[DbPhoenix]

Admitting Our Incompetence

In order to become a top-notch trader, you must have accurate insight into your own limitations. But most novice traders do not. For example, behavioral economist Dr. Terrance Odean has shown that online investors tend to trade beyond their skills. They don't have an accurate picture of what they can and cannot do. These biased exaggerations of abilities are not restricted to traders. It's a widespread phenomenon. Research studies suggest that when it comes to estimating how well you are doing as a novice trader, it is best not to trust your intuition.

Dr. David Dunning and colleagues (2003), in a recent article in "Current Directions in Psychological Science," argue that most people are "blissfully unaware of their incompetence." This tendency to overestimate one's abilities has been documented in several studies. 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 (60% and above), yet they are actually performing in the bottom 25%. This research finding isn't restricted to taking tests. People in a variety of settings and skill areas overestimate how well they are doing. Debate teams in college tournaments wrongly think they are superb debaters. Hunters think they know more about firearms than they really do, and medical residents think they know how to diagnose patients more accurately than they really can. Studies have even shown that when people are offered money to estimate their performance accurately, they still can't do it.

Dr. Dunning and colleagues suggest that poor performers are "double-cursed." Not only do they perform poorly, but they also lack the psychological ability to perceive that they are doing poorly. So what do poor performers do compared to top performers? Poor performers start with the belief that they are "good performers" and don't take the time to develop a method to assess their actual performance. Top performers, in contrast, try to gauge their performance accurately, and tend to avoid worrying about whether they are "good performers" or not. Indeed, studies show that they actually underestimate their performance. When they see how others have performed on a similar skill, they are surprised how well they do compared to others.

Fortunately, poor performers are not doomed to remain at the bottom of the heap. In their experiments, Dr. Dunning and colleagues have shown that when poor performers are shown how poorly they do, and are given instruction on how to improve their skills, they perform better and are more accurate with regard to their performance estimates.

These studies offer ways that novice traders can improve their trading performance. First, one should be aware that novice traders' intuitive performance estimates are grossly exaggerated and take active steps to ignore them. Second, create an objective log of your trading results, such as a trader diary, so that you know exactly how well you are performing. Third, get some trading instruction to improve your skills (trading coach, mentor, workshops, etc.). As your skills improve, you will perform better and your estimates of your performance will be more accurate. So keep these guidelines in mind. An objective and accurate estimate of your abilities is vital for trading success. Make sure you have one.

--Innerworth

[DbPhoenix]

The Bottom Line

Should I buy? Should I sell? Many traders often focus their efforts on identifying buy and sell signals. The research and analysis they do are geared towards reaching the goal of getting that “bottom line” directive to guide their actions. Any successful, experienced trader will tell you that although properly identifying buy/sell signals is important, it’s not the key to being successful. Instead, the way you manage each trade is what will determine your success.

Traders who take the bottom line approach tend to believe that the success of their trading activity is dependent on following the right buy/sell signals at the right time. Clearly, it’s important that a trader be able to understand the process of generating signals and to use the methods involved. Realistically though, almost any trader can find a way to generate signals (whether using technical methods already out there, coming up with their own system, or using their platform’s automated signal generation tools).

Any successful, experienced trader will tell you that your trade doesn’t begin and end with a buy or sell. There’s a trade management process involved. For each trade you make, you’re making a group of decisions. The way you manage and time those decisions is what will determine the success of your trade.

Suppose two traders get the same signal at the same time and act on it. One’s trade may result in profits while the other’s results in losses. This could occur because each trader made a combination of additional decisions throughout the process of the trade. These decisions might include scaling in and/or out of the trade, using trailing stop losses, setting profit objectives, waiting, etc. The trader who made the more effective overall combination of decisions will have the better trade results in the end.

