The Discipline Behind Translating Market Analysis Into Results, Part II

• December 27, 2002
• Mark Douglas

What
Technical Indicators Don’t Do

They
don’t tell you what is going to happen next, at
least not on a trade-by-trade basis. To many of you, it may seem as if I’ve
just contradicted myself (see Part
I). How can an indicator give you an edge, but at the
same time not tell you what is going to happen next? Actually, there’s a very
simple explanation for this phenomenon.

The markets
produce behavior patterns. The patterns repeat themselves over and over again.
They can look and measure exactly the same from one occurrence of a particular
pattern to the next. The presence of a pattern implies a consistent outcome.
In other words, if the pattern is the same, the outcome to the pattern should
also be the same. Unfortunately, this is not the case with the markets. The
reason is, all of the patterns are composed of individual traders — any one
of whom, at any particular moment, can act as a force on prices in a way that
is inconsistent with the expected outcome of any particular pattern.

The principles at
work here aren’t really any different than the principles that underlie the
outcome of a series of coin flips. For example, if you flipped an evenly
weighted coin 1000 times, you could expect an outcome of roughly 500 heads and
500 tails. For every sample set of 1000 flips, you can reasonably expect the
same 50/50 outcome. We can define the results of a large sample size of flips
as a pattern with a statistical reliable outcome.

The statistical
reliable outcome is at the macro level (the entire sample size). However, at
the micro level (flip by individual flip) there’s no statistical relationship.
Here’s what I mean: If, in the course of flipping the coin a 1000 times, heads
came up 10 times in a row, does this streak of heads have any bearing on the
next flip? No, it does not. The odds of seeing heads on the next flip is still
50/50. In other words, there’s a completely random distribution between heads
and tails over any given series of flips.

Technical
indicators work the same way. No matter how good any particular edge may be,
there’s still a random distribution between wins and losses in any given
series of occurrences of that edge. For example, if, as a result of past
performance, you found an edge that produced winning traders 70% of the time,
is there any way you could know in advance which seven trades are going to be
the winners and which three trades are going to be the losers, out of the next
10 occurrences of that edge? Not unless you had a way of reading the mind of
every individual participating or who had the potential to participate in that
market.

Furthermore, if
outcomes of the last two occurrences of your edge were winners, does that mean
the next trade will be a winner? There’s really no way to know. Why? Because
it only takes one trader somewhere in the world to come into the market with
enough volume to negate the expected outcome of any edge, regardless of how
convinced you may be that it’s going to work. And vice versa, if the last two
outcomes were losers, does that mean that the next trade will be a loser?
Again, there’s no way to know.

Technical
indicators get you into the collective mind of the market, to give you a
statistically reliable outcome for any given edge over a large sample size.
They do not get you into the mind of each individual trader participating in
any given market, to tell you what the outcome will be for each specific
occurrence of that edge.

What
Are The Psychological Implications?

Here’s where the
interface difficulties I referred to above come into play: On the one hand, we
have technical indicators that provide us with this never-ending stream of
opportunities to do something on our own behalf. However, these opportunities
exist within a context of patterns that appear to be exactly the same.
However, within these patterns are individual forces that cause the outcome of
each pattern to be unique and random, with no relationship to the last
outcome, or the next.

On the other hand,
to effectively take advantage of these opportunities, you have to be able to
execute your trades properly — meaning you have to keep your mind focused in
a way that causes you to do exactly what you need to do, when you need to do
it, without fear, hesitation, internal argument or conflict. This is no easy
task.

Our minds have two
inherent design characteristics:

1. to associate,
   and

2. to avoid pain

This makes taking
advantage of this never-ending stream of opportunities extremely difficult.

The first
characteristic we will look at is our natural tendency to associate.
Our minds seem to be “wired” so that we automatically link or
associate situations, circumstances and events that have “similar”
qualities and characteristics in a way that causes us to think, assume or
believe we that know what will happen next. Of course, this characteristic can
have a profound influence how we live our everyday lives, but it’s not always
that easy to attribute the effects of what we experience to this source.
However, when it comes to trading, the effects of allowing our minds to
associate two “seemingly” identical events that in reality have
“unique,” unrelated outcomes, are usually very dramatic and
inescapable.

For example, let’s
look at a hypothetical trader who discovered or somehow acquired an edge. Keep
in mind that we are defining an edge as a higher probability of one thing
happening over another. He decides to start trading this edge and his first
three trades turn out to be winners. The market is now setting up in a way
that indicates his edge is present again.

Is this next trade
going to be a winner or a loser? The reality is he doesn’t know. He doesn’t
know because, as I explained above, there’s a random distribution between wins
and losses on any given set of variables that define an edge. And the reason
there’s a random distribution is because it only takes one trader somewhere in
the world to do something that negates the positive outcome of his edge — or
any edge, for that matter. However, because of the last three trades the
situation doesn’t feel like he doesn’t know what will happen next. In fact, it
feels quite the opposite: He’s virtually convinced a winner is coming his way.

What we have here
is a huge gap between what’s possible from the market’s perspective, which is
virtually anything — and what’s possible from his personal perspective, which
is only one thing. This gap is caused by the mind’s natural tendency to
associate. This is something everyone is susceptible to, until we learn how to
think like a trader. We’ll look at the underlying dynamics of this
characteristic a little closer.

The fourth
occurrence of his edge came from the same pattern that produced the last three
winning trades. Because of the similarity of the situation the “now
moment” edge will automatically and instantaneously get linked to the
memory of those last three trades. I say automatic because this process does
not require any conscious decision-making on his part. Since the last three
trades were winners, I am going to assume that the experiences caused him to
be elated. If that’s the case, the instant his mind connects the “now
moment” (seemingly identical situation) with his memories, the same
feelings of elation will flood his body and mind, making it seem as if he’s
already won. His previous experience then becomes his “now moment”
reality.

The problem is the
market may not share that reality. He may feel as if he’s already won, but the
market hasn’t spoken yet. Certainly one possibility is that it could move in
the opposite direction of his edge. If it’s possible for the market to move in
the opposite direction of his edge, then the outcome of his edge is uncertain.
If the outcome is uncertain, then there’s a genuine risk of being wrong and
losing money. However, his current state of mind makes it virtually impossible
to appropriately take these risks into consideration.

In
Part
III, I look at the consequences of believing we know what will happen next.