Why Trading Well Has Little To Do With Money

Have you ever wondered: what is trading well really all about?

At first glance, the answer is obvious: make money. Everyone involved in financial markets can agree on that much.  In terms of the results from trading, that is totally correct and we are all on the same page.

My question is different: what is it all about to obtain those results? How do we make trade so as to make money?

It’s actually quite trite to say “It’s simple, just make money”. One could conceivably buy  a basket of T- bills and walk away, assuring oneself of a tiny yet positive return. That’s one way to make money. In the end, I think that most traders would not be satisfied with that level of return and they would definitely think that there is more to the whole process. Thus, trading involves taking calculated risks in financial markets in order to make money.

The challenge comes in figuring out the nitty-gritty of what to buy and sell, and when, so as to evaluate properly those calculated risks. In order to make money, one has to gather information and then undertake a series of judgments and decisions, which lead to risk/reward decisions. In other words, what choices does one need to make in the moment in order to realize that goal?

Which brings me to my point: trading is all about making the right decisions in order to make money. Over any kind of timeframe, it is the individual decisions that dictate whether or not we make money. Making good decisions constantly will result in making money—and making better decisions will result in making more money.

Taken in this light, trading assumes a new dimension. In order to become more profitable, we need to turn our whole focus to the decision-making process itself. If we examine how we make individual decisions about buying and selling, then we can improve the actual decision-making process in a way that will lead to more profits. In effect, the profits are just a natural byproduct of successful risk/reward decisions. By fine-tuning the decision-making process, the profits will take care of themselves.

Another illustration: in the financial markets, there is an  over-abundance of information. Thanks to the Internet, everyone can access a wealth of resources for making investment decisions: in-depth financial news from multiple sources, quotes and charts for every market from a host of providers, company information from corporate websites, and analysis from a plethora of gurus and blogs. No one can complain about a lack of information.

Arguably, the biggest challenge is to  extract the most relevant information on what to buy and sell in order to make money because everyone has access to more than enough information to be successful.  What differentiates losers from winners is the type and quality of the decisions they make with that information. Traders should focus more on what they do with the information available to them and how to turn it into profits, instead of looking for that little extra piece of information that probably won’t have any impact.

The ultimate goal of that decision is to enter into a good risk/reward setup, one where the probabilities are in your favor. You can’t expect to make money on every trade, thus as long you keep your bet size reasonable, then the laws of statistical expectation will work out. They key is to have a guess about your possible upside, either because of take-profit orders that you place or because historical patterns suggest that. Against that, set a stop loss that predefines your risk, so you can’t lose more than that.

For some trading systems, it could mean that you expect a 2-to-1 profit/loss on every trade and a win rate around 50%. Or it could mean an average 4-to-1 profit/loss ratio on every trade but a win rate closer to 30%. In any event, both have a positive statistical expectancy and will produce healthy returns over time.

What is decision-making?

I don’t want to throw around complicated terms without defining them accurately. For the purposes of this article, I will define decision-making as the series of steps taken to evaluate inputs, considering them against a certain goal, and then undertaking the appropriate action.

While you probably don’t think about it, we make hundreds, if not thousands of decisions every day. Some are relatively inconsequential, such as which finger to push a button on our phone. Others are quite meaningful, like whether or not we decide to show up to an important meeting. Another crucial distinction: some decisions are taken very consciously while others are taken at an unconscious level—like smoking a cigarette or taking the correct turn while driving home.

Taking a decision consists of three parts: gathering relevant inputs, evaluating them, coming up with possible actions and then taking the most appropriate action. For instance, when deciding what to make for a family dinner, someone would consider the following inputs: what there is available in terms of ingredients; what people like/don’t like to eat; what is healthy; how much time the various options would take to prepare. Then, they would weigh those various factors compared to the goal (making a tasty dinner) and according to the criteria laid out and decide the best course of action. Some criteria may have critical importance—for instance, chicken satay from peanut oil is out of the question if someone has a nut allergy. Others may be less important—if there is not quite enough chili sauce to follow the recipe exactly, then you can still make the dish.

To describe a theoretical model, it would look like this:

 

In short, the decision-making process is a giant filter, first by reducing a plethora of inputs to a much more manageable set of possible decisions, and then guiding somebody towards one or more possible decisions. The same is true of making trading decisions. The key task is to filter the wealth of information into a set of useful inputs, and then to determine appropriate outcomes, and finally, to make the best decision.

