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Psychology lessons for market traders

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D. Murali

Over 90 per cent of all traders lose, declares Brent Penfold in The Universal Principles of Successful Trading: Essential knowledge for all traders in all markets (www.wiley.com). He says that the reason why the traders lose is ignorance, arising from gullibility and laziness.

“It's human laziness that causes traders to look for the line of least resistance. Why work harder when you can work smarter, right? Unfortunately, this can make traders gullible, and they start to believe what they read, what they hear, and what they install on their computers. This is because traders desperately want to believe there is a simple path to trading riches.”

Three pillars

To succeed in trading, you need to cover three important areas, that is, methodology, money management, and psychology, advises Penfold. First is the analysis and trading plan behind why you buy and sell; second, the amount of money you commit to trades; and third is about having the discipline to follow your trading plan. The opening chapter, titled ‘A reality check,' lists the common mistakes under each of these three pillars, in years one to three. For instance, the methodology in year one is described as listening to others and following tips, reacting to the nightly news, asking others for their opinions, averaging entry levels, failing to use stops, and failing to have a trade plan.

Listening to others and following tips can be a recipe for disappointment, the author warns. Sometimes the tip may be successful, but over a long-term, it is a loser's game, he rues. “You should trade only because of what you think, not because of what others say in the corridor or over a dinner table.”

The question ‘What is money management?' summarises the status of the second area in the first year, because the only concern for first-time traders is usually that they have enough money to initiate a trade. Penfold bemoans that new traders often have no concept of their ‘risk of ruin' brought about by risking too large a slice of their account balance on any one trade.

From excitement and revenge

The author finds that the ‘psychology' in the first year is one of trading for excitement, and trading for revenge or to get even.

He observes that one of the reasons many people trade is that it provides an exciting distraction from what may be a relatively orderly and conservative life. “Trading gets the heart racing and adrenalin flowing. Even if they're losing, traders often keep at it because the next trade is always an exciting mystery – will they win or will they lose?”

Sadly, when the greenhorn trader loses, he tends to get angry and wants to get ‘even' with the market, because ‘losing is like receiving two blows: one to your pride and one to your wallet.' Being emotional is a common behaviour for new traders; alas, it is also a shortcut to the poorhouse, alerts Penfold.

Continuing on the psychology thread, you will discover that the second year has the trader becoming addicted to the market, being impatient, having unrealistic expectations, and turning a rationalist. The last mistake is about traders seeking to explain away their losses.

“They always find a reason the market took their money – ‘If the Dow Jones hadn't fallen last night, I would have been able to take my profits this morning!' or ‘Oh no, I miscounted my waves. How did I do that?' or ‘The 20-bar cycle must have inverted!' In the minds of novice traders, it's never their fault.”

Subconscious mind

A chapter on ‘psychology' counsels traders to manage three main emotions, that is, hope, greed, and fear. A simple guidance the author offers is that if you are ever feeling stressed about your trading you should stop. “Listen to your subconscious mind: it's trying to tell you something that probably everyone around you knows – that you're clueless about what actually works in trading and in all probability, you're out of control!”

The key, he says, is not to go by the consensus view that you need to understand how to access your subconscious mind to unlock your potential.

Instead, if traders adopted a sensible money management strategy and combined it with a simple and robust trading methodology, their subconscious mind will be aware of their competency, and will remain happily in the background, assures Penfold.

Hope, greed

On hope, the author's take is that when you find yourself hoping a trade will come good, you are almost certainly guaranteed to lose. Hope is the last feeling you have before being stopped out of a trade, and is usually magnified when the market is a few ticks away from your stop, he adds. “Hope stems from two areas – not applying correct money management and not knowing your expectancy. Trading in the dark. The solution is to stop trading and to get your risk of ruin down to zero per cent.”

Watch out, if you find you are too concerned about a trade's outcome, it is because you are risking too much money given your methodology's expectancy, worst drawdown, and account size, reads a clue.

You can recognise greed when you start wanting more, pushing your insecurity button, and making you think you are missing because you believe others are doing much better than you, the author instructs. As he outlines, this is where you will start wanting more money, and where you will believe more trading will give that to you.

“Wanting more will lead to impulse trading, which inevitably leads to a cycle of pushing marginal trades, mounting losses, and revenge trading. This cycle will continue to repeat itself at increasing frequency until you either come to your senses or your account is ruined.”

Penfold traces greed to emotional disorientation, arising from flawed objectives and expectations. He frets that most traders, when they begin, have an objective to achieve 100 per cent accuracy, and expect to earn a 50 per cent plus or 100 per cent plus return on their account. “Establish a modest return target for your risk capital, whether it be a 20 per cent, 30 per cent, or 40 per cent return. Remember, the higher your expectations, the higher risk you'll face…”

Fear, pain

Fear can be of many things, such as of losing, or of the unknown. Confront your fear and take control, urges Penfold. “Expect the worst. If you can do this, you'll never have to consider whether or not to follow one of your methodology's signals. You'll trade all the setups, inevitably lose, but benefit over the longer term from your methodology's positive expectancy.”

The fourth dimension unravelling in the psychology lesson is pain, to which the concluding section of the chapter is devoted. Trading is a world of pain, and when you lose money, it will hurt, the author philosophises. Again, it could hurt when you make money, he continues, because you will then think about how much more money you could have made if you had stayed in the trade a little bit longer, and therefore miss the imaginary money you have left on the table!

Successful traders, in Penfold's view, know how to manage the pain, how to numb it. “It'll never go away, but through experience you'll learn how to dull its incessant hum… The constant pain will challenge your commitment to your trade plan, your methodology. You will need to accept that you can experience a long streak of consecutive losing trades.”

Lest you think he is a killjoy, the chapter wraps up with hope of rewards for hard work, though the path may not be a walk in the park for most. But you need to remember the market's number one rule – ‘maximum adversity' – which ensures that the market will do what it has to do to disappoint most traders. If you can remain humble, remain aware of maximum adversity and remain defensive, you will be in a good position to persevere through the pain, guarantees the author.

Field notes of immense value to traders.

(This article was published in the Business Line print edition dated September 26, 2010)
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