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I consider the psychology of trading to be the hardest for most to grasp, with not a lot of good information out there on the subject. I have written in the past on trading psychology, I am considering writing more, but wondering if there is enough interest to do so.
Below is some of what i have posted on other websites. If interested in more of my ideas, please comment.
Thanks,
Josh
Edge Execution
Trading is a numbers game, and markets are based on the mathematics of the traders equation. However, understanding this alone will not guarantee profits. The ability to apply and conform to the math of the current market context is what leads to consistent profits. Beginners often have a misconception that they need to know what is going to happen over the period of the next X number of bars in order to make a profit. They believe they must enter at the exact right time and price in order to win on a trade. This could not be further from the truth, and anyone consistently making money from the markets knows the reality. The reality is a trader does not need to know what is going to happen next in order to make a profit. In fact, a professional trader knows that any given trade is irrelevant to the bigger picture, and an income is generated over a series of trades; not any single trade. This mentality is past the duality of winning and losing, which are simply accepted as part of the job. This can be called the "probability mindset."
Profits are generated over a series of trades, not any single trade. Therefore, it is not necessary to make money on every trade, every day, or even every month to be a successful trader. It takes time to build confidence, believe this is true and fully understand this concept. Perhaps this is why most traders fail, by giving up before coming to this realization. It has been said that professional traders have "Won the game before they started playing." (Jack Swagger). This confidence can only come from the probability mindset, when a trader accepts he may lose on this trade, the day, or even this year. But he accepts his risk, and trusts the math that over time he will generate a profit. Even if he takes a large loss, or several, it does not matter; he knows he will make it back up. The overall point of this is that losses are part of the trading process. If a trade is a loser, it does not matter; move on to the next trade. Dwelling on losses or a draw down does not bring the money back, but continuing to trade does. In this sense it can be said that a successful trader "trades his way out of a draw down."
It is helpful to think of losses as the "cost of doing business" just like any other business would incur expenses while conducting its operations. There are very few (if any) businesses that do not require heavy start up costs, or capital to continue the business while generating profits. Ever heard the saying "It takes money to make money?" Trading is no different, although most traders fail to realize this, and focus solely on profits. In trading, our costs are commissions and losses, which are offset by gains, resulting in a net profit.
Employing your Edge
So what does this have to do with executing an edge? Well, it is necessary to understand not every trade is a guaranteed success, and there is a random distribution between wins and losses, with any edge. Even the best setup or edge will result in a loss 30-40% of the time. It is virtually impossible to know in advance, which trade will win and which will lose. Therefore it is absolutely imperative to take every trade that meets a traders edge, regardless of how the trader feels , thinks, or any other variables unrelated to the edge. With this said, here are the basic steps to executing and employing an edge.
1). Identify edge. Pick a setup (second entry, wedge reversal, follow through bar, ect.) It is a good idea to start with one until familiar with reading prices.
2). Ask yourself at the close of every bar "Is my edge present?" If no, wait. If yes, enter the trade.
3). Execute the edge with a series of 10 or 20 trades, document every trade. At the end of the series analyze results and tweak.
I would be interested. I am struggling with the crossover from sim- to live-trading, my first attempt was awful, my second attempt, much better but I'm still a little shook from the first time I went live and I am constantly fearing some unknown element is going to ruin me. I'm tracking expectancy and trying to keep stats on as much as possible, so I think I am on the right track but it is rough.
I think the thing I need is simply more experience trading live, but the sad paradox is that when I am live the products are too big and you can lose a lot quickly. This fear causes compounding errors in execution that I find difficult to pull apart and examine individually. The micros might help, otherwise I will have to sim trade and use live trading judiciously here and there.
In summary, to do the thing to get better, you have to go through a lot of pain, and I'm not sure the books and videos can solve that, but I am open-minded
Yep I'm interested in any type of trading psychology discussion. Please share! I have a question for you, MC29...In your opinion, are the most relevant 'trading psychology' issues that most traders experience actually related to misunderstanding the nature of trading the markets? For example...In your post you mention trade execution and edge. If a trader doesn't look at the markets through the lens of probability, they will be more prone to confusion and emotional actions while trading. I know in my own trading I've been able to reduce impulsive actions, reduce fear, and increase clarity through gains in knowledge about how these markets work. But I don't attribute this progress to a better understanding of psychology, but rather to learning about market dynamics. Is this along the lines of your thinking?
Yep, this has been a battle for me as well. It would be accurate to say that I am losing money more slowly than ever, but have yet to achieve the type of consistency live that I have in sim.
Part of this though is that you are not under capitalized in a sim. If the sim gives you 100k in paper money and you only trade 1 contract this is not the same if you have 5k of capital.
IMO most traders have a sharpe ratio and capitalization problem, not a psychology problem. Starting out you simply don't have the sharpe ratio to use the amount of leverage for even 1 contract on a small account.
