CHAPTER 11
THINKING LIKE A TRADER
If you asked me to distill trading down to its simplest form, I would say that it is a pattern recognition
numbers game. We use market analysis to identify the patterns, define the risk, and determine when to
take profits. The trade either works or it doesn't. In any case, we go on to die next trade. It's that simple,
but it's certainly not easy. In fact, trading is probably the hardest thing you'll ever attempt to be
successful at. That's not because it requires intellect; quite the contrary! But because the more you think
you know, the less successful you'll be.
Trading is hard because you have to operate in a state of not having to know, even though your analysis
may turn out at times to be "perfectly" correct. To operate in a state of not having to know, you have to
properly manage your expectations. To properly manage your expectations, you must realign your
mental environment so that you believe without a shadow of a doubt in the five fundamental truths. In
this chapter, I am going to give you a trading exercise that will integrate these truths about the market
at a functional level in your mental environment. In the process, I'll take you through the three stages of
development of a trader.
The first stage is the mechanical stage. In this stage, you:
1. Build the self-trust necessary to operate in an unlimited environment.
2. Learn to flawlessly execute a trading system.
3. Train your mind to think in probabilities (the five fundamental truths).
4. Create a strong, unshakeable belief in your consistency as a trader.
Once you have completed this first stage, you can then advance to the subjective stage of trading. In
this stage, you use anything you have ever learned about the nature of market movement to do
whatever it is you want to do. There's a lot of freedom in this stage, so you will have to learn how to
monitor your susceptibility to make the kind of trading errors that are the result of any unresolved self
valuation issues I referred to in the last chapter. The third stage is the intuitive stage. Trading intuitively
is the most advanced stage of development. It is the trading equivalent of earning a black belt in the
martial arts.
The difference is that you can't try to be intuitive, because intuition is spontaneous. It doesn't come
from what we know at a rational level. The rational part of our mind seems to be inherently mistrustful
of information received from a source that it doesn't understand. Sensing that something is about to
happen is a form of knowing that is very different from anything we know rationally. I've worked with
many traders who frequently had a very strong intuitive sense of what was going to happen next, only
to be confronted with the rational part of themselves that consistently, argued for another course of
action. Of course, if they had followed their intuition, they would have experienced a very satisfying
outcome. Instead, what they ended up with was usually very unsatisfactory, especially when compared
with what they otherwise perceived as possible. The only way I know of that you can try to be intuitive
is to work at setting up a state of mind most conducive to receiving and acting on your intuitive
impulses.
THE MECHANICAL STAGE
The mechanical stage of trading is specifically designed to build the kind of trading skills (trust,
confidence, and thinking in probabilities) that will virtually compel you to create consistent results. I
define consistent results as a steadily rising equity curve with only minor draw downs that are the
natural consequence of edges that didn't work. Other than finding a pattern that puts the odds of a
winning trade in your favor, achieving a steadily rising equity curve is a function of systematically
eliminating any susceptibility you may have to making the kind of fear, euphoric or self-valuation
based trading errors I have described throughout this book. Eliminating the errors and expanding your
sense of self-valuation will require the acquisition of skills that are all psychological in nature.
The skills are psychological because each one, in its purest form, is simply a belief. Remember that the
beliefs we operate out of will determine our state of mind and shape our experiences in ways that
constantly reinforce what we already believe to be true. How truthful a belief is (relative to the
environmental conditions) can be determined by how well it serves us; that is, the degree to which it
helps us satisfy our objectives.
If producing consistent results is your primary objective as a trader, then creating a belief (a conscious,
energized concept that resists change and demands expression) that "I am a consistently successful
trader" will act as a primaiy source of energy that will manage your perceptions, interpretations,
expectations, and actions in ways that satisfy the belief and, consequently, the objective. Creating a
dominant belief that "I am a consistently successful trader" requires adherence to several principles of
consistent success. Some of these principles will undoubtedly be in direct conflict with some of the
beliefs you've already acquired about trading. If this is the case, then what you have is a classic
example of beliefs that are in direct conflict with desire.
The energy dynamic here is no different from what it was for the boy who wanted to be like the other
children who were not afraid to play with dogs. He desired to express himself in a way that he found, at
least initially, virtually impossible. To satisfy his desire, he had to step into an active process of
transformation. His technique was simple: He tried as hard as he could to stay focused on what he was
trying to accomplish and, little by little, he de-activated the conflicting belief and strengthened the
belief that was consistent with his desire.
At some point, if that is your desire, then you will have to step into the process of transforming yourself
into a consistent winner. When it comes to personal transformation, the most important ingredients are
your willingness to change, the clarity of your intent, and the strength of your desire. Ultimately, for
this process to work, you must choose consistency over eveiy other reason or justification you have for
trading. If all of these ingredients are sufficiently present, then regardless of the internal obstacles you
find yourself up against, what you desire will eventually prevail.
Observe Yourself
The first step in the process of creating consistency is to start noticing what you're thinking, saying, and
doing. Why? Because everything we think, say, or do as a trader contributes to and, therefore,
reinforces some belief in our mental system. Because the process of becoming consistent is
psychological in nature, it shouldn't come as a surprise that you'll have to start paying attention to your
various psychological processes. The idea is eventually to learn to become an objective observer of
your own thoughts, words, and deeds. Your first line of defense against committing a trading error is to
catch yourself thinking about it. Of course, the last line of defense is to catch yourself in the act. If you
don't commit yourself to becoming an observer to these processes, your realizations will always come
after the experience, usually when you are in a state of deep regret and frustration.
Observing yourself objectively implies doing it without judging about yourself. This might not be so
easy for some of you to do considering the harsh, judgmental treatment you may have received from
other people throughout your life. As a result, one quickly learns to associate any mistake with
emotional pain. No one likes to be in a state of emotional pain, so we typically avoid acknowledging
what we have learned to define as a mistake for as long as possible.
