Systems - Buy Them Or Build Them?

Since we offer systems for sale one might assume that we would suggest
that systems should be purchased rather than built from scratch.
Actually we are very strong advocates of building your own system if you
are capable of doing so.

One of the reasons that we make this recommendation is that we believe
it is important that trading systems should fit the needs and
preferences of the user. A system may appear to have excellent
performance data but another trader may consider one trader's favorite
system as completely worthless. It seems that everyone has a different
level of comfort when it comes to following a particular system and the
comfort level increases dramatically if you are personally involved in
the planning and research that produces the system.

In addition to comfort levels and other psychological issues,
preferences for systems may vary because the resources of traders will
vary. For example some traders have very large amounts of capital to
work with while other may have much smaller amounts to put at risk. Due
to differences in capital or risk tolerances these traders may require
different systems. In addition to the amount of capital available there
are other resources that may influence the choice of systems. Some
traders have many hours a day available and want to trade for a living
while others have very demanding occupations and limited time to devote
to trading. Many systems traders have extensive experience with
computers and a great deal of knowledge about programming. But on the
other hand, many of us will have little knowledge and experience in this
technical field. Some systems traders have many years of actual trading
experience and others are admitted novices. Some traders have access to
the newest and most expensive hardware and prefer to receive real time
price data while many traders will find they can trade well using less
sophisticated equipment and simple end of day data.

We could continue with additional examples of important differences
among traders that might influence their preference in trading systems
but the point has been made. The advantages of building your own
trading system might be compared to the advantages of owning a tailor
made suit as opposed to buying one off the rack. If you build your own
system you can tailor it to your exact specifications so it fits your
preferences and resources.

However, just as most of us would not consider making our own clothing,
designing and testing a trading system is a task that may not be
appropriate or realistic for everyone. Assuming that you have the
necessary knowledge and resources to create your own system there are
still many obstacles to overcome. For one thing there is the
frustration of investing in equipment, software and data only to find
that most of our best ideas don't work. It would not be an exaggeration
to reveal that ninety nine percent of our research winds up in the
wastebasket. Also keep in mind the value of your time because until a
system is completed you will be working hundreds of hours for less than
minimum wages. There are no shortcuts so you had better enjoy the
entire process.

However the benefits of building the system yourself can be substantial
and we think the benefits are worth the effort. You will know and
understand the logic behind each step in the system. The knowledge
gained in the testing process should give you confidence in the system
so that you will have the necessary discipline to follow the system
correctly when it comes time to start trading it with real money. The
testing process should also give you a "feel" for the system that will
help you to sense when it is not performing as intended. If necessary
you will also have the ability to fine tune the system based on your
real time experience. We believe that over the long run the discipline
and confidence of the system operator have a great deal to with
determining the ultimate success of any system. By creating the system
yourself you are most likely to trust it and operate it correctly.

We suggest that you should seriously consider building your own systems
if you can satisfy most of the following criteria:

1. You enjoy challenges and have a knowledge of the commitment required
to excel at anything. If you have been an outstanding success at any
endeavor then you already understand commitment. In particular we
believe that success at competitive games like bridge, chess,
backgammon, poker and other pastimes requiring discipline, patience and
strategy would be a good indication that you can build a good system and
operate it successfully.

2. You own or are prepared to purchase a testing platform (like
TradeStation or something similar) and will spend the time required to
learn how to operate it.

3. You understand how to program the software you will be using or you
are willing to pay a professional programmer to assist you. If you do
not have a programming background you will find that there is nothing
easy about Omega's so-called Easy Language. If you have no programming
experience and decide to hire a programmer you should study enough about
the programming to enable you to communicate with your programmer. As a
minimum you need to be able to express your ideas in "if / then"
statements.

4. You need to have studied some basics on testing procedures and know
how to analyze and evaluate the test results. Some training in
statistical analysis would be very helpful.

5. You will need a source of clean historical data and the software to
convert the data to the format that will be used in testing. For
example you may want to convert the data to continuos back-adjusted
contracts. There are other popular formats for historical data and you
should know which format is appropriate for the testing and type of
system you will be creating.

6. You have spent some time clearly defining exactly what you want from
your system. You need to list and prioritize these desired
characteristics because they will guide your research.

7. You must have an abundance of time and patience. Picture yourself as
Thomas Edison setting out to invent the light bulb. Will you have the
commitment and patience to keep trying one element after another to find
the one that works? (As an example, we have been working on S&P trading
systems for years and we have yet to come up with one that we would be
willing to trade. We are still trying.)

8. Can you be truthful with yourself and analyze your test results
without letting your natural optimism cloud your judgment. (However, if
you are not an optimist you are automatically disqualified.)


Chuck Lebeau is the co-author of Computer Analysis of the Futures Market, and the former co-editor of Technical Traders Bulletin. Chuck is currently operates a website devoted to trading topics; www.traderclub.com.

Measuring Exit Efficiency

Those of you who have read our book and followed our work over the years will quickly recognize that we have long been outspoken advocates of the importance of good exits. In our opinion exits are much more important than entries yet the majority of new traders spend most of their time seeking the ideal entry strategy as if this would solve all of their problems.

In the System Building workshops that I teach with Dr. Tharp, we play an exit game where everyone enters a series of trades at the same point and then implements their own exit strategy as prices are reported to the group. After about ten quick trials of this game the results typically range from one extreme to the other. A few traders make a lot of money, a few lose a lot of money and most fall somewhere in between. It would be rare for any two players to have the same results. The point of this simple exercise is to illustrate the effect of exits on our trading results. Everyone has identical entries yet the outcome of the simulated trading always ranges from big losses to big profits.

The same is true in actual trading. Exits determine the outcome of our trading and have more impact on the results than any other factor. Yes, exits are even more important than money management (position sizing). Not even the best money management strategy can make a losing system into a winner but a minor change in the exit strategy can work miracles. We quickly discovered this years ago when attempting our first tests of indicators. We found that even a slight variation of the exit strategy used in the testing would affect the number of trades, the size of the winners and losers, the percentage of winners, the drawdown and the total profitability. We set out to test entries but quickly learned that in most cases we were testing exits because the entries had little if anything to do with the results.

We eventually began isolating, as best we could, our testing of entries and exits. We now test entries based solely on the percentage of winning trades, exiting after a specified number of bars. This method of testing entries is based on our conclusion that the only purpose of entry timing is to get the trade started in the right direction as accurately as possible. Everything that happens after that has nothing to do with the entry because the outcome of the trade is now in the hands of our exit strategies. We want our entries to accomplish only one purpose and that is to get our trades started in the right direction as quickly as possible and this function is easy to measure. The higher the winning percentage after a few bars the better the entry. But how do we measure the efficiency of our exits? How can we tell if one exit is better than another? What is a good exit? What is a bad exit? Which is better: exit A or exit B?

To try and quantify the relative merit of various exits we created the Exit Efficiency Ratio and contributed an article on this topic to Futures Magazine several years ago. (I'm trying to get this Bulletin out today and I am sorry that I don't have the specific reference for the article in front of me. I'll find it and post it on the FORUM page.)

