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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Most traders place their trading method at the base as the most important and substantialThe Complete FOREX Trader Psychology of Trading Ten years ago you would find, if you looked, perhaps one or two books written about the psychology of trading. Today there are nearly a dozen on the market. I think this is partly a function of the fact almost every that can be said about trading methods has been said. I say almost because I am constantly peppering my editor with proposals for more books! There is perhaps another reason. Traders are finally coming to the realization that a trading methodno matter how gooddoes not in itself lead to consistent success in the market. When you were a teenager, your mother or father probably accused you at one time or another of having an attitude. Traders have an attitude also, although probably not of the kind your parents meant. While trading methods are as varied and different as snowflakes, successful traders seem to share a set of attitude traits and money management techniques. In this chapter and Chapter 15, Money Management Made Simple, I will delineate and discuss these common traits and techniques. The Trading Pyramid As I have mentioned previously, there are three components to a trading program: trading method, money management, and psychology or attitude. The vast majority of traders spend almost all of their efforts effecting a trading method. Ninety percent of market books are still trading method tomes. In fact, most successful traders will tell you, of the three components, the trading method is the least important. You will be well advised to allocate significant thought and effort to attitude and money management. How much you order their relative importance determines your trading pyramid. Most traders place their trading method at the base as the most important and substantial. Money management is in the middle and psychology of trading gets little attention at the top. To my way of thinking money management is the base, then psychology, and a trading method as a finishing touch. An argument could be made that psychology of trading should be the base. Top traders share more attitude characteristics than anything else. Fear and Greed, Greed and Fear Fear and greed are the base emotions that drive every market. They are instinctive to humans and unless you use an automated computer program to trade, your goal can only be to control them and not to eliminate them. Since economic booms, busts and bubbles keep recurring, year after year, century after century, it is clear evolution isnt going to transfer the skills learned in one generation to another. People have short memories, and fear and greed keep returning; the dot.com bubble was followed by the real estate bubble in less than a decade. A hedge fund bubble may not be far behind. We tend to get greedy when we are making money and overstay our welcome; we tend to become fearful when we are losing and again overstay our welcome. These emotions cause us to mentally freeze and delay making critical decisions that would be in our own best, rational interest. One very successful trade may cause overconfidence and lead to what we call the King Kong Syndromethe warm feeling that we can do no wrong. A large losing trade can lead to enormous self-doubt, leading us to make revolutionary changes in our trading program when, in fact, a little time away from the market and a few evolutionary changes would put us back on track. The late Pete Rednor, office manager at Peavey and Company where I apprenticed as a commodity trader in the early 1970s, would wait for a trader to get the King Kong Syndrome. When the trader next placed an order, Pete would go to a telephone in the back office and place the identical orderbut in reverse. He usually won, and when the trader lost it all and stopped trading, Pete lamented the loss of a meal ticket. The key is containing the emotions of fear and greed within a relatively slight area. To do that, you must in turn be able to anticipate the onset of fear or greed, and find methods for controlling them before they impact trading decisions. Never be afraid of the markets but always respect them. Never be hesitant to simply walk away for a few hours or a few days. The markets wont go away; they are happy to wait for you to return. Never trade when you are emotionally distraught. Profiling Good records of your trading will help you build profiles you can review from time to time. Often a marked change in profiles will be a leading indicator of a bout of fear or greed. Monitor your trading results on a weekly basis. Look not only for how much money you are makingyou cant win them allbut look also to see the patterns in trade series that went well for you. Profit/Loss ratios, the currency pairs that worked the best for you, the types of marketstrading or tendingthat worked well. How often did you move a stop or profit objective? Know Thyself, the ages-old Socratic saying, is a traders watchword. Only you know which factors cause emotional unbalance, and which do not. The Attitude Heuristic In Chapter 13 I suggested a heuristic for your trading method. I like to keep a mental chart of my emotions. Imagine a graph going from 0 in the middle to 0 at the bottom and 10 at the bottom. (See Figure 14.2.) Greed is the top half; fear, the bottom half. Sure, it is exciting to make a trade. It is even more satisfying to close out a winner. And it is a disappointment to see a trade go bad. Dont expect your emotions to stay between 4 and 6; youre human. They will not. At least after tracking yourself for a few weeks you will know when you are in the danger zones, perhaps above 8 or below 2. Review these numbers vis-vis your performance. You will be surprised how much you learn and the ways you can benefit. If you can eliminate 1-out-of-3 losing trades youll almost certainly be successful in the long run. The line between winning and