Tuesday, November 13, 2012

The Trader's mind VI - Conviction and doubt

In the world outside trading, persistence and conviction are good traits. A persistent man is likely to solve the problem, get the date with the woman of his choice or get a job. We judge people's conviction in their positions by how well they can defend their own views. A telling example is the characterization of an election candidate as a flip-flopper resulting in their election loss. Holding fast a misinformed opinion is seen as a sign of strong ethos than switching position based on new evidence.

Your conviction or faith in your opinion endears you to your social clique. Conservatives feel comfortable hanging with other conservatives and greens with other greens. This piece of human nature is something we learn very young and use it to adopt various facets of our identity and stick to it lifelong.

I'm a Mets fan. I'm a libertarian. I'm against the death penalty and so on. The adoption of identity facets is an automatic social behavior and its function is primarily social.

When this behavior is carried to the trading world, it works against the trader from the very beginning. Trading is ultimately a non-social function as far as your account is concerned. Your losses are your own and forming an opinion and sticking to it in the face of hell or high water works against you every time.

A trader who is convinced the market has gone up too far may short the market and when it stops him out, try again on the next high and eventually short his way to the top. A seasoned trader often does not have an opinion as to the general strength or weaknesses of the market and follows the principle: "Trade what you see, not what you think."

To develop the ability to abandon a damaging view when you are wrong, adopt a rule where if you are wrong twice, you won't trade in the same direction until the price moves substantially away from the current location. Remember that you are always wrong and the market is always right.

The flip side of conviction is doubt. A trader who has a long series of losses (including consistent winning traders) are subject to losing confidence in their system, their ability to read the market and follow their own system. Such traders are subject to buyer's regret right after entering a trade, being shaken out on even the smallest pullback and tightening stops too early and thereby exiting on a loss just before the market makes a huge move in the direction of their trade.

Even when the market moves in their favor, they are unable to hold for many points. The very first pullback causes them great distress and forces them to exit at a small profit. Imagine seeing an open profit of four points and then panicing and exiting at +1 when the market pulls back. To build confidence and enable yourself to hold through pullbacks, always take a partial profit on the first push in your direction. Especially during the first hour, reversals can be abrupt and take out your stop and change your winning trade to a losing trade, which damages your confidence even more.

The partial profit enables you to hold your runner beyond the first pullback after which it gets easier since your swing stop moves into profit once the next swing point forms. Taking partial profits and sticking to your trade management rules builds confidence.

In general, you need to work on abandoning your precious opinions regarding the economy, news, the government or anything else you think may be impacting the market. These things may impact the market long-term but you have to realize that your opinions and identity relations are worthless for trading the market. You can only rely on what you see, your trade management rules and your discipline.

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