What Are The Consequences Of Believing We Know What Will Happen Next?

Two words answer this question: trading errors. For example, there are three typical errors our hypothetical trader in the illustration in Parts I and II is likely to make. First, he won't pre-define the risk of getting into the trade. In other words, what does the market have to do to tell him this edge isn't working? Every edge derived from a technical pattern has parameters that define how far the market can move against your entry point, to tell you the trade isn't working. Said another way, technical patterns will give you a point where the potential for the trade to work is so diminished in relationship to how much it's going to cost to find out, that it's not worth staying in any longer. The dollar value of the difference between this point and where you get into the trade, is your risk.

Not determining what the risk is before getting into a trade is, by far, the most common trading error committed by all traders. Except, of course, for the very best. But it's also very easy to be susceptible to not doing it. Most traders won't pre-define the risk of getting into a trade, because they won't get into a trade until they've convinced themselves that they're right, or know what's going to happen next. Of course, if they're absolutely right, there is no risk -- making the exercise of deciding what the market would have to do to tell them the trade isn't working, irrelevant. On the other hand, if they're not right, the consequences can be -- and usually are -- disastrous.

This leads us right into the second error our hypothetical trader is likely to commit. He won't be able to get out of the trade if the market doesn't go his way. Most everyone has heard the trading axiom "cut your losses and let your profits run." Well, it can be a little difficult to cut your losses when you get into a trade believing you can't be wrong and that the possibility of a loss doesn't exist. This is where the second inherent characteristic of the way our minds are designed to think comes into play.

Our minds are wired to avoid pain, both physical and emotional. I think everyone understands the underlying nature of avoiding physical pain. If you were to accidentally or unknowingly lay your hand on something very hot, the pain-avoidance mechanisms in your brain will instantaneously cause you to remove your hand from the hot object. You didn't have to think about it, make any decisions, or contemplate your situation. Your response was automatic.

The nature of emotional pain, on the other hand, can be very difficult to understand. All of us experience various forms of emotional pain like fear, disappointment, dissatisfaction, regret, despair or betrayal, but our reasons for experiencing these negatively charged states of mind can be vastly different. For example, to my knowledge, there is no universally accepted definition for betrayal, regret, despair or disappointment. Nor is there a universal standard for what people should be afraid of. Two or more people can be in exactly the same environmental situation, exposed to the same information, and yet each individual's reaction can range all the way from happiness to terror.

What accounts for these differences? To experience emotional pain requires an interpretation of environmental information. How we define and interpret information in any given circumstance or situation is a function of what we believe to be true. Our hypothetical trader will illustrate this point quite nicely.

If you will recall, he is trading the fourth occurrence of his edge. Let's say for the purposes of this example that he got a buy signal, so he bought "XYZ" stock. He is working off of three winning trades in a row and, as a result, is convinced the market will go up. Does the market have the potential to generate any information that he will define and interpret as painful? The answer is unequivocally yes. Any price action against his position will represent not getting what he wants, having to admit that he is wrong, and losing money. All three possibilities could cause him to tap into a huge reservoir of negatively charged emotional energy, for several reasons:

1. Nothing has more potential to cause emotional pain than not getting what we want. Or said another way, there isn't anything that has more potential to cause us to experience emotional pain than an unfulfilled expectation. I am defining an expectation as what we assume we know or believe to be true, projected out into some moment in the future.
   
   To the degree the environment conforms to our mental representation, meaning it either looks, sounds, tastes, smells or feels the way we expect it to, we will experience satisfaction. To the degree that it doesn't, we will feel what we refer to as emotional pain (fear, anger, disappointment, regret, betrayal, etc.). I would say this phenomenon is a universal characteristic of human existence.
   

2. If he has to admit that he is wrong on this trade, it will likely tap him into the accumulated emotional pain of every time he has been wrong in his life. Remember, our minds are wired to associate.
   

3. Having to take a loss will also have the potential to tap him into the accumulated emotional pain of every time he has lost something in his life.

