Psychology of Trading

COVERSTORY

2013 I 03 Norman Welz Mr Norman Welz is a trading psychologist at GodmodeTrader and Bestselling author of “Trading Psychology – This Is How Pros Think and Trade“. He has a psychotherapy practice in Hamburg and is a trained trader. Mr Welz coaches beginners and professionals in the fields of applied trading psychology and the craft of trading. He has produced the bettermind coaching program for traders and the CD box set TRADERS TALK. Contact: www.bettermind.de, www.godmode-training.de

Success Begins in the Mind

THE PSYCHOLOGY OF TRADING Those who want to be consistently profitable in trading must not neglect the issue of trading psychology. More often than not, however, that’s exactly what happens because people are often conditioned in such a way that they are hardly interested in selfreflection or have a downright aversion to psychology. The reason is the way society generally treats the issue. To need psychological help still carries the stigma of “being crackers“ or of “belonging in the loony bin.” Aspiring traders are convinced that they can solve any problem arising in trading all by themselves. That‘s why they first look for flaws in the trading system and then fail to realise how much their own mental state causes them to do things that have unintended consequences. To a large extent, the key to any change in behaviour is in the subconscious. After all, that is where a good 95 per cent of all our decisions are triggered. It is also important to incorporate these mental insights and actions into your trading from the outset since it is harder to change one’s customary behaviour than to learn to do the right things from the very first moment. Norman Welz, a Trading Psychology expert, explains how all these things are interrelated and what it takes to improve one’s trading. www.tradersonline-mag.com

5

2013 I 03

Æ

COVERSTORY

Whoever has anything to do with trading cannot help but deal with the issue of psychology. The reason is that humans are emotional beings whose everyday decisions and actions are heavily influenced by their

itself, consequently, it tends to indulge in massive simplification. The explanation is that our brain uses a lot of the energy that we take in nourishment. If we were to consciously process all our impressions, we

Our trading style gets to be a copy of our psyche, as it were. emotions and behavioural imprints emanating mainly from their own subconscious. In trading in particular, you clearly get a sense of these mechanisms and how they massively influence our success and advance us on our way to becoming profitable market players. THE POWER OF THE SUBCONSCIOUS Modern research has shown that human beings unconsciously decide each of their actions about 230 milliseconds prior to their execution. For some it is even up to seven seconds in advance of execution! Certainly, this means that it is the trading doing the driving rather than us driving the trade, so to say, influenced as we are by our many experiences. That is precisely why it is extremely important that we as traders have an exact plan of behaviour to follow while trading the markets and that we routinely implement it in order to guarantee that our activities are carried out accurately. These correlations are usually called discipline. You’ve probably also noticed in your trading that this important capability is more easily said than done. Just making a resolution doesn’t get you anywhere near achieving the desired objective. People need to change their behaviour and do so actively and sustainably! And that‘s hard. ENSLAVED BY YOUR OWN MIND The reason for this is that man is a slave to his mind. He thinks that he is capable of making all his decisions rationally, i.e. consciously. This belief is a grave error and one that leads to a majority of trading mishaps. But what is the root of this evil? The human brain tries to make everything as easy as possible for

would need to eat 24 hours a day in order to be capable of meeting the demand for the energy required to sustain this performance. All the other organs would then be starved of energy. To avoid letting it come to this, most of our perceptions are passed on to the subconscious part of our brain. That, as it were, is the basement of all our experiences and perceptions.