It’s very important to regard trading as a process, and to understand that a trader’s efforts need to be focused on the activity of trading itself, as opposed to getting a quick bottom line answer. Because there are many aspects involved in making your trades successful, it’s essential that you educate and train yourself in all the different areas. Learn how to develop better trading plans and analysis methods, and then learn how to apply what you’ve developed to the process of a making a trade – from the original impetus to enter or stay out of a trade to the psychology of managing that trade.

--Innerworth

[DbPhoenix]

Possibility Mapping

Traders often hear about the potential benefits of preparing actionable trade plans prior to the next trading day. The goal of such preparation is to make yourself immune to mental edge breakdown. One of the greatest threats to your mental edge is coming across something that's unexpected during the trading day. Seeing an unexpected price move (especially one you perceive to be a big move) is likely to stress and panic you and therefore cause your psychology to shift into an emotional, reactive state. An effective way to prevent this is to prepare with possibility mapping.

Possibility mapping is a process which will mentally prepare you to expect the potentially unexpected, and therefore will allow you to numb, in advance, any potential emotional responses.

There are two major types of possibility mapping: Exact possibility mapping, which you would use if you tend to make your trade decisions the day before; and Price Pattern possibility mapping, which you would use if you tend to make your trade decisions while you watch price patterns forming.

With exact possibility mapping, you first identify a trade you might make. You would then write out all possible scenarios of price activity following your entry. Yes, there are more scenarios than you could possibly define. However, you'll be able to identify major groups of scenarios where each of the scenarios in a given group would ultimately result in the same signal. These groups are limited and can easily be defined. Then, in your objective state of mind, you decide how you would react in each case.

On the other hand, with pattern possibility mapping, you would define the several possible groups of general, overview patterns you might see and decide what actions you would take in each case. Over time, you'll find yourself mapping possibilities faster and more accurately. You can also prepare further by defining what you might think the chances are of each scenario actually occurring.

With such preparation, you've already "experienced" tomorrow's markets. Therefore, you virtually eliminate the chance of mental edge breakdown due to unexpected scenarios. Possibility mapping can also drastically improve the quality of your trade decisions and your recognition of certain patterns. In addition, reviewing and comparing your possibility mapping records with your trade diary will help you find key patterns in your trading, identify areas in which you might have a lack of preparation and ones in which you have strengths.

--Innerworth

[DbPhoenix]

Forward Opportunities

What was the last thing you traded? Look at its 1 year, 6 month, 1 month, and 3-5 day charts. Can you see all the opportunities where you could have made a profit? Should have gone long there, shorted here . . .. You're assessing "opportunity" based on price activity subsequent to the point at which you believe the opportunity existed, which means that you're working backward to identify that point of opportunity.

While trading, these are the very opportunities a trader is aiming to spot. This and the desire to make trades will often drive the inexperienced trader to "see" opportunity where there is none, simply because the trader can easily envision the price pattern moving in any given direction. If his predisposition or any of his analysis makes him inclined to forecast a certain direction, he can quickly envision the movement of price in the direction that will yield profits. By envisioning such price pattern formations, it's often the case that the trader will mentally emulate what he has previously viewed on historical charts, and perhaps even had a desire to experience. And this psychology is made even more complex when the trader begins to find "evidence" in current price activity that supports his forecast/vision and ignores any information that contradicts it, thereby providing a false justification to make the trade.

This type of thinking will cause a trader to make trades when no real opportunity exists. The fundamental problem is that the reason for action is based on a forecast/vision, and not on what has happened and what is happening right now. Given the fact that forecasts and visions are not realities and that historical and current activities are, decisions that are based on the proper interpretation of what has happened and is happening will be correct far more often. It's critical to avoid mentally creating opportunities and to know when to stay out of a trade.

Looking at the charts again, try to identify forward-looking opportunities, where you consider only each price point and the price patterns before it. You'll find that it's now far more difficult to spot the winners, but those are the opportunities that you need to identify and then appropriately act on in order to be a successful trader.

Any experienced and successful trader will agree that it's very important not to trade until there's a true opportunity.

