Topics covered in this chapter:
The most common beliefs in financial trading
What character traits arise from stubborn beliefs
Advice about how to trick your mind to overcome traps and pitfalls
In the first half of the Learning Center you could gain a vast understanding of why the market reacts and responds as it does. This was achieved by distilling the market down into several core principles. In the second half we then started connecting all the dots. One of the dots is the trader's profile.
Much has been written about what type of personality it takes to be a successful trader. It's a particularly difficult question because there is no definitive answer about what character traits compose a trader's profile. It is more about gaining awareness of your mental structure.
When our experts explain how they approach the market, chances are that a beginner can't grasp that information easily. It's not that they fail in transferring that information in the form of techniques or basic knowledge. It's just that when they try to transmit the essentials of how they trade, they fail to transfer to you, the listener, their mental structure. The way the expert thinks is probably not the same as the way a novice trader thinks. As a result, many people feel discouraged and abandon their education thinking they lack talent or intelligence. But that is far from true! Before we can teach you how a trader thinks, let's start by displaying the most common beliefs in trading.
It took three to five years for many of our experts to become good traders. Becoming an expert takes even longer. There are no magic formulas. What it takes is a sound working knowledge of the basics and an understanding of yourself.
It happens not only in trading but also across a wide range
of fields: in order to achieve excellence an amount of deliberate practice is required. The second and third part of the chapter will help you do just that: achieve excellence.
1. Stubborn Beliefs
The Holy Grail Metaphor
This metaphor has been used extensively in Western culture to refer to all sorts of significant quests for perfectionism, and even enlightenment and unity with the divine. Finding the Holy Grain in trading means to be freed from deprivation and losses once the secret about the market is revealed. Indeed, many traders believe there must be some kind of inherent order to the market which is only known by a few people. So their quest is to discover such people and ultimately gain access to that secret.
The belief in a methodology which is able to bank profits with little effort or investment is based, partly, on the Holy Grail quest.
An example: this cognitive bias
is very present in the widely-extended term “trading system”. The concept of “system” commonly used in the financial markets makes sense when talking about an automated trading
models. But when we are faced with a reality that is far from being purely mechanical and linear, the ideas carried by the notion of a system
may lead many people to search for a mechanical or systematic solution for their financial problems. If purely mechanical approaches could be easily translated into profits, rest assured no great theories would have been developed to study the markets.
The Philosophy Underlying Market Analysis
For the analyst and trader to interpret the action of the market and make a profit out of it, charts
were found to be the most satisfactory tools so far devised. The chart
will not transmit all the information behind price action, but rather it requires the trader to apply judgment and perspective in order to translate its mechanics into manageable information.
The methods of analysis that have been explained throughout the Learning Center are those which have been adopted by the traders' and analysts' community as being the most useful and relatively simple to understand. This happened because, for the most part, they rely on these basic principles: they are not meant to predict the market with a 100% certainty; and they need to be complemented with each other to be used effectively.
Despite these basic principles of market analysis, from a psychological point of view, many traders still want to understand all that happens in the markets. Topics like correlations between currency pairs, intermarket analysis, institutional order flow, are topics which always fascinate market followers. Not to speak about conspiracy theories which adorn the reality with a fictional and romantic flair in their intent to explain why certain things happen.
Right in the core of Technical Analysis we can find some theories (Dow Theory
, Elliott Wave
Theory, etc.) which are themselves attempts to explain market intricacies on a rational level. With Fundamental Analysis
it's not very different. For example, if one day the EUR/USD plunges over 400 pips
, the next day the financial media is filled with numerous explanations. The same explanations may not serve the next time the pair plunges 400 pips
, but it serves momentarily to satisfy the audience's need to know what is going on.
In trading, it really doesn't matter what causes the prices to move. The fact that prices move is all that counts. There is no method capable of accurately appraise the infinity of data affecting the markets: events, mass moods, individual realities in the form of necessities, hopes, fears and estimates all combine to generate supply and demand for a certain currency, which is ultimately what moves the exchange rates.
Did you know that bear
markets make technical analysis and market timing
more popular? Bob Prechter, Elliott Wave
Theorist, explains: "[There is a] connection between social-mood trends
and the shifting view of the validity of technical analysis. In 1982, after 16 years of sideways
markets (and four recessions
), the majority of interviewees on Financial News Network (FNN) were technicians. By the late 1990s, the vast majority of interviewees on CNBC were economists and money managers.
