Your Personality & Successful Trading
Windsor Advisory Services
DESTRUCTIVE
EMOTIONS & THE
MARKETS
“Money alone sets all the world in
motion.”
Pubilius Syrus Maxims
1st century BC
Most people dream of being totally
independent and self-suf.cient .nancially.
These people spend millions of pounds on
lottery tickets, hoping to be the lucky one
to scoop the jackpot. There is another way
to make a million, the highly leveraged
futures markets. Everyone has heard
stories of investors turning small stakes
into vast fortunes, and it is this chance that
attracts traders to open futures accounts
and dream, just like the lottery ticket
buyers, of receiving the big payout. The
reality of futures trading is different; the
pro.ts always seem to be elusive so each
time the trader trades he suffers consistent
losses rather than consistent pro.ts.
Trading looks deceptively simple, yet few
succeed. If you read interviews with
the great traders, you will perhaps be
quite surprised to learn that very few are
intellectuals, many have never been to
college, and a considerable number even
dropped out of school. Additionally, most
will claim they have simple trading systems
that almost anyone can understand.
So what separates winners from losers?
The answer is not just knowledge of
the trading environment, but also an
understanding of our personality make-up
and how it needs to interact with the
market in order for the trader to emerge
with consistent pro.ts. In the following
pages you will learn why an understanding
of our own personality is the key to
successful trading, and how the emotions
of greed, fear, pride and hope are fatal to
trading success.
“A cloud does not know why it moves in
such a direction at such speed, it just feels
a compulsion that this is the place to go
now. By the sky knows the reasons and
patterns behind the movements, and you’ll
know too if you lift yourself high enough
to see beyond the horizon.”
Richard Bach - Illusions
Take any price of any commodity and
you will notice trends over a sustained
period of time, where the price moves in a
speci.c direction for a sustained period of
time. Many analysts believe that prices are
random and that trying to predict future
price movement is futile and doomed to
failure. However, behind the seemingly
chaotic price movements there is order.
In the following pages I will give you an
insight into how and why price movements
occur and how, over a period of time, you
can capitalise on these moves and how
you can trade with the odds of success
being .rmly in your favour.
SELF CONTROL & DISCIPLINE
“To the destructive element submit
yourself.”
J. Conrad
Successful trading is 80% psychological
and 20% methodical. As I have already
said, self-knowledge is the key to market
success. A trading method by itself, no
matter how well thought out, cannot be
successful if it is not applied in the correct
manner. It is in the application of a
trading method that many traders end up
losing. Consider the analogy of a high
performance-racing car. No matter how
aerodynamic or technically advanced, it
needs to be driven. An advanced piece
of engineering such as racing car needs
to be driven by a person who can drive it
with care. Just as a disciplined driver is
needed to race a car, a disciplined trader
is needed to apply a trading method. All
traders have heard the word “discipline”,
but few really understand what it is and
why it is so important to develop it.
EMOTIONS AT WORK
“When dealing with people, let us
remember that we are not dealing with
creatures of logic. We are dealing with
creatures of emotion, creatures bursting
with prejudices and motivated by price
and vanity.”
Dale Carnegie
Intelligence, knowledge and talent have to
be applied. Any person who is successful
knows that application requires discipline,
self-control and con.dence in one’s
abilities. Bjorn Borg was a great tennis
player, he had talent. However, what
always gave him the edge when playing
was his mental control, which earned him
the nickname “Iceman”. He combined
talent and discipline to achieve his success
and you must do the same.
We are all put in situations where, after
they have occurred, we look back and
feel that if only our emotional control
had been better. You are going for a
job interview and role-play Th a friend
beforehand. You come over as assertive
and con.dent. In the interview itself,
however, the con.dence goes. You practise
a best man’s speech, it .ows well and
sounds great; however, on the day, delivery
suffers as you feel nervous and shy.
All the above we can associate with.
The fact of the matter is, when the
pressure is on, our actions are in.uenced
by our emotions. The more important the
scenarios, the greater the in.uence will
be.
Trading is no different. As soon as money
is committed, logic can go out of the
window and basic emotions take over.
Consider the difference between paper
trading and trading real time. Whilst paper
trading, you earn very good pro.ts, you
are con.dent and optimistic. You see a
very lucrative business opportunity, so you
now decide to open an account and trade
for real.
On studying your charts you see an
opportunity, a perfect double bottom and
prices low in historical terms, now is the
time to buy. You ring your broker to place
the trade; however, the overwhelming
con.dence of paper trading has now
deserted you. Perhaps you had better
double-check the formation. After much
deliberation you decide to phone the broker
and the trade enters the market. For
the next two days prices rise dramatically,
your pro.ts grow; you feel great, what an
easy way to make a living. The next day
prices drop and your pro.ts are cut in half.
You feel uncertain; perhaps you should
take the pro.t now before it gets away.
You decide to wait. The next day prices fall
further and close below your mental stop
loss. Your system is telling you that you
should be cut. However, you only have a
small loss and it should turn around and
you will soon be back in pro.t. The next
day, to your horror, prices have collapsed
and the majority of your equity is now lost.
Your reaction is now one of anger, why
didn’t you bank the pro.t when you had it!
The market’s move is totally illogical, you
feel anger, pain and frustration, you are
now totally disillusioned and fed up, and
all you want to do is exit the trade.
Welcome to the real world of trading!
“Seeing is believing, but feeling is the
truth.”
