Market Snapshots

This is the third, and last, post in a series of three posts that started by looking at the 10,000 hour fallacy and the importance of deliberate practice. Those posts were broad in scope, and some of you asked how to related them specifically to trading and financial markets. That’s the point of today’s post: why deliberate practice fails most developing traders, and how to approach the problem of trading smarter.

More answers, better answers?

Research can be confusing because answers are often unclear. We would like to think that science is black/white, true/false, but this is not at all the case: answers only come within the bounds of statistical uncertainty, researchers have motivations and perspectives that shape those answers, and many answers that appear to be solid defy replication. Errors in thinking can persist for decades. (We’re seeing a good example of this now with the revision of thinking on low-fat “heart healthy” dietary guidelines that were supported mostly by research funded by sugar producers.)

Some of the best answers tend to come from meta-studies, which are large studies of other studies. A researcher doing this work has an eagle-eye perspective on a lot of data and different methodologies and can often create analytical techniques that compensate for the weaknesses and biases in some studies. No, there’s still no certainty, but a good meta-study will often get us closer.

Brooke Macnamara, Hambrick, and Oswald published a substantial metastudy of the deliberate practice literature in 2014 (alas, to nowhere near the fanfare created by pop science bobbleheads over the “10,000 rule”): Deliberate Practice and Performance in Music, Games, Sports, Education, and Professions: A Meta-Analysis. That paper is worth your time to read, but here is the authors’ conclusion, followed by one of the charts from the paper (emphasis mine):

Ericsson and his colleagues’ (1993) deliberate-practice view has generated a great deal of interest in expert performance, but their claim that individual differences in performance are largely accounted for by individual differences in amount of deliberate practice is not supported by the available empirical evidence. An important goal for future research on expert performance is to draw on existing theories of individual differences to identify basic abilities and other individual difference factors that explain variance in performance and to estimate their importance as predictor variables relative to deliberate practice. Another important goal is to continue to investigate how and when task and situational factors such as task predictability moderate the impact of deliberate practice and other individual difference factors on performance. Research aimed at addressing these goals will shed new light on the underpinnings of expert performance.

Things that matter

The conclusion of this paper was that 12% (that’s the take-home number) of variation in performance was explained by deliberate practice, across a wide range of situations and fields–twelve percent. That is not most, nearly all, or even a lot. It’s some. It probably separates the very, very good from the absolutely top in some of these fields (but maybe not–that’s an assumption not supported by the research). For everyone else, it’s probably important, maybe very important, but it’s also clearly not, based on this study, the most important place on which to focus.

I think one of the other key points is that deliberate practice seems to work best in highly predictable fields. You tell me, is learning to trade more like learning to play a Beethoven sonata on the piano–a task in which nearly every aspect is known and defined beforehand–or is it more like fighting forest fires? We can see clearly from the chart above that deliberate practice appears to fail in explaining peoples’ success in professions (and, perhaps, in education), so perhaps this is not where traders should be focusing.

I think one of the problems with learning to trade is that there are no, true, “fundamentals” of trading. Before you object, let’s consider fundamentals in other fields. In music, we have basic aspects of technique and theory. In knifemaking, we have fundamental techniques of moving hot metal, managing stresses in the piece, and controlling hardness. Every sport has a set of techniques that can, and must, be assimilated into muscle memory. In chess, we have the endgame, fundamental pieces of tactics and combinations, and patterns that occur, with variations, over and over.

Is trading the same? Though people have substituted things like booking screen time and doing silly keyboard drills, I would argue that the “fundamentals” of trading have been misunderstood. These are primarily psychological skills relating to performance under risk and pressure. There are ways to move toward mastery of this psychology–both from an emotion and intellectual perspective–but one of the critical factors is time. A beginning trader is a nervous, twitching mess every time he even thinks about putting on a trade. He swings between extremes of elation and depression with every tick. He can’t see or think clearly (literally cannot because his brain is chemically compromised by the emotions of trading) while the market is moving.

If that trader does not blow himself up, after a few years he stops caring so much; he becomes desensitized to the movements of the market. The emotions naturally abate as he moves toward mastery. (An important linguistic note: English encourages the use of the gendered pronoun, so I realize I’ve written “he” throughout this explanation, but women, who account for a tiny percentage of traders, generally do this better and faster than men. More women should probably be traders because they seem to adapt to this world much quicker, in my experience, than do men!)

We need exposure to market patterns. We need education. We need to understand statistics, probability, cognitive bias, market microstructure and efficiency–all the things that explain why trading is hard, but we also need a lot exposure to the market and a lot of times at bat.

Discipline fails

I gave a presentation last week to a group of options traders who work with a good friend of mine. In that presentation, I argued that we think about discipline the wrong way. We tell traders they must be disciplined, and they fail to be disciplined. Why? It’s not because these traders are stupid failures or that we are incompetent teachers–it’s because we are asking the impossible. Discipline is an outcome as much as it is a goal. Discipline shows that a lot of things are working correctly in a trader’s world, and that the trader has achieved some degree of mastery. To tell a developing trader to be disciplined is akin to handing someone a basketball, putting them on the free throw line, and telling them to sink 50 in a row.

Discipline is the outcome of the right mental framework, emotional skills (largely including the systematic desensitization to the stimuli of trading achieved over many years of exposure), and process. These things matter, and perhaps we don’t focus on them enough.

What might matter most

One of the things that always bothered me about the 10,000 hours was that it did not line up well with my experience. When I started music, frankly, I was almost immediately “good”. Though I started late in life (for a classical musician) I easily leapfrogged people who had been studying for years, and, perhaps even more important, I loved it–there was a virtuous circle in which I saw that I had skill, which reinforced my excitement and love for the field (passion), which led me to develop more skills. I can see a clear difference between the things that I have tried to do with moderate success and the fields in which I have achieved some significant degree of mastery. In the latter, I always had that “aha” moment at the beginning–some early successes, and an immediate attraction for the field.

When I had the experience of teaching a reasonably large body of music students, I saw some did much better than others, regardless of my effort as a teacher. In fact, because I was so aware of my potential failings, I think I worked harder with and for many mediocre students. Sometimes they sucked because they didn’t care (not to mince words!), but that was not always the case. I saw several cases in which the students put in time, but just simply did not get the same improvement that someone else might have. I could also make the observation that passion again seemed to be a necessary, but not sufficient, precondition for success. Some of the less successful students loved what they were doing (and, I hope, will always find it to be a contribution to their life and happiness), but, without exception, every good to great student was on fire with the rage to master their discipline–success was only a road to the next challenge to be conquered.

I think this is harder in trading. Do you really love the process of trading, or are you focused on the financial success and the (very real) change it can make in your life? You don’t have to love everything you do, and you might even need to fight the tendency for obsession that comes with passion, but I think your life will be best rewarded if you can bring some coherence. Trading is going to be hard, and it’s going to take you at least a few years to have any measurable success. If you don’t love it, you probably shouldn’t be doing it–that’s probably the most important thing of all. Life is short; if you don’t love what you’re doing, find something you do love.

This post is a followup to my recent post which looked at Malcolm Gladwell’s 10,000 hour fallacy. That post focused on what is wrong with pop science soundbites. This post is different: today, I’m going to tell what you can do to work toward mastery–practical tips toward deliberate practice. Soon, I’ll follow up with a final post that asks the question no one ever seems to ask: should you even be doing this? What’s the right thing for you?

