For a while, I had been thinking that I just had too much of my ego invested in the success of *my* trading systems…when they win, I’m a winner…when they lose, I’m a loser…after all, they’re *my* systems.  I thought that the solution to this issue could be found by actively detaching my ego from the results, but this seemed difficult and ineffective.

Well, I now realize that there was at least one piece missing from the puzzle.  That piece is called “doing the right thing”.   You see, after years of being immersed in personal finance literature and financial media, I have an underlying sense that I’m investing my retirement money well by investing mostly in index funds, both domestic and international.  So when the market goes down, I can easily think that it’ll come back eventually (at least before I retire) and that I have nothing to worry about.

BUT, with my trading systems, I have no underlying sense that I’m doing the right thing…it seems that the systems need to be tweaked often or they fall apart completely…a bit like the difference between buying a house and buying a car.  In the case of the house, present downturn notwithstanding, we can expect the value to rise in the long run…with the car, well, we know it’s destined for the junk heap eventually.

Mechanical approaches are ideal for beginners, as they force us to trade what we see as we develop a feel for the market.  In my former life as a stock and option trader, I would bounce around from one idea to the next, blowing up my account several times in the process.  The problem with such a random approach was that sometimes luck did shine on me and save me from losing…and of course these random rewards are the most addictive and difficult to reproduce.

When I shifted focus to the currency markets and became aware of all of the great tools for developing mechanical trading systems, I firmly made the mental shift that a mechanical approach would be best for me…after all, my discretionary trading had led me to a track record of 8 consecutive losing years.  You know what they say…quitters never win and winners never quit, but those who never win and never quit are idiots!

Now that I’ve focused almost exclusively on the British pound for a few years, I believe that I’m starting to develop a reliable feel for the market.  I am certainly NOT ready to incorporate much discretion into my trading plan, because the mechanical approach has worked so well, but I’m becoming more interested in how an experienced trader moves from a mechanical approach to a discretionary one and consistently outperforms the mechanical approach.

Of course, when we talk about intuition, we must carefully define the term.  The first definition on dictionary.com comes closest to what we are referring, but it is still incomplete:  “direct perception of truth, fact, etc., independent of any reasoning process; immediate apprehension.”  Well in this case, we’re not really talking about understanding that is independent of reason, but rather immediate understanding derived from unconscious integration of our experience trading the market.  It’s quite a fascinating process, but one that I’ll admit that I’m at a loss to describe the mechanics of.

All that I can do is make a note of just how long it has taken me to begin to develop a market intution and remind beginners that the goal of consistent profitability is a mountain with an unseen (and uncertain!) peak.  If your trading plan keeps you in the game long enough, your “into-wishing” just might turn into intuition after all.

Pain of loss

a) True Drawdown that SEEMS avoidable (1)

Whenever I’m in a drawdown where entry signals were BARELY triggered and then the trades reverse and take me out for a loss, this is the most painful, because it seems that optimizing my entry parameters differently could have saved me this pain.  This is the most painful, because a drawdown always feels like a threat to my ability to continue as a full time trader, and losses that I ALMOST avoided make me feel unlucky too.  The longer or deeper the drawdown, the worse the pain gets.

Antidote: I need to remind myself that my system at any given time represents my best attempt to make profit in the market and that drawdowns are unavoidable.  Indeed, I’ve recovered from several drawdowns, and even if this particular drawdown really does end my run as a professional trader, I will never regret my decision to try.  Anyway, I’m likely to recover from the drawdown, and losses are just what I need in order to be able to build better systems for the future.

b) True Drawdown that seems unavoidable (3)

If I suffer a drawdown that seems unavoidable, that is to say that most parameter sets would have still resulted in a drawdown, I don’t feel quite as bad, but I’m still in a real drawdown, which is a threat to my full time trading career.

Antidote: Same as (1)

c) Giving back profits on subsequent trades (6)

Giving back profits on subsequent trades is the least painful, because I know that losses are inevitable and it’s nice to initiate a drawdown from a new equity peak.  No antidote is necessary.

Pain of not participating (2)

This is the second most painful of all.  I trade a system that uses event-based filters to keep me out of the market.  When things are going REALLY well, these filters are counter-productive.  Missing a move is painful because I wonder whether I will experience the double whammy of missing a big profit and then participating in the subsequent losses.

Antidote:  Most of the time, my event filters work well.  They often allow me to have profitable months when a system without filters would have suffered losses.  Event filters allow me to take a break from the market and recharge my batteries.  A system that is in the market less of the time is inherently less risky.  Whenever the unfiltered system does well, the filtered system usually does well too.

Pain of Profit

a) Why didn’t I trade more contracts? (5)

This one always creeps into my mind a little bit at the end of each winning trade, but it’s easy to suppress as I know that if I were taking more contracts, my risk to reward would not be properly balanced.

b) Why didn’t I take profits at the top? (4)

This one is painful too, but it’s not a big deal.  My system does not attempt to catch tops, and will always give back some profit before exiting.