Not confronting mistakes in our everyday lives usually doesn't have the same disastrous consequences
it can have if we avoid confronting our mistakes as traders. For example, when I am working with floor
traders, the analogy I use to illustrate how precarious a situation they are in is to ask them to imagine
themselves walking across a bridge over the Grand Canyon. The width of the bridge is directly related
to the number of contracts they trade. So, for example, for a one-contract trader the bridge is very wide,
say 20 feet. A bridge 20 feet wide allows you a great deal of tolerance for error, so you don't have to be
inordinately careful or focused on each step you take. Still, if you do happen to stumble and trip over
the edge, the drop to the canyon floor is one mile.
I don't know how many people would walk across a narrow bridge with no guardrails, where the
ground is a mile down, but my guess is relatively few. Similarly, few people will take the kinds of risks
associated with trading on the floor of the futures exchanges. Certainly a one-contract floor trader can
do a great deal of damage to himself, not unlike falling off a mile-high bridge. But a one-contract trader
also can give himself a wide tolerance for errors, miscalculations, or unusually violent market moves
where he could find himself on the wrong side. On the other hand, one of the biggest floor traders I
ever worked with trades for his own account with an average position of 500 Treasury bond futures at a
time. He often puts on a position of well over a thousand contracts.
A position of 1,000 T-bond contracts amounts to $31,500 per tic (the smallest incremental price change
that a bond contract can make). Of course, T-bond futures can be very volatile and can trade several
tics in either direction in a matter of seconds. As the size of a traders position increases, the width of
our bridge over the Grand Canyon narrows. In the case of the large bond trader, the bridge has
narrowed to the size of a thin wire. Obviously, he has to be extremely well-balanced and very focused
on each step that he takes. The slightest misstep or gust of wind could cause him to fall off the wire.
Next stop, one mile down. Now, when he's in the trading pit, that tiny misstep or slight gust of wind is
the equivalent to one distracting thought. That's all, just a thought or anything else where he allows
himself to lose his focus for even a second or two. In that moment of distraction, he could miss his last
favorable opportunity to liquidate his position.
The next price level with enough volume to take him out of his trade could be several tics away, either
creating a huge loss or forcing him to give a substantial winning trade back to the market. If producing
consistent results is a function of eliminating errors, then it is an understatement to say that you will
encounter great difficulty in achieving your objective if you can't acknowledge a mistake. Obviously,
this is something very few people can do, and it accounts for why there are so few consistent winners.
In fact, the tendency not to acknowledge a mistake is so pervasive throughout mankind, it could lead
one to assume that it's an inherent characteristic of human nature. I do not believe this is the case, nor
do I believe we are born with the capacity to ridicule or think less of ourselves for making a mistake,
miscalculation, or error. Making mistakes is a natural function of living and will continue to be until we
reach a point at which:
1. all our beliefs are in absolute harmony with our desires, and
2. all our beliefs are structured in such a way that they are completely consistent with what works from
the environment's perspective.
Obviously, if our beliefs are not consistent with what works from the environments perspective, the
potential for making a mistake is high, if not inevitable. We won't be able to perceive the appropriate
set of steps to our objective. Worse, we won't be able to perceive that what we want may not be
available, or available in the quantity we desire or at the time when we want it.
On the other hand, mistakes that are the result of beliefs that are in conflict with our objectives aren't
always apparent or obvious. We know they will act as opposing forces, expressing their versions of the
truth on our consciousness, and they can do that in many ways.
The most difficult to detect is a distracting thought that causes a momentary lapse in focus or
concentration. On the surface this may not sound significant. But, as in the analogy of the bridge over
the canyon, when there's a lot at stake, even a slightly diminished capacity to stay focused can result in
an error of disastrous proportions. This principle applies whether it's trading, sporting events, or
computer programming. When our intent is clear and undiminished by any opposing energy, then our
capacity to stay focused is greater, and the more likely it is that we will accomplish our objective.
Earlier I defined a winning attitude as a positive expectation of our efforts, with an acceptance that
whatever results we do get are a perfect reflection of our level of development and what we need to
learn to do better. What separates the "consistently great" athletes and performers from everyone else is
their distinct lack of fear of making a mistake. The reason they aren't afraid is that they don't have a
reason to think less of themselves when they do make a mistake, meaning they don't have a reservoir of
negatively charged energy waiting to well up and pounce on their conscious thought process like a lion
waiting for the right moment to pounce on its intended prey. What accounts for this uncommon
capacity to quickly move beyond their errors without criticizing themselves?
One explanation may be that they grew up with extremely unusual parents, teachers, and coaches, who
by their words and examples taught them to correct their miscalculations and errors with genuine love,
affection, and acceptance. I say "extremely unusual" because many of us grew up with just the opposite
experience. We were taught to correct our mistakes or miscalculations with anger, impatience, and a
distinct lack of acceptance. Is it possible that, for the great athletes, their past positive experiences with
respect to mistakes caused them to acquire a belief that mistakes simply point the way to where they
need to focus their efforts to grow and improve themselves? With a belief like that, there's no source of
negatively charged energy and consequently no source for self-denigrating thoughts.
However, the rest of us, who did grow up experiencing a plethora of negative reactions to our actions,
would naturally acquire beliefs about mistakes: "Mistakes must be avoided at all costs," "There must be
something wrong with me if I make a mistake," "I must be a screw-up," or "I must be a bad person if I
make a mistake." Remember that every thought, word, and deed reinforces some belief we have about
ourselves. If, by repeated negative self-criticism, we acquire a belief that we're "screw-ups," that belief
will find a way to express itself in our thoughts, causing us to become distracted and to screw up; on
our words, causing us to say things about ourselves or about others (if we notice the same
characteristics in them) that reflect our belief; and on our actions, causing us to behave in ways that are
overtly self-sabotaging. If you're going to become a consistent winner, mistakes can't exist in the kind
of negatively charged context in which they are held by most people.
You have to be able to monitor yourself to some degree, and that will be difficult to do if you have the
potential to experience emotional pain if and when you find yourself in the process of making an error.