Deliberate practice

After I published the previous post, several of my readers raised the objection that I was oversimplifying Gladwell’s book, and that he emphasized the importance of deliberate practice rather than just spending 10,000 hours doing something. Actually, it was the original research done by Anders Ericsson that emphasized deliberate practice, the research that Gladwell misrepresented and oversimplified. Here is what Ericsson himself has to say on the topic:

…Gladwell didn’t distinguish between the type of practice that the musicians in our study did — a very specific sort of practice referred to as “deliberate practice” which involves constantly pushing oneself beyond one’s comfort zone, following training activities designed by an expert to develop specific abilities, and using feedback to identify weaknesses and work on them — and any sort of activity that might be labeled “practice.” For example, one of Gladwell’s key examples of the ten-thousand-hour rule was the Beatles’ exhausting schedule of performances in Hamburg between 1960 and 1964. According to Gladwell, they played some twelve hundred times, each performance lasting as much as eight hours, which would have summed up to nearly ten thousand hours. “Tune In,” an exhaustive 2013 biography of the Beatles by Mark Lewisohn, calls this estimate into question and, after an extensive analysis, suggests that a more accurate total number is about eleven hundred hours of playing. So the Beatles became worldwide successes with far less than ten thousand hours of practice. More importantly, however, performing isn’t the same thing as practice…an hour of playing in front of a crowd, where the focus is on delivering the best possible performance at the time, is not the same as an hour of focused, goal-driven practice that is designed to address certain weaknesses and make certain improvements — the sort of practice that was the key factor in explaining the abilities of the Berlin student violinists.

So, yes, deliberate practice is important, and we should turn our attention there, rather than to the 10,000 hours. But what is it? In a nutshell, it’s practice that challenges you; it’s practice that pushes your limits. Deliberate practice may not be fun—in fact, if you’re doing it right, you will have many failures—many times where you try to do something but are unable. This is a natural consequence of working at the edge of your ability, and it is uncomfortable.

An easy example might be to compare two piano players. One plays pieces of music he likes, sometimes plays in front of friends, and when he can play something pretty well, moves on to another piece he likes. He will stop to work on the parts that challenge him so he gets better, but he mostly enjoys playing things through from beginning to end.

Contrast that to the serious player who spends hours working on details, might work on a piece for weeks or months, and may spend days in which he does not play the piece in its entirety. If you were to listen to him practice, sometimes you couldn’t even recognize the piece he’s playing because he is playing very slowly, or is playing small sets of notes (sometimes as few as two or three) over and over in different ways.

One of these guys is not right and the other wrong; they are doing two almost completely different activities. The first person is playing casually, for fun. The second person has a different objective, and may not, on the surface, be having as much “fun”. The serious worker may end practice sessions dejected, and will begin again tomorrow by focusing on places he is likely to fail.

Passion matters

When we work in deliberate practice, we frequently face our limitations—we fail, over and over again. Though, as I’ve said, this is not fun, it can be profoundly rewarding. When we overcome obstacles, and someone working in deliberate practice certainly will, the emotional rewards are very sweet indeed.

Deliberate practice is not drudgery. In fact, I don’t think you can do it without passion. Passion is a word that gets thrown around casually (especially by every business school student on a job interview. No… I don’t think you are passionate about capitalizing operating expenses…), but it is the driving force behind the will to succeed. Unless you love something so much that it is a part of you, I don’t think you can muster the constant work and struggle to work toward mastery. Without passion, you are doomed to be a hobbiest and mastery will ever elude you.

How to do deliberate practice

Deliberate practice is a mindset, and if you are working toward mastery, it will be a lifestyle. Let me share some ideas that will apply to a wide range of disciplines, then we will look at trading and financial markets, specifically

Deliberate practice requires time and effort. This is one of the true lessons of the 10,000 hours: it takes a lot of time and work to develop mastery. If you want to succeed at something at the highest level, assume that your path to mastery will be measured in years, or perhaps decades. You can expect to achieve some real competence and proficiency in most fields in perhaps 2-3 years, but there will be others where you are still building a foundation at 5 years. Your time commitment will be pretty much every day. On average, probably 5-6 days a week. You can take vacations and breaks—you’ll likely find that doing so speeds your progress—but you will not get where you want to be working 2-3 days a week. It’s ok to switch your focus and plan once you get into something, but if you do decide to master a field, go into it with your eyes wide open: the days will turn into months will turn into years, and you will have thousands of hours invested in your mastery.

What you do matters. You can’t spend time just playing and exploring. You must work in deliberate practice. (Yes, this is a list about deliberate practice, but this point is so important it must be re-emphasized.) These thousands of hours you are putting in must be well-spent.

Understand the goals and ways to evaluate your progress and get feedback. This is one reason why you may get much better results working with a coach or teacher. When you’re learning, you truly don’t know what you don’t know. Even when you are well along your path, having the outside perspective of a master teacher can speed your progress along. You may well create your own path, but you’ll do that most effectively if you have a foundation of basic knowledge in the field. As you develop, you’ll learn to tell good from bad, but even this must be taught at the beginning. The beginner picking up the golf club probably feels equally awkward holding it correctly or incorrectly.

Break things into parts and parts of part. Watching a master do something, it often seems easy. Everything flows, but this ease is deceptive. What you’re actually seeing is mastery of many little details, and some of these details may seem very boring. For instance, I recently returned to serious piano playing (after achieving a good degree of mastery in the field) and worked with a master teacher to build my technique. We spent many weeks playing one note at a time with a single finger dropped on a key. After that, we spent months playing one note at a time, hands separately, very slowly. I think many people would not have had the patience to endure this type of training, but it was essential–we were focusing on the atomic elements of technique, and everything I will do rests on a firm mastery of those basic elements. This is true of any discipline, and working toward mastery doesn’t mean “doing really cool and hard stuff” as much as it means doing very basic things very well. One of the consistent reasons I’ve seen people fail in various pursuits is that they are unwilling to spend this time on basic. They are too good, too proud, too “advanced”–and it is exactly this thinking that will doom us to mediocrity.

Failure is good. Most people create their lives around the idea of avoiding failure. Failure is scary, and failure doesn’t feel good. Someone working in deliberate practice will work toward failure and will cultivate practice techniques that assure failure. Now, there’s abject catastrophic failure, which is a sign that we’re reaching too far and can be harmful (and in some disciplines physically harmful), but good practice will assure thousands of small failures in a week. You might think of it like this: if you don’t fail, you’re not trying hard enough. Failure shows us where our “growing edges” are, and only by exploring those edges can we grow.

Repeat and repeat and repeat. This almost goes without saying, but you’re going to be repeating basic elements over and over. You’re going to be learning something, relearning it, and then working on it long after you’ve mastered it. Once you think you’ve polished something, you’ll begin to see imperfections and to see ways in which you can grow further. This might relate to part #4, but I’ve seen many people who are on a quest to accumulate as much knowledge as possible. They would rather have tons of superficial knowledge (e.g., reading hundreds of books on a subject) without really digging deeper. Master is both broad and deep, but going deep is not natural. Going deep takes many repetitions, and then many more.

