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Chapter 10: Trading Psychology
What are the ingredients for being a successful online Forex trader? Professional trader Tom Hougaard discusses the importance of managing your money and handling risk when trading FX.
Transcript:
Introduction:
Whether you know this or not, one of the greatest obstacles that a trader has to face is his own ego - and over the next two chapters we will discuss the fears that the trader will face when venturing into the world of online trading, and how to manage them.
Scene 1: Intro
What's the difference between investing and trading? Frequency comes to mind. Trading is a fast paced activity which requires monitoring, while investing is pursued on a much longer time frame. Investing is for growth and dividend yield while trading is to generate a profit.
Scene 2: Managing Risk
I believe that the major difference between traders and investors is how each manages the risk involved.
Investors manage risk largely via diversification. Ten well chosen shares can be managed with less risk than one share. This is the basic tenet of modern portfolio management.
Traders manage risk via a stop loss order. Sometimes when a trader is looking on a chart they say if the market comes up or down here, I am just plain wrong and I need to get out of the market.
Scene 3:
What ingredients go into making a successful trader? I believe you need to consider the 3 M’s.
You need a method. In a later chapter you will be taught a complete trading method, which I use extensively in my own foreign exchange trading
You also need to know how to manage your money. Because without money management you are playing a game which can’t be won.
Finally you need to manage yourself. My old mentor used to tell me that managing your emotions was more than 90% of the game when it came to trading. Being able to manage your emotions under pressure takes practise and a willingness to learn and to accept that you are not going to win every single time you pull the trigger and place a trade.
Scene 4:
Money management is not an easy topic to teach. First of all there is a general reluctance by traders to use apply any kind of money management to their trading. Secondly, most traders coming into the trading arena genuinely don’t believe they will lose money.
But the facts tell a different story. The facts state that most people coming into the trading arena will at some point suffer significant set-backs, which are actually completely unnecessary and avoidable.
What most newcomers fail to accept is that there is a degree of randomness to the financial markets. Let me attempt to make that clear with an illustration from old “flip a coin” game. You know the game I am talking about: you chose a side, heads or tails, and you flip the coin.
You know as well as I that the outcome over hundreds of throws is 50/50. So if you were to throw the coin 100 times, you would expect about 50 heads and 50 tails. The result may vary a little, but not significantly.
But is there the same kind of order when you are just throwing the coin once? Is there the same kind of predictability? Yes, the outcome of one coin throw is 50/50, but the reality is that I have no way of knowing if the next coin throw will produce a “head” or a “tail”.
As such there is complete randomness at the outcome of one event, but there is perfect order in the outcome of hundreds of coin throws. I like to illustrate that a bit further with an example from my own trading.
I decided to throw a perfectly normal coin 100 times, and write down the outcome for each throw. Yes, I agree with you, it is not the most exciting experience I have come across, but the result was so significant that I repeated the experiment 3 times more to ensure that I hadn’t gotten lucky the first time around. The results that I found had a huge impact on my own trading, and I like to share the results with you now.
Scene 5:
My first 100 throws gave me 51 tails and 49 heads. Since the coin game is a 50/50 experience, you would expect this outcome. However, what is hiding underneath these seemingly predictable numbers is the fact that I hit 8 tails in a row. In the same 100 throws I also had 6 heads in a row.
The 2nd trial of 100 throws was even more interesting. The distribution between heads and tails were this time 48 heads and 52 tails. But the internal distribution was even more skewed than on the first 100 throws. This time I threw 11 tails in a row during the experiment, and I also had a series of 7 heads in a row.
What does this mean and why is it important to your trading?
Imagine you are playing the coin game with me, but we have changed the parameters of the game slightly. As a matter of fact we are playing a game where every time you accurately predict the outcome of a throw, you will receive £10, but if you get it wrong, you will pay me £5.
Would you play this game?
Before you answer this question, imagine the following scenario. We are playing the game and you have chosen “heads”. I throw the coin, and for the next 11 throws I hit a tail. Would you carry on playing this game? You have lost 11 times in a row. Would you still want to play this game?
I have taught thousands of people how to trade, and have asked them this question. Most of them have said they would not like to play this game.
But the fact of the matter is that this is a great game to play. As a matter of fact this is one of the best games to play because it has a positive expectancy. It is a positive expectancy system, but you hit a cluster of bad outcomes. That does not change the overall expectancy of this game being a 50/50 system.
Scene 6:
We know that a coin game is a 50/50 proposition. Therefore we can expect you will have 50 bad trades and 50 good trades. On 50 trades you will lose £5, and on 50 trades you will make £10. Overall you will statistically make £500 in total on 50 throws and you will lose £250 in total on 50 throws.
In total you should statistically end up with £250 net in your pocket. This is called a “positive expectancy” game, and it has everything to do with trading.
Let us imagine this was not a coin game but it was a trading strategy. You had extensively back tested it and you were confident that it would work out to your advantage over time. Would you be upset with 11 losing trades in a row?
Well I have no doubt that you may suffer some discomfort, but the fact of the matter is that even trading a system with a 70% hit rate, you will experience clusters of bad trades and clusters of good trades.
No one knows when the clusters will come, but when they come, you either feel like a king, because every single trade is a winner, and you feel like every single trade that you place is bound to be a winner, but the opposite will also happen. The money is pouring into your trading account, and you think trading is the best job in the world. Then you hit a cluster of bad trades, and you begin to question the system. You wonder if you are cut out for this business. Have you got what it takes? Is the system not working any longer? Is it you who is the problem?
