Technical analysis is worthless without a thorough understanding of the psychology behind winning and losing, buying and selling, fear and greed, risk versus reward, the past versus the future, the knowable versus the unknowable. Technical analysis is best used as a psychological tool to help the trader manage random price action and the emotions associated with it, not as a way to predict price action and thus confirm the trader’s egotistical need to be right.
Psychology first; Technical second.
One of my favorite “go to” authors on trading psychology is Mark Douglas. Although he is best known for his book Trading In The Zone, Mr Douglas’ first book The Disciplined Trader is a gem of a read also. I recommend both but start with The Disciplined Trader. It will help you better understand and appreciate the principles discussed in Trading in the Zone.
The following is from the INTRODUCTION and provides the thesis for the book. In it Douglas discusses the following:
THE MENTAL GAME IS MUCH DIFFERENT IN THE MARKETS THAN IN EVERYDAY LIFE
THE MARKETS HAVE NO POWER OR CONTROL OVER YOU
YOU ALONE ARE RESPONSIBLE FOR YOUR ACTIONS AND REACTIONS
YOU MUST LEARN TO CONTROL YOURSELF
YOU CREATE THE MARKET YOU CHOOSE TO TRADE
YOU MUST DEVELOP YOUR OWN RULES…AND FOLLOW THEM
YOU MUST ALWAYS BE PREPARED…OR FACE DISASTER
WHILE YOU CANNOT CONTROL THE MARKET YOU CAN CONTROL YOUR PERCEPTION OF IT
YOU MUST WORK ON SEEKING OPPORTUNITY INSTEAD OF TRYING TO AVOID PAIN
IN YOUR ATTEMPTS TO AVOID LOSSES YOU ACTUALLY CREATE THEM
TO BE SUCCESSFUL YOU MUST DEVELOP SELF CONFIDENCE AND SELF TRUST
One thing you will learn as a trader is that the mental resources you use to get what you want in your everyday life will not work in the trading environment. The power and control that are necessary to manipulate the markets (make them do what you want them to do) are beyond all but a handful of individuals. And the external constraints that exist in society to control your behavior don’t exist in the market environment. The markets have absolutely no power or control over you, no expectation of your behavior, and no regard for your welfare.
If, in fact, you can’t control or manipulate the markets and the markets have absolutely no power or control over you, then the responsibility for what you perceive and for your resulting behavior resides only in you. The one thing you can control is yourself. As a trader, you have the power either to give yourself money or to give your money to other traders. And the ways in which you choose to do this will be determined by a number of psychological factors that have little or nothing to do with the markets. And this will be so until you acquire some new skills and also learn how to adapt yourself to suit conditions as they exist in the market environment.
To operate successfully in this environment you will need to learn how to control yourself in ways that may be completely alien to you.
You will also have to learn how to grant yourself the mental freedom to shift your perspective to notice alternative possibilities to getting what you want in the trading arena, regardless of your expectations of how you are going to get it. There are only a few traders who have come to the realization that they alone are completely responsible for the outcome of their actions. Even fewer are those who have accepted the psychological implications of that realization and know what to do about it.
Rarely do any of us grow up learning how to operate in an arena that allows for complete freedom of creative expression, with no external structure to restrict it in any way. In the trading environment, you will have to make up your own rules and then have the discipline to abide by them. The problem is, price movement is fluid, always in motion, quite unlike the highly structured events that most of us are accustomed to. In the market environment, the decisions that confront you are as endless as the price movements you intend to take advantage of. You don’t just have to decide to participate, you also have to decide when to enter, how long to stay in, and under what conditions to get out. There is no beginning, middle, or end – only what you create in your own mind.
In addition to the negative psychological implications that accompany these decisions, you must be aware that even if you make the minimum financial commitment of one contract per trade (as in the futures market), there is an unlimited potential for profit as well as an unlimited potential for loss. From a psychological perspective, this means that each trade has the possibility of fulfilling your wildest dreams of financial independence, and simultaneously presents you with the risk of losing everything you own. The constantly changing price movement makes it extremely easy for you to ignore the risk and tempt yourself into believing you don’t have to follow your own rules, this time.
