Weblog of Joe Ross, Trading Educator and Trader for over 5 Decades

Hey Joe! I heard that when you start out you have more losses than wins. Is it true?

A cold, hard fact of trading is that you’ll see more losses than wins, especially when you are first starting out. Yes, it is true. Trading is a business where losses can be numerous, especially at the beginning. Feeling that you have to trade perfectly and make a profit on almost every single trade is unrealistic. It is important that you not allow yourself to become stressed out to the point where you have difficultly focusing on the trades that actually will produce a big profit.

The best advice I know of is to be flexible and ready to adapt to market conditions. Markets change and you must change with them. The concept of the Law of Charts has never changed. But the management to properly use that law does change, because speed at which formations change varies with the volatility of the market. Management changes as well with the magnitude of move as it changes. You have to be wise in trading, and acknowledge that many times things will not go your way. Every time you make a trade, you put money on the line. To the professional trader, money is nothing more than intangible “capital.” It loses some of its significance. There is a danger to that as well. Once money loses its significance, it is easy to become careless. But to a novice trader, money represents need for essentials, like food, clothing, and rent. When you think of your margin account as real money, there’s a strong need to want avoid any losses at all. You are afraid to make a mistake and lose your hard-earned money.

Fear and greed drive market action. We enthusiastically put on trades when we think a huge profit is assured, but when we see the market shift dramatically, we get out as quickly as possible. We fear being trampled by the masses as they all rush to sell. Fear and greed are powerful emotions that underlie the actions of the masses, but behavioral economists argue that regret is equally powerful. Regret is so powerful, in fact, that we may avoid putting on a trade because we do not want to beat ourselves up for making a bad mistake. We have our pride, after all. To preserve our feelings of worth, it is often easier to avoid taking a risk, than facing humiliation and self-reproach when we lose. But you’ll never learn to trade profitably if you don’t take risks. It’s essential to learn to control your feelings of regret before you find yourself stuck.

We experience regret when we look at a decision and imagine it could have turned out differently. In the trading arena, it can be hard to escape regret, since we can feel regret by taking action or by doing nothing. When we open a position, for example, and end up losing, we can regret executing the trade. But we can also feel regret when we let a winning trading opportunity pass by because we were afraid to take a risk. In both cases, we let our mind imagine alternative realities, and when we start to think that one of those imagined realities are better than the way things actually turned out, we feel regret. We think, “If things had turned out differently, I would now be in paradise.”

Regret may be unpleasant, but it isn’t always bad. Sometimes regret can actually motivate us to take action. Regret forces us to take action to fix matters. If you hate your neighborhood, and regret you moved there, you are likely to fix matters by searching for a new house. If you regret buying a gas-guzzler as gasoline prices hit $3 a gallon, you might decide to take the bus more often or buy a scooter to do daily errands. And similarly, when you make a losing trade, you may feel regret for making a mistake, but this uneasiness can also force you on to make a new trade in order to earn back the capital you have lost. A study by Dr. Keith Markman, a psychology professor at Ohio University, and his colleagues illustrates how regret can motivate people to take action when they believe that their efforts will result in positive change.

They observed participants who played a blackjack computer game. The researchers controlled whether a participant won or lost. As you might expect, regret was strongest after a loss than after a win. But regret was more intense when participants were allowed to make an additional bet in order to win back what they had lost, compared to when they were allowed to make only a single bet. It’s hard to feel regret when you were allowed to make only one bet. What else could you do? You made your bet, you lost, and now there is nothing you can do about it. The adaptive thing to do is to just forget about the loss and go home. If you are allowed to make a second bet, however, you are bound to feel a little regret. You start thinking, “It is too bad that I lost on the last bet. Maybe I can turn things around. If I do things differently next time, I can win.” When we believe that we can fix a problem, we may feel more regret, but we are motivated to take action.