Filtering is absolutely necessary just getting rid of the noise and getting to what’s important—a distressed debt investor does not give a hoot about the indicators on a USD/JPY, just as a foreign exchange trader is not interested in a small-cap company’s latest earnings announcement. That way, we are only dealing with the most relevant information for our purposes. Amongst traders, both amateurs and professionals, you often encounter “paralysis by analysis”—whereby they are so overloaded with information that they become unable to take the right action. This is because they have no systematic way of sorting and determining what is most relevant for their ultimate decision.

Once the information has been filtered, then it’s a question of evaluating the relevant inputs relative to some set of criteria to make a decision. You must establish several criteria for a good trade and then evaluate our inputs relative to that. If you trade forex based on technical patterns, then you should define several technical setups, like candlestick patterns; moving average-based signals; or divergences on an oscillator. If one or more of these are present, then you possibly have a trade; if not, then you don’t. While it may sound overly simplistic, this is the core of the idea.

Once you have run through your market criteria, you will know if you have a trade or not. The last part of the process is to evaluate return versus risk. Given your market research, you should know what the potential upside is to a trade. Against, you set a stop loss, in order to limit your risk.

The practical importance of an emphasis on decision-making

While the last part was very theoretical, I want now to show its practical relevance. If you think of trading this way, then there are several immediate and profound benefits. The most notable is that it gives you a blueprint for trading that will help you to get much better.

The first benefit is that it offers you a new perspective on how to play the game. Now, you are going to measure yourself against a new benchmark: how well you make trading decisions. Thus, instead of focusing on short-term results, or beating yourself up about “what could have/should have been”, you are going to decide to trade better. You are going to focus on the process and not on the immediate results.

In his excellent book, One Good Trade, Mike Bellafiore offers a nice synopsis of this concept:

“I am not trying to make money as a trader. My focus is on ‘doing the right thing’. All I can ask for is excellent risk/reward opportunities. And then I execute. Being good at my job requires an obsession to trading fundamentals. Money is just the byproduct of me executing fundamentally solid trades”

The real key is to have firmly set in your mind what constitutes a good trade and then to use that as your guideline. After you have your guidelines in place, you just repeat ad infinitum. As Bellafiore later writes, after laying out his criteria for a good trade,

If they follow all of these tenets in their trading from start to finish, then they have made One Good Trade. And this is what we do. Or certainly try to do. And we do it over and over again. We make One Good Trade, and then One Good Trade, and then One Good Trade.

Thus, by continually staying focused on executing solid risk/reward decisions, your trading will improve as your focus on what really matters—trading well.

Another benefit to this approach is that it mirrors how we actually build skill at an activity. In his excellent book The Talent Code, Daniel Coyle explains how certain coaching methods and circumstances lead to the creation of clusters of talent. The most prominent example is the explosion in Russian tennis players following the breakout performance by Anna Kournikova. One point that the Russian tennis coach emphasizes in her training is the importance of fundamentals—“it looked a ballet class: a choreography of slow, simple, precise motions with an emphasis on tekhnika– technique”.

Such repetitive practice, focused on technique, has one outcome: to build and strengthen the neutral pathways (the myelin tissue) that the brain uses to perform the action. First, the emphasis is on doing it right, correcting the small errors and getting the neural pathway to fire correctly. Next, they repeat it and try it under various circumstances to build automaticity and the flexibility required for different circumstances and skill combinations. To go back to the tennis example: it’s one thing to hit a forehand; then you have to hit a forehand while moving top speed in the middle of the last round of a tournament.

Thus, by focusing on the technique itself, correcting small errors and doing the action correctly, you actually strengthen the neural pathway responsible for the action. The wonderful thing about trading is that as market conditions change over time, as long as you focus on executing your trading systems, then you will build flexibility and robustness.

Poker is in many ways similar to trading: you are risking money on an individual outcome that is governed by probability. The only way to get an edge is to consistently make risk/reward decisions with high statistical expectancy. Anything else, long-term, will result in losing money. David Sklansky writes in his book Theory of Poker, that there is a Fundamental Theorem of Poker:

“Every time you play a hand differently from the way you would have played it if you could see all your opponents’ cards, they gain; and every time you play your hand the same way you would have played it if you could see all their cards, they lose “

An analogue for trading would be that every time you deviate from your trading system and make a lower expectation trade, you have make a mistake.

How to Make Better Decisions

We have discussed how trading is really about making good risk/reward decisions, and how having some decision-making process helps you to improve as a trader. The next obvious point is to figure out how to make better decisions.

  1. Make sure you have a system.

Most traders don’t have a system, at least not one that they consciously follow. There is one caveat: some very experienced traders may have a system that has become automatic for them and thus think that they don’t have a system, when in fact they do. I would suggest that every trader, if he or she makes the effort, can come up with at least a simple rubric to explain what they are doing. A similar situation would be driving—while it may have become a completely unconscious competence, if you sit down and think about it, you could list a few of the important steps that you take in order to drive successfully, like sitting a certain way, holding the wheel a certain way, how you monitor traffic, etc.