If you do this right, it’s hard work. But it’s also incredibly satisfying. Even more important: it’s the only way to get to mastery.

That’s enough for today. I have one more post coming on this topic. In that post, we will revisit the nature/nurture question, ask what the limits of practice might be, and if you should be doing this at all. Oh, and we’ll also look at why all of this might not apply so well to trading and financial markets in general.

Have you ever heard someone say they are “working toward their 10,000 hours?” I’m sure everyone reading this has heard of the “10,000 hour rule”: the idea, drawn from Malcolm Gladwell’s bestselling book Outliers, that it takes 10,000 hours to become an expert in any field. There’s a big problem with this: the 10,000 number is not real. It’s made up. It is a carefully chosen fabrication intended to sell books, but it causes us to miss the things that are truly important–the things that will move us toward mastery.

It’s a lie!

I think the 10,000 hours rule has been re-hashed enough that everyone knows it, but let’s just cover the broad bases. In his book, Gladwell looked at some research that focused on German violin players. The research found that the “best violinists” accumulated significantly more hours of deliberate practice than did violinists who were to become music educators, noting that that group had to fulfill lower admission requirements.

After creating the 10,000 hour rule from this research, he then finds other narrative examples, such as the Beatles’ time spent playing together and Bill Gate learning coding, and backs into the magical 10,000 hour math. A reasonable extension of this rule, if it were true, would be that that natural talent or ability do not matter (or don’t matter much), and, in fact, might not even exist–all that matters is what you work toward the 10,000 hours to mastery.

There are a few problems with this, but the biggest problem is that it simply is not and never was true. Gladwell did not conduct the research himself. Rather, he took the work done in this paper: The Role of Deliberate Practice in the Acquisition of Expert Performance (1993) by Anders Ericsson, Krampe, and Tesch-Romer and used that as the seed for a best-selling book.  Gladwell is a great writer and knows how to craft a story, but that story does not reflect a solid understanding of the actual research.

For example, he cherry picked the 10,000 hours from the average of the elite groups’ estimated lifetime practice at age 20. Had he picked another age, he wouldn’t have come up with such a memorable number, and probably wouldn’t have sold many books! At any rate, the 10,000 was an average, hiding a vast range between the high and low, and half of the violinists had not reached 10,000 hours by age twenty. Gladwell claimed conclusively that they all had; whether this was his misunderstanding of the research or a willful misrepresentation to strengthen his 10,000 hour narrative, we do not know. He then took this idea and extended it to other examples, fabricating a record for the Beatles and Bill Gates to explain their success in diverse fields as a product of 10,000 hours of “practice”.

Too many people who should have known better (particularly in the field of trading), but it’s a very catchy idea that plays to our idea of the importance of passion and hard work. Pop cultuer seized on the idea, and it’s become deeply entrenched. At the same time, people who do understand the issues have pushed back. The whole concept of 10,000 hours has been roundly criticized by scientists, perhaps none more so than Anders Ericsson himself, who has said that Gladwell simply didn’t understand the research. Other writers have pointed out that mastery can be achieved in far less than 10,000 hours, and some people can never attain mastery, and that different fields require very different investments… the list of objections goes on. In the storm of controversy, Malcom Gladwell had this to say about the book:

Yes. There is a lot of confusion about the 10,000 rule that I talk about in Outliers. It doesn’t apply to sports. And practice isn’t a SUFFICIENT condition for success. I could play chess for 100 years and I’ll never be a grandmaster. The point is simply that natural ability requires a huge investment of time in order to be made manifest. Unfortunately, sometimes complex ideas get oversimplified in translation.

So there it is in a nutshell: complex ideas get oversimplified in translation.

Why we care

Let me give you a few examples, drawn from my experience. If we approach mastery with the idea that we need to push toward some mythical goal of 10,000 hours, we start thinking of ways to do just that, and this is a lot of time. For reference, if you work a standard 40 hour work week and took no vacations during the year, you’d hit your 10,000 hours somewhere before year 5. On the other end of the scale, if you imagine a serious hobby at which you spend 10 hours a week (2 hours a day 5 days a week, or maybe 6 hours on the weekend with a sprinkling through the week–realistic for most serious hobbies), it would take you 20 years to reach 10,000 hours. Something you do only occasionally throughout the week? You probably wouldn’t get there in a lifetime.

Now, here’s our first clue that something might be wrong: how many people have logged far more than 10,000 hours in careers, but have not achieved “mastery” (whatever that means) in those fields? There are good reasons for that, and we’ll get to those reasons in my next post. But if you convince people that logging these hours is the key to success, a surprising number of people will start working toward that goal. Here are some specific things I’ve seen:

Traders at a prop firm, probably laboring under the Puritanically-derived American “work ethic” that hard work should be miserable and require long hours, planning on getting to the desk early in the morning, sitting there all day, and staying until evening so they can work toward their 10,000 hours.

There’s a community (or was) of people learning self-taught piano playing who record their practice hours toward 10,000 hours.

Well-meaning online communities of traders encouraging each other and saying they just gotta put in the screen time and log their 10,000 hours. Traders have always thought (wrongly) that learning to trade was just a matter of logging “screentime”, but once the book came out some traders went nuts. I read a sad blog of a kid who graduated from college and passed on job offers so he could spend the next 3 years working toward his 10,000 hours… on a simulator.

There’s a community of online creative writers who set writing projects for themselves to work toward the goal of the mythical 10,000 hours…

You get the point. Pop science is a dangerous drug, but the messages resonate for a reason–because they are catchy and memorable–not because they are right.

What else matters

The discussion about the 10,000 hours cuts right to the heart of the nature/nurture divide. On one side, people say that genes and natural ability are all that matters, and the other side says that it’s all training and anyone can learn to do anything. (If you want a shortcut to the truth, it’s usually in the middle of any argument.) The 10,000 hours is all about hard work, but what else might matter? We now have some solid research that quantifies the effect hard work has on achievements in different fields. In the 2014 paper Deliberate Practice and Performance in Music, Games, Sports, Education, and Professions: A Meta-Analysis, authors Macnamara  et al conclude:

researchers proposed that individual differences in performance in such domains as music, sports, and games largely reflect individual differences in amount of deliberate practice…. This view is a frequent topic of popular science writing—but is it supported by empirical evidence? To answer this question, we conducted a meta-analysis covering all major domains in which deliberate practice has been investigated. We found that deliberate practice explained 26% of the variance in performance for games, 21% for music, 18% for sports, 4% for education, and less than 1% for professions. We conclude that deliberate practice is important, but not as important as has been argued.

So what else might matter? That’s the right question, and it is also the topic of my next post.

We’ve had a very large decline in stocks this week. Depending on what index you use and how you measure, it’s the biggest or one of the biggest in the past few years. The world is also tense with geopolitical concerns: economic numbers from major economies are conflicted, world leaders exchange tense words, and the threat of armed conflict, even of a nuclear exchange, seems more real than it has at any time in the past few decades.

Add to this an investing environment that already challenges investors and traders alike: volatility has been historically low, key groups of stocks have failed leadership, and many traders are frustrated at every turn. People, especially talking heads and social media commentators, are on the wrong side of moves with stunning regularity, but even level heads are asking “how much longer can this bull market go?”

