Today’s Trading Lesson From TradingMarkets

Brice

The
Mindful Discipline Of The Medium-Term Trader

By Loren Fleckenstein

The unexamined life is not worth living.

Socrates

I have set initial price stops with
every trade ever since. Without exception, I have enforced my sell/cover rules
whenever a trade hit my stop. Instead of feeling a dent to my ego over being
“wrong” on a trade, I feel a sense of satisfaction whenever I sell for a small
loss to elude a big loss. I take professional pride in living up to my plan. And
call me perverse, but I feel almost as good about seeing a stock tank after I
sell as I do when bagging a profit!

Okay, enough smugness. Now that I’ve
boasted about my righteous loss-cutting discipline, let me confess my dirty
little secret.

Loss containment forms just one part of disciplined trading. While I
practiced consistent money management toward losing trades, I failed miserably
in my early trading to act with self-control in the selection and entry of
trades. Early on, I indulged an amateurish tendency to shoot from the hip rather
than confining all my entries to a carefully researched set of stocks.
Inevitably, this led me to enter many losing trades.

While this might sound like a stupid
mistake (which it was), it was not a shortcoming of intellect that led me
astray. Underlying my behavior I discovered a deeper, psychological root, one
that I have since noticed in many traders. Once I discovered this root, the path
to turning around my performance became clear.

By sharing this personal experience with you, I hope that you can learn to
recognize counterproductive tendencies embedded in your own unique personality.
You may suffer from the same flaw as I did. Or your hidden weaknesses may lie
elsewhere. But I believe the solution is the same. One of my teachers calls it
mindfulness.

As a beginning trader, I had access to
an institutional stock market database as well as a real-time quote service.
Armed with these wonderful tools, I would continuously scan the market for
stocks moving on healthy volume during the trading day. If I saw a high
relative-strength stock pop out of a picture-perfect pattern (“picture perfect,”
that is, to my novice eye), I would run a quick-and-dirty check of the corporate
earnings. If that cursory once-over flashed no red lights, I’d jump in with both
feet.

This mindless, gung-ho behavior got me
in all sorts of trouble. In my haste, I would often overlook danger signs in the
chart or problems buried in the corporate fundamentals which might have revealed
themselves upon a more painstaking inspection. I also entered otherwise great
stocks too late. Trying to find breakouts the same day I traded them, I wound up
hitting the order-execute button after stocks had extended well past their
pivotal points. As a result, I was shaken out in many subsequent pullbacks.

Consequently, you must pounce once a stock sends you an entry signal. If you
let a stock telescope more than 3% in price while you hem and haw over your
decision, you’ll miss out on an early paper profit created by the breakout.
Capturing that profit provides a critical margin of safety. Combined with your
loss allowance, it forms a cushion to insulate you from normal bouts of adverse
volatility after entry. Miss out, and the odds increase that a pullback will hit
your stop, throwing you back into cash right before the stock resumes in the
direction of your trade.

My stop-loss and position-sizing
regimes steered me clear of catastrophe, but I was dying the death of a thousand
cuts! Small losses mounted. Meanwhile, stop-outs from otherwise winning trades
denied me profits needed to offset the drain on my overall capital. I was losing
a war of attrition to the market, and the casualties were psychological as well
as financial. I felt increasingly frustrated and discouraged. A winning trader
must possess his or her nerve as well as a bankroll. I was in danger of losing
both.

Trading with discipline requires more
than knowing the proper rules. You also must possess self-knowledge. What are
your bad habits? What are your emotional needs, your compulsions, your
vulnerabilities? Unless you address them honestly, they will influence your
trading on a subconscious level and lead you astray, no matter how well your
intellect grasps your chosen trading strategy. The market is a zero-sum game, an
impartial, unsympathetic referee of the adversity of thousands of combatants.
You can enter the fray heedless of your self, but the market won’t turn a blind
eye! The market is like any of life’s forums of adversity. It possesses an
uncanny talent for uncovering your vulnerabilities, and it will turn them
against you.

In my own case, at some level, I knew darn well that my early gun-slinging
ways were unduly risky. So why did I fool around like that? The answer was, I
craved the “action” too much.

Now don’t misunderstand me. To trade
successfully, a trader must love the action. Great traders love to trade. Wealth
is the byproduct of successful trading, but pursuit of wealth is not the primary
motivation of great traders, at least not in their formative years. Unless the
markets fascinate you, unless you wake up each day with a passion for the game,
you will not become a successful trader. I believe great traders share this
quality with great athletes. I’m sure Alex Rodriguez, Michael Jordan and Tiger
Woods enjoy the immense material fortunes that their careers have brought them.
But long before they won fame and fortune, they fell overwhelmingly in love with
their chosen sports. That passion drove them to mastery and excellence.

