Dick Diamond is a fairly well known trader whose approach differs from mine. However, this section on “Emotional Discipline” is fairly universal.
As you’ve read and heard me say countless times, scale into your positions. He has a similar 80/20 style position building approach.
Where we might differ a bit is that he is a quick “cord cutter” when it comes to trades that move against him. If you are going to be a day trader (trades lasting minutes to days) or swing trader (trades lasting months), then quick disposals of losing positions is essential.
If you are going to be a position trader – trades generally lasting years for the majority of a full business cycle – then you must understand the slow handed nature of building positions. You must be comfortable with the emotional patience that takes.
Another important skill is to not believe that you have done something right, when you haven’t. You must also know when you have done things right, but the market simply didn’t cooperate.
Self-validation via rationalization, people’s third strongest drive, after staying alive and procreation, has to be avoided at almost all costs. An unwillingness to accept mistakes or emotional inability to assess what truly moves a price against you will lead to further mistakes.
When prices move against you as a position trader, you will have a decision to make. Did I make a mistake, was it normal volatility or did the markets just present an unusual situation?
Usually, we make mistakes or we are facing normal volatility. The main reason I say to build positions over months at significantly different prices, is to create a margin of safety in our position building.
Our challenge is not compound mistakes that we do make. From time to time, the markets present an unusual situation. The 4th quarter of 2018 was one such occurrence (read 4 Pieces Of Missing Money Crushing Markets) where investors took significant rapid losses.
Was last December 2018 a time to buy or sell? For those with cash, it was a time to buy. For others, it was a time to “high grade” their portfolio with better positions for an eventual rebound. It was not a time to become emotional and sell or put our head in the sand.
Enjoy and learn from this excerpt from Trading As A Business By Dick Diamond:
The centerpiece of my trading is the identification and proper execution of what I call 80/20 trades. I define 80/20 trades as setups that historically have been profitable about 80 percent of the time. I don’t trade 60/40 situations. And I don’t trade situations where I have a feeling that market is going to go in a particular direction if my feeling is not corroborated by one of my 80/20 setups.
I spent years experimenting with various technical indicators and combining them in different ways to create the best possible trading setups. Some of the technical indicators I use are fairly common, such as moving average convergence-divergence (MACD) or stochastics. Others are a little more esoteric, such as the Walter Bressert indicator and the Rahul Mohindar oscillator (RMO). I use them because they work in trading. I’m a pragmatist, not a theoretician.
I look for all my indicators on any particular template to be pointing in the same direction before putting on a trade. That means waiting patiently for the right situation to emerge and passing up many situations that do not completely match my criteria. It’s perfectly acceptable to miss a trade. There will always be new opportunities. What you don’t want to do is force the action and get into 60/40 trades out of greed, boredom, or some other emotional motivation. You must avoid 60/40 trades at all costs!
[Here I will interject: this is not unsimilar to poker. In poker, we only take 60/40 or 40/60 bets when there is very significant upside and it will not bust us, or when we are desperate late in a tournament. Investors should never feel desperate. And, if you are going to take a 60/40 bet or 40/60 bet, you better have huge upside (10x or more) and risk only a very small piece of capital.]
[The following is a short-term trading section that carries some conceptual value for position traders, however, does not fully apply in practice. For example, I rarely use stops. Also, for positions traders, we have better systems for screening trades.]
If you want to exactly replicate my trading screen, you’ll need to subscribe to the MetaStock service. I’ve used a few other software programs in my career, but, in my opinion, MetaStock is the best. Of course, you may like another software system and choose to continue with it. You should know, however, that while most of my indicators are on other services, only MetaStock has the Bressert and EMOTIONAL DISCIPLINE 10 RMO indicators. In the appendix, I’ve included a section written by Kelly Clement of MetaStock that describes how to set up my templates via MetaStock.
Once you have the templates on your computer, I suggest monitoring how they respond in real markets for at least four weeks. It’s one thing for me to assert that these setups work. It’s another thing—and much more important—for you to be convinced that you can make the setups work for you.
