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The Best of ATrend jJyn!Jmics

How Professional Trader's See the World

VOLUME FOUR- BOOK ONE

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Trading Psychology 301

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TREND DYNAMICS INC. PUBLISHERS ARROYO GRANDE CALIFORNIA

Trading Psychologf- 301

How Professional Trader's See the World

Edited by

Jesse Thompson

Page Design by Scott Freutel

Illustrated by Dave Hudson

Contents

INTRODUCTION

THE LAWS OF TREND DYNAMICS

Volume One: How Markets Are Structured

BOOK ONE: MARKET STRUCTURE 101

Introduction to the Trend Dynamics Market Language

BOOK TWO: MARKET STRUCTURE 201

How Major Trend Changes Develop

BOOK THREE: MARKET STRUCTURE 202

How Trading Ranges Terminate

Volume Two: Trading Strategies That Work

BOOK ONE: TRADING STRATEGIES lOlA

Trading Complex Countertrend Reactions

BOOK TWO: TRADING STRATEGIES 101B

Using Market Structure to Formulate Profit Objectives

BOOK THREE: TRADING STRATEGIES 102

Trading Simple Countertrend Reactions

BOOK FOUR: TRADING STRATEGIES 201

Using Mean Reversion as Market Context

BOOK FIVE: TRADING STRATEGIES 202

Using Momentum as Market Context

Volume Three: Tactical Entries That Minimize Risk

BOOK ONE: TACTICAL ENTRIES 201

Using Pattern Recognition to Reduce Risk

Contents

Volume Three: Tactical Entries That Minimize Risk (continued)

BOOK TWO: TACTICAL ENTRIES 202

Using Buy/Sell Pressure to Reduce Risk BOOK THREE: TACTICAL ENTRIES 301

Using Range Breakout Models to Reduce Risk

Volume Four: Developing the Mindset of a Professional Trader

BOOK ONE: TRADING PSYCHOLOGY 301

How Professional Trader's See the World

BOOK TWO: TRADING STYLES 402

Daily Routines of Four Professional Traders

BOOK THREE: TRADING PLANS 301

How to Build Robust Trading Plans

Volume Five: Executing Advanced Trading Tactics

BOOK ONE: UNORTHODOX TRADING TACTICS 301 Trading What is Not Happening

Part I: Failing to Reach Price Objectives

BOOK TWO: UNORTHODOX TRADING TACTICS 302 Trading What is Not Happening

Part II: Line Extension Failure

BOOK THREE: TRADING IN THE ZONE 405

Leveraging Intraday Entries into Higher Timeframes

BOOK FOUR: FORMLESS TRADING 505

Market Principle-Based Execution Strategies

Introduction

r-rHE VARIOUS BOOKS that comprise the Best of Trend Dynamics originally appeared in the _l highly acclaimed serial publication titled the Trend Dynamics Course, which is no longer in print.

There were 77 original installments published in a monthly, and bimonthly format from February 1994 until December 2002. Twenty-five year trading veteran Joseph Hart authored most of the installments, and Jess Thompson edited each of the 77 installments. In addition, several professional traders contributed various articles, research and interviews to the Trend Dynamics body of trading knowledge. In late 2002, the core concepts of the original source material were compiled and reorganized by topic into five volumes comprised of eighteen books (course modules), each of which focus on developing explicit trading strategies & tactics as well as the psychology necessary to execute them.

What you are about to read is unusual because it reveals in detail the lost art of trading-reading the flow of price action in its purest form. For well over a hundred years, long before computers existed, traders have been plying this art to extract profits from markets, and still do today. Our hope is that this series will document this lost art of trading for future generations to come.

The eighteen books in this series share a common theme: every concept, strategy and tactic is based on one or more of twelve trading principles, referred to as the Laws of Trend Dynamics. They are listed on the page that follows. These twelve trading principles are the reason why the trading strategies and tactics taught in this series have been remarkably robust and stable through all types of market conditions and every bull and bear market extending back to 1860.

Jesse Thompson Trend Dynamics Managing Editor 1994-2002

Trade what you see, not what you think

The Laws of Trend Dynamics

FIRST LAW

Time conditions and affects the potency of any price movement. SECOND LAW

Trends that run counter to the next larger timeframe tend to be abortive. THIRD LAW

Positive trade expectation occurs when the perception of the probability of a price action event diverges from the actual probability of such an event.

FOURTH LAW

Trading ranges usually terminate coincident with tests of their extremes. FIFTH LAW

Old demand levels become new supply levels, and old supply levels become new demand levels. SIXTH LAW

A change effort is often followed by a test of the point of change. SEVENTH LAW

Dramatic price movements tend to unfold from price structures that minimize profitable participation.

EIGHTH LAW

The absolute value of a given price-relationship pattern is the product of the intrinsic value of that pattern modified by the context in which it occurs.

NINTH LAW

Trading ranges that follow clear trend changes are likely to terminate, then continue in the direction of the new trend in force.

TENTH LAW

A dominating trend will generally run until the next larger time frame can provide offsetting support or resistance.

ELEVENTH LAVE

Under most circumstances, the markets will be either readable or reliable.

TWELTH LAW

Small risk attracts large size.

4 Trend Dynamics

FEBRUARY 1994

Originally appeared in ...

16 TrendDynamics

FEBRUARY 1994

"All I ever think about is, my next winner's in front of me ... :' -Marty Schwartz

. SECTION I I I .

The Ecology of Trading:

The Mental State of the Prosperous Trader

As A PROFESSIONAL TRADER, your trades must have the quality called positive mathematical expectation: that is, taken as a series they represent positive expectation for profitability. Because the psychological component of trading is so important to consistent execution, let's expand this concept of positive expectation to encompass your psychological state of mind as you're trading.

Your attitude toward individual trades your system or method mandates reveals your degree of faith in your own trading plan. Which trades do you consider the really "good" trades? Is the "good" trade the home run that makes your week (or month, or year )--or is it one of those day-in and dayout trades that shows a modest but reasonable profit?

And what about your attitude toward the losers? How we handle losses is crucial to maintaining our mental stability. Even though losses are no more than the trader's expense of doing business, many traders have great difficulty dealing with their losses. We need to alter our perception of trades. We live in a society that values those things that make money and devalues those that do not. We love the winner, pity the loser. For the trader who brings this baggage to the markets, this value system more often than not creates personal psychological havoc.

To the prosperous trader there are only two kinds of trades: good trades and lesson trades.

The good trade is any trade that your trading plan dictates should be taken regardless of the result-loss or profit. Because they are part of a continuum of events that, taken as a whole, shows expected profit, all trades your system mandates are good trades,

Assuming that like most professionals your bet -size is not more than one to three percent of your capital, you should impart no individual significance to any single trade. The huge profit that comes along by virtue of your being a consistent player is but a result of its connectedness with all the small losses you've taken. It is the universe of trades, the wholeness of the combined trade events, that has value and ultimately leads to profits.

-------------------------------------------_-

Focusing on the outcome of every single trade as ifits outcome were a lifeor-death matter, and evaluating each as good or bad, demonstrates lack of faith in your trading plan. Indulging yourself in such trivial judgments is at best a distraction from your ultimate goal as a trader-and that is to get your trading into the long run. Attaching significance to single trades-whether elation over profits, or remorse over losses-seduces you into riding an emotional roller coaster caused by refocusing your energy from executions in general to a single trade in particular. This particular weakness undermines your faith, your belief in your plan, and can severely undermine your ability to trade consistently.

The business of trading is simply the process of making lots of good trades as consistently as possible. This process is independent of timeframe. Whether \ you trade short-term like Raschke, or position-trade like Dennis, you must follow this principle or your trading will falter.

I must add that taking all good trades on a consistent basis is more critical to the position trader than to the short-term trader. Because of the higher quantity of trades available to him, the short-term trader can much more quickly get himself into the long run.

Because the position trader inherently has a reduced number of potential trades relative to the short-term trader (he might only have twenty or thirty good trades a year), his capacity to execute the maximum number of trades is critical. This is why long-term trading approaches should incorporate entry techniques that are not so elaborate (so "optimized") that you miss good moves because the entry setup wasn't perfect.

The onlywayto insure you'll take the good trades is by instilling in yourself qualities all pros must have: discipline and courage combined with persistence. These are not lofty ideals-these are are bedrock qualities all good traders call upon. Even if you have them, in the jungle of the market they are not easy to live by, day in and day out. And if you don't have them, get them soon--or the markets will quickly eliminate you as a player.

The other type of trade is what I call your lesson trade. These are trades that result from a plan that shows itself flawed (after which you stop trading that plan), or trades made as mistaken executions.

These lesson trades may in fact have individual value, because their purpose in your trading career can be said to be to teach specificlessons about yourself or your trading. These trades are the tuition you must pay in the school of trading. They are not bad trades (remember, bad trades do not exist--only good trades and lesson trades do. Acknowledge no other reality in your trading.) Your purpose is only to take lots of good trades, and to learn. The money is secondary: It derives from your commitment to execution.

17 'TrendDynamics

FEBRUARY 1994

"I don't trade for money. 1 don't think that way:' - Tom Baldwin quoted in Intermarket, February 1985

18 All lesson trades that are losses can be transformed into assets quite easily.

TrendDynamics You do this by analyzing yourself and analyzing the trade or series of trades

FEBRUARY 1994 to determine the positive lesson to be learned from the loss.

Monitor your attitudes toward individual trades with the idea of rooting out narrow vision, and then replace such instances of wasted energy with positive mental expectation. You do this by constantly looking forward to the next good trade--the trade that gets you closer to and deeper into the statistical long run. Use your lesson trades to enrich your growth as a trader.

Originally appeared in ...

4 Trend Dynamics

MARCH 1994

14 TrendDynamics

MARCH 1994

"I never stop and think I'm going to hit a ball crosscourt or down the line. 1 just do it:' -BJORN BORG World champion tennis player

§ "We cannot control the external environment but we can control the internal .... "

§ "The internal trading environment has three dimensions: experience, knowledge, & stability of personality:'

. SECTION III·

The Ecology of Trading Maximizing Trade Executions

To SAY THAT TRADING is ultimately a mental game is ahnost a cliche. Our business even boasts its own sub-industry of psychologists anxious to teach us (or to sell us) techniques on building our mental skills. But to achieve a heartfelt understanding of the psychological potential for failure, you need hands-on experience as a trader. A well-developed trading psychology may have tangential benefits such as self-discovery and self-healing, but its direct benefit is simple: maximizing one's capacity to execute trades.

In thelast issue, I said that successful professional trading really boils down to making lots of good trades as consistently as possible. The illustration accompanying my text depicted mind at the center of a convergence of energies-mind at the center of a whirlwind. Execution is a mental decision made within a specific environment-what I call the mental trading environment. This environment comprises two primary factors: internal (mental components), and external (news and events, and price itself).

We have no control over external variables, which we see reflected as price action and to which we react accordingly. Ideally; our relationship to those external variables is that of the detached observer reacting calmly and with precision to price itself in the "now':

I think of "now" as an eternal present, a place uninfected by emotion attaching to any past trade-whether elation or remorse, there shouldn't be any-orto some projected or anticipated outcome of a future trade. Trading should be done in this eternal now. Your plan is already in place: Stop analyzing it, stop thinking about it-just do it. Leave thinking outside execution. Leave it embedded in your trading plan, where it belongs.

We cannot control the external environment but we can control the internal environment-that is, the mind. Once you have an idea of how this internal mental environment is structured, you can invest in it, you can manage it. Doing so takes commitment, effort, and discipline.

Let us suppose this internal trading environment, in which all decisions are made, to be a structure of three dimensions: experience, knowledge, and personality. Then let's examine how we might make the best use of each dimension so that we can consistently achieve excellent decision-making.

The first part of our internal trading environment is experience. Two important things happen when your trading experience is maximized.

First, your ability to execute is increased because you understand by experience the mistake of not following your trading plan. Because you've seen similar situations before, you encounter fewer market situations that confuse you and make you hesitate. (You'll also become comfortable trading counter to crowd psychology, when necessary.) In short, your faith in the necessity of trading according to plan is enhanced, and so is your poise in carrying out that plan.

Second, as you accumulate experience you begin to be able to perceive patterns and repetitive formations-you begin to formulateyourown broad frameworkofhowmarketsfunction. Total experience is a sequence of events. By accelerating the accumulation of experiences we can, in a sense, reduce the amount of time required to gather enough experience to become proficient at trading.

Suppose that Trader A watches 10 markets on a daily basis. At roughly 250 daily bars (events) per market per year, he will have experienced some 40,000 events in sixteen years (Fig. 2.1, above). Now, suppose another Trader, B, watches the Bonds andtheS&P on a 5"basis.That'sroughly80bars a day each for the Bonds and the S&P times 250 days each, or some 40,000 events. By accumulating more events in a given event -space, Trader B has compressed into a single year what might normally take 16 years of daily bar experience (Fig. 2.2, below).

Close study of small-timeframe events is one way to accelerate a trader's learning. Many successful off-floor traders started out on the floor or created for themselves some equivalent opportunity to maximize their timeframe experience. Many plodded one day at a time through thousands of days of historical price charts. In a sense, all that price action was re-created, to some degree, in their own experiences.

Trader B: the effect of accelerated learning

15 TrendDynamics

MARCH 1994

§ "By accelerating the accumulation of experiences we can, in a sense reduce

the amount of time required to gather enough experience to become proficient

at trading .... "

16 At one point, having spent so much time studying foreign currency daily

TrendDynamics bars, I could mentally scroll through about seven years of price action on a

MARCH 1994 mental screen. In order to increase my experience further, I also handconstructed hundreds of current and historical daily charts, including some grain charts as far back as 1920.Afterthe S&P started trading in 1982,I spent three or four years hand-drawing 5" and 15" charts by reading every tick on an actual ticker tape as it came across a Trans-lux paper ticker machine. I was

§ '~ .. intuition is directly proportional to the time you spend charting or studying charts."

. .. .

maxnTIlzmg myexpenence.

Because trading is so competitive, you need to exploit your advantages.

Study as many bars as you possibly can. If they're available to you, study smaller timeframes, or walk through historical charts one day at a time. (Be sure to cover up the days to the right of the bars you're studying.) By expanding your timeframe experience you can, in a sense, accelerate time. Your proficiency will benefit directly.

The second of the three dimensions of our internal trading environment is knowledge. Knowledge comes in part from your own thinking and reflecting about the markets and specific price patterns, and in part byyour appropriatingtheknowledgeof others.Asexperienceneeds to be broad,soknowledge needs to be deep and penetrating.

After experiencing thousands of bars you will begin to form your own internalized understanding of how markets work. Intuition will lead to breakthroughs in your market understanding-but intuition has to be helped along by your spending hour after hour looking at charts. Intuition is directly proportional to the time you spend charting or studying charts. I rememberstayingup many a Fridayor Saturday night until two or three a.m., intensely studying patterns and price actions until my eyes ached.

You'll find no harder workers than professional futures traders. I personally know of none who works less than ten or twelve hours a day-none. Many traders, especially foreign exchange (FX) traders, work fourteen to sixteen hours a day.

Ofcourse I know that many Subscribers may not have the opportunity to log these kinds of hours. Then you must take every opportunity to study and re-study every interview, every book, every utterance by a professional trader or great market thinker. Learn as much as you can about their methods and how they relate to the charts you study, and their psychology. Take every opportunity to glean new ideas you can incorporate into your trading practice.

