The best traders have certain characteristic, measurable trading patterns. The largest percentage of their profitability comes from a small percentage of their trades. This means success comes from a small number of very large trades, where they have developed an edge (based on such things as inter market information, supply and demand, and the movement of other stocks) over and above their basic understanding of the fundamentals of a stock (for example, earnings and cash flow).
The best traders have a high risk-adjusted rate of return (RAROC) and Sharpe statistics. (The Sharpe ratio is a risk-adjusted measure of profitability.) They tend to do better trading low-volatility/low-beta stocks. Their profitability correlates positively with the number of shares, price per share, and amount of dollars invested. They tend to have higher average dollar gain per winning share and per trade than average dollar loss per share and per trade. Their success is also positively correlated with length of time a stock is held.
Examining some of the negative characteristics of less successful traders, on the other hand, one finds negative correlations to holding periods and dollar volume, as well as high commissions and acute clustering of profit and loss (P&L) around a handful of transactions that suggest overtrading. In other words, some traders may hold on to positions too long.
One trader with a high winning trade percentage shows a relatively flat ratio of winning trade/losing trade margins on a per-trade and per-share basis. This suggests that he might be able to increase his profitability by staying with winning positions longer.
Of course, there are differences among successful traders. Some excel at using the Instinct, trading the short side of the market, and trading in the technology and financial sectors. Others tend to perform better using brokers rather than automated trading mechanisms. One trader who thrives by focusing on biotech and pharmaceutical stocks shows lower Sharpe and RAROC statistics, which are reflective of the erratic nature of biotech stocks.
There are variations within these ideal patterns, too. Some successful traders don't hold their shares for a long time, even though they are winning trades. Others have their performances too highly correlated with market indexes in general. Still others may hold on to losers too long, as indicated by the relative equivalence of their average dollar gain per winning trade and the average dollar loss. They may even show that their average losses exceed average profits on a per-share and per-trade basis.
Psychologically, the best traders all have much in common. They possess risk taking ability, flexibility, and a capacity for conviction. They are able to trade without letting their ego get in the way. In other words, they have the ability to stay in the present and view events truthfully and, therefore, objectively. They focus on the movement of stocks, without distraction by disappointment or euphoria—either of which may interfere with the correct view of reality.
While I know extremely successful traders who do not share all of these characteristics, including a good friend of mine who is convinced he lacks a "capacity for conviction," most successful traders have a strategy for winning, and they adhere to it with persistence, creativity, and drive. And when they are winning, they don't become lax but actually play bigger, continually upgrading their game.
The best traders set an objective—an amount of money they want to make, a percentage gain they want to achieve in a given period, a portfolio total number they want to reach—and then try to make decisions in line with that vision. They strive to become independent and self-actualizing, and they are ready to face the consequences of their own decisions rather than rely on others.
Like them, you need to develop your own power, and to be circumspect about the power you bestow on others. Like them, you can let others contribute to your vision, but you can't depend on others to make you whole or to realize your objectives.
The most successful traders bring their vision to a focus with specific goals. You need to do the same—and to promise die result to yourself. Many traders are reluctant to do that. "How can I know what I will do until I see where the market goes today?" they ask. "I'll see where the market is headed, then take advantage of the opportunities I see." Some traders are hesitant to really win big, either because of an unconscious belief that they may not deserve that much money or because they aren't clear about the complex meaning of profits and high salaries on Wall Street.
However, when you look at the market, what you see reflects what you think you'll see. If you commit to a certain vision or concept of a result and keep looking for evidence of that result, you will watch the market in terms of this new set of expectations. You will thereby increase the likelihood of your expectations becoming a reality.
When thinking about your goal, imagine what it will do for you or enable you to do and how it will increase your ability. As you begin to consciously choose your own trading objectives, you will notice how much of your life has been focused on pursuing unconscious objectives conditioned in childhood. You will learn how much more satisfying things can be when you begin to actively pursue consciously chosen goals.
When it comes to trading, motivation is critical. Make sure you really want to trade. People are often drawn to the "easy" money of trading. It's easy in the sense that all it takes is money to get underway in the business. But more than money is involved. Self-understanding and self-mastery are critical. You have to be willing to put in time and effort to learn about yourself, and to do what it takes to change attitudes and behavior so as to make them consistent with your trading objectives. There's nothing easy about this "easy" money.
If you want to gamble, this isn't the right field for you, nor should you enter trading if you are unwilling to tolerate, or learn to tolerate, the emotional changes and roller-coaster effects of risk. The basics—an ability to solve problems, analyze situations, and work with numerical choices—should feel natural so that your efforts don't infringe on your performance and leave you too uptight.