If regret can motivate people, then why do behavioral economists view it as one of the biggest obstacles that traders must overcome? Many times, traders are consumed with regret even before they have something to regret. They have yet to make a trade, but worry about feeling badly if they made a trade and lost. Once we make a losing trade, regret isn’t as unpleasant as you think it will be. But if you are often consumed with regret, just thinking about the possibility of making a future regrettable mistake can prevent you from trading. You may ruminate about what you should have done. If you suffer this ailment, it is useful to tell yourself encouraging thoughts. Remind yourself that if you do make a mistake, you can always fix matters. It isn’t the end of the world, and it isn’t the end of your trading career. You can work harder to develop a winning strategy to make back all the profits you have lost. Or you can tell yourself encouraging thoughts, such as “losses are the tuition you have to pay to become a trader.

If only humans were more like machines. In theory, the ultimate trader would act like a robot, analyzing market data with unfailing accuracy, devising a trading plan, and executing it without flaw. But does trading work that way? Trading is more art than science. Without an intuitive grasp of the markets, it’s difficult to successfully trade the markets using short-term trading strategies.

As Captain Kirk would constantly remind Mr. Spock on “Star Trek,” humans have the potential to intuitively grasp situations that evade pure logic. There are times when the world doesn’t operate in terms of logic. The physical world is the exception. The universe surely operates according to the laws of physics. If it didn’t, we could never travel through space or reach the moon. The human world, however, rarely operates with precise accuracy. Sure, there are those traders with fancy algorithms and mathematical equations to forecast the market action, but ultimately, the markets are really just humans making decisions and acting on their beliefs and emotions. Psychologists learned long ago that people’s actual real life behavior could not be broken down and predicted with mathematical equations.

It’s vital to remember the fact that people are not machines, and because they aren’t, their behavior cannot be reduced down to simple formulae. As much as we want to believe science can do anything, it’s hard to fully account for human motives. You may ask, “Can’t we put multiple streams of information together in a multiple regression equation and forecast what the masses will do?” The answer is no, not in the short term.

The best you can do is use past data to forecast the future. But history only repeats itself when it does. The “weighting” of a variable in the equation is not fixed, as it is in the physical sciences. One day the weight may be 1 while on another day, it may be 0. We don’t know what the precise weighting of the variable is until it’s too late. What can you do instead? You must trust your intuition. Again, trading is more art than science. You have to look at patterns and try to anticipate where the market will go next. Is it perfect? No. Is it uncertain and chaotic? Yes!

As students of the markets, it’s informative to study everyday examples of mass psychology. Although humans are highly intelligent, they can act like cattle blindly following the leader of the pack to the slaughterhouse. For example, have you ever observed how people drive in busy rush hour traffic? On a crowded freeway, it’s common to see people refuse to acknowledge that the flow of traffic has slowed from 65 to 35 miles per hour. There’s nothing they can do but patiently wait for the speed to pick up again. Rather than flexibly considering realistic alternatives, however, they waste time switching lanes in a fruitless attempt to make up the time they’ve lost. Similarly, on a congested downtown street, frustrated drivers are willing to turn into a busy intersection even though there is no way to complete the turn before the light changes. Soon they are stuck in the middle of the intersection, and they and everyone trying to cross the intersection are trapped.

There is safety in numbers. We follow the crowd out of fear. We try to control the world because we are afraid of chaos. But the quest for certainty usually leads to rigidity. And when you are closed off from the creative parts of your intuitive mind, it’s hard to trade the markets innovatively and with the carefree mindset characteristic of traders at the top of their game.

How can you trade more freely and creatively? First, manage risk. Rigidity reflects fear, and if you trade with money that you can’t afford to lose, you will know deep down that you really can’t lose. If you risk relatively little on a trade, however, you’ll feel more at ease.

Second, try to cultivate a carefree attitude. Don’t make everything so personal. Trading doesn’t have to be about your self-worth or abilities. Remember, no matter what happens, you have inner worth. Stay emotionally detached. The more you can remove your ego from trading, the more you can enjoy the process of trading. When you ease up, you’ll feel as if a weight has been lifted. Suddenly, you’ll see trading opportunities that were illusive before. When you take some of the pressure off of yourself, you allow your mind to expand. Your vision becomes clearer and you think creatively and intuitively.

