Articles
Changing The Trader’s Mindset By Ronald M. Brandt
Reorienting a mindset for specific trading components requires understanding your current one, knowing what leads to trading success, identifying what needs to be changed, and developing a plan during trading activity. So how do you do it?
A trader’s profession requires a blend of training and experience from the fields of business, economics, mathematics, and psychology. What percentage comes from each discipline, however, is always a matter of debate. Some traders say that psychological factors can be removed by using rule-based mechanical systems with automated entry and exits. Some believe that combining discretion with mechanical signals provide the best results, while still others believe that trading is 100% psychological and that traders only trade their belief system about the markets and not the markets themselves.
WINNING VS. LOSING
But one thing that everyone can agree on is that succeeding as a trader is difficult. Statistics suggest that in the commodity futures and forex markets, 90% of everyone who try their hand at trading lose over the long term. But there are untold numbers of successful trading systems and methods that have proven to be winners. So why do so many traders lose money?
The key is how they trade. How people must think during trading is exactly the opposite of how they are conditioned to think in business and society. How a trader views his or her trading means everything in the realm of the financial markets! It is the difference between winning and losing.
Groundbreaking work has been achieved in the field of trading psychology, but little attention has been paid to the business paradigms and social norms that affect a trader. Here, I look at several critical ingredients in the recipe for successful trading and the kind of mindset change that must take place within the trader for him or her to succeed. The trading components evaluated are:
- Probability of reward and risk
- Expectation for trading outcomes
- Revenue management techniques to maximize trading income
- Memory and the use of historical trade data
- Fairness toward other market participants
- Hope and its role in preventing fear and greed
PROBABILITY THINKING
In business, probability thinking takes several forms including but not limited to:
- The odds of acquiring a new customer
- Attainable share of a defined market segment
- Risk adjustment of a financial forecast
In business, probability thinking is used to develop sales and market share projections, to forecast, and to risk-adjust revenues and expenses, and to evaluate projects. These probabilities can be very subjective because they are often developed using the judgment of subject matter experts who may have hidden biases and personal agendas. Testing the market acceptance of new concepts and products can be expensive and therefore limited (a sample size of one or two events is not uncommon). Usually, the measurement protocol (for example, market share estimations) must be redefined for every case, depending on function and goals. Experience and historical data may not be useful in predicting the future. Countless numbers of product launches have failed because the statistical results from small focus groups of potential customers did not shed light on important, unknown market variables. And many a brand manager has been embarrassed when results do not meet targets because faulty probabilities were applied to known market factors.
You must always think in probabilities over a series of events (trades). You can never take a single trade thinking that you must have a winner on that particular trade. For an individual trade, the resulting probability will either be zero percent or 100% when the trade is closed out. But over a series of trades, a finite probability, determined from a large sample of historical closed trades, provides a statistical basis for making trading decisions. The edge provided by your system is based solely on probabilities based on signals from a winning methodology. Thinking in probabilities requires that you take an attitude of not caring about the outcome of an individual trade and participate in many trades to achieve the desired outcome.
Why must a trader change his or her mindset? In business, probability thinking depends on function and is used to satisfy diverse needs. In society, probability thinking comes into play but indirectly, and in most activities thinking in terms of probabilities is irrelevant.
In trading, because of market uncertainty, probability thinking in the evaluation of reward/risk is essential to any trading strategy. In trading, the winning probability across a large sample of closed historical trades is coupled with the reward/risk ratio and position size to assess potential return. Trading success comes from having a strong belief that you will be able to win in the face of uncertain outcomes. But you are not entitled to win on any individual trade, no matter how high the probability of winning is with your system.
EXPECTATION
In business, management expects you to be successful in each of the sales calls you make, and they set goals against which results are measured. Failures are always considered learning exercises. If you do not have the objective of getting the business on every sales call, why make the call in the first place? Salespeople are taught to close by asking for the business each time. They are trained to think positively.
