I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Tuesday Book Club, I share an idea from a book.
I’ve realized that to improve my trading results, I need to address my psychology, not learn more about options or about certain corners of the markets or start trading futures.
Mark Douglas’ book Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude addresses exactlly what I need to fix: my thinking.
An interesting point he makes early in the book is that one dysfunctional pattern he sees over and over again in unsuccessful traders is the attempt to avoid losses by learning more and more about the market.
Instead of learning more about the market, he suggests, you need to fully accept the risk you are taking on, and the possibility of losses:
[It] would stand to reason that the best way to avoid losses and become consistent would be to learn more about the markets.
This bit of logic is a trap that almost all traders fall into at some point, and it seems to make perfect sense. But this approach doesn’t work. The market simply offers too many—often conflicting—variables to consider. Furthermore, there are no limits to the market’s behavior. It can do anything at any moment….
This means that no matter how much you learn about the market’s behavior, no matter how brilliant an analyst you become, you will never learn enough to anticipate every possible way that the market can make you wrong or cause you to lose money…. The hard, cold reality of trading is that every trade has an uncertain outcome. Unless you learn to completely accept the possibility of an uncertain outcome, you will try to either consciously or unconsciously to avoid any possibility you define as painful. In the process, you will subject yourself to any number of self-generated, costly errors.
Douglas continues:
You have two choices: You can try to eliminate risk by learning about as many market variables as possible. (I call this the black hole of analysis, because it is the path of ultimate frustration.) Or you can learn how to redefine your trading activities in such a way that you truly accept the risk, and you’re no longer afraid.
How do you truly accept the risk of trading? He says, “you have to neutralize your expectations about what the market will or will not do at any given moment or in any given situation.” And this requires thinking probabilistically.
Douglas offers these five fundamental truths for trading:
- 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.
Douglas believes that, by accepting these as true, you can eliminate your tendency to interpret market information as painful or threatening, and you create a carefree state of mind.
My own evolving trading attitude
I confess for the past few years, since I’ve turned my attention to investing, I thought I could predict what would happen. I thought by reading financial pundits, and studying the macroeconomy, and learning about various markets that I could know what would happen with some certainty.
I’ve learned that I’m wrong. I can outline possibilities. I can develop instincts about what is more likely to happen. But what actually happens? That’s not something I can predict in advance.
My emerging trading approach — which combines the options wheel, swing trading, and a comprehensive, quantitative hedging approach — does not rely on predictions. I use technical analysis (looking at charts of price and volume action) to determine which of many possible tickers to trade. I use diversification across sectors and factors because one never knows what rotation might take place, or what bad news might hit a particular corner of the market.
Changing my thinking
I have noticed that a phenomenon Douglas describes has happened to me. That is, when I expect the market to do one thing, and another thing happens, leading to (as-yet-unrealized) losses, my attention narrows. I start looking for evidence that actually things are going to turn around. My losses will turn into gains. All my attention gets taken up by that big red number flashing on my positions page.
When I think that I can predict where the market will go based on analyzing tweets or news reports or Substack articles, then I start to get tunnel vision, only looking for evidence that confirms what I’m hoping for. It drags my attention away from my portfolio as a whole.
A trading system that honors the reality of the market
A trading system that truly acknowledges and accepts that anything can happen can be constructed by using the following approach:
- Selecting which kinds of trades you are going to enter and exit, on what time frame (day trading, weekly, a month, a couple months, more?)
- Determining which assets of a certain class you are going to consider (only equities? equity options? commodity futures? etc).
- Defining a set of filters for your watchlist — for example, if trading stocks, what company sizes will you consider? What geographies? What industries? What profit metrics? And going further, you can limit yourself to only those equities where their current price is higher than one month ago, three months, and 12 months.
- Defining entry and exit criteria — for example, those with charts that have a bullish major trend only, and that have taken a dip, but bounced off of support?
- Specifying position sizing criteria along with maximum risk you’ll take on per trade
- Specifying diversification criteria — i.e. don’t have all your account in semiconductors!
- Determining exit criteria up front for both profits and losses and possibly using stop loss orders to ensure you automatically get out in the case of losses
Onwards
I wish I had read Douglas’ book before I started trading, but I’m not really sure that it would have made a difference. The reason I went looking for such a book is because I’m having trouble translating knowledge and learning into the realized results I’m hoping for. And it’s because of exactly what he identifies: I haven’t fully accepted that the market can offer up anything — anything can happen — the solution is not to learn more technical skills or trading systems. The solution is to fully embrace the probabilistic nature of market outcomes, with a trading system that gives me an edge, but also allows for and protects against outcomes I didn’t predict.
As a story, as a literary narrative, the more pain for our heroine (me) the better. Books I’ve read about crafting a compelling novel or screenplay suggest that you have to keep turning the screws on the protagonist. It must get worse and worse and worse, before there is peak conflict, and a turning point, and the capturing, by the protagonist, of some reward.
I’m still in that part of the hero’s journey where things get worse and worse.