losing can be razor thin. Characteristics of Successful Traders No one has all these characteristics all of the time. But having known literally hundreds of traders, I can assure you that most of them share most of these characteristicsmost of the time. The characteristics of successful traders are: Successful traders tend to have control over their emotionsthey never get too elated over a win or too despondent over a loss. Successful traders do not think of prices as too high or too low. Prices are numbers; zeros are zeros whether there are three of them or seven of them. Successful traders dont get emotionally attached to a market or a trade. They dont anthropomorphize about the markets: Theyre going after stops now, or, The market is nervous, or The market must know something I dont. Just thinking in such terms is an error. The market isnt going, nervous, or seeing anything. Successful traders do not panic. They make evolutionary changes to their trading program, not revolutionary changes. Successful traders do not flinch at making a decision, pulling the trigger once everything has lined up for a trade. even if it is a hobby. under duress. trading. Successful traders treat trading as a business, not a hobby or game Successful traders stay physically fit. Successful traders do not trade when they are emotionally stressed or Successful traders hang up the DO NOT DISTURB sign when they are Successful traders come prepared for all eventualities on any given trading session. They come to work with a plan that includes many contingencies and not just for what they hope will happen. In your trading program you should have predetermined responses to the following, What happens if . . . situations: Prices open sharply higher or lower; the market is very quiet; the market is very volatile; the market makes new highs; the market makes new lows; the market opens higher and reverses; the market opens lower and reverses. Successful traders trade only with money they can afford to lose. Trading FOREX is speculation, not investment. It can be exciting, exhilarating and addictive. Being emotionally involved with the money at risk is a formula for losing if ever there was one. with others. Successful traders spend as much time on improving their attitude and money management as they do their trading method. Successful traders keep a low profile and dont discuss their trading Successful traders let the market do its thing and try to take advantage. Unsuccessful traders attempt to impose their will on the markets. Successful traders consistently review their trades. FOREX trading will greatly magnify any emotional or psychological hangups or concerns you bring to the table with you. Trading when not in top form is asking for financial injury in the same way driving drunk is asking for physical injury. Dismiss the importance of attitude at your own peril. More than any other factor, it is what separates the winners from the losers in FOREX and other trading arenas. Money Management Made Simple For the new trader, money management is the art and science of breaking even. That does not sound very exciting, does it? Not what you expected from the FOREX markets? I am reminded of the person who purchased a one-dollar lottery scratch ticket and won one dollar. I already had a dollar; if I wanted it I would have kept it! But the logic here is quite sound. Most new FOREX traders are shown the door quickly. They leave discouraged, never to return, and write pamphlets proclaiming The FOREX Big Scam! and such. Breaking EvenThe Belgian Dentist No, you do not enter a trade just to exit 30 seconds later. Breaking even is about managing your money and staying in the game. It is about thinking in terms of capital preservation and waiting for good trades to present themselves. My mentor, Charles B. Goodman, said it over and over: Youll make most of your money sitting on your hands. The longer you stay in the game, the more you will learn about it, and the more you will develop your skill set. The longer you stay in the game, the more likely a good trade will find you. If you lose your grubstake, it is over. Be conservative. Mr. Goodman preached the Belgian Dentist approach to money management. In Europe a Belgian Dentist is a term for an ultraconservative investor. Even a Belgian Dentist would buy this stock! Money management is not difficult to understand. Many new traders find money management rules impossible to live by and are usually the first to leave. Expectations Your trading method will tell you when to enter a market. Your money management program will tell you if you should. Money management is also vital to placing stop-loss orders to minimize risk and take-profit orders to capture gains. Do not expect to hit 80 percent winning trades with a 10:1 ratio of winnersto-losers. Do not expect to make millions trading a $500 account. Trader Profiles You will need to set money management parameters and live with them and by them. To do this you must first determine your trader profile. Although traders are in actuality on a continuum from very short-term traders to very long-term traders, all of them fall into three or at most four distinct classes with specific money management needs. The Guerilla The guerilla trader seldom stays in a position for more than a few minutes. Taking 10 to 20 pips from a trade is considered a good deal. Guerillas often trade the news and need very low pip-spread even to survive. When you make 20 trades a session, the pip costs add up very quickly. I do not recommend that the new trader attempt the guerilla style of trading. The Scalper One level up from the Guerilla is the scalper. A scalper may extend his profit horizons to perhaps 30 or even 50 pips in a very volatile market. A scalper might trade a pair once or perhaps twice a session. Being a scalper is a reasonable space for the new trader. But, again, costs can be significant. The counterbalancing idea is that you cant (usually!) lose too much money only being in the market or exposed