Trading Psychology - Stage 3. Clarity

Finally. Painful process of hatching is over, and a trader is born. You are no longer a slave of your emotions, you are your own person. You are in full control of your own actions. You don't jump in the middle of action or out of it on a whim - rather you are capable of pausing and weighing your options and making your decisions in a cold blood. You can see the crowd's emotions on a chart clearly, and you are no longer a part of that crowd nor you are affected by their emotions. You can evaluate those emotions and utilize them. This is an amazing state of clarity, and it's very liberating. These two words (clarity and liberation) probably constitute the essence of this stage of a trader's development. Ability to see clearly the reality of what happens and the freedom of making your own choices as to how to react - this is what makes you a master of your trading vs. being part of the crowd.

You are but detached observer of the market, never involved emotionally yet constantly evaluating the emotions of other participants, waiting patiently for the moment when the opportunity presents itself and the odds are the most favorable; entrenching yourself where you anticipate the action to unfold; pouncing when the right moment comes; having no problem to retreat if proven wrong; having no emotional baggage over any outcome and ready to act again.

All above is the description of this stage and how it feels. Let's talk a bit of how you arrive to it. The transition from stage 2 to stage 3 is not a single moment of epiphany. It's a gradual process of many small clicks, each being another piece of the puzzle falling in its place. Realization of how market's logic is different from conventional Aristotle type of logic - click. Understanding how Smart Money acts vs. how Crowd acts - click. Understanding how a chart reflects emotions - click. Realization that you don't have to participate in any market event and are free to choose your battles - click. Each click comes as a result of another lesson taught by the market - and a good teacher it is for rarely does it miss a chance to put you through another lecture or test. If you are an avid student of the market, you will listen carefully and take notes, collecting knowledge and experience. Ore comes in, steel comes out. This process takes time but it's so worth it, as all the sinter is being discarded and the final result is extremely rewarding - Clarity and Liberation.

A little sidenote is in order: when you arrive at this point in your trading career, you find out that this whole transformation has changed you not only as a trader - it changed you as a person, reflecting in other aspects of your life, making you more disciplined and in control of yourself, giving you the clarity in seeing "behind-the-curtain" happenings, better understanding people and events around you, better ability to deal with them. This comes as a side effect and is an icing on a cake... or maybe it's an ultimate achievement in and of itself, and better trading performance is merely a side effect?

Now, all above sounds so good, I just have to throw a spoon of tar in all that honey. The bad news is, this state of mind once being achieved is not necessary going to stay with you once and for all. Now and then you are going to have unpleasant lapses of sanity when old habits seem to return. We touched on this earlier in this post. The process of kicking nasty habits is not a single event, it's a process. There are sound reasons for those temporary setbacks. When we succeed we tend to stop doing what made us success in a first place. Complacency, letting your guard down, overconfidence, feeling that we became so good rules don't apply to us anymore... However, as frustrating as it can be, there is a good news, too. As you move along, overcoming another drawback and returning to the right path, your skill of dealing with this phenomenon becomes better. Relapses become less frequent, you learn to recognize them sooner and eliminate them faster and easier. They will finally stop altogether when the right way to act in the markets becomes your second nature. Or first.

So, is this all there is to the stages of psychological transformation from the sheep to be slaughtered to the money extractor, aka trader? Almost... there is just one little twist left, and that twist will constitute stage 4. Next post will go over it and conclude this mini-series on trading psychology.

For how long can you afford being wrong?

Response to the previous post warrants one more dip in the topic before I go back and finish Psychology 101 series. While the concept of "being right on the reasoning doesn't mean being right on the direction" is accepted by all who wrote back to me, one more issue has rise in discussion. The question is, since price is bound to go where it belongs sooner or later, why not just close one's eyes and let "them" play their games? Wait it out, however stomach-churning the process is, and greet the return of fairness and common sense with victorious throaty laughter?

It's surely tempting. Idea of closed eyes appeals to anyone who experienced the phenomenon of the market kicking one's butt for doing the most sensible well thought through and reasonable thing. The problem with this approach is this:

The market can stay irrational much longer than you can stay solvent.