Thomas Fuller
The above is a hypothetical yet common
example of how traders who have made
money on paper suddenly crumble under
the strain of real trading. Many people
deride paper trading and say it is of little
use. However, providing you know the
pitfalls in advance, it is a great way to
mentally prepare yourself for the day you
have to trade real money.
“The mainstay of training her is con.dence.
That’s why we show them how to let a tank
run over them -it gets their con.dence
up.”
Of.cer in Charge
US Special Operations Command
Of course nothing will take the place of the
real trading arena; however, practicing the
basics on paper is a very useful exercise.
To ridicule paper trading is similar to saying
soldiers should not go on manoeuvres
because the bullets are not for real! In
conclusion, paper trading is useful if we
adopt the right attitude to it, (i.e. we make
it as realistic as possible and we don’t
cheat).
Going back to our hypothetical example,
it is clear that the trader was making
investment decisions based upon his
emotions rather than logic. No matter
how good the trading system was that he
used, he would still fail due to his lack of
discipline and self-control. This is not to
imply that you can trade any system with
discipline and be successful; however, a
disciplined trader with a mediocre trading
system has the edge on the best trading
system in the world if its operator lacks
discipline.
To develop discipline you need to acquire
total con.dence in your abilities, i.e.
acquire self-control. You can do this by
acquiring knowledge, practicing on paper
and real time trading experience. Nothing
replaces real time trading, but preparation
in terms of understanding the markets and
how you should relate to them will give
you a distinct edge in the quest for the big
pro.ts.
CHARACTERISTICS OF THE
MARKETS
The unique world of trading futures is
one that encourages traders to reject
objectivity and logic in favour of the basic
human emotions of greed, fear, hope and
pride, with disastrous consequences. Let’s
take a closer look at the markets and the
psychological problems they create.
Operating in an unstructured environment.
Trading requires you to operate in an
environment with few rules and little
structure. Most people need order and
rules for guidance, it is the way their
lives have been structured since childhood.
Man is brought up in a society that is
held together by rules and laws that are
imposed by an external authority.
Society is structured, and it is its de.nitive
structure that makes people feel
comfortable. Laws and rules are perceived
as protection when our security and well
being are threatened. We can, for instance,
go to the police or Courts to look into and
act on our grievances.
In contrast, the trading environment has
no clearly de.ned rules and no structure.
It would be, in society terms, total anarchy.
The market moves where it wants,
whenever it wants. The society of trading
has no governing body that makes or
enforces rules; there is no judicial body to
appeal to should the investor feel prices
are not moving in the right direction. This
anarchy can be extremely unsettling for
investors if they think prices should go
up and they actually decline. There is
absolutely nothing we can do about it. The
market does not care whether investors
make or lose money, it has no conscience,
and it is a natural phenomenon and never
has to justify its actions.
A harsh and hostile environment. Every
trader tries to take money from everyone
else. Everyone is trying to make money at
everyone else’s expense. It is a uniquely
harsh environment, everyone is against
you and you are against everyone else.
One analyst compares it to a medieval
battle - a man used to go to the battle.eld
and hill his adversary while his opponent
tried to do the same to him. The winner
took the loser’s weapons, his chattels and
sold his wife and children into slavery.
Today traders to battle on the Exchanges
instead of on the .eld. When you take
money away from a trader, it is not that
different from drawing blood, he may
los his home, his chattels, and his wife
and children may also suffer. Is this
description a bit exaggerated? Perhaps;
however, there is no denying how hostile
the trading environment feels when you
trade in it, to stand alone can be, and is,
uncomfortable.
Confronting your inner self. Standing
alone is uncomfortable because it makes
people do one thing that most feel uneasy
about, which is taking responsibility for
one’s actions. Most people like to delegate
responsibility, blame others and make
excuses when they don’t succeed. Most
people simply cannot face the simple truth
that they are responsible totally for the
consequences of their actions. A person
can go for a job interview and convince
himself that he did not get the job due
to a personality clash with the interviewer.
A lawyer can drink too much before an
important case and convince himself he lost
because the Jury was biased, a salesman
can convince himself that it was his product
that was not up to scratch and not his
presentation.
The trader, however, has nowhere to hide
when interacting with the market. He is
really competing against himself, and the
market will judge every day how well he
is doing. This confrontation with our own
personality, our strengths and weaknesses
graphically exposes, is something most
people would rather avoid.
The work ethic does not apply. The normal
work ethic of time, effort and reward that
is common in most job situations does
not apply in the markets. For example,
a factory worker putting in overtime and
working extra hours is rewarded with more
money. As a general rule, the greater the
effort we put in, the greater the reward
we expect. However, no such work ethic
exists with the markets. A trader can
spend years creating a trading system,
only to see his equity wiped out in a matter
of days. A trader, however, may quickly
develop a simple system and reap huge
pro.ts. Whether we acknowledge it or
not, we normally believe that we deserve
money under certain conditions where
we have to expend a certain amount of
effort to get our reward. For example,
an investor sitting on a big pro.t feels he
does not deserve it, and therefore tries to
snatch it. When a trader loses, he feels
that his input in terms of effort means
he deserves a reward and he holds his
loss. His subconscious mind constantly
equates time and effort with reward, and
this affects his objective judgment.
There is unlimited pro.t and loss potential.
This is the one characteristic that brings out
the worst emotions in traders and causes
them to lose. They simply cannot cope
with the unlimitedness of the markets’
movements. This “unlimitedness” and
the massive leverage available causes
traders to create risk by their emotional
desire to avoid it. This may sound
illogical until we examine how an investor’s
emotions interact with his perception of
risk reward.