For those of you using Rina/Omega's Portfolio Maximizer software you should be aware that the Exit Efficiency Ratio that we wrote about is not the same calculation presently used in Portfolio Maximizer. Here is our original version of the Exit Efficiency Ratio.

You need to start by keeping or creating a record of your winning trades. You must also keep a record of the total number of bars in the trade from entry to exit. As an example, lets assume that we made a profitable trade that lasted 12 bars from entry to exit and the trade captured $1500 of gross profit.

The next step is to go back and look at our entry point and 24 bars of data after our entry. Our theoretical holding period is now twice the actual holding period. We then use perfect hindsight to identify the best possible exit point within this theoretical holding period. Don't be shy, pick the absolute best tick for the theoretical exit and compute the theoretical gross profit. In this case lets assume that somewhere in the period we could have exited the trade with a $2500 profit at the absolute high point of the theoretical trade.

The Exit Efficiency Ratio is then calculated by dividing the actual gross profit by the theoretical gross profit. We divide 1500 by 2500 to arrive at an Exit Efficiency Ratio of 60%. This tells us that we actually captured 60% of the profit that might have been possible for this trade.

The Portfolio Maximizer formula for exit efficiency measures only the efficiency during the actual holding period. I'm sure this is for practical reasons because the trade by trade listing used for most calculations would not include data outside the range of the holding period.

When calculating the best theoretical exit point, the doubling of the holding period is critical to evaluating the exit fairly because most traders err on the side of exiting their profitable trades much too soon. By extending the theoretical holding period beyond the actual exit bar we can see if this was the case. In our example we exited the actual trade after 12 bars and lets assume that the ideal exit point was on the 20th bar. If we only measured the bars in the actual trade our ideal exit point might have been on the 12th bar where we closed out our trade just as we were climbing to a new peak. Measuring only the duration of the actual trade would credit us with an exit that was 100% efficient. The tendency of any calculation based only on the bars during the trade would be to reward us for exits prior to the peak and to penalize you for exits after the peak that might have been more profitable than the earlier exit. By doubling the holding period in our theoretical calculation of the ideal exit point we can easily see if we closed out any of our trades too soon.

We typically use a combination of exit strategies and by giving each of our exits a name we can evaluate our exits individually or as a complete exit package. Some exits (like the Yo Yo exit) score better than others but since this can not be the only exit in a system we must evaluate the combination of exits as well as each individual exit.


Chuck Lebeau is the co-author of Computer Analysis of the Futures Market, and the former co-editor of Technical Traders Bulletin. Chuck is currently operates a website devoted to trading topics; www.traderclub.com.

Twenty Questions

Gamblers Anonymous offers the following questions to anyone who may have a gambling problem. These questions are provided to help the individual decide if he or she is a compulsive gambler and wants to stop gambling.

TWENTY QUESTIONS

1. Did you ever lose time from work or school due to gambling?
2. Has gambling ever made your home life unhappy?
3. Did gambling affect your reputation?
4. Have you ever felt remorse after gambling?
5. Did you ever gamble to get money with which to pay debts or otherwise solve financial difficulties?
6. Did gambling cause a decrease in your ambition or efficiency?
7. After losing did you feel you must return as soon as possible and win back your losses?
8. After a win did you have a strong urge to return and win more?
9. Did you often gamble until your last dollar was gone?
10. Did you ever borrow to finance your gambling?
11. Have you ever sold anything to finance gambling?
12. Were you reluctant to use "gambling money" for normal expenditures?
13. Did gambling make you careless of the welfare of yourself or your family?
14. Did you ever gamble longer than you had planned?
15. Have you ever gambled to escape worry or trouble?
16. Have you ever committed, or considered committing, an illegal act to finance gambling?
17. Did gambling cause you to have difficulty in sleeping?
18. Do arguments, disappointments or frustrations create within you an urge to gamble?
19. Did you ever have an urge to celebrate any good fortune by a few hours of gambling?
20. Have you ever considered self destruction or suicide as a result of your gambling?

Most compulsive gamblers will answer yes to at least seven of these questions.

Traders Anonymous offers the following questions to anyone who may have a trading problem. These questions are provided to help the individual decide if he or she is a compulsive trader and wants to stop trading.

TWENTY QUESTIONS

1. Did you ever lose time from work or school due to trading?
2. Has trading ever made your home life unhappy?
3. Did trading affect your reputation?
4. Have you ever felt remorse after trading?
5. Did you ever trading to get money with which to pay debts or otherwise solve financial difficulties?
6. Did trading cause a decrease in your ambition or efficiency?
7. After losing did you feel you must return as soon as possible and win back your losses?
8. After a win did you have a strong urge to return and win more?
9. Did you often trade until your last dollar was gone?
10. Did you ever borrow to finance your trading?
11. Have you ever sold anything to finance trading?
12. Were you reluctant to use "trading money" for normal expenditures?
13. Did trading make you careless of the welfare of yourself or your family?
14. Did you ever trade longer than you had planned?
15. Have you ever traded to escape worry or trouble?
16. Have you ever committed, or considered committing, an illegal act to finance trading?
17. Did trading cause you to have difficulty in sleeping?
18. Do arguments, disappointments or frustrations create within you an urge to trade?
19. Did you ever have an urge to celebrate any good fortune by a few hours of trading?
20. Have you ever considered self destruction or suicide as a result of your trading?

Most compulsive traders will answer yes to at least seven of these questions.

Expectancy

Las Vegas. Great food, show girls, and a multi-billion dollar gambling business. The money made by the casinos is only matched by the profits on Wall Street. And the profits of both are based on mathematical probabilities.

Casinos make money because “the odds” or a game’s expectancy are in the house‘s favor. This means that if you play long enough, the casino wins. Over the short term, the casino knows it may win or lose. But if you play long enough, the house always wins. The casinos increase their profits by offering games that are completed in a short period of time – a roll of dice, a spin of a wheel or a few cards turned over.

What does this have to do with trading systems?

• We want the odds of a trade to favor us – expectancy
• We want a lot of trades – opportunity
• We want turn over so we can compound the profits – holding time.

What we as traders must do is become the house. The odds in our trading must favor us, we need a reasonable number of trades during the year and the trades must be completed in a reasonable amount of time for compounding to be effective.

Expectancy is simply the product of your profit percentage per win and your win rate minus the product of your loss percentage per loss and your loss rate. For example:

• Win percentage 6%
• Win rate 60%
• Loss percentage 4%
• Loss rate 40%.

The expectancy is 2.0% per trade, or (6% x 60%) - (4% x 40%).

That means, on an average trade, 2% of the money traded is yours to keep. That’s better odds than a casino gets on blackjack. Now, that may not sound like a lot of money. If your average trade is $10,000 – 2% is $200 profit per trade. If you have 300 trades per year, then you have a $60,000 profit per year with an average trade of only $10,000. This does not even include the profits if you compounded the average trade.