Third, accept your limitations. Don’t try to live up to unrealistic standards. Rigid traders believe they can force the markets to do what they want. It’s just like a frustrated driver trying to travel at 55 miles an hour when a chemical spill on the freeway has created a traffic jam. It isn’t going to happen. It’s better to realize that you are human, and there are those times when there is nothing you can do to change matters. In the end, you must accept the fact that you can’t control the whole world, and similarly, you can’t turn yourself into something you are not. The irony is that you probably are quite intelligent and creative. But when you force yourself to be intelligent and creative, you stifle these qualities. By accepting life circumstances and personal limitations, you unleash talents that are suppressed.

So remember, you’re human. You don’t need to be right all the time, and you don’t need to fully control things you can’t control. Be human. Accept your limitations. When you do, you’ll free up psychological energy that you can use to trade creatively and profitably.

Are you experiencing an emotional roller coaster, euphorically celebrating wins, but facing despair when losses mount? If you are, you may be taking things a little too personally. If you want to trade like a winner, it’s vital that you take responsibility for your actions, taking every precaution possible to neutralize adverse events and to control risk. That said, when things go wrong, it may not always be your fault. You may merely be part of a faulty “system.”

Have you ever worked at a large corporation where the general business plan was faulty? Take Hewlett-Packard, for example. We’ve all read how major changes have been made in the past year, undoing what the last CEO accomplished in the previous two years. Who were some of the victims of a faulty plan? Mid-level managers probably paid the price for decisions for which they had little input. Was it their fault that the old business plan wasn’t working? No, they were merely trying to make the company profitable using a business plan that just wasn’t going to work in today’s business climate. It’s the same with trading. You may have trading strategies that could have worked under different market conditions, but they don’t work today. You may not have the financial resources you need to trade profitably, yet you are trying to make it work when there’s little chance that even a “Market Wizard” could do it. You may be under-capitalized for your methods, or lack the personal time required to achieve your trading goals.

Why beat yourself up if you can’t fix something that is severely broken? You can’t put a broken egg back together again, so you might as well make scrambled eggs. Similarly, with trading, you need to fix whatever is wrong with your strategies or methods as soon as possible. You don’t have time to blame yourself for what went wrong. It’s better to concentrate on how you can change what’s going wrong by taking an objective, problem solving approach. Don’t take things personally and emotionally.

When things don’t go your way, do whatever you can to change matters, and do it fast. Don’t continually assume that every unpleasant event you encounter is your fault, and that you should take the blame as if you did something wrong. Don’t ridicule yourself for making an understandable mistake. Now, at some abstract level, it may be your “fault.” Ultimately, you are in control, but it doesn’t help you recover from a setback to constantly dwell on how you did something wrong and should be blamed for it. When we take too much responsibility for our actions, we tend to blame and punish ourselves when things go wrong, the same way our parents may have punished us when we were children. When it comes to performing a task, such as entering or exiting a trade, it’s vital to de-personalize or objectify matters. Rather than consider the “meaning” or “personal significance” of an action or event, it’s more useful to think strategically. Concentrate on the ongoing process of trading.

So when things go wrong, don’t think emotionally, think strategically. Concentrate on what you can do next to solve the problem. Enjoy the intellectual challenge and rise to meet it. If you can avoid taking setbacks personally, you’ll rise to higher levels of experience, and trade like a master.

On the popular sitcom, “That ’70s Show,” Eric asks his father, “Bad things always seem to happen to me. Why do I have such bad luck?” His father replies, “Son, you don’t have bad luck. Bad things happen to you because you’re a dumb-ass.” Novice traders often feel like Eric. They make trade after trade and watch their account balance dwindle with each trade. They may feel unintelligent and thoughtless, and wonder why they are making so many losing trades. At times they may wonder if they are thoroughly incompetent. But it’s all a matter of perspective. If you aren’t trading profitably, it isn’t because you can’t. It isn’t because you have bad luck. It is a matter of gaining experience with the markets, and gathering rock solid, reliable knowledge about them.