Consider the following: If making money
is important to you, as it is to most people,
you will have dif.culty taking a small loss.
If you bear in mind a trader’s self esteem
and the fact that money is on the line, you
will appreciate the psychological turmoil
this can cause. Pro.ts, on the other hand,
are just as dif.cult to cope with. When
a large pro.t occurs, he gets excited, and
the bigger the pro.t becomes the harder it
is to resist the temptation to take it now.
However, pro.ts need to be run to cover
inevitable losses. In their efforts to avoid
risk, investors actually end up creating it.
Consider the following psychological test:
A group of people are given the following
choice over a number of trades:
A 75% chance to win $1,000 with a 25%
chance of getting nothing, or a sure $700.
Four out of .ve subjects take the second
choice, even after it is explained to them
that the .rst choice leads to a $750 gain
over time.
Another test gives people the following
option; a sure loss of $700 or a 75%
chance of losing 1,000 and a 25% chance
of losing nothing. Three out of four took
the second choice, condemning them to
lose 50 more than they have to. So, in
trying to avoid risk, investors create it.
Emotion causes most traders to act in a
way that will lead to their ultimate demise.
They prefer a sure gain, however small,
to a logically based speculation to seek
a large pro.t. On the other hand, they
actually seek risk in the realms of losses.
They let losses run to avoid taking a
small loss and, by doing so, they create
greater risk for themselves. They expose
themselves to bigger losses when they
could have had a certain small loss.
THE PARTICIPANTS
Wall Street, the famous .nancial area of
New York, is named after a wall built in
Manhattan in the early settlement days,
to stop animals wandering. Today the
farming connection lives on in the language
of the brokers; namely bulls, bears, hogs
and sheep.
Bulls are buyers: a bull .ghts by striking
upwards with his horns. A bear, on the
other hand, .ghts by striking with his
paws. Bulls look up, bears look down,
and the price is a constant .ght between
the two. So, who are the hogs and
sheep? These are the majority of investors
trampled underfoot. A hog is greedy and
takes positions that are too large and is
wiped out by small, adverse moves, or
holds pro.ts for too long in the hope that
prices will go on for ever. Sheep are
passive and fearful followers of the media,
gurus, brokers and friends. They bleat
at everyone when they lose, and cannot
accept they were responsible.
The farming analogy is very close to what
happens in reality. Only strong bulls and
bears make money. The crowd-following
characteristics of the sheep, combined with
the greed of the hog, characterises most
losing traders in the market.
DESTRUCTIVE EMOTIONS
There are four that are really important in
investing, greed, fear, hope and pride.
Greed Greedy investors tend to be overcon
.dent and want to make as much
money as they can in a short period of
time. They want big pro.ts and they
want them now. The desire to make
money, however, is in many instances
unrealistic. If, for example, I gave you a
small vegetable patch and told you to feed
your family from it, you would probably
think about it logically and deduce that you
had insuf.cient resources at your disposal
to achieve the aim. Contrast this with the
amount of people I speak to who want
to invest $5,000 in a commodity account,
and earn a living from it and retire from
their job. The chance of achieving their
desire is almost nil, but over con.dence
and desire overcome logic and objective
thinking.
Fear All people fear losing money,
worrisome news in relation to their
investments and savings stimulates more
fear. Fear then spreads; a fearful man’s
psychology is contagious. If people around
us are fearful, so are we. If we have
suffered fear in the past, we retain all
our past experiences in our subconscious
mind. Finally we have the fear of losing.
Also, if we see other people making money,
we want to be in on the action as well.
Hope This is de.ned as the expectation of
something desired. However, investment
decision making should not be based purely
on desire, but on a rational assessment of
the facts. When a trader loses he hopes
that things will get better when he really
should be being objective.
If you read the great traders, you will
constantly see them refer to Hope and
Fear and their destructive power.
“Hope and fear: I have written about this
often in my books, and I feel I cannot
repeat it too often. The average man or
woman buys commodities because they
hope they will go up or because somebody
advises them they will go up. This is
the most dangerous thing to do, never
trade on hope. Hope wrecks more people
than anything else. Face the facts and
when you trade, trade on facts, eliminating
hope.”
“Fear causes many losses. People sell out
because they fear commodities are going
lower, but they often wait until the decline
has run its course and sell near the bottom
… never make a trade on fear.”
W.D. Gann
“The successful trader has to .ght … two
deep-seated instincts, instead of hoping
he must fear, instead of fearing he must
hope. He must fear that his loss may
develop into a much bigger loss, and hope
that his pro.t may become a big pro.t.
It is absolutely wrong to gamble in stocks
the way the average man does.”
“The speculator’s chief enemies are always
boring from within. It is inseparable from
human nature to hope and to fear.”
Jesse Livermore
After greed the average speculator, to
achieve his desire, falls victim to both hope
and fear and ultimately loses his money
PRIDE
“Price of opinion has been responsible for
the downfall of more men on Wall Street
than any other factor.”
Charles Dow
Pride of opinion is a characteristic of losing
traders that have not been able to see
their inner selves; they do not know their
own strengths and weaknesses. They
do not understand themselves and their
emotions. Pride is simply stubbornness
and the inability to admit a mistake. Any
trader who insists on holding a viewpoint
in total contradiction to what is actually
going on around him for no other reason
that he cannot admit he is wrong, will meet
the .nancial disaster. Price can be a direct
re.ection of the preceding emotions.