--Innerworth

[DbPhoenix]

Cracking Under Pressure

Whether it is trading or playing sports, when the pressure is on, many of us crack under the strain. Consider the Olympic performances of Sarah Hughes and Michelle Kwan in the 2002 Winter Olympics.

Michelle tried to meet high expectations of winning the Gold Medal and made several mistakes in her performance. Sarah, on the other hand, went into her performance with fewer expectations and a carefree attitude. She said, "I really thought there was no way in the world I would win. Realistically, there was this little window, but I didn't think I would win. I went out and just skated." By taking this carefree attitude, she skated freely and without worry. This stance allowed her to react to the moment, express her creativity, and win the Gold Medal. It's like saying, "I didn't worry about how much money I would make, I just traded." It's also similar to something Andy Bushak, a trader with Advanced GET, said in his Innerworth Master Interview about successful traders on the floor of the Chicago Mercantile Exchange. "They don't have too many rules for themselves. They keep it simple, do a little bit of homework, and simply react to market conditions." In other words, they just trade.

Successful traders make trades in a carefree manner. They don't put pressure on themselves to succeed. They don't believe they need to be right, and they don't need to predict the future behavior of the market. Instead, they objectively observe market conditions, react to them, and let the market take them where it wants them to go. Successful traders are "in the zone" as Mark Douglas claims. In his book, Trading in the Zone, Douglas notes that seasoned traders do not doubt or second-guess themselves. They freely enter and exit trades without worrying about the consequences. This carefree approach to trading allows them to see trading opportunities more easily and allows them to take advantage of these opportunities when they arise. How does one enter the zone? It takes intense concentration and focus, and it's difficult to maintain this stance when the pressure is on you to perform. Mark Douglas suggests removing some of the pressure by thinking in terms of probabilities and carefully managing risk. You may not win on any single trade, but after a series of trades, you will have enough winners to make a profit in the long run. Remembering this and having confidence that your trading strategies, or edges, will ensure you make money in the long run will help you stay in the zone. It's also important to manage your risk. Specifically, determine your risk on a given trade before making it, and risk only a small amount of trading capital on a single trade. Doing so will take some of the pressure off, allowing you to be more open to see the opportunities that the market offers. Be open-minded. Remember that the market is always right. It's your job as a trader to see what the market is doing, rather than imposing your will or expectations onto it.

Flow with the market. Move with the market. React to the market. Let the market tell you where it wants you to go. By taking the pressure off of yourself, you will feel more free and open. You will be able to identify trading opportunities, quickly react, and take home the profits.

--Innerworth

[DbPhoenix]

Misplaced Confidence

Confidence can be an important psychological tool for the trader - important enough to make the difference between a winning trade and a losing trade. When you develop your trading plan, it is obviously important that you have confidence in its accuracy and usefulness and in your belief that you can follow your plan closely and execute it successfully.

Often, traders fall into a mental "I know it all" trap, where they use their confidence to nurture their ego instead of using it to be appropriately decisive in their trading and investing decisions. Such misplaced confidence can be crippling to trading success, because any potential influence from the environment (media, others' opinions, etc.) that could sway the trader from sticking to his trading plan will have far more power. When a trader is caught in this type of trap, his ability to question his opinions and ideas diminishes. If his initial reaction to a suggestion is to accept it, he loses the capacity to question his acceptance; and if his initial reaction is to disagree, then he loses the capacity to question his disagreement, which can cause even the slightest suggestions from news, colleagues, and other influential sources to be magnified in the trader's psyche.

If you're caught in this trap, you'll tend to make these magnified suggestions your own. When you do this, you give yourself logical reason and justification to act on them, even if it means you have to sway from your trading plan. Falling into this trap is characterized by being confident about things you really don't know, instead of being confident about the things you know well, such as your trading plan.