for 30 minutes to an hour. The Day Trader The day trader seeks profits in the 50-to-100 pip range. Such a trader must often sit between multiple sessions or seek markets with high directional movement. By seeking larger profits a day trader can afford to make quite a few losing trades; if none of them are very large. The day trader only needs a few good trades a week to make the program effective. By staying longer in the market day traders are exposed to more unforeseen circumstances and market-jarring news events or announcements. I am a day trader. It is a good profile for new traders, also. The Position Trader Few retail FOREX traders can afford the heat of staying over not only several sessions but several days in a market. Yes, you can make a killing as the EUR/USD goes from 1.25 to 1.30 in two weeks. You can also lose it all in a single trade. The exposure is enormous over such periods of time. If you perceive a longer-term trend, you can catch most of itor perhaps even more by trading the intermediate swingsas a day trader. This is certainly not a profile for the new trader. Now we can examine the primary money management parameters and build out each for the two suggested trader profiles. (See Table 15.1.) These factors are dependent variables. In many instances, one depends on the other. Once youve done a few dozen FOREX calculations, the relationship of these factors will be second nature to you. Practice. Dont be afraid to heat up your Demo account or use an online FOREX calculator such as the ones at www.forexcalc .com or www.oanada.com. Refer to Chapter 6, The Calculating Trader. Capital AllocationAggregate What is the maximum amount of your total margin capital that you should allocate at any one time? Brokers may require different margins for the same number of units of different pairsand they change them often, as well. I recommend that the new trader never have more than one position going at a time. You will have a lot of unused margin but a lot of cushion and staying power, also. Typically, gorillas and scalpers may be often margined at nearly 100 percent. Day traders generally should stay under 75 percent and position traders, 50 percent. The more exposure you have, the less total margin you should have in play at any given time. Capital AllocationPer Trade If you never want to go over 75 percent margined and a trade takes an average of 25 percent, thats a maximum of three concurrent positions, more than enough simultaneous action for most of us. Leverage Leverage is the total value of the trade divided by the margin required. Trade Value/Margin. If a trade has a value of $10,000 and it cost you $500 to trade that pair, your margin is 20:1. Your broker will give you multiple leverage possibilities which can be set on your trading platform. Start at the lowest, usually 10:1 and move up by the smallest increments possible as you have success. For these next two ratios, it is vitally important that they work together and with your trader profile in harmony. Profit/Loss Ratio The higher your Winner/Loser Ratio, the lower can be your Profit/Loss Ratio. If you average a $500 profit for every $100 loss you can have a Winner/Loser Ratio of less than 50 percent (more losers than winners) and still do very well. /Losers Ratio Heres the flip side. The higher your Winner/Loser Ratio, the lower can be your per-trade Profit/Loss Ratio. If you hit 80 percent of your trades, your Profit/Loss ratio can be razor thin, and you will still be successful. The goal is to have all these work together in harmony, in a realistic structure, in accordance with your trader profile. Note how these last two are inversely proportional to one another. Parameters for Trader Profiles We may now set suggested money management parameters for the two recommended Trader Profiles. Scalper Profile Parameters Campaign Scenario: A Scalper makes 12 trades. He wins on six and loses on six. On the winners he nets 30 6 pips = 180 pips. On the losers he nets -10 6 = 60 pips. Hes on fire, but hell feel cold water if either ratio goes the wrong way for any length of time. Many scalpers would give an arm to maintain a 3:1 per trade ratio. Campaign Scenario: A day trader makes 12 trades. He wins on four and loses on eight. On the winners he makes 60 pips 4 = 240 pips. On the losers he is -15 8 = 120 pips. Life is good, but it depends on keeping the per trade ratio very high. The success of a trader is always a delicate and precarious thing. You can see from the above how small changes in ratios could turn either one of these traders to the negative side. When analyzing your performance, use these ratios and observe how they might be changing over time, and how much they vary per trade. It is very important to understand the basic FOREX calculations before actually trading. I cannot emphasize enough the importance of understanding the basic FOREX calculations. Learn them from this book, then go into your brokerdealers Demo account and generate as many What If ? Campaign scenarios as you possibly can. You will learn not only how FOREX works but perhaps most importantly what is required for it to work for you. The Trade Campaign Method (TCM) This concept was developed by Bruce Gould in his enormously insightful advisory letter for commodity traders published in the 1970s. Mr. Goulds work is highly recommended to all traders in all markets. For information on his offerings, www.brucegould.com. In conjunction with the trader profile this method provides an ad hoc method of setting fixed stops and taking profits. Once you have some experience trading, you may wish to discontinue this approach or meld it with a method of stop-loss and take-profits inherent in your trading method. The moving average stop, below the moving average line, would be much further away than a fixed stop. Either use the fixed, campaign method or pass the trade. The perfect scenario is for a trading method stop to be within the accepted set parameters of the campaign fixed stop. If a method stop is not