The market is all-powerful, it moves
regardless of any man. You can do nothing
to in.uence where it is going and you
cannot control its behaviour. When you
compete in the market only you can be
wrong, and it can never be the other way
around. Although the market is a harsh
environment and does not care about your
welfare, it is not, as many losing traders
think, out to punish you.
Consider an analogy with the sea. A sailor
cannot control the sea but he can control
himself, and in doing so he can earn a
reward. A skilled mariner knows that the
ocean needs to be respected, but he does
not fear it. He develops skills and discipline
to help him bene.t from it. By using
his acquired skills, no matter what the
weather, the sailor is con.dent of getting
into port without harm, and earning his
living. An ocean is like the markets, it can
make a man money or he can drown in it,
the choice is there for each individual.
Just as mariners follow rules to navigate
from A to B, so must a trader follow rules
to keep him from being sidetracked. The
rules that I will outline are not new and they
are not original. They will, however, help
you reach your goal of consistent pro.ts.
If you do not have rules and guideline
you will fall victim to outside in.uences
and be in.uenced by your emotions, your
objectivity will be lost and so too will your
money.
THE SECRET OF THE GAMBONI
The secret of the Gamboni is the secret
of how to survive in the .nancial markets.
Understand it … really understand it … and
you are on your way to success as a trader,
speculator, or investor. So, here it is.
Joe was a card player, a good one. He was
so good, in fact, that he had to move from
city to city and .nd games where he wasn’t
known in order to play for high stakes.
One afternoon, in a bar in the suburbs of
Chicago, he’s shooting the breeze with the
bartender and asks, “Say, where can I .nd
a good card game around here?”
“What kind of stakes are you talking
about?”
“Big,” Joe says, “the biggest game you
know about.”
“Well now, I hear there’s a game out in
the farm country. It’s a bit of a drive,
but these particular farmers play for big
money. Let me make a call and see if it’s
OK.”
So the bartender makes the call, and then
gives Joe directions to the game.
That evening, after a long drive, Joe
pulls up to this barn in the middle of
nowhere. Tentatively, he walks inside,
tiptoeing around the fetid piles on the
.oor. At the back of the barn, he spots a
partially open door, with light and smoke
pouring through the opening. The familiar
rush of anticipation and energy sweeps
through him as he enters the room and
introduces himself.
Farmers in overalls sit around the table,
chewing cigars and puf.ng their pipes. In
a quick glance, Joe estimates the current
pot to be about $40,000 -perfect. So
he sits down. “Ante up,” says the farmer
holding the deck of cards. And Joe begins
to play.
About an hour later, Joe is holding is own.
He is about even when he draws three
aces and two queens - a full house. With
a large pot already on the table, he raises
$15,000. The next two guys fold, but the
leather-faced farmer across the table calls
him and raises another $15,000, without
so much as batting an eye. Joe, certain
that the guy us bluf.ng, calls the bet and
lays down his aces-high full house. The
farmer lays down junk: three clubs and
two diamonds of mixed numbered cards.
Joe, suppressing a smile, starts to rake in
the pot.
“Wait just a darn minute,” says the farmer,
a stern and reprimanding tone in his
voice.
2Whattaya mean, wait a minute,” says
Joe, “you got nothin.”
“Take a look at the sign over your right
shoulder,” smiles the farmer.
Joe looks:
THREE CLUBS AND TWO DIAMONDS
CONSTITUTE A GAMBONI, THE TOP
WINNING HAND IN THIS
ESTABLISHMENT.
Joe is really angry, but after all, rules are
rules, so he continues to play with what is
left of his holdings. About an hour later,
he draws three clubs and two diamonds …
a Gamboni! He bets everything, and on
the .nal round of betting with the same
leather-faced farmer, he has to throw in
his solid gold Rolex to make the call. The
farmer turns over his cards, a queen-high
spade .ush. Joe turns over his Gamboni
and starts to rake in the pot.
“Hold it there, fella,” says the farmer, his
grin cutting deep lines in his cheeks.
“But I got a Gamboni!” cries an exasperated
Joe.
“Sure ‘enough, but look at the sign over
there,” and he points over Joe’s left
shoulder.
Joe looks:
ONLY ONE GAMBONI WILL BE PERMITTED
PER NIGHT IN THIS ESTABLISHMENT.
Joe, broke but thankful for the invention
of credit cards, leaves the barn with dung
on his shoes, and the leather-faced farmer
drives his tractor home feeling the weight
of a solid gold Rolex on his wrist.
So the secret of the Gamboni is this: if you
want to win, you’ve got to know the rules;
and also, you can’t win if you’re not at the
table.”
Reprinted by permission of J. Wiley &
Sons. Excerpts from Trader Vic - Methods
of a Wall Street Master.
See enclosed reading list.
Any gambler will tell you that to make
money you need to keep the odds in your
favour, and the same is true in trading,
there are no certainties, only probabilities.
To win, you need to speculate when the
odds are in your favour, so succeed you
need to accurately predict and play the
odds. You need to know how to place your
bets to maximise your pro.ts and keep
your losses small. To do this you need
a disciplined trading plan. The following
rules, if followed, will help you keep the
odds in your favour, know and follow the
rules and you will succeed. If you break
any of the rules you will end up losing
money.
“Luck, continued the gambler re.ectively,
is a might queer thing. All you know about
it is it’s bound to change, and it’s .nding
out when it’s going to change that makes
you.”
Berte Harte - The Outcasts Of Poker Flat
We stated earlier that when we trade we
confront an unstructured environment and,
to operate effectively, we need to create
a structure for ourselves. The reason
we need rules is we need to combat the
destructive emotions referred to earlier
and give us discipline. Assuming you
have educated yourself and developed a
trading method, you will now need to
execute it with con.dence, entering and
exiting trades in a consistent manner.
