The most important component of your trader toolkit is Emotional Capitalᵀᴹ or EC for short. That’s all the psychological “mumbo jumbo” that most traders ignore. Patience, discipline, determination, focus, and belief are some of the components of this tool.
Ignore them at your peril.
A parable to drive the point home.
Fred was annoyed.
Trader: What’s up Bud? How are things?
Fred: Great… I just lost money on yet another trade.
Trader: How many losses is that in a row?
Trader: Ouch… In a row?
Trader: Did you lose more on this trade than you planned to risk?
Fred: No. I jumped out because the idea started to go against me. I just couldn’t take another full size loss.
Trader: Did you jump out like that on the previous 10 trades?
Fred: Not all of them.
Trader: How many?
Fred: How many what?
Trader: How many of the 11 trades did you exit before it hit your initial stop loss?
Trader: Okay… X them out. Of the remaining 7, how many were trades that fit your setup?
Fred: What do you mean?
Trader: How many of the trades were impulse trades? I.e., unplanned trades that you just kinda jumped into?
Fred: Oh… 3. No, wait… 4.
Trader: X them out altogether since you should never take Impulse Trades.
Fred: “Never” is a big word.
Trader: And yet…
Fred: Okay… fine. Go on.
Trader: So, the remaining 3 trades were good trade setups that reached your pre-determined stop loss point and were closed out?
Trader: As you look back on the trades, can you see that 8 of those losses have nothing to do with the normal wins and losses of your trading approach?
Fred: I guess… but what’s my problem then?
Trader: We’ll get to that in a sec. 1 more thing about those trades. How did you determine where to place your stop loss?
Fred: I used 3*14 Day ATR (Average True Range) like a lot of books suggest. Is that wrong?
Trader: It’s neither right nor wrong. It’s definitely good to have a clearly defined loss exit point. I prefer to place stop loss orders based on price action and chart structure, but the truth is it really doesn’t matter as long as you size your positions correctly.
Fred: Size my positions?
Trader: Oh dear.
The Most Important Component of Trading
As a trader or would be trader, you spend an inordinate amount of time searching for and/or developing trading strategies. You work incessantly on your approach to the markets… You conduct exhaustive research on stop placement and position sizing… You catalog the infinite number of entry techniques… and you read about every indicator and the settings for said indicators.
To be clear, this is all important work. You should know your approach, strategies, setups and tools cold. You should also understand how each of those things works and the variance that will come with different circumstances.
However, developing your approach and tools to the nth degree will mean bupkus (yes, that’s a technical term) if you haven’t developed your Emotional Capital to the same degree.
What is Emotional Capitalᵀᴹ?
It’s the so called soft stuff. The stuff that “tough” traders don’t like to acknowledge as being part of their makeup. Trading is all about excitement and activity right? Who wants to think that the centered, Zen practitioner is likely a better (i.e., more profitable) trader than the swashbuckling, big balled, type A, alpha?
Alas, that is very much the case. “Big-balled” traders are celebrated because of their ability to “take the pain” of positions being deeply in the red. In reality, these risk be damned traders only seem to have nerves of steel… The truth is it requires very little strength to avoid accepting a loss. You can deceive yourself into perpetuity regarding “paper losses.”
The centered, simple trader knows that true trading greatness is defined by the ability to accept relatively small, relatively quick losses… repeatedly if need be. To manage risk by refusing to accept a large loss… rather than refusing to accept a loss at all.
Emotional Capitalᵀᴹ is the patience to wait all day for the perfect trading opportunity and the decisiveness to enter that trade when the opportunity presents itself.
It’s the discipline to repeatedly take small losses in order to avoid the debilitating effect of a single large loss.
It’s the will to remain in a trade that is working for you as opposed to succumbing to the (sometimes overwhelming) desire take a profit (can’t go broke taking profits right?).
Make no mistake… an abundance and continued development of Emotional Capitalᵀᴹ is the single best determinant of your capacity to succeed as a trader.