In Figure 1 we see a chart with explanations of where the trader could enter sensible trades. Everything looks very simple and is quickly and logically comprehensible to the viewer. Such representations are shown in many specialist journals, books, webinars, and seminars. What viewers often do not realise is the fact that this apparent clarity includes a deceptive element. It can make our brain believe that trading is quite simple to implement. Let me repeat that – to implement! What is more, such explanations reinforce the impression that the signals shown will lead to success and that we are dealing here with a seemingly successful trade. But the reality in this business is that in some cases 70 per cent of all trades are negative ones. However, what those who are interested get to see is, above all, winning trades, or trades that carry the message,

F1) THE POWER OF THE SUBCONSCIOUS

Many people underestimate the subconscious. By the same token, it is this very part of our brain that most courses of action in trading emanate from. A good 95 per cent of our decisions are made unconsciously. Source: www.fotolia.de

www.tradersonline-mag.com

6

COVERSTORY

2013 I 03

“How to be successful”. So we are constantly dealing with an imbalance between myth and reality! Feel free to have a look in your trading library – the contents of most books promise one formula for success after another. Realism is something else! It‘s as if I‘d send you across a busy thoroughfare and tell you, “You may cross at a green traffic light”, but I had previously swapped the colours green and red. The important thing is that trading psychology starts even before the actual trading activity. It should also not be forgotten that all the impressions gained on this subject make a lasting impression on our brains. That is why advertisements, too, include more than just factually informative text. THE BRAIN IS A MAGIC BOX The fact of the matter is that our brain creates its own reality based on all those representations of profit which are then permanently imprinted. However, that reality often has nothing to do with everyday trading. Our brain concocts its own fairy tale of rapid success based on thought patterns roughly running along these lines: • • • •

Trading is very simple. Using this system, this trader will be consistently profitable. I only need to trade like this and stick to it and I will be successful too. The description matches the reality and everything will happen just like that.

The brain is like a magic box. It invents realities where there aren’t any, which of course is no surprise either. Imagine making sense of a 10,000-piece puzzle in which you are only allowed to combine eight pieces! After all, the human brain cannot remember much more than eight pieces of information at any moment in time, so any result achieved can only be inadequate. However, since the human brain is not satisfied with half-finished meanings, it just makes up the rest itself. And that remainder is usually heavily influenced by

what each individual goes by or what he wants for himself and provides him with a sense of security: “If I do what I see here, then I will be successful, too.” THIS IS WHAT REALLY MATTERS In reality, things are usually quite different! All too often, our experience in real life is that the examples shown no longer seem to work as soon as we apply them ourselves. Of course this may have a variety of reasons. One explanation certainly is the irrational assessment of the situation by the brain. Not to worry, we have no intention of spoiling your joy in this great business, but it is important for you to understand why most market players lose their money in trading. The solution to the problem lies in our mental control centre. More on that shortly.

THE LOGICAL LEVEL The logical level includes: • • • • • • • • •

Understanding market developments Knowing when there is movement entering the market Selecting an appropriate entry Determining monetary risk Establishing an initial stop Calculating a risk/reward ratio (how much you can earn on a trade in relation to the risk of loss) Carefully moving stops when the trade becomes profitable Checking the execution of my trades according to a plan If necessary, pyramiding if the trade is going my way

F2) THIS IS HOW TRADERS ENVISAGE PRICE DEVELOPMENT A set of signals that are clear in hindsight can give a false sense of security, misleading traders into thinking that this pattern will continue. By the same token, there is a danger of counter-trend traders prematurely speculating on falling prices because the market has already “gone far“. What is often forgotten by both sets of traders is that no one had previously known the way these prices were going to develop. However, our brain’s own imprints and desires cause it to imagine a certain price development. Those thoughts that are usually mixed with hopes significantly influence the future entry decisions made by traders. Source: www.tradesignalonline.com