We don’t know the answer to that question (or to any of the questions raised by the concerns above), but we do have some guidelines. Take a look at the following chart, which shows what happened following the eight biggest declines in the S&P futures over the past five years. This is not an easy chart to read. In fact, it’s an ugly chart (and I’m sorry–I abhor ugly charts), but there’s an important lesson to this presentation.

A little explanation is in order: This chart shows what happened each of 20 trading days following the large single-day declines indicated. The large declines are measured in sigmas (standard deviations of the past 20 trading days) rather than percent changes or points, so these are volatility-adjusted large declines. (You’d get very similar results no matter how you define the declines.) Each of the light traces is price path (in percentage terms) following the corresponding day. The heavy black line is the average of all the days on this chart, and the thick red line (labeled “All Days”) is the average of all days in the S&P. This is important because it shows the baseline drift we can expect from stocks.

It’s clear from this chart that 1) stocks tend to snap back rather strongly following large single-day declines. It looks like we’re up about 4%, on average, a month later, while the S&P usually only goes up about a percent a month. There’s also a wide range of outcomes: we’ve been up over 7% a month later, but all of the days in this study were positive 20 trading days following a decline. There was some pain: we can see a few of the days continued to decline, with a couple going down about another 3% over the next week or so, but the overwhelming tendency is up.

Lessons

What do we do with this information? Well, I know there are all kinds of flashy sayings like “Never cross a river because it is, on average, a foot deep”, and “trade the averages if you want average returns”, but what better guide do we have? If we want to understand the market, don’t we want to understand what usually happens?

Now, maybe this time is different. Maybe something will happen in the world that will send stocks down 10% next week. It’s possible, but, to my thinking, it’s the ultimate arrogance for me to assume that I can say this is the time that is different! It usually is not different. The best guide to our actions is understand what the market usually does, and applying that knowledge within a disciplined framework of risk management. This is how we make money in the market, folks.

Other lessons: When we talk about averages, it’s easy to forget that some very large deviations from those averages do happen. Our results are only meaningful over a large sample of trades, and the market can certainly throw us some surprises. This sample size is very small, and you might raise the objection that the past five years were an abnormal market environment. (Good point, and here’s a blog post that basically does the same thing I’ve done here for a longer time period back.)

So, temper your fear. Put aside your political concerns and unease about what the future might hold. This time might be different… but it probably won’t be.

I received a good question from Gareth this morning: “Your book is one of my top sources in trading literature, though there are some ideas that I find it difficult to agree. Specifically, I’ve found your idea of many support/resistance levels being created randomly hard to understand, since movement in every tick is the result of large institutional trading. Is there anything that I’m missing with this concept?”

This is a good question, and there are at least two good points to consider.

First, is that even deliberate action can result in random motion. For instance, think of throwing a piece of fish food into a tank full of small fish. Though I’ve never analyzed this scenario (and I’ll wait for someone to email me and tell me why I’m wrong), I’m betting that piece of food, if we were to run the experiment over and over, would move randomly on the surface of the water. However, each fish is not moving randomly! Each fish is trying to get a piece of food in its mouth, and it’s doing so with the deliberate eating strategies a fish has honed over eons of evolution and selection. Fish are good at eating, and this is what each fish is trying to do.

But, their actions together are a mess. Sometimes two fish hit the food from opposite sides and cancel out. Sometimes more hit one side than another. Sometimes one comes from far away, so he’s moving very fast and imparts a lot of energy to the food. You get the idea: no individual fish is acting randomly, but their actions as a whole could be very random.

It’s the same in the market. People buy and sell for many different reasons. Even if you think a stock is a screaming buy, there are a lot of people selling too. In some cases they are selling to establish shorts. In others, to take profits on longs. (Maybe they knew it was a screaming buy months before you figured it out!) In other cases, they may buy and sell for unrelated reasons: I could very well establish a bullish options position that might involve selling the stock. The list goes on.

The second reason is that I think one of the worst offenses in the “educational” literature is the idea that each and every tick has significance. I believe quite the opposite is true, particularly when analyzing intraday bars. Most of what we see is random. The idea that someone has to take the other side of your trade is silliness–no one who has any idea how markets work could actually believe this. (See previous paragraph again.) The big picture structure is important, and some elements are important, but much of what we see is probably just patterns that pop out of a soup of randomness and touch some of our cognitive biases–in other words, they aren’t real.

Is support and resistance random? I don’t know… there’s no reliable way to answer that. I can show you that there is unusual activity around certain kinds of levels, which strongly suggests those levels might not be random. I can also show you that any line drawn on a chart will appear to be meaningful and non-random to a trader; you cannot trust your sense and perception about this. So I do think that a lot of what passes for technical analysis, being driven by observation and untempered by actual analysis, is simply people finding patterns that appear meaningful, but actually are not. Sadly, books and entire disciplines have been anchored on these concepts, and much of modern TA is less than useless because of this.

So, yes, I’d say what you’re missing is a full understanding of the potential for action in the aggregate to be random, even if the actions of the individual actors have clear intent. The markets may be much more random than we’d like to believe… at least consider that possibility.

Over the past few weeks, I’ve been hanging out a bit more in internet trading rooms and groups. It’s been a good reminder of the kinds of questions and mistakes people make as they are learning about markets. Room moderators strut (including one who told his group he made mistakes that cost him millions of dollars last year, but no biggie because his life wouldn’t change either way). People give horrible advice (you are losing on a trade? Hedge it with options! While you’re at it, try penny stocks. I made 10,000% yesterday!) And arguments over market direction are actually thinly veiled expressions of fear, hate, and political sentiment. (And of course the Illuminati need to hold gold prices down. Do you know how much gold they need to cover the pyramids they use to communicate with Xenu? Time travel is expensive. At least they do not manipulate the price of aluminum, so you can still make those hats to keep the satellite waves out of your brain…)

I’m having a little fun at their expense (and I’m very aware that I’m about to be kicked out of every trading forum I have joined), but that’s not the point of this post. The point is that there is a better way–there are patterns in markets that can show you where those markets are likely to go. If these patterns are hard to see, it might because they are simpler than anyone expects. Trading them is not trivial; the edge they provide is very small. The only way they will work is over a large set of trades, so all the things you hear about–discipline, risk control, process, consistency–these are all essential because they keep you in the game long enough to let the small edge work in your favor. But the basic patterns of the market are not difficult to read.

Many of the more complicated patterns in the market are actually variations of simple patterns. Of all the patterns I know and use, the best, and probably the most useful, is the pullback. Now, trading pullbacks in trends is a well-known strategy. I gave a presentation recently explaining, in detail, how to find pullbacks, where to enter, where to put stops, how to manage the trades as they develop, and backed it up with about a dozen examples of pullbacks from recent market action–showing some working and some that failed. In the middle of it, someone raised his hand and asked “are you going to be talking about more interesting stuff? Everyone knows about pullbacks…” I gently asked him how many pullbacks he had actually traded and how they had worked out–a question to which he had no answer.