The bottom line is, he has a lot of good reasons to avoid any of these possibilities. And his mind is designed to accommodate him at both a conscious and subconscious level. At the conscious level, he can negate the negative effects of any conflicting information through outright denial, rationalization and justification.

At the subconscious level, his pain-avoidance mechanisms will narrow his focus of attention in a way that actually causes him to experience exactly what he is afraid of, not getting what he wants, being wrong, and losing money.

Here's how the process works: At the most fundamental level, the market has two kinds of information to offer our trader: up tics and down tics. Now, you have to ask yourself, "Are any of these up and down tics positively or negatively charged?" Meaning, does the market generate positively or negatively charged information as an inherent characteristic of the way it exists?

It may seem that way, but there is no charge attached to the up and down tics. They are neutral -- and (in and of themselves) as such, they have no capacity to cause our trader to experience any particular state of mind -- like fear, dissatisfaction, regret, despair or betrayal. In their purest form, the up and down tics only represent the market' potential to move in a particular direction, if some recognizable pattern is present. The only way they can take on the quality of "charged" information, is based on how the information is defined and interpreted.

Since our trader is expecting the market to generate up tics, any down tics are going to represent a confrontation with some degree of emotional pain -- especially if the trade immediately goes against him. And let's say that's exactly what happens. The market trades below his entry point and drifts lower at the rate of three down tics to every one up tic. At this point, every down tic or series of down tics will be defined and interpreted as painful. Whereas, every up tic will be defined and interpreted as relief from pain.

The last thing he wants to do is admit the trade may not be working. So his mind will automatically compensate for the down tics by causing him to place an inordinate amount of significance on the implications of each up tic. Since each up tic is a relief, he naturally interprets one as a "strong, indisputable" indication that the market is coming back. Depending on the degree of pain he needs to shield himself from, his focus of attention will narrow to a point where all he will be able to perceive are the up tics.

But keep in mind that the market is generating both up and down tics, and most of them are down. In fact, if you were to visualize the relationship between the up and down tics, the market is clearly trending against his position. A trending market is the most definitive technical indicator of an imbalance between the traders who believe the price is going up, and those who believe the price is going down. In this illustration, the traders who believe it is going down have the greatest conviction in their belief.

Our trader is experiencing what is commonly referred to as perceptual blindness. A trending market is a distinction about the nature of price movement that he could otherwise perceive quite clearly, if he was in an objective state of mind -- meaning he didn't have the potential to define and interpret the down tics as painful.

As blind as he may be to his predicament, however, there are other forces at work that will eventually get him out of this losing trade. Being wrong is not the only thing our trader wants to avoid. He is also afraid of losing money. As the market moves further and further away from his entry point, his losses are building and his fear of losing is correspondingly getting closer and closer to the forefront of his consciousness. There will come a point where his fear of losing one more dollar is at least one degree greater than his fear of admitting that he's wrong. This is when he will finally get out of this trade. Afterwards, if he happens to look at a chart, he will immediately see the down trend and be mystified as to how he could have stayed in the trade as long as he did.

The third typical error he is likely to commit is in the area of money management. If he's getting into this trade convinced it's a winner, then it will be easy, if not compelling, for him to break his money management rules. That's of course assuming he has any money management rules to break. For example, if he normally puts on a 1000 share position, it will be extremely difficult for him to resist the kind of logic that says, "If I'm right -- and I wouldn't be doing this if I wasn't sure that I am -- why be right for a little, if I can be right for a lot?" In other words, why not cash in?

So instead of doing 1000 shares, he is likely to do five or ten times the normal amount -- whether he can afford it or not. By increasing his size, he has correspondingly magnified the psychological effect of any price movement against his position. Now if the market moves against him by even a little bit, he is susceptible to becoming absolutely paralyzed. The trading community calls this phenomenon "mind freeze."