You have to get used to being wrong, because you are going to be wrong most of the time. As in baseball, you may be wrong seven out of ten times. If you can't handle that, you don't belong in the business. The key issue is to minimize your imperfections and maximize your potential, to ride out errors, to keep your emotions under control, and to continually assess the variables of the market so that you begin to make optimal choices more of the time.
To do this, you have to learn to stay with the winners and focus on getting rid of losers. You can't do this without internal strength, faith, trust, and acceptance of uncertainty. Without these qualities—or the eagerness to develop them—fear is going to govern your behavior.
In the following chapters, I will help you learn how to take action and begin working toward the changes that will help you become a more successful trader.
Can Tou Commit?
A dictionary defines commitment as a decisive choice that involves a definite course of action. In trading, this refers to a proactive approach where you promise a result—a financial goal—and then behave at your trading desk in such a way as to bring about that result. The promise creates a discrepancy—a gap—between where you are and where you have chosen to be. That gap is the source of creative tension that, ideally, motivates you to determine what new style you need to follow in order to bring reality in line with your new objective.
Commitment in finance is not simply a matter of working harder or motivating yourself with positive affirmations. You must be enthusiastic
The Ten Cardinal Rules
1. Learn to function in a tense, unstructured, and unpredictable environment.
2. Be an independent thinker versus a conventional thinker.
3. Work out a way to handle your emotions and maintain objectivity.
4. Don't rely on hope and fear in the conventional sense.
5. Work continuously to improve yourself, giving importance to self-examination and recognizing that your personality and way of responding to events are a critical part of the game. This requires continuous coaching.
6. Modify your normal responses to certain events.
7. Be willing to face problems, understand them, and recognize that they are in some way related to your behavior.
8. Know when problems can be resolved and then apply methods to solve them. That may mean giving up some control in order to gain a different control. It may mean changes in your personality, learning self-reliance, or giving up independence and ego to become part of a trading team.
9. Understand the larger framework in which trading occurs— how the complexity of the marketplace and your personality both must be taken into account in order to develop the mastery of trading.
10. Develop the right mind-set for trading—a willingness to commit to the kinds of changes in personal habits and beliefs that will drastically alter your life. To do this requires a willingness to surrender to the forces of the game. In order to be able to play at a maximum level, you have to let go of your ego and your need to have things your way.
enough to explore all the ramifications of your trading behaviors. Trading in a committed way is a lifelong practice, and requires continuous self-examination and monitoring of your attitude and approach.
In all the best traders I've met, I see three crucial attributes. The first is a willingness to dig in, put yourself at risk, and become what you say you will become. To do this, you need to ask yourself very specific questions and commit to the answers.
As you will see in more detail in Part Two, one top trader rarely deviates from a set of ironclad rules he has set for himself. They include:
• Initiate every trade with a long or with a short position.
• Consider your costs on a trade before you make it, rather than merely selling.
• Shun safe, boring stocks, and instead dig out stocks that will move.
This trader knows ahead of time that if the twelve stocks on his sheet include National Semiconductor he can sell whenever he wants to, unless he is trading enormous amounts, like 500,000 shares of stock. If he does have a huge position, he scales out 50,000 shares at a time.
But the master traders also ask themselves broader questions and know what their answers are.
These are simple questions, but they are not easy to answer in a committed way. Until you learn to tolerate the discomfort of trading at new levels, you will feel psychological pressure to lower your target and revert to familiar old ways of buying and selling. It takes awareness to resist such tension-reducing impulses as scalping quick profits or holding on to a losing position in the hope that "things will turn around." It takes just as much awareness to catch yourself when you are beginning to withdraw from your commitment because of the tension that naturally intensifies as you get closer to the fulfillment ofyour objectives.
The second attribute, then, is the identification of those pesky, persistent, sometimes painful beliefs, conditioned since childhood, which, without your knowledge, influence your performance. I call this set of beliefs and responses the "life principle." It governs what you think, what you perceive, and how you interpret the world. Your life principle is the largely unconscious template around which you organize your life.
Ten Commitment Questions Every Trader Should Internalize
1. What is the amount of money you intend to make?
2. How long will it take you to make it?
3. What do you have to do to make it?
4. How much capital do you need?
5. How many shares must you purchase?
6. How long should you hold on to those shares to reach your objective?
7. When should you change your position?
8. When should you enlarge your position?
9. What must you pay attention to with regard to managing your losses?
10. How much more capital can you put at risk so as to increase your profitability on the upside while managing your downside risk?
