Trading for a Living helps you discipline your Mind, shows you the Methods for trading the markets, and shows you how to manage Money in your trading accounts so that no string of losses can kick you out of the game. To help you profit even more from the ideas in Trading for a Living, look for the companion volume--Study Guide for Trading for a Living.
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Psychology Trading Tactics
Money Management
By Dr. Alexander Elder.
INTRODUCTION
TRADING-THE LAST FRONTIER
THE ODDS AGAINST YOU
FANTASY VERSUS REALITY
If you hear from a friend with little farming experience that he plans to feed himself with food grown on a quarter-acre plot, you will expect him to go hungry. We all know that one can squeeze only so much blood from a turnip. The one field in which grown-ups let their fantasies soar is trading. Just the other day, a friend told me that he expected to support himself trading his $6000 account. When I tried to show him the futility of his plan, he quickly changed our topic of conversation. He is a bright analyst, but he refuses to see that his intensive farming plan is suicidal. In his desperate effort to succeed, he must take on large positions-and the slightest wiggle of the market is sure to put him out of business. A successful trader is a realist. He knows his abilities and limitations. He sees what is happening in the markets and knows how to react to them.
He analyzes the markets without cutting comers, observes his own reactions, and makes realistic plans. A professional trader cannot afford illusions. Once an amateur takes a few hits and gets a few margin calls, he becomes fearful instead of cocky and starts developing strange ideas about the markets. Losers buy, sell, or miss trades thanks to their fantastic ideas. They act like children who are afraid to pass a cemetery or look under their bed at night because they are afraid of ghosts. The unstructured environment of the market makes it is easy to develop fantasies.
Most people who have grown up in Western civilization have several similar fantasies. They are so widespread that when I studied at the New York Psychoanalytic Institute, there was a course called Universal Fantasies For example, most people have a fantasy in childhood that they were adopted rather than born to their parents. A fantasy seems to explain the unfriendly and impersonal world. It consoles a child but prevents him from seeing reality. Our fantasies influence our behavior, even if we are not consciously aware of them. In talking to hundreds of traders, I keep hearing them express several universal fantasies. They distort reality and stand in the way of trading success. A successful trader must identify his fantasies and get rid of them.
The Brain Myth
Losers who suffer from the brain myth will tell you, I lost because I didn’t know trading secrets Many losers have a fantasy that successful traders have some secret knowledge. This fantasy helps support a lively market in advisory services and ready-made trading systems. A demoralized trader often whips out his checkbook and goes shopping for trading secrets He may send money to a charlatan for a $3000
can’t miss, back tested, computerized trading system. When that self-destructs, he sends another check for a scientific manual that explains how he can stop being a loser and become a true insider and a winner by contemplating the Moon, Saturn, or even Uranus. The losers do not know that trading is intellectually fairly simple. It is less demanding than taking out an appendix, building a bridge, or trying a case in court. Good traders are often shrewd, but few of them are intellectuals. Many have not been to college, and some have even dropped out of high school. Intelligent and hardworking people who have
succeeded in their careers often feel drawn to trading. The average client of a brokerage firm is 50 years old, is married, and has a college education. Many have postgraduate degrees or own their businesses. The two largest professional groups among traders are engineers and farmers. Why do these intelligent and hardworking people fail in trading? What separates winners from losers is neither intelligence nor secrets, and certainly not education.
The Undercapitalization Myth
Many losers think that they would be successful if they could trade a bigger account. All losers get knocked out of the game by a string of losses or a single abysmally bad trade. Often, after the amateur is sold out, the market reverses and moves in the direction he expected. The loser is ready to kick either himself or his broker: Had he survived another week, he might have made a small fortune! Losers take this reversal as a confirmation of their methods. They earn, save, or borrow enough money to open another small account. The story repeats: The loser gets wiped out, the market reverses and proves the loser right, but only too late- he has been sold out again. That’s when the fantasy is born. If only I had a bigger account, I could have stayed in the market a little longer and won.
Some losers raise money from relatives and friends by showing them a paper track record. It seems to prove that they would have won big, if only they had had more money to work with. But if they raise more money, they lose that, too-it is as if the market were laughing at them! A loser is not undercapitalized- his mind is underdeveloped. A loser can destroy a big account almost as quickly as a small one. He overtrades, and his money management is sloppy. He takes risks that are too big, whatever the size of his account. No matter how good his system is, a streak of bad trades is sure to put him out of business. Traders often ask me how much money they need to begin trading. They want to be able to withstand a drawdown, a temporary drop in the account equity. They expect to lose a large amount of money before making any!
They sound like an engineer who plans to build several bridges that collapse before erecting his masterpiece. Would a surgeon plan on killing several patients while becoming an expert at taking out an appendix? A trader who wants to survive and prosper must control his losses. You do that by risking only a tiny fraction of your equity on any single trade (see Chapter 10, Risk Management). Give yourself several years to learn how to trade. Do not start with an account bigger than $20,000, and do not lose more than 2 percent of your equity on any single trade. Learn from cheap mistakes in a small account.