If you explore the expectancy formula, you will notice that there is no one set of numbers that could give a positive expectancy but an infinite number of sets and therefore an infinite number of trading systems that could be profitable.

Given that, it is possible to develop systems where the stop loss is larger than the profits. The stop loss is academic, as long as your profit expectancy is positive.

Here’s another example: we could use a 20% stop loss and a 5% profit target and come out with the same exact 2% expectancy as long as my win rate is high enough! An 88% win rate in this example would yield 2.0%, the result of (5% x 88%) - (20% x 12%).

Or, you could arrive at a positive expectancy with a very low win rate. One of the more famous expectancy numbers comes from William O’Neil, advocate of the CANSLIM system and founder of Investors Business Daily. If we use his stop and target numbers of 8% and 20% and his published win rate of 30%, the expectancy can be calculated to be: (20% x 30%) - (8% x 70%) or +0.4%.

The bottom line is: expectancy must be positive if you want to make a profit over time. Never use a system with a zero or negative expectancy. You will not win. You can not beat the house over a long series of bets or trades. Be the “House”.

No matter what your expectancy is, you will not make a great deal of money unless you have a lot of opportunities to trade. Again, the casino analogy. The casino may only make 1-2% per hand of blackjack, but they turn over those hands very quickly – 30 to 40 hands per hour. Play blackjack long enough and you will lose over 40% of your money per hour! No wonder they can offer those wonderful comps.

We now know how to create a method, at least on paper, with a positive expectancy. Let’s say we develop a system with 8% expectancy, but if the system only yielded one trade per year, what good would it be? We might as well just put the money in a savings account. Or, if we had a method that yielded 0.2% per trade, you might pass on it? But what if that system generated 1,000 trades per year? 1,000 times 0.2% becomes serious money in a very short time.

The most overlooked area of trading is the "holding period." In order to make money, you must have a system that generates a positive expectancy and a lot of opportunities. But you must have access to your money. If your trade’s hold time is too long, you can't take advantage of all or even most of your opportunities. Your trading money or buying power is always tied up because you have to wait too long to close your trades.

Casino analogy time. If the house odds in Blackjack are 2.5%, that means for ever $2 bet, the casino makes, on average, 5 cents. If you only play 1 game per hour, the casino makes 5 cents per hour. If you play 60 games per hour, the casino has all of your $2 in 40 minutes. All things being equal, the game with the fastest turnover is the more profitable for the casino.

It's no different with trading. You will be more profitable with $100,000 that you could "turn" 250 times per year, than $500,000 that was tied up in one trade for 12 months. As an example, let's say we have one trade and that trade yielded a 50% return. You just had a great year - a $250,000 profit.

On the other hand, say you had $100,000 for stock purchases, and your expectancy was only 1.2% per trade but you turned over your stocks 250 times in the same year. This method ends up generating $300,000 for the year, and that assumes you never increase the position size as the equity grows. You just had a better year. And it is easier to get 1.2% per trade than 50%.

The bottom line for a great bottom line is:

• A positive expectancy
• A good number of trades
• A short holding period

Source: www.arbtrading.com

I Read the News Today, Oh Boy

Consider the following three news headlines:

• The CEO of Company XYZ has just resigned
• The markets were down today due to profit taking
  
• The FED will raise interest rates at the next FOMC meeting.
  

All of them are typically grouped under the heading ‘news’, but actually only one of them is of any use to a trader. Each of these news items belongs to one of the 3 kinds of financial news. These are:

Facts - something that has happened or is scheduled to happen in the future
Explanations – an attempt to identify a cause and effect relationship
Predictions – a forecast or guess

In trading, explanations after the event or predictions serve no useful purpose in making money. They are ‘old news’ at best, or simply incorrect or misleading. The only thing that you should pay attention to is the facts, and even then you should understand that they are mainly a lagging indicator that is difficult to trade.

Unless you have very fast news feed there is always a slew of market participants that have seen (and acted on) the news before you even click the refresh button on your browser. As ever in trading, if your edge depends on you being the fastest at something then you are unlikely to succeed in the long run. If you must create a trading system or method that uses the news as an input, make sure that you only use the factual news items, and that your system does not require you to be the ‘first to act’ in order to make money.

Paul King
PMKing Trading LLC
www.pmkingtrading.com

Marketing Hype to Avoid

• If a firm declares longer term secrets to shorter term trading...
• If a firm calls a system just a small, no-risk investment...
• If a firm refers to you as friend...
• If a firm promotes secrets to S&P daytrading...
• If a firm declares that an offer may disappear at any moment!...
• If a firm describes everything as simple...
• If a firm refers to a trading method as most valuable ever...
• If a firm refers to anything as secret...
• If a firm tells you to act quickly...
• If a firm says an offer may evaporate at any moment...
• If a firm tells you to please send your order now...
• If a firm calls the trading approach 'exciting'...
• If a firm talks about day trading gold...
• If a firm talks about buy and sell signals primarily...
• If a firm boasts about new break throughs...
• If a firm says something is limited to only a finite number of people...
• If a firm states it can precisely time the market's next swing...
• If a firm touts the secret of exiting the market with profit every time
• If a firm declares it can pinpoint market turns...
• If a firm raves about the secrets of seasonal influences...
• If a firm talks about the opportunity of a lifetime...
• If a firm says you must buy low and sell high...
• If a firm states that the markets repeat directly or inversely relative to the total interaction of the sun, moon and earth...

Read Bestselling Book Trend Following and visit the Trend Following Blog at Michael Covel

Trading as a Performance Sport

For the past 15 years, I have served as a therapist, counselor, mentor, and advisor to the medical students and physicians at an academic health center. Most of the people I work with are bright, motivated, educated individuals who are free from debilitating psychological problems. Their goal in counseling is to bring their performance to a higher level. They know that if they are going to be competitive in a field such as orthopedic surgery or emergency medicine, they need to be firing on all cylinders.

Interestingly, their interests and needs are not unlike those of Olympic athletes, active traders, bodybuilders, concert musicians and others engaged in performance-oriented pursuits. They realize that, if they spend years honing their skills, they can ill-afford to have their state of mind interfere with their peak performance.

The hypothesis I'd like to share with you is straightforward: There is a core set of characteristics that distinguish the greatest participants in any field of endeavor-including mastering the markets. If you read Jack Schwager's interviews with such accomplished traders as Mark Cook, Linda Bradford Raschke, and Mark Ritchie, you'll notice a recurring theme: success in trading is as much a function of the qualities of the trader as the system being traded.

In his text entitled "Greatness", Professor Dean Keith Simonton points out that mastery of any domain requires approximately 50,000 "chunks" of information. This applies across different domains, from chess and sports to scientific research. To acquire such a wealth of experience and data, the great individual needs to be able to sustain focused attention on work for considerable periods. The psychologist Mihalyi Czikszentmihalyi has found that this is possible because the creative person enters a pleasurable emotional state-a state of flow-when immersed in effortful activity. This intrinsic pleasure enables achievers to weather periods of uncertainty and discouragement on the way to success.