I guess the point of this post is this: if you’re looking for a way to read the market, understanding pullbacks in trends is a good place to start. If you can read pullbacks well, you can understand which trends are likely to continue and which are likely to fail, and you can also know where to get in with reasonable stop points, and where to take profits. There’s a lot of nuance to these patterns, but the basic pattern is extremely simple. (For more reading, check out this post, this one, and then you can scour the archives for other posts. If you want to build a complete trading system around this idea, then check out my (completely free) trading course here.)

Let me leave you with these charts. Here are four examples of simple pullback patterns drawn from recent market action (daily charts). These are not “after the fact” charts–all of these were identified before the moves developed. Of course, these are trades that worked, and they don’t all work. But they do, over a large set of trades, provide a strong statistical edge; you can build a trading program on that edge. You can build a career on that edge. Simple patterns work.

A developing trader said something to me a few weeks ago that has stuck in my mind: he said that he has to be careful what websites he reads because negativity can be dangerous; when you live in a constant state of fear, it colors everything you see. Be careful: you are what you eat (and read and think about!)

I think it goes even deeper. Negativity and fear change our perception deeply. When we absorb certain kinds of information, or information placed in emotional contexts, we create blind spots for ourselves. We are not able to see and think rationally if we allow too much emotion, and too much emotional contamination from others, into our thought process. Emotional context changes how think and how we are able to think.

I’d challenge you to take a moment and think about the information you consume on a daily basis. First, major media is not perfectly unbiased. Anyone who works in media wants to engage an audience. We (I’m including myself here because, among other things, I’m a blogger) all know that emotion generates clicks, shares, and reads and negative emotion resonates much more strongly than positive. So, news stories naturally come wrapped in an emotional wrapper with a provocative and emotional headline, and our brains naturally accept the emotion with the facts.

Major media has a mandate to be more or less unbiased, and most major media sources accomplish this fairly well. But what about blogs and newsletters and sources that are intended to be biased? Some of the most popular sites on the internet feature an incredible dose of emotion—fear and hate will provoke and engage an audience and build a core audience very well.

So take a few moments today and do an information inventory. Ask yourself what sites and sources you regularly read and how much emotion is baked into them. (I’m not going to call out any specific sites or authors, but I think you will be able to read between the lines.) For traders, there are a few specific things to watch for:

Do you frequent discussion forums that are filled with frustrated, failed traders and investors? Some of these forums also include a healthy dose of constructive work by traders who are either committed to figuring out the game or helping others, but be sure you can separate out the wheat from the chaff. I’ve been involved in these forums since they were mailing lists, and I can say I’ve rarely seen the degree of anger that comes from failed traders. They are certain the system is rigged, and just throw abuse at anyone and everyone in the forum like a monkey throwing poop at the zoo. You can hang out in these forums, but watch out for the flying poop.

Speaking of flying poop, there’s been a lot of focus lately on fake news, especially politically-driven news on Facebook and other social media feeds. It takes less than a minute to do some basic fact checking, so please do this before you share and get upset about something you read.

Do you read newsletter writers who constantly predict the end of the financial world, World War 3, or who focus on conspiracy theories? If so, you’re probably hurting yourself. There are writers who have built multi-million dollar industries playing on the emotions of the public. These newsletter writers have been constantly predicting THE END for decades, and they’ve been wrong. They will continue to be wrong, but the harm they have done to their readers is almost beyond measure. If you read anyone like this, consider carefully what your world would be like without this influence.

Do you frequent blogs that repost or aggregate content like this? Is there a constant flood of posts predicting crashes, talking about why the system is rigged, or drawing great significance from hidden datapoints? Is everything blamed on HFTs? Again, this stuff generates clicks and shares, but it does not help you as a trader and investor.

Once you’ve taken a serious look at the information you consume, then you’re in a position to figure out what do to about it. I suggest trying an information diet: First, cut out virtually everything you read. If you are a news junkie, this may feel uncomfortable. You may feel blind or cut off, but give it a chance. Avoid clicking or reading for a week, and see how your emotional state changes.

Then you can start adding things back, a little at a time, and monitoring your emotional state while you do so. If you find yourself sucked into hours of clicking and sharing emotional and negative articles, first of all congratulate the blog owner on building an engaging blog, but then step away and rethink. You can absorb information, but you need to be careful about the emotion that goes with it.

We have limited time and attention. This is one of the realities that developing traders soon face—no matter how hard you work or how well-intentioned you are, there’s a limit to what you can look at, analyze, and understand. It’s important to filter out the noise so we know where to focus that precious resource of time and attention, but how do we do that?

Another way to ask this question is something like “what’s the most important thing on a chart?” or “where do you start reading a chart?” The answer is simple: you want to pay attention to the big moves.

Why big moves? Because most of what we see on a chart is random. Most of the time, the market moves unpredictably from point to point, and we can’t make money if the market is moving randomly. If we’re going to risk our money (and other resources like time and mental and emotional energy), we need to have some evidence that there’s an edge in the market. Looking around big moves is a good way to start looking for an edge.

So what is a big move? The answer is “it depends”, but that’s not the useless answer it might appear to be! What does it depend on? It depends on how the market usually moves; a more precise way to say the same thing is that it depends on the volatility of the market, and that’s the key: using measures that automatically adjust for the volatility of the market can help us find these big moves we want to focus on.

We can think of “big moves” either as single bars or swings—we can look at large single bars, relative to some measure of “average bar size” on the timeframe we are monitoring, or we can also look at large swings that somehow rise above the average swing length for the

The first is visual inspection. Simply look at the chart and ask yourself which moves jump out as big moves. The problem with this is that this is a purely subjective measure. What stands out to you today might not stand out tomorrow; if you look at the same chart twice you might come up with two different answers. That answer might depend on the charts you look at before, how long you’ve been studying, what you had for breakfast—you get the idea. This certainly doesn’t invalidate this approach, but you do need to realize that it may not be fully reproducible. The chart below highlights some big moves with red arrows, but the orange arrows point to bars that might or might not be considered big moves. We also can’t use this in any kind of backtest because it’s so subjective. Even with those limitations, this is something anyone can start doing today and simplicity is often a good thing.

We can pick out big bars just by looking at the chart, but this raises some questions

If we want to have something more consistent, we can start applying some mathematical measures to charts. One of the tools I use is something I’ve called SigmaSpikes, which is simply each day’s move expressed as a standard deviation of the past 20 trading days. One way to use it is to go through a chart and highlight all the moves that exceed a certain threshold value. (I often use 2.0) The beauty of this measure, to my eye, is that it lines up very well with the points I would pick out subjectively, but it’s an objective measure. I can scan charts for it, create screens that rely on it, look at markets that have made big moves in recent history, and use it in a backtest—all good tools to help me narrow down the universe and to know where to focus my attention.

Big bars measured with sigma spikes

Another useful tool is to put some kind of band on the chart, and to look at the spots where the market engages the bands. Personally, I prefer Keltner Channels, but Bollinger Bands are probably more common. Don’t get too caught up in the search for the perfect tool or perfect parameters; the concept is much more important. The concept here is that we put some volatility-adjusted bands around the market and only look at the point where swings (or single bars) rise to the level of significance by touching the bands. Again, we can look at historical measures of this objective tool and even incorporate it into backtests and systematic approaches.

Bands can also be useful to measure big swings

Many of my readers probably already use tools like this, but, if you don’t, think about adding this concept to your toolkit: focus on markets that have made big, sharp moves, as these moves may point to the way to some imbalances in buying and selling pressure that could give opportunities for profits.