Alternatively, when you have the right kind of confidence, you empower yourself to stick to your trading plan and deflect fear and doubt. Before making a trading or investing decision, be certain that you're confident about what you're confident about. The key is not to be confident about what you don't know (especially when it comes to others' opinions) but to be confident about your knowledge of objective facts and the trading plan that you have so laboriously developed.

To prevent misplacing your confidence, review decisions that you've made confidently but that turned out to be incorrect, evaluating exactly where your confidence was placed. Most of the time, you'll discover that your decision was based on a suggestion not your own, but that you had made your own.

--Innerworth

[DbPhoenix]

Your Trading Plan & Your Trading Personality

As a trader, you often hear about how the success of your career depends on the quality of your trading plan. What you don't hear is that the process of developing your trading plan can be as important as, if not more important, than the end result.

Most traders are consistently swayed into modeling their trading plans on what other seemingly more successful or experienced traders are doing. Whether they make their plans identical to another's, or they just adjust theirs to accommodate someone else's opinions and ideas, the bottom line is that most traders develop trading plans that aren't their own. As a result, they also tend to compare their trading results with those of more successful traders and wonder why they're not doing as well.

Working with a trading plan that's not entirely your own can cause you to develop typically unforeseen psychological issues that will be detrimental to your trading success. One of the most obvious of these "side-effects" is the effect on your confidence. Knowing that your trading plan is not your own will never allow you to be completely confident about your plan's reliability, which can seriously affect your ability to stick to it. You'll also continuously struggle with the idea that any success you achieve will not be entirely your own. Feelings of being a "cheater," and not deserving your winnings may creep into your mind and negatively affect your trading decisions. Additionally, your trading plan will be the first to serve as an excuse for your losses, preventing you from taking responsibility for your actions - after all, it wasn't your idea.

It's critical that you develop your trading plan based on your own interpretations, analyses, and thoughts, so that it's compatible with your trading personality. Working with a trading plan that you've laboriously developed based on your own knowledge and research will give you the confidence that's key to your trading abilities. It will also encourage you to take responsibility for your decisions, and help you to actively improve your trading plan based on your experiences. Even the process of the development itself will better shape your trading psychology.

Additionally, when your trading plan is tailored to your trading personality, you'll find that you can use your intuition to trade more effectively and you'll feel more comfortable in making your decisions.

--Innerworth

[DbPhoenix]

Resistance & Momentum

The classic boom and bust theory of the market is that a given price pattern cycle is initiated by mass mentality or perception of what future price movement will be. As investors establish their opinions (these cycles usually begin with bullish opinion) and the media reports support them, they begin to act on it, inevitably and seemingly causing their predicted pattern to develop (the boom).

This confirmation of their opinions bolsters their confidence and is a source of encouragement for them to maintain their positions and to even add to them. As the predicted directional movement forms and the activity slows down, experienced traders come in and set their positions against the mass opinion. The price trend begins to change (the bust).

Logically, it would seem that this would be a good point for most people to begin liquidating their positions and taking either some profit or if they were a bit late to enter, to cut their losses short. But this is not what happens. As the price declines, investors tend to hold on, with the hopes that the price will begin rising again or that they'll have an opportunity to at least sell at the price they bought.

In general, once people are taught a certain way, and especially when they've received positive reinforcement in what they've learned, they have great difficulty altering their behavior. Even if they see clear evidence to the contrary of what they believe, they will persist in their opinions. Successful traders who utilize momentum in their decision-making are basing their choices, at least partly, on this type of market psychology. The boom created by the mass opinion originally has a form of "inertia" as people receive affirmation about their opinions. At some point, as this momentum slows, the experienced trader realizes an opportunity of optimized probability to take advantage of the market pattern.

The resistance to alter one's behavior is what causes the trader to give back unrealized gains and more often than not, to even take realized losses. When you're speculating or have an opinion about where the market's headed, no matter how solid you think your analysis is, it's always only good for a limited time. Recognizing this and realizing how others think and invest will give you the added edge to take advantage of opportunities to make trades with optimized probabilities.

--Innerworth