CHAPTER 7
THE TRADER'S EDGE: THINKING IN PROBABILITIES
Exactly what does it mean to think in probabilities, and why is it so essential to one's consistent success
as a trader? If you take a moment and analyze the last sentence, you will notice that I made consistency
a function of probabilities. It sounds like a contradiction: How can someone produce consistent results
from an event that has an uncertain probabilistic outcome? To answer this question, all we have to do is
look to the gambling industry. Corporations spend vast amounts of money, in the hundreds of millions,
if not billions, of dollars, on elaborate hotels to attract people to their casinos.
If you've been to Las Vegas you know exactly what I am talking about. Gaming corporations are just
like other corporations, in that they have to justify how they allocate their assets to a board of directors
and ultimately to their stockholders. How do you suppose they justify spending vast sums of money on
elaborate hotels and casinos, whose primary function is to generate revenue from an event that has a
purely random outcome?
PROBABILITIES PARADOX: RANDOM OUTCOME, CONSISTENT RESULTS
Here's an interesting paradox. Casinos make consistent profits day after day and year after year,
facilitating an event that has a purely random outcome. At the same time, most traders believe that the
outcome of the market's behavior is not random, yet can't seem to produce consistent profits. Shouldn't
a consistent, nonrandom outcome produce consistent results, and a random outcome produce random,
inconsistent results? What casino owners, experienced gamblers, and the best traders understand that
the typical trader finds difficult to grasp is: even that have probable outcomes can produce consistent
results, if you can get the odds in your favor and there is a large enough sample size. The best traders
treat trading like a numbers game, similar to the way in which casinos and professional gamblers
approach gambling. To illustrate, let's look at the game of blackjack. In blackjack, the casinos have
approximately a 4.5-percent edge over the player, based on the rules they require players to adhere to.
This means that, over a large enough sample size (number of hands played), the casino will generate
net profits of four and a half cents on every dollar wagered on the game. This average of four and a half
cents takes into account all the players who walked away big winners (including all winning streaks),
all the players who walked away big losers, and everybody in between. At the end of the day, week,
month, or year, the casino always ends up with approximately 4.5 percent of the total amount wagered.
That 4.5 percent might not sound like a lot, but let's put it in perspective. Suppose a total of $100
million dollars is wagered collectively at all of a casino's blackjack tables over the course of a year. The
casino will net $4.5 million. What casino owners and professional gamblers understand about the
nature of probabilities is that each individual hand played is statistically independent of every other
hand. This means that each individual hand is a unique event, where the outcome is random relative to
the last hand played or the next hand played. If you focus on each hand individually, there will be a
random, unpredictable distribution between winning and losing hands. But on a collective basis, just
the opposite is true. If a large enough number of hands is played, patterns will emerge that produce a
consistent, predictable, and statistically reliable outcome.
Here's what makes thinking in probabilities so difficult. It requires two layers of beliefs that on the
surface seem to contradict each other. We'll call the first layer the micro level. At this level, you have
to believe in the uncertainty and unpredictability of each individual hand. You know the truth of this
uncertainty, because there are always a number of unknown variables affecting the consistency of the
deck that each new hand is drawn from. For example, you can't know in advance how any of the other
participants will decide to play their hands, since they can either take or decline additional cards. Any
variables acting on the consistency of the deck that can't be controlled or known in advance will make
the outcome of any particular hand both uncertain and random (statistically independent) in
relationship to any other hand. The second layer is the macro level. At this level, you have to believe
that the outcome over a series of hands played is relatively certain and predictable. The degree of
certainty is based on the fixed or constant variables that are known in advance and specifically
designed to give an advantage (edge) to one side or the other.
The constant variables I am referring to are the rules of the game. So, even though you don't or couldn't
know in advance (unless you are psychic) the sequence of wins to losses, you can be relatively certain
that if enough hands are played, whoever has the edge will end up with more wins than losses. The
degree of certainty is a function of how good the edge is. It's the ability to believe in the
unpredictability of the game at the micro level and simultaneously believe in the predictability of the
game at the macro level that makes the casino and the professional gambler effective and successful at
what they do. Their belief in the uniqueness of each hand prevents them from engaging in the pointless
endeavor of trying to predict the outcome of each individual hand. They have learned and completely
accepted the fact that they don't know what's going to happen next. More important, they don't need to
know in order to make money consistently.
Because they don't have to know what's going to happen next, they don't place any special significance,
emotional or otherwise, on each individual hand, spin of the wheel, or roll of the dice. In other words,
they're not encumbered by unrealistic expectations about what is going to happen, nor are their egos
involved in a way that makes them have to be right. As a result, it's easier to stay focused on keeping
the odds in their favor and executing flawlessly, which in turn makes them less susceptible to making
costly mistakes.