If this potential exists, you have two choices:
1. You can work on acquiring a new set of positively charged beliefs about what it means to make a
mistake, along with de-activating any negatively charged beliefs that would argue otherwise or cause
you to think less of yourself for making a mistake.
2. If you find this first choice undesirable, you can compensate for the potential to make errors by the
way you set up your trading regime.
This means that if you're going to trade and not monitor yourself, but at the same time you desire
consistent results, then trading exclusively from the mechanical stage will resolve the dilemma.
Otherwise, learning how to monitor yourself is a relatively simple process once you have rid yourself
of negatively charged energy associated with mistakes. In fact, it's easy. All you have to do is decide
why you want to monitor yourself, which means you first need to have a clear purpose in mind. When
you're clear about your purpose, simply start directing your attention to what you think, say, or do.
If and when you notice that you're not focused on your objective or on the incremental steps to
accomplish your objective, choose to redirect your thoughts, words, or actions in a way that is
consistent with what you are trying to accomplish. Keep redirecting as often as necessary. The more
willfully you engage in this process, especially if you can do it with some degree of conviction, the
faster you will create a mental framework free to function in a way that is consistent with your
objectives, without any resistance from conflicting beliefs.
THE ROLE OF SELF-DISCIPLINE
I call the process I just described self-discipline. I define self-discipline as a mental technique to
redirect (as best we can) our focus of attention to the object of our goal or desire, when that goal or
desire conflicts with some other component (belief) of our mental environment. The first thing you
should notice about this definition is that self-discipline is a technique to create a new mental
framework. It is not a personality trait; people aren't born with self-discipline. In fact, when you
consider how I define it, being born with discipline isn't even possible. However, as a technique to be
used in the process of personal transformation, anybody can choose to use self-discipline. Here is an
example from my life that illustrates the underlying dynamics of how this technique works. In 1978 I
decided that I wanted to become a runner.
I don't exactly remember what my underlying motivation was, except that I had spent the previous
eight years in a very inactive life style. I wasn't involved with any sports or hobbies, unless you call
watching television a hobby. Previously in both high school and at least part of college I was very
active in sports, especially ice hockey. However, coming out of college, my life was unfolding in the
way that was very different from what I had expected. It was not to my liking, but at the time I felt
powerless to do anything about it. This led to a period of inactivity, which is a nice way of saying that I
was severely depressed. Again, I'm not sure what prompted me to suddenly want to become a runner
(maybe I saw some TV program that sparked my interest).
I do, however, remember that the motivation was verv strong. So, I went out and bought myself some
running shoes, put them on, and went out to run. The first thing I discovered was that I couldn't do it. I
didn't have the physical stamina to run more than fifty or sixty yards. This was very surprising. I didn't
realize, nor would I have ever believed, that I was so out of shape that I couldn't run even a hundred
yards. This realization was so disheartening that I didn't attempt to run again for two or three weeks.
The next time out, I still couldn't run more than fifty or sixty yards. I tried again the next day with, of
course, the same result.
I became so discouraged about my deteriorated physical condition that I didn't run again for another
four months. Now, it's the spring of 1979. I'm once again determined to become a runner, but, at the
same time, very frustrated with my lack of progress. As I was contemplating my dilemma, it occurred
to me that one of my problems was that I didn't have a goal to work towards. Saying that I wanted to be
a runner was great, but what did that mean? I really didn't know; it was too vague and abstract. I had to
have something more tangible to work towards.
So I decided that I wanted to be able to run five miles by the end of the summer. Five miles seemed
insurmountable at the time, but thinking that I might be able to do it generated a lot of enthusiasm. This
increased level of enthusiasm gave me enough impetus to run four times that week. At the end of this
first week, I was really surprised to discover even a little bit of exercise improved my stamina and
ability to run a little farther each time. This created even more enthusiasm, so I went out and bought a
stop watch and blank book to be used as a running diary. I set up a two-mile course, and marked off
each quarter mile. In the diary I entered the date, my distance, my time, and how I felt physically each
time I ran. Now I thought I was well on my way to the five miles, until I literally ran into my next set of
problems.
The biggest were the conflicting and distracting thoughts that flooded my consciousness every time I
decided I wanted to go out and run. I was amazed at the number (and intensity) of the reasons I found
for not doing it: "It's hot [or] cold outside," "It looks like it's going to rain," "I'm still a little tired from
the last time I ran (even though it was three days ago)," "Nobody else I know is doing this," or the most
prevalent, "I'll go as soon as this TV program is over" (of course I never went). I didn't know any other
way to deal with this conflicting mental energy except to redirect my conscious attention on what I was
trying to accomplish. I really wanted to get to five miles by the end of the summer. I found that
sometimes my desire was stronger than the conflict. As a result, I managed to get my running shoes on,
actually step outside, and start running. However, more times than not, my conflicting and distracting
thoughts caused me to stay put. In fact, in the beginning stages, I estimate that two-thirds of the time I
was unable to get past the conflicting energy.
The next problem I encountered was that when I started approaching the point where I was able to run
one mile, I was so thrilled with myself that it occurred to me I was going to need an additional
mechanism to get me to the five miles. I reasoned that once I got to the point where I could run two or
maybe three miles, I would be so overwhelmingly pleased with myself that I wouldn't feel any need to
fulfill my five-mile objective. So I made a rule for myself. You could call it the five-mile rule. "If I
managed to get my running shoes on and get outside in spite of all the conflicting thoughts trying to
talk me out of it, I committed myself to running at least one step farther than the last time I ran." It was
certainly all right if I ran more than one step further, but it couldn't be less than one step, no matter
what. As it turns out, I never broke this rule, and by the end of the summer, I made it to five miles.
But then, something really interesting and completely unanticipated happened before I got there. As I
got closer to fulfilling my five-mile objective, little by little, the conflicting thoughts began to dissipate.
Eventually they didn't exist at all. At that point, I found that if I wanted to run, I was completely free to
do so without any mental resistance, conflict, or competing thoughts. Given what a struggle it had been,
I was amazed (to say the least). The result: I went on to run on a very regular basis for the next 16
years. For those of you who may be interested, I don't run so much now because five years ago I
decided to start playing ice hockey again.
