Majority of new traders enter the market with knowledge they gained from a weekend seminar, talking to friends or reading some books. If some of the initial trades are winners, novice trader will start believing in his knowledge and abilities to navigate the market. Brimming with confidence, he will go ahead and place more trades and increase the number of stocks or contracts per trade. As per the book, he will place the stop loss and appear to be a disciplined trader. This will continue until the trader is hit with some loosing trades.
Euphoria to fear
Suddenly the euphoria is replaced with fear. The initial confidence is lost and now the trader is on the edge after placing a trade. He will start micro managing the position and monitor ticks. He will hold on to loosing positions hoping the price will turn in his direction soon. He will only see the one tick in his direction whilst ignoring the 5 in the opposite direction.
Psychology of Random Trader
Trader set the stop loss but he never truly accepted it as a probability. He was so confident that his analysis was right and the price should move in his direction. When the market did the opposite and took out his trade, he was met with fear, fear of not being right, fear about his analysis and fear about the market itself. Fear will create emotional pain. When a situation (external environment) is encountered, mind will look for an internal experience that is similar to the current situation and generate a response. The experience from the loosing trades and the associated emotional pain is the prevalent internal experience for the novice trader every time he places a trade. He is hesitant to enter, second doubts his analysis and once entered micro manages the trade itself.
Rather than accepting the outcome of a trade, accepting that trading is based on probability, the immediate response from the novice trader is to expand his knowledge of market analysis. He will add more indicators to his arsenal and hope he will be right with next trade, eventually adding more emotional pain.
If you are emotional while placing a trade, that means you haven’t accepted the risk. Trading is based on probability. No matter how good your technical analysis is, no matter how great the setup looks, market can move in either direction. Every setup is unique no matter how similar the chart looks to an older one. The simple reason for this is, there are lot of unknown variables in the market that are different from when the chart got generated in the past. Unless all these variables are same, there is no way we can confirm with certainty that the market will follow the past setup. Market analysis and context will point to a high probability setup NOT a confirmed outcome.
Professional traders are not emotional because they think in probability. They understand and accept the risk. There is no ego involved or fear of being not right. When you flip a coin and loose the call you are not upset. You are not upset because you understand and accept that coin flip is based on probability with a 50% chance. Trading is the same as coin flip except that you increase the probability of the outcome to 70 or 80% based on your edge. There is a random distribution between wins and losses, you hope to tilt this in your favor by increasing the probability of the trade using your edge . Please note, your edge could be anything. It could be technical analysis or fundamental analysis or using a crystal ball etc.
“Once you understand and accept that anything can happen with a trade, every moment in the market is unique, your edge or analysis is nothing more than an indication of a higher probability outcome, and there is a random distribution between wins and losses, you are no longer emotionally attached to the outcome. Hitting a stop loss is nothing more than the risk involved in doing business.” Mark Douglas – Trading in the Zone (tm)
Market is Neutral
Market is neutral, it generates a constant flow of opportunities which you can enter or exit based on your edge. Market doesn’t care whether you win or loose. When a professional trader says “cut the loss” and “go with the flow”, he implies just that. “Once you are not blinded by emotional pain, you can read the opportune signals generated by the market and trade without fear, in the zone” Mark Douglas – Trading in the Zone (tm) .
A wonderful book to learn more on this topic is Trading in the Zone by Mark Douglas.