My nearly two decades of market experience notwithstanding, I remain a student of the markets. I read with great interest any information I come across about the methods or techniques of fellow bona fide professional

traders. (Incidentally, I've discovered that much of other traders' wisdom and methodology is transferable across other timeframes.) Study excellence in other fields, too---especially in world-class sports. In professional trading you need the same toughness, poise, and positive expectancy great athletes exhibit.

Combined with knowledge, your experience yields a considerable and broad market understanding, which will give you the confidence and poise you'll need to execute well under the fire of dramatic events or the tension of drawdowns.And of course experience allows your understanding to evolve. You'll be able to adjust your trading as conditions and markets change.

(Speaking of market changes: Although long-term trends are, as a class, most stable [because they're limited to supply and demand fundamentals], over time markets do change. Back in 1980 and '81, when short -term rates were highly volatile, I used to day-trade T-bills. T-bills were the equivalent of the S&P in those days. Now look at T-bills-they're a thin, dead market.)

As time passes, you must be alert for any divergence between your perception of market realities (as defined by your plan) and the markets' current actual behavior. If such a divergence grows too wide, disaster can follow. (See Fig. 2.3, right.) As described in the last issue, one tech-

nique for minimizing this divergence is to be ~~ I, 'I:' divergence

o/~ I

sure your trading practices are linked to at least __ /2%~~_~~ ~:_

one of the three basic types of price action - Your plan -

(period, line, and swing relationships). If you'll workconstantlytoexpandyourknowledge and experience, you'll be able to rapidly re-adjust your trading plan as needed to maintain its positive expectation. (See Fig. 2.4, right.)

The third dimension of our internal trading environment is stability of personality. As traders, our psychological well-being, our internal stability, is continually challenged by external forces. Money and emotion can be a hell of a volatile cocktail. After all, it is no mechanical robot who is executing trades but alive humanbeingwho harbors complex emotions as well as some very basic ones, such as greed and fear. And as Fig. 2.5 (left) shows, if your

Xit'l" .' trading plan defines ideal execution,

0(\0 x r 1,_ • • •

• \\e \>e~ ~, '_ ~ ~ff!!!; then a volatile personality will lead to

~O\O'" ill~1 ~ \~

- '~1j .' a great variance in your capacity to

executeyourtrades.Anypersonal volatilitymust be minimized-tamed and

Ideal

17 TrendDynamics

MARCH 1994

§ "Back in 1980 and '81, when short-term rates were highly volatile, I used to day-trade T-bills. T-bills were the equivalent of the S&P in those days. Now look at T-bills-they're

a thin, dead market."

18 TrendDynamics

MARCH 1994

"If you keep thinking about what you want to do or what you hope will happen, you don't do it and it won't happen:' -JOE DIMAGGIO one of baseball's greatplayers

stabilized-if you're to have any chance to execute at maximum capacity. And if you're not executing your plan at somewhere near 85 percent of its potential, then you're really trading some other, amended plan-in effect, no plan at all.

As Fig. 2.6 (right) illustrates, the goal is to maintain a stability of personality to minimize deviation between your actualtradesandyour trading plan's potential trades. In short, stability of personality contributes markedly to capacity to execute.

To be a successful trader you don't have to exhibit angelic presence and have neither physical nor mental bad habits. Still, it is helpful to do what you can to balance and stabilize your personality. Physical toxins or even ordinary food combinations can affect your chemical balance and therefore your mental state. And mental poisons such as fear, avarice, jealousy, and anger surely upset that balance as well. We need to rid ourselves of all such poisons that foster instability.

Exercise and a good diet can help to maintain your stability of personality and to minimize the effects of stress. It is no coincidence that many great investors and traders are committed to varying programs of physical and mental self-maintenance, programs that increase their energy and benefit their well-being-and thus their trading. The object, of course, is to maximize one's ability to remain centered and focused when executing one's trading plan.

Trading in the futures markets puts you in competition with some of the brightest minds on the planet. Age is irrelevant; you can be in your late twenties, as are many floor traders, or you can be in your sixties, like George Soros. You don't have to be a rocket scientist or a great intellect. (As a matter of fact, while thinking is critical to planning, too much thinking can be an impediment to execution). Like a fine-tuned, well-practiced athlete, you must execute your plan precisely and consistently even when you're under pressure.

Futures trading can bring you more wealth than you could ever spend.

But success doesn't happen overnight-and when it comes, it comes at a price. In order to exercise the techniques I discuss here one needs discipline, effort, and hard work.

Really it all comes down to one word: commitment. What price are you willing to pay? What is your level of commitment?

4 Trend Dynamics

APRIL 1995

Originally appeared in ...

Three Edges

The laws of TrendDynamics and the trading tactics derived from them will permit you to stand toe-to-toe with traders for deep-pocketed New York banks and hedge funds. In a world moving inexorably toward highly mobile and liquid capital flows, the underlying forces that drive markets are your best ally. Your deep understanding of them provides both your best offense and defense.

Many people are fearful of trading foreign currencies. I find them one of the easiest markets to trade in: Trend tenacity in these markets often works wonderfully in our favor. The fairly liquid Mid-America contracts help modestly capitalized traders to trade in multiples. I encourage you to watch these markets. It is no accident that most of the fortunes of the past fifteen years have been wrought from Currencies, Bonds, and the S&P.

The isolation most of us endure as private traders is a two-edged sword.

The individual private trader who is on his own is in an ideal position to see the markets clearly. He is undistracted by the often irrational energy found amidst the smoke and mirrors of the maddening crowd. And that is a major edge.

Anotheris that the particulartimeframe I teach for position trading-the IBD-is underexploited. I believe it will remain so. To those thirsty for constant action, it's just plain boring. And from the commission-dependent broker's point of view, its velocity is too slow to generate much in the way of commission income. Furthermore, trading this timeframe calls for patience, self-control, and discipline-all commodities that are, luckily for us, in perennial short supply among most inexperienced futures traders. The young buck comes into futures for the fast buck. Who wants to wait two or three months for a trade to ripen? Who wants to wait six months for a major trading-range breakout? I do, and so do people like George Soros, Ed Seykota Paul Tudor Jones, and Bruce Kovner. Were in good company.

A related third edge is the ability to trade on your terms, to pick and choose your batdes. Fight the compulsion to make substandard trades just because you we feel the need to do something. Billionaire investor Warren Buffet once

19 TrendDynamics

APRIL 1995

§ '~ .. He will win who knows when to fight and when not to fight:'

-SUN TZU

on the first of the five essentials for victory from The Art of War

Whether you are a position trader or a day trader, standing with your bat on your shoulder waiting for the right pitch-that's an edge, an edge that allows you deftly to profit in a very competitive environment of fast money. Our batting practice will continue around the first of next month. Bringyour bats and glove. See you then.

20 aptly described this particular edge. Translate what he said into your own

TrendDynamics trading terms:

APRI L 1995 "You're a batter in a game in which there are no called strikes. They can throwyou General

Motors at40and you don't have to swing. They can throwyouIBM at 120 and you don't have to swing. They have to keep pitching, so if you're patient, the odds are with you. You can wait until you get the right one right where you want it.

"You might not swingfor six months.

"You might not swing for two years. If you have impatient shareholders, they start

§ " ... boredom limits the hollering, 'Swing, you bum.'

capabilities of many "Isn't it boring, standing with a bat on your shoulders for two years?

money managers. n "It can be, and boredom limits the capabilities of many money managers. n

-WARREN BUFFET

Originally appeared in ...

~TrendDynamics

SEPTEMBER 1995

ing"-thatis, anticipatingtrend reversals. fTradingwhatwesee, notwhat

. VtsualizationPractices we think, yields us considerable leverage and long-term profitability,

of Top Traders p.l

especially when we've take the trouble to broaden ourfield of vision. f One

Trading in the Zone

In a three-part series, Trading the Vision, which begins with this lesson, we'll consolidate much of what we've explored and developed into a model three-parttradingplan. f"We begin with the first component, "Anticipat-

VOLUME 2 NO.9 SEPTEMBER 1995

In this issue-

critical fadorin full-vision trading is the pre-conditioning of the mind with regular exercise. We'll begin with a discussion of this critical prerequisite.

TRADING THE VISION: PART I

Visualization & Peak Performance

THE PINNACLE of athletic competition, visualization is a major

part of preperformance rehearsal. Visualization is widely practiced among professional and Olympian athletes. Willie Davenport, the five-time Olympian who was only the second American ever to compete in both the summer and winter Olympic Games, employed intense visualization. «When I got in the starting blocks:' he said, «the first thing I put in my mind was the image of the perfect race:'

Holly Flanders, 1980 and 1984 Olympian in downhill ski racing, put it this way: «In racing it is very important to visualize everything! Your reaction time is not something you can think about and react to. It is something that is already trained inside of you. It is something already a part of your muscle memory. We use visualization every moment of our training ... :'

Usingtoday's technology, the muscle memory or imprinting that Flanders refers to can be measured and documented. In his book Mental Tennis Vic Braden says,«Weve done a number of tests with people wired up with EMGs [ electromyography sensors] to measure responses. In one of these tests, we

2 'TrendDynamics

SEPTEMBER 1995

§ "I'm lookingfor a mosaic in the stock market, so I'm lookingfor an impression over [the] period of time that I'm doing my homework." -MARTY SCHWARTZ

asked a high hurdler to imagine himself actually running a high hurdle race. Sure enough, we began to see faint muscle contraction patterns that matched those used for leaping over high hurdles:'

Through visualization and mental rehearsal, a pathway of patterns or imprints is laid down in the brain; it is an extraordinary mind/body connection. Athletes who have learned to visualize in high-pressure situations automatically call upon this connection. By doing so, andconsequently performing with lessened self-consciousness, they avoid potential mental blocks that might impede their performance.

[ VISUALIZATION AMONG TOP TRADERS ]

Trading excellence also demands peak performance under pressure. Not surprisingly, an analogous sort of visualization or mental rehearsal is employed by the world's top traders.

Ed Seykota, Richard Dennis, David Ryan, and Linda Bradford Raschke, who are among the world's top traders, all practice a sort of mental rehearsal. Before they trade, each does hours of homework of one kind or another.

Ed Seykota describes his homework as "spending quality time with my charts;' and says this preparation is one of the most important things he does. Richard Dennis has said, "I think most traders do too much thinking on the spot. They should come in with 90% of the decisions made and just be putting frosting on the cake:' David Ryan, the top stock trader, prepares for a trading week by looking over some 4,000 stock charts every Saturday. (He winnows down the ensuing impressions into approximately 100 trade candidates; of these, he gives detailed study to five or ten trading ideas for the following week. He says this process is akin to "treasure-hunting:')

Linda B. Raschke, who is both a short-term and day- trader, says, "I always do my homework the night before, and 1 always go in with a plan:' Raschke builds what she calls a "lillie road map in my head:' She explains that "it teaches me to anticipate. Anytime market action is deviating from my road map, I'm out of there because the market is not doing what 1 expect it to be doing:'

What happens in the cogs of these traders' minds during this process?

Marty Schwartzi, who says he spends three or four hours alone over the weekend just doing his pre-Monday-opening homework, says, "You see certain things byporingthrough your chart books .... I'm looking for a mosaic in the stock market, so I'm looking for an impression over [the] period of

1 Schwartz is almost in a category by himself: Much of his success is due to his spending so much time gathering raw material-patterns and impressions-in order to stoke his remarkable intuition.

time that I'm doing my homework?'

In describing his own visualization process, the successful trader Paul T.

Jones says, "One thing ... about discretionary traders is they always spend time poring over their charts.'He continues, "Suddenly, a light bulb clicks on and you start visualizing in advance the script the markets are following?' Jones, who "scripts" markets by looking at the cyclical, seasonal, and sentimental factors at work, also says, "You've got to have a game plan and it's certainly got to be far reaching enough timewisethatyou can be comfortable standing moves against it-you've got to anticipatethem. You've got to strip everything away and down so that if the deal jackknives on Sunday night you're prepared for that, if the Federal Reserve Board eases next week you're prepared for that-and you're not being reactive, but proactive?'

You may have heard of Amos Hostetter, who was a key figure in the early days of Commodity Corporation, and who died in 1977. Commodity Corporation was the training ground for a host of up-and-coming traders in the 1970s and 1980s, and Hostetter was a mentor to many of them. Some of these traders, like Michael Marcus, have gone on to accumulate great fortunes. I consider myselffortunateto have been among those exposed early on to Hostetter's trading ideas and principles.

Hostetter emphasized the importance of what he called "dreaming:' He defined a trader's dreaming as the playing out of various scenarios in the mind in order to anticipate areas from which market changes could likely come. He used the facts at hand, the fundamental and technical conditions, as clues to guide him to the areas where he might expect potential surprises to originate. Hostetter believed that the trader who keeps himself prepared for surprises, in both directions and in advance, is in possession of possible explanations for such surprises, and hence will be less hesitant to act (or less likely to overreact) if and when they come.

Bruce Kovenor explains: "One of the jobs of a good trader is to imagine alternative scenarios. I try to form many mental pictures of what the world should be like andwait for one of them to be confirmed.Youkeeptryingthem on one at atime. Inevitably, most of these pictures will turn out to be wrongthat is only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click?'

Hostetter dreamed; Jones scripts markets; Schwartz looks for a mosaic.

Kovenor forms mental pictures of alternative scenarios; Raschke builds road maps of price action. The common ground here is visualization & anticipation-the process of mentallyworking out various potential scenarios. If one has in mind a clear framework for understanding market action and trend logic, then such scenarios branch off as natural extrapolations from current price action. This holistic approach to trading is trading as an art.

3 TrendDynamics

SEPTEMBER 1995

§ "Suddenly, a light bulb clicks on and you start visualizing in advance the script the markets are following." -PAUL T. JONES

§ "If one has in mind a clear framework for understanding market action and trend logic, then such scenarios branch off as natural extrapolations from current price action."

4 'TrendDynamics

SEPTEMBER 1995

§ "We typically enjoy the greatest confidence, and execute excellent trades well and profitably-that is, see the best resultswhen we trade in a market that's following a technical scenario we've anticipated, a script we've worked out in our minds."

This homework process may be a filtering and pattern selection process, like Ryan describes; or it may be a more elaborate visualization and scenariobuilding process like Jones and Kovenor describe. We'll look closely at this filtering and selection process in this and the next two issues. We'll pay equivalent attention to building scripts and to holistic trading in the forthcoming TD Applied and in discussions on TD Online.

Whether their trading preferences are holistic or filtering, all these successful professionals have one thing in common: They spend a lot of time poring over charts and data. By thus preconditioning their minds, these wellprepared pros can readily adjust to new market-generated information as they go along. The process of building alternative scenarios lessens a trader's uncertainty, reduces his or her emotionality and complements trade execution. Such a prepared trader is unlikely to feel the pressure of turmoil in reacting to an unexpected situation. To minimize reacting emotionally, which is almost always damaging to a trader, we need to learn to anticipate, to be proactive, not reactive. Preparation, homework, and hard work are key.

[ SCRIPT-BUILDING 101 ]

In Vol. 2 No.7 (July 1995), I pointed out that an appreciation of and understanding of swing freedom and supply/demand bias can help a trader develop long-term scripts that have a high probability of success. When we calculate AS/AD levels and uQ/LQ levels based on these concepts, we're enhancing our sensitivity to important price-action that occurs at subsequent, projected price levels. These simple, powerful, and for the most part objective tools are all called upon in script development.

[ TRADING IN THE ZONE ]

The more we engage in script development, the more we improve our ability to gauge the market's pulse. We typically enjoy the greatest confidence, and execute excellent trades well and profitably-that is, see the best results-when we trade in a market that's following a technical scenario we've anticipated, a script we've worked out in our minds. According to Paul T. Jones, such situations (~ .. are the occasions that you have to max out with mega-positions and play just as hard as you can stand:'!

