CHAPTER 1
THE ROAD TO SUCCESS:
FUNDAMENTAL, TECHNICAL,
OR MENTAL ANALYSIS?
IN THE BEGINNING: FUNDAMENTAL ANALYSIS
Who remembers when fundamental analysis was considered the only real or proper way to make
trading decisions? When I started trading in 1978, technical analysis was used by only a handful of
traders, who were considered by the rest of the market community to be, at the very least, crazy. As
difficult as it is to believe now, it wasn't very long ago when Wall Street and most of the major funds
and financial institutions thought that technical analysis was some form of mystical hocus-pocus.
Now, of course, just the opposite is true. Almost all experienced traders use some form of technical
analysis to help them formulate their trading strategies. Except for some small, isolated pockets in the
academic community, the "purely" fundamental analyst is virtually extinct. What caused this dramatic
shift in perspective? I'm sure it's no surprise to anyone that the answer to this question is very simple:
Money! The problem with making trading decisions from a strictly fundamental perspective is the
inherent difficulty of making money consistently using this approach.
For those of you who may not be familiar with fundamental analysis, let me explain. Fundamental
analysis attempts to take into consideration all the variables that could affect the relative balance or
imbalance between the supply of and the possible demand for any particular stock, commodity, or
financial instrument. Using primarily mathematical models that weigh the significance of a variety of
factors (interest rates, balance sheets, weather patterns, and numerous others), the analyst projects what
the price should be at some point in the future.
The problem with these models is that they rarely, if ever, factor in other traders as variables. People,
expressing their beliefs and expectations about the future, make prices move—not models. The fact that
a model makes a logical and reasonable projection based on all the relevant variables is not of much
value if the traders who are responsible for most of the trading volume are not aware of the model or
don't believe in it.
As a matter of fact, many traders, especially those on the floors of the futures exchanges who have the
ability to move prices very dramatically in one direction or the other, usually don't have the slightest
concept of the fundamental supply and demand factors that are supposed to affect prices. Furthermore,
at any given moment, much of their trading activity is prompted by a response to emotional factors that
are completely outside the parameters of the fundamental model. In other words, the people who trade
(and consequently move prices) don't always act in a rational manner.
Ultimately, the fundamental analyst could find that a prediction about where prices should be at some
point in the future is correct. But in the meantime, price movement could be so volatile that it would be
very difficult, if not impossible, to stay in a trade in order to realize the objective.
THE SHIFT TO TECHNICAL ANALYSIS
Technical analysis has been around for as long as there have been organized markets in the form of
exchanges. But the trading community didn't accept technical analysis as a viable tool for making
money until the late 1970s or early 1980s. Here's what the technical analyst knew that it took the
mainstream market community generations to catch on to.
A finite number of traders participate in the markets on any given day, week, or month. Many of these
traders do the same lands of things over and over in their attempt to make money. In other words,
individuals develop behavior patterns, and a group of individuals, interacting with one another on a
consistent basis, form collective behavior patterns. These behavior patterns are observable and
quantifiable, and they repeat themselves with statistical reliability. Technical analysis is a method that
organizes this collective behavior into identifiable patterns that can give a clear indication of when
there is a greater probability of one thing happening over another. In a sense, technical analysis allows
you to get into the mind of the market to anticipate what's likely to happen next, based on the kind of
patterns the market generated at some previous moment.
As a method for projecting future price movement, technical analysis has turned out to be far superior
to a purely fundamental approach. It keeps the trader focused on what the market is doing now in
relation to what it has done in the past, instead of focusing on what the market should be doing based
solely on what is logical and reasonable as determined by a mathematical model. On the other hand,
fundamental analysis creates what I call a "reality gap" between "what should be" and "what is." The
reality gap makes it extremely difficult to make anything but very long-term predictions that can be
difficult to exploit, even if they are correct.
