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How To Trade With Discipline & Without Emotion

Psychology, Expectation and Execution...



When it comes to trading psychology and the developing of winning attitudes, there is no better teacher than the market itself, after all, the lessons provided by the market in the past, will help set the right expectation for the future. We only need to look back over the last decade to see some of the market falls, such events can and should be expected in the future. A few of our videos in the past dig deeper into trader psychology, in this video however we look more at the discipline portion.

Several popular books discuss key concepts into trading discipline, and we learn how to apply them to our own trading and investing endeavours.

Author Van Tharp made a great quote through his teachings, when he said:

“A peak performance trader feels totally responsible for whatever happens in the market and can therefore learn from mistakes, these people typically have a working business plan for trading, because they treat trading as a business”.

Once we fully accept that the journey to become a disciplined trader requires treating trading as a business, the journey, and eventual path to success, will become much easier.

Emotional control is arguably one of the main differentiators between being an unsuccessful trader and one that takes a more disciplined route.

So how do we become a less emotional, more disciplined trader?

Mark Douglas, author of the popular book Trading In The Zone and The disciplined Trader, links the many trading challenges to that of a trader’s perception of the market.

The first lesson is to know that the market is always right, only you can be wrong, never the market.

Second, the market does not care about you, it does not care how much money you have won or lost, it has its own rhythm. It is only through experience, trial and error, that you begin to accept that the market has no emotion, only you do.

Remember, the market is an irrational, uncontrollable entity.

Once we have the right perception of the market we can then look inwardly at our own psychology.

There are three aspects to consider:

Identifying opportunity, executing trades, and growing equity.

Each are however hindered by emotional pitfalls, and traders will find it hard to succeed unless these emotions are managed, ensuring they do not interfere with the trading plan.

One of the ways we can address these emotions is to create rules, these rules help us identify opportunities, execute our trades, and manage position size and risk. Such rules take away subjectivity and help our emotions from getting drawn into irrational market behaviour.

Having these rules is however not the complete solution, if we hit a series of losses following our rules, we start to doubt them. Such losses can create irrational blind spots in our cognitive reasoning. The more we are hit by losses the less likely we are to follow the rules, this comes despite knowing the market is itself irrational.

This cycle repeats endlessly until we accept that losses will occur, we must manage them accordingly with solid risk management and allow the market to do its thing. It’s important to note however that rules should not be followed blindly, they must be considered from past performance and analysis that supports the viability of the strategy. It goes without saying that following rules to a flawed or unproven strategy could lead to financial ruin.

Another important aspect discussed in the book is expectation and goal achievement.

Many new traders start with an expectation, maybe targeting $500 per day, or achieving 100% annual returns. Giving too much focus on such targets inhibits the trader from developing a robust process, after all, the returns are simply a by-product of the process. New traders tend to have this in reverse, focusing on returns first and thinking about the process last, an approach I’m strongly against. Focus and energy must always be given to the strategy and process first. A link at the end of the video expanding on trading expectation may be of use.

After completing the study, preparation, and creating the rules and process, we need the discipline to ensure we always stay within that framework. Be as mechanical and as emotionless as you can without focusing on the financial reward.

Psychology is the foundation of all successful disciplined traders, but there are several flawed psychological biases of failing traders which we should understand. None more so than the Gamblers Fallacy, or sometimes referred to as the Monte Carlo Fallacy. Although the myth is linked to gambling the same belief is associated to trading.

Let’s first take the game of roulette.

Imagine a table which has seen the colour of red four times in a row, would you be more inclined to bet black on the next spin?

What if the table had eight spins all seeing red, would you expect black to have more of chance on the next spin?

Well, in both scenarios there is absolutely no reasoning as to why the next spin would be black, or red for that matter. Remember the wheel has no memory, the probability of either colour appearing has not changed. This is why it is called a fallacy, it is a mistaken belief based on unsound arguments.