1 Jones is suggesting that you take maximum positions on those highest -quality trades, those trades that follow your script. True, this is how a trader often generates 100% and higher returns. But trading at full unit-size is one thing, "maxing out with megapositions" quite another. To me, there's a danger this attitude can lead to over-trading. Never put yourself in a situation where you cannot withstand three or four limit-day moves in a position and walk out of the fire alive. Jones can blow his clients out one day

[ ENTERING AND TRADING IN ((THE ZONE" ]

Those athletes who do prepare themselves with sufficient mental and physical rehearsal often find themselves in an altered mental state; theyreport feeling "on," altogether immersed in the present. Some call this mental state "the Flow:' some "entering the Zone:' People who've experienced it say that one's perception of time often slows down or altogether disappears.

When we're trading, an analogous mental state is most likely to occur when we've visualized or predicted a scenario that thereupon unfolds in real time before our eyes. If we've already worked out the entry and risk details of a scenario before its actual occurrence, we have in a real sense already removed the emotional component from the execution process.

I occasionally experience periods of perfect trading: Without intervening losses, one profitable trade follows another in succession. This I call trading in the Zone.

Normally, and unfortunately, when it dawns on me that I'm in the Zone, the bubble pops. In the Zone, I have little recollection of the sort of selfconsciousness in which fear or anxiety can lodge itself. I can never recall having put myself or my decision-making through analytical processes during these in - the-Zone trades. And I come out of these periods in a sort of daze.

If, for the sake of this discussion, time can be defined as a sequence of events, then when, by scripting, we perceive a given event ahead of its actual occurrence, there follows a sense of stretching-out or straddling of the time that passes from the moment of our perception of the event to its realization. Without the benefit of script-dreaming or something like it, we can but witness events as they occur: Such events unfold in normal real-time sequence. And since most investors and traders don't trouble to scriptdream, and aren't otherwise well prepared for the unexpected, they're just pushed along from one event to another. In consequence they're almost always reacting. They're seldom or never executing a well-thought -out plan.

It is not necessary that we often or even ever trade in the Zone. I describe my in-the-Zone experience here so that if you should experience it at some point , you'll know what it is, or at least what I think it is, and nurture it as best you can.

and start over with new millions the next. You and I may not be in such a fortunate position. Perhaps because it is my own capital that's at risk, I'm more conservative on this issue than Jones is. {Despite having been offered opportunities to manage other people's money, I preferthelibertyoftradingwith my own, and onlymyown.) Nearly two de cades of trading has convinced me that on occasion the markets go wild and destroy anyone positioned against the torrent.

5 TrendDynamics

SEPTEMBER 1995

§ "[ occasionally experience periods of perfect trading:

Without intervening losses, one profitable trade follows another in succession. This I call trading in the Zone."

Originally appeared in ...

~TrendDynamics

DECEMBER 1995

VOLUME 2 NO. 12

Knowledge is the kindling that sparks the firstflame of trading excellence. No one who does not know a good deal about the markets will succeed as a trader. But knowledge by itself is not enough. Many knowledgeable traders lose money. Good traders also need the two-fisted skills of money management and risk control. But those who seek trading excellence must climb a steeper path yetthat of self-mastery.

Itis only through self-mastery that we can develop the iron discipline we need to consistently execute a trading plan day in and day out, week after week. We do not have the luxury of trading in the false isolation of computer algorithms or among the skeletons of past events captured by our historical charts. On the contrary, we trade in a rough, noisy, hurly-burly world of the now. *'re constantly buffeted by headwinds: distracting news, price shocks, evidence of flare-ups in volatility. And amidst the turmoil, what we need to do to survive and prosper, more often than not goes against our deepest human instincts.

In this Course we've identified and described how to manage many of the external problems and pitfalls that can ensnare the unwary trader; such asseductivefalse breakouts, abortive trends, tricky trading ranges, parabolic moves, stopseeking market noise etc. But there are other, internal obstacles and snares that endanger even the most knowledgeable, the most savvy trader. And nothing more baldly exposes our hidden weaknesses and psychological delusions than trading. The dangers within keep trading excellence just beyond the reach of most traders. In this issue, we'll explore seven prevalent dangers, and how to avoid them.

[ 1 ]

DECEMBER 1995

In this issue-

. Trading Excellence p.l Mixing science & art

2 TrendDynamics

DECEMBER 1995

Countering the Dangers Within:

Abstract Trading In A World of Emotion

ATHOUGH WE CAN physically isolate ourselves from the noise and distractions of our culture, we can neither hide from nor ignore the impact that culture has had upon us. Imbedded deep within each of us are biases towards self-maintenance, self-perpetuation, and self-gratification that are peculiar to our culture. In general, our culture has evolved along a long term tendency to increasingly reduce the risk element in the individuals mode of living. Our internalized risk -avoiding, self-gratifying cultural biases, and the behavior that follows from them, allow us to live at relative peace and in relative prosperity. But their effect on our tradingpersonalityis almost wholly negative. In what follows, I'll try to explain specifically how some of these biases can undo a trader's efforts to succeed, and how to overcome them.

[ REACT TO PRICE EVENTS-NEVER ANTICIPATE THEM

All humans are possessed of unrelenting curiosity about the future. We wonder what it will bring. We love to peer into the crystal ball. This curiosity serves us well in science, in research, and in exploration. But it can do us a disservice in our trading.

Uncertainty creates tension. Our human tendency is to ease this tension and return a the more comfortable state of certainty. To do so, we turn to We hang on the somber pronouncements of soothsayers, economic and other-

wise. We have our palms read, »>

worryoverour astrological charts, --

consult psychics.

Throughout this Course I've encouraged visualization in the form of the working out of "scripts" for dealing with what I I

may happen in the market. I've suggested that you develop a script and wait to see if it is confirmed-that is, that you take no action until price provides the entry-signals your script calls for, thus triggering your participation. You're reacting to price action. Your trading behavior is re-

.- ---:- .. -

_-=

... -'"":-

active, not predictive. As a wise trader once said, "Do what the market is doing, not what you think it is going to do:'

Being predictive is another matter altogether. It takes various forms such as entering a market prematurely or notwaitingforprice to confirm areversal at the end of a reaction. Being predictive shows itselfin your anticipating that your stop is going to get hit and bailing out ahead of it to save a few bucks. It manifests in your expecting that a certain price structure or pattern is all but certain to develop, and then acting on it as ifithad. These examples of trading ahead of your self, of predictive not reactive trading, are a consequence of our tendency to want to know what the future will bring-and to act as though we do know.

DO THE HARD THING, NOT THE EASY ]

We humans tend to avoid suffering pain. This is understandable, and in many ways desirable. But in it can produce a tendency to do the easy thing. We take shortcuts, procrastinate, take our relationships for granted, put off exercise, avoid difficult daily endeavors in favor of easy and enjoyable ones. And we pretend that major problems do not exist. A writer I knowwill clean the entire house and scrub the floors to avoid the difficult task of putting pen to paper. In short we often choose the ease of self-gratification over the necessityofse Ifmaintenance.

In trading, the easy thing to do is, by and large, the wrong thing to do.

Taking small profits is just about the easiest thing to do in trading, and by its very nature it is pain-free .. But you will surely go broke just taking small profits. Small profits will probably not cover the daily overhead of your tradingbusiness--especiallysince that overhead must cover the costs of your occasional whipping by the market. Letting a prime position react against you while you do nothing is a hard thing to do. The easy thing is to get out and end the duress. But getting out can be the wrong thing to do; at least occasionally, you need a large profit.

With rare exceptions, you do not capture fat profits without first sitting through difficult reactions.In describing his distribution of trades, Ed Seykota says that the single trades of 10- and 15-to-l profits represent the lion's share of his annual profits. The rest of his trades essentially balance one another. My twenty odd years of experience has led me to the same conclusion

One of the hardest things for any trader to do is to let a position flush with profit go to a loss. In fact, many traders believe that you should never let this happen. But, for most traders, unless they're making an entry on an important price event, the exact price-point where they enter has little

3 TrendDynamics

DECEMBER 1995

§ "In trading, the easy thing to do is, by and large, the wrong thing to do .. "

4 technical importance. It is far better to do the hard thing and to place a

TrendDynamics technically significant stop than to base a stop willy-nilly on whatever price

DECEMBER 1995 where you happened to get in on. From the market's viewpoint, such a stop is arbitrary and easy to swallow; ripe to be picked off by the randomness of market noise.

Of course letting a position react against you is difficult. In fact, the very idea of non- trend liquidation tactics was devised primarily as a psychological aid to provide taken profit and therefore relieve to some degree the nerve needed to hold onto with-trend positions.

Buying a single daily close above a poe (point of change) is certainly an easier thing to do than buying a WRB (wide-ranging breakout) at a much higher price. Nonetheless, the harder tactic is almost always to be preferred.

Similarly, taking and holding a short position in opposition to a market's current bullish sentiment is hard. Doing so in a market that has been recently reinvigorated by bullish news is harder still, for it means ignoring our natural human tendency to seek the reassurance of the crowd. No matter how hard, ittoo is often the right thing to do. But, be careful to avoid mistaking the hard thing with the stupid thing. Overtrading for example could be considered a hard to do because it take more nerve, but it is also a stupid thing to do.

Among successful traders independent thinkers, contrarians, and iconoclasts are disproportionately represented. The reason is obvious: They're the traders who are least uncomfortable acting against prevailing crowd sentiments. They don't care what other people think,much lesswhat"everybody" thinks or says. They go their own way, even when doing so is hard.

Is it enough, then, just to go against the crowd? Can a trader imitate an iconoclast and thereby succeed? Of course not. But a trader can learn to trust his own instincts and his own preparation, and learn to let the crowd and their sure bets, their "everybody knows ... :' go their own way and you go yours.

[ AVOIDING THE INFLUENCE OF EMOTIONAL MARKET MEMORY ]

Emotional experiences affect us strongly. Because they linger in the memory, they affect our interpretations of reality, and shape and direct subsequent actions that may be quite unrelated to whatever provoked the emotional expenence.

Our memories affect our trading. When we take a big loss, the emotional resonance of that loss can linger. It often causes us to fixate on the market in which we endured a recent helping of pain. By reason of this lingering «market memory" we take repeated stabs at trading the same market again and again, regardless whether such trading is wise or even appropriate. Perhaps we're trying to negate or assuage or cancel out our loss. In any case, we are liable to trade tactics that are inappropriate to the current marketwe're still basing our trades on a trade situation that has long passed. It makes for a kind of licking of wounds, this lingering emotional market memory, and it is almost always destructive to good trading.

Awareness of having missed a great trade can be even more disturbing than the sting of having taken a significant loss. The emotional memory fueled by having missed the boat can be powerful indeed. The trader who is kicking himself for having missed a trade he feels he should have caught can easily become obsessed with making good his mistake. He looks for a reversal-he hopes to regain on the other side what he failed to capture the first time around.

In a sense, he's out to avenge himself for having been so unalert or stupid or blind (or whatever he thinks he was) to have missed this great-inhindsight trade. Meanwhile, of course, his attention is diverted from more rational, more pressing trades-from the trading plan and script he should be following.

For example, suppose we miss a remarkable trade to the long side or let's say we just plain sold out too quickly. We watch in dismay as the market we just missed or pulled out of rushes higher. If we're not careful, the emotional market memory I'm talking about will overwhelm us. It may well manifest as an irrational focus on when that damned market will reverse so thatwe can trade it short, in the opposite direction. It's as though finding a way to trade it profitably in the other direction will somehow stop it from continuing upward, and will thus end our pain over the long we missed.

As traders, we must be especially on our guard for this all-too-human weakness. It is particularly insidious. It almost always diminishes the the integrity and objectivity of our analysis, and the effectiveness of our trading. To seek to avenge a poor trade is the antithesis of the coolheaded response we need to cultivate in reacting to our losses (and gains!).

5 TrendDynamics

DECEMBER 1995

§ "It's as though finding a way to trade it profitably in the other direction will somehow stop it from continuing upward, and will thus end our pain over the long we missed."

6 'TrendDynamics

DECEMBER 1995

§ "Losing money can be psychologically debilitating, but making money can be toxically exhilarating.

Either emotional extreme handicaps your trading. »

[ TRADE ABSTRACTIONS, NOT MONEY ]

This is gorilla drags down more traders than we can count. Never underestimate the emotional power of profits and losses, of making and losing money. Our culture constantly bombards us subtle and not -so-subtle messages that suggest that if were making money were successful and good, and that if we're losing money we're losers-we're bad.

This psychology so ingrained in all of us, and is so linked to issues of personal self-worth, that most professional traders have had to construct abstract mental trading worlds into which they can figuratively retreat to isolate and protect themselves from this pervasive money/success paradigm. Manybighitters,peoplewhotradeinhundred-andthousand-Iotpositions, would surely go crazy if they were not trading in such a self-created abstract mental realm.

This is why traders such as Tom Baldwin, the kingpin of the bond pit, a man who trades as many as ten or twenty thousand bond contracts a day, say such things as, "I don't trade for money, 1 trade tics:' By convincing himself that he's trading tics [numbers] and not money, he's trading in the abstract. In doing so, he's effectively diminishing his susceptibility to the emotional consequences of trading money.

Do not trade money, trade numbers. Create for yourself an abstract trading world. But be careful not to lose contact with reality--don't deceive yourself. Never place real money you cannot afford to lose within this abstraction; the emotional attachment to money is too strong to gloss over, no matter how hard you try. Trade only money that you can lose-money the loss of which would not threaten you or your family's well-being. Once you know how much that is, view that money through whatever lens you can construct to make it abstract. Separate yourself from the emotional content of your money-your trading capital, your losses, your gains. All of it.

[ STAY EVEN-TEMPERED ]

The more even-tempered we can be, the better decisions we make and the better we trade. The problem of emotional market memory we discussed above is exacerbated if our emotional state is volatile and explosive. We need, instead, emotional quietude.

To promote and enhance an even temperament in your trading, train yourself to react to losses in just the samewayyou react to gains-and be cool and tranquil about both.

Losing money can be psychologically debilitating, but making money can be toxically exhilarating. Either emotional extreme handicaps your trading. Do not allow yourself to experience euphoria over big gains; if you do,

DECEMBER 1995

you'll surely experience dysphoria over big losses. It is impossible to exult in 7

gains and not despair over losses. Better to be even-tempered about both. T rendDynamics

For the most part, I've trained myself to stop making value judgments on my individual trades. When I make a remarkable profit on a trade, I don't crow. When 1 make a notably bad trade, and lose a lot of money on it, 1 shrug it off. 1 just execute one trade after another. Of course I permit myself to registerthefactthatI'vemademoneyorlostit,butIdon'tdwelloneithergain or loss: I just move on to the next trade.

Learn to view all your trades, wins and losses, as equivalent and necessary small pieces that form the large pattern of your trading. The large pattern matters--the overall results matter. Individual trades just plain do not.

Incidentally, it is important to learn not to invest your ego in your trades.

A successful trade is not an affirmation of your brilliance. A poor trade does not signify, let alone confirm, that you're an idiot. You should even avoid viewing trades as affirmations of your being right or wrong. Don't use your involvement in the markets for this purpose. Marty Schwartz once said, "I started to become successful when I was able to detach my ego from whether to be right or wrong:' If you like, give your ego a much-desereved retirement in Tahiti-but leave it out of trading.