Hockey is an extremely strenuous sport. Sometimes I play as many as four times a week. Considering
my age (over u\j) and the level of exertion the sport requires, it usually takes me a day or two to
recover, which doesn't leave much room for running any more. Now, if you take these experiences and
put them into the context of what we now understand about the nature of beliefs, there are a number of
observations we can make:
1. Initially, my desire to be a runner had no foundation of support in my mental system. In other words,
there was no other source of energy (an energized concept demanding expression) consistent with my
desire.
2. I actually had to do something to create that support. To create a belief that "I am a runner" required
that I create a series of experiences consistent with the new belief. Remember that everything we think,
say, or do contributes energy to some belief in our mental system. Each time I experienced a
conflicting thought and was able to successfully refocus on my objective, with enough conviction to get
me into my running shoes and out the door, I added energy to the belief that "I am a runner." And, just
as important, I inadvertently drew energy away from all of the beliefs that would argue otherwise. I say
inadvertently because there are various techniques specifically designed to identify and de-activate
conflicting beliefs, but at that time in my life, I didn't understand the underlying dynamics of the
process of transformation I was going through. So, it wouldn't have occurred to me to avail myself of
such techniques.
3. Now I can effortlessly (from a mental perspective) express myself as a runner, because "I am a
runner." That energized concept is now a functioning part of my identity. When I first started out, I
happened to have a number of conflicting beliefs about running. As a result, I needed the technique of
self-discipline to bfCCITic One. Now I don't need self-discipline because "bHn" a. rj^iicr" 'c "who I L
~o am." When our bfeliers are completely aligned with our goals or desires, there's no source of
conflicting energy. If there's no source of conflicting energy, then there's no source of distracting
thoughts, excuses, rationalizations, justifications, or mistakes (conscious or subconscious).
4. Beliefs can be changed, and if it's possible to change one belief, then it's possible to change any
belief, if you understand that you really aren't changing them, but are only transferring energy from one
concept to another. (The form of the belief targeted for change remains intact.) Therefore, two
completely contradictory beliefs can exist in your mental system, side by side. But if you've drawn the
energy out of one belief and completely energized the other, no contradiction exists from a functional
perspective; only the belief that the energy will have the capacity to act as a force on your state of
mind, on your perception and interpretation of information, and your behavior. Now, the sole purpose
of trading mechanically is to transform yourself into a consistently successful trader. If there's anything
in your mental environment that's in conflict with the principles of creating the belief that "I am a
consistently successful trader," then you will need to employ the technique of self-discipline to
integrate these principles as a dominant, functioning part of your identity. Once the principles become
"who you are," you will no longer need self-discipline, because the process of "being consistent" will
become effortless. Remember that consistency is not the same as the ability to put on a winning trade,
or even a string of winning trades for that matter, because putting on a winning trade requires
absolutely no skill. All you have to do is guess correctly, which is no different than guessing the
outcome of a coin toss, whereas consistency is a state of mind that, once achieved, won't allow you to
"be" any other way. You won't have to try to be consistent because it will be a natural function of your
identity. In fact, if you have to try, it's an indication that you haven't completely integrated the
principles of consistent success as dominant, unconflicted beliefs. For example, predefining your risk is
a step in the process of "being consistent." If it takes any special effort to predefine your risk, if you
have to consciously remind yourself to do it, if you experience any conflicting thoughts (in essence,
trying to talk you out of doing it), or if you find yourself in a trade where you haven't predefined your
risk, then this principle is not a dominant, functioning part of your identity. It isn't "who you are." If it
were, it wouldn't even occur to you not to predefine your risk. If and when all of the sources of conflict
have been de-activated, there's no longer a potential for you to "be" any other way. What was once a
struggle will become virtually effortless. At that point, it may seem to other people that you are so
disciplined (because you can do something they find difficult, if not impossible), but the reality is that
you aren't being disciplined at all; you are simply functioning from a different set of beliefs that compel
you to behave in a way that is consistent with your desires, goals, or objectives.
CREATING A BELIEF IN CONSISTENCY
Creating a belief that "I am a consistent winner" is the primary objective, but like my intention to
become a runner, it's too broad and abstract to implement without breaking it down into a step-by-step
process. So what I'm going to do is break this belief down into its smallest definable parts and then give
you a plan to integrate each part as a dominant belief. The following sub-beliefs are the building
Thinking Like a Trader 185 blocks that provide the underlying structure for what it means "to be a
consistent winner."
I AM A CONSISTENT WINNER BECAUSE:
1. I objectively identify my edges.
2. I predefine the risk of every trade.
3. I completely accept risk or I am willing to let go of the trade.
4. I act on my edges without reservation or hesitation.
5. I pay myself as the market makes money available to me.
6. I continually monitor my susceptibility for making errors.
7. I understand the absolute necessity of these principles of consistent success and, therefore, I
never violate them.
These beliefs are the seven principles of consistency. To integrate these principles into your mental
system at a functional level requires that you purposely create a series of experiences that are consistent
with them. This is no different from the boy who wanted to play with dogs or my desire to be a runner.
Before he could play with a dog, the boy first had to make several attempts just to get close to one.
Eventually, as the balance of energy in his mental system shifted, he could play with dogs without any
internal resistance. To become a runner, I had to create the experience of running in spite of everything
inside me that argued otherwise. Eventually, as the energy shifted more and more in favor of this new
definition of myself, running became a natural expression of my identity.
Obviously, what we're trying to accomplish here is far more complex than becoming a runner or petting
a dog, but the underlying dynamics of the process are identical. We'll start with a specific objective.
The first principle of consistency is the belief, "I objectively identify my edges." The key word here is
objectively. Being objective means there's no potential to define, interpret, and therefore perceive any
market information from either a painful or euphoric perspective.
