Trade Psychology

FinanceTrading / Investing

  • Author Troy Noonan
  • Published September 2, 2010
  • Word count 919

When I think of the major components that are necessary to successful trading, I like to think of a 3 legged stool.  It has to have all 3 legs or it topples over.  Whether you base your trades on technical analysis or fundamental trading, this analogy should be very helpful.

The first leg is you trading strategy, trade system or methodology and is self explanatory.  Everyone has some sort of method for taking trades and it can be something as simple as buying a break of yesterday’s high or as complicated as a strict mechanical trade system with rules, custom indicators, etc.

The 2nd leg is Risk & Money management.  Let’s face it.  If you have an effective trade system (1st leg of the stool) but you are reckless with your money management and you over trade or put too much risk on a trade, you can easily wipe yourself out with a few consecutive losses, which is normal when trading.  A trader with good money management will succeed with a mediocre system but a trader with poor money management will fail with an excellent system.

The 3rd, and in my view, the most important leg of the stool is trade psychology.  Even if you have both of the other 2 legs in place, if you can’t stick with the plan and take the next trade as intended, you can not succeed.  You need all three, of course, but trade psychology is the mastery of oneself and for most traders, it is the hardest part of trading and the leg that often causes the stool to topple over for most traders.  How do we fix that? It is very difficult to teach because trading often is counter intuitive and is in conflict with our basic instinct for survival.  After taking 3 losses in a row, it is very hard to take the 4th trade.  It’s like reaching out to touch a hot burning stove again.  Your instinct to survive will not let you do it so easily.  This must be overcome or this critical leg will always fail and your stool will always fall.

A stool needs to be set onto a strong foundation.  And you need to dig some ditches before making a foundation.  Manual backtesting with one of the backtesting tools available, is the key.  I refer to it as the ditch digging of trading.  Without it, you can’t create the strong foundation you need.  Your backtesting tool needs to show you your trading system’s wins and losses, winning percentages, and other important trade statistics. 

The important thing is to go through the trades one by one, recording each one into your backtesting tool.  You will feel the discomfort when you key in the 3rd, 4th or even 5th losing trade in a row.  Then you will feel something altogether different when you key in the next 23 trades, where 19 of them win!  Then some losers.  More winners, etc.  You will learn to understand the relationship between wins and losses and the random distribution that they will come at you.  Another important trade statistic though will be the equity curve that takes form as you continue to enter your system’s trades.  Despite the losses (many of them consecutive), if your methodology has an edge in the market (something you are trying to establish), then you will see the equity curve continuing to grow, stair stepping its way up, and to the right, despite the losing trades.  You will learn that you can not divorce the losses from the winners.  You have to trade through the losses to get to the winners, which is exactly what produces the edge in the market and the thing that makes us money as traders.

Think of it like this.  Each trade is like a tree in your forest.  Some will grow strong and tall while others will fall.  The equity curve IS your forest.  I believe the sweet spot for a good trading system (leg 1) is a system that wins approximately 2/3rds of its trades, which will be reflected in your stair stepping equity curve; two steps forward, one step back.  You leverage up your position size with your money management rules (leg 2).  But winning 2/3rds of your trades means that you are losing 1/3rd.  To overcome trade psychology issues and to make that your strongest leg of the stool, think of this simple phrase:  "It is okay to sacrifice 1/3rd of the trees in your forest if you can grow your forest 2/3rds larger as a result." 

Just focus on trading each trade correctly, according to your tradeplan.  Don’t get lost amongst the trees by fretting out the result of each and every trade.  That is a loser’s proposition.  Because once this trade is over, you still will have a big problem.  You now have to now take another trade, right?!  It never ends!  That’s what trading is.  Hopefully you can see the problem.  You will have lost the forest from the trees and we make our money by growing our forest.  Take a bird’s perch above your forest and let the weak trees fall so that the forest can grow stronger and bigger, as the edge of your system pushes that equity curve, ever growing, up and to the right.

Troy Noonan a trading coach of NetPicks LLC has been trading for over 15 yrs and offers free educational resources, live forex and futures signal services, and proven trade systems. Grab this free backtesting tool

Troy Noonan a trading coach of NetPicks LLC has been trading for over 15 yrs and offers free educational resources, live forex and futures signal services, and proven trade systems. Grab this free backtesting tool: https://netpicks.infusionsoft.com/go/TTsoftware/a100/

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