They stay relaxed because they are committed and willing to let the probabilities (their edges) play
themselves out, all the while knowing that if their edges are good enough and the sample sizes are big
enough, they will come out net winners. The best traders use the same thinking strategy as the casino
and professional gambler. Not only does it work to their benefit, but the underlying dynamics
supporting the need for such a strategy are exactly the same in trading as they are in gambling.
A simple comparison between the two will demonstrate this quite clearly. First, the trader, the gambler,
and the casino are all dealing with both known and unknown variables that affect the outcome of each
trade or gambling event. In gambling, the known variables are the rules of the game. In trading, the
known variables (from each individual trader's perspective) are the results of their market analysis.
Market analysis finds behavior patterns in the collective actions of everyone participating in a market.
We know that individuals will act the same way under similar situations and circumstances, over and
over again, producing observable patterns of behavior. By the same token, groups of individuals
interacting with one another, day after day, week after week, also produce behavior patterns that repeat
themselves. These collective behavior patterns can be discovered and sub- «pnii<=-nflv identified bv
nsinf analvtical tools such as trend lines, moving averages, oscillators, or retracements, just to name a
few of the thousands that are available to any trader. Each analytical tool uses a set of criteria to define
the boundaries of each behavior pattern identified. The set of criteria and the boundaries identified are
the trader's known market variables.
They are to the individual trader what the rules of the game are to the casino and gambler. By this I
mean, the trader's analytical tools are the known variables that put the odds of success (the edge) for
any given trade in the trader's favor, in the same way that the rules of the game put the odds of success
in favor of the casino. Second, we know that in gambling a number of unknown variables act on the
outcome of each game. In blackjack, the unknowns are the shuffling of the deck and how the players
choose to play their hands. In craps, it's how the dice are thrown. And in roulette, it's the amount of
force applied to spin the wheel. All these unknown variables act as forces on the outcome of each
individual event, in a way that causes each event to be statistically independent of any other individual
event, thereby creating a random distribution between wins and losses. Trading also involves a number
of unknown variables that act on the outcome of any particular behavior pattern a trader may identify
and use as his edge. In trading, the unknown variables are all other traders who have the potential to
come into the market to put on or take off a trade.
Each trade contributes to the market's position at any given moment, which means that each trader,
acting on a belief about what is high and what is low, contributes to the collective behavior pattern that
is displayed at that moment. If there is a recognizable pattern, and if the variables used to define that
pattern conform to a particular trader's definition of an edge, then we can say that the market is offering
the trader an opportunity to buy low or sell high, based on the trader's definition. Suppose the trader
seizes the opportunity to take advantage of his edge and puts on a trade. What factors will determine
whether the market unfolds in the direction of his edge or against it? The answer is: the behavior of
other traders!
At the moment he puts a trade on, and for as long as he chooses to stay in that trade, other traders will
be participating in that market. They will be acting on their beliefs about what is high and what is low.
At any given moment, some percentage of other traders will contribute to an outcome favorable to our
traders edge, and the participation of some percentage of traders will negate his edge. There's no way to
know in advance how everyone else is going to behave and how their behavior will affect his trade, so
the outcome of the trade is uncertain.
The fact is, the outcome of every (legal) trade that anyone decides to make is affected in some way by
the subsequent behavior of other traders participating in that market, making the outcome of all trades
uncertain. Since all trades have an uncertain outcome, then like gambling, each trade has to be
statistically independent of the next trade, the last trade, or any trades in the future, even though the
trader may use the same set of known variables to identify his edge for each trade. Furthermore, if the
outcome of each individual trade is statistically independent of every other trade, there must also be a
random distribution between wins and losses in any given string or set of trades, even though the odds
of success for each individual trade may be in the traders favor.
Third, casino owners don't try to predict or know in advance the outcome of each individual event.
Aside from the fact that it would be extremely difficult, given all the unknown variables operating in
each game, it isn't necessary to create consistent results. Casino operators have learned that all they
have to do is keep the odds in their favor and have a large enough sample size of events so that their
edges have ample opportunity to work.
TRADING IN THE MOMENT
Traders who have learned to think in probabilities approach the markets from virtually the same
perspective. At the micro level, they believe that each trade or edge is unique. What they understand
about the nature of trading is that at any given moment, the market may look exactly the same on a
chart as it did at some previous moment; and the geometric measurements and mathematical
calculations used to determine each edge can be exactly the same from one edge to the next; but the
actual consistency of the market itself from one moment to the next is never the same.
For any particular pattern to be exactly the same now as it was in some previous moment would require
that every trader who participated in that previous moment be present. What's more, each of them
would also have to interact with one another in exactly the same way over some period of time to
produce the exact same outcome to whatever pattern was being observed. The odds of that happening
are nonexistent. It is extremely important that you understand this phenomenon because the
psychological implications for your trading couldn't be more important.