Awareness is the key to high performance. Top performers are thoughtful, and completely aware of what it takes to perform skillfully. Dr. David Dunning, a psychology professor at Cornell University, argues that poor performers are “blissfully unaware of their incompetence.” They overestimate their abilities. Their intuition tells them that their performance is superior, yet objective estimates show their actual performance is under par. For example, when people are asked to take a test measuring abilities, such as thinking logically, writing grammatically, and spotting funny jokes, they tend to overestimate their performance: they think they are performing well above average, yet their actual performance is in the bottom 25%. These biased estimates aren’t restricted to taking tests. People in a variety of settings and skill areas overestimate their abilities. Debate teams in college tournaments wrongly think they are eloquent debaters. Hunters who are bad shots think they are expert hunters.

When traders are unaware of how low their skill level actually is, they are likely to think that they are victims of bad luck. In reality, however, they merely have the wrong perspective. They may think trading is easier than it is. They may trade a small account and expect miracles. They may trade by the seat of their pants instead of formulating sound trading plans and following them. They may think that profitable trading setups will just fall in their lap, rather than spending time searching for those rare moments when huge profits can be taken from the markets.

Trading isn’t something people can learn in a short time. It takes years to fully understand the complexities of the markets. Market conditions change and the only way you can stay ahead of the game is to be a curious student of the markets who continually develops his or her trading skills until long-term profitability is realized.

Winning traders are extremely disciplined. They astutely study the markets, devise a trading plan, and follow it. They control their impulse to abandon their plans prematurely, and they don’t allow emotions, such as fear and greed, to influence their trading decisions. In the trading profession, emotions often get a bad rap, however. There are critical moments of investing when it’s vital to control your emotions, but there are also times when you can let your emotions run wild.

Trading can be broken down into two basic phases: Planning and Execution. In the planning phase, a trader creatively searches for trading ideas and develops a viable trading plan. During the planning phase, you can feel free to experience a variety of emotions. When you execute your trading plan, though, it’s essential to control your emotions and impulses. Once you plan the trade, you must trade the plan in order to take home profits.

During the planning stage, your goal is to find new trading strategies. It’s a creative process, and to find them, you cannot be closed off and rigid. Not only is it all right to allow your emotions to guide you, it may be necessary. It’s all right to psych yourself up. Get excited and enthusiastic. You need the energy to do the homework to discover an innovative idea. Depending on your trading style, you need energy to backtest, scan charts, or read financial reports. Go ahead and tell yourself encouraging thoughts, such as “I’m a creative person. If I let my imagination run freely, I’ll think of a brilliant idea.” When you’re in the creative planning stage, you can think emotionally.

As you search for ideas, feel free to impulsively switch from one idea to the next. Combine and recombine ideas. What’s the harm? You’re trying to find a new idea. At some point in the creative process, you might even want to show some self-reproach or even paranoia. You might want to play Devil’s Advocate as you try to figure out what might go wrong. In the planning stage, it’s useful to defensively think of every potential adverse event that may ruin your trading plan. A little skepticism can only help matters during the planning phase.

At some point during the planning phase, though, you must stop searching and deliberating and decide on a plan. You must specify when to enter and when to exit, and determine the indicators that will allow you to monitor the success of your trading plan. Once you have a plan devised, your emotions and impulses must be controlled. At some point, you must stop thinking emotionally, and move into a rational state of mind. You must carefully enter as planned, monitor the market action, and effortlessly exit should the markets go against you, or wait for your plan to come to fruition.

Emotions aren’t always a distraction while trading. There is a time and place for everything, and emotions can motivate us to develop creative ideas. But once you move from the planning to the execution stage, it’s essential to trade with discipline. The disciplined trader is the winning trader.

It is a muggy day and Skip can’t seem to do anything right. He has fumbled around all morning. He didn’t sleep well last night. He’s tired, and he is tempted to just quit for the day, drink a few tequilas, and sit in a hammock by the pool. But he still has enough willpower to fight temptation a little longer. He has been working on a trading plan for the past month and he wants to see it through. Today’s market conditions are just right. He wants to execute the trade today, a day he has patiently been waiting for the whole month. It’s a day like today that Skip is glad that he has prepared beforehand for what could go wrong. He may not be at the top of his game at the moment, but he knows that he can survive a worst-case scenario should it happen. He has taken precautions and knows deep down that he can live through a major setback. So even though it is a tough day, he’s decided to stick with his plan, execute it, and see if he can take home a profit.