Without rules your emotions will dictate
your decisions and lead you to .nancial
disaster.
HOW THE MARKETS REALLY
WORK
“It is remarkable that a science which
began with the consideration of games of
chance should become the most important
object of human knowledge … the most
important questions of life are for the most
part only problems of probability.”
Pierre Simon De La Place
Theorie Analystique Des Probabilities
Take a coin and toss it into the air. As the
coin spins in the air you have no idea and
cannot predict which way it is going to fall.
Yet over many tosses the outcome can
reasonably be predicted. Just as we can
predict the tosses of a coin with probability,
so too can we use probabilities to predict
market direction. When you trade you
need to trade with the probabilities and
odds in your favour.
In recent years many academics have
scoffed at the idea that markets can be
predicted and they point to the theory of
Random Walk. The theory is based on
the assumption that markets are ef.cient.
The market is one where a large number
of equally well informed people actively
compete to try and maximise pro.ts. In
such a market, at any time, the price
will re.ect all available information as
well as all events expected to occur in
the foreseeable future. The theory holds
that as all current and future events are
discounted, the individual’s chances of
over performing or under performing the
market as a whole are even, i.e. you can
never put the odds in your favour, and
therefore will not be able to earn consistent
pro.ts. If the theory is correct, our rules
and all our trading efforts will count for
nothing.
It is amazing this theory has become so
widespread and so many people believe it.
It is, however, completely incorrect as it
assumes that the decision-making process
conforms to scienti.c theory. It quite
clearly does not; the facts are there for
all to see. However, we all make personal
subjective judgements based upon our
knowledge, understanding and emotions.
Given the same information, we do not all
reach the same conclusions.
If we discount the Random Walk theory and
say that human behaviour is unpredictable,
then how can we put the odds in our
favour? The answer lies in probabilities
discussed earlier. To trade the markets
you need to trade to minimise risk, and
maximise gains. The way to do this is to
catch the trend. Take any chart over a
period of time and you will notice trends
and recurring patterns. If all humans think
differently, how and why do these patterns
emerge?
The answer can be found in the theory
of “chaos”, which postulates that certain
types of natural activity are chaotic except
in terms of probability. To give an example,
the heartbeat of a person can be charted
but given certain conditions, a heart will
go into random .brillation during which
time the heartbeat cannot be predicted
or modelled. Mathematically, weather
forecasting is another area where chaos
theory applies. The unpredictability of
weather forecasting comes from what
is called sensitivity to initial conditions.
Mathematical models fail in forecasting
because the slightest divergence between
simulated and actual conditions multiplies
in a complex chain of cause and effect
relationships, giving rise to results in the
model totally different than in nature. The
best meteorologists can do is to forecast
weather within the limits of probability.
While admitting that certain events in
nature don’t follow a perfect mathematical
order, chaos theory says that they can still
be understood, predicted and controlled. It
directly challenges Random Walk that there
is no way of predicting market movement.
There are no certain predictions but there
is order to the chaos, and forecasts can
be made on the basis of probability. To
understand probability in .nancial markets,
we need to look at the psychology of the
participants.
Why chaos theory is so
important.
“The organisation of the Universe demands
that matters abandon itself to the games
of chance.”
H. Reeves - Atoms of Science
The theory of chaos is not a theory to
help you make investment decisions, its
usefulness lies in the greater understanding
it gives us of the trading environment and
how we should cope with it.
1. It shows us how human psychology
in.uences price movement, why trends
occur, and how they can end up being
understood in terms of probability. The
herd mentality is fully explained in our
Special Situations Report available from the
of.ce. Human psychology has remained
constant over time, and it is this fact that
helps us predict the probability of price
movement via technical analysis.
2. It disproves Random Walk theory;
although market movements may appear
random, under statistical tests they are
not.
3. If it disproves that the markets are
random, it also shows why the quest for the
“Holy Grail” computerised or mechanical
trading system is doomed to failure. It
also confronts those disciples of such
analysts as Gann and Elliott who believe
the Universe is ruled by law.
4. It helps us to operate in an
unstructured environment by giving us a
greater understanding of it. The best you
can do is understand the original conditions
that give rise to probable future events,
and act accordingly. This may sound
disheartening, it is not. By understanding
chaos, you will be able to keep the odds
.rmly in your favour. If you can do that,
you will end up making a lot of money
from your trading, year in year out.
THE MADDING CROWD
“Whosoever be the individuals that
compose it, however like or unlike be
their make of life, their occupations, their
character, or their intelligence, the fact
that they have been transformed into a
crowd puts them in possession of a sort
of collective mind which makes them feel,
think and act in a manner quite different
from that in which each individual of them
would feel, think and act were he in a state
of isolation.”
Gustav Le Bon 1897
Chaos theory postulates that we can
make accurate predictions in terms of
probabilities and this is certainly true of
market behaviour. Although all investors
think differently, in the investment arena
people change in crowds. In crowd’s
investors, as a whole, react to their
emotions rather than their intellect, and
it is these basic instincts that can be
predicted and controlled by those investors
able to stand aside from the crown and
think in a rational manner.
Typically a bull market starts ina period of
uncertainty or fear. As more buyers enter
the market, prices rise and con.dence
appears. As prices rise, the more greed
and hope that prices will continue upwards
for the foreseeable future. After a period
everyone has bought, and there is no
one left to push prices higher, a small
number of investors exit the market, fear
emerges, and there is a mad scramble to
exit the market. This scenario to a greater
or lesser degree occurs in all investment
markets.