We can all cultivate healthy habits that work to decompress and de-stress us, and stabilize our emotions. Regular exercise, napping, and meditation can help, and so can paying attention to what (and how much) we eat and drink .. Anything that helps to shed stress out of us promotes emotional stability and thus better, more clear-headed trading.

It would not have been unusual to walk into Richard Dennis's office in his heydeyand find him napping even while holding huge limit positions. Every day, to decompress after the close, Marty Schwartz runs several miles .. Paul T. Jones remembers being impressed, as a young trader, that his mentor, the Memphis cotton speculator Eli Tullis, could maintain total composure and carry on a relaxed conversation during market hours while his huge cotton positions were undergoing volatile swings in value.

This is where you want to be--even- tempered, almost detached, disinterested in any particular trade. Execute each trade, then quietly put it aside and move on to the next. Your trading will improve, and so will your wellbeing, emotional and otherwise.

[ START ACTING AS IF YOU RUN A BUSINESS ]

For some reason, when most traders begin trading they somehow assume that the business they're embarking upon is different from any other.

8 Whether you trade full-time or part-time, you must treat your trading as a

TrendDynamics business. (If you are in it just for the thrills, for the gamble, close your account

DECEMBER 1995 and go to Las Vegas.)

I can assure you that those you pit your money against are hard-working, shrewd people who run their businesses with steely commitment. If you do not think like an entrepreneur who is running a business, you and your money will be soon be parted.

Asa businessperson you need especially to have a handle on two problems that notoriously affect the business of trading: undercapitalization and margin controL

UNDERCAPITALIZAITON

For want of sufficient capital, thousands of business die every year. Trading businesses, too, fall prey to undercapitalization. The business executive who fully understands the risks of undercapitalization at his day job typically fails to transfer that awareness to his part-time futures trading, which he maywell think of as a hobby. The consequence is unfortunate.

One contributing factor that leads to futures trading being treated as somehow different from other businesses is the widespread and wholly wrong perception that the margin rates set by the exchanges and brokerage firms are somehow meaningful-that tally doesn't take much money to get into (or stay in) this business. But margin deposit amounts for trading futures contracts are not an indication of what's a sufficient amount to deposit to safely and effectively trade a specific contract.

On the contrary, margin rates act chiefly to induce a great flow of trading activity (or to delimit it). Margin rates are set as low as possible to induce the maximum flow of retail paper onto the floor. This maintains liquidity and insures that floor traders can make a good living. Low margins are an inducement to speculate in futures contracts, not meaningful indicators of how much capital is really needed to speculate successfully. Margin rates are not set to encourage your our profiting in futures. In fact, quite the opposite.

The low margin rates generally prevalent in futures trading seduce many participants into believing that they can capitalize their newfound trading business with much less capital than they really need to do it successfully. Low margin rates make the start-up cost of a trading business seem seductively low. This in turn increases the number of trading business start-ups, many of them grossly undercapitalized and thus doomed to failure. Markets are ruthless agents that transfer capital from weak businesses to strong. undercapitalization

UNDERCAPITALIZATION AFFECTS YOUR TRADING IN TWO DELETERIOUS WAYS.

First, undercapitalization limit your ability to trade in multiple contracts. Thoroughout this course, I have, in case study after case study, illustrated the tactical advantages of trading in multiple contracts. Undercapitalization controls what an acceptable risk is, therefore it often limits the ability to engage in multiple-contract trading.

Second, lack of sufficient capital discourages you from placing meaningfulstops.As a general rule, the less capital you have, the less likely it is that yo u will place stops at meaningful areas.

As I explained in the last lesson, if you are stalking a reaction and that reaction is followed up by entrylbuy signals, more often than not this means that the downward reaction is over -nothing more. Therefore, sell-stops placed at a price level that can be caught bya reaction that retests the reaction extreme but does not pentrate downward to new reaction lows is often a meaningless stop. Because of the additonal risk that meaningful stops imply, undercapitalization discourages their use. Remember, the noise that catches so many meaningless stops is the sound of undercapitalized businesses being washed out.

Trading, even on a small scale, even part-time, is a business. and a difficult one. It needs to taken seriously and respected as a business. Trading is no crapshoot.Again: If you want to gamble, head for Las Vegas. margin control Margin control is the essence of good trading-business management. You make money as a trader in part because you take risks others find unacceptable. Your profit margins are a direct result of your ability to exploit and sustain the gap that exists between the common level of market knowledge and trading savvy and your own. In this gap lie all trading profits. You need to exploit that gap through consistent execution-and you need to invest in a constant effort to forestall the closure of that gap.

In the 1970s, you could make a living with a simple Donchian 4-week breakout system- and Richard Dennis could amass $100 million dollars in profits trading simple 10-20 day line changes. We can no longer trade Donchian breakouts and Dennis-like line changes and make the same profits.

The profit margins that rewarded that level of knowledge have diminished. Overall trading competency has increased as market knowledge inexorably rises over time.tAs it increases, our profit-margin gap is under constant pressure to narrow. The greater information flow induced by the

9 TrendDynamics

DECEMBER 1995

In our culture, decisiveness and tenacity and courage are much praised. Decisiveness is considered an outstanding leadership quality. We admire people who stick to something and see it through. And we universally praise courage. These are all virtues. But here again, as traders, we must put a different spin on them.

One of the premier traders of our time is MartySchwartz; he's said to make some 250% per month trading the S&P 500 index. When asked how he typicallyputs on the average 200 -lot S&P position he trades, he says he moves into his positions gradually and in piecemeal fashion.

The average trader does just the opposite: He typically plunges into a position in an emotional blur, acting in a surge of trading that's usually inspired more by crowd behavior than by any thought -out plan of his own.

Do not fall into the trap of all-or-none trading decisions. (You can avoid this trap nicely if you trade multiple contracts.) Black or white decisions exacerbate emotional market memories. Avoid them. Learn to discern among and appreciate greys.

At least as a trader, Schwartz is neither tenacious nor courageous. In fact, in describing himself he says, "Basically I'm chicken: I run like crazy:' Being tenacious, hanging on courageously to the end, at least in this sense, has no place in excellent trading. To his regret, the average trader holds fast to losses and runs like crazy from holding on to profits. Tenacious stubbornness is financial suicide.

Profit margin

-

Overall level of market knowledge

enlarged capacity for instant communication provided by the Internet is accelerating this pressure further. That's why we must constantly keep our profit edge from collapsing-must be both more knowledgeable, and tacticallymore savvy, than the average trader.

MAKE DECISIONS PIECEMEAL

The reason why the failure rate is high among those who aspire to trade like professionals is that their execution of their trading plans occurs in a tumultuous external environment that's echoed in the mind: Most traders, including many who are quite knowledgeable, are fraught with emotion. Aspiring traders and old hands too get mired in the pitfalls I've described here.

The trader who aspires to excellence, to success and profitability, must 11

confront and deal with his own emotions. It is very difficult to do well in TrendDynamics

trading if you continue to fall under the spell of emotional habits that work DECEMBER 1995

against you in trading. Understand who you are and the baggage of cultural

habits you carry and you can identify the emotional pitfalls you face. But

discipline, self-mastery, and tools that encourage healthy trading habits are

the kit that allow you to meet and solve these problems head on.

Originally appeared in ...

4TrendDynamics A P P LIE D

FEBRUARY 1997

---------------------------------------------------------.

•

annes APPLI ED

Practical applications ofT R END D Y N A M I C s insights & ideas for the professional trader

PUBLISHED ONLY FOR GRADUATES OF THE TREND DYNAMICS COURSE :: FEBRUARY 1997

STRATEGIES :: TACTICS :: ANALYSIS

The Effective Trader; or, Samurai & Catfish Hunter

by Joseph Hart

A FRIEND RECENTLY ASKED what was the biggest obstacle I had to overcome in making the n transition from avid student of the futures markets to professional trader. The short answer is, my own perceptions. Thsese I changed by internal transformations.

In Trend Dynamics and TD Applied, my main purpose all along has been to put before you everything I know about trading, with an emphasis, of course, on technical factors. I've set out the Laws of Trend Dynamics and explained where they came from and how they work in day-to-day trading. Along the way I've discussed certain attitudes and psychological factors that I feel to be important. Here, I'd like to talk about those internal transformations-three in particular. As components of trading success they're no less important than technical sophistication or market savvy. In fact, they're what lets us take advantage of the trading edge I've discussed in these pages.

A popular Los Angeles attraction is the La Brea Tar Pits, an ancient pool of tar in which the remains of prehistoric animals-mastodons, giant sloths, saber-tooth tigers-have been trapped and preserved for ages. For the trader, the misperceptions I'll explore here are like tar. Even the traderequivalent of the saber-toothed tiger-acute of sense, quick, fearsomely well defended-risks being trapped in them, to say nothing of the slow-moving sloth or the heavylimbed mastodon.

Being Intelligent vs. Being Effective

As a beginning trader, I labored for a long time under the illusion that if one were intelligent and creative, and through diligent study acquired a great deal of knowledge about the markets, success would surely follow. I was wrong. In fact, few false beliefs are as insidious, or as common, as this one. This one nearly sank me early on, and badly impeded my progress.My greatest obstacle was to make the transition from market theoretician (one who thinks deeply about how markets work) to market practitioner (one who effectively uses market knowledge to create trading profits).

204

.. '- TrendDynamics ....".APPLIED

FEBRUARY 1997

Intelligent and creative people everywhere are drawn to trading the markets. Many are drawn by the markets' complexity as much as by the prospect of making money; such traders enjoy testing their intelligence against the problems the markets present, and against one another. But as Peter Drucker, the seminal assayer of what makes businesses and business people successful, once wrote,

There seems to be little correlation between a man's effectiveness and his intelligence, his imagination, his knowledge. Brilliant men are often strikingly ineffectual; they fail to realize that brilliant insight alone is not achievement. They have never learned that insights become achievement only through hard systematic work.'

Most traders come into the trading business burdened with two kinds of baggage that detract from their effectiveness as traders. First, most of us spend 15 or 20 years enmeshed in an educational system where intelligence, insight, and creativity are considered to be achievement enough. But in the world of business, and in trading in particular, the achievement that counts is something altogether different-something that is not at all synonymous with high intelligence. In trading, the kind of achievement that counts is effectiveness.

Being intelligent and creative and the having of a great stock of know 1- edge about price movement is not the same thing as being an effective trader. The two simply do not go hand in hand. The sooner a struggling trader swallows this pill and considers to what degree he or she believes in and acts on this myth, the quicker he or she can get back on course.

Second, as we grow to maturity we pick up a good many erroneous perceptions about the markets that we need to unlearn if we're to be successful traders. We need to correct our conceptualizing. In his book Zen and Japanese Culture (Princeton: Princeton University Press, 1959), Daisetz Suzuki provides an apt description of the consequences of erroneous conceptualizing. (In this passage, try substituting the phrase "the markets" for the phrase "a mountain")

Unfortunately, as soon as we begin to grow up we are indoctrinated by every means accessible to us. Because of conceptualization, our sense-experiences inform us with

1 The Effective Executive. New York: Harper & Row, 1966, p. 1.

an incorrect picture of the world. When we see a mountain, we do not see it in its suchness, but we attach to it all kinds of ideas, sometimes purely intellectual, but frequently charged with emotionality. When these envelop the mountain, it is trans- ..;f TrendDynamics formed into something monstrous. This is due to our own indoctrination out of A P P LIE D our "scholarly" learning and our vested interests, whether individual, political, so- FEB R U A R Y 1 9 9 7 cial, economic, or religious. The picture thus formed is a hideous one, crooked and

twisted in every possible way. Instead of living in a world presented to the Primary

Nature in its nakedness, we live in an artificial, "cultured" one. The pity is that we

are not conscious of the fact. (p. 175).

205

Most aspiring traders are mired in misperception about how markets really work and what one truly needs to do to trade them effectively. A first step to trading effectiveness is simply to realize and understand that possessing market intelligence is not enough-and isn't the same thing as being an effective trader. While the role of market theoretician has its place in fostering sound trading plan development, at some point, we need to make the conscious transition to market practitioner.

Being Right & Making Money

Most trading models fall into one of two categories: those designed to forecast, and those designed to make money. Obviously a trader who wants to make money needs to distinguish between them.

Ned Davis, founder of a well respected institutional research firm, published a book in 1991 entitled, Being Right or Making Money (Ned Davis, Inc.). In it he says,

Like nearly all novice investors and analysts coming into the investment business, I was convinced back in 1968 that all I had to do was discover the way the investment world worked, develop the best indicators available to forecast changes in the markets, and then have the conviction to shoot straight and gather my profits.

And if I say so without much modesty, my record from 1968 to 1978 was so good at forecasting stock prices that during a "Wall Street Week" broadcast in 1978, Louis Rukeyser said, "Ned Davis has had an outstanding record in recent years ... and has been absolutely right about most the major ups and downs .... "

The only problem was that at the end of each year, I would total up my capital gains and, unfortunately, I would not owe Uncle Sam much money. Before someone else could question me, I said to myself, "If you are so smart, why aren't you rich?" It was at about that time (1978-1980) that I began to realize that smarts, hard work, and even a burning desire to "be right" were really not my problem, nor the

egy, not forecasting that was holding me back.

So I set out to get a computer and a good program, and started building timing models that I felt would give me the objectivity, discipline, flexibility, and risk management that I needed to make consistent profits.

And since 1980, my company, Ned Davis Research, Inc. has been dedicated to building timing models that do not forecast, but simply are designed to make money. I can tell you, it made a real change in my investment profits, and both Uncle Sam and myself are now much better off. As far as my forecasting of the market, if anything it suffered, because timing models that make money invariably are not nearly as cocky as a crystal ball guru, and they are so concerned with managing any disastrous risks that they try to hit singles and doubles rather than home runs. But I found that not being the top forecaster on Wall Street at anyone time was not all that much of a liability. Again my financial well being improved significantly, and the humility and discipline that the timing models forced upon me actually relieved me of a lot of stressful anxiety. The game changed from winning or losing glory and prestige to a serious business designed to make money with less risk. ... So being right is not really where it's at, since at least as much of your focus should be on risk management tactics and a disciplined strategy. (pp. 1--4. Emphasis added.)

206 solution to my problem. What I realized was that my real problems were a failure to cut losses short, an inability to be disciplined, difficulty admitting mistakes, fear 4 TrendDynamics and greed, and a lack of risk-management, none of which had much to do with A P P LIE D being right in the stock market world. It was thus a lack of proper investment strat-

FEBRUARY 1997

" ... So being right is not really where it's at ... "

Davis goes on to say that through his company he's been exposed to highly effective traders, and that

The winners are very flexible and very disciplined, and they're risk managers. While I am not trying to knock the importance of study, hard work, and being right in terms of investment success, the key is how to make money. I still believe that objectivity, flexibility, discipline, and risk management are the keys to making money. (ppA.)

These passages resonate with me because my experience was so similar.

Early on, I considered myself a gifted forecaster of markets; but when I looked at my bottom line I saw few capital gains. It doesn't do the trader much good to forecast markets he's not profiting from trading. Ultimately I came to realize that models that are designed to make money are substantively different from forecasting models. Trading models that make money tend to be armored with risk-management safeguards, and are chiefly if

-------------_---._------------_

not entirely concerned with generating trading profits. In short, they tend to be focused on making money over and against being right.

Many aspiring traders are also mired in the misperception that being right is all-important. Another first step to trading effectiveness, then, is to forget about being right and concentrate on adapting trading concepts, and building and modifying trading models, in which the goal is not to forecast markets but to make and compound trading profits. For most of us this too requires a considerable degree of unlearning.