In contrast, technical analysis not only closes this reality gap, but also makes available to the trader a
virtually unlimited number of possibilities to take advantage of. The technical approach opens up many
more possibilities because it identifies how the same repeatable behavior patterns occur in every time
frame—moment-tomoment, daily, weekly, yearly, and every time span in between. In other words,
technical analysis turns the market into an endless stream of opportunities to enrich oneself.
THE SHIFT TO MENTAL ANALYSIS
If technical analysis works so well, why would more and more of the trading community shift their
focus from technical analysis of the market to mental analysis of themselves, meaning their own
individual trading psychology? To answer this question, you probably don't have to do anything more
than ask yourself why you bought this book. The most likely reason is that you're dissatisfied with the
difference between what you perceive as the unlimited potential to make money and what you end up
with on the bottom line. That's the problem with technical analysis, if you want to call it a problem.
Once you learn to identify patterns and read the market, you find there are limitless opportunities to
make money. But, as I'm sure you already know, there can also be a huge gap between what you
understand about the markets, and your ability to transform that knowledge into consistent profits or a
steadily rising equity curve.
Think about the number of times you've looked at a price chart and said to yourself, "Hmmm, it looks
like the market is going up (or down, as the case may be)," and what you thought was going to happen
actually happened. But you did nothing except watch the market move while you anguished over all the
money you could have made.
There's a big difference between predicting that something will happen in the market (and thinking
about all the money you could have made) and the reality of actually getting into and out of trades. I
call this difference, and others like it, a "psychological gap" that can make trading one of the most
difficult endeavors you could choose to undertake and certainly one of the most mysterious to master.
The big question is: Can trading be mastered? Is it possible to experience trading with the same ease
and simplicity implied when you are only watching the market and thinking about success, as opposed
to actually having to put on and take off trades? Not only is the answer an unequivocal "yes," but that's
also exactly what this book is designed to give you—the insight and understanding you need about
yourself and about the nature of trading. So the result is that actually doing it becomes as easy, simple,
and stress-free as when you are just watching the market and thinking about doing it.
This may seem like a tall order, and to some of you it may even seem impossible. But it's not. There are
people who have mastered the art of trading, who have closed the gap between the possibilities
available and their bottom-line performance. But as you might expect, these winners are relatively few
in number compared with the number of traders who experience varying degrees of frustration, all the
way to extreme exasperation, wondering why they can't create the consistent success they so
desperately desire.
In fact, the differences between these two groups of traders (the consistent winners and everyone else)
are analogous to the differences between the Earth and the moon. The Earth and moon are both
celestial bodies that exist in the same solar system, so they do have something in common. But they are
as different in nature and characteristics as night and day. By the same token, anyone who puts on a
trade can claim to be a trader, but when you compare the characteristics of the handful of consistent
winners with the characteristics of most other traders, you'll find they're also as different as night and
day.
If going to the moon represents consistent success as a trader, we can say that getting to the moon is
possible. The journey is extremely difficult and only a handful of people have made it. From our
perspective here on Earth, the moon is usually visible every night and it seems so close that we could
just reach out and touch it.
Trading successfully feels the same way. On any given day, week, or month, the markets make
available vast amounts of money to anyone who has the capacity to put on a trade. Since the markets
are in constant motion, this money is also constantly flowing, which makes the possibilities for success
greatly magnified and seemingly within your grasp. I use the word "seemingly" to make an important
distinction between the two groups of traders. For those who have learned how to be consistent, or have
broken through what I call the "threshold of consistency,"the money is not only within their grasp; they
can virtually take it at will. I'm sure that some will find this statement shocking or difficult to believe,
but it is true. There are some limitations, but for the most part, money flows into the accounts of these
traders with such ease and effortlessness that it literally boggles most people's minds.
