The task of writing is always complicated by the difficulty of gauging how deep the author should delve into the subject matter. While it is impossible to address the particular needs of each reader, the common denominator is most likely the desire to make money.
The material presented herein is geared toward independent thinkers, individuals willing to roll up their sleeves and take the time to investigate a host of issues that need to be considered and addressed prior to undertaking the challenge of trading.
In the final analysis, some will decide to proceed while others may come to the conclusion that passive participation in the capital markets is more appropriate. Either way, the objective of this book will be achieved if a realistic appraisal of what it takes to succeed in this endeavor is provided.
Back in the 1980s
I went to work at a top investment dealer straight out of university. It was easy to figure out who’s who at the firm. On one end of the spectrum, there were the realistic doers and the charismatic leaders. On the other were the fantasizers and the bunker mentality cranks. I dealt with seasoned market professionals on a daily basis, guys that made money, day in, day out. The best floor traders, desk traders, salesmen, deal makers and executives instantly became part of my universe along with perpetual also-rans that were forever at the cusp of making it, but never did.
By virtue of working for the right people, I gained insight into what works and what doesn’t. I learned to think about the markets in a certain manner by osmosis. Most importantly, by observing the winners and the losers inside the firm, I quickly acquired the mind-set and the playbook prerequisite for consistent performance while receiving a priceless education into the attitudes and perceptions of those who were destined to leave the game.
The Threshold of Pain
Be aware of new, useful information. When you feel yourself growing angry because someone presents a new idea to you that leaves your previous beliefs shattered and previous efforts effectively useless, expect yourself to resist considering the idea fully. No matter how strenuous and long-held old beliefs are, be open to the possibility that you were wrong. Holding on to bad ideas or wrong information because you are heavily invested in it is pretty common. …Obviously not all new information is more correct than what you believe, but that anger is your internal sensor that tells you when someone is presenting new information that threatens your heavy investment with devaluation. Be open to the possibility that the new information is actually better than what you have now. It may not be, but you can sleep on it for a while before you decide. — Bob Redmond
Anyone who has traded will know right away why Bob’s words ring true. There are simply huge disagreements when it comes to trading and investing philosophy. Starting with the fundamental analysis vs. technical analysis debate, people tend to align themselves with the camp that appeals to them and go from there. In time, our views becomes rigid. We disregard anything that does not fit the mold and even dismiss new findings to the contrary.
…be open to the possibility that you have held on for far too long and that it may be time to let go - even though you feel you have too much investment in it to do so. Investment is only a perception. The truth about history is that it is in the past. And the past is no longer happening. Only now is happening. We imagine a bank account with investments in it, but in reality, there isn’t one. Nothing truly stops you from changing direction right now and giving up an old hobby, a bad relationship, or a terrible job. Take good care of yourself. — Bob Redmond
Inevitably, disaster strikes. While most of us would conduct an exhaustive (but superficial) review of our methods, few will ever question the tenets of our approach to trading because so much investment has been made in one set of beliefs. With time, our thinking process becomes fixed. Our self-esteem becomes one with our dogma.
I have not failed 700 times. I have not failed once. I have succeeded in proving that those 700 ways will not work. When I have eliminated the ways that will not work, I will find the way that will work. — Thomas Edison
If you are reading this because you acknowledge dissatisfaction with your trading results, be encouraged. You have already taken a giant first step to crossing the threshold of pain. Give yourself permission to say, “The time, effort and money I devoted to trading WERE NOT wasted. I learned a lot about what DOESN’T WORK. I REFUSE to allow this experience to defeat me.” By doing so, you are on your way to thinking like one of the winners; you are taking good care of yourself.
Or as they taught us at the old Xerox sales course, “Every no is one closer to a yes.”
The Biology of Fear
Assessing and reacting to risk is one of the most important things a living creature has to deal with, and there’s a very primitive part of the brain that has that job. It’s the amygdala, and it sits right above the brain stem, in what’s called the medial temporal lobe. The amygdala is responsible for processing base emotions that come from sensory inputs, like anger, avoidance, defensiveness, and fear. It’s an old part of the brain, and seems to have originated in early fishes. When an animal–lizard, bird, mammal, even you–sees, hears, or feels something that’s a potential danger, the amygdala is what reacts immediately. It’s what causes adrenaline and other hormones to be pumped into your bloodstream, triggering the fight-or-flight response, causing increased heart rate and beat force, increased muscle tension, and sweaty palms.
This kind of thing works great if you’re a lizard or a lion. Fast reaction is what you’re looking for; the faster you can notice threats and either run away from them or fight back, the more likely you are to live to reproduce.