The implications of this line of research for trading are profound. Most texts on trading psychology emphasize such techniques as positive thinking and visualizations. These can be helpful, to be sure. But to transform oneself as a trader, it is necessary to transform one's state of consciousness. Traders lose when their mind states interfere with their natural processing of market data. To become a lean, mean, trading machine, it is necessary to cultivate the capacity to enter and sustain the flow state. Notice that Schwager found that most "Wizard" traders engage in extensive research and preparation before their trades. This is not simply a tool for scoping out the markets: it is mind-training, developing the trader's capacity to stay immersed in their craft. Simonton also examined the specific works of some of the most eminent creative individuals in different fields and came to a startling conclusion. The odds of generating a work of lasting merit did not increase over the creator's lifetime. That is, the greatest writers, artists, and thinkers produced the same ratio of clunkers to works of genius throughout their careers. They were successful, Simonton notes, because they simply produced more. Whether a given work becomes famous or not is a matter of natural selection. Creative talents who are more productive increase their odds of generating a memorable work.

Once again, the implications for trading are clear. Even master traders are likely to produce a fair number of clunker trades. Like power hitters such as Mark McGuire, they will often strike out on their way to slugging a number of home runs. To become a master trader, traders need to trade, and need to continually hone their skills. Persistence, especially in the face of adversity, is a quality shared by most of the Wizard traders.

Indeed, in his excellent text "The Road to Excellence", K. Anders Ericsson concludes that future expert performers engage in intensive training activities over a period of ten or more years in the cultivation of superior performance. Success, he finds, is a function of intensive, deliberative practice conducted while in a state of heightened attention and concentration.

Ericsson likens the mind's development under such training to the physical benefits of athletic training. Former Mr. Universe and bodybuilding coach Mike Mentzer has written extensively on the benefits of high intensity strength training. It is the intensity of the workout-not its duration-that contributes to physical development; only under brief, intense demands will the body devote the resources to its muscles that become manifest as physique. Ericsson points out that superior performers conduct similar "natural experiments" with their growth, achieving unusual cognitive mastery through repeated, intense skill rehearsal.

From this research, we can infer two reasons why traders fail. First, they become emotionally involved in their trades-eager for profits, despairing of losses-and thus exit the flow state needed for immersion in the learning experience. One cannot be immersed in an experience and also preoccupied with its outcome.

The second reason traders fail is less appreciated. They lack the sustained concentration and focus needed to benefit from intensive practice. Imagine going to the gym and lifting a 20 pound barbell a few times. Surely we would not develop our strength or physique under such conditions. The capacity for trading success remains similarly dormant when traders attempt to beat the market with part-time preparation, impulsive hunches, and untested strategies. When asked to identify a loser on the trading floor, Wizard Tom Baldwin told Jack Schwager, "Losers don't work hard enough…They don't concentrate…You can see it in their eyes; it is almost as if there is a wall in front of their face."

To these worthy observations, I would add the following. If market opportunities are born of inefficiencies inherent in human information processing, as behavioral finance researchers suggest, then the ability to profit from these opportunities requires the capacity to stand apart from such biases and patterns. One cannot simultaneously fall prey to human nature and profit from it. This requires a considerable measure of self-development, the kind that can only occur as the result of immersive experience and practice. Those who aspire to trading greatness must find some measure of greatness within. Such is the challenge and nobility of the path we've chosen.

Brett N. Steenbarger, Ph.D. is an Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and a daily trader of the stock index futures markets. He is the author of The Psychology of Trading (Wiley, 2003) and coeditor of the forthcoming The Art and Science of the Brief Psychotherapies (American Psychiatric Press, 2004). Many of his articles on trading psychology and daily trading strategies are archived at his website, www.brettsteenbarger.com.

Aiming for the Right Target in Trading

When trading goes right, it can be a great feeling. When trading goes wrong it can be a nightmare. Fortunes are made in a matter of weeks and lost in a matter of minutes. This pattern repeats itself as each new generation of traders hit the market. They hurl themselves out of the night like insane insects against some sort of karmic bug-light; all thought and all existence extinguished in one final cosmic "zzzzzzt". Obviously, for a trader to be successful he must acknowledge this pattern and then break it. This can be accomplished by asking the right questions and finding the correct answers by rational observation and logical conclusion.


This article will attempt to address one question:

"What is the difference between a winning trader and a losing trader?"

What follows are eleven observations and conclusions that I use in my own trading to help keep me on the right track. You can put these ideas into table form, and use them as a template to determine the probability of a trader being successful.

OBSERVATION # 1

The greatest number of losing traders is found in the short-term and intraday ranks. This has less to do with the time frame and more to do with the fact that many of these traders lack proper preparation and a well thought-out game plan. By trading in the time frame most unforgiving of even minute error and most vulnerable to floor manipulation and general costs of trading, losses due to lack of knowledge and lack of preparedness are exponential. These traders are often undercapitalized as well. Winning traders often trade in mid-term to long-term time frames. Often they carry greater initial levels of equity as well.

CONCLUSION:

Trading in mid-term and long-term time frames offers greater probability of success from a statistical point of view. The same can be said for level of capitalization. The greater the initial equity, the greater the probability of survival.

OBSERVATION # 2

Losing traders often use complex systems or methodologies or rely entirely on outside recommendations from gurus or black boxes. Winning traders often use very simple techniques. Invariably they use either a highly modified version of an existing technique or else they have invented their own.

CONCLUSION:

This seems to fit in with the mistaken belief that "complex" is synonymous with "better". Such is not necessarily the case. Logically one could argue that simplistic market approaches tend to be more practical and less prone to false interpretation. In truth, even the terms "simple" or "complex" have no relevance. All that really matters is what makes money and what doesn't. From the observations, we might also conclude that maintaining a major stake in the trading process via our own thoughts and analyses is important to being successful as a trader. This may also explain why a trader who possesses no other qualities than patience and persistence often outperforms those with advanced education, superior intellect or even true genius.

OBSERVATION # 3

Losing traders often rely heavily on computer-generated systems and indicators. They do not take the time to study the mathematical construction of such tools nor do they consider variable usage other than the most popular interpretation. Winning traders often take advantage of the use of computers because of their speed in analyzing large amounts of data and many markets. However, they also tend to be accomplished chartists who are quite happy to sit down with a paper chart, a pencil, protractor and calculator. Very often you will find that they have taken the time to learn the actual mathematical construction of averages and oscillators and can construct them manually if need be. They have taken the time to understand the mechanics of market machinery right down to the last nut and bolt.

CONCLUSION:

If you want to be successful at anything, you need to have a strong understanding of the tools involved. Using a hammer to drive a nut in to a threaded hole might work, but it isn't pretty or practical.

OBSERVATION # 4

Losing traders spend a great deal of time forecasting where the market will be tomorrow. Winning traders spend most of their time thinking about how traders will react to what the market is doing now, and they plan their strategy accordingly.