But any emotional need, indulged
without balance, is a prescription for disaster, whatever your field of
endeavor. In the world of trading, the pros learn to harness their passion for
the game with a disciplined, businesslike approach aimed at maximizing returns
and minimizing risk. To find that balance, you need more than a defined trading
plan. You must align your emotions with your goals. Only then will you possess
the resolve to carry out your trading plan.

We all consciously desire profits, but deeper impulses lurk at a subconscious
level. If those impulses remain in the subconscious, they will influence our
trading decisions to our disadvantage. By becoming mindful of those impulses, we
can take corrective action.

Hyperactive hunger for the action was
my own psychological Achilles heel. I’ve overcome this weakness through
sustained effort. I remain vigilant against it every day of my trading life, but
over time, the temptation to overtrade has diminished considerably. What is your
Achilles heel? Nefarious influences come in many different forms. It doesn’t
take a psychologist to find out, but you must put forth an honest effort at
mindfulness throughout your trading career.

The next step involves regular post-game analysis of your trades. You should
already be doing this. The study of losing trades is the best way to improve
your skills and technique. However, don’t focus exclusively on technique. Ask
whether something within you blinded you into making those technical mistakes. I
assure you: You will make many startling discoveries as you find misjudgments
rooted in yourself rather than in the market!

If this sounds too touchy-feely for
the macho trader in you, you’re missing the point. Self-appraisal is key to
success in any field. Consider the examples of Stuart Walton and Steve Cohen,
two phenomenal money managers profiled in

Stock Market Wizards, the third in Jack Schwager’s famous “Wizards” series
of books.

Walton trades in complete solitude,
with not even a secretary to help him manage a $150 million fund. Is this
lone-wolf machismo? Quite the contrary. In his interview with Schwager, Walton
said: “I found that having another opinion in the office was very destabilizing.
My problem is that I am very impressionable. If I have someone working for me
every day, he may as well be running the money because I’m no longer making my
own decisions.”

In contrast, Cohen requires a team
approach. He told Schwager: “I’m not a lone wolf. Many traders like to fight
their own battles. I prefer to get a lot of support. The main reason I am as
successful as I am is that I’ve built an incredible team.”

Each Wizard has evolved to reinforce
his psychological strengths and minimize his psychological weaknesses.

One of the most insightful interviews
that I ever read was with trend-follower Ed Seykota in Schwager’s first

Market Wizards. Seykota is one of those people who are so perceptive that
it’s scary! I’ll never forget his quote: “Win or lose, everybody gets what they
want out of the market.”

When I began trading, I consciously
desired profits, of course. But on a deeper level, the trading action itself
gave me my immediate pleasure. So on a subconscious level, I got what I wanted
from the market, even though I was losing money! It was only after I recognized
this fact that I developed the emotional control needed to carry out a rational
trading plan. I still love to trade. I still enjoy the action. But I have
subordinated those pleasures to the goal of making money.

At that point, I ceased shooting from
the hip and became an ambush artist. I adopted and stuck by two rules:

1. Trade no stock that is not already
on my watchlist. If I discovered a stock breaking out during the trading day, I
might analyze it to develop an idea of current market conditions and strength,
but I would not trade it. I also would ask why I had missed the stock in my
afterhours research. Sure, I’ll miss out on some great winners, but I’ll avoid
even more losers. This discipline has upgraded the overall quality of the stocks
that I do trade while curbing my risk to capital.

2. No idea qualifies for my watchlist
without passing a thorough review conducted outside normal trading hours.
It’s not just a matter of giving myself the time to conduct thorough research. I
want my mind as free as possible from the pressures and distractions of the
trading session. My watchlist work includes fundamental analysis, analysis of
daily and weekly charts, careful week-by-week inspection of the
accumulation-distribution picture, a check for upcoming splits (which can
produce excess supply), comparison to group brethren and comparison with all my
other ideas. This last hoop forces me to allow only the very best names into the
watchlist. Many times a stock will meet my minimum criteria, but I will still
reject it if it appears distinctly inferior to the other names on my watchlist.
I want only the very best merchandise on my watchlist at any point in time.

Aligning your emotions with your
trading rules is not limited to overcoming bad habits. I also draw on my
aversion to risk and my pride in my craft to reinforce good habits.