Amateurs neither expect to lose nor are in any way prepared for it. The notion of being undercapitalized is a cop-out that helps them avoid two painful truths: their lack of trading discipline, and their lack of a realistic money management plan. The one advantage of a large trading account is that the price of equipment and services represents a smaller percentage of your money. A manager of a million-dollar fund who spends $10,000 on computers and seminars is only 1 percent behind the game. The same expenditure would represent 50 percent of the equity of a trader with a $20,000 account.
The Autopilot Myth
Imagine that a stranger walks into your driveway and tries to sell you an automatic system for driving your car. Just pay a few hundred dollars for a computer chip, install it in your car, and stop wasting energy on driving, he says. You can take a nap in the drivers seat while the Easy Swing System whisks you to work. You would probably laugh the salesman out of your driveway. But would you laugh if he tried to sell you an automatic trading system? Traders who believe in the autopilot myth think that the pursuit of wealth can be automated. Some try to develop an automatic trading system, while others buy one from the experts. Men who have spent years honing their skills as lawyers, doctors, or businessmen plunk down thousands of dollars for canned competence.
They are driven by greed, laziness, and mathematical illiteracy. Systems used to be written on sheets of paper, but now they usually come on copy-protected diskettes. Some are primitive; others are elaborate, with built-in optimization and money management rules. Many traders spend thousands of dollars searching for magic that will turn a few pages of computer code into an endless stream of money. People who pay for automatic trading systems are like medieval knights who paid alchemists for the secret of turning base metals into gold.
Complex human activities do not lend themselves to automation. Computerized learning systems have not replaced teachers, and programs for doing taxes have not created unemployment among accountants. Most human activities call for an exercise of judgment; machines and systems can help but not replace humans. So many system buyers have been burned that they have formed an organization, Club 3000, named after the price of many systems. If you could buy a successful automatic trading system, you could move to Tahiti and spend the rest of your life in leisure, supported by a stream of checks from your broker. So far, the only people who have made money from trading systems are the system sellers.
They form a small but colorful cottage industry. If their systems worked, why would they sell them?
They could move to Tahiti themselves and cash checks from their brokers! Meanwhile, every system seller has a line. Some say they like programming better than trading. Others claim that they sell their systems only to raise trading capital. Markets always change and defeat automatic trading systems. Yesterday’s rigid rules work poorly today and will probably stop working tomorrow. A competent trader can adjust his methods when he detects trouble. An automatic system is less adaptable and self-destructs. Airlines pay high salaries to pilots despite having autopilots. They do it because humans can handle unforeseen events. When a roof blows off an airliner over the Pacific or when a plane runs out of gas over the Canadian wilderness, only a human can handle such a crisis. These emergencies have been reported in the press, and in each of them experienced pilots managed to land their airliners by improvising. No autopilot can do that.
Betting your money on an automatic system is like betting your life on an autopilot. The first unexpected event will destroy your account. There are good trading systems out there, but they have to be monitored and adjusted using individual judgment. You have to stay on the ball-you cannot abdicate your responsibility for your success to a trading system. Traders who have the autopilot fantasy try to repeat what they felt as infants. Their mothers used to fulfill their needs for food, warmth, and comfort. Now they try to re-create the experience of passively lying on their backs and having profits flow to them like an endless stream of free, warm milk. The market is not your mother. It consists of tough men and women who look for ways to take money away from you instead of pouring milk into your mouth.
The Personality Cult Most people give lip service to their wish for freedom and independence.
When they come under pressure, they change their tune and start looking for strong leadership. Traders in distress often seek directions from assorted gurus. When I was growing up in the former Soviet Union, children were taught that Stalin was our great leader. Later we found out what a monster he had been, but while he was alive, most people enjoyed following the leader. He freed them from the need to think for themselves. Little Stalin’s were installed in every area of society-in economics, biology, architecture, and so on. When I came to the United States and began to trade, I was amazed to see how
many traders were looking for a guru-their little Stalin in the market. The fantasy that someone else can make you rich deserves its own discussion later in this chapter.
Trade with Your Eyes Open
Every winner needs to master three essential components of trading: a sound individual psychology, a logical trading system, and a good money management plan. These essentials are like three legs of a stool-remove one and the stool will fall, .together with the person who sits on it. Losers try to build a stool with only one leg, or two at the most. They usually focus exclusively on trading systems. Your trades must be based on clearly defined rules. You have to analyze your feelings as you trade, to make sure that your decisions are intellectually sound. You have to structure your money management so that no string of losses can kick you out of the game.