Early in life, to avoid painful experiences like fear, rejection, or criticism, we each adopted a set of beliefs and responses—such as being good, not making mistakes, fitting in, taking it slow, or not taking risks. You have been living out of these patterns and perspectives ever since. Mostly, you do this automatically. (It's not just you—it's all of us!) You are not aware that these patterns, while they feel comfortable, keep the original underlying fear alive. These defenses manifest themselves in behavior patterns that become permanent aspects of your personality. They include old perceptions about impossibilities or about what you perceive to be the agonizing consequences of "pushing the envelope."
Every time you try to break out of these patterns, you experience fear and anxiety, and usually resign yourself to conforming to the life principle without taking significant risks.
I hold the view that to achieve trading mastery, you must learn to live your life by interacting more directly with reality, rather than through the filter of your life principle. To do this, you have to relinquish those patterns that both create and perpetuate your underlying fears.
To gain maximum effectiveness and vitality you must learn to recognize these fixed patterns, so that you can respond to trading events in terms of what the events call for, not in terms of automatic responses that were programmed in you during childhood.
As you begin to be aware of how much your unconscious life principle rules your responses, you can begin to act more consciously in terms ofyour own present choices, in line with your new financial objective or vision. When you trade independently in terms ofyour newly designed vision, you bypass your inclination to withdraw, withhold, or retreat in order to protect yourself from imagined fears.
When you can do this, you will be able to engage in your trading career at 100 percent and not have to wait for the so-called right moment before you begin to act.
Ask yourself two questions to find out where you really stand as a trader: How much are you governed by automatic thoughts of failure or a fear of losing? Do you secretly believe that you are inadequate or unworthy of success?
Such doubts may lead you to blow your gains after a successful run or to rely too much on positive pronouncements, which may ultimately result in burnout from excessive efforts. It's important, therefore, to learn to emancipate yourself from self-doubts, from your outmoded life principle. Negative judgments are merely thoughts that have to be noticed and then allowed to dissipate, so that you can get to that Zenlike state where your mind is "empty."
You don't see yourself as a Zen-type person? Neither did a master trader I'll call Sandy, whose trading partner had to take an eight-week sick leave. Sandy had to make the research calls his partner ordinarily handled, as well as trade for both of them. The double duty forced Sandy to focus so single-mindedly that he made several million dollars more than usual for two months in a row. "I don't know what happened," Sandy said. "I don't know what was going on in the market. But I was trading out of my mind"—with extraordinary results.
You must become prepared to observe events without imposing inaccurate interpretations on data. Otherwise, when you're faced with the frustration of failure, you risk watching the goals to which you've committed erode. You feel internal pressure not to lose. As your perceptions of the market become distorted by your emotional reactions, you begin to make compromising decisions. At this point, it is important to be able to declare a breakdown. You must acknowledge this emotionally so that you can change your actions and once again bring them in line with your commitment.
Putting aside these old, negative thoughts is not a rote exercise. Nor will you master this ability simply by reading about it. What I'm suggesting is a rigorous self-examination, during which you must overcome part of the natural human instinct for self-preservation—the part that inhibits action and creativity in favor of maintaining the status quo.
We humans don't ordinarily practice these maneuvers. Life involves functioning with uncertainty, but we usually don't embrace it. You must ask yourself, "How willing am I to allow my trading success to be as good as it can be?" When you can achieve this step, you can maximize your performance and learn to ride out the creative tension of the gap or even the excitement of extraordinary trades.
The third attribute of great traders is their capacity for increasing the complexity of the task at hand and the size of the promise. This demands even more ofyourself. You must be able to find ways of supporting yourself in the gap so as to trade bigger, such as calling on someone to coach you, making more research calls, and reassessing your strategies in light of changes in the marketplace.
Strategy—The Hallmark of the Super-Trader
The super-traders always formulate a strategy or set of rules that enable them to act quickly while watching the market. It's a strategy that leads them to trade or take action in line with objectives rather than in terms of old habits and beliefs about what is possible.
At a periodic trading review, Dirk, an experienced trader, brought up his strategy for staying with airline stocks. "The numbers I want are somewhere around two hundred thousand dollars a month until I get consistent. This month, it's seventy or eighty.