Thinking Dangerously

One of our Subscribers, a trader in the City, London's financial district, has hung this motto on the wall in his office: "Don't think, it's very dangerous:' To someone who esteems his hard-won intellectual understanding of the markets, this statement may seem odd indeed. But to the experienced trader this caution is wisdom itself As traders, all of our thinking should go into developing and understanding our trading model, and not into trade execution.

Good trade execution is simple and should be virtually automatic. Unfortunately, when we start thinking about a position we're about to initiate, we typically introduce stress and doubt-inhibiting distractions in the form of second thoughts or rational misgivings. Or, faced with the uncertainty that every trade presents, we scramble for more information to reduce the uncertainty while the trade passes us by. What should be straightforward is inhibited and messy; what should be consistent is erratle.

The samurai warriors of 16th and 17th century Japan, great swordsmen who engaged in armed battle that often resulted in loss of limb or life, knew keenly just how dangerous thinking can be. A lapse into thinking while engaged in a swordfight was known as a suki, literally "a moment of relaxation"; it gave the opponent a momentary advantage. Samurai warriors were taught to look for and strike the enemy the moment he showed a suki. Avoiding such lapses into thinking is no less important to the trader working at executing trades consistently than it was to the great samurai swordsman. For both, it's a matter of maintaining concentration.

In Zen and Japanese Culture, which I've referred to above, Daisetz T.

Suzuki says that the samurai considered the last stage in mastering the art of swordplay was sustaining a specific state of mind that prevented suki. Suzuki writes,

207

.. '- TrendDynamics -l'"APPLIED

FEBRUARY 1997

"Models that are designed to make money are substantively different than forecasting models."

"As traders, all of our thinking should go into developing and under standing our trading model, and not into trade execution."

desires to do well, or to display his skill, or to excel others, or if he is too anxiously bent on mastering his art, he is sure to commit more mistakes than are actually necessary. Why? Because his self-consciousness or ego-consciousness is too conspicuouslypresent over the entire range of his attention which fact interferes with a free display of whatever proficiency he has so far acquired or is going to acquire. He must get rid of this obtruding self- or ego-consciousness and apply himself to the work to be done as if nothing particular were taking place at the moment. When things are performed in a state of "no-mind" (mushin) or "nothought" (munen), which means the absence of all modes of self- or ego-consciousness, the actor is perfectly free from inhibitions and feels nothing thwarting his line of behavior. Ifhe is shooting, he just takes out his bow, puts an arrow to it, stretches the string, fixes his eyes on the target, and when he judges the adjustment to be right he lets the arrow go. He has no feeling of doing anything specifically good or bad, important or trivial; it is as ifhe hears a sound, turns around, and finds a bird in the court. This is one's "everyday mind"

The swordsman is thus advised to retain this state of mentality even when he is engaged in a deadly combat. He forgets the seriousness of his situation. He has no thought of life and death. His is an "immovable mind" (fudo- shin). The Judo- shin is like the moon reflected in the stream. The waters are in motion all the time, but the moon retains its serenity. The mind moves in response to the ten thousand situations but remains ever the same. The art culminates here. All the scheming of the intellect has been quieted, and no artifice finds room for its demonstration (pp. 147-148).

208 To be of no-mind" (mushin) means the "everyday mind" (heiji-shin), and when

this is attained, everything goes on well. In the beginning, one naturally endeavors .t. TrendDynamics to do his best in handling the sword, as in learning any other art. The technique has

..-yAPPLIED b

to e mastered. But as soon as his mind is fixed on anything, for instance if he

FEBRUARY 1997

..... His self-consciousness or ego-consciousness is too conspicuously present over the entire range of his attention."

It isn't stretching things too far to note obvious parallels between the high art of swordsmanship and our more mundane activity, consistent trade execution. Note, in Suzuki's discussion, the importance of detachment as to outcome, the self-forgetfulness. We need to cultivate this sort of detachment. When we think about something we should do nearly automatically, we allow the mind to attach itself to outcome and ego-consciousness. Thinking distracts us.

This interference by the mind is well known among high-achievers in athletics. In his book book In the Zone (New York: Penguin Books, 1995), Michael Murphy describes a typical example:

[World-class athletes] seem to know that conscious thought must be held in abey- 209 ance. Catfish Hunter, in describing the perfect game he pitched against the Minne-

sota Twins in 1968, said, "I wasn't worried about a perfect game going into the ~ TrendDynamics ninth. It was like a dream. I was going on like I was in a daze. I never thought about it A P P LIE D the whole time. If I'd thought about it I wouldn't have thrown a perfect game-I FEB R U A R Y 1 9 9 7 know I wouldn't," (p. 26. Emphasis added.)

I have repeatedly suggested how important it is to "trade what you see, not what you think:' To trade what one sees is to interpret price action in the absence of all modes of self- or ego-consciousness, uninterrupted by mental intrusions, and guided entirely by your trading plan. It is serene trading-it is trading in the zone.

Summary

A first step to becoming an effective trader is to realize and understand that at some point we must make a transition from market theoretician (synthesizer of market knowledge) to market practitioner (effective user of market knowledge).

Second, the effective trader is unconcerned about being right about the markets or about being a good forecaster; instead, he or she is committed to acquiring, developing, and adopting trading plans specifically designed to making money.

And third, the effective trader has the discipline to execute trades without handicapping himself or herself by thinking about the trades. Instead, the successful trader trusts his or her trading plan, and works to eliminate negative mental intrusions into the execution process.

"To trade what one sees

is to interpret price action in the absence of all modes of self- or ego-consciousness, uninterrupted by mental intrusions, and guided entirely by your trading plan."

~TrendDynamics A P P LIE D MAY 1997

Originally appeared in ...

•

annes A P P LIE D

Practical applications ofT R END D Y N A M I C s insights & ideas for the professional trader

PUBLISHED ONLY FOR GRADUATES OF THE TREND DYNAMICS COURSE :: MAY 1997

STRATEGIES :: TACTICS :: ANALYSIS In a Crystal Ball Darkly

by Joseph Hart

TN THE LATE 1970S, I woke up. That's when it became obvious to me that almost everything the .1 experts said about what the markets were going to do in the future was flat wrong, and most of the rest was by no means accurate enough to be of use to this novice trader trying to eke out a living in a sleepy little brokerage office. Predicting the future was clearly not as easy as the pundits pretended it was. Twenty years have rolled by, and the experts are still pontificating, windy and inaccurate as ever. But I pay them little mind.

As traders, one of our chief tasks is to use our knowledge of the past, and the assumptions we reasonably derive from that knowledge, to pick our way thorough the booby-trapped and uncertain landscape of the future. Like driving a car forward using only the rearview mirror as a guide, this is an endeavor it is easy to do badly. In this issue, let us consider some ways in which what seems intuitively reasonable or even inarguable is often wrong, sometimes dangerously so. Over time we begin to better understand which reasonable assumptions are likely to be dangerous allies, and which ones we can have more confidence in.

The Well Understood Trend

Prolonged advances or declines, such as the orderly decline in the Dollar on Chart 191, overleaf, often present a classic structure: a procession of mainly lower tops and bottoms that lope along to more or less consecutive new lows. The first declines in this progression are typically met with disbelief. Market soothsayers assure all who will listen that these downward thrusts are just corrections to a bull scenario. Each new low is said to be the last in the series-at least until the trend becomes so pronounced that the forces driving it become understood on the periphery of market -watching. Then, typically, a continuation of this now-acknowledged trend is taken for granted, and lower prices are promised by expert writers in the major financial publications. (These writers answer to subscribersensitive editors who insist on explanations for every phenomenon that has recently reached a critical mass of consciousness in their subscribership.) Pundits who initially denied the existence of or were oblivious to the trends in their emerging states now clamor over one another to be the first to explain what is now obvious.

[247]

r-====~=========:;:::=====:=====~==:;;1;;-'15 On Chart 191, left, the

Dollar Index, at X indi-

cates a point of inflection. Over the course of the preceding few weeks, in March 1995, a plethora of articles on the Dollar had appeared. With scant variation, these articles told why the Dollar bear market of several years' duration had come about, and how it was that it must continue lower .

At Trend Dynamics we reproduced several of these articles and sent them to Subscribers with the April 1995 issue. (Fig. 36, below, is a reproduction of what we sent.) The Economist, Forbes, Barron's, and Investor's Business Dailywere among the pub-

··················r································· ···········110

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March X 1995

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Chart 191. The well understood trend.

(rom the cover page of '"".,Ior·, Bu,i""" Daily. March 15. 19~.

Marriotts smart divorce Safer Ginnie Maes Dollar crash ahead?

$4.00 Cc..-Ia ~50~

Cover page of Barron's. VOL- LXXV, NO. 10, March 6, 1995. Dow Jones & Company. Inc.

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Dollar IsU

Regain Its Strength?

Fig 36. Confluence of headlines from March 1995.

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lications represented in our collage. All clamored to tell why the Dollar had 249 been captured by bears. If ever there was one, this was surely a well under-

stood-certainly a well publicized-trend. And yes, at the time, in March of .. "- 'TrendDynamics 1995, to assume a trend continuation to lower prices did seem reasonable, by ..-'f A P P LIE D

reason of fundamentals and trend tenacity both. MAY 1997

As shown on Chart 192, below, such extrapolation of that particular bear trend into the future was highly lethal. It is precisely this type of reasonable assumption, an assumption based on obvious and widely understood underlying fundamentals, that is almost inevitably followed by a confounding reversal-for many traders, a fiasco. Such reversals snag heavily leveraged cor-

porate or institutional traders and investors and small-scale traders alike.

become undeniable) was emerging in accord with our analysis of the 18D (monthly) swing structure. After all, it is preciselywhen a long-established and apparently orderly trend becomes so well understood that Trend Dynamics tells us to call to mind the Third Law: the perception of the probability of a certain price action or event (in this case, trend continuation) diverges from the actual probability. And, employing Trend Dynamics tactics, we've traded the Dollar long and most currencies short, and correctly so, for nearly two years now-since the major bottom in the Spring of 1995.

A healthy skepticism about the durability, let alone the inevitability, of an aged and well understood trend is useful. Such skepticism is especially warranted when the financial press is falling all over itself with explanations of the phenomenon and projections of its inevitable extension into "the foreseeable future" (whatever that might mean).

The major reversal in the Dollar that emerged from this news context was of more than passing interest. In fact, the heady confluence of bear-siting headlines helped us to determine at the time, not after the fact, that a bull market in the Dollar (a bull market that has now

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29-Dec-95 19-Mar-96 18-.11111-96

27-Sep-96

27-Dee-96

Chart 192. The well understood trend becomes misunderstood.

The Artificial Trend

The orderly bear market in the Dollar described on Chart 191, p. 248, was at least real. It was a clear, natural trend etched out over time by the forces of the market. The soaring bull market we see on Chart 193, below, is another animal altogether.

This chart represents a hypothetical bull market-the artificial construct of some 24 trading systems. This chart does not represent a real and natural trend, a trend beyond the reach of the system developer's tweak and massage, like that in the Dollar. Instead, it is wholly an artifice of man-and therein lies the problem. Its data springs from an imaginary past and an untouchable reality. It has been neatly tailored to curve-fit the past. Charts like this are, more often than not, an accident waiting to happen. If we create and attempt to draw conclusions from such charts, we're in danger of making serious missteps.

Chart 194, opposite, presents the cumulative results of those same 24 systems in the years after release date, and applied to real prices. I present this chart as a reminder of the dangers of curve-fitting the past, to show how our best -laid plans all too often unravel in real time, and to point up how difficult it can be to accurately extrapolate the known past into the unknown future. (If Chart 193, below, were a chart of achieved and not hypothetical results, and absent the artifice, it would be a much more valuable source of information.)

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ILL

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.... : .... : ... "1" ..

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250

lilt'.. TrendDynamics ...,-APPLIED

MAY 1997

Chart 193. Composite pre-release performance of 24 systems.

Merged Composite Equity Curve 24 Systems Combined

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Danger in the Obvious

In the late 1970s and early 1980s Edson Gould wrote a monthly report titled, «Findings & Forecasts': It had a solid institutional following and was widely thought to be one of the premier publications in technical analysis, and I was a long-time subscriber. In his 1979 forecast, Gould printed the chart reproduced here as Fig. 37, overleaf The chart was meant to illustrate an «obvious" seasonal bias favoring an advance in the month of January, and to set out probabilities for advances over the rest of the year. The trouble was, the data presented only seemed significant. Close analysis of Gould's data results showed it to be not statistically significant.

Sometime what appears obviously true is just that--a matter of appearances only. I use seasonal data to make inferences, but I don't weigh it heavily and I acknowledge that such data can appear more significant that it really is. A market's current structure, major trend, and its current price action always take precedence over historical patterns.

The Predictable and the Unpredictable

Compared with the quiescence of the 1950s and 1960s, the decade of the 1970s was a watershed for the futures market-a period of high price volatility. It brought currency gyrations, Oil price-shocks, unprecedented parabolic runs in Gold and Silver, huge blowoffs in Grain prices, the bear-market collapse in Bond prices and concomitant surges in interest rates. This explosion

· ·s 107000

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Chart 194. Composite post-release performance.

"Sometimes what appears obviously true is just that-a matter of appearances only"

252

.. "- TrendDynamics ...,-APPLIED

MAY 1997

Fig. 37. Obvious seasonal tendency?

3.00

Seasonal Pattern of Stock Prices
1900-1978
X




L_ 2.50

2.00

1.50

1.00

.50

o

J F M A M J

J A S 0 N
79 78 78 78 78
51 44 45 40 48
28 34 33 38 30
1.82 1.29 1:36 1.04 1.60 D TOTAL

78 943

42 534

36 409

1.17 1.31

Total months 79 79 79 79 79 79

Total + months 57 41 40 46 37 43

Total - months 22 38 29 33 42 36

*Odds of advance 2.59 1.08 1.03 1.39 0.88 1.19

NOTE: Figures based on monthly mean of Dow Jones Industrial Average. Plus months are those showing advance fromprevious month; minus months are those showing decline from previous month. "Plus months + minus months

in volatility brought in train a new expanded awareness of the potentials for risk and reward.

The futures markets and futures trading surged. More and more private and eventually institutional money was funneled into futures trading. But how was all that money to be sanely deployed? There were relatively few experts on futures trading, and there was a pronounced paucity of data on futures trading results.

In the early 1980s much of the smart money went to trading veterans from the floor, ambitious traders who formed private pools and migrated upstairs: people like Paul Tudor Jones and Richard Dennis. Lots of money went to such systems pioneers as Richard Donchian and Ed Seykota, and to traders like Michael Marcus who were beginning to emerge from the Commodities Corporation. As commodity funds began to corral huge sums of trading capital, publicly-available data began to accumulate on these funds and pools. When it did, academics and students of the futures markets finally had in

hand the objective data they needed to try to understand relationships between past and future performances.

Such people were called on by investors to help them determine how to allocate capital to and invest capital in the futures markets. It was thought, or at any rate hoped, they could help make the risks understandable, and could determine to what degree performance was predictable.

Studies on Predicting Future Performance

In 1987, Edwin J. Elton, Martin J. Gruber, and Joel C. Rentzler published a pioneering study titled, "Professionally Managed, Publicly Traded Commodity Funds,"! The study, which was based on data generated by commodity funds up through 1985, sought to determine whether a fund's performance during a given prior period was useful in predicting its performance in the next. To most observers, it certainly seemed reasonable to assume that a previous years' return would correlate, at least to some degree,with subsequent years:

Five pairs of adjacent one-year periods, from July 1979 to June 1985, were examined. The number of funds examined ranged from lOin the first pair to 67 in the last. The assumption that the prior period's return would usefully predict the next period's return was compared with a prediction of a return of zero in following periods. Risk/return was defined by the Sharp ratio, and risk itself was defined by the standard deviation of past returns.' (Standard deviation is a statistical measure of the range or dispersion of returns around the mean or average return.)