It doesn't matter if you are the buddha himself, if you only have $10k you aren't going to make money on ES. You don't have the sharpe ratio for that so even a profitable system that could use 2X or 3X leverage gets killed when you are using 15X.
The worst part of that too is maybe your system would have worked great if you weren't hell bent on trading ES or something else with crazy leverage.
I think its a probably more of a trader not understanding himself. You can reduce emotions and fears, but can never completely remove them. so instead use them as tools.
i just got done writing a 75 page book on psychology, and it has a lot to do with understanding your self and markets. see my website under my user name.
I think if you can trade well on sim but cannot with real money you are lacking in confidence of your system. you either havent defined your edge and plan or are simply not carrying it out with real money. i would recommend not trading sim at all. trade a market that allows you to trade small like forex, SPY, or maybe the new emini micro if it turns out to have enough volume when it opens in May.
On trading psychology, I believe focus on popular psychology on "performance mindset" is misguided and will lead to losses without subtle distinctions and deep understanding. Because, it leads to overly focusing on winning or improving as a trader vs. making money. It can lead to losses as traders want to practice and get better even after they made money. Performance mindset is useful for the simulator, practice, train, rehearse but not the live. Some trades can be profitable but too difficult to capture or damage the psyche. It is better to focus on easy trades even if you make less.
On going from sim to live, there is always risk of degradation in performance. Many methods will translate well but methods that require maintaining a "peak performance" are more likely to fail. This is why trading should not be a performance discipline -- if you want to make money. Basically even if you can drive 250 MPH on the simulator, you are more likely to have success at 120 MPH and under in the live. Many losses are caused by operational problems and loss of situational awareness. A very significant cause of losses is losing track of position size, costs, and dollar risk. This is psychology but not one that is talked about too much.
Right, most people need to be able to win easily to continue to trade as losses are not fun to deal with. Maybe it is the secret to "beginner's luck". Each loss has potential to create negative feedback loops. It can start with random losses on good trades or bad trades too but over time risk lead to decreased performance.
Discipline is key. However, most problems with discipline start with other types of mistakes or errors first. Fluid discipline is what's important but difficult to develop or account for.
Many problems are results of using too much leverage as it magnifies not only the profits and losses but every little mistake. Most problems related to psychology are actually problems of leverage and skill. The key to leverage trading is understanding vertical movement because the vertical movement allows for compounding of gains. However, any small mistake can swing one from large wins to losses.
On edge, most traders do have some edge but do not have enough edge for their leverage or psyche. Traders underestimate how much edge they need for psychological well-being. This is where performance mindset can actually help and applies. But, there is a subtle difference between trying to get better at trading in general versus specializing in a few trades that can be executed well. Of course, there is no guaranteed edge in the markets which is another reason we need bigger edges.
I do think both a focus on the process and p&l is important. It doesn't matter if you are improving as a trader if you are losing too much money. This goes also for "pay to tryout" ventures. You can improve in the simulator for almost free. Protection and preservation of capital and psyche are the most important consideration.
On day trading, it is very difficult without significant edge because most day trades that work will have a 1:1 R or worse-- unless you are only trying to make 30% to 50% yearly returns. A 1:1 R means that if you lose your first trade or even win and then lose your next you are likely negative. So, you really need at least a 2:1 or better R:R. As well, as you move beyond 1:1 R most traders win ratio will drop below 50% or even 40%. On the other hand, for a host of reasons, you need win ratio above 50%. So, you really need to get into trades with high R's but use fluid intelligence to keep your win ratio high.
I think there is too much emphasis on down playing sim or paper trading for new traders or even old traders. On the other hand, many good trades are not statistical in nature and that has implications.
I agree with everything you said besides this.
To me by definition most traders can't have an edge. An edge is on the entire field of other players so everyone can't have an edge. It has to be a small minority have an edge on the majority.
Edge is used in such on odd way on trading boards. As if it is a property of the brain and no matter what happens in the markets once you acquire this magical property it can't be lost or change. Even when we know the brain is pretty much terrible at acting like a probability engine with all these heuristics and bias. An absolute joke at trying to do inference with more than a few variables(if not just one).
Edge is used the way anyone who has ever learned the rules of poker can point to some aspect of their life experience that gives them an "edge" against the field. Same psychological process that makes every person believe they are a good driver of an automobile.
If you put up a pole "are you a good driver, yes/no" everyone will click yes. Do you have an edge in the markets? Of course I do because of x, y, z, theta, gamma and rho.
It is amusing trading psychology wise that everyone loves to point to Thinking, Fast and Slow but this quote pretty much sums up how to optimize your trading psychology.
"You should replace humans by algorithms whenever possible. Even when algorithms don't do very well, humans do so poorly and are so noisy that just by removing the noise you can do better than people"
--Daniel Kahneman