"I can take a huge amount of risk," he added. "In the past, I wasn't taking the right risks." To begin with, he had to get his ideas "all squared away." When he stopped doing charts on the weekend, thinking they gave him "too many ideas," he wound up losing money for two consecutive days. This made him so defensive that he feared he had "missed the whole market." He saw himself "going back and forth, following my reactions," instead of having more of an opinion.
"I have to go back to trading to make money," Dirk vowed. "If I play by these rules, I'm going to win more often. I won't make sixty-two hundred dollars, I'll make sixty-two thousand dollars, and it will be less aggravating."
Commenting on Dirk's observation, Benny, another trader, said to him, "The rules are there. All you have to do is to follow the rules. You don't have to do anything but follow the rules and it will make your life very easy. Obviously, you know how to pick stocks and you know how to trade. But if you follow the rules, there's less of a burden on you. Last month you didn't have to think that much. You were in the zone. When you're not doing well you've got to go back to fundamentals and consistently do things the same way."
Benny listed some specific rules: "Don't play takeover stocks; be patient—you can come back to them. Don't take home losers. Don't average down. Eliminate the things you do poorly. And stop rationalizing your mistakes by pointing to how well you're doing."
He summed this up by saying, "In a nutshell, do the things you do well consistently. Make the commitment, create your own lists, and live by the lists. Consider what you are willing to do so you don't lose. Can you make a list of ten things you're not going to do to save yourself money? Make it up before you get in the game."
Benny concluded: "If you are sticking to it and you're losing, then the list doesn't include all the things you need on it. The one thing that has to be on the list is to be brutally honest with yourself; you have to be honest enough not to allow yourself to screw up."
Benny's methodology helps him make choices and make sense of the volume of data that is available at any given time. He develops skill at his own personal method while also empowering colleagues to help supplement and expand his ability. He can then create research, statistical analyses of operations, and analyses of statistics so as to determine where he needs improvement. He also has a risk-management method for assessing the negative characteristics of the trade in both the in and out positions. When put together, this amounts to a set of guidelines for evaluating positions, measuring the effectiveness of trades, and improving subsequent trades.
Four Pertinent Questions to Ask Tourself before Going into a Tmde
1. What amount of capital am I willing to risk in a trade?
2. What will be my exit point?
3. If I lose a predetermined amount of capital, do I retreat and take a breather?
4. When I am losing overall, do I cut down on trading size of only the losing positions and enlarge the winners?
The master traders' strategy takes their competition into consideration but leaves plenty of room to execute their own vision. They have a positive mental image of the actions needed to make money. They may get much input from others, but ultimately they choose their own goals and targets and remain independent, trading and developing their own ideas rather than simply following the choices of others.
To be a super-trader, you'll need an edge to overcome the laws of probability and the uncertainty of the marketplace. That edge comes from information flow, the ability to correct your habits in terms of the market's characteristics, and being able to take risks, cut losses, expand your information network, ferret out ideas, and take recommendations.
To do this, you will need to develop a trading strategy that is suited to your personality and temperament. If you are naturally cautious, build elements of this personality characteristic into your strategy. Ifyou don't like the decision-making aspect of trading, then find more mechanical or mathematical models. The point is to know yourself well enough to develop a strategy that fits your temperament so that you can push the envelope of success.
Truth, Confidence, and Creativity
In trading, telling the truth is what separates the big people from the little ones. Are you willing to face the truth about your trading? Or are you inclined to withhold the truth from yourself?
One of the most critical characteristics of a successful trader is an ability to take responsibility for results. A pro who blames others and the market, or the seasons, for outcomes cannot get to die next level. That's why you will need to admit vulnerability and identify problems in order to deal with them and reduce uncertainty. The only acceptable uncertainly in trading is the uncertainty found in the gap between what is present and what is possible, not in the realm of hope and wishes.
While super-traders own up to mistakes and do not rationalize failures as being at the mercy of market forces, they are also willing to surrender to the market, recognizing that they have no control over it. This does not mean that they trade willy-nilly. They do not fight the "elephants" and get crushed. They go with the trend of the big players, follow the momentum of stock movements, and don't short a stock at the bottom when it is certain to go up.
The positive value of committing to the truth is that it will not only optimize your trading results but transform your capacity to be more fully present to your trading experience. Facing the truth about the market and yourself will allow you to remain an independent thinker, not dependent on how other people are trading. Follow the trend of the market, influenced by huge mutual funds—the elephants—which create momentum by the size of their orders. You can thus make your own assessments and stock choices with confidence and go into the trading day with the expectation of winning more often than not.