However, for the traders who have not evolved into this select group, the word "seemingly" means
exactly what it implies. It seems as if the consistency or ultimate success they desire is "at hand," or
"within their grasp," just before it slips away or evaporates before their eyes, time and time again. The
only thing about trading that is consistent with this group is emotional pain. Yes, they certainly have
moments of elation, but it is not an exaggeration to say that most of the time they are in a state of fear,
anger, frustration, anxiety, disappointment, betrayal, and regret. So what separates these two groups of
traders? Is it intelligence? Are the consistent winners just plain smarter than everyone else? Do they
work harder? Are they better analysts, or do they have access to better trading systems? Do they
possess inherent personality characteristics that make it easier for them to deal with the intense
pressures of trading?
All of these possibilities sound quite plausible, except when you consider that most of the trading
industry's failures are also some of society's brightest and most accomplished people. The largest group
of consistent losers is composed primarily of doctors, lawyers, engineers, scientists, CEOs, wealthy
retirees, and entrepreneurs.
Furthermore, most of the industry's best market analysts are the worst traders imaginable. Intelligence
and good market analysis can The Road to Success certainly contribute to success, but they are not the
defining factors that separate the consistent winners from everyone else. Well, if it isn't intelligence or
better analysis, then what could it be?
Having worked with some of the best and some of the worst traders in the business, and having helped
some of the worst become some of the best, I can state without a doubt that there are specific reasons
why the best traders consistently out-perform everyone else.
If I had to distill all of the reasons down to one, I would simply say that the best traders think
differently from the rest. I know that doesn't sound very profound, but it does have profound
implications if you consider what it means to think differently.
To one degree or another, all of us think differently from everyone else. We may not always be mindful
of this fact; it seems natural to assume that other people share our perceptions and interpretations of
events. In fact, this assumption continues to seem valid until we find ourselves in a basic, fundamental
disagreement with someone about something we both experienced. Other than our physical features,
the way we think is what makes us unique, probably even more unique than our physical features do.
Let's get back to traders. What is different about die way the best traders think as opposed to how those
who are still struggling think? While the markets can be described as an arena of endless opportunities,
they simultaneously confront the individual with some of the most sustained, adverse psychological
conditions you can expose yourself to. At some point, everyone who trades learns something about the
markets that will indicate when opportunities exist. But learning how to identify an opportunity to buy
or sell does not mean that you have learned to think like a trader.
The defining characteristic that separates the consistent winners from everyone else is this: The winners
have attained a mind-set—aunique set of attitudes—that allows them to remain disciplined, focused,
and, above all, confident in spite of the adverse conditions. As a result, they are no longer susceptible to
the common fears and trading errors that plague everyone else. Everyone who trades ends up learning
something about the markets; very few people who trade ever learn the attitudes that are absolutely
essential to becoming a consistent winner. Just as people can learn to perfect the proper technique for
swinging a golf club or tennis racket, their consistency, or lack of it, will without a doubt come from
their attitude Traders who make it beyond "the threshold of consistency" usually experience a great
deal of pain (both emotional and financial) before they acquire the land of attitude that allows them to
function effectively in the market environment. The rare exceptions are usually those who were born
into successful trading families or who started their trading careers under the guidance of someone who
understood the true nature of trading, and, just as important, knew how to teach it.
Why are emotional pain and financial disaster common among traders? The simple answer is that most
of us weren't fortunate enough to start our trading careers with the proper guidance.
However, the reasons go much deeper than this. I have spent the last seventeen years dissecting the
psychological dynamics behind trading so that I could develop effective methods for teaching the
principles of success. What I've discovered is that trading is chock full of paradoxes and contradictions
in thinking that make it extremely difficult to learn how to be successful. In fact, if I had to choose one
word that encapsulates the nature of trading, it would be "paradox."
(According to the dictionary, a paradox is something that seems to have contradictory qualities or that
is contrary to common belief or what generally makes sense to people.)
Financial and emotional disaster are common among traders because many of the perspectives,
attitudes, and principles that would otherwise make perfect sense and work quite well in our daily lives
have the opposite effect in the trading environment. They just don't work. Not knowing this, most
traders start their careers with a fundamental lack of understanding of what it means to be a trader, the
skills that are involved, and the depth to which those skills need to be developed.