We can use all the various tools to analyze the market's behavior and find the patterns that represent the
best edges, and from an analytical perspective, these patterns can appear to be precisely the same in
eveiy respect, both mathematically and visually. But, if the consistency of the group of traders who are
creating the pattern "now" is different by even one person from the group that created the pattern in the
past, then the outcome of the current pattern has the potential to be different from the past pattern. (The
example of the analyst and chairman illustrates this point quite well.) It takes only one trader,
somewhere in the world, with a different belief about the future to change the outcome of any particular
market pattern and negate the edge that pattern represents. The most fundamental characteristic of the
market's behavior is that each "now moment" market situation, each "now moment" behavior pattern,
and each "now moment" edge is always a unique occurrence with its own outcome, independent of all
others. Uniqueness implies that anything can happen, either what we know (expect or anticipate), or
what we don't know (or can't know, unless we had extraordinary perceptual abilities). A constant flow
of both known and unknown variables creates a probabilistic environment where we don't know for
certain what will happen next.
This last statement may seem quite logical, even self-evident, but there's a huge problem here that is
anything but logical or selfevident. Being aware of uncertainty and understanding the nature of
probabilities does not equate with an ability to actually function effectively from a probabilistic
perspective. Thinking in probabilities can be difficult to master, because our minds don't naturally
process information in this manner. Quite the contrary, our minds cause us to perceive what we know,
and what we know is part of our past, whereas, in the market, every moment is new and unique, even
though there may be similarities to something that occurred in the past. This means that unless we train
our minds to perceive the uniqueness of each moment, tiiat uniqueness will automatically be filtered
out of our perception. We will perceive only what we know, minus any information that is blocked by
our fears; everything else will remain invisible.
The bottom line is that there is some degree of sophistication to thinking in probabilities, which can
take some people a considerable amount of effort to integrate into their mental systems as a functional
thinking strategy. Most traders don't fully understand this; as a result, they mistakenly assume they are
thinking in probabilities, because they have some degree of understanding of the concepts. I've worked
with hundreds of traders who mistakenly assumed they thought in probabilities, but didn't. Here is an
example of a trader I worked with whom I'll call Bob. Bob is a certified trading advisor (CTA) who
manages approximately $50 million in investments. He's been in the business for almost 30 years. He
came to one of my workshops because he was never able to produce more than a 12- to 18-percent
annual return on the accounts he managed.
This was an adequate return, but Bob was extremely dissatisfied because his analytical abilities
suggested that he should be achieving an annual return of 150 to 200 percent. I would describe Bob as
being well-versed in the nature of probabilities. In other words, he understood the concepts, but he
didn't function from a probabilistic perspective. Shortly after attending the workshop, he called to ask
me for some advice. Here is the entry from my journal written immediately after that phone
conversation.
9-28-95: Bob called with a problem. He put on a belly trade and put his stop in the market. The market
traded about a third of the way to his stop and then went back to his entry point, where he decided to
bail out of the trade. Almost immediately after he got out, the bellies went 500 points in the direction of
this trade, but of course he was out of the market. He didn't understand what was going on. First, I
asked him what was at risk. He didn't understand the question. He assumed that he had accepted the
risk because he put in a stop. I responded that just because he put in a stop it didn't mean that he had
truly accepted the risk of the trade. There are many things that can be at risk: losing money, being
wrong, not being perfect, etc., depending on one's underlying motivation for trading. I pointed out that
a person's beliefs are always revealed by their actions.
We can assume that he was operating out of a belief that to be a disciplined trader one has to define the
risk and put a stop in. And so he did. But a person can put in a stop and at the same time not believe
that he is going to be stopped out or that the trade will ever work against him, for that matter. By the
way he described the situation, it sounded to me as if this is exactly what happened to him. When he
put on the trade, he didn't believe he would be stopped out. Nor did he believe the market would trade
against him. In fact, he was so adamant about this, that when the market came back to his entry point,
he got out of the trade to punish the market with an "I'll show you" attitude for even going against him
by one tic. After I pointed this out to him, he said this was exactly the attitude he had when he took off
the trade. He said that he had been waiting for this particular trade for weeks and when the market
finally got to this point, he thought it would immediately reverse.
I responded by reminding him to look at the experience as simply pointing the way to something that
he needs to learn. A prerequisite for thinking in probabilities is that you accept the risk, because if you
don't, you will not want to face the possibilities that you haven't accepted, if and when they do present
themselves. When you've trained your mind to think in probabilities, it means you have fully accepted
all the possibilities (with no internal resistance or conflict) and you always do something to take the
unknown forces into account. Thinkine this way is virtually impossible unless you've done the mental
work necessary to "let go" of the need to know what is going to happen next or the need to be right on
each trade. In fact, the degree by which you think you know, assume you know, or in any way need to
know what is going to happen next, is equal to the degree to which you will fail as a trader. Traders
who have learned to think in probabilities are confident of their overall success, because they commit
themselves to taking every trade that conforms to their definition of an edge.