Thus, for every trader, you should make an effort to define how you make decisions- what inputs you look at, what criteria you use to weigh them, and how you take action. It can be a simple list or a flow chart. A quick example for a stock trader following the William J O’Neill system: (described in How to Make Money in Stocks):

  1. Evaluate market environment to see if it’s bullish, neutral, or bearish;
  2. Filter the universe to find leading stocks within the strongest sectors
  3. When those stocks’ charts have been basing for a while and demonstrate a breakout:

i.      If the market is bullish, buy

ii.      If the market is neutral, wait for sustained strength before buying

iii.      If the market is bearish, wait until the market acts better

  1. Set your stop at 7-8% below; set a take/profit higher, usually at 20%
  2. Risk no more than 1-2% of your equity on each trade

There you have a simple trading plan. You could expand it by adding more steps or sub-steps, but the basic idea remains the same. This is intended as a guide to your trading, something that you can use to take decisions. Over time, it can be modified and improved to account for things you’ve learned or for changing circumstances.

Do you have a plan to guide your decision-making? Do you have a conscious understanding of what you are doing? And how are you trying to improve it?

  1. Change your record keeping to focus on decisions, not results

I am going to assume that you’re keeping records. They should be as basic as account statements, but hopefully you also have a blotter that keeps track of when you got into positions, why and what you were thinking. With your trading plan in place, the best way to review your records is to go over them and see if you were following this plan with every single trade. If you had a long string of losers, or just a couple disasters, then it’s likely that you deviated from your plan along the way.

One quick way to improve your trading is to change your records to include the steps in your decision-making, and then to market off systematically each step. That way, when you put on a trade, you can be confident that it met all of your criteria. By looking over this in the future, you can also identify if there are any weak or strong spots in your process that are making the difference in your results. If you have friends who are traders as well, this is a great group exercise to go through—keeping each other honest by making sure that each trade was One Good Trade and identifying where each trader can improve in the decision-making process.

One last thing about results—you could just stop tracking P&L entirely for a period of time. While I agree that generating profits is the ultimate goal of the game, the point of stopping tracking it for a while is to remove the short-term focus on results from your thinking. Thus, just make sure that you are getting into the correct trades and getting out at the right time.

I remember when I worked at a large investment bank, there was a trader who suffered a disastrous outtrade and lost his whole year of profits. In order to get out of the hole , his boss advised him to tape a piece of paper where his screen displayed his daily P&L and to delete any emails that arrived showing P&L.

He ended up having his best year ever.

  1. Practice your decision-making skills

As mentioned above, the best athletes are trained to have a solid grounding in technique and then build these skills to the point where they are automatic. If you are just starting out as a trader, or if you are just starting out, then the best way to build your decision-making skills is to narrow your focus.

Thus, instead of trying to become George Soros overnight, you should focus on finding and trading one setup—just one setup. It should be very straightforward and easy to recognize and it should have clear risk/reward characteristics- for instance, a take-profit of 15% and a stop loss of 6%. Trade tiny, miniscule size so that P&L considerations don’t influence you.

If you were trading foreign exchange, one example would be to focus just on one currency pair, e.g. GBP/USD,  and to trade one simple setup: e.g., if the currency pair crosses above its 50 day moving average, buy; if it crosses below, sell. Set take-profit orders of 6% and stop losses of 2%. It may sound basic, but that is the point of the exercise! It’s trading on training wheels.

Then, just follow this currency pair and trade it accordingly. Do not look at your trading results. Just make sure that every time your criteria are met, you put on that One Good Trade. Then manage the risk accordingly. If your criteria are not met, then don’t trade. Review your trades with some regularity to see if, in hindsight, they actually did meet your criteria.

Once you are comfortable that you have mastered it, then scale up. Add more currency pairs. Come up with different setups. Fine-tune your risk/reward parameters. Trade bigger size. With each iteration, you are reinforcing your neural pathways and improving your ability to make more complicated trading decisions—and to stick to your process.

Conclusion

As you no doubt realize, this has been oversimplified for illustrative purposes. Trading at an elite level is much more complicated and intricate than the simple model presented here. Nonetheless, I hope that the point of the exercise is clear. By understanding the decision-making process, from the filtering step all the way to action, you can then evaluate and design a better way of making investment decisions.

A large part of this blog’s emphasis will be on exactly that—understanding better the how of trading. How we make decisions now, how we can make better ones , which tools that we can borrow from other walks of life to improve how we trade.

And naturally, all of this is with the goal of making more money. We are traders after all.

 

 

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