Mind Over Market Part 4 of 7
The interview starts off with Mark Douglas talking about how believing in a random result affects your expectations.
Douglas: We don’t want to get into trading with the possibility of being disappointed, dissatisfied, or betrayed. A lot of traders feel that way. The problem is, when that potential exists it has the affect of affecting the way that we see market information in detrimental ways.
Mark Douglas is absolutely right. Many traders, including myself when I first started, are afraid to take losses. I always wanted to be right. Every time I would take a loss I would feel the exact emotions above of disappointment, dissatisfaction, and betrayal. I couldn’t believe that the market could cause me such pain. After all, I was expecting my trades to be winners. I had back tested the chart patterns and technical indicators, seen the great trades and charts on the forums, so I thought that I was going to be a winner.
There were some problems with my chart and price pattern analysis that I only discovered at a later point.
William Eckhardt from the book New Market Wizards was asked why he doesn’t use chart patterns in his systems. The answer he gave was:
The human mind was made to create patterns. It will see patterns in random data. A turn-of-the-century statistics book put it this way: ‘Too fine an eye for pattern will find it anywhere.’ In other words, you’re going to see more on the chart than is truly there. Also, we don’t look at data neutrally – that is, when the human eye scans a chart, it doesn’t give all data points equal weight. Instead, it will tend to focus on certain outstanding cases, and we tend to form our opinions on the basis of these special cases. It’s human nature to pick out the stunning successes of a method and to overlook the day-in, day-out losses that grind you down to the bone.
Eventually I didn’t just look at the time the chart patterns worked. I started spending more of my time on when the chart patterns failed – and failed miserably. That is where the order flow light bulbs turn on and the market epiphanies come.
Distorting Market Information
Mark Douglas then proceeds to talk about how traders have pain avoidance mechanisms that affect their perception. The trader who is in a trade that is moving against them, they will a tendency to focus on the information that they believe validates their trade and avoid the information that tells them the market is trending against them.
The way this manifests itself in trading is for example if you are in a long trade and the market has just taken out a low point and posted a huge down day. Instead of the trader focusing on the fact that their pain tolerance point was just hit and they should get out of the market, the trader can focus on the small upward retracements that occur in the market. The trader can just look at and focus on the small green bars, instead of the large red bars. That is for a chartists.
An order flow trader can focus on the small pieces of bullish news that he or she believe support the trade instead of the big bearish news that caused the market to sell off hard.
Which is why becoming an order flow trader, especially global macro and news traders, involves understanding and assigning importance to the information that is going to move the market. Knowledge of market sensitivity is crucial.
People can latch on to all sorts of different market information. The chartists can latch on to their head and shoulders pattern. The technical indicator trader can latch on to their divergence signal. The price pattern trader can latch on to their engulfing pattern at a major support/resistance level. The astrological trader can latch on to the planets aligning in a certain pattern. The order flow trader can latch on to a stop loss and option barrier location.
What is important is that the thing that you latch on to generates order flow and moves the market.
Mark Douglas offers some more words of wisdom:
Regardless of the reason for getting into a trade, if other traders don’t buy into that reason, or if other traders don’t have another reason to want to buy at a price that is worse than yours. You bought the stock at $10, someone is going to want to buy it at $11, buy it at $12, at $13, and not only be able to buy it at 11, 12, 13 and 14, there are going to have to take out all the offers, all the traders who think it is high at 11, 12 and 13. And so, if these people aren’t coming into the market to do that, then whatever reason you thought you had might not be so good. That is why it is critical to pre define your risk before you get into a trade. Professional traders do not think of it any other way because they know it takes other people. My reason might be great, but if someone else isn’t buying into it what different does it make? It doesn’t matter because it is not a winning trade.
This is a very important quote. Professional traders know it takes other people to move the market. They know it takes order flow.
Therefore it stands to reason that your analysis method, your reasons for entering a trade should be as closely linked to what the other traders are thinking about, and more importantly, what their future actions will be.
Why is it important to know what the market is currently thinking? Because if you know what the market is currently thinking, then you can project out future scenarios for what could happen. You can know what shocks to the market can cause order flow to be generated.
I do not go into trading with the expectation that my next trade or next series of trades are a random outcome. I go into trading believing that I will take small losses, but I never believe that my trades have a random outcome, for there are always order flow and liquidity reasons. Most of the time they are identifiable. Some of the before the trade and hence I place a trade. Other times in the middle of a trade, hence the management of trade occurs. Other times after the trade, where it is either a profit or a loss. If it is a profit then you can re affirm whether your analysis caused the market to move. If it is a loss, then you can examine what went wrong. Only on a small number of occasions do I attribute it to some fluke event.
Some more words of wisdom from Mark Douglas:
The pattern shows up first. Then what we have to do is put up our money. Meaning, how much am I willing to risk to find out if it will work. Most traders because they evaluate, because they judge and because they analyze and build a case for the pattern being right, they actually talk themselves out of believing that the risk even exists.