In the 1970s during a bear market, the Foundation for the Study of Cycles
, which was formed during bear
-market years in 1941, had a renaissance. In 1999, it folded, a victim of bull
market mood and the resulting disdain for cycle
[...]In the 1970s, the Merrill Lynch Market Analysis Department boasted a staff of 15 [analysts]. By the late 1990s it had slowly slipped to 1/3 its old size. [During] bull
market, investors poured their money into fully invested institutional structures rather than handle it themselves; after all, they have learned that the 'long run' is always upward, so who needs analysis and timing?
A very important and necessary step in becoming a consistently successful trader is to understand how psychology plays out in your own make-up and in the way the crowd reacts to changes in the markets. The reason for this is that a trader must realize that once he or she makes a trade, he or she is part of the crowd.
It is critical to realize just how important psychology is – not only your personal psychology but also the psychology of crowds.
Many experts postulate that outside factors such as economic data cannot change the mood of market participants and change a larger trend
. Instead, it's the mood of the crowd that changes first, for endogenous reasons, and in turn shapes trends
in the markets.
Technical analysts as well as neurophysicists are familiar with an increasing amount of evidence which supports the idea that patterns
in financial markets are not the result of rational thinking but of herd behaviors. According to neurophysics, this behavior lies in the most primitive parts of the brain: the limbic system. Once very useful for the survival of the species, the limbic bypasses the neocortex, leading the person to pure emotional responses.
When you watch price action, you are really watching waves of collective optimism and pessimism that unfold in a more or less predictable manner right before your eyes. One of the reasons why Technical Analysis is working exceptionally well nowadays is basically because markets are free floating
and very emotional in nature.
Indicators Reduce Reality
In order to interpret what we see on the charts
, we need to select the information we want. With the help of technology, we are able to make such a selection in the form of indicators so that we are able to easily process large amounts of information. If we were to try to calculate a Simple Moving Average
just by looking at an sequence of Close prices on a chart
, most of us would probably fail because our brain is not able to do it.
But the fact is that a moving average
is based on an idea that processing an average of the past array of data will help interpret the chart
. This means we first have to believe that such a processing of data is useful in order to build this type of indicator and effectively use it. It's OK to base
our decisions on indicators, but we should also be aware that each indicator is based on a belief. This awareness alone will start to change your way of understanding markets.
Another step into gaining awareness about this phenomenon is to realize that indicators are a mechanism designed to reduce and process the available information given in a chart
. Therefore, they are not representing the market reality as a whole, but only representing a part of it. Many traders fail to realize that the MACD
, RSI, or even an economic indicator
such as the Gross Domestic Product, are just attempts to represent market reality, but they are not reality in itself.
The same happens with the notions of support and resistance: they are often taken as if they were real phenomena rather than concepts representing the relationship between buyers and sellers. Tools such as trend lines, Fibonacci levels or Pivot Points do not exist anywhere except in the charts
. This might sound obvious, but assuming it already takes you one step closer to the mind of an expert trader.
Cognitive Bias in Trading
As we have been seeing, there are several beliefs, or biases, starting from the assumption that charts
are reliable because they are what we trade, not the market. These beliefs are also found in the illusion that a buy or sell signal generated by an indicator gives the trader some sort of control or increased knowledge of what is happening in the market.
System vendors know their audience is fascinated by this ability to enter the market following signals. This gives the trader a sense of control, to be executing the trade at the very moment the market is doing something determinant. Even if it doesn't work and it leads to a loss, at least the trader was in a fake state of control which he/she prefers rather than being left in a position
where decisions have to be made.
Remember the notion of “opportunity scanning” we mentioned as one of the main problems that mechanical backtesting
tries to defeat (see Chapter C01
) This is also a phenomenon based on a cognitive bias
: we don't look at charts
neutrally. When visually scanning a chart
we will intend to see what we want rather than what is. Since this acknowledgment is essential to derive our hypothesis, being aware of our bias
is crucial right from the start when we are developing a trading method.
If a trader's bias
says that the market moves by breaking out of previous high and low swings
, this trader will inevitably see only breakouts in the chart
, to the point that contradictory evidence will not be recognized. The common problem here is that, on the one hand, we need a trading concept in order to develop a trading system (see Chapter C01
), but, on the other hand, we totally ignore all evidence contradicting our concept.