You may want to paper trade for a period of time. You can gain experience and the feel of putting on trades, placing stops, moving stops, and exiting trades. Monitor your results closely, and when you feel you’ve reached a good level of proficiency and your results are satisfactory, you can begin trading with real money.
[As I’ve shown, I use several screens regularly and others as verification methods. The commonality is that we are trying to have emotional discipline. When I first recommended GameStop, it was because the screens told me to investigate it. It seemed to me there was an apparent way for the company to succeed and it had the resources to do so. Ultimately, management made a series of decisions that didn’t seem to make sense to me and I sold the stock about even. Don’t forget, we are fundamental investors first. Even though GameStop was not moving against us, it lost its luster because management was disappointing. GameStop ultimately fell dramatically and we avoided that drop.]
You always want to use stops—even in paper trading. Put a stop in with your initial order and move the stop in the direction of the trade as the trade becomes profitable. That’s what I do. Never take for granted risk control, and don’t let a profit turn into a loss. Markets can change in an instant, and you should always protect your position.
I trade on two-minute charts. I usually set my initial stop two ticks away from entry price. As the price moves in my favor, I’ll push the stop higher or lower to protect my position.
[Or build your positions slowly over months or quarters or years, changing your opinions based on the business, not volatility. If your thesis is right, volatility is an opportunity. We must of course review our thesis at each potential buy point. Remember, our time frame is years.]
If the market doesn’t move fast enough, I may liquidate the trade before it hits my protective stop. It’s better to break even than take a two-tick loss. My initial goal is not to lose money.
When I enter an 80/20 trade on a two-minute chart, I expect the market will move quickly in the direction of the trade. I’m looking for a free ride. If the ride doesn’t come quickly, I’ll get out.
My templates work on longer time frames, too. You may not be able to monitor the market throughout the day, or you may simply prefer to trade on a different time frame. That’s fine. You can adjust the bars to 30, 60, 120 minutes—whatever time frame you prefer. As you move out to a longer time frame, remember two things: (1) you’ll need to set wider stops, perhaps six to eight ticks, and (2) you’ll need to hold on to your trades for a longer period of time.
Apart from any time frame adjustment, I would advise sticking with the settings I use on the indicators and templates. If you want to tweak an indicator to see how it responds to a different setting, that’s OK. It may give you some valuable insights. However, you don’t want to constantly change the settings. The worst thing you can do is to change the settings following every trade that doesn’t work.
About one in five or six 80/20 trades identified by my templates doesn’t work out. That’s acceptable because if you execute the templates consistently, you will make money. The templates enable you to identify situations where the percentages are in our favor and execute trades in a disciplined and consistent manner. If you keep changing your indicators, you’ll undermine your confidence, and without confidence it’s difficult to trade.
Everything in trading is connected: trade setups, money management, and emotional discipline. To be profitable, you need both high-percentage trade setups and good money management tactics. And to execute 80/20 trades and adhere to sound money management principles, you need to be emotionally disciplined. All three elements are required to be a successful trader.
Why Traders Fail
The most important component to successful trading can be described in two words: emotional discipline. You must develop the ability to patiently wait for a tradable situation to develop, and then, when it’s in front of you, execute the trade. It sounds simple, but, believe me, the lack of emotional discipline is the number one reason that traders fail.
Some traders tend to force trades when the odds are not in their favor. Others have difficulty pulling the trigger when a good trade presents itself. On the back end, some traders hold on to trades too long. As a result, losses frequently become bigger and profits frequently become smaller. These are all problems of emotional discipline.
As I transformed myself from a losing trader to a winning trader, it became apparent to me that emotional discipline was my key to success. Sure, I had developed a process for analyzing the market and identifying good trades, and that was a big challenge. But emotional discipline proved to be a much more difficult skill to master.
Regardless of whether you’re a short-term trader like me or a long-term trend trader, emotional discipline is central to success. One of the most famous long-term trend traders of all time is Richard Dennis. Like me, he believes the emotional and psychological factors are more important than market analysis in determining success or failure.
‘‘The key is consistency and discipline,’’ Dennis said in the book Market Wizards. ‘‘Almost anybody can make up a list of rules that are 80% as good as we taught. What they can’t do is give people confidence to stick to those even when things are going bad.’’