1. Human nature in investment markets
on mass is constant and repetitive over
time.
2. Investors tend to be followers, not
leaders, and this causes trends to
develop.
3. Investors tend to generally exhibit
the basic emotions of greed, fear and hope
when making investment decisions.
4. The more bullish or bearish the
market becomes, the greater the
probability of a reversal.
Human nature has remained constant
for thousands of years, and although all
humans think differently, the in.uence of
the crowd allows ut to predict market
turning points and market trends with a
degree of accuracy. I have covered the
predictability of man’s investor behaviour
in greater detail in my “Special Situations”
essay, which should be read in association
with this work.
UNDERSTANDING OUR NATURE
“A man’s character is his fate”
Heralatus
What actually is man, why does he think
and act in the way that he does? What is
the relationship between mind and body?
What in.uences his behaviour? Since
the ancient Greeks de.ned Psyche as the
Goddess loved by Eros, philosophers have
produced numerous con.icting theories of
human nature.
In 1762 J.J. Rousseau wrote his famous test
“Emile”, which introduced a revolutionary
theory of childhood and human nature that
is still relevant today. Rousseau argued
that man’s nature was essentially good;
however, his nature was in.uenced and
corrupted by society. Rousseau believed
that a child’s mind was “Tabula Rosa” or
a clean slate when the child was born,
and it was at this stage that the child
has the potential within itself to develop
almost unlimited talents. The clean slate
has experiences and rules written upon
it as the child learns and develops. As
a child moves from birth to adulthood,
he effectively becomes a re.ection of his
experiences.
Rousseau’s theory is very idealistic and
perhaps naïve; however, he does pose
two very important questions. First, how
much of human behaviour is learned and
how much is genetic? Secondly, how
much in.uence does society have upon
us? There are undoubtedly instincts and
primary needs that we are born with,
and no two infants are exactly alike, i.e.
children have different responses to stress.
However, it is the environment that is
the major in.uence on our behaviour.
Children take on the attitudes, behaviour
and opinions of those around them. With
investment there is no doubt that all
aspects of investment behaviour can be
learned.
“It’s the psychosomatic form in which man
experiences his estimate of the bene.cial
or harmful relationships of some aspects
of reality to himself.”
De.nition of Emotion
As we have stated earlier, method and
knowledge by themselves are simply not
enough. If there is one crucial factor that
makes an investor a winner, it is emotional
discipline, which gives the will and ability
to execute knowledge. In order to acquire
it we need to look at our desire and
motivation, and how these two con.icting
emotions need to be reconciled in order
that we can trade successfully.
All of us, at certain times, lack motivation.
We may desire a whole host of different
goals, yet we lack that spark of motivation
to get us there. To ful.l our desires and
reach our goals, we need to channel our
desire through positive motivation.
Positive motivation is needed to get us to
our goals. Without it, all our knowledge
and desires are useless. Consider the
area of weight loss. You can go into
any bookshop and you will see countless
scienti.cally proven methods of losing
weight. Yet out of every 100 people who
start a course, only 10 succeed in losing
weight, and only 2 in 100 keep it off
for more than a year. The success rate
is less than futures trading! Ever seen
those step-by-step language courses -just
follow the tapes and in no time at all you
will be speaking your desired language
with .uency. Now everyone can learn
a language, yet the success rate here is
about the same as in the area of weight
loss.
“People who deal with stress believe that
an increase in the pain and strain must
happen before the pain will go away. Their
approach to stress and life is similar to
Nietzche’s statement ‘whatever does not
kill makes me stronger.”
Salvadore Madd
There are two fundamental emotions that
stand in the way of positive motivation.
The two emotions are the need to avoid
pain and the desire to achieve pleasure. In
order of importance, the need to avoid pain
dominates. If our desires remain unful.lled
we will, however, feel empty, depressed
and dissatis.ed. Our motivation to reach
our goals is continually undermined by
con.icting emotions.
To achieve our desires and feel ful.lled,
we need to suffer some pain. It is the
ability to see this pain in a positive way
that will help us reach and ful.l our desires
and give us happiness. In the case of
the language course, it is working with
boring repetitive material; with the diet it
is the pain of being deprived of food we
crave. If you think of the pain/pleasure
relationship in trading, you should consider
the fundamental rule of trading: cut your
losses and let your pro.ts run and you will
see why the majority of investors .nd it so
dif.cult.
Taking a loss, however small, is painful
and ego de.ating. It means an admission
of being wrong. Rather than take the
loss, people hold on and hope that it will
turn around and become pro.table, and
therefore pleasurable. In the world of
trading this very rarely happens -the
result is normally a bigger loss and greater
pain. Similarly, when we see a pro.t in the
market, the pleasure we derive from this
means that most investors take it before it
has the chance to turn around and cause
pain. To be successful, it is clear that one
needs to be able to positively accept short-
term pain to reach our ultimate goals and
desires.
“Let me tell you the secret that has led me
to my goal: my strength lies solely in my
tenacity.”
L. Pasteur
To achieve positive motivation you need
to set clear, long-term goals and motivate
yourself towards them. An acceptance of
short-term pain, therefore, is inevitable. If
you make a complete honest commitment
on what you want from life, why you
want it, and how you intend to ful.l your
desires and goals, this personal honesty
will release you from the pain/pleasure
paradox that most investors suffer from.