But the world is actually more complicated than that. Some scary things are not really as risky as they seem, and others are better handled by staying in the scary situation to set up a more advantageous future response. This means that there’s an evolutionary advantage to being able to hold off the reflexive fight-or-flight response while you work out a more sophisticated analysis of the situation and your options for dealing with it.
We humans have a completely different pathway to deal with analyzing risk. It’s the neocortex, a more advanced part of the brain that developed very recently, evolutionarily speaking, and only appears in mammals. It’s intelligent and analytic. It can reason. It can make more nuanced trade-offs. It’s also much slower.
So here’s the first fundamental problem: we have two systems for reacting to risk–a primitive intuitive system and a more advanced analytic system–and they’re operating in parallel. And it’s hard for the neocortex to contradict the amygdala. — The Psychology of Security, Bruce Schneier
I never had much to say whenever clients asked me for insight into trader psychology, particularly how to handle fear. I always paid more attention to the psychology of the crowd and market sentiment. When pressed, my usual response was, “If you don’t know what you are doing, there is good reason to be afraid. If you know what you are doing, then trade smaller size.”
While performing research for this book, I became acutely aware that the fear factor looms large for most traders. Perhaps I don’t have the genes, since Dad survived 28 years fighting in the jungles of Asia with only minor shrapnel wounds. Perhaps working at the firm imparted a huge advantage because I modeled myself after the winners. For whatever reason, I do not experience fear very much, but understanding the problem allows me to be helpful and provide solutions for those who do.
The Psychology of Fear
Identifying the Fears
The professional trader knows that to be truly successful, he must be consistent – and to be consistent, he must have the right attitude.Why is it that after a string of wins, he repeatedly gives it all back and more? With confidence shaken, he cannot enter a trade without wondering if he is making a mistake. Doubt gnaws at his every decision. What is different? Is it the market or him? It is at this point that the trader must step back and perform a careful reassessment. Because it is not the market, it must be in his approach. Which of his assumptions are inconsistent with reality, causing him to experience periods of glorious feast interspersed with agonizing times of famine?
Douglas describes the problem that all traders face. “Ninety-five percent of the trading errors you are likely to make – causing the money to just evaporate before your eyes – will stem from your attitudes about being wrong, losing money, missing out and leaving money on the table.” These are what Douglas calls the four primary fears.
So how does one overcome them? The answer lies in examining beliefs and attitudes, because they are the source of all fears. Realizing that they exist is the first step. The trader has walked through door number two. — Matt Blackman, SFO Magazine
Time and again, traders would tell me that Mark Douglas’ books were the best. I hate to admit it, but every time someone brought up the subject of trader psychology, I would quietly roll my eyes. In my mind, the inner game of trading was a non-issue. But I was wrong.
In his book, Trading in the Zone, Douglas does an amazing job of breaking it all down into baby steps. He shows his readers a clear path from fear to enlightenment. What I liked most about it is the lack of “stand in front of the mirror and repeat P.M.A. a hundred times.” Instead, it is action-oriented. The characteristics of winning market participants have been analyzed and presented in detail.
Douglas’ treatment of the subject involves understanding what he calls…
The Five Fundamental Truths…
- Anything can happen.
- You don’t need to know what is going to happen next in order to make money.
- There is a random distribution between wins and losses for any given set of variables that define an edge.
- An edge is nothing more than an indication of a higher probability of one thing happening over another.
- Every moment in the market is unique.
…and The Seven Principles of Consistency
- I objectively identify my edges.
- I predefine the risk of every trade.
- I completely accept the risk or I am willing to let go of the trade.
- I act on my edges without reservation or hesitation.
- I pay myself as the market makes money available to me.
- I continually monitor my susceptibility for making errors.
- I understand the absolute necessity of these principles of consistent success and, therefore, I never violate them.
This sums up everything I learned at the office so long ago from watching the winners win and the losers lose. I couldn’t agree more.
No investor is going to be right every time. The secret to successful investing is not to be right all the time, but to lose the least amount of money possible. Everyone will make mistakes, so investors have to be able to admit early on that they wrong, and cut their losses so that they live to invest another day. — Investor’s Business Daily founder and Chairman William O’Neil
While there are numerous ways to skin the proverbial cat, it doesn’t take long to figure out that the common denominator of long-term consistency and performance is a winning mind-set. It is the foundation of success.
In Chapter Two, we will explore the concept of “the edge” and how to sustain a winning attitude in order to Own The Zone.