They don't attempt to pick and choose the edges they think, assume, or believe are going to work and
act on those; nor do they avoid the edges that for whatever reason they think, assume, or believe aren't
going to work. If they did either of those things, they would be contradicting their belief that the "now"
moment situation is always unique, creating a random distribution between wins and losses on any
given string of edges. They have learned, usually quite painfully, that they don't know in advance
which edges are going to work and which ones aren't. They have stopped trying to predict outcomes.
They have found that by taking every edge, they correspondingly increase their sample size of trades,
which in turn gives whatever edge they use ample opportunity to play itself out in their favor, just like
the casinos. On the other hand, why do you think unsuccessful traders are obsessed with market
analysis.
They crave the sense of certainty that analysis appears to give them. Although few would admit it, the
truth is that the typical trader wants to be right on every single trade. He is desperately trying to create
certainty where it just doesn't exist. The irony is that if he completely accepted the fact that certainty
doesn't exist, he would create the certainty he craves: He would be absolutely certain that certainty
doesn't exist. When you achieve complete acceptance of the uncertainty of each edge and the
uniqueness of each moment, your frustration with trading will end. Furthermore, you will no longer be
susceptible to making all the typical trading errors that detract from your potential to be consistent and
destroy your sense of self-confidence. For examnle not rlefminff the risk before crRftincr into a trarle is
hv far rhp most common of all trading errors, and starts the whole process of trading from an
inappropriate perspective. In light of the fact that anything can happen, wouldn't it make perfect sense
to decide before executing a trade what the market has to look, sound, or feel like to tell you your edge
isn't working? So why doesn't the typical trader decide to do it or do it every single time?
I have already given you the answer in the last chapter, but there's more to it and there's also some
tricky logic involved, but the answer is simple. The typical trader won't predefine the risk of getting
into a trade because he doesn't believe it's necessary. The only way he could believe "it isn't necessary"
is if he believes he knows what's going to happen next. The reason he believes he knows what's going
to happen next is because he won't get into a trade until he is convinced that he's right. At the point
where he's convinced the trade will be a winner, it's no longer necessary to define the risk (because if
he's right, there is no risk). Typical traders go through the exercise of convincing themselves that
they're right before they get into a trade, because the alternative (being wrong) is simply unacceptable.
Remember that our minds are wired to associate.
As a result, being wrong on any given trade has the potential to be associated with any (or every) other
experience in a trader's life where he's been wrong. The implication is that any trade can easily tap him
into the accumulated pain of every time he has been wrong in his life. Given the huge backlog of
unresolved, negative energy surrounding what it means to be wrong that exists in most people, it's easy
to see why each and every trade can literally take on the significance of a life or death situation. So, for
the typical trader, determining what the market would have to look, sound, or feel like to tell him that a
trade isn't working would create an irreconcilable dilemma. On one hand, he desperately wants to win
and the only way he can do that is to participate, but the only way he will participate is if he's sure the
trade will win. On the other hand, if he defines his risk, he is willfully gathering evidence that would
negate something he has already convinced himself of.
He will be contradicting the decision-making process he went through to convince himself that the
trade will work. If he exposed himself to conflicting information, it would surely create some degree of
doubt about the viability of the trade. If he allows himself to experience doubt, it's very unlikely he will
participate. If he doesn't put the trade on and it turns out to be a winner, he will be in extreme agony.
For some people, nothing hurts more than an opportunity recognized but missed because of self-doubt.
For the typical trader, the only way out of this psychological dilemma is to ignore the risk and remain
convinced that the trade is right. If any of this sounds familiar, consider this: When you're convincing
yourself that you're right, what you're saying to yourself is, "I know who's in this market and who's
about to come into this market. I know what they believe about what is high or what is low.
Furthermore, I know each individual's capacity to act on those beliefs (the degree of clarity or relative
lack of inner conflict), and with this knowledge, I am able to determine how the actions of each of
these individuals will affect price movement in its collective form a second, a minute, an hour, a day, or
a week from now."
Looking at the process of convincing yourself that you're right from this perspective, it seems a bit
absurd, doesn't it? For the traders who have learned to think in probabilities, there is no dilemma.
Predefining the risk doesn't pose a problem for these traders because they don't trade from a right or
wrong perspective. They have learned that trading doesn't have anything to do with being right or
wrong on any individual trade. As a result, they don't perceive the risks of trading in the same way the
typical trader does. Any of the best traders (the probability thinkers) could have just as much negative
energy surrounding what it means to be wrong as the typical trader.