The way to be objective is to operate out of beliefs that keep your expectations neutral and to always
take the unknown forces into consideration. Remember, you have to specifically train your mind to be
objective and to stay focused in the "now moment opportunity flow." Our minds are not naturally wired
to think this way, so to be an objective observer you have to learn to think from the market's
perspective. From the market's perspective, there are always unknown forces (traders) waiting to act on
price movement. Therefore, from the market's perspective, "every moment is truly unique," even
though the moment may look, sound, or feel exactly the same as some moment logged away in your
memory bank.
The instant you either decide or assume you know what's going to happen next, you will automatically
expect to be right. However, what you know, at least at the rational level of thinking, can only take into
consideration your unique past, which may not have any relationship to what is actually happening
from the markets perspective. At that point, any market information that is not consistent with your
expectation has the potential to be defined and interpreted as painful. To avoid experiencing the pain,
your mind will automatically compensate, with both conscious and subconscious pain-avoidance
mechanisms, for any differences between what you expect and what the market is offering. What you
will experience is commonly referred to as an "illusion." In a state of illusion, you are neither objective
nor connected to the "now moment opportunity flow."
Instead, you become susceptible to committing all the typical trading errors (hesitating, jumping the
gun, not predefining your risk, defining your risk but refusing to take the loss and letting the trade turn
into a bigger loser, getting out of a winning trade too soon, not taking any profits out of a winning
trade, letting a winning trade turn into a loser, moving a stop closer to your entry point, getting stopped
out and watching the market trade back in your favor, or trading too large a position in relationship to
your equity). The five fundamental truths about the market will keep your expectations neutral, focus
your mind in the "now moment opportunity flow" (by disassociating die present moment from your
past), and, therefore, eliminate your potential to commit these errors. When you stop making trading
errors, you'll begin trusting yourself. As your sense of self-trust increases, so will your sense of
selfconfidence. The greater your confidence, the easier it will be to execute your trades (act on your
edges without reservation or hesitation).
The five truths will also create a state of mind in which you will genuinely accept the risks of trading.
When you genuinely accept the risks, you will be at peace with any outcome. When you're at peace
with any outcome, you will experience a carefree, objective state of mind, where you make yourself
available to perceive and act upon whatever the market is offering you (from its perspective) at any
given "now moment." The first objective is to integrate as a dominant belief, "I objectively identify my
edges." The challenge now is, how do you get there? How do you transform yourself into a person who
can consistently think in the market's perspective? The process of transformation starts with your desire
and your willingness to refocus on the object of your desire (self-discipline). Desire is a force. It does
not have to coincide or agree with anything that you currently believe to be true about the nature of
trading.
A clear desire aimed squarely at a specific objective is a very powerful tool. You can use the force of
your desire to create an entirely new version or dimension to your identity; shift energy between two or
more conflicting concepts; or change the context or polarity of your memories from negative to
positive. I'm sure you are familiar with the saying, "Make up your mind." The implication of "making
up our minds" is that we decide exactly what we desire with so much clarity (absolutely no lingering
doubts) and with so much conviction that literally nothing stands in our way, either internally or
externally. If there's enough force behind our resolve, it's possible to experience a major shift in our
mental structure virtually instantaneously.
De-activating internal conflicts is not a function of time; it's a function-focused desire (although it can
take a considerable amount of time to get to the point where we really make up our minds). Otherwise,
in the absence of extreme clarity and conviction, the technique of self-discipline, over time, will do the
job quite nicely (if, of course, you're willing to use it). To get there, you must "make up your mind,"
with as much conviction and clarity as possible, that more than anything else you desire consistency
(the state of mind of trust, confidence, and objectivity) from your trading. This is necessary because if
you're like most traders, you're going to be up against some very formidable conflicting forces. For
example, if you've been trading to get high from the euphoria of catching a big move, to impress your
family and friends, to be a hero, to fulfill an addiction to random rewards, to be right about your
predictions, or for any other reason that has nothing to do with being consistent, then you'll find the
force of these other motivations will not only act as an obstacle making the trading exercise I'm about
to give you veiy difficult, but it could very well be strong enough even to keep you from doing the
exercise at all. Remember the boy who had no desire to be like the other children and interact with
dogs? In essence, he decided to live with the active contradiction between his minimally charged
positive belief that not all dogs are dangerous and his core, negatively charged belief that all dogs are
dangerous. He had the ability to perceive friendly dogs, but at the same time found it impossible to
interact with them. Unless he desires to change it, the imbalance of energy between these two beliefs
will stay exactly as it is for his entire life.
To even start this process, you have to want consistency so much that you would be willing to give up
all the other reasons, motivations, or agendas you have for trading that aren't consistent with the
process of integrating the beliefs that create consistency. A clear, intense desire is an absolute
prerequisite if you're going to make this process work for you.
EXERCISE: LEARNING TO TRADE AND EDGE LIKE A CASINO'
The object of this exercise is to convince yourself that trading is just a simple game of probabilities
(numbers), not much different from pulling the handle of a slot machine. At the micro level, the
outcomes to individual edges are independent occurrences and random in relationship to one another.
At the macro level, the outcomes over a series of trades will produce consistent results. From a
probabilities perspective, this means that instead of being the person playing the slot machine, as a
trader, you can be the casino, if:
1. you have an edge that genuinely puts the odds of success in your favor;
2. you can think about trading in the appropriate manner (the five fundamental truths); and
3. you can do everything you need to do over a series of trades. Then, like the casinos, you will own the
game and be a consistent winner.
SETTING UP THE EXERCISE
Pick a market.
Choose one actively traded stock or futures contract to trade. It doesn't matter what it is, as long as it's
liquid and you can afford the margin requirements for trading at least three hundred shares or three
futures contracts per trade.
Choose a set of market variables that define an edge. This can be any trading system you want. The
trading system or methodology you choose can be mathematical, mechanical, or visual (based on
patterns in price charts). It doesn't matter whether you personally design the system or purchase it from
someone else, nor do you need to take a long time or be too picky trying to find or develop the best or
right system. This exercise is not about system development and it is not a test of your analytical
abilities. In fact, the variables you choose can even be considered mediocre by most traders' standards,
because what you are going to learn from doing this exercise is not dependent upon whether you
actually make money.
