trading psychology probabilities

As an educator working with traders of all levels of ability, I am always struck by how little most traders really concern themselves with the issue of market psychology and their own personal trading psychology. In my opinion, this is the single most significant part of a winning approach and no trader can reach his or her full potential without a sound understanding of market psychology and their own psychology.

For example, I work regularly with traders who have very well-thought out methods of analyzing markets and very carefully select their positions. They have back-tested their approach and have a high degree of confidence in what they uncover with their system—but lack the ability to “pull the trigger” at the best execution spot. They can show me very precisely why a market had potential to move in a particular direction and often have uncovered a significant turning point that may last for weeks in some cases—but they have missed the best point to execute for no other reason than they were afraid of taking the risk at that particular moment. Often, these same traders feel a strong sense of anxiety once they finally take a position or “kick themselves” for missing the perfect place to trade. In the long run, although they have a solid method of finding opportunity, their participation is fraught with emotional turmoil.

What is the problem here?

A lack of personal understanding and acceptance of what trading really is

In my view, the problem is a lack of personal understanding or acceptance about what trading really is and a lack of understanding of underlying market structure. First, there is only so much analysis of the market we can do. There is only so much to learn. Additionally, traders often place too much reliance on study/education/analysis in the first place. Analysis does not produce 100% winning trades no matter who you are or how much you have to invest. This over-confidence in analysis is compounded by the traders own need for confidence when he executes. When working with traders directly, I find that most traders resist the concept of thinking in probabilities; which is all that you can do when working in any traded market. Trading is about probabilities—not certainties.

Because the markets are zero-sum transactions it is not mathematically possible to ever know with certainty that any trade hypothesis is the correct one until later. No matter how you slice it, there will always be orders placed into the market from both sides as long as there will be markets to trade. No matter the current level of price, there will always be a group of traders who feel the price is “too high” or “too low” relative to their individual point of view or the systematic approach they use. In fact, this potential increases with each “new” advance in economic theory, fundamental change, computing power or mathematical hypothesis. The more people think and the more people participate, the potential for something “new” to grab someone’s attention remains. This is why every year there are new methods of analysis, new trading systems based on something never thought of before, and new ways of reading into the fundamentals; none of which improve the net result traders are seeking.

But the fact is—all of this technology and/or change still results in the same thing happening: someone has to decide to place an order. There will always be a certain percentage of them going long/short and someone will be on the other side. Therefore, as this order flow develops and changes, it creates a constantly changing price level for the market. Learning to accept the probabilities in your analysis is the first step in learning to take every signal you get from your system. You will never be 100% correct anyway and you don’t need to be.

Your only need is to get on the right side of the order flow often enough to get a lead on the price change. The rest is discipline to hold your winners and cut your losses. The issue of trusting your analysis/system and maintaining discipline is a purely psychological one—it has very little to do with the markets.

A lack of understanding of underlying market structure

Next, once you have learned to develop the psychology behind thinking in terms of probabilities, you need to adjust your developing market awareness to focus on underlying market structure—not prices. The inherent limitation (some would say failure) behind technical analysis is that it uses price to project and/or predict price. Through various ways of applying algorithms or mathematical variation all technical analysis attempts to “massage” prices in such a way as to provide some clue as to where prices are going next. The reason this can’t be done with any certainty is for the reason mentioned before: the issue of zero-sum transactions. At the simplest level—there must be a buy order matched to a sell order for any transaction to complete. This happens at the last traded price. If those orders are both orders to open a position, one trader is now long at that traded price and the other is short. The issue of why two people can come to equal yet opposite conclusions about any price is an entire different discussion but for now, we are concerned about how prices move from the moment after the execution is done.

After the order was filled only one thing can happen: more buy orders will come in and more sell orders will come in. If the buy orders are larger than the sell orders from that moment on, the market will rise. If the sell orders are larger than the buy orders, the market will fall. There is no way on earth to know if that will happen until it DOES happen. Technical analysis cannot “predict” that nor can you. Your system cannot know for certain if the order flow will come on larger from which side. BUT—and this is a huge “but”—you MIGHT be able to find a reasonably sound reason for a change in the order flow and a reasonable guess as to which price that MIGHT happen at. But there is no way to know for certain. This is why you need to think in terms of probabilities and be concerned with the underlying market structure.

For example, if a market has been in a steady climb for several straight days and each day the highs are higher, the lows are higher and the closes are higher; one thing is certain: the order flow has been dominate on the buy side. If this action represents an “overbought” condition from some form of analysis a system might offer a “sell” signal. If at this point the market corrects, your system is “right” and a winning trade is now on the table. But if your system signals a short—and the market rises—you have a loss. In either case, the analysis did not predict the next price action; that was determined by the order flow and that represents the psychology of the traders involved. Another system might have signaled a “breakout” while another might have signaled “neutral”.

In any case, the system is not the important thing. It is the trader’s discipline that creates the eventual gain or loss in the account. If the trader knows the probability of his approach and a short works, that is one of the winners the system finds. How the trader manages that lead determines his results; not the signal. If the system puts the trader in a loser, it is how fast the trader liquidates that determines his results. If the trader “overrides” his system and takes a trade the system did not call—his results again are determined by his discipline.

The point is for the trader to get beyond the flawed thinking that the trading system is the key to his long-term success. Whatever the issues are that a trader is dealing with, for the most part, they have nothing to do with the market. They have to do with his trust in himself, his willingness to think in terms of probabilities and his commitment to managing his trades no matter how they are found. In the end, the trader himself determines his results; not the market. The market will only do one thing and that is process the orders as traders place them. If you can learn more about what is likely to cause a rush of orders into the market that is certainly an edge. More importantly is to trust your approach and take every signal. After that, your thinking determines how far you go.

Of course, this short discussion cannot offer a quick solution to managing trader psychology or understanding market psychology but hopefully it will give you a start. In my experience, I have found that journaling your trading thoughts and logging your trade results can help provide you a solid foundation to finding clues needed for you to win. Always remember: the market is a machine that processes orders. Nothing more. We as traders participate in that machine and it is how we participate that makes all the difference. The more you study your actions the more you can get knowledge of how you use the machine. In any case, you determine your results.

Jason Alan Jankovsky