But as long as they legitimately define trading as a probability game, their emotional responses to the
outcome of any particular trade are equivalent to how the typical trader would feel about flipping a
coin, calling heads, and seeing the coin come up tails. A wrong call, but for most people being wrong
about predicting the flip of a coin would not tap them into the accumulated pain of every other time in
their lives they had been wrong. Why? Most people know that the outcome of a coin toss is random. If
you believe the outcome is random, then you naturally expect a random outcome. Randomness implies
at least some degree of uncertainty. So when we believe in a random outcome, there is an implied
acceptance that we don't know what that outcome will be. When we accept in advance of an event that
we don't know how it will turn out, that acceptance has the effect of keeping our expectations neutral
and open-ended. Now we're getting down to the very core of what ails the typical trader. Any
expectation about the markets behavior that is specific, well-defined, or rigid—instead of being neutral
and open-ended—is unrealistic and potentially damaging. I define an unrealistic expectation as one that
does not correspond with the possibilities available from the market's perspective. If each moment in
the market is unique, and anything is possible, then any expectation that does not reflect these
boundary-less characteristics is unrealistic.
MANAGING EXPECTATIONS
The potential damage caused by holding unrealistic expectations comes from how it affects the way we
perceive information. Expectations are mental representations of what some future moment will look,
sound, taste, smell, or feel like. Expectations come from what we know. This makes sense, because we
can't expect something that we have no knowledge or awareness of. What we know is synonymous
with what we have learned to believe about the ways in which the external environment can express
itself. What we believe is our own personal version of the truth. When we expect something, we are
projecting out into the future what we believe to be true.
We are expecting the outside environment a minute, an hour, a day, a week, or a month from now to be
the way we have represented it in our minds. We have to be careful about what we project out into the
future, because nothing else has the potential to create more unhappiness and emotional misery than an
unfulfilled expectation. When things happen exactly as you expect them to, how do you feel? The
response is generally wonderful (including feelings like happiness, joy, satisfaction, and a greater sense
of well-being), unless, of course, you were expecting something dreadful and it manifested itself.
Conversely, how do you feel when your expectations are not fulfilled? The universal response is
emotional pain.
Everyone experiences some degree of anger, resentment, despair, regret, disappointment,
dissatisfaction, or betrayal when the environment doesn't turn out to be exactly as we expected it to be
(unless, of course, we are completely surprised by something much better than we imagined). Here's
where we run into problems. Because our expectations come from what we know, when we decide or
believe that we know something, we naturally expect to be right. At that point, we're no longer in a
neutral or open state of mind, and it's not difficult to understand why. If we're going to feel great if the
market does what we expect it to do, or feel horrible if it doesn't, then we're not exactly neutral or open
minded. Quite the contrary, the force of the belief behind the expectation will cause us to perceive
market information in a way that confirms what we expect (we naturally like feeling good); and our
pain-avoidance mechanisms will shield us from information that doesn't confirm what we expect (to
keep us from feeling bad).
As I've already indicated, our minds are designed to help us avoid pain, both physical and emotional.
These pain-avoidance mechanisms exist at both conscious and subconscious levels. For example, if an
object is coming toward your head, you react instinctively to get out of the way. Ducking does not
require a conscious decision-making process. On the other hand, if you clearly see the object and have
time to consider the alternatives, you may decide to catch the object, bat it away with your hand, or
duck. These are examples of how we protect ourselves from physical pain. Protecting ourselves from
emotional or mental pain works in the same way, except that we are now protecting ourselves from
information. For example, the market expresses information about itself and its potential to move in a
particular direction. If there's a difference between what we want or expect and what the market is
offering or making available, then our pain-avoidance mechanisms kick in to compensate for the
differences. As with physical pain, these mechanisms operate at both the conscious and subconscious
levels.
To protect ourselves from painful information at the conscious level, we rationalize, justify, make
excuses, willfully gather information that will neutralize the significance of the conflicting information,
get angry (to ward off the conflicting information), or just plain lie to ourselves. At the subconscious
level, the pain-avoidance process is much more subtle and mysterious. At this level, our minds may
block our ability to see other alternatives, even though in other circumstances we would be able to
perceive them. Now, because they are in conflict with what we want or expect, our pain-avoidance
mechanisms can make them disappear (as if they didn't exist). To illustrate this phenomenon, the best
example is one I have already given you: We are in a trade where the market is moving against us. In
fact, the market has established a trend in the opposite direction to what we want or expect. Ordinarily,
we would have no problem identifying or perceiving this pattern if it weren't for the fact that the market
was moving against our position. But the pattern loses its significance (becomes invisible) because we
find it too painful to acknowledge.