Personifying The Market
When establishing your own personal view of the market you will define it in a way that makes sense to you. During this process, you may tend to view the market as just another person, an entity by itself. At some point this makes sense because, just like people who are creatures of habit, the market also apparently behaves following patterns
Personifying concepts used in the trading world leads to false myths and wrong associations. Joseph Trevisani, in this brilliant article, unveils some false myths around the market idea:
This sense of the decision making power of markets and of the ‘market’ as a living entity is reflected in the terms we use to describe the price action. We often say’ ‘the market reacted badly to the news’ or ‘the market took profit today’. We personify the market and its behavior. Of course we know that there is no “market” somewhere below the pavement on Wall Street
making the decisions for the stock exchange. But the common use of this ‘market’ shorthand tends to obscure what is the most important psychological point in understanding market behavior. Namely, that the ‘market’ is a picture of the thoughts of its participants, the market is a snapshot; it is a mass mind.
[...]The logic, analysis and fear that motivate market behavior have their source within the mind and psychology of market participants, that is, within each of its traders.
The fundamental analyst assumes causality between external events and market movements, a concept which is uncertain as these cause-effect chains are subject to changes. Besides, Fundamental Analysis almost always requires a forecast of the fundamental data itself before conclusions about the market are drawn. For example, the previous result of a certain piece of data is needed to estimated the result for the next release, and so on.
In Technical Analysis, the analyst doesn't have to forecast the indicators, but still there is the danger to fall into the belief that, for example, a RSI going above 70, being an indication of an overbought
market conditions, has to lead to a turn in the exchange rate
. As a consequence, people try to pick tops and bottoms guided by a deep ingrained belief that trends
can't be sustained for a long time.
On the opposite side of the causality bias
we see that traders, both those who rely on fundamentals
as well as technicians, are prone to fall into the belief that markets are random, meaning that anything can happen, including the least expected. The market may have characteristics of randomness, as it may have characteristics of causality, but that does not mean that it is random or ruled by cause-effect relationships. Humans show this tendency to treat reality as if everything were understandable and predictable and have a hard time dealing with uncertainty.
The danger of the randomness bias
is to underestimate the importance of a proper education. If markets can't be predicted anyway, then trading results will be dependent on luck rather than on skills- so why bother to control risk
, for example? Strange as it may sound, the belief in randomness has the same consequence as the belief in causality in the sense that when observing a trend
, the least expected - a market reversal
- is precisely what should happen. This brings people to try to pick tops and bottoms as well. The already mentioned gambler's fallacy is another consequence of this cognitive bias
(see Ralph Vince's experiment in Chapter C02
These biases can affect the trader during the phase of system development, during the testing phase and obviously during execution and trading.
Perfect Trading Conditions
There is a common belief the more we fine tune the system's rules, the better we will trade. If you have to line up ten conditions in order to generate an entry or an exit signal, you will do a lot of chart watching and less trading. Perfect trading conditions, like the ones you see in the trading manuals, rarely exist. That is why we have insisted many times throughout the Learning Center that summing edges is much better than summing indicators, which is redundant. Professionals understand that many indicators signal the same thing at nearly the same time. Moreover, a trader should accept the ambivalence when some indicators signal a buy and others a sell. Trading is about making decisions with imperfect information.
Your mental attitude has to change from a normal person to that of a speculator. With the exception of a few successful traders who really profit from trading in the market, most traders don't go further than learning the basic theory in perfection. But trading is a mind game and without having a right frame of mind, it is a losing game even before it starts.
What Can I do to Avoid The Search For The Perfect Trade?
We suggest that you understand the concept behind your trading system so well that you don't feel the need to change it, optimize it, add indicators or build a complicated theory explaining why it works. Besides, the more you understand the concept you are trading, the less you will need confirmation based on historical testing. That is surely a thing that many of you will be thankful for!
A very common belief, and one that should be avoided at all costs, is that success in one area of life automatically means success in another area in life. If you have been achieving a high performance in another professional area, it does not mean you can just waltz into the trading industry and success is going to welcome you with open arms.
The False Myth Of Discipline
Dr. Woody Johnson explains how discipline is seen as something self-imposed, rather than something that grows from a inner passion:
Another myth is one associated with self-discipline. To most people, self-discipline has to do with will power while saying, "I'm gonna make myself do it," or biting the bullet. Does this sound familiar? Well, the problem lies in the fact that these notions about self-discipline tax the system enormously and often lead to stress, burnout, or psychosomatic illness. With psychosomatic illness, the ailment is real - ulcers, severe headaches, backaches, depression
or major fatigue - but the cause can't be found. Obviously, this type of self-discipline is on par with the successful operation that kills the patient - the cure is worse than the ailment.
Identifying and accessing passion releases a chain reaction
, a magnificent obsession that rages deep inside. This is the self-discipline of being internally driven and attracted to your life which makes your heart sing. And when you find joy in what you do, you are going 'to play' instead of 'to work'.