A reader recently sent us an email:

I have been trading since 2007. I first started part-time beside my fulltime job. I developed my own method and I used Excel for developing my edge […] and during these years I worked fulltime and I traded part-time in the evening with daily prices and I did fine. I traded small on the Forex majors and I kept my risk willingly very small. My goal was to develop my edge with the help of the indicators I used and deleted in Excel and so I did.

I didn’t need the money and I used my small profits to buy more study material. Besides developing my trading edge I also kept good records and expanded my trading journal with information. So I knew where my psychological issues were playing a role in my trading. So far so good!

Last year the firm I worked for didn’t need me anymore. Since I am 57 years young now I thought I could pick up my trading for a daily program but my main trading issue comes back to haunt me; it just feels that way. Because of my good record keeping I know that this is my main and only problem:

I CANNOT AND WILL NOT ACCEPT THE RISK I HAVE TO TAKE. It is killing me!  I can’t stand to lose on an individual trade. Although I know I am overall profitable on my series of 25 trades. But emotionally I cannot and will not accept the risk of trading. My original plan was:

  • Learning to trade with 1 Forex micro-contract and accepting the risk 
  • Learning to trade with 3 Forex micro-contracts and learning to take profits
  • Learning to trade Forex and use position-sizing according Van Tharp

[…] Trading stage 1 and 2 was no problem but stage 3 is a disaster for me. And it has nothing to do with my financial situation. I know rationally that accepting the risk is necessary in trading and it is an investment. But somehow it creates a kind of fear in my trading. And for what? I don’t need the money I use and gain or lose in trading for my living. That’s the weird thing.
And now I am back at stage 2 and I have set aside all my objectives I developed for stage 3. Help! – R.S.

Once again Sam & I need to thank R.S. for allowing us to reply in public, hence helping others that are facing the same issues (you know who you are!). It takes courage to ask for help, because it feels like a personal defeat. And yet even Charlie Munger, possibly one of the smartest investors alive, frequently suggests learning through the experiences of others in order to avoid facing the same problems over & over again.

Getting to the bottom of this trader’s issues was not easy. This trader most likely needs to mature on both a personal and technical level. His current issues are most likely a combination of “hating losses”, not fully understanding the market dynamics his system captures, and the lack of a solid trade management vehicle. Together, they create emotional instability:

  • the trader doesn’t have the confidence to replicate the method he himself tested.
  • the trader lacks confidence because he likely doesn’t really understand how the market moves and doesn’t know what to expect.
  • the trader also hates to lose, so he doesn’t give his trades the chance to play out.

 

Get to the Essence

This trader has done, and is doing, a few things right:

  • he does not need to trade for a living and is in a comfortable personal situation. This is important because many psychological issues come from pressure to perform.
  • he has kept good records: this is important because it gave us the possibility to verify what the trader was stating. You would be surprized to realize how many traders actually lie to themselves, or tell themselves stories that just don’t stand up to inspection. So in this case, we were able to verify that the trader put in the hard work, came up with a plan, and had some sort of edge.
  • he started small: once again this was a good move, because it allowed the trader to actually study & develop an edge without pressure or stress. So many people we talk to have thrown thousands of dollars at the markets before even having a viable trading system in place!

So all in all, it seems like the trader is a smart cookie. So where’s the catch? Superficially, it would seem like this trader’s issues are purely linked to the amount he is risking: “stage 3 [i.e. moving from microlots to a 2-25 position sizing method] is a disaster for me”.

But we weren’t convinced. In our experience, traders that obtain consistent results on a simulator usually transition onto the live platform without issues. So we had to dig deeper and amongst other things inquired:

  • How does the issue manifest itself?
  • Would you mind showing us your trading records?

To which the trader replied: […] I feel bad about my recent live trading results.  After all these years I still cannot accept the loss of  3 micro-contract  sized trade. […] I still leave out trades because I am not willing to accept the risk. […] I cannot stand the individual loss; and certainly not 3 or more in a row. As this applies to my main problem that I skip trades because of my issue with not mentally accepting the risk. This issue causes me to not take trades and really often it would have been a profitable trade. But that is in hindsight!

We were finally getting somewhere. The trader has contraddicted himself:

  • in the first email he said “Trading stage 1 and 2 [i.e. using 1 to 3 microlots] was no problem”  when instead he now says “After all these years I still cannot accept the loss of  3 micro-contract  sized trade”. 
  • our suspicions regarding a trading system built in Excel also came to the surface when the trader says “often it would have been a profitable trade […] in hindsight!”  

It was becoming clear that the trader’s issue is not about the size of his trades. There’s something more, that has to do with how he developed his method. He has been using hindsight to evalute his method.

Trading with Hindsight

The trader had shown us his elaborate excel sheets in which he had utilized 3 main technical indicators:

Now it is not our intention to disclose his method. It’s our intention to illustrate the issue of building trading systems with hindsight and indicators. 

First of all, everyone should notice that  most indicators do not capture any other useful market dynamics than a blank chart on it’s own.

The chart above is a Heikinashi chart of EURUSD with Macd and Bollinger Bands. Compare it with the chart below, only with Bollinger Bands, as Sam utilizes them.

There is no material difference in the information you are receiving from the charts. The Euro is trending up, and any indicator will tell you the same thing, which you can also see with your own eyes.

Secondly, building trading systems based on hindsight is futile. Let’s take a simple rule that, in some circumstances, looks profitable: “fade a close outside the bollinger bands”

In the chart above, appartently this strategy is quite good….