To avoid the pain, we narrow our focus of attention and concentrate on information that keeps us out of
pain, regardless of how insignificant or minute. In the meantime, the information that clearly indicates
the presence of a trend and the opportunity to trade in the direction of that trend becomes invisible. The
trend doesn't disappear from physical reality, but our ability to perceive it does. Our pain-avoidance
mechanisms block our ability to define and interpret what the market is doing as a trend. The trend will
then stay invisible until the market either reverses in our favor or we are forced out of the trade because
the pressure of losing too much money becomes unbearable. It's not until we are either out of the trade
or out of danger that the trend becomes apparent, as well as all the opportunities to make money by
trading in the
All the distinctions that would otherwise be perceivable become perfectly clear, after the fact, when
there is no longer anything for our minds to protect us from. We all have the potential to engage in self
protective painavoidance mechanisms, because they're natural functions of the way our minds operate.
There may be times when we are protecting ourselves from information that has the potential to bring
up deepseated emotional wounds or trauma that we're just not ready to face, or don't have the
appropriate skills or resources to deal with. In these cases, our natural mechanisms are serving us well.
But more often, our pain-avoidance mechanisms are just protecting us from information that would
indicate that our expectations do not correspond with what is available from the environments
perspective. This is where our pain-avoidance mechanisms do us a disservice, especially as traders. To
understand this concept, ask yourself what exactly about market information is threatening. Is it
threatening because the market actually expresses negatively charged information as an inherent
characteristic of the way it exists?
It may seem that way, but at the most fundamental level, what the market gives us to perceive are
uptics and down-tics or up-bars and down-bars. These up and down tics form patterns that represent
edges. Now, are any of these tics or the patterns they form negatively charged? Again, it may certainly
seem that way, but from the market's perspective the information is neutral. Each up-tic, down-tic, or
pattern is just information, telling us the market's position. If any of this information had a negative
charge as an inherent characteristic of the way it exists, then wouldn't everyone exposed to it
experience emotional pain? For example, if both you and I get hit on the head with a solid object, there
probably wouldn't be much difference in how we would feel. We'd both be in pain. Any part of our
bodies coming into contact with a solid object with some degree of force will cause anyone with a
normal nervous system to experience pain.
We share the experience because our bodies are constructed in basically the same way. The pain is an
automatic physiological response to the impact with a tangible object. Information in the form of words
or gestures expressed by the environment, or up and down tics expressed by the market, can be just as
painful as being hit with a solid object; but there's an important difference between information and
objects. Information is not tangible. Information doesn't consist of atoms and molecules. To experience
the potential effects of information, whether negative or positive, requires an interpretation. The
interpretations we make are functions of our unique mental frameworks. Everyone's mental framework
is unique for two fundamental reasons.
First, all of us were born with different genetically encoded behavior and personality characteristics
that cause us to have different needs from one another. How positively or negatively and to what
degree the environment responds to these needs creates experiences unique to each individual. Second,
everyone is exposed to a variety of environmental forces. Some of these forces are similar from one
individual to the next, but none are exactly the same. If you consider the number of possible
combinations of genetically encoded personality characteristics we can be born with, in relation to the
almost infinite variety of environmental forces we can encounter throughout our lives, all of which
contribute to the construction of our mental framework, then it's not difficult to see why there is no
universal mental framework common to everyone.
Unlike our bodies, which have a common molecular structure that experiences physical pain, there is
no universal mind-set to assure us that we will share the potential negative or positive effects of
information in the same way. For example, someone could be projecting insults at you, intending to
cause you to feel emotional pain. From the environment's perspective, this is negatively charged
information. Will you experience the intended negative effects? Not necessarily! You have to be able to
interpret the information as negative to experience it as negative. What if this person is insulting you in
a language you don't understand, or is using words you don't know the meaning of? Would you feel the
intended pain? Not until you built a framework to define and understand the words in a derogatory
way. Even then, we can't assume that what you'd feel would correspond to the intent behind the insult.
You could have a framework to perceive the negative intent, but instead of feeling pain, you might
experience a perverse type of pleasure. I've encountered many people who, simply for their own
amusement, like to get people riled up with negative emotions.
If they happen to be insulted in the process, it creates a sense of joy because then they know how
successful they've been. A person expressing genuine love is projecting positively charged information
into the environment. Let's say the intent behind the expression of these positive feelings is to convey
affection, endearment, and friendship. Are there any assurances that the person or persons this
positively charged information is being projected toward will interpret and experience it as such? No,
there aren't. A person with a very low sense of self-esteem, or someone who experienced a great deal of
hurt and disappointment in relationships, will often misinterpret an expression of genuine love as
something else. In the case of a person with low self-esteem, if he doesn't believe he deserves to be
loved in such a way, he will find it difficult, if not impossible, to interpret what he is being offered as
genuine or real. In the second case, where one has a significant backlog of hurt and disappointment in
relationships, a person could easily come to believe that a genuine expression of love is extremely rare,
if not non-existent, and would probably interpret the situation either as someone wanting something or
trying to take advantage of him in some way.