MARKET GURUS
Gurus have been with us ever since the public entered markets. In 1841, the classic book on market manias, Extraordinary Popular Delusions and the Madness of Crowds, was published in England. It is still in print today. Its author, Charles Mackay, described the Dutch Tulip Mania, the South Seas Bubble in England, and other mass manias. Human nature changes slowly, and today new mass manias, including gum manias, continue to sweep the markets. Gum manias spring up faster now than they did centuries ago, thanks to modern telecommunications. Even educated and intelligent investors and traders follow market gums, like the devotees of the false Messiahs in the Middle Ages. There are three types of gurus in the financial markets: market cycle gums, magic method gums, and dead gums. Some gums call important market turns. Others promote unique methods9-new highways to riches. Still others have escaped criticism and invited cult following through the simple mechanism of departing this world.
Market Cycle Gurus
For many decades, the U.S. stock market has generally followed a four-year cycle. Significant bear market lows occurred in 1962, 1966, 1970, 1974, 1978, and 1982. The broad stock market has normally spent 2.5 or 3 years going up and 1 or 1.5 years going down. A new market cycle gum emerges in almost every major stock market cycle, once every 4 years. A gums fame tends to last for 2 to 3 years. The reigning period of each guru coincides with a major bull market in the United States. A market cycle gum forecasts all major rallies and declines. Each correct forecast increases his fame and prompts even more people to buy or sell when he issues his next forecast. As more and more people take notice of the gum, his advice becomes a self-fulfilling prophecy. When you recognize a hot new guru, it pays to follow his advice. There are thousands of analysts, some of whom are certain to be on a hot streak at any given time. Most analysts become hot at some point in their careers for the same reason a broken clock shows the right time twice a day. Those who have tasted the joy of being on a hot streak sometimes feel crushed when it ends and they wash out of the market. But there are enough old foxes who enjoy their occasional hot streaks, yet continue working as usual after their hot streak ends.
The success of a market cycle gum depends on more than short-term luck. He has a pet theory about the market. That theory-cycles, volume, Elliott Wave, whatever-is usually developed several years prior to reaching stardom. At first, the market refuses to follow an aspiring gums pet theory. Then the market changes and for several years comes in gear with theory. That is when the star of the market guru rises high and bright above the marketplace. Compare this to what happens to fashion models as public tastes change. One year, blondes are popular, another year, redheads. Suddenly, last year’s blonde star is no longer wanted for the front cover of a major women’s magazine.
Everybody wants a dark model, or a woman with a birthmark on her face. A model does not change- public tastes do. Gurus always come from the fringes of market analysis. They are never establishment analysts. Institutional employees play it safe and never achieve spectacular results because each uses
similar methods. A market cycle guru is an outsider with a unique theory. A guru usually earns a living publishing a newsletter and can grow rich selling his advice. Subscriptions can soar from a few hundred annually to tens of thousands. A recent market cycle guru was reported to have hired three people just to open the envelopes with money pouring into his firm. At investment conferences, a guru is surrounded by a mob of admirers. If you ever find yourself in such a crowd, notice that a guru is seldom
asked questions about his theory. His admirers are content to drink in the sound of his voice.
They brag to their friends about having met him. A guru remains famous for as long as the market behaves according to his theory-usually for less than the duration of one 4-year market cycle. At some point the market changes and starts marching to a different tune. A guru continues to use old methods that worked spectacularly well in the past and rapidly loses his following. When the gurus forecasts stop working, public admiration turns to hatred. It is impossible for a discredited market cycle guru to return to stardom. The reigning guru in the early 1970s was Edson Gould. He based his forecasts on policy changes of the Federal Reserve, as reflected in the discount rate. His famous rule of three steps and a stumble stated that if the Federal Reserve raised the discount rate three times, that showed tightening and led to a bear market.
Lowering the discount rate in three steps revealed a loosening of the monetary policy and led to a bull market. Gould also developed an original charting technique called speediness-shallow trendiness whose angles depended on the velocity of a trend and the depth of market reactions. Gould became very hot during the bear market of 1973-1974. He vaulted to prominence after correctly calling the December 1974 bottom, when the Dow Jones Industrials fell to near 500. The market rocketed higher, Gould presciently identified its important turning points using speediness, and his fame grew. But soon the United States was flooded with liquidity, inflation intensified, and Gould’s methods, developed in a different monetary environment, stopped working. By 1976, he had lost most of his following, and few people today even remember his name. The new market cycle guru emerged in 1978.
Joseph Granville stated that changes in stock market volume preceded changes in prices. He expressed it colorfully: Volume is the steam that makes the chop-chop go Granville developed his theory while working for a major Wall Street brokerage firm. He wrote in his autobiography that the idea came to him while sitting on a toilet contemplating the design of floor tiles. Granville took his idea from the bathroom to the chartroom, but the market refused to follow his forecasts. He went broke, got divorced, and slept on the floor of his friends office. By the late 1970s, the market started to follow Granville’s scripts as never before or since, and people began to take notice.
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