[Watch the movie Trading Places, it’s partly based on Dennis and his partner William Eckhardt’s bet.]
Dennis believed trading could be taught. As an experiment, he recruited 23traders from a large pool of applicants and taught them a trend-following strategy, money management techniques, and gave them capital to trade. While some of them failed, a significant number were highly profitable. The experience reinforced Dennis’ conviction that discipline is the most important component of trading. The traders who most closely followed the system and money management rules were the most successful.
The trading system that Richard Dennis taught has been public knowledge for years. Similarly, Warren Buffett’s method for buying and selling stocks is well known. In addition, Buffett’s stock holdings are fully disclosed and easily available. Yet very few investors and very few traders come anywhere near the performance of Dennis and Buffett.
Sometimes it strikes me that trading is similar to weight loss. Knowledge is not the problem. Everyone knows that to lose weight you need to burn more calories than you consume. If you eat the right foods in the right amounts and exercise consistently, you’ll lose weight. It’s as simple as that. Yet there are hundreds of books on dieting and an entire industry devoted to helping people lose weight. Just as in trading, in weight loss the critical factor is emotional discipline. You have to do the right thing consistently, even if it feels uncomfortable.
[I like that example.]
For a complete understanding of the topic, I recommend a book entitled Emotional Discipline by Charles Manz (Berrett-Koehler, 2003). In essence, the book talks about a process to identify, understand, and reframe your emotions. I think the process can be a great help to traders who have trouble trading in an objective, rational, and disciplined manner.
Core Position and 80/20 Trades
While I believe emotional discipline is the most important factor in trading success, you also need a method to identify profitable trades and sufficient capital to trade. Later in the book, I provide the templates I use to identify high-probability trades. In regard to capital, determining and adhering to your core position is an absolute necessity to succeed over the long haul.
A core position is the trading size that you can execute in the market without becoming emotional. Sure, you enter into every trade intending it to be a winner. But when a trade doesn’t work out, you should be able to exit with a small loss and without any emotional pain. Similarly, when a trade works in your favor, you should be able to grab your profits at the right time. You shouldn’t hold on too long out of greed or exit too early out of fear.
My core position is very small relative to my account size. My maximum position is 10 E-minis, which is equivalent to two Standard & Poor’s (S&P) futures contracts. I often scale into positions whereby I buy/sell maybe 5 E-minis initially. But even if the initial position is very profitable, I will not exceed my core position of 10 E-minis in building out the trade. I simply don’t trade over my core position.
You need to find a position size where you’re not overwhelmed with feelings of hope, fear, and greed. If you only have a few thousand dollars to trade, the position might be a few hundred dollars of individual stocks. That’s fine. Once you identify and adhere to a core position from which you can trade with emotional discipline, you’re on the way to long-term success.
[Re-read that last paragraph!!!]
The Emotions of Trading
The feeling you want to cultivate in trading is quiet confidence and self-control. When you begin trading, you need to base your confidence on knowledge that you can identify high-probability trades and you can follow the trading rules. You need to trade small. As you gain experience, your confidence will grow. You may be able to increase the size of your core position. But be careful. Many traders, after a string of good trades, get cocky and take on too much risk. Trust me—the market is a merciless teacher.
The object of trading is to make money. However, to make money you have to focus on finding good trades and executing according to your trading rules. If you focus too much on the money, you very well may lose sight of the trading process that generates long-term success.
In its most blatant form, greed leads traders to take too much risk, override their systems, and hold on to losing trades too long. A trader who is thinking about an expensive car or an oceanfront vacation home is setting himself up for big problems. Banish that kind of thinking and imagery from your mind. Greed can be subtle, too. It can creep into your trading at any point in your career. If you’re on a hot streak, you may be tempted to trade too large or stay in trades too long. Or you may start taking lesser trades when you have a feeling about the market direction, even though the feeling is not corroborated by your signals.
Some traders set profit objectives. I think this is a mistake. What are you going to do on the last trading day of the month if you are 10 percent short of your monthly profit target? The natural inclination is to trade more aggressively to hit your target. To do so, you might override your signals and break your rules.
[All you can do is try to make consistently good decisions, the returns will take care of themselves.]