I don't remember who said that but boy, was he right. I will go down the memory lane for one of the most remarkable examples, to illustrate just how powerful contra-obvious movement can be. I already talked about it as one of my prominent lessons (learned the hardest way, too) - those of you who got Techniques of Tape Reading (TTR) can open page 21. For those who for some incomprehensible reason still haven't read it, reminder of how the story went.

K-Tel, NASDAQ symbol at the time KTEL, little company with tiny float, announced that it was going to sell the albums with music of 60-70 over the Internet. Fine, who cares, right? Wrong. It was the beginning of Internet era. Netscape already went into stratosphere. K-Tel became a symbol of a new way of doing things. E-commerce was a new word. And a new world - as usual, brave one. Stock shot up from under 5 to over 20 in a couple days. Warranted? Heck no. Fundamentals were laughable. Perspectives were bleak. No one believed this move could mean much for the company's bottom line. So, every sensible trader on the planet, and I suspect some for Mars, went ahead and shorted it. Stock danced a bit around 20, then slowly moved closer to 30 (those were fractions times, they moved easier than under decimal system these days). Next morning it opened at 31 and proceeded higher. Then brokers called shorts in, to the horror or those who decided to close their eyes. If you don't remember those days or haven't read TTR, try to guess where the stock finally topped out? Eighty dollars!

Now, even if not for shorts being called in, would you be able to sit out such ride? I highly doubt it (unless you ARE from Mars that is). Chances are, you would have given up long before it was over, and the closer to the top your capitulation occured the more insulting it would have been. Worse yet: let's suppose blue-eyed miracle happened and against all odds you did manage to sit tight through this experience (nothing short of being made to watch Inconvinient Truth five times a day two weeks in a row). Do you think you would be able to profit from subsequent price drop? I wager Victoria, biggest crater on Mars , that as soon as KTEL dropped closer to $20 making you even, you would have covered your short with sigh of relief loud enough to be heard from that same crater. And if I am right about this, then all this horrible risk and gut-wrenching experience was for what, to get out about flat? Give or take couple millions nerve cells?

Oh, and for the irony... K-Tel's CEO, when interviewed those days, said he was not selling his shares because "he was told stock goes to 100". Now that KTEL is long gone, I wonder... if that's what happened and he never sold, was it an ultimate case of market killing both sides or what?

"History teaches us..."

As you know, I don't commment on current market conditions on this blog. Being an educational blog, it's simply not the purpose. Being that, it would also be a crime not to comment on immense learning opportunity provided by the market conditions we are seeing.

Make no mistake, we are going through the crisis of historic proportions. It's almost time to start coining a name for it. Great Liquidity Crisis? Credit Crunch of the Century? The Day (insert bank name) Fell? If you as a trader went through this market unharmed - good job protecting your behind while sharks circle around. If you make money in this market - congratulations, you do not belong to majority anymore. If you are a newer trader just starting your quest - consider yourself very lucky. Yes, lucky, because if you learn in this environment - you will find the "normal" market to be piece of cake to trade in.

Let us outline the lessons to be learned during such extreme times.

First and foremost, and the most important:
1. Logic of underlying events vs. logic of market movement.
This is one of the most confusing aspects of the market for many investors and inexperienced traders. We are conditioned to see causes and outcomes as being linked in a logical fashion. Bad news should send the price down. Good news should cause rallies. We want to buy good news and short bad news. We want to trust our analysis and act on our conclusions - and we, naturally, expect the market to follow. So, shouldn't we feel perplexed seeing how the market stages stunning rally when there is nothing but doom and gloom in all the sources of information? What else can we do but dismiss it as manipulation?

Well, manipulation it is in many cases. However, this notion doesn't take us anywhere as far as money-making is concerned. The major lesson in this is old as the market itself: if something is exceedingly obvious, the market will act against it. Market by its very nature cannot reward the obvious with money - simply because majority follows the obvious, and majority cannot be profitable. It can't because there is no pool of money set aside for the winner - money is being extracted from other market participants. Who could majority extract the money from? And, if there is no money for a group betting on certain direction, then this group in fact renders this direction as wrong by simply being too big.