I got a good question from a reader, Eric:

Adam, can you please help me? I am going crazy because I feel I am missing the best and biggest trades. Overall I am making money but when I look at my charts and review I see that I am missing big moves and not picking the best stocks. This is making me driving me crazy. Any ideas?

Hi Eric. Thanks for a good question, and I can tell you that you are not alone in feeling this. Most traders struggle with this feeling. It pops up in two ways: sometimes we will just not be involved in a move that we wish we were in. For stock traders (and currency traders, to a lesser degree), there are so many “things” to trade that we can always look back and find stocks or currencies that moved better than the ones we picked. This is just because there are a thousand (give or take) choices and you have to select a few–odds are, you usually don’t pick the absolute best. (This is the same reason you usually aren’t in the fastest lane on the freeway!)

So what do you do about this? Well, first of all, make sure you have a good system that works. You didn’t give me a lot of information that I wish I had: what do you trade? How long have you been trading? How long have you been profitable? Without knowing things like that, it’s difficult to say for sure, but I’m focusing on this part of your question: “overall I am making money…” So, it sounds like maybe you do have a system and approach that works. You’re making money. You’re winning the game.

I’ll take a brief pause here and say that the type of intensive individual trade review advocated by some educators is, I believe, a serious mistake. This usually results in us digging deeper into randomness and inviting random influences to sway our opinions and trading. It’s better to review your methodology, process, and overall edge than to spend a lot of time at your desk going through charts of individual trades. So make sure you understand the edge you have over a large number of trades, and work to apply your system with discipline.

Pay attention, because I think this is truly the answer to your question: you must define what your job is as a trader. Your job is not to catch any move. Your job is not to be in the market when the market does anything. This mindset is damaging, and puts you in a position in psychological weakness. I’ve seen many professional traders and managers struggle because they are caught between the classic rock and hard place of wanting to manage risk but being terrified that clients will be angry if they are not in the market should it go up. You, as an individual trader, have no such restrictions built in. You are free. With the freedom comes power and possibility.

Define your job as simply following your system and process perfectly. Do what you’re supposed to do, and then do it again. Don’t stress about missing any move. It’s not your job and not your responsibility. Your only job is to follow your system and to do the right thing.

I’m sitting here at my desk looking out the window. On my desk is a (perfectly normal and fair) coin that I had been flipping a while. Question: can you tell me how many heads I flipped?

Now, think about that question a few moments. If you had to guess, what would you guess? Maybe I’ve been sitting here watching Netflix for a couple of hours flipping a coin. Maybe I flipped it while I was on the phone for just a few minutes. Maybe I just flipped it once or twice. You probably could figure out some reasonable estimate of how long a (mostly sane) person would sit flipping a coin, add into it an estimate of how many times you could flip each minute, and come up with some kind of answer. You can probably guess that there’s some practical upper limit to how many times I flipped it, and the probability distribution of how long I’ve been flipping probably has a lot of weight near the origin and not much out in the tail.  If this was an interview question for a consulting firm, you could come up with some answer.

Now, here’s another question: how sure are you of that answer? How confident can you be that you’re within 10% of the right number of coin flips? This is the question that really matters. Ok… hold on to that thought.

Let me give you one more piece of information. If I tell you I flipped 67 tails, does that change your answer to how many heads I flipped? It should–now you know if 5, or 65, or 65,000 is a better guess. How confident are you about your guess now?

Here’s the point of this post, and it’s not a math lesson: heads and tails go together. You can’t have one without the other. The same process that generates the tails generates the heads. You might even say that heads and tails “live together” or that “tails live in the land of heads”.

This is such a simple observation that many of my readers probably already clicked away, but I want you to think of this in two ways. First, this lesson generalizes to life. I think you can often tell how successful someone is by asking how many times they have failed. Most big, successful businesses (and individuals) have a string of dramatic failures behind them. In some sense, we learn from those failures and move forward.

But there’s another way to think about this–life and business are really about the odds. Chance and luck do play a part, but you have to put yourself in those situations where chance and luck can work in your favor. The more times you’re at bat, the better the chance you’re going to hear that crack and everyone can just stand and watch the ball sail over the fence. One of the most inspiring quotes I’ve ever heard–and maybe it’s as much for its gritty realism as anything else, comes from Mark Cuban: “it doesn’t matter how many times you fail.It doesn’t matter how many times you almost get it right. No one is going to know or care about your failures, and neither should you… All that matters in business is that you get it right once. Then everyone can tell you how lucky you are.

If you’re a trader, think about your losses in this context. How do you feel about those losses? Do you feel shame? Fear that your next trade might be a loser? Do you do things designed to minimize the size and chance of your losses? (Be aware that those two things work against each other–fearful traders often generate very small, but very certain losses. This is one way to die as a trader.) Or do you welcome your losing trades?

Do you know that all of your winning trades live in the land of loss? Do you realize, wholeheartedly, that your losses and wins are two sides of that same coin? Do you know your losses are essential to your success? The more winning traders you have in the course of your career, the more losing trades you will have–winning lives in the land of losing, just like the heads and tails on that coin I flipped.

When we understand this–and if we are sure that we are trading with an edge–then trading becomes easy. Fear of loss vanishes

To me, this is a simple, but profound truth. It also just happens that this simple thing is one of the keys of approaching trading with a professional mindset, and becoming fully comfortable with probability, risk, and the nature of a trading edge–all essential to your eventual success as a trader or investor.

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I just wanted to take a few minutes here at the end of the week and share some things I’m working on. Some of these things you will see soon, and some not so soon!

New book

First, I announced a few weeks ago that I have begun working on a new book. I’ll share an outline of the book soon, but let me tell you a bit about it. I’m working with the title The Trader’s Edge, but that is subject to change. The book really is about trading edges–how to find them, how to test them, how to trade them, and how to monitor your performance and behavior while you’re doing so. In many ways, this book will be the long-awaited followup to The Art and Science of Technical Analysis, but with a different perspective–broader (covering everything from technicals to fundamentals to macro), looking at more types of trading (relative value and options trades as well as directional), and with an even more “how to”, practical focus. You will be able to read this book as a pure system development book, but it’s also designed for a broader audience. If you are a discretionary trader and just want to make your trading “smarter” (i.e., with a better understanding of how to align your trading with the market and make better trades) this book should be a great fit for you.

I have completed the outline/planning portion of the book, and will begin writing soon. A book is a monumental undertaking, so I’ll ask you for some patience–editing, layout, graphics, and all that take more time than you might imagine. I’ll likely blog a bit on writing and the process of writing a book, so keep an eye out for that.

Track and understand your edge

Over the years, I’ve seen many traders do things that just don’t make sense–they’re doing the same trades and losing money, losing money and trying to increase size, mostly doing things that work but giving all their profits back in a few trades… and the list goes on. I’m working with a programmer to develop a tool that will help: this will be a tool to analyze your P&L and to understand your edge–sort of a trading journal on steroids. We are in the software development stage, and expect to have a long open beta test launching in the next few months. I’m creating this tool to fill a need, and I think it will be able to help many of you, and maybe make a huge difference for some of you. There are some products on the market, but, frankly, I think we can do better. I’m very excited about this project and will share more details as things progress.