Here is an environment that offers complete freedom of expression combined with unlimited possibilities and unlimited risk. If you place in it a participant who is oblivious to these psychological conditions (one who operates from a mental framework oriented toward external structure, constraints, and expectations), then what you have is a formula for emotional and financial disaster. This grim scenario certainly explains why so few people ever make money as traders. Actually, almost all of those who make an attempt at trading completely underestimate the difficulty and consequently over estimate their ability to fulfill their inflated expectations. Therefore, most, if not all, people who trade inflict some degree of psychological damage upon themselves. I am defining “psychological damage” as any mental framework that has potential for generating fear.
Fear results from any belief about environmental conditions that has the potential to cause either physical or emotional pain such as stress, anxiety, confusion, disappointment, or betrayal. Painful emotional conditions are basically the result of unfulfilled expectations. Unfulfilled expectations create a conflict between a person’s beliefs about the way things should be and the actual environmental conditions that don’t match those beliefs. This conflict is expressed through our emotions in the form of pain that we generally label as stress, anxiety, confusion, and so on.
People seem to avoid pain instinctively by building up mental defenses against the intrusion of environmental information that would confirm the existence of any conflict. These defenses consist of denials, rationalizations, and justifications – all of which will result in perceptual distortion.
“Perceptual distortion” occurs when our mental system automatically distorts environmental information by shaping and selectively excluding certain information to compensate for the conflict between what we expect and what the environment is offering us. This will be done in such a way that we will believe a shared reality exists between ourselves and the outside environment, thus avoiding any pain. I am defining a “shared reality” as a correspondence between one’s beliefs about the environment and the actual environmental conditions that exist.
If you are distorting market information, you are not sharing a reality with the markets, and you are also indulging yourself in an illusion, to the extent that you hide from the possibility of disappointment. At this point, you would be setting yourself up for what could be called a “forced awareness.” Obviously, if the markets are doing something other than what you are allowing yourself to perceive (because some, if not most, of the information the markets have to offer won’t validate what you want or hope), then something has to give. These distortions will continue until there is such a disparity between your acquired mindset and the conflicting market information that the mental defenses (illusions) will break down. This usually creates a state of shock, where you may wonder how things could get so bad so quickly.
In such a situation, the market forces you to confront your illusions of a shared reality, creating a painful forced awareness. At some point in your trading career you will need to understand how all of us, because of our common upbringing, try to control market events through our perception of what we think will happen next and then rigidly hold on to these expectations. This is where you need to learn how to gain the kind of mental flexibility that allows you to shift your perspective to be aware of other alternatives and possibilities. You may not be able to control the markets, but you can control your perception of them in order to achieve a higher degree of objectivity, resulting in a higher degree of shared reality with the markets.
As painful as these forced awarenesses may be, they are not likely to deter you from being attracted to the opportunities the markets have to offer. However, the cumulative psychological effect on you will be very negative. If you have suffered through several forced awarenesses, your perception of market activity will eventually become heavily weighted towards avoiding pain instead of seeking opportunity. Your fear of losing money, being wrong, or missing an opportunity will become your primary motivation to act or not act.
Now, there are several major problems that result when fear becomes a motivation to do or not do something. First, it will limit your range of perceived opportunities by narrowing your focus of attention, keeping it on the object of your fear. This means that out of all available market information, you will only perceive information that will, in effect, validate what you fear the most. Your fear will systematically exclude from your awareness market information that would indicate the existence of other alternatives and opportunities.
As you begin to understand the negative relationship between fear and perception, you might be surprised to learn that in your attempts to avoid losses, you actually create them. Fear will also limit your range of responses to any given situation. Many traders suffer considerably when they know exactly what they want to do but, when the moment to execute arrives, find themselves completely immobilized.
Before anyone can become successful in an environment with the unstructured character of the trading environment, one needs to develop a supreme sense of self-confidence and self-trust. I am defining self-confidence as an absence of fear and self-trust: knowing what to do at the moment it needs to be done, and then doing it without hesitation. Any hesitation will only create self-doubt and fear. To whatever degree self doubt exists as a state of mind, to that same degree you will feel fear, anxiety, and confusion.
The few successful traders who have, in some way, transcended these psychological obstacles have been generous with their one-line gems of trading wisdom: “Learn to take a loss,” “Go with the flow,” “The trend is your friend,” “Cut your losses and let your profits run,” “To know the markets you need to know yourself,” and on and on.