I'm sure that I don't have to go on and on, sighting examples of all the possible ways there are to
misinterpret what someone is trying to communicate to us or how what we express to someone can be
misconstrued and experienced in ways completely unintended by us. The point that I am making is that
each individual will define, interpret, and consequently experience whatever information he is exposed
to in his own unique way. There's no standardized way to experience what the environment may be
offering—whether it's positive, neutral, or negative information—simply because there is no
standardized mental framework in which to perceive information. Consider that, as traders, the market
offers us something to perceive at each moment. In a sense, you could say that the market is
communicating with us.
If we start out with the premise that the market does not generate negatively charged information as an
inherent characteristic of the way it exists, we can then ask, and answer, the question, "What causes
information to take on a negative quality?" In other words, where exactly does the threat of pain come
from? If it's not coming from the market, then it has to be coming from the way we define and interpret
the available information. Defining and interpreting information is a function of what we assume we
know or what we believe to be true. If what we know or believe is in fact true—and we wouldn't
believe it if it weren't—then when we project our beliefs out into some future moment as an
expectation, we naturally expect to be right. When we expect to be right, any information that doesn't
confirm our version of the truth automatically becomes threatening. Any information that has the
potential to be threatening also has the potential to be blocked, distorted, or diminished in significance
by our pain-avoidance mechanisms.
It's this particular characteristic of the way our minds function that can really do us a disservice. As
traders, we can't afford to let our pain-avoidance mechanisms cut us off from what the market is
communicating to us about what is available in the way of the next opportunity to get in, get out, add
to, or subtract from a position, just because it's doing something that we don't want or expect. For
example, when you're watching a market (one you rarely, if ever, trade in) with no intention of doing
anything, do any of the up or down tics cause you to feel angry, disappointed, frustrated, disillusioned,
or betrayed in any way? No! The reason is that there's nothing at stake. You're simply observing
information that tells you where the market is at that moment. If the up and down tics that you're
watching form into some sort of behavior pattern you've learned to identify, don't you readily recognize
and acknowledge the pattern? Yes, for the same reason: There's nothing at stake.
There is nothing at stake because there's no expectation. You haven't projected what you believe,
assume, or think you know about that market into some future moment. As a result, there's nothing to
be either right about or wrong about, so the information has no potential to take on a threatening or
negatively charged quality. With no particular expectation, you haven't placed any boundaries on how
the market can express itself. Without any mental boundaries, you will be making yourself available to
perceive everything you've learned about the nature of the ways in which the market moves.
There's nothing for your pain-avoidance mechanisms to exclude, distort, or diminish from your
awareness in order to protect you. In my workshops, I always ask participants to resolve the following
primary trading paradox: In what way does a trader have to learn how to be rigid and flexible at the
same time? The answer is: We have to be rigid in our rules and flexible in our expectations. We need to
be rigid in our rules so that we gain a sense of self-trust that can, and will always, protect us in an
environment that has few, if any, boundaries. We need to be flexible in our expectations so we can
perceive, with the greatest degree of clarity and objectivity, what the market is communicating to us
from its perspective. At this point, it probably goes without saying that the typical trader does just the
opposite: He is flexible in his rules and rigid in his expectations. Interestingly enough, the more rigid
the expectation, the more he has to either bend, violate, or break his rules in order to accommodate his
unwillingness to give up what he wants in favor of what the market is offering.
ELIMINATING THE EMOTIONAL RISK
To eliminate the emotional risk of trading, you have to neutralize your expectations about what the
market will or will not do at any given moment or in any given situation. You can do this by being
willing to think from the markets perspective. Remember, the market is always communicating in
probabilities. At the collective level, your edge may look perfect in every respect; but at the individual
level, every trader who has the potential to act as a force on price movement can negate the positive
outcome of that edge. To think in probabilities, you have to create a mental framework or mind-set that
is consistent with the underlying principles of a probabilistic environment. A probabilistic mind-set
pertaining to trading consists of five fundamental truths.
1. Anything can happen.
2. You don't need to know what is going to happen next in order to make money.
3. There is a random distribution between wins and losses for any given set of variables that define an
edge.
4. An edge is nothing more than an indication of a higher probability of one thing happening over
another.
5. Eveiy moment in the market is unique.
Keep in mind that your potential to experience emotional pain comes from the way you define and
interpret the information you're exposed to. When you adopt these five truths, your expectations will
always be in line with the psychological realities of the market environment. With the appropriate
expectations, you will eliminate your potential to define and interpret market information as either
painful or threatening, and you thereby effectively neutralize the emotional risk of trading. The idea is
to create a carefree state of mind that completely accepts the fact that there are always unknown forces
operating in the market. When you make these truths a fully functional part of your belief system, the
rational part of your mind will defend these truths in the same way it defends any other belief you hold
about the nature of trading.