CONCLUSION:

Success of a trade is much more likely to occur if a trader can predict what type of crowd reaction a particular market event will incur. Being able to respond to irrational buying or selling with a rational and well thought out plan of attack will always increase your probability of success. It can also be concluded that being a successful trader is easier than being a successful analyst since analysts must in effect forecast ultimate outcome and project ultimate profit. If one were to ask a successful trader where he thought a particular market was going to be tomorrow, the most likely response would be a shrug of the shoulders and a simple comment that he would follow the market wherever it wanted to go. By the time we have reached the end of our observations and conclusions, what may have seemed like a rather inane response may be reconsidered as a very prescient view of the market.

OBSERVATION # 5

Losing traders focus on winning trades and high percentages of winners. Winning traders focus on losing trades, solid returns and good risk to reward ratios.

CONCLUSION:

The observation implies that it is much more important to focus on overall risk versus overall profit, rather than "wins" or "losses". The successful trader focuses on possible money gained versus possible money lost, and cares little about the mental highs and lows associated with being "right" or "wrong".

OBSERVATION # 6

Losing traders often fail to acknowledge and control their emotive processes during a trade. Winning traders acknowledge their emotions and then examine the market. If the state of the market has not changed, the emotion is ignored. If the state of the market has changed, the emotion has relevance and the trade is exited.

CONCLUSION:

If a trader enters or exits a trade based purely on emotion then his market approach is neither practical nor rational. Strangely, much damage can also be done if the trader ignores his emotions. In extreme cases this can cause physical illness due to psychological stress. In addition, valuable subconscious trading skills that the trader possesses but has no conscious awareness of may be lost. It is best to acknowledge each emotion as it is experienced and to view the market at these points to see if the original reasons we took the trade are still present. Further proof that this conclusion may have validity can be seen in even highly systematic traders exiting a trade for no apparent reason, and pegging a profitable move almost to the tick. Commonly, this is referred to as being "lucky" or being "in the zone".

OBSERVATION # 7

Losing traders care a great deal about being right. They love the adrenaline and endorphin rushes that trading can produce. They must be in touch with the markets almost twenty-four hours a day. A friend of mine once joked that a new trader won't enter a room unless there is a quote machine in it. Winning traders recognize the emotions but do not let it become a governing factor in the trading process. They may go days without looking at a quote screen. To them, trading is a business. They don't care about being right. They focus on what makes money and what doesn't. They enjoy the intellectual challenge of finding the best odds in the game. If those odds aren't present they don't play.

CONCLUSION:

It is important to stay in synch with the markets, but it is also important to have a life outside of trading. It is a rare individual who can do anything to excess without suffering some form of psychological or physical degradation. Successful traders keep active enough to stay sharp but also realize that it is a business not an addiction.

OBSERVATION # 8

When a losing trader has a bad trade he goes out and buys a new book or system, and then he starts over again from scratch. When winning traders have a bad trade they spend time figuring out what happened and then they adjust their current methodology to account for this possibility next time. They do not switch to new systems or methodologies lightly, and only do so when the market has made it very clear that the old approach is no longer valid. In fact, the best traders often use methodologies that are endemic to basic market structure and will therefore always be a part of the markets they trade. Thus the possibility of the market changing form to the extent that the approach becomes useless, is very small.

CONCLUSION:

The most successful traders have a methodology or system that they use in a very consistent manner. Often, this revolves around one or two techniques and market approaches that have proven profitable for them in the past. Even a bad plan that is used consistently will fair better than jumping from system to system. This observation implies that stylistic foundations of a trader's market approach must be in place before consistent profitability can occur.

OBSERVATION # 9

Losing traders focus on "big-name" traders who made a killing, and they try to emulate the trader's technique. Winning traders monitor new techniques that come on the trading scene, but remain unaffected unless some part of that technique is valuable to them within the framework of their current market approach. They often spend much more time looking at how the market seeks and destroys other traders or how traders destroy themselves. They then trade with the market or against other traders as these situations arise.

CONCLUSION:

Once again, we can note that the individuality of a trader and his comfort level and knowledge regarding his system are far more important than the latest doodad or Market guru.


OBSERVATION #10

Losing traders often fail to include many factors in the overall trading process that affects the probabilities of overall profit. Winning traders understand that winning in the markets means "cash flow". More cash must come in than goes out, and anything that effects this should be considered. Thus a winning trader is just as thrilled with a new way to reduce his data-feed costs or commissions as he is with a new trading system.

CONCLUSION:

ANYTHING that affects bottom line profitability should be considered as a viable area of study to improve performance.

OBSERVATION #11

Losing traders often take themselves quite seriously and seldom find humor in market analysis or the trading environment. Successful traders are often the funniest and most imaginative people you will ever meet. They take joy in trading and are the first to laugh or relate a funny story. They take trading seriously, but they are always the first to laugh at themselves.

CONCLUSION:

Its no wonder that one of the first things psychiatrists test for when treating a patient is whether or not the patient has any sense of humor about his affliction. The more serious the tone of the individual, the more likely that insanity has set in.


SUMMARY OF CONCLUSIONS AND OBSERVATIONS

Both winning and losing traders consider trading a game. However, winning traders take the game not as a diversion but as a vocation which they practice with an intensity and dedication that rivals the work ethic of a professional athlete. Since the athletic metaphor seems appropriate, I will sum up on that note.

If trading were a game like basketball perhaps novice traders would realize more readily that what appears as effortless ease of the professional trader in sinking three-point shots is in fact the product of endless hours spent shooting hoops in deserted back yards and empty playgrounds.

As in sports, the governing factors are internal and external. We deal with the market and ourselves. Both are like weapons and they can be used proactively or destructively. Each and every trade should be taken with professional care and planning

In order to bring these observations home in an even more compelling form, lets add an element of ultimate risk to life and limb and say that our "sport" is more like target practice with a handgun. While it is certainly important to hit the target, it is more important to make sure the gun isn't pointed directly at ourselves when we pull the trigger.

Minute differences in how we take aim in the markets can have amazing impact on the final outcome. The difference is clear: One method is accurate target practice. The other is Russian Roulette.



Copyright@1999 Walter T. Downs All Rights Reserved. Distribution is
allowed with due credit to the author. http://cistrader.com

Chuck Lebeau is the co-author of Computer Analysis of the Futures Market, and the former co-editor of Technical Traders Bulletin. Chuck is currently operates a website devoted to trading topics; www.traderclub.com.

The Flow of the Markets

Imagine yourself flowing down a river, only you don't know that you are. You do, however, notice that when you move in one direction, with the flow of the river, you move rapidly. When you move in another direction,against the river, you move slowly or not at all. In fact, when you go in that direction, you seem to put out a lot more effort just to stay in place. Your life becomes a struggle. It just seems to push you in another direction. Feeling miserable, you fight against it. But it doesn't help. You still seem to move only in one direction—with the flow of the river.Most people prefer to struggle against the river.