in the campaign stop, I would reconsider the trade. Calculating TCM Profit and Loss Step One. What is your trading capital or grubstake? If you are in the midsection of the bell curve, it is probably between $1,000 and $10,000. You can trade with less (in a mini- or micro-account), or you can trade with more. We are here considering not your micro- or mini-account, which should be funded with no more than $500, but your full-fledged trading account. Let us assume your stake is $3,000. Remember, this is money you can afford to lose. Your spouse may yell at you if you lose it but at least the kids wont go hungry. Step Two. Allocate your money into three imaginary campaign parcels. You will have three campaigns to get long term traction in the markets. If you lose campaign #1 you can regroup and go on to campaign #2, and so forth. This gives your tradink some basic structure, something almost no new traders have or even think about. Step Three. Allocate each of your $1,000 pots into ten trades, risking a set $100 per trade. Your stop-loss is mechanically calculated in advance as a pip value equal to $100. See, I told you that you would need the calculations in Chapter 9! Step Four. Refer to the profile parameters above, and work backward. If you are a scalper and seek 3:1 profit to loss ratio, you want to make $300. Step Five. You only now need to know how many units to buy or sell. Refer to your pip gain in the same profile. The scalper wants to make 30 pips per trade, on average. All you must do now is calculate how many units make $300 on 320 pips, and your trade money management parameters are ready to go. Do not reset or adjust your campaign schedule until you have made 30 trades and completed all three campaigns. Before you execute a trade, review these five steps. Together they constitute your money management heuristic. Stop-Loss OrdersA Brief Discussion As above you may either set stops using my campaign method or you may set them in accordance with your trading method. Some trading methods generate stop-loss prices, some do not. In the later instance I continue to advise that you pass a trade if the stop-loss your trading method requires is excessive. If you are trading as a scalper, do not take a trade requiring a 75-pip stop-loss. When in doubt, stay out; do not let your trading method overrule common sense. Tip: Once entered, do not change your stop-loss order. Live with it, good, bad, or ugly. Manipulating stop-losses is for the expert, and even for experts, it is a dicey business. A trade is a process and tinkering with the process once it is in motion is a bad idea. As a new trader be sure your stop order is in the market at all times. Enter it as a pure stop order so that if the price is hit, the stop is executed. A bad fill in a fast market is better than no fill at all. There is an ongoing discussion among traders, teachers, and researchers as to whether stops should be mental or actually placed in the market. For the new trader I believe the answer is slam-dunk territory. Put them in the market. Whatever you dodont walk away leaving a position open, unattended, without a stop in the market. New traders have so much sensory and emotional data hitting them from all sides that adding the duty of exiting a trade per ones strategy on the fly is just asking too much. Selecting Markets I recommend the novice trader begin by trading the major USD currency pairs only. These pairs usually entail a lower bid/ask pip spread, which increases your profit potential while reducing your transaction costs. While it may not matter for the small trader, they are also the most liquid of all currency pairs. If you venture forth past the majors, stay with combinations of the Euro (EUR), British Pound (GBP), Japanese Yen (JPY), Australian Dollar (AUS), and Canadian Dollar (CND). Irrespective of currency pair, attempt to trade only markets with modest volatility and high directional movement. Scalpers and guerilla traders prefer high volatility pairs; day traders and position traders prefer markets with high directional movement. Over long periods of time both directional movement and volatility for any given pair changes, but typically the change is gradual. After you trade a pair for a reasonable period of time, you will see that each has its own unique personality. We can often identify an unlabelled pair simply by doing a market environment analysis. See Chapter 16, Tactics and Strategy. Table 15.3 is also a useful guide. Absolute range is converted from a decimal value of pips by multiplying by 1,000 (or 10 in some cases) and expressed as pips in the quote (second currency). Summary Know your FOREX calculations, and practice with them on a Demo account as much and as often as you can. Play What If ? scenarios to sharpen your understanding of the relationships between not only the calculations but the basic money management ideas presented here. Once you are comfortable, factor in your trader profile. I recommend the campaign method of money management for new traders. You may meld in parameters derived from your trading method as it develops, if you wish. But the basic campaign parameters should always trump anything else, in my humble opinion. If your trading method money management parameters are, too often, too far away from your campaign parameters, it is probably the trading method parameters that need changing. The best way to learn how a ratio or conversion works is to do multiple scenario calculations, leaving the other numbers unchanged and manipulating the one you are learning. A very small change in only one or two money management factors can make a big difference in overall trader performance. Keep this in mind especially when evaluating trade performance. Add the money management heuristic to your trading method and attitude heuristics, and go through all of them before executing a trade. It will take time at first, but after 20 or 30 trades it will require but a few seconds. |
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