Their analysis of the results of the study revealed no statistically significant correlation between a prior year's return and each subsequent period's. Nor was there a statistically significant correlation between a prior period's risk! reward ratio and the subsequent period's. In fact, the zero prediction for future period returns was the best predictor in all five subsequent years.

On the other hand, Edwin et al did find strong statistical evidence that lower risk (as defined by the range or dispersion of returns, i.e. standard deviation) in one period was correlated with lower risk (standard deviation) in subsequent periods for each fund, and that high risk in one period similarly correlated with high risk in subsequent periods.

A 1994 study by Scott H. Irwin, Carl R Zulauf, and Barry W. Ward, "The Predictability of Managed Futures Returns;' was performed on more recent data and a broader range of trading managers-specifically, 134 Commodity

1 The Journal of Business, 60(2) (1987),175-179.

2 The Sharp Ratio is the expected return, which is normally the average of past returns, minus I, the risk-free rate of return (theT-bill rate) divided by the standard deviation.

253

.. !'.. TrendDynamics ""'-APPLIED

MAY 1997

" ... The zero prediction for future period returns was the best predictor in all five subsequent years"

254

.. "- TrendDynamics ...,-APPLIED

MAY 1997

"While it may seem reasonable to assume that prior returns have predictive value relative to subsequent returns. this assumption may be overstated at best. and at worst not statistically significant."

Trading Adsvisors (CTAs) in the last period examined (over against the 67 pools examined in the earlier study).'

The findings of this more recent study paralleled the earlier study's findings: the Irwin study found no statistically significant correlation between past performance and future returns. (Neither have other, similar studies undertaken between 1987 and 1994.) But Irwin et al. did find some evidence of consistency in performance by those CTAs who performed in the top decile of previous periods. (By contrast, those eTAs whose performance fell into deciles 2 through 10 were subsequently scattered randomly around the average return for all eTAs.) Like other researchers, Irwin et al. did find strong evidence of predictive reliability with the past standard deviation (that is, the dispersion of returns) by eTAs in subsequent standard deviation rankings.

What do we make of all this? While it may seem reasonable to assume that prior returns have predictive value relative to subsequent returns, this assumption may be overstated at best, and at worst not statistically significant. The best we can do is to make sure we're trading in the top decile, where at least there's evidence of consistency of return. I believe those trading in the top decile of performance tend to posess profitable trading methods that are unusually robust due to an ability to incorporate and adapt to feedback derived from a detailed understanding of how markets work at primal levels; while those in the lower deciles have trading methods which lack this dynamic, adaptive quality. Trend Dynamics students, who have studied in earnest, have this same edge-a detailed understanding of how markets work at primal levels.

Furthermore, what has been shown to be useful in study after study is that standard deviation, the dispersion or variability of returns, is a useful measure of inherent risk. And, insofar as it describes a phenomenon well, the variability of return is a strong predictor of the range in which future events will also lie.

We will return to this topic again and explore its ramifications in more detail in subsequent issues.

! Journal of Derivatives 20-7, Wmter 1994.

Originally appeared in ...

4TrendDynamics LABS

JANUARY / FEBRUARY 1998

---------

TrendDynamics LA B 5 JAN /FEB 1998

10

Tribal Dialogue 2

How to Improve Your Trade Execution

The following dialogue addresses the question of how to begin executing consistently, and some of the issues that prevent us from doing so. The discussion was held on the TD Basic forum in November and early December, 1997.-J. T.

Martin T. Tribe, for six months now I've followed the forum. I've been fascinated to see how naturally and in an apparently problem-free way you move in and out of the market consistently regardless of the outcome of the previous trade. For example, the last SP short trade [a Sh5D short on 11-06- 97]. We entered on the short side in the absolute heat of the bulls.

Having a working methodology is one thing, but turning it into money quite another (at least for me). This leads me to a paragraph I read in Mark Douglas's book The Disciplined Trader: Developing Winning Attitudes:

Either in the beginning or at some point early in their trading career, all traders experience confusion, frustrations, anxiety, and pain of failure. The few traders who pass through this phase to accumulate wealth are those who eventually confront and work through some very difficult psychological issues about what it means to be a trader, and this process of realization and change normally takes several years, even for the best of them. (p. 4)

Meanwhile I've a good notion about what it takes to prepare a working

trading plan. But-

1. What should one know about consistent trade execution?

2. What kinds of realization are most important?

3. What stages does a trader normally go through?

4. What should one unlearn first?

5. Does anyone have any simple but helpful tips?

[The participants address these questions one by one. J

What should one know about consistent trade execution?

Tyler K. You need a crystal-clear vision of what it is you are attempting to do, and you need to have experimented with that methodology over as many years of data as you can find. You need to believe in it. But how can you believe in it before doing it? That is the great mystery.

Christos S. It seems that you do not have to do before you believe.

-----~-------------

Constant repetition of crystal-clear vision, whether your own or somebody else's or an imagined one, seems to do the job. It does not even have to be real. I personally want to see someone else do it, live, in front of me, and have the person show me detailed track records and the trades put on. I may not be the one to make breakthroughs, but I probably will make money.

This process is part of what we call internalizing a method.Yourmind seems to believe repetitions of clear visions whether they are real or not.

Ashok P. In order to be consistent at anything one has to have a plan no matter what one is trying to be consistent at. Once you have a plan (which I understand you have), then just follow that plan as per the rules you have laid down for yourself These rules must suit your psychological makeup. Do not think about the outcome: just execute.

Tyler K.: What I think would make the above recommendation much, much easier to realize would be to either trade the plan in very small sizeperhaps the mini-S&P mightwork-orto try it first with Auditrack. Once you have seen how profitable your system is, you will gain the confidence to deploy it in real time, trading real money, without that devil-fear always nipping at you. And it's that devil that caused me the most difficulty over the years.

What kinds of realization are most important?

Tyler K For me it was perhaps timeframe, learning what timeframe I was comfortable with. Mine is much longer than most of the Tribe's, and I am much less at ease at the short end.

Some years ago I was discussing the psychological difficulties involved in system trading with someone I considered to be a real expert at it. This led to a discussion of trading in general. He said, "Tyler, think of something you can do really well, something you think you can do better than almost anyone else in the world, something where you are absolutely positive that you fall in the top one percent of everyone involved in that field. And when you have the answer, just think about how you feel when you're involved with that particular thing:'

After a few moments of thought, I told him I had the answer. Then he said, "Now imagine how well you would trade if you felt the same way about that," Of course I knew he was right, that in was in the top one percent of all traders, it would be very easy, and I would be able to do it just as effortlessly as other things I did very well. I knew he was right, but I wasn't exactly sure how to get there.

Time has taught me a lot about that. It would be grossly unfair to deceive oneself into thinking one could be a great trader in less time than it would take to become a great teacher, doctor, engineer, or Indian chief. Greatness is not

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"It would be grossly unfair to deceive oneself into thinking one could be a great trader in less time than it would take to become a great teacher. doctor. engineer. or Indian chief."

TrendDynamics LABS JAN /PEB 1998

"When someone gets blown out of the

business. it is usually due to failure to execute the

defensive script. not the offensive one."

12 something that can be bought in a box. It has to grow for a long time, an almost unbearably long time.

Jess T. Two key realizations. No.1, The belief that my approach, my method of analysis (based on Trend Dynamics) sufficiently removed the "unknown:' that it adequately explained the cause and effect of the majority of the major price events that were unfolding before my eyes. See, until I reached that point, my trade execution was sporadic and interfered with

because of the reoccurrence and interjection of fears of the "unknown" that handicapped execution. So I had to reach a certain level of competency in my analysis to be able to develop two particular types of scripts.

The first kind is an offensive script where I could delineate certain normal events that I expected to unfold in a given market if my essential assumptions about trend and structure were in fact true and in effect.

The other kind is a defensive script, which delineates what a market should not do, if my assumptions about trend and structure were true and in effect.

The former script outlines a plan of execution, the "what to do" part. But the latter script is just as important, because it either tells me not to proceed any further and/or to immediately stop doing what I am doing right now.

When someone gets blown out of the business, it is usually due to failure to execute the defensive script, not the offensive one. Niederhoffer, Nick Neeson, Robert Citron, etc., all failed to execute their defensive scripts. Masterful traders master the discipline to execute both offense and defense.

Realization No.2. The realization that only God knows the exact sequence of profits and losses, and He's not telling.

This changes the feedback mechanism from that of a single trade outcome to that of a series of trades. I never have 100% confidence that a particular trade is going to work for me, but I have 100% confidence that over any given oneto three-month period,l'll net trading profits. It's the latter mind-set that helps me to execute consistently, but I'll admit it's an area I still struggle with today.

Ashok P. The realization that you are no longer going to be a flutter in the market-but that this is your business, and you are going to make sure that

your business succeeds.

What should one unlearn first?

Mick 1. In my opinion, having any strong belief(s) on which way the market is headed must be unlearned.

Tyler K. Unlearn what is not working-and unlearn it completely. Things either work or they do not work.

Ashok P. Unlearn your emotions (fear, euphoria, panic). If your trading plan is stable, most of these will be covered by it. Wayne has covered this particular part extremely well in the past. Joseph talks about it continuously.

What stages does a trader normally go through?

13

Ashok P. In my opinion there are only two stages: Amateur and Professional, with a fair amount of pain in between. This pain can be drastically reduced with total commitment and discipline on your part and the help of teachers like Joseph and Jess, and with interaction on a forum such as ours. TrendDynarnics LA B S

Jess T. I'm not sure the stages are the same for all traders, but these were JAN /FEB 1998

stages for me (and I'm sure many will recognize some or parts of them):

I think it is very similar to learning how to walk. First you crawl around, then you start to walk and fall down a lot, bump your head: you lose money, often

consistently. This is Stage One. If you are as stupid as I was, you lose lots of "Th' . S 0 If

IS IS tage ne. you are

money. In this stage you tend to do things that maximize your losses and as stupid as I was, you lose

minimize your gains. lots of money. In this stage you tend to do things that

If you survive that period, you start to get better. Eventually you make some, maximize your losses and

you lose some-but you stop losing money consistently, and you startto break minimize your gains." even. You have usually either learned how to maximize gains or how to

minimize losses-but not both. Or you do one of the other erratically. This is

Stage Two.

This is an important trading plateau. Traders often stay at this level for long stretches of time. Still, it can be a very productive period. The payoffis that you begin to realize you know enough about the markets to swim with sharks and not get eaten up. You get used to the water.

Your fear of markets begins to recede, and you can begin to execute consistently because you begin losing your fear of losing all your trading capital. You can now work on your trading form, with lots of live execution at no great expense to your capital.

You ply your capital in the markets and all around you people are getting blown out, whether you realize it or not. Meanwhile you can happily tread water in the midst of the sharks. You are not making anything worth writing home about, but you aren't sinking, either.

You keep working on your trading form, you get more and more in tune with price action itself to the exclusion of everything else. News gradually recedes and price action begins to mean more and more. You begin reading the "language" of price action.

You are not sinking, because you've gathered enough market knowledge and understanding of the "language" to recognize a few things that work; but you also have the discipline to do less of what does not work.

If you do not have this discipline, or when it slips, you regress back to Stage One. Sometimes you might fall back into Stage One for certain periods, but as you regain your balance and muster new discipline you climb back up to Stage Two. You eventually remain in Stage Two for longer periods of time.

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"Part of my education was learning that loss is an integral part of any trading business. At that point, the gains were less frequent. but the losses dried up."

14

Years later, perhaps, you reach a critical level, a point where you've refined your offense (maximizing profits) andyour defense (minimizing your losses) until you can do both competently. This is Stage Three. (Remember, in Stage Two you could do one or the other with competency-but not both.) Your profits begin consistently to overcome losses. Not on a per-trade basis but over a series of trades this begins to happen again and again. For some traders, this happens because they begin to mechanically follow scripts. For others it is a nonmechanical, free-flowing experience. Both approaches can work.

You work very hard at sustaining this edge, but trading is still very effortful.

Nevertheless you are making money consistently now. Some traders never leave this stage (and you don't have to).

Much later, at Stage Four, the process begins to become second nature. You begin to do all the various things that trading entails not just efficiently but with little or no self-consciousness. This, which Joseph calls "trading in The Zone:' is where you begin to reach trading mastery. The process is now effortless instead of effortful.

Your whole stalking process lacks emotion and any kind of stress, but retains a watchful alertness. Once a trade is put on, you are totally detached from the outcome. You don't think in terms of open profits. Price rises, price falls. You adjust, you react, but you just watch it as you might watch a river flow or the tide go in and out. It is no longer about"you;" "you" are no longer in the picture anymore. It is just the river flowing and you are lost in the flow of that river.

Stage Three is sufficient unto the day. As for myself, I float between Stages Three and Four, and relapse on occasion into Stage Two. But Stage Four is a very, very nice space to be, and most of my outlying, oversize profits seem to emanate from there.

WayneB. As I've followed the path laidoutbyloseph and Jess, I've noticed how I've become so much more selective in my trades. I used to jump at JO, PA and PL [Orange Juice, Palladium, and Platinum]-even CC [Cocoa] at one point three years ago. I reviewed my lists of errors over the past three years, and they conform nicely to Jess's roadmap.

The days of complete wipeout were pre- TD, thankfully. But for the first two years of TD I had my ups and downs. I could make money hand over fist, and then lose it just as quickly. At this point I usually carried a portfolio of 10-12 contracts at any given time.

Then I learned to stop my losses-my stupid losses, that is. I cut entry risk to 1 % from my routine 3%. Part of my education was learning that loss is an integral part of any trading business. At that point, the gains were less frequent, but the losses dried up. I carried 6 to 8 contracts at that point, mostly because I shifted to a greater NTL liquidation method. Holding on to the trend-based positions through thick and thin simply didn't matter to me much anymore.

Finally, I became even more selective, down to 4 to 6 contracts at a time. I got better at taking RLOs and letting trades run. I had already learned to take NTLs in my sleep (sometimes literally in the overseas markets). I had long ago given up on illiquid markets, with the few exceptions being PL and HG [ Copper] when a crystal-clear setup occurred (e.g., PL when it turned RJ Up [right-justified up] this past spring, and H G when it turned RJ down a couple months ago). I took my BP [British Pound] NTL profits so I could ride the trade until stopped out yesterday [12-04-97], and the same with the NG (Natural Gas) NTL and RLO profits [10-28-97]. I don't miss missing trades anymore. I can't keep up with everything and maintain my equanimity, so I don't push myself to try to do so anymore. I can even trade Sugar now-I did it, took my NTL, and now I don't care anymore. In can't figure out the 18D direction for the dollar, I'll wait until it clarifies. I waited for the Bonds to take out the TR [trading range] upper extreme [in November, 1997]-now that was a long wait. But it was worth it. Joseph pointed out a long time ago that your good trades last 1 to 3 months, on average, while the bad ones take you out within the week. Very true.

I guess if you think of becoming a professional trader in the same vein as becoming a doctor or lawyer, it no longer seems onerous that it takes 10 to 15 years to finally get in the groove. Many of us figured we were smart enough to do those jobs, so this should be a piece of cake. Sorry. If you do it quickly, you blow it just as quickly. It's got to be slow and steady, because personal psychological changes always come slowly. The shock of revelation seems instantaneous, but it comes on top of a great deal of foundation-laying and groundwork.