Your belief in yourself will grow by testing your own hypotheses, facing the truth, improving your performance, and developing confidence that you can avoid losing money, develop methods for getting new ideas, and, finally, learn how to let the winners run. This set of skills will give you the confidence to trade successfully. Without them, it is easy to trade and not succeed.
Being Comfortable, Being Right
The market is a force bigger than any one trader. If you go against it, you will feel pain. The traders who go with the tide are more free and easy. They don't like the pain. They like themselves. They know there is no point in fighting the force of the market. They let go of their egos and admit that the market is greater than they are.
For some traders, this is difficult to do. Take Leo, who like many
Eight Questions for Truthful Traders j pi
1. Are you willing to face your failures without recrimination? • - ; :
2. Do you delude yourself with notions and rationalizations that you are limited by the nature of the marketplace or the tape? |
3. Are you willing to acknowledge your successes, or are you afraid that others will be disappointed or hurt if you tell them I you have succeeded? f
4. Do you hold back from succeeding because of some childhood | notion about not deserving to win? *
5. Do you hold back in your trading because of a reluctance to let it be as good as it can be?
6. Are you held back by imagined restrictions placed on you by -other obligations? 1
7. How much do you distort reality because of fear of the conse- | quences? S
8. How willing are you to commit 100 percent to being in the f game? |
short sellers has a high tolerance for pain. He likes to trade against the tide. He doesn't want to admit fear and doesn't want to put a tremendous premium on cutting risks by making a trade with a higher upside potential and lower downside risk. Sometimes this happens after he has had a good month and wants to "give something back." Feeling good and having money in his pocket, he slips into a gambler's mentality and "bets it up."
The best traders, though, are patient. They can wait for the right moment—when a stock turns—and then trade to win. This is important, since the result may take twice as long as they anticipated if they're holding while a stock is rising. Yet they're not so patient that they waste opportunities, nor so anxious to take a profit that they nibble at it and lose upside opportunities. They may trade to test the market, but they don't ride it just to ride. They have the drive to stay with trades that are working, and the ability to sit tight and wait for the trade to be completed. They know they can go broke by taking small profits, since the slippage and brokerage costs are so high.
Characteristics of the Master Trader
Has a rational approach to trading. Does not trade for egotistical reasons, to feel good, to get high, to work out long-standing psychological needs.
Is skillful at self-mastery in the setting of high tension and stress in the marketplace. Is confident of ability to deal with reality rather than be governed by interpretation and reactivity. Builds confidence from experience and learns skills from adversity. Regularly monitors his or her performance so as to enhance it.
Is able to see low-risk ideas. Can read reality without misinterpreting it in terms of hidden agendas or unrealistic dreams. Is able to drop low-risk ideas that don't work, without investing in failure cycle, or overreacting to own reaction. Has basic disciplines of hard work and concentration, and knows about extra effort. Has self-monitoring skills and capacity for visualizing future events and rehearsing them mentally. Interested in activities and'in the processes involved. Is committed to objectives and able to modify strategy based on feedback from performance. Is able to cut losses and increase risk appropriately and not hedonistically or foolishly. Is able to empower others to assist him or her in realizing objectives; able to identify with others compassionately and to assist them to stretch and grow; able to rely on others and to profit from them but not dependent on their approval. Takes responsibility for success of efforts. Is humble in recognizing the necessity for the support of others. Is adaptable to change and able to modify course as he or she progresses.
Sees the challenge of the trading game. Is not overly invested in money. Is able to enjoy profits but not dominated by them; able to bounce back from failure; able to recognize that losses are inherent in die process.
Can handle success and failure without self-destructing.
Trading requires the drive to take new risks. Ideally, you minimize losses by measuring the risk/reward ratio, but you cannot trade without living with some inherent uncertainty. Losing is part of trading. The best traders don't get perturbed by losing trades, since over the long run they know they will be successful more often than not. When you are afraid of losing, you end up losing or missing opportunities because you are afraid to trade.
The best traders are able to distinguish between the right trade and the comfortable trade. In fact, they know that the right trade is often uncomfortable and have devised a strategy or set of rules that will let them override their emotional fears. Less experienced traders have a hard time distinguishing what is really happening. When they are under stress, they don't adapt to the new market but rely stubbornly on what they think they know.
To continue rising to the challenge, successful traders need to increase the money available and find new ways to maintain profitability. They try to identify new trends in the market and reassess their own personality traits in order to determine how best to trade. The great trader will view this as a magnificent adventure, a great challenge. Most of all, he or she will trade even if there is no money in it, simply because he or she loves the game.
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