If you consider this exercise an educational expense, it will cut down on the amount of time and effort
you might otherwise expend trying to find the most profitable edges. For those of you who might be
wondering, I'm not going to make any specific recommendations about what system or variables you
should use, because I assume that most of the people reading this book are already well schooled in
technical analysis. If you need additional assistance, there are hundreds of books available on the topic,
as well as system vendors who are more than willing to sell you their ideas. However, if you've made a
genuine attempt to do this on your own but are still having problems picking a system, you can contact
me at markdouglas.com or tradinginthezone.com and I will make some recommendations. Whatever
system you choose to use has to fit within the following specifications.
Trade Entry. The variables you use to define your edge have to be absolutely precise. The system has
to be designed so that it does not require you to make any subjective decisions or judgments about
whether your edge is present. If the market is aligned in a way that conforms with the rigid variables of
your system, then you have a trade; if not, then you don't have a trade. Period! No other extraneous or
random factors can enter into the equation.
Stop-Loss Exit. The same conditions apply to getting out of a trade that's not working. Your
methodology has to tell you exactly how much you need to risk to find out if the trade is going to work.
There is always an optimum point at which the possibility of a trade not working is so diminished,
especially in relationship to the profit potential, that you're better off taking your loss and getting your
mind clear to act on the next edge. Let the market structure determine where this optimum point is,
rather than using an arbitrary dollar amount that you are willing to risk on a trade. In any case,
whatever system you choose, it has to be absolutely exact, requiring no subjective decision making.
Again, no extraneous or random variables can enter into the equation.
Time Frame. Your trading methodology can be in any time frame that suits you, but all your entry and
exit signals have to be DUSCCi Hi cne same time frame. For example, if you use variables that identify
a particular support and resistance pattern on a 30-minute bar chart, then your risk and profit objective
calculations also have to be determined in a 30-minute time frame. However, trading in one time frame
does not preclude you from using other time frames as filters. For example, you could have as a filter a
rule that states you're only going to take trades that are in the direction of the major trend. There's an
old trading axiom that "The trend is your friend." It means that you have a higher probability of success
when you trade in the direction of the major trend, if there is one. In fact, the lowest-risk trade, with the
highest probability of success, occurs when you are buying dips (support) in an up-trending market or
selling rallies (resistance) in a down-trending market. To illustrate how this rule works, let's say that
you've chosen a precise way of identifying support and resistance patterns in a 30- minute time frame
as your edge. The rule is that you are only going to take trades in the direction of the major trend. A
trending market is defined as a series of higher highs and higher lows for an up-trending market and a
series of lower highs and lower lows for a downtrending market. The longer the time frame, the more
significant the trend, so a trending market on a daily bar chart is more significant than a trending
market on a 30-minute bar chart. Therefore, the trend on the daily bar chart would take precedence over
the trend on the 30-minute bar chart and would be considered the major trend.
To determine the direction of the major trend, look at what is happening on a daily bar chart. If the
trend is up on the daily, you are only going to look for a sell-off or retracement down to what your edge
defines as support on the 30-minute chart. That's where you will become a buyer. On the other hand, if
the trend is down on the daily, you are only going to look for a rally up to what your edge defines as a
resistance level to be a seller on the 30-minute chart. Your objective is to determine, in a down
trending market, how far it can rally on an intraday basis and still not violate the symmetry of the
longer trend. In an up-trending market, your objective is to determine how far it can sell off on an
intraday basis without violating the symmetry of the longer trend. There's usually very little risk
associated with these intraday support and resistance points, because you don't have to let the market
go very far beyond them to tell you the trade isn't working.
Taking Profits. Believe it or not, of all the skills one needs to learn to be a consistently successful
trader, learning to take profits is probably the most difficult to master. A multitude of personal, often
very complicated psychological factors, as well as the effectiveness of one's market analysis, enter into
the equation. Unfortunately, sorting out this complex matrix of issues goes way beyond the scope of
this book. I point this out so that those of you who might be inclined to beat yourselves up for leaving
money on the table can relax and give yourselves a break. Even after you've acquired all the other
skills, it might take a very long time before you get this one down pat. Don't despair. There is a way to
set up a profit-taking regime that at least fulfills the objective of the fifth principle of consistency ("I
pay myself as the market makes money available to me").
If you're going to establish a belief in yourself that you're a consistent winner, then you will have to
create experiences that correspond with that belief. Because the object of the belief is winning
consistently, how you take profits in a winning trade is of paramount importance. This is the only part
of the exercise in which you will have some degree of discretion about what you do. The underlying
premise is that, in a winning trade, you never know how far the market is going to go in your direction.
Markets rarely go straight up or straight down. (Many of the NASDAQ Internet stocks in the fall of
1999 were an obvious exception to this statement.) Typically, markets go up and then retrace some
portion of the upward move; or go down and then retrace some portion of the downward move. These
proportional reiracerr^nts can make it very difficult to stay in a winning trade. You would have to be an
extremely sophisticated and objective analyst to make the distinction between a normal retracement,
when the market still has the potential to move in the original direction of your trade, and a retracement
that isn't normal, when the potential for any further movement in the original direction of your trade is
greatly diminished, if not nonexistent.
If you never know how far the market is going to go in your direction, then when and how do you take
profits? The question of when is a function of your ability to read the market and pick the most likely
spots for it to stop. In the absence of an ability to do this objectively, the best course of action from a
psychological perspective is to divide your position into thirds (or quarters), and scale out the position
as the market moves in your favor. If you are trading futures contracts, this means your minimum
position for a trade is at least three (or four) contracts. For stocks, the minimum position is any number
of shares that is divisible by three (or four), so you don't end up with an odd-lot order. Here's the way I
scale out of a winning position. When I first started trading, especially during the first three years (1979
through 1981), I would thoroughly and regularly analyze the results of my trading activities. One of the
things I discovered was that I rarely got stopped out of a trade for a loss, without the market first going
at least a little way in my direction. On average, only one out of every ten trades was an immediate
loser that never went in my direction. Out of the other 25 to 30 percent of the trades that were
ultimately losers, the market usually went in my direction by three or four tics before revising and
stopping me out. I calculated that if I got into the habit of taking at least a third of my original position
off every time the market gave me those three or four tics, at the end of the year the accumulated
winnings would go a long way towards paying my expenses. I was right. To this day, I always, without
reservation or hesitation, take off a portion of a winning position whenever the market gives me a little
to take.