Does anyone have any simple but helpful tips?

Michael 1. For what it's worth, Martin, of the many gems Jess has posted online, the one that remains with me every day is that in order to capture those trades that make a difference we have to trade as if no trade makes a difference. By keeping this thought in mind.all attachment to a trade is removed. Trading in this state of mind has enabled me to trade consistently, knowing [any] one trade is not important; beingin the trade is.

Tyler K. Pore over historical data, the more the better. And emulate those who are slightly ahead of you on the curve to success. Take those parts of their trading that seem to fit you, and make them part of your own. But remember, you cannot copy success. It really does have to be your own. You're really on the right track, Martin.

Wayne B. Welcome to the group, Martin! I published a series of personal observations (on psychological crises) a few years ago [seeTDA 1:7:104-106]

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"Joseph pointed out a long time ago that your good trades last I to 3 months, on average, while the bad ones take you out within the week. Very true."

'Trend Dynamics LA B 5 JAN /PEB 1998

16 in which I laid out a good deal about my development of emotional maturity. will give you one particular history to work from.

As you mentioned, there are a number of good books on the market (The Disciplined Trader, Aerodynamic Trading, Market Wizards, etc.) dealing with this critical issue. Read them over and over until you get it. Keep a daily trading diary, and be bold in listing both your successes and failures at each level of each trade. We must be cruel to ourselves to root out our natural tendency

towards self-deception and denial. If you're lucky, the process will just take years. If not, a lot more. You've probably noticed that many great traders took ten or fifteen years to finally get it. It's my belief that they didn't finally discover the trading-system Holy Grail, but that they finally understood themselves and were able to successfully integrate their system into their psyche. Remember that it is an extremely difficult process, and the smarter you are the more difficult it is. The sooner you get rid of your ego, the better. -Good luck.

Tribal Dialogue 3

Obstacles to Consistent Trade Execution

Martin T. also asked, "What are the names of the devils who prevent the trader from pulling the trigger consistently?" Three participants' discuss their experience with identifying & overcoming obstacles to consistent trade excecution. -]. T.

Tyler K. About the devils: I have had to battle with two in particular, although there are a great many minor devils as well.

1.) First Devil: The need to be intellectually right, as opposed to intellectually wrong.

2.) Second Devil: Fear and Greed. Actually, to me they are the same devil. No matter how you approach trading it really boils down to developing (or learning) a methodology that has strong positive mathematical expectancya matter of statistics, one might say-and then being able to execute it at very dose to perfection.

Now there is an intellectual way of understanding statistics, and a feeling way to understand them. It is the feeling way, or the gut way, that is the hard one to arrive at-yet that is the one that must be totally ingrained in us in order to trade well. We cannot really do what we do not believe in!

The first devil will be vanquished when one really understands that each trade is nothing more than one of a series of trades, and that winning or losing has no affect other than to become part of a statistical run. Gettingto this point is not so simple as it might appear, and I do not have any solution other than time. Certainly plotting through all the data, taking allthose historical trades, can speed up this process a good deal.

You can either suffer the indignities ofloss on historical data, or suffer it in real time, but you cannot escape it completely.

The second devil is easier to beat. Fear and Greed can be removed from the equation by removing money from the game. Would you fearful of the outcome in a spin of roulette if the chips were worthless?

It is my opinion that anyone serious about trading should have anAuditrack account. Here is real-time trading with no money involved. Trades can be placed 24 hours a day on the Net, and it costs less than $100 per month. This is nothing even remotely similar to paper trading. If you sense fear and greed while dealing with your Auditrack account, then it is actually the first devil poking at you, so at least you know whom to address. Devils do not appreciate being whistled at or addressed as «hey, you!"; they require being addressed with dignity.

BeyondAuditrack,ifyoucan trade in such small size that the outcome really has no affect financially on you, then that's OK-but you need a good deal of capital to do that. However, once you have become comfortable trading the Auditrack account, and are consistently profitable, then you can try trading a small account while continuing to trade the Auditrack account. If you feel differently about the same position in the two accounts, once again you will know right off the name of the devil that is after you.

I have found this a superb way of identifying devils. And to me a devil uncovered is a devil (almost) vanquished. It is those devils we cannot identify that tear us apart. Like a thief in the night, they really will try to steal all your money.

Even though I think I sent these devils packing a while ago, I still trade my Auditrack account. Every few months, usually late at night, another devil comes creeping in-and thatAuditrack account sure is a great devil- identifier. It strikes almost like lightning. Suddenly, while placing or planning orders, something is different between the real-time and non-money accounts. What is it, what devil is here now? And suddenly I know whom I'm talking to, and we come to some sort of peace, and I solve the problem with minimal suffering.

Jess T. Oh, I know these devils well; there are three of them. They are Me, Myself and I. I know them all well. The markets do not beat us. The devils are not external, they are internal. In the early stages we most often beat ourselves.

Ashok P. In my opinion, [this is] the syndrome that makes me break my own trading plan-the plan that has taken me many years to devise, but the one I would break in a second-just because I thought I would be left out of a particular trade: i.e., the indiscipline.

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"To me a devil uncovered is a devil (almost) vanquished. It is those devils we cannot identify that tear us apart."

.4TrendDynamics LABS

JANUARY / FEBRUARY 2002

Originally appeared in ...

Making Better Trading Decisions: Part I

In the first installment of Principle-Based Trading Methods, Hart defined trading as "learning what trade opportunities look like, training yourself to believe what you see, then acting quickly with bold calculation': While his goal in this six-part series is to teach you what trade opportunities look like, my goal in this series is to support the second step of the trading process by elucidating many of the issues that prevent us from believing what we see.-Ed.

IN RECENT YEARS the field of social psychology has emerged as central in psychology's quest to better understand human thought, feeling and behavior. In trading environments there is a strong "emotional element intertwined with the money flows and transactions" and that emotional element creates a plethora of obstacles preventing us from seeing clearly, from believing what we see, and from acting on that information.

In this series, I draw upon a substantial amount of conclusive research from alternative fields of inquiry, such as social psychology, to address important issues in the psychological realm as they impact and impede our trading perceptions.

I confess I do not have tidy solutions to the broad range of psychological pitfalls that traders encounter; my own self-mastery in this area is a work-in-progress. My hope is that by highlighting the key psychological pitfalls and by describing what dedicated psychologists have learned that I can help the tribe recognize the nature of the problem and the need for developing pro-active solutions allowing us to maximize our trading abilities.

DUAL-CONTEXT & DECISION MAKING

Trade decision-making always occurs in a dual-context. One context is external-what we study and utilize in terms of the Trend Dynamics framework along with any other technical information we bring to bear prior to taking a trade. The second context is psychological and internal-the perceptions we hold within our own minds that effects how we see markets and the actions we take in response. In this first installment, I'll describe what social psychology has revealed to us about how our decision-making is influenced by selective perception.

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"They found they could categorize the reactions into one of four types: dominance, compromise, disruption and recognition:'

SELECTIVE PERCEPTION

One of the classic experiments in the area of selective perception was published by Jerome Bruner and Leo Postman in 1949. Bruner and Postman presented people with a series of five playing cards on a tachistoscope (a machine which displays images for a brief interval that can be adjusted and fine-tuned by the researcher). While four of the playing cards were normal, one was a trick card, such as a black three of hearts. The purpose of inserting a card which does not exist in a normal playing deck was to introduce incongruity in order to measure how people react to incongruities in perception.

Bruner and Postman discovered that it took people more than four times as long to recognize a trick card than a normal card. They also found they could categorize the reactions into one of four types: dominance, compromise, disruption and recognition.

A dominance reaction consists of c perceptual denial" where faced with a black three of hearts, people become very sure that the card was a normal three of hearts or a normal three of spades. Some 96% of the subjects exhibited dominance reactions at some point.

A compromise reaction means that a subject viewed a red six of spades but reported he saw a purple six of spades or a purple six of hearts; or after viewing a black four of hearts reported he saw a "greyish" four of spades. Of the subjects in the experiment, 50% showed compromise reactions to red cards and 11 % to black cards.

A third reaction was categorized as disruption. This is relatively infrequent, but occurs when a respondent had trouble forming a perception of any sort. For example, one subject exclaimed: cc I don't know what the hell it is now, not even for sure if it is a playing card!"

The final reaction was, of course, one of recognition of the incongruity.

Yet, in many cases where recognition occurred, the subjects sometimes misperceived the incongruity. For example, one subject who viewed a black four of hearts recognized the incongruity, but declared the spades were "turned the wrong way':

MOTIVATIONAL VS. COGNITIVE FACTORS

In Bruner and Postman's experiment people's perceptions, their ability to see clearly what was presented before them, was strongly influenced by prior beliefs and expectations. Psychologist refer to these influences as "cognitive" factors. Besides being influenced by what people expect to see, they are also influenced by what they want to see. Factors that deal with hopes, desires, emotional attachments are knows as "motivational" factors.

How motivational factors can influence what we see can be illustrated

by something social psychologists call the "hostile media effect': Three psychologists (Vallone, Ross & Lepper, 1985) used the context of the 1980 presidential election (Carter vs. Reagan) to measure this. Three days before the election they asked 160 voters to indicate whether media coverage of the candidates had been biased, and if so, to indicate the direction of that bias. One-third indicated the coverage had been biased and in 90% of these cases respondents felt the media had been biased against the candidate that they supported.

A second study was then undertaken in which 68 "pro- Israeli" college students, 27 "pro-Arab" students and 49 "generally mixed" or "neutral" college students watched the same set of televised news segments covering the tragic Beirut massacre in the Sabra and Hatilla refugee camps in Lebanon in 1982. The news segments were drawn from six different evening and late- night news programs broadcast nationally in the United States over a 10-day period.

When the results were tabulated, each side saw the news coverage as biased in favor of the other side. Pro-Arab students thought the news programs had excused Israel "when they would have blamed some other country" whereas pro-Israeli students felt the programs blamed Israel "when they would have excused some other country:'

On the average pro-Arab students reported that 42% of references to Israel had been favorable, and 26% unfavorable; pro-Israeli students reported 57% of references to Israel had been unfavorable, and 16% favorable.

Vallone, Ross & Lepper concluded from the data that partisans tend to view media coverage of controversial events as unfairly biased and hostile to the position they advocate. Traders also fall prey to (or at least need to guard) against selective perception whenever we examine the financial media to gauge sentiment or measure media bias.

SUMMARY

Human tendencies toward selective perception can have a tremendous impact on what traders see in the price action. There is a much food for thought here in terms of analogies to trading. Certainly all of us have experienced this in our trading, and the impact on the bottom line can be significant. Trading involves evaluating a tremendous flow of incoming data and pattern recognition, yet we are susceptible to various forms of dominance, disruption and compromise reactions when faced with incongruities in price action and pattern identification.

When engaged in the trading process we expose ourselves to a wide

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cc [P] artisans tend to view media coverage of controversial events as unfairly biased and hostile to the position they advocate:'

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range of reactions deleterious to our trading. For example, when stalking a trade if we are anxious about missing an entry we are prone to seeing a marginal entry pattern as fully validated. I see this a lot in myself and among fellow traders. We might accept a marginal pattern as a highquality pattern due to perceptual denial instigated by an overriding desire to take a trade-we begin to see what we want to see.

Once in a trade, if we are fearful or oversensitive to our risk exposure it is easy to erroneously construe marginally negative price action as a fully validated exit pattern.

When monitoring a trade we are engaged in, when presented with clear negative price action, we can become subject to perceptual denial of a different sort, one where we view clearly negative price action as marginally negative.

Selective perception is a tendency all humans exhibit in various facets of our existence and in particular in the arena of trading where emotions can be very powerful. The challenge is to quickly recognize when we are falling prey to some of these perceptual tendencies; to execute pro-active tactics, such as maintaining a trading diary to isolate whether our errors derive from cognitive or motivational sources; and to guard against these tendencies and minimize their impact on our bottom line.

Originally appeared in ...

4TrendDynamics LABS

MARCH / APRIL 2002

Making Better Trading Decisions: Part II

Atthe level ofunderstandingofmarkets that you now have as astudentin the final phases of the Trend Dynamics Course, the most egregious errors in trade decisionmaking that you'll make are likely to be subtle. We've already discussed two of those subtleties in the previous installment. In this installment we examine more ways to identify when your decision-making has become unstable.- Ed.

REVIEW

In the first installment of Making Better Trading Decisions: Part I, I referred to two authoritative studies from the field of social psychology to underscore how vulnerable traders are subject to two types of selective perception. The first is a cognitive condition whereby the normal human mind seeks out patterns that it is already familiar with and when faced with distortions or incongruities will compromise reality to match those pre-existent patterns. Since patternrecognition is at the heart of the trader's analytical process, making sure the patterns you are seeking are actually those unfolding before you on the screen is one key to sustaining the flow of accurate information so you can make good decisions.

The second type of selective perception is motivational. When one has a vested interest in specific kinds of outcomes, one tends to restrict the perceptions to data that support that vested interest. Since traders have such a strong vested interest in seeing trades unfold profitably, they are vulnerable to excluding incoming negative information that contradicts the profitable unfoldment of a given trade.

PREREQUISITES FOR PROFITABLE TRADING

Let's digress for a moment. There are two key requirements for making profitable decisions in trading:

1. You must have a definitive, objective trading plan with positive expectation centered on how markets really work.

2. You must exercise consistently good judgment in your trade decision-making.

Obviously, if you don't have an excellent understanding of how markets work, at least on an intuitive level, you will not be able to trade well. You also need good judgment. An understanding of theory enables you to identify the elements you need to make sound trading decisions.

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~ ~~~------------------------------------

350 But upon considering those elements you must frequently exercise judgment to make the best possible decision.

'Trend Dynamics LAB S MAR/APR 2002

"Thus, any interference with the application of sound judgment affects not only difficult decisions, but these routine decisions as well:'

GOOD JUDGMENT WAXES AND WANES

This is a topic to which few market -writers have devoted much attention, but which is of critical importance to traders who want to do really well at trading.

Consider the decisions made over the course of a normal trading month. For a knowledgeable, experienced trader, many are fairly straightforward if not automatic. Of course not all of trading is that easy. As you know, you will inevitably be confronted with a few difficult decisions as well, but those obviously difficult decisions are not the only ones that present problems because among the normally simple, straight forward decisions lies a class of decisions with a special character.

If you are a very good trader these are relatively easy, clear decisions as long as your judgment is unimpaired. However, there are instances in which, if anything interferes with your judgment, it is easy to rationalize the wrong decision. Thus, any interference with the application of sound judgment affects not only difficult decisions, but these routine decisions as well.

I submit that a large percentage of Trend Dynamictrained traders who have learned enough to trade quite well damage and sabotage their results by occasionally, subtly, and often unknowingly, making their trading decisions in the absence of their normal best judgment. They sometimes trade with this subtly impaired judgment over many trading sessions, rationalizing incorrect decisions and severely cutting into their profits.

Two of these issues have to due with the aforementioned errors of selective perception. But, there are other ways that alert you that your decision-making is undermined in not so obvious ways. Here are two more which I believe are especially important, one emotional and the second, systemic.

RESURFACING EMOTIONAL MARKET MEMORY

One kind of lapse in judgment is stimulated by a relapse into emotional market memory. This is often triggered by a losing streak or a disruptive or abnormally large loss. If an otherwise solid trader becomes frustrated (or in some other way distressed) about a string of losses, the frustration can drag up old emotional market memories that effect perceptions and leads to a breakdown in your discipline affecting your judgment and hence your trading results.