When it comes to mastering your psychology, feeling safe and protected can do wonders. If you are truly afraid of making a mistake, you will not feel calm and relaxed. You’ll be on the verge of making a trading error. And when you are under extreme pressure to perform flawlessly, you feel it. There’s an old trading adage that is apt to trading in the calm, calculating state of mind: Make the trade so insignificant in the big scheme of things that you wonder why you are even bothering executing it. Managing your risk is the key to cultivating an unwavering, psychological sense of safety and security. If a trade requires you to risk only a relatively small percentage of your account balance, you’ll feel at ease. You’ll know that you can survive a setback, and you’ll think, “What do I really have to lose? I can relax a little and see what happens.”

There are other obvious ways to feel protected and safe. For example, you can use a protective stop to make sure that you restrict the amount you can lose on any given trade. Look at the past performance of a stock and estimate an ideal stop loss point that protects you, but does not allow you to get “stopped out” too early. Once you’ve determined an optimal stop-loss point, use the automatic settings on your trading platform to ensure that you are protected even when your self-discipline fails you. Perhaps the most important form of protection, though, comes in the form of a well-developed trading plan. If you know specifically when to enter and when to exit, you can execute the plan even while feeling a little stressed out. You can mechanically follow your plan, focusing on your immediate experience rather than the long-term consequences of a trading loss. It’s also important to anticipate adverse events as part of your trading plan. Make sure that earning reports or a Federal Reserve report don’t come upon you unexpectedly.

Just like engaging in a dangerous sport, you feel better when you know that you have some form of protection. Athletes protect themselves with helmets, and airbags and seat belts protect us as we drive in rush hour traffic. Successful trading also requires adequate protection. Protection not only ensures that you can survive to trade another day, but it also allows you to feel relaxed while you execute and monitor a trade. So protect yourself. If anything can go wrong, it usually does. You don’t have to worry, however. If you take precautions, you’ll survive the inherent setbacks in trading, and end up winning in the long run.

Do you remember your first impressions of trading? Perhaps you were young and had a strong desire to achieve early success, but if you were like most people, you had unrealistic expectations about the financial resources and skill level that were needed to trade profitably. You probably figured that you could just open a typical online brokerage account and turn $1,500 into a fortune. You probably didn’t hold this misconception very long, though.

Soon, you learned that you needed a lot more capital than $1,500 to make profits as a trader, and you probably found a brokerage that allowed you to make trades in real time. As you gained knowledge and experience with the markets, you started learning how your original ideas were naïve. Sure, in hindsight, it seemed obvious that your ideas about trading were off base, but at the time, your perceptions seemed quite valid. Everything seems obvious in hindsight, but at the time, you didn’t see it that way. In the midst of it all, nothing made sense.

The human mind is capable of extreme optimism. We have a strong desire for success, and it can be so strong that we see things that just aren’t there. Our thinking can be biased and self-serving. We can convince ourselves that making money in the markets is easier than it really is. We can believe that good quality setups are easy to spot, and we can convince ourselves that we will have rock solid confidence and unwavering discipline when the time comes. But our expectations don’t always match reality.

Acknowledging the ability of the mind to create a fantasy world that builds up our ego is crucial. When we are desperate to win, we start to distort reality. We can’t see things clearly. In hindsight, though, we look back and think, “How could I have been so stupid?”