Blog redesign and course content

You’ve probably noticed some slight redesign for the blog. Expect to see some more changes and additions, and also some changes to the trading course page. Also, there will be a new module for that course in the foreseeable future. I do think the course is essentially complete as-is, but it was designed to always have some growing edges. I’ll update you when more content is available.

Other things in the pipeline

There are several other things a bit further back in the development pipeline, but here two that don’t have the top secret sticker on them!–I am planning to write a comprehensive options trading book, but will certainly not begin work on that book until the current book is finished. Also, I may be bringing you a game-changing backtesting/testing platform that will put some powerful new tools in your hands… stay tuned for more info!

I saw this interesting article from Bloomberg last week, with the almost-clickbait title of “Train your brain for trading (No, Really!)” I just happened to click on it, and found that it was actually an interesting perspective on some earlier research. When I wrote my book (which you should check out if you haven’t already!) that particular paper was relatively new, and it had some perspectives that shaped the way I thought about teaching and developing intuition. Key points are that 1) this is a normal aspect of human cognition, just slightly re-tooled to work in the market environment, 2) intuition is normal, and 3) if everyone has it, it’s not a stand-alone source of a market edge.

If you want to read the original paper, “Exploring the Nature of ‘Trader Intuition'”, you can find it here, but here’s a little excerpt from pp. 361-362 of my book that hits some of the important points for traders. For developing traders, many of the tools and techniques we use are designed to nurture and to refine this intuitive sense of market action:

There have been many studies in the social sciences and in psychology that have established the reality of human intuition. Focusing specifically on trading and market-related intuition, Bruguier, Quartz, and Bossaerts (2010) structured a set of experiments designed to “better define what is meant by ‘trader intuition,’ and to understand why some traders are better than others.” They did this by creating a number of scenarios representing markets that both had and did not have trading by informed insiders, with the goal of seeing if novice traders could intuit the intentions of these informed insiders through price movements. Perhaps surprisingly, they found that uninformed traders with no experience in financial markets were quickly able to discern the intentions of these informed insiders, based on nothing more than information contained in price changes themselves.

The logical question, of course, is how did they do that? Bruguier et al. postulated a connection between traders’ intuition in market situations and a specific ability known in the literature as theory of mind (ToM). ToM is the human ability (perhaps shared with some other primates) to read benevolence or malevolence through the patterns in one’s surroundings—for instance, the ability to read another person’s intentions through eye expression or through moves in a strategic game. Since markets with insiders represent an environment that may be deliberately manipulated against the uninformed trader, ToM becomes a potentially relevant skill. Not only did Bruguier et al. find that trader intuition in their market simulations was strongly correlated with tests for broader ToM-based abilities, but it was specifically uncorrelated with ability on mathematical or logical tests. Last, they confirmed in brain scans that subjects were activating areas of the brain that have been associated with ToM in previous tests and experiments. It appears that subjects were using highly evolved portions of their brains in new contexts and applications to drive market intuition.

This paper is one of many that confirm the reality of intuition, but these results are particularly interesting because they suggest a fairly mundane explanation for the phenomenon. Intuition is not some mystical skill that only supertraders have; it is a retooling and reapplication of normal human abilities built from our social interactions. However, the most important point is that intuition is not special. Even inexperienced, uninformed traders quickly begin to develop intuition about market patterns (a fact that has been confirmed in many other experiments.) If everyone has it, intuition cannot, in itself, be a source of a trading edge.

An interesting debate emerged in the comments to one of my posts. In the post, I had suggested the discipline was the most important thing; a reader countered that patience was more important. Now, I could (and did) argue that patience is a subset of discipline, but the discussion could quickly devolve into an argument over the exact meaning of words–all of this could so easily miss the point: patience is absolutely essential for success in trading. And learning to have patience… well… it sucks!

The patience to wait for an entry

People who haven’t traded often have trouble understanding the psychological stresses of trading. I can remember my early days: I’d have a plan and I would know exactly what I would/could/should do and which markets I would trade. I would review this plan, write it down on paper so it was “real”, and then resolve to follow it exactly. Then, when the hoped for entry didn’t develop, I found myself almost magically in another trade in an unrelated market. I wish I could tell you this only happened once, but it was a part of my struggle several times, and then again when I switched markets and asset classes.

From a logical perspective, this is baffling. It’s beyond stupid. But nearly all traders do it, and some never get over it. The simple patience to wait for the right entry to develop is truly an essential skill in trading, and, if you can’t manage to do this, I don’t think you can be a trader.

We can come up with whatever powerful and correct imagery we wish: for instance, a hawk sitting motionless on a pole, watching the grass below for the telltale whisper of lunch. That hawk will sit for hours if need be, and then pounce at exactly the right moment. Far more often than not, things work out well for the hawk and badly for the “lunch animal”. Ideas like this should be compelling to a developing trader, but we can rehearse and pound the ideas into our heads, only to do something stupid in a I MUST TRADE NOW moment the next day. What to do about it? Hold on, we’ll get to that, but let’s look at a few other ways patience is important.

The patience to be sure you have an edge

This one seems obvious too: It shouldn’t be too hard for me to convince you that the markets are a difficult place and that you don’t stand a chance without an edge. It’s also not terribly hard for someone to learn how to develop and verify an edge. Knowing this, it would seem to be logical that any trader should carefully do the work to be sure he has a reason to risk money in the market, right? Of course, this doesn’t always happen.

Again, the solutions I’m going to offer will help here, but it’s also worth spending a few moments on the intellectual side of this. Whether you are trading or investing, you don’t have any reason to risk money or time until you are sure you have an edge. If you got a system idea from a chatroom, are trading some indicator or candle pattern, or just think you can figure out what companies make really cool products, you don’t have an edge. I would argue you can’t be reasonably certain you have an edge until you have some good data (ideally back and forward tested) that shows an edge, so consider this carefully before you risk money. Solutions in a few lines, but let’s look at one more kind of patience we need.

The patience to become a trader

Now, I know this borders on New Agey-touchy feely stuff, but there’s truth here: if you want to do this well, you don’t trade, you must become a trader. I think this is true whether you develop computer trading systems, actively trade technical patterns, or invest in longer-term stocks based on fundamental criteria–no matter how you are involved in the market, you aren’t likely to be successful until you have become a trader. This journey can be long and frustrating; it takes time and conviction. You’ll probably want to give up along the way, but just know that this is really the only way to succeed.

Many disciplines have clear apprenticeship paths, so the developing cook/shoemaker/architect is more or less assured of putting in the time needed. This process is also designed to slow things down so that the student doesn’t feel the need to push through and work too fast. While learning, growing, and developing skills, an apprenticeship program virtually forces patience. Yes, you can find someone selling you programs for trading that claim to do this, but the true apprenticeship path probably lasts 3-5 years. Does your two month course do the same thing? Of course not. You must be patient with yourself and give yourself time to grow into being and becoming a trader–there’s no other way. (Despite the already brewing arguments from the quants who think it might be different if we’re coding. Even here, there’s a long path to actually being able to effectively implement these ideas in the market.)