And I say to you relax.
This is the nature of the game. You have to learn to deal with the clusters. Trades are randomly distributed. You can’t predict in advance if your next trade is a winning trade or a losing trade. And you have to learn to accept that in the outcome of one single trade, there is complete randomness, but over the course of 100’s of trades, there is statistical order.
I can’t emphasize enough how important this concept is. Most traders will grow disheartertened with their system after a string of losses, but if they only knew that this is perfectly normal, they may stick with the system. Instead they abandon their method and try something else. And that is a real shame, because all that really happened was that they hit a cluster of bad trades.
The internet is full of trading systems for sale, which have hit rates in excess of 90%. One of those systems promises a hit rate of 99%. It sounds good, doesn’t it? But don’t be fooled. This system uses huge stops, and takes very small profits. When I looked into this system I discovered that the hit rate was correct. It did indeed have a 99% hit rate.
The problem was that when it was right it made 5 pips, but when it was wrong it lost 600 pips.
And if you do the math 99 correct trades making you 5 pips, well if we round it up, you would have made 500 pips and that sounds great, but then you would have one trade that would have cost you 600 pips.
So as soothing and pleasing it sounds to have a hit rate north of 80% or 90%, it really doesn’t mean anything. Nor does it guarantee you will make money from the system. As a matter of fact I once read that some of the hedge funds applying trend following techniques have a hit rate in the 20’s, but they still manage to make money from their system.
Scene 7:
The decision of how much to speculate, how much to wager every single time you place a trade is the most important question in trading.
The bet size is the difference in pounds between your entry point and the stop loss which is appropriate when you place the trade.
We are playing a 50/50 game with a 2:1 risk to reward ratio. This concept is called position sizing.
Scene 8:
It was a gentleman called Ralph Vince who attempted to create the optimal formula, he called it the optimal f.
He has written two books on the subject which are not for the mathematically challenged.
His books address the arithmetic optimal position size which is known in trading as optimal f.
I find optimal f somewhat aggressive and firmly believe that your risk on any trade shouldn’t be more than 2-3% of your account size. I will look at the probabilities of the game to justify that statement next.
Scene 17:
Let’s take a look at the probabilities when you are trading a 50/50 system. If you have a 50/50 outcome on a positive or negative trade the probability of two loosing trades in a row is ½ * ½ = ¼
The probability of a cluster of 3 bad trades in a row is ½ * ½ * ½ which is 1/8.
This means that in a 50/50% system, if you bet one third of your coins on any one trade you go broke every 8 trades.
Many small traders go broke with a great system because a run of bad luck occurs, which is a mathematical certainty. A run of bad luck will take them out before the good streak starts.
Scene 18:
The first thing you need to do when you turn on your computer for the trading day, is how much money is in your account.
Very few people decide on this. They believe the euro is going up and they buy lots of it.
It does not go up, and before they can trade again they must top up their account. And that’s really not what we’re trying to achieve here.
The only thing that affects the risk of a trade is the account size and the position sizing model used. It’s got nothing to do with the Euro going up or down.
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So your first decision of the day is if you don’t decide and commit to an account amount and size your positions properly then you are gambling and not trading. This is the most important aspect of trading.
You cannot control market direction but you can control and decide upon your risk.
This will keep you alive in a normal losing streak without too much drawdown and ready to profit from a winning streak which is always just around the corner.
The most important thing in trading is to have enough money to trade tomorrow.
Scene 21:
Take a look at this table on probabilities on 3 different kinds of trading systems. There is a 50/50 system, a 1/3 – 2/3 system and an 80/20 system
This table summarizes the relationship between hit rate and the probability of a streak of poor luck. This will help you work out how much drawdown is probable with your trading system, assuming you have data correct regarding its hit rate.
Clearly a higher position sizing model will be possible with a high hit rate system
Scene 22:
But the question is, can you do this? I hope that if I have convinced you that if you watch and control your position size then the coin game is a great game to play. Why is it so difficult to translate this to our trading? I will tell you why later on in the chapter of risk management and trading psychology.
Scene 23: Risk Management
Assume your account size is £100,000 and furthermore assume that you only wish to risk 2,000 pounds per position. Let N be the number of shares. We also know what our risk is going to be because we know where we’re going to get into the market and we know where we’re going to place our stop loss. In other words, if I know that my risk is 1 pound per share and I only want to risk 2000 pounds, it stands to reason that I can buy 2,000 shares, because if I get stopped out of the position I will have lost 2000 pounds, or two percent of my account size.
Scene 24:
The final component in a trading strategy is you. After method and position sizing the final aspect of our trading strategy is that we have to consider is ourselves.
It’s all about thinking in probabilities. Now, this should not be judged over one trade, but over a series of trades. I always tell people that you’re only about 30 trades away from being the trader you want to be. And when I teach people how to trade, I often find that by supporting them and guiding them, it only takes somewhere between 10 and 15 trades before they lose the fear of trading and loose the fear of losing money. By then they are perfectly happy with the fact that not every trade they place is a winning trade. In my eyes they have learned to play the game of trading over and over without any fear or any hesitation in placing trades. And the chapter on trading psychology is all about how to get to that state of mind.
18:20 minutes
Tags: forex, fx, tom hougaard, trading