If this sounds confusing, let's put it in simpler terms. If there are just 10 participants in the market and 9 out of 10 bet on downward move, who is left to sell more and push the price lower? They all sold short already, so what are they going to do when they see that the price is not dropping anymore? What other choice do they have but to start closing their short positions, pushing the price higher? That single player that took long position against those 9 may be wrong about the events in economy - but he will be right on the market direction. He will make money by betting against majority. Of course this is simplified way to look at things, the reality is much more complex, with all the different timeframes, new participants jumping in or getting out. This simple case, however, explains the divergence between the logic of the market movement and the logic of economy events.

This is the major lesson of this market because rarely can it be seen as clearly as these days. Do not fall into the trap of obviousness. Being right in a long run will not protect you from the losses today. Being right about the meaning on events does not mean the market hasn't priced those events in yet. Alternatively, market may be preparing to move in your direction, and its way of preparation is to shake out prematurely taken positions. Market is doing its best to move having as few participants on board as possible - and it's doing it by means of moving against the obvious. Price action overrides everything. We traders profit from price changes - that's the ultimate market language. This divergence is your friend, not your foe - it allows you to distinguish the Smart Money action from the Crowd actions and position yourself on the right side. This is major difference between the way traders think and the rest of population think.

2. Handling extreme volaitity.

If you are a short-term trader, imagine being an investor at the times when major indices swing as wide as they do these days. 400 points range is almost a new norm for Dow. NASDAQ rallying 40 points in a matter of minutes after talking head on CNBC mentions a rumor? Gut-wrenching... How do you control your risk under such circumstances, challenging even for a day trader?

- keep your position size reasonably smaller than usual
- shorten your holding period to limit your exposure and minimize your chance to get caught into sudden move; book your profits. These are the times when investors go to swing trading; swing taders go to day trading; day traders go to scalping; scalpers.... umm, scalpers remain scalpers, some of them haven't even noticed that there are some major changes underway. Lucky bunch eh?
- never ever let these wide ranges lure you into false sense of security of "it will be back to my price on the next pendulum swing anyway" kind. Market can stay insane much longer than you can stay solvent - keep your stops religiously.

3. Use this market as a tremendous learning opportunity even when you stay in cash.

This is a lifetime opportunity to learn. A lot of things that are usually muted and barely visible are very "in your face" right now.

Watch how major players react and interact - financial stocks, techs, metal-related. Watch how market reacts on news and rumors. Watch how breakouts work, how breakdowns work, how ranges hold. Watch market reactions on news and rumors. Watch which moves get follow-through and which get faded; try to get a feel for the difference so you would be able to tell in the future one from another. Watch when the market becomes totally unpredictable and erratic so that in the future you could recognize such situation as early as possible and go to cash.

Finally, one more thing to observe... it takes us back to our title:

4. History teaches us that it teaches us nothing.

Watch eternal cycle of hope based on denial and fear stemming from lack of understanding of market inner workings. Every piece of "good news" spat out by propaganda machine sparkles explosion of optimism - no matter how lame "news" is. Someone comes to TV and says something, with agenda or just striving for attention - and their words become a gospel or anathema, depending on listener's positioning in the market. Positions are being held despite market going against the holder. Positions are being taken and dumped out of pure emotions; rules are being abandoned. Emotions run high making people do a lot of stupid things. Observe it all as, just as in previous point, when the heat is that high all these things are seen very clearly . Such heightened tension as we have now serves as a photo film development.

It may sound a bit cynic at the time when the wealth is being destroyed at such rate, but let's say it again... as a trader consider yourself lucky to have such learning opportunity. Use it to its full extent.

Oh, and by the way... The quote that served as a title for this post is a cute simplified form. Full quote from Hegel is even more telling. “What experience and history teaches us is that people and governments have never learned anything from history, or acted on principles deduced from it”.