Remember, you can only trade what the market gives you. There will be periods with many trading opportunities and periods when there are few chances to make money. Focus on the market, your signals, and your rules. The money will take care of itself.
It’s very difficult to trade when you’re anxious and nervous. Not only is anxiety an uncomfortable feeling, it actually worsens performance. A fearful trader anticipates failure. When you’re wracked by fear, it’s difficult to objectively interpret market activity and to follow your trading rules. You have trouble assessing opportunities and pulling the trigger. You’re prone to paralysis by analysis.
From my personal experiences and knowledge of other traders, fear can have many causes:
■ Lack of confidence in your trade selection criteria.
■ Lack of confidence in your trading rules.
■ Fear of losing money.
■ Fear of failure.
First, it’s important to acknowledge that trading is not easy. No one can forecast where markets will go. All you can do is search for tradable situations and execute your trades in a disciplined fashion. Given the challenges of trading, a healthy respect for the markets is certainly warranted. However, you can’t let respect grow into fear. You can’t let yourself become immobilized.
One of my goals in this book is to provide you with high-probability trade setups and a set of trading rules that have worked for me for many years. You need to study the setups, get the proper indicators on your computer, and monitor the markets until you can consistently identify the 80/20 trades. At the same time, you need to ingrain the rules of trading discussed throughout this book. Once you have mastered both the setups and the rules, you’re ready to begin trading. Then, as you execute correctly in live markets, you will develop confidence.
Fear of losing money and having insufficient capital to trade go hand-in-hand. You need to have enough trading capital and then trade in a size that won’t lead you to become overly emotional. If you’re counting how much money you’re winning or losing with every tick, you need to reduce your trading size. You have to trade the market and your indicators, not the money. Economists who have studied investor behavior have discovered that, for most people, the pain of losing money is greater than the pleasure in making money. They call this loss aversion. For traders, loss aversion can lead to paralysis. You become unwilling to take a trade because there’s a possibility of losing money.
As a trader, you need to accept that losses are part of the game. Every trade you make has the potential to be a loser. If you adhere to a sound method and sound trading rules, you will win over time. As long as your trading process is correct, you shouldn’t allow yourself to be bothered by losing trades. You just have to keep your losses small.
Fear of failure is similar but slightly different than the fear of losing money. The trader who is afraid of failure typically spends an enormous amount of time and energy on analyzing markets and creating and testing trading systems. This type of trader is afraid that his or her intellectual understanding of the markets will be proven wrong if he actually trades on the basis of his analysis. For this type of trader, the market is more of a fascinating intellectual puzzle than a playing field where money can be made by skillful trading.
There are many intelligent and perceptive people who closely follow the financial markets. Some of them write newsletters and provide analysis on behalf of brokerage firms. Surprisingly, a significant number of these people do not trade on the basis of their own analytical work. To trade and fail would undermine the value of their work—at least in their own minds. Fear of failure keeps them on the sidelines.
A trader who tries to make money too quickly by overtrading or who desperately wants to be in the market to feel the excitement of the game is destined to lose in the long run. You have to have the patience to choose your spots. There are days I sit in front of my computer and do not make a trade. Now, it isn’t as though I’m doing nothing. I’m monitoring the market and waiting for a tradable situation. If a good situation doesn’t materialize, I stay on the sidelines. Patience is a virtue in trading.
Similarly, your long-term goals in trading should be realistic. Banish the thought of getting rich quickly through trading. You should strive to diligently follow your trading rules and trade only high-probability setups. The money will follow. Remember, the turtle wins the race.
The Importance of Commitment
Most people do not succeed as traders due to a lack of emotional discipline. While following your trading rules and trading well-defined setups may sound easy enough, the reality is that following these principles in live markets with real money at stake is always challenging. You’re going to have successes and you’re going to have failures. The most important thing is to always limit your risk and remain consistent in the application of trading rules and the situations you choose to trade.
As with any worthwhile endeavor, commitment is necessary for long-term success in trading. You can’t become a profitable trader with a half-hearted effort. You need to fully commit intellectually, financially, and emotionally. Above all else, commit yourself to emotional discipline.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.