Here is a prime example of what I am talking about: Trading is inherently risky. To my knowledge, no
trade has a guaranteed outcome; therefore, the possibility of being wrong and losing money is always
present. So when you put on a trade, can you consider yourself a risk-taker? Even though this may
sound like a trick question, it is not.
The logical answer to the question is, unequivocally, yes. If I engage in an activity that is inherently
risky, then I must be a risktaker. This is a perfectly reasonable assumption for any trader to make. In
fact, not only do virtually all traders make this assumption, but most traders take pride in thinking of
themselves as risk-takers. The problem is that this assumption couldn't be further from the truth. Of
course, any trader is taking a risk when you put on a trade, but that doesn't mean that you are
correspondingly accepting that risk. In other words, all trades are risky because the outcomes are
probable—not guaranteed. But do most traders really believe they are taking a risk when they put on a
trade? Have they really accepted that the trade has a non-guaranteed, probable outcome? Furthermore,
have they fully accepted the possible consequences?
The answer is, unequivocally, no! Most traders have absolutely no concept of what it means to be a
risk-taker in the way a successful trader thinks about risk. The best traders not only take the risk, they
have also learned to accept and embrace that risk. There is a huge psychological gap between assuming
you are a risk-taker because you put on trades and fully accepting the risks inherent in each trade.
When you fully accept the risks, it will have profound implications on your bottom-line performance.
The best traders can put on a trade without the slightest bit of hesitation or conflict, and just as freely
and without hesitation or conflict, admit it isn't working. They can get out of the trade—even with a
loss—and doing so doesn't resonate the slightest bit of emotional discomfort. In other words, the risks
inherent in trading do not cause the best traders to lose their discipline, focus, or sense of confidence.
If you are unable to trade without the slightest bit of emotional discomfort (specifically, fear), then you
have not learned how to accept the risks inherent in trading. This is a big problem, because to whatever
degree you haven't accepted the risk, is the same degree to which you will avoid the risk. Trying to
avoid something that is unavoidable will have disastrous effects on your ability to trade successfully.
Learning to truly accept the risks in any endeavor can be difficult, but it is extremely difficult for
traders, especially considering what's at stake. What are we generally most afraid of (besides dying or
public speaking)? Certainly, losing money and being wrong both rank close to the top of the list.
Admitting we are wrong and losing money to boot can be extremely painful, and certainly something to
avoid. Yet as traders, we are confronted with these two possibilities virtually every moment we are in a
trade. Now, you might be saying to yourself, "Apart from the fact that it hurts so much, it's natural to
not want to be wrong and lose something; therefore, it's appropriate for me to do whatever I can to
avoid it." I agree with you. But it is also this natural tendency that makes trading (which looks like it
should be easy) extremely difficult.
Trading presents us with a fundamental paradox: How do we remain disciplined, focused, and
confident in the face of constant uncertainty? When you have learned how to "think" like a trader, that's
exactly what you'll be able to do. Learning how to redefine your trading activities in a way that allows
you to completely accept the risk is the key to thinking like a successful trader. Learning to accept the
risk is a trading skill—the most important skill you can learn. Yet it's rare that developing traders focus
any attention or expend any effort to learn it.
When you learn the trading skill of risk acceptance, the market will not be able to generate information
that you define or interpret as painful. If the information the market generates doesn't have the potential
to cause you emotional pain, there's nothing to avoid. It is just information, telling you what the
possibilities are. This is called an objective perspective—one that is not skewed or distorted by what
you are afraid is going to happen or not happen.