More generally, anything which shifts your focus away from what you

know to be good trading form (regardless of short-term results) to the 351

myopic effect of short-term results (and this includes large gains or windfall profits, as well as losing streaks) is likely to trigger a resurfacing of emotional market memory which only distracts from the precise impartial judgment needed to trade with good form and make consis-

tently correct decisions. 'Trend Dynamics LAB S MAWAPR 2002

RIGID TRADING PLANS

Another insidious threat to sound judgment in trading is systemic - the adoption of habitual ways of trading that do not adapt to market conditions. Market conditions can and do change. As Hart has advised there are specific market conditions when orthodox structures are reliable, and market conditions when unorthodox structures are preferable.

Habitual trading can arise from excessive adherence to a "mechanical" trading approach. Make sure your trading plan is constructed so that it accounts for the detection of changing market conditions and the correct adaptation in strategies and tactics. Don't try to force a trading plan to fit all conditions. Build formless trading into your trading process by installing an array of tactics that work well in various market conditions; then pro-actively seek to monitor those market conditions as part of your homework process.

EARLY WARNING SYSTEMS

I've outlined four factors that undermine good decision-making: selective perception (both cognitive and motivational); relapses into emotional market memories and fourth, rigid trading plans. Being human and not a robot, you will find yourself periodically regressing in some of the ways outlined herein. The trick is to build up your self-awareness and install monitoring devices to catch this regression in it's earliest phases.

Selective perception as it effects trade decision-making is particularly insidious and often difficult to detect and root out because it lies buried in the mindal processes and is often not obvious until you perform a review of your trades to determine what went wrong. The best way to minimize these kinds of errors are to frequently review your trades. If in your review you find a pattern you thought you were trading was not present after all, or that you ignored obvious signs that a trade was turning sour, it likely your trading is being undermined by selective perception.

If you find this recurring, that may be a sign your trading tactics are too loose and you need to define the patterns you are looking for with greater precision.

"Build formless trading into your trading process by installing an array of tactics that work well in various market conditions; then proactively seek to monitor those market conditions as part of your homework process:'

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One warning sign that emotional market memory is seeping into your trading is that you find yourself feeling concerned about short-term results, instead of sustaining your focus on the bigger picture-good trading form regardless of short-term results. There are two other sure warning signs that should alert you that your decision-making is under assault:

1. A sudden increase in the number of trades you are taking - taking marginal trades. Overtrading or taking marginal trades is one of the easiest errors to fall prey to when your judgment is slightly impaired. There are a number of reasons for this. It easy to rationalize trading substandard trade setups once emotional market memory takes hold.

2. Overstaying trade setups. This can evolve out of a trader's effort to extract more profit from trades than are justified in the situation. He rightly takes to heart the importance ofletting profits run, but is trying to extract profits in situation where a market is already extended, where swing freedom is not sufficient to allow the trade to run, or where there is so much overhead supply or underlying demand that the trade can not offer much in trend-based profits.

The first warning sign that you have a systemic problem is if you sustain an out-of-character string of losses in a period where there should be sufficient volatility to take home some profits. Another is when you find the opportunity cost of missing good trades is increasing.

If this is the case, review what you know about pairing market tactics with market conditions and see if you can't revise your trading plan in a way that will be more robust and adaptive, yet not overly intricate or unrealistically curve-fitted to the past.

CONCLUSION

If you have good reason to believe that you are capable of a certain level of trading results, but your actual results over a subsequent (sufficiently long) period are disappointing, one explanation to rule out is that you have been trading with subtly impaired judgment. As a conscientious trader you should frequently monitor your trading for the errors I have described above, as well as others which reflect diminished judgment. By being self-aware, by analyzing your trading and looking for the evidence described in this installment on subtle losses of judgment, you will improve your chance of trading consistently at your best.

Originally appeared in ...

~TrendDynamics LABS

JULY / AUGUST 2002

TrendDynamics LA B 5 'UI/AUG 2002

Making Better Trading Decisions: Part III

by Jesse Thompson

In The Right Stuff, Tom Wolfe's vivid account of what it was like to be an astronaut during the infant days of NASA's space program, the term «ziggurat" crops up regularly.

The dictionary defines ziggurat as an ancient Babylonian temple tower having the form of a terraced pyramid. According to Wolfe, the most righteous possessor of the «right stuff" will reach the top of the ziggurat. Fighter pilots who possessed an unblinking acceptance of danger and enough of the «right stuff" were selected to become test pilots - those willing to demonstrate their ability to fly right to the edge of an aircraft's performance. From this cadre of test pilots, an elite group of space pioneers rose to the top of the ziggurat as participants in the space program.

Which characteristics are common among that elite group of discretionary traders who are scaling the high -performance ziggurat in a world of sub-standard stock market returns? What comprises the «right stuff" in the discretionary trading world?

THE RIGHT STUFF

High-performance traders have behavior patterns and specific qualities that we should definitely try to nurture and emulate in our own trading and persona. What follows is a description of the most important of these unique characteristics:

Characteristic #1: High-performance traders only trade when they have a distinct edge. That edge may be number of or combination of many things: a systematic approach tested and proven in real market conditions; a really favorable risk-reward setup that one knows backwards and forwards and has experience with in a real-time trading environment; an incredible trade location in a well-defined context with known probability; a clear read of the intraday price action in play and the correct tactic to deploy in that moment and context; or as Hart has just elucidated, an entry setup that holds a high probability of attaining at least a partial profit (NTL) with a hand-off to a higher timeframe as a kicker.

A trade with an edge is never executed out of boredom, restlessness or hope. It is not an impulsive trade, nor a set-of-the pants trade constructed

ad hoc in the heat of battle. Edge trades do not include marginal trades of any kind. If you ask yourself the question: "Is this the type of trade I must take? Do I really want this position?" If your answer is not: "Yes! I have to take this trade" then you probably have a marginal trade on hand or it may mean a particular part of your trading plan needs more development.

Simply put, a trading edge is any tradable situation that one can readily identify that when taken and executed repeatedly over a large universe of trades yields a consistent profit. Without that qualification high-performance traders don't trade period. They'll do anything but trade. They'll do research, sit it out, go for a walk, take a day off. They'll wait until a context that they understand appears; they'll wait until they see the conditions or the setup that they know must exist in order for them to ply their particular edge. Any other condition is a high - roller's crapshoot, a gamble; and highperformance traders don't gamble.

Characteristic #2: High-performance traders are obsessed with winning. As Marty Schwartz, one of the premier stock index traders of our time, is wont to say: "All I ever think about is my next winner is in front of me." And he's fond of quoting Vince Lombardi as saying: "Winning is not a sometime thing, it's an all time thing. You don't win once in a while, you don't do the things right once in a while; you do them right all the time, winning is a habit:'

The reason high-performance traders are obsessed with winning is because it takes an obsessive attitude to consistently trump those natural reactions that are inevitably the wrong reactions in trading. It is natural to let your discipline slide a little when you are bored, or impatient. It's natural to procrastinate or waffle when faced with stress or important decisions. It's natural to succumb to trading against yourself, instead of trading the market, when momentarily stunned by that unexpected I ossas emotional-market memory starts to well up again. It's natural to give a loser a little more room. It's natural to want to pocket the profit in the core position when you sense a countermove is coming; when in fact the right thing to do may be to just sit tight and hold that core position into the close or into week's end in order to maximize your gains.

The natural impulse is almost always the wrong thing to do in trading; and the hard thing to do is normally the right course of action. And it's the obsession with winning that pushes us to do those unpleasant and unnatural things that most traders refuse to do. It's unnatural to set your ego completely aside and hard to suffer inaction while waiting patiently for the trade that gives you your edge to come along; and it's hard to give that trade time to develop once you do get in.

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" ... High- performance traders don't gamble:'

"The natural impulse is almost always the wrong thing to do in trading .. :'

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"High-performance traders are brutally realistic:'

High-performance traders are obsessed with winning because that obsession provides the drive and energy to do the hard, unnatural thing.

Characteristic #3: High - performance traders exercise extreme discipline and self-control. In one sense obsession itself is evidence of a passion and without extreme discipline and self-control, that obsession can degenerate quickly into self-destruction. Obsession with winning can lure you to take foolish risks, to overtrade, to continue to trade when you've lost your edge, to refuse to take quick losses, to admit you are wrong.

High performance traders sometimes walk a razor's edge one where the only thing that separates one from self-destruction is extreme discipline and self-control. Let extreme discipline and self-control be your touchstone, let it permeate, consume and guide your trading personality.

Characteristic #4: High-performance traders are brutally realistic.

Denial is pervasive among traders, but high-performance traders do not kid themselves about their skill level, natural capabilities and weaknesses. Nor do they delude themselves over what their edge trades are capable of producing in profits, and what the odds, expectation and performance demand should be for each kind of trade they execute in certain contexts. As Hart just illustrated, high performance traders do not have unreasonable expectations for price events to unfold from structures that simply do not provide the context for such expectations.

High-performance traders are brutally realistic about themselves, their trading plan, the market environment and the nature of the distribution of profits and losses that are produced by specific types of market contexts.

Characteristic #5: High-performance traders have intense focus and concentration. They focus 110% of their attention on what they are stalking, on correct form and execution. They realize that concentration is itself a huge edge, that in an otherwise even contest that the trader with the best concentration will win and being obsessed with winning they sustain a laser-like focus and concentration on the market-at-hand.

High-performance traders sustain intense concentration by physically and mentally removing any and all distractions that take away from concentration during trading hours and deploying any and all devices, mental or otherwise that sustain that concentration.

Characteristic #6: High-performance traders convert mistakes into opportunities. High-performance traders are able to rapidly recognize mistakes by virtue of being brutally realistic and by exercising control over their ego. High-performance traders are not just quick to recognize

mistakes and to take losses rapidly when they occur, but they have the capability to differentiate between normal losses versus those errors of analysis and execution that reveal underlying weaknesses in their trading form, their personality, their tools or trading plans.

They capitalize and leverage those mistakes by incorporating whatever new lessons are to be learned into their trading habits and trading plans. High-performance traders do everything possible to avoid repeating mistakes; instead they see mistakes as opportunities for positive feedback and self-improvement.

Characteristic #7: High-performance traders own up to responsibility. High-Performance traders do not depend on others to do their research, their analysis or generate their trading decisions. They do not shift the blame losses or mistakes on bad luck, ill-timed economic reports, dull markets, unexpected news, unstable trading platforms, internet outages, or Alan Greenspan. They take 100% of the responsibility for all facets of their trading.

Characteristic #8: High-performance traders adjust to change. Markets change over time. In the early 1980's, traders had a preoccupation with the weekly money supply releases - now no one cares; ten years ago the ForEx markets were the premier trading markets for CTAs and trendfollowing futures traders - today the ForEx pits at the Chicago Mercantile Exchange often look deserted; and the legions of NASDAQ Level II SOES traders prevalent in the mid-to-late 1990's have dwindled. Markets change character, participants come and go, generational influences and appetite for risk wax and wane. Over time the main focus of speculation changes from one market to another. High-performance traders anticipate and adjust to these changes. High - performance traders are constantly focused on doing more of what is working today and less of what's not.

Characteristic #9: High-performance traders are selectivelyaggressive. This selective aggressiveness manifests in a couple of ways. Highperformance traders are usually passive when they have no edge and discipline themselves to not participate; but when they see the high probability trade they are looking for, when they see that special opportunity develop where they have confidence and conviction they'll attack whatever market they are stalking in a controlled, but very aggressive way.

In an interview with Stanley Druckenmiller, who was mentored by George Soros, he said: "The few times that Soros has ever criticized me was when I was really right on a market and didn't maximize the opportunity." Its very important to high-performance traders to be very aggressive

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about high probability or high reward potential opportunities. As the 12th Law suggests: Small risk attracts large size.

Second, when high performance traders are booking good profits they will still sustain the offensive. For example, many traders might get up by a sizable amount for the day, or week or year then slack off and tread very lightly to preserve profits, whereas high performance traders will reach that same threshold and then push it as long as it can be pushed, all the while staying very controlled, but selectively aggressive.

SUMMARY

This list of nine essential characteristics of high-performance traders is a model for our emulation, it represents the "right stuff» that high performance traders seek to develop and integrate into their trading behavior and trading plans. You can also use this list for comparison and analyses of your own strengths and weaknesses to see which part of your trading activities need improvement. It's also a template that can provide guidance toward trading research and trading plan development. This series has been titled Making BetterTradingDecisionsandpartofthatdecision-makingprocessistoevaluate each decision regarding your time management, research, and various elements of your trading in terms of whether or not every single thing you do contributes toward building your strengths in one or more of these nine categories.

THE TREND DYNAMICS

TRADING CLASSICS LIBRARY

VOLUME ONE:

HOW MARKETS ARE STRUCTURED

Market Structure 101:

Introduction to the

Trend Dynamics Market Language

Market Structure 201:

How Major Trend Changes Develop

Market Structure 202:

How Trading Ranges Terminate

These self-guided trader training courses available now

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Or order online at: http://www.trend-dynamics.com

THE TREND DYNAMICS

TRADING CLASSICS LIBRARY

VOLUME TWO:

TRADING STRATEGIES THAT WORK

Trading Strategies lOlA:

Trading Complex Countertrend Reactions

Trading Strategies 101B:

Using Market Structure to Formulate Profit Objectives

Trading Strategies 102:

Trading Simple Countertrend Reactions

Trading Strategies 201:

Using Mean Reversion as Market Context

Trading Strategies 202:

Using Momentum as Market Context

These self-guided trader training courses available now

at your local bookstore,

Or order online at: http://www.trend-dynamics.com

THE TREND DYNAMICS

TRADING CLASSICS LIBRARY

VOLUME THREE:

TACTICAL ENTRIES THAT MINIMIZE RISK

Tactical Entries 201:

Using Pattern Recognition to Reduce Risk

Tactical Entries 202:

Using Buy/Sell Pressure to Reduce Risk

Tactical Entries 301:

Using Range Breakout Models to Reduce Risk

These self-guided trader training courses available now

at your local bookstore,

Or order online at: http://www.trend-dynamics.com

THE TREND DYNAMICS

TRADING CLASSICS LIBRARY

VOLUME FOUR:

DEVELOPING THE MINDSET OF A PROFESSIONAL TRADER

Trading Psychology 301:

How Professional Trader's See the World

Trading Styles 402:

Daily Routines of Four Professional Traders

Trading Plans 301:

How to Build Robust Trading Plans

These self-guided trader training courses available now

at your local bookstore,

Or order online at: http://www.trend-dynamics.com

THE TREND DYNAMICS

TRADING CLASSICS LIBRARY

VOLUME FIVE:

EXECUTING ADVANCED TRADING TACTICS

Unorthodox Trading Tactics 301:

Trading What is Not Happening Part I: Failure to Reach Price Objectives

Unorthodox Trading Tactics 302:

Trading What is Not Happening Part II: Line Extension Failure

Trading in the Zone 405:

Leveraging Intraday Entries Into Higher Timeframes

Formless Trading 505:

Market Principle-Based Execution Strategies

Thesese~-guided trader training courses available now

at your local bookstore,

Or order online at: http://www.trend-dynamics.com

OTHER TREND DYNAMICS BASED PRODUCTS

MENTOR-BASED ONLINE TRADER TRAINING

http.i/www.tribal-traders.com

DAILY MARKET COMMENTS & TRADING ALERTS

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TRADING PSYCHOLOGY 301 ISBN 0-9728184-1-3

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