Here is the king of Thought Demons for a trading system developer…

The new system underperforms the old system in live trading.

The antidote for this is to realize that the system IS my edge and that system changes represent my best attempt to improve my edge.  Each change is either an attempt to increase profits or to limit risk.  A change that is intended to increase profit often has the side effect of increasing risk or drawdown in the short term.  If the new system passed all of my criteria to be traded live, then I simply have to go with it until such time that I discover a better alternative.  If the system change is meant to decrease risk, but it lowers my profit, I need to remind myself that that is exactly the price I pay for controlling risk, and in fact, risk has been controlled.  In fact, if I look at my list above, I’ll see that the pain of missed profits is less than the pain of real losses.

Here is a short description of the course, taken from their website.

”

What is Dynamic Structure Trading?

Dynamic  adapts to recent market conditions and can be used in range-bound or trending markets

Structure  based on market structures of support/resistance, pivots, daily ranges, basic Elliot Wave patterns, and others

Trading  a proprietary Strength of Signal system is used to qualify trades and determine position sizing for each trade

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The Dynamic Structure Trading course was developed to take advantage of any market condition in any time frame. This allows us to trade based on structure, patterns, and what we see not what we think.

Dynamic Structure Trading is a robust trading strategy for the serious trader looking to invest in a time-tested, highly profitable style of trading that can be applied across a broad range of time frames and markets. Day trade a 1 and 3-minute bar chart in the Following Emini Futures Indexes: Russell 2000, S&P 500 Index, NASDAQ, Dow Jones Industrial Average. DST is also applicable to Foreign exchange currencies. The Emini Index Futures represent the best vehicle that the DST model can capitalize upon most effectively and efficiently.

”

The idea of trading what we see, not what we think, is very important.  Remember, there is no such thing as what the market “should” do…only what it IS doing and HAS done.

At the bottom of their main index page, there is a heading called “The Four Elements of Successful Traders”.

Excellent trading psychology and state management
Proven money management systems
Proper tools and training
A profitable trading system (actually the least important!)

This is very interesting, and for me, it rings very true…at least the part about trading psychology being the most important element of success even when we have a profitable trading system. To view some excellent free content on trading psychology and state management, please follow my affliate link (so they’ll know that I’m sending them some traffic), and click on the “Market Trading Videos” link under the “Free Services” menu.  They posted two videos on May 16th, 2007 that are just fantastic. Enjoy!

Here are direct links to the videos:

Trading State Management 1

Trading State Management 2

Most successful traders (and gamblers) tend to focus on the process and not the results.  Translation?  Define the rules that give you an edge and stick to the rules.

Forex trading is stressful enough without the additional pressure of time sensitive, results-based goals.  The more that we attempt to force order upon the market by demanding consistent weekly or monthly profits (paychecks?), the more pressure we put on ourselves to “make it happen” even when it might be obvious that the market action won’t support our lofty, and very specific goals.  Expecting the market to conform to our goals is similar to a surfer expecting big waves on Saturday morning just because HE has that day off…

Cut yourself some slack, and define some goals that do not add undue pressure to an already stressful process.  This might be as simple as setting a goal to design a system that has worked in the past, to follow the rules at all times,  and to have a profitable year.  If the majority of small traders lose all their money in their first year and never return, then I guess we win simply by not losing.

Remember, whatever your account balance is right now, you are at even money.  There is no such thing as “the house’s money” or “winning it all back”.  Your next trade is independent of your last one, so treat it that way.  Learn what you can from your past mistakes, protect your precious capital, and give yourself a chance to gain enough experience to learn how to ride the waves, and perhaps more importantly, to learn what days to stay out of the water!

One of the many benefits of running an automated trading system is being able to see the historical peaks and valleys in the system’s equity curve.  With the Cable Glider “cranked up” to its current high degree of leverage, it can and does experience drawdowns in excess of 20% with regularity, and occasionally suffers drawdowns even higher than that.  The current version and leverage level of the Cable Glider shows a maximum historical drawdown of 42%.  That occurred in May 2006 after the system experienced a 400% gain in April 2006. This means that the system had more than doubled its equity over the two month period, but had done so in a wildly volatile way.  I was not trading the system live at that time, but I was trading live in February and March of 2007, where the system saw a similar drawdown (39%) after a relatively smaller run up.

It might be easy to think that such drawdowns “do not hurt” because they are typically occurring after gains in the equity curve.  Well, with 5 months of real experience with this system under my belt, I can say that drawdowns are most certainly painful even if they occur after big gains, BUT ONLY if I have mentally anchored myself to the new equity level.  It’s a simple matter of mental framing;  if I focus on the 40% gain, I am happy.  If I focus on the 14% loss since the last equity peak, I am unhappy…

So when is it appropriate to mentally reset my “even money clock”? Well, as far as I can see, there are only 2 timeframes that SHOULD matter to me, but in reality there are 3 timeframes that DO matter to me.  The timeframes are weekly, monthly, and yearly.  I believe that it is appropriate to measure the results of the system on a monthly basis because there are lots of market moving pieces of data that come out on a monthly basis.  I believe that yearly results measurement is also appropriate, because we need to pay taxes on our gains once yearly.  Weekly measurement really doesn’t serve any purpose, but since I am always out of the market on weekends, I end up having a lot of time to think about the last week’s results.