To quote Seykota: “One of the best
ways to increase profits is to do goal setting and visualizations in order to
align the conscious and subconscious with making profits.”

In my case, I now feel “right” only about only those stocks that made it
through my watchlist vetting. When I happen to see an attractive-looking
breakout that I have not yet researched, I imagine the danger of the unknown
lurking behind that stock. I practice the same emotional alignment when I sell a
stock for a small loss. I mentally reward myself for playing good defense. Don’t
limit your positive emotional reinforcement to profitable trades! Mentally
congratulate yourself whenever you enforce sound trading rules.

Here are 10 rules that I believe will
improve your self-discipline:

1. Always cut losses small. Never
cheat on a stop. This not only protects you financially. It also protects you
psychologically. Nothing can shatter a trader’s nerve like severe losses.

2. Be aware that in almost all its
aspects, human emotions run contrary to successful trading. Fear, greed, hunger
for action, anger with the market and mood swings are all inimical to profitable
trading and risk management. During a recent informal discussion among
TradingMarkets contributors on psychology, Len Yates expressed the view that the
only human emotion conducive to successful trading is the desire to win.

3. Know thyself. While you cannot
become an unemotional human being, you can practice mindfulness, which is to
say, awareness of your emotional states, of your thoughts, of everything
entering your mind. Then you will be better equipped to prevent your mental
state from influencing your trading. Keep a trading diary of your market
observations and reasons for entering trades. When you conduct your postmortem
analysis of losing trades and you spot errors in judgment, ask yourself, what
was behind the lapse? Did you get greedy? Did a desire for action lead you to
making a hasty, ill-considered decision? Did you allow something in your
personal life to distract you? Did arrogance, born of a string of successful
trades, blind you to sell signals? Did discouragement, born of a string of
losing trades, paralyze your ability to act on buy signals? Mindfulness is not a
one-time accomplishment. It is a lifelong practice.

4. You can and should watch the market
for ideas during the trading day, but defer the heavy research on those ideas
until after the close. Prepare all aspects of your trading plan — watchlist
composition and stock selection, position size, entry and exit points — outside
normal trading hours. Leave as little to improvisation as humanly possible. When
a watchlist stock or account holding sends an entry or exit signal, there is no
“decision” to make. You instantly and robotically execute your plan.

5. Never project your emotions onto
the market. If a stock stops you out, then resets and breaks out again,
re-enter. Don’t allow the previous trade to color your view of the same stock.
The only thing that matters is whether the new setup appears valid.

6. Never, ever double up in an effort
to come back from a losing trade. Amateurs fall prey to “gambler’s fallacy,” the
misguided notion that the next trade is more likely to succeed because the prior
trade failed. Doubling up on your losers is a sure-fire way to the poor house.
This kind of behavior, incidentally, is how a 28-year-old investment officer
named Nick Leeson racked up losses of $1.3 billion in the derivatives market and
brought about the collapse of Britain’s Barings Bank in 1995.

7. Pare back your trading around major
lifetime events. (I learned this one from Dave Landry.) Episodes of euphoria or
great hardship — divorce, the birth or adoption of a child, the death of a
loved one — all can shift your emotional balance in ways that can distort your
perception and acuity.

8. Hold your theoretical risk per
trade — the total amount of money you are willing to risk on a single trade
before executing your stop — to a fixed percentage, probably no more than 2% of
your total account size. This is a matter of psychological risk management as
well as financial risk management. You will not make balanced decisions under
market pressure if you take on more risk than you can stomach. For example,
let’s say your account is worth $500,000 and you set your stop 8% below your
entry price. You decide to limit your risk to 2% of your account. Your maximum
loss in any stock would be $10,000 (.02 X $500,000) and your maximum position
size would be $125,000 ($10,000/.08). Set that fixed percentage at a level where
you feel comfortable with the risk level while still being able to gain
materially from a favorable trade.

9. In the morning, your first
assignment is to establish mental clarity and balance before diving into your
pre-market research in preparation for the bell. Some traders just go into a
clear, distraction-free state as soon as they sit down to business. If you’re in
that category, great. If you face a lot of distractions or demands in the
morning, start your day earlier to find some time to yourself. You’ll probably
find this practice enhances your mental performance through the rest of the day.
A quiet breakfast. A morning walk. Jogging. Meditation. Whatever puts you in the
best possible space for the remainder of the day.

10. Mental clarity and balance are as
much a result of brain chemistry and metabolism as they are of logical thinking.
Incorporate regular exercise and proper nutrition into your life.

What the mind does, that it experiences as truth.

The Yoga Vasistha