The 3 Things Traders Must Work On

​Context
Beginner traders and even many more experienced ones are often not sure “what to do” to improve. Most of the effort is in the eternal quest for “THE system” – something that will give them systematic profits month after month, without big drawdowns. In fact, there are several spheres to work on as a trader and even more generally, as a participant in financial markets. Here are the 3 “categories” to work on and the issues that people forget about in each one in a short post. Psychology impresses me a lot, because many people who COULD trade do not even TRY it, because they have limiting personal beliefs that it’s for others or for geniuses (trust me – it’s not the case at all!), and they don’t think it’s possible, even if they are bright and could fully understand everything. This never ceases to amaze me. Here are a few aspects to work on as a trader. What do you think?

The 3 aspects to improve
Once a beginner is past the initial “hump” of the basics such as placing buy and sell orders, at least understanding the basics of stop placements and risk management, and so on, there is a need to clarify how to proceed in order to embark on a path of long run profitability. The 3 aspects that need constant work are:
 

• Finding systems that work for you
• Always improving your understanding of the market
• Psychology

 
These are the 3 broad categories of things to work on. You can add many other things that will help, but these are pretty obvious. The one thing that the vast majority of traders work on relentlessly is finding a good system… This can indeed take time to fine-tune, but in the end, believe it ot not, it is NOT “rocket science” and it’s not that hard to do. The 2 other aspects are totally ignored, to great cost. Let’s briefly discuss each one in turn.
 
Finding systems that work for you
Finding a system that works for you is important. I say “that works for you” because one system may work for one type and not for the other type of individual. For the system to work, it must 1) be profitable on average, which does NOT mean it must have a 50% or more “success rate” at all – it can be “right” only 30% of the time and be hugely profitable. The thing that matters is that long run profits must comfortably exceed average losses. The other issue is 2) average and max drawdowns, because maybe the system IS “profitable”, but you may not have the courage OR the funds to deal with the drawdowns. Of course a system must also 3) take into account timeframe of charts and open positions, as well as 4) have rules to define stops (hard or mental) and profit targets (hard or dependant on price action and/or indicators), and last but not least 5) entry signals.
 
Complex is not necessarily better, as I have learned by personal experience. In fact, in general simple is better, because there is less variables and conflicting signals in the system. Making things more complicated than it really is only blurs the picture and creates confusion and hesitation. KISS: keep it simple, stupid. I fully adhere to this classic, because it works.
 
Once an OK system has been defined AND back-tested at least visually and even better with back-testing software and tested out of sample (not on the charts you developed it), then you can go ahead and apply the system. Generally speaking, one family of systems will work better in heavily trending markets (e.g. MA crossovers, Fib retracements, etc.) and one family of systems will be better for sideways markets (price action, R/S analysis, retests, bouce-off, breakouts, etc.). I have 2 types of approaches that I use, depending on the existence or not of heavy trends in the H4 and daily charts that are driven by fundamentals.
 
Once a system is found to hold up, it must be applied appropriately, which sometimes causes a perfectly fine system to render poor results, because the individual applying it does not apply it well due to poor psychology or poor understanding of the market, both the fundamentals (global capital flows, major central bank policies, wealth effects, etc) AND the strategic considerations of the market (ATR, stop hunting, news risk and weekend risk, gaps and slippage, etc.).
 
You need a system that it adapted to your personality and lifestyle, which is why each person should find his/her own system.
 
Always improving your understanding of the market
Some people start trading and they stagnate in their understanding of the market out of laziness. This means that the big picture is never totally clear to them and they have fuzzy zones in their understanding of what is going on, which causes problems to adapt to the ever-changing market.
 
You do NOT need to be a pro economist like me to “get it” and I will add that most typical economists are awful traders (if they even try – very rare case, because they think the efficient market hypothesis applies to each individual even if they know it’s a theory of the average trader not beating the market), because they are too academic and theoretical. That said, the best traders are those who get the big picture AND know that trading is about calculated risk in which you tilt the probabilities in your favour by appropriate strategies.
 
Improving your understanding of the market simply means you are able to look at 2 currencies and check out the associated economies of each one and get a clear “macro bias” for each one based on inflation, inflation expectations, growth and trade dynamics, ability to interpret changes in FOREX reserves at the central bank, central bank policies of interest rates and QE, and central bank bias (data dependant, dovish, hawkish), housing and stock wealth effects, herd behaviour, labor market dynamics, credit, bond spreads, oil, and CRB Index movements.
 
It is an initial investment at the start, just like any value-added project, but it becomes as easy as riding a bike after a while and you do it within 15 minutes. Once you are able to interpret these things easily and make all the causal links, things clear up and you see what is happening, thus feeling more on top and having a significant edge.
 
Psychology
THE number one killer of profits, which makes it easy to be above-average, if you really understand this part! Humans are wired to take immediate opportunities of pleasure (profits) and push back pain and live in denial of losses… this makes them unable to exit a losing trade fast enough and makes them cut profits short.
 
These long-standing human reflexes boil down to fear, greed, and impatience. A scarcity mindset makes you set stops too close and take profits too fast. The issue is that upon any entry into a trade, the ex ante (expected) profit is E(profit) = p1(-loss if exit with loss) + p2(profit if exit with profit). ALL trades start with an unknown ending and end with a loss or a profit, big or small. The idea is to tilt probabilities and average profit in your favour by avoiding the emotional/psychological issues that so many traders are plagued with, which pretty much all fall into the 3 problems previously mentioned: fear, greed, and impatience. I would add over-confidence also in the mix.
 
Fear makes you avoid the market altogether or set super tight stop losses, which INCREASE the probability of getting hit (even if your entries are super tight), especially when you factor in stop hunting and the simplistic ways in which many traders set stops. Fear also makes you take profit too fast, by fear of losing the unrealized profit that you currently have in a trade.
 
Greed and over conficence make you see trade opportunities that do not exist, push back profit targets, which turn winning trades into losers, and not set stops and end up in catastrophe.
 
Impatience makes you enter trades that were not yet ready. The “planets are not aligned” and may well have been if you had waited another hour/day/whatever. Learn to sit on your hands and look at the market without doing anything.
 
These issues also cause traders to move stops AWAY from their initial spot… you set it there in the first place because (I hope) that is the price level that tells you that you were clearly wrong. So you are in denial if you move the stop OR you don’t set stops intelligently.
 
All psychological issues related to trading are very powerful unconscious forces that create cognitive bias, denial, avoidance, illusion, excuse-seeking (avoidance of personal responsibility), and all the other poisons of Ego. All these make you spin in a web of confusion, impatience, Holy-Grail-seeking… in a word: bullshit.
 
These in turn make you end up taking bad decisions, which cost you real money, time, energy, and confidence. Read Daniel Kahneman’s “Thinking, Fast and Slow” to improve your trading by understanding the way we think and act, and stop the eternal quest for the perfect system. It will be time well invested – I promise! You will better understand herd behaviour and “flavour of the month” effects in markets, which actually open up profit opportunities for those who can extract themselves from the day-to-day crazyness and see the bigger picture while understanding the power of mass psychology and expectations.
 
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YourPersonalEconomist
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