What to do about it

I can remember, as a very young boy, my grandmother telling me to never pray for patience because that was a lesson usually taught in miserable ways! Know this: if you have decided to be a trader, you’ve already committed to accepting the brutal lessons of developing patience, and the market god is a ruthless teacher! Though the market will certainly teach you these lessons if you stay in the game long enough, let me share a few thoughts that might help:

None of this makes rational sense. Accept that from the beginning, and don’t expect that you can rationalize your way around these issues. Here, we are confronting behavioral and emotional factors that are, to a large degree, outside the umbrella of rational control. Fixing behavioral problems requires a different tool set, and you be careful of emotions (e.g., anger, frustration, despair) that can make the process harder. Be kind and… um… patient with yourself as you work through these issues.

It is a discipline problem. At the same time you are being kind to yourself, inject a healthy component of “tough love.” If you can’t solve these issues, you’re probably going to eventually lose every dollar you risk in the market. This stuff matters, and you have to hold yourself to the highest standards. Demand perfect compliance to your rules.

Rules and accountability help. If you don’t know what you’re supposed to do, then it’s pretty hard to do it. Even with those rules, most of us will discover that it’s still harder than we might expect. Setting up some kind of accountability–to a mentor, to a family member, to a community, or even to yourself–is a good idea. Get some rules and then get some accountability.

It just takes time. Back to my grandmother’s point–developing patience sucks because there’s a lot of this that just takes time. The new trader is too hungry for action, and hands will often seem to make trades without conscious control. The new trader is a swirling mass of emotions and energy; we can try to channel those, but a pressure cooker needs a vent–otherwise we have a bomb.

Limit the damage while you learn. If there’s one truth I’ve learned about learning to trade, it’s this: you’re going to make mistakes. As a new trader, you’re going to make a lot of them, and you may make them for years. Make yourself earn the right to trade bigger. Monitor your growth and performance, and be smart about it. Don’t plan on supporting yourself from your trading income, perhaps for a very long time. All of this is designed to give yourself the time and space you need to grow and develop as a trader.

Just a few thoughts here that may help someone to take a few more steps along their path. Be prepared for how hard this is and how long it can take, and limit the damage while you learn–simple stuff, but powerful solutions.

I have a little pile of reader’s questions here, so let me just get to them.

John asks: “Should I use stop or stop limit orders to protect profits and limit risk?”

John, like pretty much everything else in trading, the answer is a solid “it depends.” Your answer to this will come with understanding the tradeoff: a stop order might be filled at a truly horrible price, but a stop limit order might trade through (e.g., on an opening gap) and never be filled at all. Both order types have a way they can go wrong, so the question is which is worse.

And the answer, of course, is it depends. What does it depend upon? One key issue is the microstructure of the market you are trading; there’s a world of difference between a liquid, active currency and a very thin stock that might not print a trade for hours some days. The size of your order relative to the liquidity of the market is also a consideration, and this is something that has may have changed a bit with the HFTs–even moderately sized orders can have a surprising impact on a liquid market. It also depends on your trading style and what you’re trying to accomplish. It depends on your trading style and what you’re trying to accomplish with the trade. It might even depend on where the trade is in its lifecycle (i.e., just entered, old trade but hasn’t really moved, significant profit, or nearing an exit at a loss.)

In many markets, the question is basically solved for you, as there are no true market orders (meaning that a stop cannot elect to a market order, only a limit order.) You can still set the limit price so wide that the order is effectively a market order, and then you are subject to tradeoffs like I mentioned above.

  Two readers asked a question that I can paraphrase as: “How do I think about all of the influences that might be acting on my trade? If I want to buy a stock, how much to I consider the market? How about the Dollar because that will move the stock. How about things that might or might not happen like the Fed raising rates? How about what is happening with the spread between this stock and its competitors? It seems there is an overwhelming amount of influences, so how do I know what’s important?”

This is another good question, and one for which there is no easy answer. Let me present the two opposite extremes: on one hand, a trader might try to look at everything you mentioned, and more. There certainly are traders who try to absorb all possible and relevant information, process it, synthesize it, and make a decision. On the other hand, there are traders who make a set of rules that might look at only price patterns. They are deliberately blind to every other influence and religiously exclude those other influences from their thought process. So those are the two extremes–look at everything or only look at one thing–and there are people who live on both extremes and do it very well.

Most traders fall in the middle somewhere, and I think we need to be careful of the middle. The problem with being in the middle is that it can work against discipline and consistency. Imagine if you are a technical trader who trades breakouts, and you’re looking at a trade in crude oil. Now imagine you get concerned about the trade over the weekend, and you do some reading on macro events, you do a little back of the envelope modeling with production, storage, and consumption, and you spend some time reading about OPEC decisions and you try to think about what might change there in the future. What have you just done? You’ve completely changed your trading process for this one trade, and that might be very dangerous.

I think the answer always comes back to discipline. Who are you and how do you make your market decisions? Define that, and then create a trading plan based on who you are and how you trade. That plan should clearly include the factors you will look at, and that’s your information set for every trading decision. In fact, one of the biggest warning signs of an impending break of discipline is when we find ourselves drawn to look at or to do something we would not normally do while we are in a trade (e.g., read articles, ask a friend, look at new indicators.) Short answer: be consistent.

  Mattias asks: “What is the best way to transition from sim trading to real trading? How much of my sim experience can I expect to be similar with real money?”

The short answer (and I know some of my readers who have experienced this themselves are feeling a wave of emotion as they read your question)… the short answer is “probably not much.” Let’s think about why sim results might be different than real money. First, the accuracy of the execution assumptions is important. Let’s say you have a limit order to sell a market, and price trades there. Were you filled? Maybe, but maybe not. What if price goes bid at your level (yes) or trades through (yes)? Many sims do not model this correctly, and I would always take the worst possible assumption: assume it has to print through for you to be filled.

There’s also the obvious issue of slippage: Your sell order at $100.00 will rarely be executed at $100.00, and, depending on market conditions, may be executed at a very different price. These two issues alone can make all the difference between making or losing money, and it becomes more of an influence the more actively you trade. In the limit, if you sim test a daytrading strategy and are picking up an “extra tick” on most of your trades that you would not have in the real world, that, alone, can make a badly losing strategy look wildly profitable on sim. It’s hard to appreciate how powerful this influence can be until you’ve experienced it yourself.

However… the real issue is you! The way you react to having risk on in the market is totally different than how you will react to a sim. Yes, there are things you can and should be doing to increase accountability and to make it feel a bit more real, but the experience of seeing your P&L fluctuate often destroys every shred of discipline for a first time trader. (And many of my readers are knowingly nodding their heads right now–we’ve all been there, done that, and have the t-shirt.)

So, I think what you do is first adjust your expectations. When you move to live ammo you are basically starting a completely new leg of the journey. Some of your experiences and skills will carry over, but the goal of your first experience with real money trading is basically to not do anything stupid. (I say that with complete seriousness. That’s the best advice I can give a new trader–don’t do anything stupid.) Open a very small account, and trade with correct risk parameters and position sizing. (Maybe you’re risking $20 / trade, for instance.) Can you do that? I think that’s the smoothest transition–start with a very small risk per trade, and then gradually increase once you have earned the right to do so. How do you earn the right? Trade consistently, with perfect discipline, and don’t do anything stupid.