…but as soon as the market trends, the strategy shows it’s limitations. And people start adding all kinds of filters (additional conditions) to try and pinpoint the “certain” occurrances that will work. It’s all futile.

It’s true that we do need to analyze in an IF -> THEN kind of way, and  through observation uncover repetitive patterns in the market. But we need to start the whole process by knowing what to look for. What market behaviour are we trying to capture? Why does it exist? Does it make sense? When does it appear most frequently?

If you must use indicators, they should help you “highlight” the behavioural traits you studied and that give you higher ex-ante odds of a higher potential reward than your risk outlay. So go from principles to charts, and not the other way around.

Now this is an important point because we believe that the trader’s issues are also partially anchored in his confidence regarding the ability to actually replicate his successful paper trades on a real account. The trader has not been able to provide us with an account statement showing positive results from the 2010-2015 period, and was only able to provide us with the statement from 2016 onwards, in which there is no trace of an edge.

We do think that by lying the foundations of any trading system in market structure, and not within indicators, is an easier and more profitable road to take.

The Psychological Gap

Now we can confront the psychological gap between the trader’s paper trades, his presumed successful performance in 2010-2015 and his performance in 2016-2017. To note, the trader states that he had utilized his successful method in 2016-2017 also  – but the results in the past 2 years just don’t justify the existence of a successful trading system in the first place!

So we had to ask the trader a few more questions, and here’s what he replied:

The big difference to me is in the period 2010-2015 I still was working and I had no time to follow my open trades of 1 micro contract during the day. And I really didn’t care at that time; I was mentally prepared to test my edge and follow my plan of learning to accept the risk. Which was really small! […] But now I can follow the actual prices all day long and I noticed a difference in my accepting the risk because of the actual losing part of taking the risk. I have had several open positions that I closed with a small loss during the day while in fact they ended the period as winning trades.

Now the picture is quite clear. The trader is self-sabotaging himself. There are a whole bunch of issues here:

  • the trader does not have any reliable way to gauge “good market behaviour” from “bad market behaviour” and the wiggles of the market scare him.
  • the trader does not have a reliable trade management vehicle that can give him peace of mind when making decisions.
  • the trader lacks the discipline to stick to his plan (because, we believe, he implicitly realizes something is missing in his plan)

All of this means that the trader is not in control of his trades. Between 2010 and 2015 he was using a set & forget method which, based on the Excel sheets he sent us, may have an edge on the Eurostoxx 50 but not in FX. This difference can be based on volatility conditions alone (which are much higher in Eurostoxx compared to FX). We believe the trader’s instincts have picked up on this, just that he has yet to accept it: his edge, if it exists, is weak and he is most likely trading noise.

Furthermore, not having a consistent way to manage trades – if not leaving them to either hit the stop loss or hit the target – the trader is only making things worse by interveining at will. 

The Need to Win

In our email exchanges, the trader also voiced his historical battle with the concept of “loss”. Whether it was in sports,  games or else, the trader hated to lose. And this is yet another component of his issues. Since the market is inherently uncertain, there is no “clear way to win”. And when the trader is sitting there in front of the screens, he can’t conjure up a way to “win”. And at the same time, he doesn’t want to lose.

Again, the trader needs to mature. It’s not about winning or losing: it’s about playing the game well, and making sure your wins are larger than your losses. A highly competitive mentality  is damaging, because like gambling in Vegas, the odds are against you. You will lose most of the time, because you can’t win all the time. So every trade/game/competition sets up the potential for humiliation, embarrassment, and demotivation, if the aim is winning.

Let’s put this into perspective. You are teaching your child how to play Chess. Would you let your child win, now & again? If you adopt the same competitive mentality, your child will never win. He will never develop any self-confidence and will most likely abandon the game. Your desire to win would effectively ruin your child’s life.  A healthier approach is to alternate wins & losses, praising what the child did right when he won, and teaching the child what he did wrong when he lost.

It appears to us that the trader doesn’t have this kind of mental maturity. Winning, for him, is an addiction. His focus on winning makes him focus on his trading results for validation of his worth. The focus needs to shift from winning to the satisfaction of success and doing the best you can, showing  emotional maturity and strong personal identity.

The Way Forward

The first thing to do would obviously move back to a “set & forget” stance, which apparently worked during the 2010-2015 period:

  • If, by removing himself from the equation, the trader’s results improve, then we know the system is in fact viable and it’s the trader that needs work. We would suggest working on a trade management vehicle that compliments the objectives for the system. Hopefully, by uncovering key decision points where the market needs to confirm it’s intent, the trader can actually sit at his charts and oversee the system, because he understands what would represent a red flag/poor behaviour. Not being able to tolerate market gyrations is usually cured by reaching an understanding of what the market should do vs. what the warning signs are when the market starts to behave poorly.
  • If even by removing himself from the equation, the trader doesn’t obtain better results, then it’s the system that needs to be revisited. We still have a suspicion that the system needs work, because there is a big difference between the paper trading results on Eurostoxx and FX.
  • Finally, the trader should in any case work on his need for victory. By placing your self-worth on the line, each time you trade, you’re setting yourself up for eternal frustration.

Hopefully by following these steps, the trader can overcome his current problems and start obtaining a healthy alternation of wins & losses that sooths his soul above & beyond his equity curve.

Good Luck!

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.