To date, the longest recorded streak of one colour appearing in roulette happened in 1943, the colour red appeared 32 consecutive times, and with each spin the participants were sure the next colour would be black…

But why is this important in trading? Well, its because although you may have a trading strategy with a positive expectancy, just like a casino, but a losing streak can occur at any time without reason, it does not mean the strategy is flawed. Just like a roll of a dice, or a toss of a coin, a trading candle has no memory.

Mark Douglas summarised these flawed psychological biases by saying:

“When you achieve complete acceptance of the uncertainty of each edge and the uniqueness of each moment, your frustration with trading will end”.

Understanding that losses are an integral part of trading will provide some comfort when your results are not going your way.

Legendary trader Mark Minervini himself says that he builds failure into his system, meaning that he expects his trades to lose 50% of the time, and his other trades to win 50% of the time, albeit his winning trades will be larger than his losses when they occur.

If you step back and really accept that losses are at the core of most successful strategies, the acceptance of their occurrence is far easier to digest. It is the managing of these losses that really makes the difference, if you allow a loss to grow out of control it could make your winning trades less significant. Accept you will have many losses, keep them small, and make them a core focus of your strategy.

Ultimately, embrace the prospect that losses and wins are an inevitability within any strategy, and any outcome is just as likely as the other.

Mark says:

If you can't learn to accept small losses, sooner or later you will take big losses”.

A key factor to becoming a disciplined trader is the merging of expectation with probability, which ultimately provides the foundation for unemotional trading. The ability to accept trading unpredictability in the short term, but equally have faith in the law of large numbers in the longer term, is what separates the professional from the amateur.

You may know the concept of a Bell Curve, the concept plots a distribution of data points and is used as a measure of probability and deviation.

In this example we keep the concept simple. In the middle we have trades with an average return, to the left trades with poor performance and to the right, good performance.

The neutral return is plotted centrally on the chart, and each trade, which remember is a random event, is plotted based on their return.

A trader makes perhaps 10 trades, providing random results.

At first glance, in the short term, the review would suggest a losing strategy or a strategy without positive expectancy. But remember, a statistical edge should only be measured when we have enough meaningful data, not on a micro level with such a small sample size. The predictability is determined by the law of large numbers.

Once we have a large data sample we can then determine if a statistical edge is present. We already knew from the position of the bell curve that the large majority of trades were positive in comparison to the losing trades, this provides some predictability on a macro level, the level at which a Casino bases its model.

Casino’s are aware of the need to pay out infrequent large winnings to the minority, but the positive expectancy built into the game will far outweigh those costs.

A previous video on probability and expectancy helps explain the theory in greater detail.

Leaning on my own trading experience of more than 30 years, I know with certainty that my personal approach will see periods of lacklustre performance, followed by periods of outperformance, but by position sizing and managing risk accordingly, the losses and psychological biases are well anchored. In recent times we have seen a dreadfully volatile period, and most long strategies would have suffered. Myself and many others on the other hand remain unnerved, focused on the process, and well prepared for the longer term market expectation.

Once we understand the probability at a macro level, we can set the expectation, once we have an expectation, we can ignore the random results over the shorter term and stay disciplined to the strategy.

My approach has that long-term macro expectation, I tend to measure it through the R distribution, which is simply the risk taken and the reward achieved.

For example, I know many of my trades will lose up to 1 R, whereas my winning trades are spread from winning 1 R through to winning 10 R, or 10 times my risk.

Having this predefined probability and expectation over a large sample of data, makes it easy for me to be unnerved when I get a series of losses.

Another great quote from the late Mark Douglas said:

“When you really believe that trading is simply a probability game, concepts like right or wrong or win or lose no longer have the same significance.”

In summary, the journey to becoming a successful disciplined trader requires us to accept that the market does not care about us.

We must expect that losses will always come our way, and we should build the management of losses into the core of our strategy.

Stop focusing on the rewards and stay focused on the process.

Understand that anything can happen, a singular trade is unique and has no memory.

Know the longer-term statistics of your strategy, and ensure your expectations are aligned.

As always, thanks for watching, and if you need help staying disciplined, why not join our group of like minded individuals, we share thoughts, insights, scanning software and a set of rules to keep you on the right track.

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