However, each sales call is one step in what may be a series of steps designed to convert the customer. The outcome of any one call is most likely dependent on what happened in a prior call; you cannot look at each call on a particular customer as an independent event. And success on future calls will depend on what happens on the current call.
Even a one-shot offer under a bid and tender is not an independent event. These “make it or break it” deals depend on prior relationship building activities with that customer and a series of presell activities. Once the customer awards the business, your expectation is either zero or 100%. If you have lost the business, there is no opportunity to improve on that negative outcome.
Human nature dictates there is always an expectation for any social event in which you participate. Going into most situations, you expect to gain some type of personal satisfaction. If the outcome of your participation gives you an unexpected negative feeling, it is unlikely you will participate again in the same type of event.
Trading is different: Your expectation must be neutral on each individual trade. In trading, expectation is the product of the probability of winning times the size of each win minus the probability of losing times the size of each loss over many occurrences (trades).
What happens next in a market is unpredictable and may defy rational explanation. Therefore, you must always operate on the assumption you don’t know what will happen next. Expectation only becomes meaningful when used over multiple, independent events. Traders know there should be no expectation for a positive (or negative) outcome on an individual trade. Yet they still hang onto a losing trade far too long, expecting a positive outcome for a trade that has gone awry.
Suggested Books and Courses About Psychology and Risk Management
Why is it important for a trader to change his or her mindset? The business and social conditioning we go through is unlike the conditioning needed to succeed as a trader. To trade successfully, you must change your mindset about the outcome. Expectation is only meaningful in relation to a long series of events (trades). Traders know this, but because of their real-world conditioning, they do not shift their mindset when entering the trading room.
The inability to treat each trade as an independent event and having biased expectations for the outcome of the next individual trade is one of the biggest reasons traders lose. Even if you have a methodology that wins 80% of the time, your expectation cannot be for a positive outcome on the next trade. Your expectation should be at best neutral until you exit at a profit.
REVENUE MANAGEMENT
Savvy top executives of American corporations know that maximizing long-term shareholder value cannot be accomplished by maximizing short-term sales and profits. Managing and controlling revenues and profits is a critical function. Too low and the consequences can be devastating to the stock price, but equally disastrous are revenues and profits that are too high for a given reporting period and cannot be sustained. Consistent and controlled sales growth is far better than maximum but sporadic sales growth, especially since Wall Street rewards consistency. Companies find ways to smooth sales and profit forecasts.
Taking profits too quickly and erratically will prevent you from being a successful trader in the long term; there should be no predefined endpoints in trading. You must let your winners ride in order to make a profit. Let your system define an endpoint for taking profits.
To do this, you must have an external system that you trust to give you a trading edge. You must accept signals from a trading system without questioning the validity of each signal. As long as you play by the margin rules, there are few, if any, external forces to protect you from trading to excess, and you should take advantage of that within the constraints of your trading methodologies.
To maximize profits, traders must not seek predictable, limited, and equal income from each trading period, nor should they put predefined limits on the money they will take out of a trade. Markets move from periods of low volatility to high back to low and from trends to sideways movements to trends again. Trades must be taken when the market type is in sync with the type of system(s) you are trading.
Do not expect to ever make consistent, predictable profits in your trading, because volatility can ebb and flow. Volatility and trend are the main factors governing your profits (assuming you are on the right side of the market). Too many traders develop trading plans that seek to make a fixed amount of money on a predictable basis. It simply does not work that way. For most trading systems, 80% of the profits are made on 20% of the trades, and time in trades varies significantly from one trading period to the next.
MEMORY
A collective corporate memory is required to build a successful business. A business cannot be a learning organization and succeed in its mission unless it builds on past successes and learns from prior failures. Traders must not think about the past or the future but always the present. You must remove yourself from specific memories of past trades, whether winners or losers. Only in this way can the trader be unbiased in following the market and apply the signals generated by his or her trading system.