As with many other issues on the “mental” side of trading, simply recognizing the problem goes a long way toward eliminating it…as long as I am “up” over some time frame, whether monthly, yearly, or even all-time, I can improve my trading psychology by reminding myself of the gains…this mentally anchors me to my starting equity point, and not my current equity point.  However, if I were showing losses in all time periods, the only reasonable way to stay psychologically strong is by placing smaller trades, and looking for ways to improve my trading to get it to profitability.

Seeing as how the FX market offers all traders fantastic opportunity to get creative with their position sizing via a smart use of leverage, I have a hard time understanding why anyone would quote their profit and loss in terms of pips.  If I invest in a stock, it would be common for me to tell you that I made 10%, not that stock XYZ went up by 326 cents.  To quote profit and loss in terms of pips is to completely ignore the least sexy, but of course, most important part of any successful trading strategy, and that is the position sizing algorithm.  It may be convenient to quote an individual trade’s profit or loss in terms of pips, but over a series of trades, the percentage return will tell the only story that is relevant for the trader;  the MARKET may have moved a certain number of pips, but my ACCOUNT‘s return depends heavily on how I vary my position size relative to my account size, market volatility, etc.  While it IS fun to speak in pips to describe price action, it’s more fun to talk about how that price action affected the account.

Part 2 is here

No, I’m not saying that 12 months or 16 months or any set period of time is “enough” to become a success.  The point I’m trying to make is that there is a high level of commitment and perseverance required in order to develop and implement a trading system that works for you.  Successful traders pay a tuition in the form of losses early in their career.  If they are properly evolving as traders, they can reach the proverbial light at the end of the tunnel, and step into a world of consistent trading success. The key is to stay in touch with one’s “evolution”.

If we make the same dumb mistakes year in and year out, we are destined to perpetual failure.  The next time you tell someone that you have 10 years experience doing one task or another, stop and think about whether or not you learned anything new in years 2 through 10.  If the answer is no, and you are still failing, quit the game, and save yourself some wasted time, money, and energy.  If, however, you are committed to the path of personal growth and continual evolution in trading attitudes and methods, AND your evolution is validated by decreasing losses and hopefully increasing profits, then never lose faith that you are on the proper path to your goal.

# closed winning trades : 3

# closed losing trades : 0

Net monthly profit % :  +42.5%

Current drawdown : 0% (at new equity peak)

After a week with no trading, the Cable Glider entered and exited three trades this week, and all were winners.  I did particularly well entering short after Thursday morning’s Bank of England interest rate policy meeting.  The trade that I entered on Thursday and exited on Friday marks the first time that a single forex trade has netted me a profit in excess of $10,000.

This is the first time that I’ve caught a really big trend following trade since November 2006.  It’s immensely gratifying to see the system succeed, and yet, as it succeeds, I must continually re-train my brain to prepare for ever greater losses as well…such is the nature of the game.  It will only be a matter of time before the first 5 – digit loss hits.  Times like these, when the system is at a new high and all seems well, are the best times to remind myself to stay humble, and stick with the system, which should have the ability to successfully weather future drawdowns, so that someday I’ll be able to report the first six-figure gainer.

However, there are some basic concepts from Economics 101 that are wonderfully useful in everyday life, and seem to be horribly under-utilized.

Today’s concept is that of Sunk Costs –  Sunk costs are costs that have already occurred and cannot be recovered.  Economic theory tells us that rational people do not consider sunk costs when making a decision about what to do next.  The rational thing to do is to consider what the best decision to make today is, taking the sunk costs as given.

This has many applications in real life, and I have to admit, I almost never see anyone properly put sunk costs out of their mind, when indeed it would be beneficial for them to do so.

Improper and common ways that “irrational” (normal) people consider sunk costs:

• Staying in an unsatisfying relationship because of the “history” the couple has shared.
• Spending more money on a bad project because money has previously been spent on it. I see this one in software development all the time.
• Making dangerously large bets or trades in an attempt to “get back to even”.
• Averaging down on a trade — another counter trend trading concept that is really just a fluffy way of saying throwing good money after bad.
• “Letting yourself go” — not caring about gaining weight because you are already overweight.

These are all scenarios where we can benefit from taking a step back and observing the situation in a detached and logical way.  Accept that life has brought you to this present moment with a set of circumstances or baggage which is a given, and cannot be changed.  All you can do is make the best decision to improve yourself or your situation going forward.  It does you no good to complain about the cards that life has dealt you.  You must play your hand to the best of your ability.