I'm sure there isn't one trader reading this book who hasn't gotten into trades too soon—before the
market has actually generated a signal, or too late—long after the market has generated a signal. What
trader hasn't convinced himself not to take a loss and, as a result, had it turn into a bigger one; or got
out of winning trades too soon; or found himself in winning trades but didn't take any profits at all, and
then let the trades turn into losers; or moved stoplosses closer to his entry point, only to get stopped out
and have the market go back in his direction? These are but a few of the many errors traders perpetuate
upon themselves time and time again. These are not market-generated errors. That is, these errors do
not come from the market. The market is neutral, in the sense that it moves and generates information
about itself. Movement and information provide each of us with the opportunity to do something, but
that's all! The markets don't have any power over the unique way in which each of us perceives and
interprets this information, or control of the decisions and actions we take as a result. The errors I
already mentioned and many more are strictly the result of what I call "faulty trading attitudes and
perspectives." Faulty attitudes that foster fear instead of trust and confidence.
I don't think I could put the difference between the consistent winners and everyone else more simply
than this: The best traders aren't afraid. They aren't afraid because they have developed attitudes that
give them the greatest degree of mental flexibility to flow in and out of trades based on what the market
is telling them about the possibilities from its perspective. At the same time, the best traders have
developed attitudes that prevent them from getting reckless. Everyone else is afraid, to some degree or
another. When they're not afraid, they have the tendency to become reckless and to create the kind of
experience for themselves that will cause them to be afraid from that point on.
Ninety-five percent of the trading errors you are likely to make—causing the money to just evaporate
before your eyes—will stem from your attitudes about being wrong, losing money, missing out, and
leaving money on the table. What I call the four primary trading fears.
Now, you may be saying to yourself, "I don't know about this: I've always thought traders should have
a healthy fear of the markets." Again, this is a perfectly logical and reasonable assumption. But when it
comes to trading, your fears will act against you in such a way that you will cause the very thing you
are afraid of to actually happen. If you're afraid of being wrong, your fear will act upon your perception
of market information in a way that will cause you to do something that ends up making you wrong.
When you are fearful, no other possibilities exist. You can't perceive other possibilities or act on them
properly, even if you did manage to perceive them, because fear is immobilizing. Physically, it causes
us to freeze or run. Mentally, it causes us to narrow our focus of attention to the object of our fear. This
means that thoughts about other possibilities, as well as other available information from the market,
get blocked. You won't think about all the rational things you've learned about the market until you are
no longer afraid and the event is over. Then you will think to yourself, "I knew that. Why didn't I think
of it then?" or, "Why couldn't I act on it then?"
It's extremely difficult to perceive that the source of these problems is our own inappropriate attitudes.
That's what makes fear so insidious. Many of the thinking patterns that adversely affect our trading are
a function of the natural ways in which we were brought up to think and see the world. These thinking
patterns are so deeply ingrained that it rarely occurs to us that the source of our trading difficulties is
internal, derived from our state of mind. Indeed, it seems much more natural to see the source of a
problem as external, in the market, because it feels like the market is causing our pain, frustration, and
dissatisfaction.
Obviously these are abstract concepts and certainly not something most traders are going to concern
themselves with. Yet understanding the relationship between beliefs, attitudes, and perception is as
fundamental to trading as learning how to serve is to tennis, or as learning how to swing a club is to
golf. Put another way, understanding and controlling your perception of market information is
important only to the extent that you want to achieve consistent results.
I say this because there is something else about trading that is as true as the statement I just made: You
don't have to know anything about yourself or the markets to put on a winning trade, just as you don't
have to know the proper way to swing a tennis racket or golf club in order to hit a good shot from time
to time. The first time I played golf, I hit several good shots throughout the game even though I hadn't
learned any particular technique; but my score was still over 120 for 18 holes. Obviously, to improve
my overall score, I needed to learn technique. Of course, the same is true for trading. We need
technique to achieve consistency. But what technique? This is truly one of the most perplexing aspects
of learning how to trade effectively. If we aren't aware of, or don't understand, how our beliefs and
attitudes affect our perception of market information, it will seem as if it is the market's behavior that is
causing the lack of consistency. As a result, it would stand to reason that the best way to avoid losses
and become consistent would be to learn more about the markets.
