleb distribution.  If you do this then there are certain regular and predictable small gains in time but a small risk of a devastating loss. 

Rational behaviour would rule out ever driving at a dangerous speed as no amount of small time gains would provide sufficient benefits to exceed the losses incurred in a bad accident.  However, when an activity has an outcome characterised by the Taleb distribution the bad outcomes, being so rare, are viewed as outside the normal course of events.  Thus, the occurrence of an accident, when it is as a result of driving habits that have produced many small benefits, will typically be considered to be an aberration i.e. outside the normally expected outcome, and as an unforeseeable event.  

In effect, the approach is to ‘rationalize’ away that which is not fully understood and proceed as though it will not happen.  In doing so, the chances of it happening are increased.  It’s a dangerous game, but demonstrates that there are powerful incentives within us to act in this ‘irrational’ manner. 

A good example of traders inability to be fully rational is the emphasis that is placed on trying to predict what will happen next in the market.  Look at almost any website about trading.  There will probably be 3 elements present: some information about the market; a product that is being sold; and some prediction about a market.  This prediction may be the product and make take many forms such as software, a new indicator, or a tip sheet or some other way to see what is going to happen.  Being able to predict what will happen is the way to profits.

Except that it is not.  You cannot know what is going to happen in the market so prediction is futile and any trading plan or product that is based on prediction will fail.  Following a plan that is doomed to fail is not the way to profitable trading. 

About 100 years ago, J.P. Morgan, the famous American bank magnate, was asked by a reporter what he thought the market was going to do. He replied that it would fluctuate, as always. How true. And his answer also shows that even he did not know in what direction the market was going to move. So he made no prediction. And if J.P. Morgan could not say in what direction the market would move then perhaps we should accept that neither can we.

Still, it’s easy to see why traders would focus their analysis on trying to predict the market. After all, if you could do that successfully then trading profitably would be more or less guaranteed. But you cannot know and do not need to know how the market will move in order to be profitable. So don’t ask: what will happen? Instead, always ask: what is happening in the market?  Focus on what you know and use this information to guide your trading by making decisions regarding different possibilities. Then assess and control the risks that are associated with your decisions.

The market will either move up, down or sideways. By looking at a chart we can know in what direction it has been moving in the recent past. So, it will either continue in this direction, reverse direction, or move sideways. And while we never know for certain which is likely to happen, by observing patterns and other indicators we can aim to assign different probabilities to each possibility. If a market is in a trend then it continues to move in that direction unless it reverses. And it only reverses once for the trend to be over. So most of the time the trend is going to continue.

However, it is important to make trading decision consistently according to a proven plan.  Only by doing so can the decisions be made without reference to the trader’s emotional state or outside factors and the results are recorded without emotion. 

The key is to be consistent.  Notice that achieving consistency is not about learning more technical material or having more information.  Indeed, consistency assumes that you have all of this right from the start.  It’s the way that you use what you have that is at issue.  This requires emotional consistency, not that you become or strive to become, an unemotional, fully rational, automaton. 

The big enemy of achieving consistency is stress.  Because the markets are always changing you are reacting to a changing environment.  You must react to what you see in the market, but you must do so consistently.  The consistency relates to how you react, the actual process of reaction.   If stress takes over you become unpredictable and reactive to forces other than the market, most notably the emotions such as fear, anger, regret or greed that are likely the source of the stress.

The best way to do this in the face of a potentially stressful situation is to have a plan you trust and keep acting based on that plan.  Decisions are kept to a minimum and, when required, they are made according to a process that is laid out in the plan.  The only inputs into the decisions are the rules of the plan and the information that is presented by the market.  Neither changes in any way in the face of you feeling stressed.  So the outcome of your decisions should not be affected.

What characteristics would a trader who is in control in situations such as this be likely to display?  Such a trader will be:

·        Emotionally stable.  Some say emotionally neutral.  What matters is that the trader’s emotional state will not change as the trading progresses and will not be unduly affected by life events unrelated to the trading.  If this is the case then the trader has a good chance of being in tune with the plan and with the market.

·        Able to see that attaching feelings of happiness or pride to winning trades is just as harmful as attaching feelings of sadness or anxiety to losing trades.  But feeling satisfied at a job well done is a very different matter.

·        Focussed on the objective.  This implies that the trader’s objectives are already well defined and that they can be envisaged so as to link them, which do not yet exist, to what does currently exist. 

·        Focused on the information that is presented, not on what ‘should’ be happening or might be desirable.  Totally accepting what is, in present time, puts you in tune with the market.

·        Able to set targets and maintain focus and mental stamina until the target is reached. It’s no good getting most of the way there and then letting it all slip. The trader’s actions must not change based on recent performance.   

·        Accept that you are not perfect.  If you are wrong, then that’s all there is to it.  Act accordingly.  Who are you hiding from?  If you have made mistakes you will not correct them if you don’t admit them to yourself.  And if you are not correcting them you are repeating them. 

·        Able to accept information and not try to control it.  You react to the market, you cannot control it or know what is going to happen next.  But that’s fine.  After all, the trades you are making now or have open now don’t really matter all that much in terms of your objectives.

·        Solution seeking.  Not everything will go right.  Only you are responsible for putting things right.  There is no outside ‘higher power’ to look to.

A trader that has followed the plan and found that the plan is working will be satisfied at the end of the day.  Then just keep repeating what is working.  That’s about as robotic as it gets.

This is, of course, much easier said than done.  But remember you always have a safety net. If you are not able to follow your plan then don’t trade.  Get up and walk away.  Nobody else will notice.  If you are responsible for your trading then you are responsible for your decisions.  And deciding not to trade is a viable decision. 

That’s the psychology of trading.  The requirement is to get to this state of acceptance and focus on the present.