www.tradersonline-mag.com

7

COVERSTORY

2013 I 03

Most neophyte traders are convinced that understanding correlations is enough to enable them to implement decisions successfully. The author himself was absolutely convinced that once he had found the right entry signal he would also trade successfully. Years later and many euros poorer, he realised that this was a fallacy. After three years of hard work and endless frustration, anger and sadness, he ended up trading exactly where he had started out once: at the same signal, but now with the insight and knowledge of what trading was really all about: namely, the ability to permanently trade the right signal taking into account market patterns – regardless of whether the signal makes any money on the current trade. You also need to have the courage to trade the signal again and again, regardless of any current result. To be capable of being successful in the markets we need to have mental strengths that meet trading requirements as much as possible. Only then will lasting success be really possible in the markets at all. WHY THINGS ARE SO DIFFICULT Trading procedures should be carried out without expending a lot of energy and without displaying hardly any emotions. The sensible and logical contexts of a trading procedure must be identified quickly and implemented almost automatically as well as accurately. As you know, thinking costs our brain a lot of energy, which is why it usually makes simple decisions that can quickly be full of sources of errors. That is why intention and action require a razor-thin linkage. Those who make use of this for themselves will become successful traders faster. All the others are like puppets of their shortcomings. They are active without consciously realising that they are, they constantly do the wrong thing and think that their mind will help solve the problem at hand. Except it won’t because it’s incapable of providing enough help! That is why it‘s so damn hard to be successful in the market.

F3A) EVEN SIMPLE THINGS CAN WORK...

Even the most simple set of rules may be profitable – provided you understand the operating procedures and can implement them almost automatically. Source: www.bettermind.de

F3B) ...BUT NOT ALL THE TIME

Once a trade is not going the way you want it to, emotions jeopardise your actions because any uncertainty is perceived by our brain as a disturbing emotion that sometimes causes devastating actions to be triggered. Source: www.bettermind.de

www.tradersonline-mag.com

8

COVERSTORY

2013 I 03

THE TWO SIDES OF THE COIN It is perfectly correct to approach trading from a logical angle as well. Market action needs to be understood, the interaction of the time units, and the knowledge of how prices come about in the first place. But the majority of novice traders approach the subject of trading exclusively from a logical perspective. More often than not, all they need is a recommendation or a mere entry signal to assume that the price is now moving in this or that direction and to risk spending huge amounts of their savings on such a gamble. The author knows this behavioural pattern from his daily work with frustrated, unsuccessful traders. He has found that they are tempted to take such actions because it’s so hard to become a successful trader. But do you seriously believe that a professional trader would behave like that? Or would you want a money manager to try and grow your funds that way? No way! So why on earth do they do it then? After all, nobody is forcing you to want to increase your wealth by way of trading – except you yourself. In trading, many preparations are made at the logical level of our brain. This is completely understandable, given that up to this point in time there are no disturbing factors emanating from the emotional centre. But that could change quickly. Let’s take an example from the definition of monetary risk. When you take your first trade, you only risk, as you promised yourself, 0.5 per cent of your trading account. Three losing trades in a row later, you will then let your sense of fear talk you into risking two per cent this time. Provided your trade is profitable, you would then have quickly recovered your previous losses – a logical conclusion ultimately controlled by your emotions though. And you can easily imagine what mental state we will find ourselves in if this trade goes wrong as well! So there are emotional pitfalls lurking around every corner. That this lack of knowledge or ignorance of the psyche, this crucial determinant, will sooner or later have serious consequences in practice is revealed by the trading results: There is more money being lost

F4) THE NEURAL NETWORK

This is the control centre of our brain. The neural network has about 200 billion brain cells, each of which communicates with some 10,000 other contact points (synapses). Source: www.fotolia.de

than made. In such a scenario, success remains just fortuitous. However, those who are also busy studying the psychological side of trading and are actively working on themselves in addition to their technical expertise, have a chance to achieve constant returns in this business. HUMAN BEINGS PREDOMINANTLY SOLVE PROBLEMS LOGICALLY There is another reason why we humans rely so much on our seemingly logical mind. In the West, logical thinking predominates. We live in a system in which people try to constantly solve their problems on the intellectual level, which apparently works in most cases: Car’s broken down – off to the garage it goes. Faucet is dripping – got to find a plumber. Light’s gone – light bulb needs to be replaced. In trading, though, this simple approach doesn’t work because market activities are strongly influenced by our thoughts and emotions. Everyone knows about