INVESTOR PROFILES
I have worked in several commodity
brokerages, introducing accounts, and now
write books and newsletters in addition
to running my own commodity brokerage.
I have probably introduced around 6,000
investors to trading over the years, and
have encountered a broad cross-section
of investors. In his book “Beyond the
Investors Quotient” J. Bernstein puts the
investors he has come across into
categories. I have done a similar exercise
below, and tried to put investors into six
main categories. They are not etched
in stone and some categories obviously
overlap.
The Universe is governed by law There
is a huge marketing campaign in futures
trading based around Holy Grail systems
that are able to accurately predict future
price movement based upon scienti.c law.
They normally claim fantastic results and
yet will only cost you a few hundred
dollars.
Many systems are based around investors
who are dead, and two of the most famous
are R. Prechter and W.D. Gann. These
two are promoted by a number of books,
courses and software companies as two of
the most successful investors of all time.
The fact that they are dead means that
they cannot answer some basic questions
like if they were so good at predicting
price movements, why did they not make
much money? The reality is, Prechter died
a pauper and W.D. Gann, who allegedly
amassed a $50 million fortune, had to
sell courses and books, as he could not
support his family by trading. When he
died, his estate was valued at a modest
$100,000. You will see all types of scienti.c
systems, many are based on astrology
-how accurate are they -probably as
accurate as your horoscope.
It amazes me how people fall for this
hype. Clients who fall for sure .re systems
vary from highly intelligent traders to
newcomers. Alas, they don’t last long,
normally the .rst couple of trades shatter
the illusion and it’s back to the reality of
working for a living. There are some good
mechanical systems around however. Just
like any good trader, they suffer periods of
drawdown.
The Educated Fool
Just like Jake Berstein, I have come across
this investor numerous times over the
years, highly intelligent, knowledgeable,
with a string of degrees and letters after
their name. The problem they encounter
is they feel the application of knowledge is
all that is needed to make money. They
create vastly complicated trading systems
that look great, and then totally collapse
in the market place. These people cannot
translate theory into practice. They have
no grasp of psychological aspects of trading
and normally have great problems
admitting their approach is wrong.
It’s everybody’s fault but mine This
person refused to take responsibility for
his trading decisions. If he makes a pro.t
he shouts how wonderful he is, and when
he loses he blames everyone from his
broker giving him bad advice, his wife and
even the market, which is acting illogically.
This investor is normally insecure, unable
to take responsibility, lacks con.dence,
and exhibits a lot of emotion in trading.
The Opinion or Advisory Service Junkie
This investor has found the secret of
investing. His logic is to get as many
advisory services as possible and wait for
them all to be looking at the same trade.
Several heads are better than one he
concludes. Once he has a trade that .ts
these criteria, he gains additional advice
from brokers and friends. This trader’s
logic is .awed in that if everyone is looking
at a trade to go in a speci.c direction, it
will normally go the other way. This trader
needs to study the theory of contrary
opinion. The old saying “if it’s obvious,
it’s obviously wrong” applies to his way of
picking trades.
The Action Man
This investor likes to trade all the time, he
loves the action. He will trade in and out
of the market continuously, rarely holding
positions for any great period of time.
This trader normally has a reasonable
understanding of market movements, but
rarely makes any money. He cuts his
pro.ts and eventually his losses and
commission charges erode his account. I
have seen traders like this trade for .ve
or six years every day, not making money,
yet still cheerfully trading.
The Inability To Pull The Trigger
This investor is one who has great dif.culty
in placing an order and there are far more
of them than you would probably think.
Sometimes traders have a problem making
the .rst trade, and this stems from a lack
of con.dence. They’re always agonising
over the perfect trade to so, and end up
doing nothing. It also happens after a
losing trade, con.dence that was there
goes. It’s like the skier at the top of
the hill who has had a bad fall and can’t
go down again. The problem is, if you
are afraid to go downhill, you can’t be a
skier. If you fear to trade, you should .nd
another profession.
So far the above traders fall into losing
categories, and represent the bulk, say,
90-95%. The other 5% are all different
individually, however, there are some
points they all have in common that are
outlined below.
SUCCESSFUL INVESTORS
Successful investors may use different
systems or approaches to the market, have
different educational backgrounds and be
of various ages. However, they would have
the following beliefs that enable them to
reap pro.ts from the markets:
1. Self-con.dence. This comes from
both knowledge of the markets and
self-knowledge of their strengths and
weaknesses. They effectively believe that
they will make pro.ts in advance. They
believe the game has been won before they
begin. If you are not self-con.dent in your
own ability, it is unlikely you will ever
become a successful trader.
2. Money itself is not important; this
allows them to emotionally detach
themselves from trading.
3. Losing money can and will occur,
and is acceptable to these investors.
4. Pro.ts will occur over a period of
time and these can be run to a signi.cantly
larger size than their losing trades.
5. These investors love and enjoy what
they are doing, and therefore have no
problem devoting regular time to trading.
6. Open-mindedness and adaptability.
Successful traders remain open-minded
and receptive to new ideas when it is
necessary. They .nd it easy to adapt and
change and they are not concerned with
admitting when they are wrong.
A well thought out and logical trading
method, combines with the above beliefs,
will give any trader an edge in the quest
for pro.ts.
BECOMING A DISCIPLINED
INVESTOR
“A key to self management is the capacity
for self-observation, it is not the same as
over-criticism … it is rather a consistent
monitoring of one’s performance from a
perspective signi.cantly detached to allow
accurate evaluation.”