They try everything they can think of to go upstream. All solutions like this—going against the flow—have the same result: frustration. If you were in the river, what could you do to make your life easier? One solution would be to get out of the river. But that would be giving up. There is only one easy solution—to acknowledge or accept that the problem has nothing to do with the river. The river just is. And it moves downstream and nothing you do can change that. When you realize that the problem stems from you, then the solution becomes obvious - just relax and flow with the river.

Buy High, Sell Low?

One of the oldest adages in market psychology is "Don't be afraid to buy high and sell low." Let's analyze what that means. If the market price is high, then the market is moving up. Those who are afraid to buy because the market is too high are fighting the flow of the river. It is possible the river may change direction, but you cannot predict if it will by determining how long it has been flowing in a particular direction. It may continue in the same direction for an unspecified length of time. Then again, if the market price is down, it also indicates the direction of the flow of the river. Those who are afraid to sell, once again, are fighting the flow.Whether you go with the flow of the market or struggle against it, the market will continue to flow, taking you with it one way or another.

Why do traders resist the flow of the markets? They do so because they play psychological games with the market. The most common game involves not being willing to give up what you perceive to be control, the need to be right, although you have no control over the market flow.

When you are struggling with the market, the struggle becomes all consuming. You don't realize that you are struggling with the market. Instead, you find yourself always looking for some solution to overcome the struggle. The struggle obscures the obvious solution: Letting go.

For example, suppose you have a tendency to be in a perpetual market bear, always expecting the market to go down. For you, every little turn in the market is evidence that the market is turning. As a result, you always go short and consequently, take a beating. You repeat the process, over and over, until the market actually turns down. With each transaction the struggle against the flow of the market intensifies for you.

Even worse is the trader who refuses to accept the inevitability of eventual loss. The market moves against each position the trader takes, but he refuses to go with the flow and refuses to accept the loss, no matter how small. It is an affront to the trader's ego. As a result, he refuses to accept it and the loss becomes larger. The bigger loss is even harder to take and the trader again refuses to accept it. The struggle continues until the loss becomes so overwhelmingly large that the trader has no choice but to take the loss.

The solution to the problem of resisting market flow is to realize that the problem has nothing to do with the market. The problem stems from you, the trader. The market is not going against you personally. The market is simply moving. Whether you go with the flow of the market or struggle against it, the market will continue to flow, taking you with it one way or another. Market flow is bigger than any individual trader. The question is whether you realize how you are creating your struggle against the market. When you push against the market, the market seems to push back. But the market is not the problem.

The trader's struggle with the market is the problem.

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at http://www.iitm.com/.

Beliefs Come First

Some people believe that an entry signal is the first (and only sometimes!) step in trading system development. In my experience this is a very short-sighted approach. For me, beliefs about yourself, the markets, and the objectives for your trading all come before any actual system design takes place.

The first 7 items in system development that I use are:

• Beliefs – your interpretation of ‘reality’ that you will base your trading on
• Objectives – what you want a trading system to achieve
• Hypothesis – an idea about how a trading system could work
• Market Selection – what market will your system be implemented in
• Instrument Filter – which instruments within the chosen market(s) you feel are ‘tradable’
• Setup – conditions that determine a trade is possible
• Entry Signal – conditions that determine it is time to enter a position

Note that 6 major items come before you even get to an entry signal! Also note that the objectives you have for your trading system come before development not as a result of it. If you don’t know what you are trying to achieve how can you design a system that meets you goals?

Because you need to design a system to meet specific objectives (how else can you determine if it is working or not) it is very important to make sure those objectives are realistic and can probably be achieved with enough hard work. Expecting to double your account every month with only 10% draw-downs is never going to happen (although I have encountered ‘traders’ who wanted to achieve these kinds of results).

You may be thinking “How do I know what’s reasonable/achievable/sensible for me?” and I can’t answer that question in a blog – it depends on how much time you have to design, develop, and implement your trading system and what your level of expertise it right now. I recommend you get professional help/advice to guide you through this process rather than “taking a shot in the dark” or “setting yourself up for a big disappointment”.

Paul King
PMKing Trading LLC
Source: http://www.pmkingtrading.com/

Resistance to Issues

When Jack Schwager visited Ed Seykota to interview him for his book Market Wizards, Jack found that he was the person being interviewed, not Ed. Jack would start to say things and Ed would indicate how the assumptions behind Jack’s questions revealed his psychological issues. As a result, Jack returned to New York with no interview. Instead, he mailed a set of questions to Ed to answer. Again, Ed turned the questions around into Jack’s issues. However, once they’d done this process about five times, the result was one of the best interviews in Market Wizards.

Ed’s approach is full of danger as a teaching tool. Socrates, who was well known for turning questions back on people, which is called the Socratic method of teaching, was poisoned. And Socrates didn’t usually enter into the most dangerous of areas—asking questions about the psychological assumptions behind what people do. Most people don’t want to know their issues. Indeed, they interpret anything designed to get you to look inward as a real threat.

Let me give you an example.

How do I develop a system in which I can be right at least 60% of the time?

Van: You seem to have a fascination with being right?

What do you mean? I just asked a reasonable question can’t you answer it.

Van: What if you could make money being right 40% of the time? Would that be acceptable?

You’re not answering my question. I want to know how to develop a system that’s designed to be right 60% of the time. But I will answer the last question—no I want to be right 60% of the time or better.

Van: I was looking at the assumption under your question. You seem to have a strong need to be right. You’d probably be a much better trader if you didn’t have that need. What would happen if you were wrong? How would you feel if you were wrong?

How can I learn anything? Why are you asking all of these silly questions? I’m not interested in being wrong, I’m interested in being right. Understood? You want to turn everything into a psychological issue. Not everything is psychological. It’s really hard to learn anything from you when you are always throwing out all of this psychological stuff. Can’t you just answer a simple question?

That’s an example of resistance to the issue. Neither of us gets anywhere. But what if the conversation went a little differently?

How do I develop a system in which I can be right at least 60% of the time?

Van: You seem to have a fascination with being right?

Well, I do like to be right, naturally, doesn’t everybody?

Van: Why do you want to be right?

Well, I’ve always worked to do a good job, to get good grades, and be successful. To accomplish that, you have to be right.

Van: Do you? What if you could be right 20% of the time and make huge profits – just because you cut your losses short and let your profits run? If you had eight 1R losses and two 10 R wins, you’d only be right 20% of the time, but you’d be ahead by 12R…that’s pretty good.

I never thought about it that way.

Van: So what if you just accepted losses when you got them, allowing them to be small losses and let your profits run when you have a good trade? Don’t you think that might be a good idea? And you’ll have trouble doing that if you want to be right all the time. For example, if you had nine 1-R gains and one 10R loss, you’d be right 90% of the time and still lose money.

Again, I never thought about it that way.

