The truth is that trading, both successful and unsuccessful, is more about psychology than tactics. As Jim Paul ultimately learns through a very expensive lesson taught by the market, successful trading is not about discovering a great strategy for making money but rather a matter of learning how to lose.
One of the premises of this book is that the rise sets up the fall; the winning sets up the losing. You can't really be set up for disaster without having it preceded by success. If you go into a situation in a neutral position, having neither successes nor failures beforehand, you acknowledge that your odds are maybe fifty-fifty; you may have a winner, you may have loser. But if you start from scratch and have a run of successes, you are setting yourself up for the coming failure because the successes lead to a variety of psychological distortions. This is particularly true if you have unknowingly broken the rules of the game and won anyway. Once that happens to you, you think that you are somehow special and exempt from following the rules.
Personalizing successes sets people up for disastrous failure. They begin to treat the success as a personal reflection rather than the result of capitalizing on a good opportunity, being at the right place at the right time, or even being just plain lucky. People begin to think their mere involvement in the undertaking guarantees success.
One of the oldest rules of trading is: If a market is hit with very bullish news and instead of going up, the market goes down, get out if you're long. An unexpected and opposite reaction means there is something seriously wrong with the position.
LESSONS LEARNED
Losing money in the markets is the result of either: (1) some fault in the analysis or (2) some fault in its application. Most of the losses are due to the latter.
The Five Stages of Internal Loss
The stages people go through when experiencing a loss in the market are strikingly similar to the stages people go through when facing death.
Denial
Anger
Bargaining
Depression
Acceptance
Discrete Events vs. Continuous Processes
Although someone could do it, it's a little hard to imagine someone going through the stages of denial, anger, bargaining, depression, and acceptance over a basketball game. Why? Because the game is a discrete event--an activity with a defined ending point. However, internalizing an external loss is a lot easier to do with the other type of loss-producing activity: a continuous process--an activity that has no clearly defined end. Losses from continuous processes are much more prone to become internalized because, like all internal losses, there is no predetermined ending point. In a continuous process, the participant gets to continuously make and remake decisions that can affect how much money he makes or loses. On the other hand, a discrete event (e.g., a football game, roulette, blackjack, or other casino game) has a defined ending point, which is characteristic of external losses. A loss resulting from a discrete event is definitive and not open to interpretation.
Behavioral Characteristics Determine the Activity
Don't make the mistake of assuming that just because you're participating in the market you are automatically investing, trading, or speculating. The markets don't make you immune from betting or gambling. Determining which of the five activities you are doing is a function of the behavioral characteristics you exhibit. Gambling, investing, and trading are not defined by any particular activity itself (i.e., playing cards, buying stocks, or trading futures) but by how the person approaches the activity. All card playing is not gambling, all stock purchases are not investing, and all futures transactions are not trading.
Betting and gambling are suitable for discrete events but not for continuous processes. If you introduce the behavioral characteristics of betting or gambling into a continuous process, you are leaving yourself open to enormous losses. In betting and gambling games, you wager and wait to see if you are right or to experience some excitement, respectively. Any resulting monetary losses are real, but they are also passive because the discrete event ends all by itself. On the other hand, a position in the market is a continuous process that doesn't end until you make it end. If you "wager and wait" in the market, you can lose a lot of money. In betting and gambling games if you stop acting and do nothing, the losses will stop. But when investing, trading, or speculating, if you're losing and stop acting, the losses don't stop; they can continue to grow almost indefinitely.
The Psychological Crowd
Emotions are neither good nor bad; they simply are. They cannot be avoided. But emotionalism (i.e., decision making based on emotions) is bad, can be controlled, and should be avoided.
The basic distinction between the individual and the crowd is that the individual acts after reasoning, deliberation, and analysis; a crowd acts on feeling, emotion, and impulses.
There are three main characteristics that describe the mental state of an individual forming a part of a crowd. As you will see, the same characteristics can also be exhibited by an individual making investment and trading decisions.
A Sentiment of Invincible Power
Contagion
Suggestibility
So instead of trying to monitor yourself for all the different emotions and what they might mean, simply monitor yourself for the few stages of crowd formation. By avoiding the tell-tale symptoms that accompany becoming part of the crowd, you will automatically avoid emotionalism.
TYING IT ALL TOGETHER
Speculating is the application of intellectual examination and systematic analysis to the problem of the uncertain future. Successful investing is the result of successful speculation.
The Plan
Regardless of the methodology used, before you decide to get into the market you have to decide where (price) or when (time) or why (new information) you will no longer want the position. Almost all commentary on the development of a plan will list the ingredients as entry, stop-loss, and price objective. However, to be effective as a loss-control tool, the plan must be derived by deciding STOP, ENTRY, then PRICE OBJECTIVE.
The distinguishing factor of "the" recipe is determining the stop-loss criteria before deciding whether and where to enter the market. Citing Drucker once again, "The first step in planning is to ask of any activity, any product, any process or market, ‘If we were not committed to it today, would we go into it?' If the answer is no, one says, ‘How can we get out--fast?'" As a market participant you don't have to be committed to the market at all, so you ask the latter question before getting in the market in the first place. After you know where you want to get out of the market, then you can ascertain whether and where you are comfortable getting into the market. In contrast to what most people do, your entry point should be a function of the exit point. Once you specify what price or under what circumstances you would no longer want the position, and specify how much money you are willing to lose, then, and only then, can you start thinking about where to enter the market.
The fluid market environment needs operational parameters that make a discrete event out of a continuous process. A plan does precisely that by creating an ending point for a market position. A plan that determines the stop-loss first enables you to convert a naturally dangerous, continuous process into a finite, discrete event.
From my trading and gambling experiences I have learned that the more the markets are treated as a game, the less likely you are to have losses due to psychological factors. Why? Games have rules and defined ending points. Their participants have a game plan. A plan takes the positive attributes of games (not gambling games per se but the concept of a game) and applies them to the market, giving you the structure necessary to create a discrete event.
After you have developed your plan, start preparing your speech, so to speak, about what you're going to do if certain conditions aren't fulfilled by a certain time and what those conditions are. Like any good speech writer, you should start by putting pen to paper. To prevent unintentional and implicit violation of your plan, no device is more effective than setting down that plan before your eyes explicitly in black and white. This objectifies, externalizes, and depersonalizes your thinking, so you can hold yourself accountable.