How much that might be depends on the market; it will be a different amount in each case. For
example, in Treasury bond futures, I take a third of my position off when I get four tics. In the S&P
futures, I take a third off for a profit of one and a half to two full points. In a bond trade, I usually don't
risk more than six tics to find out if the trade is going to work. Using a three-contract trade as an
example, here's how it works: If I get into a position and the market immediately goes against me
without giving me at least four tics first, I get stopped out of the trade for an 18-tic loss, but as I've
indicated, this doesn't happen often. More likely, the trade goes in my favor by some small amount
before becoming a loser. If it goes in my favor by at least four tics, I take those four tics on one
contract. What I have done is reduce my total risk on the other two contracts by 10 tics. If the market
then stops me out of the last two contracts, the net loss on the trade is only 8 tics. If I don't get stopped
out on the last two contracts and the market moves in my direction, I take the next third of the position
off at some predetermined profit objective.
This is based on some longer time frame support or resistance, or on the test of a previous significant
high or low. When I take profits on the second third, I also move the stop-loss to my original entry
point. Now I have a net profit on the trade regardless of what happens to the last third of the position.
In other words, I now have a "risk-free opportunity." I can't emphasize enough nor can the publisher
make the words on this page big enough to stress how important it is for you to experience the state of
"risk-free opportunity." When you set up a situation in which there is "risk-free opportunity," there's no
way to lose unless something extremely unusual happens, like a limit up or limit down move through
your stop. If, under normal circumstances, there's no way to lose, you get to experience what it really
feels like to be in a trade with a relaxed, carefree state of mind. To illustrate this point, imagine that you
are in a winning trade; the market made a fairly significant move in your direction, but you didn't take
any profits because you thought it was going even further.
However, instead of going further, the market trades all the way back to or very close to your original
entry point. You panic and, as a result, liquidate the trade, because you don't want to let what was once
a winning trade turn into a loser. But as soon as you're out, the market bounces right back into what
would have been a winning trade. If you had locked in some profits by scaling out, putting yourself in a
riskfree opportunity situation, it s very unlikely that you would have panicked or felt any stress or
anxiety for that matter. I still have a third of my position left. What now? I look for the most likely
place for the market to stop. This is usually a significant high or low in a longer time frame. I place my
order to liquidate just below that spot in a long position or just above that spot in a short position. I
place my orders just above or just below because I don't care about squeezing the last tic out of the
trade. I have found over the years that trying to do that just isn't worth it. One other factor you need to
take into consideration is your risk-to-reward ratio. The risk-to-reward ratio is the dollar value of how
much risk you have to take relative to the profit potential. Ideally, your risk-to-reward ratio should be at
least 3:1, which means you are only risking one dollar for every three dollars of profit potential. If your
edge and the way you scale out of your trades give you a 3:1 risk-to-reward ratio, your winning trade
percentage can be less than 50 percent and you will still make money consistently. A 3:1 risk-to-reward
ratio is ideal. However, for the purposes of this exercise, it doesn't matter what it is, nor does it matter
how effectively you scale out, as long as you do it. Do the best you can to pay yourself at reasonable
profit levels when the market makes the money available. Every portion of a trade that you take off as a
winner will contribute to your belief that you are a consistent winner. All the numbers will eventually
come into better alignment as your belief in your ability to be consistent becomes stronger.
Trading in Sample Sizes. The typical trader practically lives or dies (emotionally) on the results of the
most recent trade. If it was a winner, he'll gladly go to the next trade; if it wasn't, he'll start questioning
the viability of his edge. To find out what variables work, how well they work, and what doesn't work,
we need a systematic approach, one that doesn't take any random variables into consideration. This
means that we have to expand our definition of success or failure from the limited trade-by-trade
perspective of the typical trader to a sample size of 20 trades or more. Any edge you decide on will be
based on some limited number of market variables or relationships between those variables that
measure the market's potential to move either up or down. From the market's perspective, each trader
who has the potential to put on or take off a trade can act as a force on price movement and is,
therefore, a market variable. No edge or technical system can take into consideration every trader and
his reasons for putting on or taking off a trade. As a result, any set of market variables that defines an
edge is like a snapshot of something very fluid, capturing only a limited portion of all the possibilities.
When you apply any set of variables to the market, they may work very well over an extended period
of time, but after a while you may find that their effectiveness diminishes. That's because the
underlying dynamics of the interaction between all the participants (the market) is changing. New
traders come into the market with their own unique ideas of what is high and what is low, and other
traders leave.
Little by little, these changes affect the underlying dynamics of how the market moves. No snapshot
(rigid set of variables) can take these subtle changes into consideration. You can compensate for these
subtle changes in the underlying dynamics of market movement and still maintain a consistent
approach by trading in sample sizes. Your sample size has to be large enough to give your variables a
fair and adequate test, but at the same time small enough so that if their effectiveness diminishes, you
can detect it before you lose an inordinate amount of money. I have found that a sample size of at least
20 trades fulfills both of these requirements.
Testing. Once you decide on a set of variables that conform to these specifications, you need to test
them to see how well they work. If you have the appropriate software to do this, you are probably
already familiar with the procedures. If you don't have testing software, you can either forward test
your variables or hire a testing service to do it for you. If you need a recommendation for a testing
service, contact me at markdouglas.com or tradinginthezone.com for a referral. In any case, keep in
mind that the object of the exercise is to use trading as a vehicle to learn how to think objectively (in
the market's perspective), as if you were a casino operator. Right now, the bottom-line performance of
your system isn't very important, but it is important that you have a good idea of what you can expect
in the way of a win-to-loss ratio (the number of winning trades relative to the number of losing trades
for your sample size).