This bit of logic is a trap that almost all traders fall into at some point, and it seems to make perfect
sense. But this approach doesn't work. The market simply offers too many—often conflicting—
variables to consider. Furthermore, there are no limits to the market's behavior. It can do anything at
any moment. As a matter of fact, because every person who trades is a market variable, it can be said
that any single trader can cause virtually anything to happen. This means that no matter how much you
learn about the market's behavior, no matter how brilliant an analyst you become, you will never learn
enough to anticipate every possible way that the market can make you wrong or cause you to lose
money. So if you are afraid of being wrong or losing money, it means you will never learn enough to
compensate for the negative effects these fears will have on your ability to be objective and your ability
to act without hesitation. In other words, you won't be confident in the face of constant uncertainty. The
hard, cold reality of trading is that every trade has an uncertain outcome. Unless you learn to
completely accept the possibility of an uncertain outcome, you will try either consciously or
unconsciously to avoid any possibility you define as painful. In the process, you will subject yourself to
any number of self-generated, costly errors.
Now, I am not suggesting that we don't need some form of market analysis or methodology to define
opportunities and allow us to recognize them; we certainly do. However, market analysis is not the path
to consistent results. It will not solve the trading problems created by lack of confidence, lack of
discipline, or improper focus. When you operate from the assumption that more or better analysis will
create consistency, you will be driven to gather as many market variables as possible into your arsenal
of trading tools. But what happens then? You are still disappointed and betrayed by the markets, time
and again, because of something you didn't see or give enough consideration to. It will feel like you
can't trust the markets; but the reality is, you can't trust yourself.
Confidence and fear are contradictory states of mind that both stem from our beliefs and attitudes. To
be confident, functioning in an environment where you can easily lose more than you intend to risk,
requires absolute trust in yourself. However, you won't be able to achieve that trust until you have
trained your mind to override your natural inclination to think in ways that are counterproductive to
being a consistently successful trader. Learning how to analyze the market's behavior is simply not the
appropriate training. You have two choices: You can try to eliminate risk by learning about as many
market variables as possible. (I call this the black hole nf analv
frustration.) Or you can learn how to redefine your trading activities in such a way that you truly accept
the risk, and you're no longer afraid.
When you've achieved a state of mind where you truly accept the risk, you won't have the potential to
define and interpret market information in painful ways. When you eliminate the potential to define
market information in painful ways, you also eliminate the tendency to rationalize, hesitate, jump the
gun, hope that the market will give you money, or hope that the market will save you from your
inability to cut your losses.
As long as you are susceptible to the lands of errors that are the result of rationalizing, justifying,
hesitating, hoping, and jumping the gun, you will not be able to trust yourself. If you can't trust yourself
to be objective and to always act in your own best interests, achieving consistent results will be next to
impossible. Trying to do something that looks so simple may well be the most exasperating thing you
will ever attempt to do. The irony is that, when you have the appropriate attitude, when you have
acquired a "trader s mind-set" and can remain confident in the face of constant uncertainty, trading will
be as easy and simple as you probably thought it was when you first started out.
So, what is the solution? You will need to learn how to adjust your attitudes and beliefs about trading in
such a way that you can trade without the slightest bit of fear, but at the same time keep a framework in
place that does not allow you to become reckless. That's exactly what this book is designed to teach
you. As you move ahead, I would like you to keep something in mind.
The successful trader that you want to become is a future projection of yourself that you have to grow
into. Growth implies expansion, learning, and creating a new way of expressing yourself. This is true
even if you're already a successful trader and are reading this book to become more successful. Many
of the new ways in which you will learn to express yourself will be in direct conflict with ideas and
beliefs you presently hold about the nature of trading. You may or may not already be aware of some of
these beliefs. In any case, what you currently hold to be true about the nature of trading will argue to
keep things just the way they are, in spite of your frustrations and unsatisfying results.
These internal arguments are natural. My challenge in this book is to help you resolve these arguments
as efficiently as possible. Your willingness to consider that other possibilities exist—possibilities that
you may not be aware of or may not have given enough consideration to—will obviously make the
learning process faster and easier.