An Exercise – The Beginning
Have doubts? Try this exercise.
If you currently trade or have previously traded, go back and review your closed trades. Make a list of the reasons you exited every trade whether it was a winner or a loser. If you already have the habit of keeping notes on your trades, this will be easy, but in the event you haven’t yet made taking notes a habit, try to remember the circumstances of each exit. Yes… it will be hard to remember, but do it anyway.
After you’ve listed the exit reason for every trade, review the list and mark every emotional or mental exit with an M (including any mistakes you made). Mark trades where your trading strategy directed an exit as S. Finally, mark any trades where there was a mechanical glitch that took you out of a trade with an X. Be honest in your assessments. Now put this list aside… we’ll come back to it.
Advice From A “Market Wizard”
Several years ago, I attended a seminar presented by ‘Market Wizard’ and renowned trading coach Dr. Van K. Tharp. The seminar was billed as presenting a step by step guide to becoming a professional trader… All 17 of them. Very early in the class Dr. Tharp made a statement that I called baloney at the time. He said (and I’m paraphrasing) “successful trading is 15% mechanical and 85% mental.”
Now understand… Dr. Tharp is a psychiatrist, so to my mind he was “talking his book” so to speak. It’s not unlike the trading software designer who contends that a monkey could trade profitably with her software. Or my cousin, an erstwhile rapper, who claims that the previously mentioned monkey could set his lyrics to any music and have a hit.
While I disagree with some of Dr. Tharp’s ideas, I was DEAD WRONG about trading being 85% mental. With many years of actual experience under my belt, I can now say with confidence that the ratio is more like 99% mental, 1% mechanical. With all due respect to trading software and hardware vendors, the proverbial monkey could indeed take any of their tools and methods (assuming positive expectancy) and, if they apply the correct mental approach, profit over time.
Like to trade Deep Value? Awesome, just make sure you stick with a very long time horizon and limit your per trade risk appropriately.
Want to play Momentum? Super, tighten your timeframe and make sure you limit your risk appropriately.
Only interested in trading short-term price ranges? No problem, pick a volatile security (or securities), apply Linear Regression Channels (or some other channel technique) and, you guessed it, limit your risk appropriately.
You can pick virtually any internally consistent strategy and profit handsomely by applying a high level of Emotional Capitalᵀᴹ.
Don’t take my word for it… Try it yourself.
An Exercise – The Conclusion
Returning to your list of trade exit reasons, I’d wager that the majority of your exits were driven by emotional motivations as opposed to trading strategy or logic. I suspect your list includes some or all of the following:
- closed trade because it went against you by a pre-determined amount or it reached profit objective (I bet this is the least often used reason);
- had several previous losses and the current trade was profitable, so jumped out to be “prudent” (generally security went further in your direction without you)… This is from the silly ‘can’t go broke taking a profit’ myth;
- exited because shouldn’t have been in the trade in the first place;
- anticipated adverse movement from news;
- increased security or market volatility scared you into exiting;
- an analyst comment/recommendation scared you into exiting;
- a “talking head” (i.e., CNBC) comment scared you into exiting;
- not necessarily a bad trade, but position too big, so exited.
This list is, by no means, exhaustive, but just these reasons alone probably had a pretty deleterious impact on your performance. Add in a few imprudent entries (based on negative EC) and suddenly an account that should have been a profit generating machine is in the red.
What You Can Do
Whether you’re embarking on the path to learn how to trade for the first time or you’re recommitting to becoming a consistently profitable trader, devote a significant amount of time to strengthening your Emotional Capitalᵀᴹ base. In fact, commit most of your time to increasing your Emotional Capitalᵀᴹ.
Make a habit of exercising patience and discipline where appropriate. Figure out what “centers” you (exercise, yoga, meditation, religious worship, etc.) and increase your participation. Doing so will have a more positive impact on your performance than virtually anything else you can do. Literally, anything else.
Hope it helps.
Image Credit: 16th Century German Trader found in Bing Free To Use Images