this from personal experience when they change from a demo account to an account with real-value money. Suddenly, the once profitable trading system doesn’t seem so successful any more. The explanation for this is that when trading the market, all our personality traits and life experiences are a constant and unconscious influence on our trading behaviour. Our trading style becomes a copy of our psyche, as it were. And each person is unique. These imprints are additionally misled by selfactivated emotions such as anxiety, which are part of each individual. If a trader experiences moments of disturbance in the form of fear, anger, or frustration (for example, because he was stopped out several times in a row), then he usually looks for the flaw in his setup – i.e. at the logical level. As usual, the trader then turns to his “logic box” and tries to fix the problem by quickly replacing, for example, the old set of rules with a new one or by increasing the monetary risk, all of www.tradersonline-mag.com

9

COVERSTORY

2013 I 03

which is done according to the motto: The old faucet is not working, so I’ll try using another one. But the more traders continue to pursue this approach rashly, the more they will fail. After all, what they forget in doing this, is that while they do alter the set of rules surrounding the circumstances, they fail to change their mindset. And they will continue to do so until they understand that in this case thinking doesn’t get them anywhere. THE NEURAL NETWORK Hidden behind this pattern of behaviour is the power of our control centre in our brain: the neural network, which looks like flying threads in an empty room. In each strand there are data structures that are structured like a motorway with tens of thousands of adjacent lanes consisting of some 200 billion nerve cells. Each of these is connected to another 10,000 other nerve cells via synapses. They store all our skills, our knowledge, and the emotions we have experienced. Also, you can thank this part of your brain for the fact that you can read this text. Neural networks are primarily caused by experience. The more we experience a pulse, the more stable is the neural network associated with it. This virtual hard disk within the brain is influenced most intensely by feelings of great joy and fear. But constant repetition, i.e. habits, are indelibly sealed here. Man is known to be a creature of habit, and he owes this to his neural network.

During the correction phase, the resumption of the trend is to be traded. Constant negative trades cause the trader to increase the monetary risk at the 3rd trade, triggered by the thought, “I want my money back!“ After that, the trader had no courage left for a 4th entry – more the pity! If this trading style is constantly repeated, the brain will store this behaviour as a “good trading opportunity” with grave consequences for the trader’s account and psyche. Source: www.tradesignalonline.com

forget anything! And those novices whose constant incorrect behaviour while trading causes them to burden themselves with unnecessary stress leading to them getting upset, angry and desperate, will be bound to generate negative feelings right down to traumas. It is just such emotions that generate strong imprints in the neural network of our brain that may result in similar actions later. Those who constantly do their trading with strong negative emotions such as fear, downright program their brain to generate further failures. This, in turn, leads to negative loops: being unable to let profits run sensibly, deleting stops or not activating them, realising profits too early, or identifying trading opportunities where there aren’t any. We repeat these same old trading procedures without being aware that we are doing so. And it is an

illusion to think that we can wean ourselves off this bad trading behaviour just by snapping our fingers and following the motto “Once my trading is consistently profitable, I’ll be doing that differently, too.” No, because after constantly repeating those procedures, they have become part of our brain. And changing any ingrained incorrect behaviour is harder and more protracted than practising correct behaviour from the outset. Work actively and constantly on turning a correct idea into a useful action which will then become an unconscious habit – if you do, you can manage to be a successful trader, too. Please look forward to two more articles by Norman Walz which build on this piece coming in the next few issues of TRADERS´. Æ

ANYONE WHO BEHAVES CORRECTLY FROM THE VERY BEGINNING SAVES TIME, NERVES, AND MONEY This is exactly why it is extremely important that at the beginning of your trading career you find out all about the psychological influences on people trading the markets and that you behave as correctly as you can. After all, it is ultimately our sensible behaviour that spells victory or defeat when speculating – and not the much-loved entry signals which neophytes are always interested in – just like the male dog is interested in the neighbour’s bitch in heat. Remember, the brain doesn‘t

F5) A TYPICAL ERROR

www.tradersonline-mag.com

10