It’s useful to cultivate a healthy sense of skepticism. Skepticism isn’t the same thing as pessimism. A pessimist falsely distorts reality to the point that he or she believes that even a reasonable plan is doomed. A skeptic is optimistic yet is also realistic. No trading plan is foolproof. The markets don’t always cooperate with you. The winning trader is the person who questions a trading plan before executing it. He or she tries to anticipate what could go wrong, and thinks of ways to work around these potential setbacks. Being a healthy skeptic can be difficult at times. Again, most humans are naturally unrealistic. They want to believe in miracles. They tend to wrongly believe that if they can imagine it, then it will happen.
It is necessary to plan ahead. Consider what can go wrong and make a plan for what you are going to do to come out unscathed should a trading plan fail. It’s useful to remember the basics: Manage risk and follow a detailed trading plan. If you manage risk, you’ll ease some of the psychological pressure you feel. Psychological pressure can produce denial, and when your vision is clouded with denial, you’ll be prone to feel overconfident, and take risks that don’t make sense in the long run. When you risk little on a trade, or minimize risks through protective stops, then you will feel free and relaxed. You’ll be open to new experiences and you will be likely to see problems with your trading plan before it is too late. You can make some quick revisions that will prevent you from making big losses. Similarly, if you think through a trade, you’ll increase the odds of anticipating adverse events. As you mull things over, you’ll see how you may have given in to self-serving biases and discard them.

Don’t live your life fighting off feelings of regret. Things always look better in hindsight. But if you plan ahead, skeptically anticipate what may go wrong, and take precautions, you will increase your chances of winning

Social psychologists are often fond of saying that people are “lay scientists.” Like formal scientists, they try to understand their world. They make hypotheses and test them. Rather than conducting formal experiments, however, they use their everyday experience to test out theories they have about people. We do the same thing when we learn how to trade. We study the markets and try to develop our own personal theories about how the markets work. Because we don’t conduct formal experiments, though, we may fall prey to psychological biases. One of these psychological biases is the false consensus effect: we tend to wrongly think that others believe what we believe and do what we will do, but that’s only our perspective and it can mislead us.

Short term trading is often about anticipating what the masses will do. Will they buy or will they sell? It can be hard to do. Take the past two weeks, for example. With the war, the hurricane, and high oil prices, one might think that the masses would bail out of the markets. But they didn’t. It goes to show that you can’t always anticipate precisely how people will react to world events. It’s all a matter of having the right perspective, and it can be hard to find that perspective at times. Perhaps it can’t be done easily, but it’s essential that we try.

Why is it difficult to anticipate what people will do? Part of the problems lies in the fact that we are mere mortals. Humans have a limited capacity for understanding complex information. In some ways, people can process information better than a computer, but in other ways they cannot. Many times, we use heuristics or rules of thumb to make decisions.

The false consensus effect is one of those rules of thumb that may bias our decisions. No matter what decision you ask people to make, no matter how important the issue, and no matter what choice is made, social psychologists have demonstrated that people over-estimate the number of others who agree with them. There is a natural tendency to believe that our decisions are relatively normal, appropriate and similar to what our colleagues and peers would do in a similar situation. We use our decisions as an “anchor” and evaluate what others would do based on what we would do. This decision-making bias can contribute to feelings of over-confidence. Once we make a decision, we tend to be confident that we are correct and that others will agree with us, but had we seen the situations from their perspective, we may see that they would behave quite differently.

One explanation for the false consensus effect concerns how people make a decision. When making a decision regarding a position, people try to piece together evidence to arrive at a decision. At some point they organize all the information that supports one alternative over another, while discounting contradictory information. After a decision is made, evidence supporting one’s decision is readily “available” in memory and is easy to remember. When asked to decide how many people would make a similar decision, people still have these various pieces of confirming evidence in mind, can easily recall them, and believe that others will behave as they do based on the information they recall. Estimates of what others will do are based on inaccurate memories, rather than objective facts.

This bias often operates in the trading realm. As a trader, you are constantly trying to anticipate how the masses will behave. You look at and interpret the data in front of you and draw a conclusion. The only perspective you have to go on, however, is your own. And that perspective may be off.

How can we defeat the false consensus effect? The best defense is to gain awareness of it. Remind yourself that you are acting on imperfect information. You must accept this fact of trading, but you can work around it. Always be a little skeptical. Manage risk and be ready to accept the fact that you may be wrong. You’re human, after all, and you are prone to make biased decisions occasionally. Rather than beat yourself up, it’s better to take it in stride and move on.