Van: So why don’t you just play around with the idea that you can be wrong and still be successful. Being right or wrong is a meaningless invention of your mind. Instead, what if you just developed a good system and practiced following it? A loss has nothing to do with being wrong. Instead, a loss has everything to do with following your system and not making a mistake. Doesn’t that put losses in a different framework?

When you start looking at yourself, you’ll find that there are lots of things that come up for you. You’ll start noticing the patterns that you repeat over and over again. And that’s one of the most valuable lessons you could ever learn.

So, let me ask you a simple question: How do you respond when someone turns what you say into a question about your psychological assumptions?

More Examples:

Q: What do you consider good performance in a system? How does my system compare?

Response: Why haven’t you set objectives? Do you have a need to be the best?

Q: I am considering purchasing a system. Does anyone have a recommendation for one that works that allows you to see code?

Response: What you really mean is that you don’t feel comfortable developing your own system. Why not?

Q: Here’s my strategy. What do you think of it?

Response: You appear to need other people’s approval to determine if your strategy is any good. Why? How about testing it to see if meets your objectives?

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Fre-edom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at www.iitm.com.

Worst Case Analysis

Somebody once asked me “if there was only one performance report you could look at to make a decision about a system what would it be?” My first reaction was that this was a silly question. There are lots of factors that must be considered when choosing a trading system. There are countless performance indicators and ratios. Things such as average yearly return, maximum drawdown, Sharpe ratio, margin requirements, robustness, the list is very long. However, there has indeed been one report that I have come to rely on more than any other report. It’s a report that has given me more comfort and confidence as a trader than any other report. In fact, if I knew a system was properly created I could almost use this report alone to make a decision about trading it! So what is this report you ask? It’s called a “Start Trade Report”.

In my opinion, the start trade report gives you the most robust three dimensional view of a system possible. It cuts through so much of the pitfalls in traditional analysis. It even cuts through the nonsense involved in looking at real time performance. You may be thinking “wait a minute, how can you argue with real time performance?” Let me give you an example with one of my systems Synergy. In May of 2003 Synergy initiated a trade in London Copper. The trade became the most successful trade of the year. As of this writing, (March 7th 2004) the trade has profits of over $25,000 per contract. If you were using position sizing you might have had on 2 or 3 (or more) of these contracts. However, had you started a week or even a day after this trade you would have missed it! Therefore, two investors trading the exact same system with the exact same amount of money and the exact same money management rules could have a $25,000 or $50,000 or $75,000 (or more) difference in their account! AND they might have only started one day apart. This can create tremendous confusion because one broker’s real time accounts could be far different than another brokers real time accounts both trading the same system.

This phenomenon can also be used for disingenuous purposes. It’s possible for a systems vendor to cherry picked an optimal historical starting date. He can choose a date right before a huge winner (or series of winners). This can make it look like the system needed very little original starting capital and that the return on invested funds was enormous. Basically you financed trading with your initial winners. However, what if you had started on a different date? What if you had started on a date that was right before a series of losers? You might have needed 2 or 3 or 4 times the starting capital than you would have starting on a different date. Therefore, the return on invested capital would have been much less, or, you might have lost all your investment before making the profits shown.

Even if a broker or vendor shows an average of a number of accounts this can still be a very limited view. They could still cherry pick the 3 or 4 accounts and their different starting dates. Or they could have so few accounts to average from that the data suffers from what statisticians call a small sample size. Basically this means not enough data to draw any valid conclusions.

The worst offender would be if a disingenuous brokerage or vendor was pushing a day trading system because of the high frequency of trades and commissions it generated and then used some cherry picked “real time” accounts to “prove” that it worked.

The point I am basically making is that thee are countless ways that start dates can impact performance both in hypothetical reports and also “actual” real time performances.

You need to have something far more robust.

What’s the answer you ask?

Well, in my opinion it is the start trade report. What the start trade report does is tests a system hundreds or thousands of times over the given period. Each test it starts on a new date that coincides with a date that you could have taken a new trade. If there were 2000 trades over a 10 year period then it will retest the system 2000 times starting on the date of each new trade every time. In addition, it resets the equity back to the original starting amount with each test. This is important because when using position sizing you may skip certain trades in the beginning when the equity is small. It’s not correct to look at the results of trades that you would not have taken. I have sometimes seen brokerage firms report on trades my system made that many of my clients would not have taken based on their account size. For example, a $3,500 losing trade in a system where most clients would have skipped any trades with risk above $2,000. The start trade report knows to skip trades at the right time based on your starting amount. This report can also let you evaluate performance based off of the margin required. What this allows you to do is see ALL the outcomes, instead of just one.

A few things a Start Trade Report can show you are:

1. What percentage of the first 12 months were profitable over 2000 different starting dates?
2. What was the average first year performance when averaged over 2000 different starting dates?
3. How much money did I need in my account if I started on the worst possible date?
4. What was the average account size I needed to trade the system over 2000 different starting periods?
5. What was the average and the most I ever went under my original starting amount? (This is different than maximum drawdown)

The list goes on and on. This report allows you to filter out so much of the garbage seen in typical performance reporting. It filters out so many of the errors in reporting “real time” performance based on a limited sample size or “cherry picked” starting sates and accounts.

Hopefully you can see that this report is invaluable. I honestly don’t know how you could ever trade any system without it. You can see how much comfort and confidence this can build when you have looked at a system in this much detail. When I first started trading for myself this is he report that gave me incredible peace of mind. It was the only report that comforted me when there were drawdowns. It allowed me to know whether or not we were in the normal ranges of the bell curve. It also gave me a very realistic range of outcomes to expect within the first year of trading.

We feel that providing you these reports gives you an incredible edge and builds confidence. You need this confidence when the inevitable drawdown comes. In my own personal case Im able to remain very calm during those times because of these reports. To get a copy of our start trade reports please email us.

Source: www.traderstech.net

Three Dimensions (3D) Trader Personality Quiz

When traders run into emotional difficulties with their trading, they often assume that they have deep, dark, underlying personality conflicts that require therapy. Sometimes this is true, but very often the source of the problems is different. Often there is a mismatch between the method or system that a trader is trading and the trader’s needs and personality. Instead of berating themselves for a lack of “discipline”, traders need to ask whether their challenges in following a methodology might be because the methods aren’t right for them. Finding the proper fit between who you are and how you trade is a big part of finding success in trading.

The following questions are designed to help you assess facets of your personality that are related to the kinds of trading approaches that are likely to work for you. There are no right or wrong answers, and none of the questions are designed to evaluate your emotional stability or mental health. Rather, we are trying to find out your personal style, so that you can match it to your trading style. Each item consists of two statements. Please choose the statement that best describes you:

1a) I often arrive early for appointments and events to make sure I’m not late.

1b) I’m not very time-oriented and often show up late to appointments and events.

2a) When a problem occurs in my trading, I first feel frustrated and vent my feelings either outwardly or at myself.

2b) When a problem occurs in my trading, I first try to focus on what went wrong and what I can do to fix it.

3a) When I go out to eat, I generally go to my favorite restaurants and order my favorite foods.

