Month: April 2014

Many aspiring traders who have a scientific or strong common sense background would arrive at the conclusion that if they discover an edge in trading, it is the answer to everything. They think all these psychology stuff on trading are not necessary as long as they have an edge on hand. They think that they will be able to trade to financial freedom and success easily, bypassing all the horror stories of psychological roadblocks many traders experienced.

This is a reasonable conjecture from someone who has not much trading experience. In fact, anyone who have not experienced at least a prolonged period of success in trading, would easily arrive at the conclusion the only thing they are missing to achieve trading success is an edge in trading. The belief that one can avoid dealing with trading psychology completely, or that having a trading edge on hand will overcome the psychological barrier is quite naive.

To understand the reasons why trading psychology is so important, you have to see it from the big picture perspective.

High Probability Trading Setups Are Overrated

When traders talk about a trading edge, they often mean just one kind of trading edge, the entry edge.

The idea is very sexy. If you have a way to determine a low risk entry point, everything else is secondary or even not important. That’s why people are obsessed with high probability trading signals. Every time someone talks about high probability trading setups, something like 90% winning rate, many people cannot resist the urge to check out the claim immediately.

The reality is not quite what the amateurs think. Entry edge plays a very small role in a good trading plan. In fact, any good trading plan would distance itself from dependency on high probability winning setups. It may sound contradictory but once you realize that high probability entry edges come and go, it is not so difficult to understand. For high probability technical setup, it can be hot for a few weeks to a few months but the winning streak will end. When it stops working or suffers normalization, you have to look for another way to engage the market.

As a rule of thumb, very high probability entry edge does not last. Long term structural biases work over a long period of time but they do not usually produce more than 70% winning rate when used without special money management considerations.

Entry Edge Is Not Dependable

No one can strike it big with just entry edge. Not unless you can scale your operation very quickly within a very short period of time while your entry edge is hot. That means you must be well capitalize to take advantage of the situation. But capital is exactly what the newcomers lack of.

The consequence of scaling too fast based on a single entry edge is often crash and burn of the trading account. Here is an example trading model that drop dead on its traders. Not knowing that the entry edge could still be valid but suffering from seasonal or other structural effects only, amateurs turn their back on their findings and continue to search for the next great entry method. Good opportunity to achieve their dreams of financial freedom wasted because of misunderstanding of the role of entry edge.

Entry edge is necessary but it does not have to be high probability setup. In fact, it better be a stable bias than one you have to replace frequently in your trading plan. Remember your dependency on unstable components will ruin your trading completely when it is no longer performing as good as you like it to be.

This is the reason why professional traders have two distinct strategies dealing with this issue.

1. Having a basket of trading setups to trade against a very small number of markets (or even just one market). It is important to remember how to apply money management rules with multiple trading setups.

2. Having a few trading setups (or just one) to trade against a basket of markets. I am not talking about just a few markets here, I am talking about at least 15 or more.

A Proper Trading Plan Include Many Kinds Of Trading Edges, Not Just Entry Edge

A robust trading plan gives you an edge with your trading from all aspects in trading. First, you need an edge with your money management to ensure your trading can survive a failure of your entry methods. You also need an edge with your exit techniques so that they are designed to give you strong survivor bias against your mistakes and execution errors. You need an edge to scale your trading properly so that you can optimize the growth of your capital and minimize the impact of drawdown period.

Think of a good entry edge as the ticket to get you on a boat ride. How the ride goes depends on the ship you boarded. Your decision in choosing the right boat for your ride, limited by the resources you have, will determine the journey you have. People are often quite reasonable with decisions on choosing their rides but no so with their trading plans.

Having the mentality of letting go of your attachment to specifics of your trading entries is important. It opens the doors to better trading performance.

Personalities Dictate Your Ability To Discover Entry Edge

When someone examine the historical data of a market, they view it with a bias. It is a personalized view of the data and attempts to find explanation of the price movements. This personal bias would lead to certain expectations of what the data may do given certain circumstances. Hence the chance of a normal person in discovering a trading edge from historical data will be limited by their understanding of the market, which, unluckily, being tainted by their personal prejudice.

In another words, your personalities will limit your ability to discover and accept an entry edge no matter how good they are.

For example, many great trading setups would never be considered or examined closely because assumptions are made before the data is even looked at. That’s why there are so many people who attempt to create their own special trading methods and so few have discovered anything that works out. It is not because there is some kind of trading secrets that has to be figured out by some genius. It is because majority of normal people cannot see the existence of orders and structures that are hidden in plain sight.

A Test Of Your Confidence In Your Entry Edge

Amateurs dream that once they have created a high probability trading system they would be able to make lots of money in a short period of time. It often works out in the beginning if the entry edge is a pretty good one. However, there is one obstacle to their financial freedom. It is not the trading models they have that is the problem. It is the traders themselves that is the real problem.

A trading setup with 80% historical winning rate does not stay at 80% all the time. Trading models do not have a straight line with their historical winning rate. It may not perform at the same level when deployed. Even if the trading setup performs its performance will still fluctuate.

When your model is not performing for a prolonged period of time, many people will start to second guess their models. It happens even if you have the model fully automated. It happens in your head. This is the situation where an unprepared mind will be devastated by all kinds of thoughts.

Trading Edge Is Not As Important As Your Emotional Stability

Nothing prepares you to handle such situation until you are conditioned, meaning that you have experienced enough number of drawdown periods such that you have been trained in handling these scenarios objectively. It is very rare anyone can stick to their plans following their trading models when things are not working out. The reason is that there is really no simple answer to the question whether your entry edge is no longer working or that it is just suffering its normal drawdown period.

During this difficult time, the trader’s character weaknesses will dictate the reactions to the situation. Someone who has not confronted their own personal weaknesses will not be able to handle such stressful situations objectively. They are pitting themselves into a corner with only bad decisions coming out of their messed up minds at the time.

Ignoring proper psychological preparation in trading has consequence. It is not just important to discretionary traders, it also applies to anyone who think they have a trading edge.

You Are The Edge

Having a trading edge, specifically an entry edge, is not the be all and end all solution to successful trading. It is necessary to have one but it does not need to be a high probability trading setup. The more important thing is to develop a complete trading plan that you, as a person, can really follow without suffering the emotional swings caused by the performance fluctuations.

Traders are not stamped from a machine with no emotions. As traders, however, we can plan ahead of time in a way that minimize the effects of emotions on our trading. Having a contingency plan in place to deal with potential drawdown periods will save you from making costly mistakes. Such contingency plans, however, require your understanding of your own strength and weaknesses.

As a summary, your focus on finding a trading edge should not be limited to an analysis of the historical data. It should be, instead, focused on developing yourself. Your ability to adapt to the changing environment is more important than a technical trading setup. Your ability to discover and identify the current market dynamics is many times more useful that a static entry edge. You are the trading edge if you can utilize your strength and handle your weaknesses.