Recollections of historical trades should only be kept as evidence (in a journaling process) of why a trade succeeded or failed. Remembering the emotionally tinged details of specific trades will only cloud your mind. In business, historical information is key in sustaining the organization as the business changes and employees come and go. In trading, its value is in the insights gained and their application to future trade management.
In business and society, conclusions may be drawn from a single event. But in trading, conclusions and insights should only be gleaned from analyzing a large number of occurrences. The value from analyzing the historical trade detail is in the insights that you can gather about market behavior and your own discipline.
FAIRNESS
Win/win negotiations are desirable in business, but a win/win scenario is a meaningless concept in trading, because it is neither possible nor desirable. Why? If everyone could win in the market, that would imply the market was predictable. If the markets were predictable, they would not be markets. If you have no market where there is a different perception of value among buyers and sellers, there is no opportunity to make any money. If you cannot make money, no one can be a winner and so you would have a situation that is not even win/lose. Trading is never win/win; by definition it must be “If I win, you lose,” or vice versa.
Unlike in business and society where you are dealing with individuals in your negotiations, in trading other market participants are unknown. Individually or collectively, they will manage their market positions with the intent to profit on their positions and destroy you in the process.
You must trust your system until proven wrong and not let the actions of the faceless crowd on the other side of the trade force you out too early or cut your profits short. For every winner in trading, there is a loser. You must enter a trade the way a soldier goes to battle: destroy or be destroyed. When you have this mindset, you will be less prone to mismanage your trades.
HOPE
Hope is the underlying basis for carrying out all business activity. It is a mindset of wishing for something with expectation of its fulfillment based on planning and execution of that plan (that is, a positive mental attitude). Executing a business strategy is based on hope because you desire that the business processes you develop will result in the desired sales and profits.
In life, hope is a powerful force of inspiration. It can often be a powerful mind force that leads to positive outcomes for individuals struggling with both physical and mental issues.
You must remove such an attitude when it comes to trading. “Hoping” the market does something is never a virtue; hope is a warning you are nearing the fear or greed zone. These zones are destructive to your trading. Hope leads to disaster in your trading because it can keep you from exiting a losing trade or prevent you from taking profits if it moves you too far toward greed. You must get rid of the feelings associated with hope by maintaining a neutral attitude with respect to the market.
For a trader, hope is a warning that fear or greed is imminent. And both fear and greed are destructive to the trader. Left unchecked it is a deadly force that will lead to ruin. How should a trader deal with the emotional force of “hope”? The best way is to have a trading method that sets stop-loss levels to prevent fear and sets take-profit levels to prevent greed. This is possible in both mechanical and discretionary methodologies with trial and error.
For some traders who use higher risk trading methodologies, however, a different, more subjective method will work just as well. This requires taking note of your body’s reactions to your emotions and taking appropriate actions to neutralize the negative ones. It’s best to be proactive in removing hope because waiting too long “hoping” for market action is like multiplying a negative outcome. With either approach, the trader must have a very different mindset. A comparison of the trader’s mindset can be seen in Figure 1.
FIGURE 1: THE TRADER’S MINDSET
CHANGING YOUR MINDSET
We have looked at several ingredients that are important to successful trading. Changing a mindset for specific trading components requires understanding your current mindset, knowing what mindset leads to trading success, identifying what needs to be changed, and developing a plan for reconditioning your mind for trading.
The process by which people must recondition themselves to be effective traders, regardless of their vocation or background, should be better understood. Other important questions arise as well. For example, what happens to a trader who changes his or her mindset when they reenter the real world? Can they switch gears easily, or have they been forever changed? That’s something to keep in mind as you approach the markets.
Ronald Brandt is a part-time trader and active investor based in Cincinnati, OH. He has held management positions in sales, marketing, finance and materials management including international assignments in Europe, the Middle East, and Africa. His focus is the forex and commodity futures markets.