3b) When I go out to eat, I like to try new and unfamiliar restaurants and foods.

4a) I tend to be detail-oriented and try to get each aspect of a job done as well as I can.

4b) I focus on the big picture instead of details and don’t sweat the small aspects of a job.

5a) If you could hear the thoughts in my head as I’m trading, you’d hear worried or negative thoughts.

5b) If you could hear the thoughts in my head as I’m trading, you’d hear me analyzing the market action.

6a) If I had a choice of car to drive, I would choose one that is comfortable and quiet.

6b) If I had a choice of car to drive, I would choose one that is fast and that handles well.

7a) I would be good at following a diet or exercise program.

7b) I would often cheat on a diet or exercise program.

8a) It is hard for me to shake off setbacks in the market.

8b) I take market setbacks as a cost of doing business.

9a) I like vacations that are peaceful and relaxing.

9b) I like vacations where you see and do a lot of different things.

10a) I get routine maintenance done on my car when it is scheduled.

10b) I don’t follow deadlines for routine maintenance on my car.

11a) Sometimes I feel on top of the world in the market; other times, I’m down or down on myself.

11b) I don’t have many emotional ups or downs in the market.

12a) I would like a job with a stable company that pays a guaranteed salary and benefits, even if I might not get rich.

12b) I would like a job with a startup company that offers me a chance to get rich, even if I might get laid off if things don’t work out.

13a) I try to eat healthy foods and get a good amount of exercise and rest.

13b) I’m very busy and don’t always eat, exercise, and sleep as I should.

14a) I trade by my gut.

14b) I trade with my head.

15a) I avoid arguments and conflict.

15b) I like to argue and hash things out.

Scoring

Items 1, 4, 7, 10, and 13 measure a personality trait called “conscientiousness”. A conscientious person is someone who has a high degree of self-control and perseverance. If you scored mostly a) responses for these items, you are high in conscientiousness. Conscientious traders are good rule-followers, and they often do well trading mechanical systems. Traders who are low in conscientiousness will have difficulty following explicit rules and often trade more discretionarily. Ideally, you want a style of trading that is more structured and detail-oriented if you are more conscientious. Trying to trade in a highly structured manner will only frustrate a trader who is low in conscientiousness. Such a trader would do better with big picture trades that do not require detailed rules and analysis. Similarly, very active trading with rigid loss control will come easier to the conscientious trader; less frequent trades with wider risk parameters will come easier to the trader lower in conscientiousness.

Items 2, 5, 8, 11, and 14 measure a personality trait called “neuroticism”. Neuroticism is the tendency to experience negative emotions. If you scored mostly a) responses for these items, you are relative high in neuroticism. The trader prone to neuroticism tends to experience more emotional interference in his or her trading. Wins can create overconfidence; losses can create fear and hesitation. The trader who is low in neuroticism is more likely to react to trading problems with efforts at problem solving and analysis. He or she will not take wins or losses particularly personally. Neuroticism is a mixed bag when it comes to trading. Often the person who is high in neuroticism is emotionally sensitive and can use this sensitivity to obtain a gut feel for market action. The trader who is low in neuroticism may experience little emotional disruption with trading, but may also be closed off to subtle, intuitive cues when a trade starts to go sour. In my recent experience, I have been surprised at how successful gut traders are often relatively neurotic traders. Very active trading methods are particularly challenging for such traders, as they don’t allow much time for regaining emotional equilibrium after losses. This can lead to cascades of losses and significant drawdowns of equity. It is much easier for the non-neurotic trader to turn losses around, since these are less likely to be tied to self-esteem.

Items 3, 6, 9, 12, and 15 measure a trader’s risk aversion. A risk-averse trader is one who cannot tolerate the possibility of large losses and who would prefer smaller, more frequent wins with controlled losses to larger wins with greater drawdowns. If you scored mostly a) responses for these items, you are a relatively risk-averse trader. Trading with careful stops and money management, and trading smaller time-frames where risk can be controlled with the holding period will come most naturally for the risk-averse trader. The risk-seeking trader is one who enjoys stimulation and challenge. Larger positions and longer holding periods are easier to tolerate for the risk-seeking trader. Very often, the risk-seeking trader will be impulsive in entering trades and will have difficulty trading during periods of boredom (low volatility). The risk-averse trader often experiences difficulty hanging onto winning trades and will cut profits short to avoid reversals. This trader will be challenged during periods of high market volatility. Position sizing is key and often overlooked as a trading variable. Trading too small will bore the risk-seeking trader, who will then lose focus. Trading too large will overwhelm the risk-averse trader, who will also then lose focus.

Ultimately it is the blending of these three dimensions of trader personality and not any one in isolation that is most important in shaping trading outcomes. In my experience, the traders who are most poorly suited to trading are those that are risk seeking and who are low in conscientiousness and high in neuroticism. Such traders often take large gambles on impulse, and very often those impulses are driven by emotional frustrations. An example would be a trader who gets frustrated after a loss and doubles his position size on the next trade just to make the money back quickly.

Conversely, I have seen very few successful traders who were highly risk-averse. The risk-averse trader, particularly who is high in neuroticism, is motivated more by a fear of loss than a desire for gain. This makes it difficult to sustain meaningful position sizes during promising trades. Often such traders berate themselves for being self-defeating or sabotaging, but the reality is that they might be better suited for investing than trading.

If I had to identify an ideal personality pattern for traders, I would say that such a person would be risk-tolerant, low in neuroticism, and high in conscientiousness. Such traders are generally good at following trading rules (entries, exits, money management) and disciplined in their preparation. They don’t take losses personally, which gives them the perseverance to weather losing periods. When they see a good trade, they are comfortable trading in size, so that the average size of their wins exceeds that of their losses.

Finally, let me mention one other important dimension that is related to neuroticism and emotionality. I strongly suspect that cognitive style is just as important as personality style in trading. Some people process information intuitively, relying on gut cues and subtle, non-verbal information. Others process information explicitly, through reasoning and analysis. Both cognitive styles can make traders money in the markets, but it is essential that one’s cognitive style match one’s trading methodology. As one trades shorter and shorter time frames, moving from swinging to scalping, it is less practical to expect explicit analytical routines to guide trading. Very short-term trading is more about pattern recognition than historical research. Conversely, longer-term trades often benefit from modeling and statistical analysis that inform traders where the edge might lie. How traders process information most effectively is a neglected variable in selecting proper time frames to trade.

Brett N. Steenbarger, Ph.D. is Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY. He is also an active trader and writes occasional feature articles on market psychology for MSN’s Money site (www.moneycentral.com). The author of The Psychology of Trading (Wiley; January, 2003), Dr. Steenbarger has published over 50 peer-reviewed articles and book chapters on short-term approaches to behavioral change. His new, co-edited book The Art and Science of Brief Therapy (American Psychiatric Press) is due for publication during the first half of 2004. Many of Dr. Steenbarger’s articles and trading strategies are archived on his website, www.brettsteenbarger.com.