This means that, at least at the rational level, your mind will automatically defend against the idea or
assumption that you can know for sure what will happen next. It's a contradiction to believe that each
trade is a unique event with an uncertain outcome and random in relationship to any other trade made
in the past; and at the same time to believe you know for sure what will happen next and to expect to be
right. If you really believe in an uncertain outcome, then you also have to expect that virtually anything
can happen. Otherwise, the moment you let your mind hold onto the notion that you know, you stop
taking all of the unknown variables into consideration. Your mind won't let you have it both ways. If
you believe you know something, the moment is no longer unique.
If the moment isn't unique, then everything is known or knowable; that is, there's nothing not to know.
However, the moment you stop factoring in what you don't or can't know about the situation instead of
being available to perceive what the market is offering, you make yourself susceptible to all of the
typical trading errors. For example, if you really believed in an uncertain outcome, would you ever
consider putting on a trade without defining your risk in advance? Would you ever hesitate to cut a
loss, if you really believed you didn't know? What about trading errors like jumping the gun? How
could you anticipate a signal that hasn't yet manifested itself in the market, if you weren't convinced
that you were going to miss out? Why would you ever let a winning trade turn into a loser, or not have
a systematic way of taking profits, if you weren't convinced the market was going your way
indefinitely? Why would you hesitate to take a trade or not put it on at all, unless you were convinced
that it was a loser when the market was at your original entiy point? Why would you break your money
management rules by trading too large a position relative to your equity or emotional tolerance to
sustain a loss, if you weren't positive that you had a sure thing? Finally, if you really believed in a
random distribution between wins and losses, could you ever feel betrayed by the market? If you
flipped a coin and guessed right, you wouldn't necessarily expect to be right on the next flip simply
because you were right on the last.
Nor would you expect to be wrong on the next flip if you were wrong on the last. Because you believe
in a random distribution between the sequence of heads and tails, your expectations would be perfectly
aligned with the reality of the situation. You would certainly like to be right, and if you were that
would be great, but if you were wrong then you would not feel betrayed by the flip, because you know
and accept that there are unknown variables at work that affect the outcome. Unknown means "not
something your rational thinking process can take into consideration in advance of the Hi-r" ?jXCi>v'L
^ fu!Iv accept that you don't know As a result, there is little, if any, potential to experience the kind of
emotional pain that wells up when you feel betrayed. As a trader, when you're expecting a random
outcome, you will always be at least a little surprised at whatever the market does— even if it conforms
exactly to your definition of an edge and you end up with a winning trade. However expecting a
random outcome doesn't mean that you can't use your full reasoning and analytical abilities to project
an outcome, or that you can't guess what's going to happen next, or have a hunch or feeling about it,
because you can. Furthermore, you can be right in each instance.
You just can't expect to be right. And if you are right, you can't expect that whatever you did that
worked the last time will work again the next time, even though the situation may look, sound, or feel
exactly the same. Anything that you are perceiving "now" in the market will never be exactly the same
as some previous experience that exists in your mental environment. But that doesn't mean that your
mind (as a natural characteristic of the way it functions) won't try to make the two identical. There will
be similarities between the "now moment" and something that you know from the past, but those
similarities only give you something to work with by putting the odds of success in your favor. If you
approach trading from the perspective that you don't know what will happen next, you will circumvent
your mind's natural inclination to make the "now moment" identical to some earlier experience.
As unnatural as it seems to do so, you can't let some previous experience (either negative or extremely
positive) dictate your state of mind. If you do, it will be very difficult, if not impossible, to perceive
what the market is communicating from its perspective. When I put on a trade, all I expect is that
something will happen. Regardless of how good I think my edge is, I expect nothing more than for the
market to move or to express itself in some way. However, there are some things that I do know for
sure. I know that based on the markets past behavior, the odds of it moving in the direction of my trade
are good or acceptable, at least in relationship to how much I am willing to spend to find out if it does. I
also know before getting into a trade how much I am willing to let the market move against my
position. There is always a point at which the odds of success are greatly diminished in relation to the
profit potential. At that point, it's not worth spending any more money to find out if the trade is going
to work. If the market reaches that point, I know without any doubt, hesitation, or internal conflict that I
will exit the trade.
The loss doesn't create any emotional damage, because I don't interpret the experience negatively. To
me, losses are simply the cost of doing business or the amount of money I need to spend to make
myself available for the winning trades. If, on the other hand, the trade turns out to be a winner, in most
cases I know for sure at what point I am going to take my profits. (If I don't know for sure, I certainly
have a veiy good idea.) The best traders are in the "now moment" because there's no stress. There's no
stress because there's nothing at risk other than the amount of money they are willing to spend on a
trade. They are not trying to be right or trying to avoid being wrong; neither are they trying to prove
anything. If and when the market tells them that their edges aren't working or that it's time to take
profits, their minds do nothing to block this information. They completely accept what the market is
offering them, and they wait for the next edge.