A. Gar.eld
It is clear that knowledge of oneself is
just as important in trading as knowing
facts, economic theories, news or trading
methods. In the trading world, often
emotion reigns supreme, facts are ignored
and there is no wrong or right. The person
who has control of himself due to his
discipline and emotional self-control will
ultimately emerge from the battle.eld a
winner.
However, coming to terms with our
strengths, weaknesses and personal traits
is not easy. It is not easy to analyse
yourself objectively because you will
naturally have a subjective perspective.
When trying to understand yourself, you
must be willing to be totally honest with
yourself. This can be dif.cult and painful.
The person must have the ability to accept
the results of looking within. Most people,
however, .nd it dif.cult to admit they made
a mistake. Ask a room full of people how
many of them are happy admitting their
mistakes and you will see few, if any, hands
go up. Admitting mistakes, however, is a
positive not negative attribute in trading,
as it is in life. The world is full of people
who want to be right, but the reality is
everyone cannot be right all of the time.
“Learning is after all not whether we lose
the game, but how we lose and how we
have changed because of it, and what
we take away from it that we never had
before to apply to other situations’ losing
in a curious way is wining.”
Richard Bach
All of us have physical and mental
disabilities, which prevent us from
achieving all our goals and desires. No
one is perfect. It is possible, however, to
isolate and work on weaknesses. This is
similar to reviewing and working on your
trading method. You must understand the
strengths and weaknesses of the system
and try to improve it, but realise perfection
is impossible. Remember, in the .nal
analysis you have inherent weaknesses and
may not have all the required attributes
for trading, but neither does anyone else.
The more traits you possess, the greater
your advantage, but the more you work
at obtaining these traits, the better your
chances for success.
THE SECRET OF MARKET
SUCCESS
“For surely we are not … no simply
contending in order that my view or that
yours may prevail, but I presume that we
ought both of us to be .ghting for the
truth.”
Socrates
The aim of any investor is to make money
by correctly identifying and acting upon
the truth. The truth, however, is elusive,
as there is no scienti.c method to get
us to the truth. The truth is dif.cult to
see as it can be totally different to what
your emotions and natural instincts are
telling you. Furthermore, the fact that the
majority of people agree or disagree with
you has no relevance in the pursuit of the
truth.
To succeed in trading you need to
understand that there are no certainties,
only probabilities, and to seek the truth
you need to have a deep understanding
of yourself and the market you operate
in, and how you relate to it. You need to
stand-alone and, from your perception of
what is going on around you, decide what
the truth is.
I started this essay with a quote from Lao
Tzu, who founded the Chinese philosophy
of Taoism over 2,500 years ago. Many
of the beliefs of Taoism are relevant to
trading.
Trading is a re.ection of life. This is
why there are so many contradictory ideas
and shades of grey instead of black and
white answers. Just like life, trading is
unpredictable; people who believe that
there is a scienti.c law to investing that
can predict commodity price movements
are missing the point. Trying to reduce
everything to numbers if, in Lao Tzu’s
words, like trying to catch running water
in a bucket.
Many elements of Taoism hint at the
psychological course of events. This is
particularly relevant in trading. Tao in
English means “the way”. Tao is the
missing link in trading, it is effectively the
ability to see an event before it is de.nitely
known, that is the key. It is really the
intuitive ability to see and then to act.
In the world of Taoism you need the
ability to use both analytical and intuitive
skills. Relying on both right and left
hemispheres of the brain to process and
analyse information, this is the key to
identifying and acting upon the truth. Once
you have brought your thoughts to bear
on the facts of a situation, then you need
to let go. This is the incubation stage
where you are letting your thoughts go
where they may, without the in.uence of
anyone else. When you learn to think and
act in this manner, you will be surprised
how you see many situations the crowd
will never see.
Investors spend millions each year on “Holy
Grail” trading methods, books and tapes
that they believe will give them regular
and consistent pro.ts from the market,
with low drawdowns. These people will
never make money; in trading there are
no certainties, only probabilities, and a
trader must accept this if he is to make
money.
FINAL WORDS
A scorpion wants to cross a river, but he
can’t swim. He asks a frog, who can, if he
can hitch a ride on the frog’s back. “You’ll
sting me,” says the frog. “It would not
be in my interest to sting you,” says the
scorpion, “because then I would drown.”
The frog thinks about the scorpion’s logic,
.nds it impeccable, agrees to take the
scorpion on his back, and then braves
the waters. Halfway across the river, the
frog reels a burning spear in his side; the
scorpion has stung him after all. As they
sink beneath the waves, the frog cries out,
“Why did you sting me Mr Scorpion, for
now we both will die?” “I can’t help it,”
replies the scorpion, it’s in my nature.”
(From the movie “The Crying Game”
1992)
We are all human, and we all have emotions
that are inherent in our biological make-up,
we can’t rid ourselves of them. What we
can do is understand them, and try to
control them. If we don’t, our trading will
be doomed to failure.
Obviously there is limited space in this
essay to cover all the psychological aspects
of trading. I would, therefore, strongly
recommend you consult the enclosed
reading list for further information.
FURTHER READING
Some of the information enclosed has
been from direct experience. However, a
considerable in.uence on my trading has
come from the enclosed material.
Recommended:
1.
The Disciplined Trader
Mark Douglas
2.
The New Investors Quotient Jacob
Bernstein
These books cover all aspects of
psychological problems encountered in
trading and give clear guidance on how
to avoid the emotional traps that destroy
most traders’ equity. These two books
complement each other, and are essential
reading.
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