"Mind freeze" occurs when you go from a state of relative euphoria (where it's virtually impossible to perceive risk), to a state of terror or despair, because the situation you are suddenly confronted with was not possible from your perspective. In a state of "mind freeze," you can be well aware of the fact that you're in a losing trade, but still find yourself paralyzed to do anything about it. It is an understatement to say this is not a very pleasant experience.

Now, depending on what he expects in any given trading situation, the three errors I described above aren't the only ones our trader will be susceptible to. In fact, there are several more but I'm only going to give you one.

Let's expand on the above example and say that instead of the market going against him, it went in his favor as he expected it to. Now he finds himself in a winning trade. In fact, the market is trending in his favor. But he is operating out of a fear of leaving money on the table or the market taking his profits -- meaning he has memories of previous trades where the market went in his favor, but retraced back to his entry point or further, and he didn't get anything out of the trade but anguish. S, instead of placing an inordinate amount of significance on the up tics when the market was going against him, he will now place an inordinate amount of significance on the down tics.

I know this may seem confusing, but think of it like this: In a winning trade, the market is giving him exactly what he wants. But what he wants isn't actually realized until he gets out of the trade and locks in his profits. Otherwise, his profits are subject to market risk, meaning the market can retrace and take those profits away. To shield himself from the pain of having his profits evaporate, he will narrow his focus of attention on to the object of his fear, the down tics. Again he will be perceptually blinded. Only this time, he won't be able to perceive the trend that's working in his favor. Every down tic will cause his fear to build until it reaches a point that compels him to jump out of the trade. Of course, if the market keeps on trending upward, he will be in sheer agony.

Hopefully, you can see that the market did not make our trader wrong, cause him to lose money or get out of his winning trade too soon. Why? Because the market had absolutely no control over his expectations -- or how he perceived the information it generated about itself as a result of those expectations. From the market's perspective, each up and down tic gave him an opportunity to do something on his own behalf. He made himself wrong and caused himself to lose money and profits, because of his inability to think like a trader.

Is There Any Way Out Of This Psychological Morass?

Actually, the solution is relatively simple -- it's just not that easy to implement. Creating consistent results from technical indicators requires that you keep your mind objectively focused in the "now moment" opportunity flow. To keep your mind focused in the "now moment," you have to eliminate your potential to define and interpret market information as painful. To do this, you have to properly manage your expectations by training your mind to think in probabilities.

I know this doesn't sound very simple, but it all boils down to learning to believe that:

1. You don't need to know what's going to happen next to make money
   

2. Anything can happen, and
   

3. Every moment is unique, meaning every edge and every outcome is truly a unique occurrence.

   If you respond to each edge believing that you really don't know what the outcome will be, then what exactly are you expecting from the market?

   You are expecting something to happen. Something means anything, not just one thing. If you truly believe that anything can happen, then what categories of information can the market generate about itself that you will define as painful? None that I can think of. Furthermore, if you believe that each edge is a unique, independent occurrence, there will be nothing for your mind to associate or link the "now moment" opportunity with.

If you keep your mind free of emotional pain, you can then experience trading technical indicators for what it really is -- a simple pattern-recognition numbers game. Playing this game successfully requires mastering five basic steps.

1. Finding an edge and determining if this edge is present.
   

2. Defining your risk in advance of executing the trade -- meaning, what does the market have to do to tell you the edge isn't working?
   

3. Accepting the risk -- meaning, be completely reconciled that you will get out of the trade without any hesitation or reservation if the market doesn’t conform to your criteria.
   

4. Immediately executing the trade.
   

5. Having a specific plan for taking profits.

The trade either works, or it doesn't. In any case, you wait for the next edge to appear and go through the process described above, again and again. At some point, let's say every 20 to 25 trades, it's a good idea to review your results to determine the status of the edge at the macro level. If you find the results satisfactory then take another sample size (20 to 25) of edges. If not, then change the variables that define your edge, in a way that you believe can improve your results.

With this approach, you will learn in a methodical, non-random fashion what works, and what doesn't. And just as important, you will build a sense of self-trust that you won't damage yourself in an environment that has the unlimited qualities of the markets.

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