The goal of trading is to make money by forecasting future price movements.This is inherently difficult because, as human beings, we cannot tell the future.
All risk taking is associated with two human conditions, viz the greed for profits and the fear of losses. The ability to strike the right balance between fear and greed is the most vital determinant of profitable risk taking.
Human nature operates on the chance of a gain rather than maximizing gains.
There is lack of focus on the magnitude of gains and losses, which is why I maintain that successful trading and requires you to go against the basic tenets of human nature. We are programmed to learn, and we learn to a pain. But in trading , you have to learn to take a loss.
In trading, the first and the last principle is that trading is trend and price based, and not opinion based. This requires you to square an unfavorable trade regardless of your opinion. This means that if I buy a stock at Rs 100, and then the price falls to Rs 95, I take my loss and square off my trade. This is counter-intuitive to most people. This is the one common quality of all successful traders.
Surely many new traders analyze data announcements, or economic reports with the goal of buying cheaply before prices may run up, or selling ‘expensive’ before prices move lower; but those traders will often soon find out that consistent profitability is considerably more difficult than ‘out-guessing’ the market.
In this article, we’re going to approach a psychological road-block that many new traders struggle with in their effort to find consistent profitability.
Defining Trading Success
Human beings naturally recognize patterns. It’s an evolutionary trait; if a man or woman were to wander out of a cave only to get eaten by a bear, others in that cave should grow cautious of leaving.
We attach emotions to results because that’s the best way to move towards success, whatever the pursuit may be.
In trading, this often entails feeling good when we win, or feeling bad when we lose. This is the stimuli that guide our future patterns and decision making processes. But is this the best way for a trader to approach the market; hinging their decisions on what may feel ‘best?’
It’s Not How Often You are Right that Matters
This is something I found during a research done with my students who have opted for my trading course Despite the fact that traders, on average, lost money – they still won well over half of the time in trading Nifty as seen in below chart.
Think about these winning percentages for a moment. These traders had that feeling of jubilation that comes from a winning trade more often than they had the feeling of failure after taking a loss.
So, despite the fact that traders lost money, on average, in these pairings, they still ‘felt’ like they were successful.
Is Feeling Successful More Important than Being Successful?
Just as the title of this article states, default human nature – that which runs towards pleasure but away from pain is the same thing that makes it so difficult for new traders to learn to trade.
And the reason for that is what happens on a per trade basis…
Remember, the traders above – while they felt successful more often than they felt failure – they were still losing money. So, they were still, on average, facing failure.
And the reason for this is because of what happens on an individual, per-trade basis.
So we wanted to find the reason that traders were losing money despite the fact that they were winning over half the time; and the answer is below:
As you can see in the above series of pie charts, traders lost, in many cases, significantly more when they were wrong, than they won when they were right.
And this is precisely how human nature can work against us as traders. When we get a losing position, we want to wait it out, hoping that prices come back so that we don’t have to take a loss. We desire that ‘feeling’ of success as opposed to thinking of the bigger picture, and the fact that this trade that has already shown us a loss has the potential to show us an even bigger loss.
And when we do get a winning position, that same human nature comes into work against us. We watch the position with fear, hoping that this gain doesn’t turn around and become a loss. So, we have a tendency to close these positions really fast in an effort to prevent a winner from becoming a loser…. Once again, allowing our actions to be driven and directed by that desire to ‘feel’ successful.
How can we beat our own Human Nature?
While beating human nature in a larger context may be considerably more difficult than we can propose to counter in this article, doing so in trading can be quite a bit easier to implement.
First and foremost – look for minimum risk-reward ratios of 1-to-1 or better or put more simply, only enter trades in which you can make more than you stand to lose.
Secondly, remember that any given trade that you place is unlikely to be anything more than just one of a thousand insignificant trades that you place in your career.
And third, don’t expect that you are going to ‘out-guess’ the market… because it likely won’t happen.
If this is challenging, place a stop and a limit on the trade to enforce this minimum 1-to-1 risk-to-reward ratio, and let the trade work. You can add or program for a break-even stop, or a pre-determined stop movement; but at all points – Plan your trade, and trade your plan.
And last but not least Mark Douglas’ 5 fundamental truths:
- Anything can happen
- You can make money without knowing what is going to happen next
- There is a random distribution of wins and losses that define an edge
- An edge is just the greater probability of one thing happening over another
- Every moment in the market is unique