Accepting the Risk. A requirement of this exercise is that you know in advance exactly what your risk
is on each trade in your 20- trade sample size. As you now know, knowing the risk and accepting the
risk are two different things. I want you to be as comfortable as possible with the dollar value of the
risk you are taking in this exercise. Becuse the exercise requires that you use a 20-trade sample size, the
potential risk is that you will lose on all 20 trades. This is obviously the worst-case scenario. It is as
likely an occurrence as that you willwin on all 20 trades, which means it isn't very likely. Nevertheless,
it is a possibility. Therefore, you should set up the exercise in such a way that you can accept the risk
(in dollar value) of losing on all 20 trades.
For example, if you're trading S&P futures, your edge might require that you risk three full points per
contract to find out if the trade is going to work. Since the exercise requires that you trade a minimum
of three contracts per trade, the total dollar value of the risk per trade is $2,250, if you use big contracts.
The accumulated dollar value of risk if you lose on all 20 trades is $45,000, You may not be
comfortable risking $45,000 on this exercise.
If you're not comfortable, you can reduce the dollar value of the risk by trading S&P mini contracts (E
Mini). They are one-fifth the value of the big contracts, so the total dollar value of the risk per trade
goes down to $450 and the accumulated risk for all 20 trades is $9,000. You can do the same thing if
you are trading stocks: Just keep on reducing the number of shares per trade until you get to a point
where you are comfortable with the total accumulated risk for all 20 trades. What I don't want you to
do is change your established risk parameters to satisfy your comfort levels.
If, based on your research, you have determined that a three-point risk in the S&Ps is the optimum
distance you must let the market trade against your edge to tell you it isn't worth staying in the position,
then leave it at three points. Change this variable only if it is warranted from a technical analysis
perspective. If you've done everything possible to reduce your position size and find that you still aren't
comfortable with the accumulated dollar value of losing on all 20 trades, then I suggest you do the
exercise with a simulated brokerage service. With a simulated brokerage service, everything about the
process of putting on and taking off trades, including fills and brokerage statements, is exactly the same
as with an actual brokerage firm, except that the trades are not actually entered into the market. As a
result, you don't actually have any money at risk. A simulated brokerage service is an excellent tool to
practice with in real time, under real market conditions; it is also an excellent tool for forward testing a
trading system. There may be others, but the only service of this nature that I know of is
Auditrack.com.
Doing the Exercise. When you have a set of variables that conforms to the specifications described,
you know exactly what each trade is going to cost to find out if it's going to work, you have a plan for
taking profits, and you know what you can expect as a win-loss ratio for your sample size, then you are
ready to begin the exercise. The rules are simple: Trade your system exactly as you have designed it.
This means you have to commit yourself to trading at least the next 20 occurrences of your edge—not
just the next trade or the next couple of trades, but all 20, no matter what. You cannot deviate, use or be
influenced by any other extraneous factors, or change the variables that define your edge until you have
completed a full sample size. By setting up the exercise with rigid variables that define your edge,
relatively fixed odds, and a commitment to take every trade in your sample size, you have created a
trading regime that duplicates how a casino operates.
Why do casinos make consistent money on an event that has a random outcome? Because they know
that over a series of events, the odds are in their favor. They also know that to realize the benefits of the
favorable odds, they have to participate in every event. They can't engage in a process of picking and
choosing which hand of blackjack, spin of the roulette wheel, or roll of the dice they are going to
participate in, by trying to predict in advance the outcome of each of these individual events. If you
believe in the five fundamental truths and you believe that trading is just a probability game, not much
different from pulling the handle of a slot machine, then you'll find that this exercise will be
effortless—effortless because your desire to follow through with your commitment to take every trade
in your sample size and your belief in the probabilistic nature of trading will be in complete harmony.
As a result, there will be no fear, resistance, or distracting thoughts. What could stop you from doing
exactly what you need to do, when you need to do it, without reservation or hesitation? Nothing!
On the other hand, if it hasn't already occurred to you, this exercise is going to create a head-on
collision between your desire to think objectively in probabilities and all the forces inside you that are
in conflict with this desire. The amount of difficulty you have in doing this exercise will be in direct
proportion to the degree to which these conflicts exist. To one degree or another, you will experience
the exact opposite of what I described in the previous paragraph. Don't be surprised if you find your
first couple of attempts at doing this exercise virtually impossible. How should you handle these
conflicts? Monitor yourself and use the technique of self-discipline to refocus on your objective. Write
down the five fundamental truths and the seven principles of consistency, and keep them in front of you
at all times when you are trading.
Repeat them to yourself frequently, with conviction. Every time you notice that you are thinking,
saying, or doing something that is inconsistent with these truths or principles, acknowledge the conflict.
Don't try to deny the existence of conflicting forces. They are simply parts of your psyche that are
(understandably) arguing for their versions of the truth. When this happens, refocus on exactly what
you are trying to accomplish. If your purpose is to think objectively, disrupt the association process (so
you can stay in the "now moment opportunity flow"); step through your fears of being wrong, losing
money, missing out, and leaving money on the table (so you can stop making errors and start trusting
yourself), then you'll know exactly what you need to do. Follow the rules of your trading regime as best
you can. Doing exactly what your rules call for while focused on the five fundamental truths will
eventually resolve all your conflicts about the true nature of trading. Every time you actually do
something that confirms one of the five fundamental truths, you will be drawing energy out of the
conflicting beliefs and adding energy to a belief in probabilities and in your ability to produce
consistent results. Eventually, your new beliefs will become so powerful that it will take no conscious
effort on your part to think and act in a way that is consistent with your objectives.
You will know for sure that thinking in probabilities is a functioning part of your identity when you
will be able to go through one sample size of at least 20 or more trades without any difficulty,
resistance, or conflicting thoughts distracting you from doing exactly what your mechanical system
calls for. Then, and only then, will you be ready to move into the more advanced subjective or intuitive
stages of trading.