Chapter 1 - The New Trading for a Living

 The New 

Trading for a Living

Introduction 

■ 1. Trading—The Last Frontier 

You can be free. You can live and work anywhere in the world. You can be independent from routine and not answer to anybody. 

This is the life of a successful trader. 

Many aspire to it but few succeed. An amateur looks at a quote screen and sees  millions of dollars sparkle in front of his face. He reaches for the money—and loses.  He reaches again—and loses more. Traders lose because the game is hard, or out of  ignorance, or from lack of discipline. If any of these ail you, I wrote this book for you. 

How I Began to Trade 

In the summer of 1976, I drove from New York to California. I took along a few books  on psychiatry (I was a first-year psychiatric resident), several histories, and put a paperback copy of Engel’s How to Buy Stocks into the trunk of my old Dodge. Little did I  know that a dog-eared paperback, borrowed from a lawyer friend, would in due time  change the course of my life. That friend, incidentally, had a perfect reverse golden  

touch—any investment he touched went under water. But that’s another story. I gulped down the Engel book in campgrounds across America, finishing it on a  Pacific beach in La Jolla. I had known nothing about the stock market, and the idea  of making money by thinking gripped me. 

I grew up in the Soviet Union in the days when it was, in the words of a former  U.S. president, “an evil empire.” I hated the Soviet system and wanted to get out, but 

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2 INTRODUCTION 

emigration was forbidden. I entered college at 16, graduated medical school at 22,  completed my residency, and then took a job as a ship’s doctor. Now I could break  free! I jumped the Soviet ship in Abidjan, Ivory Coast. 

I ran to the U.S. Embassy through the clogged dusty streets of an African port  city, chased by my ex-crewmates. The embassy put me in a “safe house” and then on  a plane to New York. I landed at Kennedy Airport in February 1974, arriving from  Africa with $25 in my pocket. I spoke some English, but did not know a soul in this  country. 

I had no idea what stocks, bonds, futures, or options were and sometimes got a  queasy feeling just from looking at the American dollar bills in my wallet. In the old  country, a handful of them could buy you three years in Siberia. 

Reading How to Buy Stocks opened a whole new world for me. When I returned  to New York, I bought my first stock—it was KinderCare. A very bad thing happened—I made money on my first trade and then the second one, leaving me with  a delusion that making money in the markets was easy. It took me a couple of years  to get rid of that notion. 

My professional career proceeded on a separate track. I completed a residency in  psychiatry at a major university hospital, studied at the New York Psychoanalytic Institute, and served as book editor for the largest psychiatric newspaper in the United  States. I still have my license, but my professional practice these days is at most an hour  or two per month. I am busy trading, love traveling, and do some teaching. 

Learning to trade has been a long journey—with soaring highs and aching lows.  In moving forward—or in circles—I repeatedly knocked my head against the wall  and ran my trading account into the ground. Each time I returned to a hospital job,  put a stake together, read, thought, did more testing, and then started trading again. 

My trading slowly improved, but the breakthrough came when I realized that the  key to winning was inside my head and not inside a computer. Psychiatry gave me  the insight into trading that I will share with you. 

Do You Really Want to Succeed? 

For many years I had a friend whose wife was fat. She was an elegant dresser, and  she had been on a diet for as long as I had known her. She said she wanted to lose  weight and she didn’t eat cake or potatoes in front of people—but when I came into  her kitchen, I’d see her go at it with a big fork. She said she wanted to be slim, but  remained fat. 

The short-term pleasure of eating was stronger for her than the delayed pleasure  and health benefits of weight loss. My friend’s wife reminded me of a great many  traders who say they want to be successful but keep making impulsive trades—going  for the short-term thrills of gambling in the markets. 

People deceive and play games with themselves. Lying to others is bad, but lying  to yourself is hopeless. Bookstores are full of good books on dieting, but the world  is still full of overweight people.

2. PSYCHOLOGY IS THE KEY 3 

This book will teach you how to analyze and trade the markets, control risks, and  deal with your own mind. I can give you the knowledge. Only you can supply the  motivation. 

And remember this: an athlete who wants to enjoy risky sports must follow safety  rules. When you reduce risks, you gain an added sense of accomplishment and control. The same goes for trading. 

You can succeed in trading only if you handle it as a serious intellectual pursuit. Emotional  trading is lethal. To help ensure success, practice defensive money management. A good trader  watches his capital as carefully as a professional scuba diver watches his air supply. 

■ 2. Psychology Is the Key 

Remember how you felt the last time you placed an order? Were you anxious to  jump in or afraid of losing? Did you procrastinate before entering your order? When  you closed out a trade, did you feel elated or humiliated? The feelings of thousands  of traders merge into huge psychological tides that move the markets. 

Getting Off the Roller Coaster 

The majority of traders spend most of their time looking for good trades. Once  they enter a trade, they don’t manage it but either squirm from pain or grin from  pleasure. They ride an emotional roller coaster and miss the essential element of  winning—the management of their emotions. Their inability to manage themselves  leads to poor risk management and losses. 

If your mind is not in gear with the markets, or if you ignore changes in mass  psychology of crowds, you have no chance of making money trading. All winning  professionals know the enormous importance of psychology. Most losing amateurs  ignore it. 

Friends and students who know that I am a psychiatrist often ask whether this  helps me as a trader. Good psychiatry and good trading have one important principle  in common. Both focus on reality, on seeing the world the way it is. To live a healthy  life, you have to live with your eyes open. To be a good trader, you need to trade with  your eyes open, recognize real trends and turns, and not waste time or energy on  fantasies, regrets, and wishful thinking. 

A Man’s Game? 

Brokerage house records indicate that most traders are male. The files of my firm,  Elder.com, confirm that approximately 85 to 90 percent of traders are male. The  percentage of women traders among my clients, however, has more than doubled  since the original edition of Trading for a Living was written twenty years ago.

4 INTRODUCTION 

The English language being what it is, “he” flows better than “he or she” or jumping between the two pronouns. To make reading easier, I’ll use the masculine pronoun throughout this book. Of course, no disrespect is intended to the many women traders. 

As a matter of fact, I find that the percentage of successful traders is higher among  women. As a group, they tend to be more disciplined and less arrogant than men. 

How This Book Is Organized 

The three pillars of successful trading are psychology, market analysis, and risk management. Good record-keeping ties them together. This book will help you learn the  essentials of all these areas. 

Part One of this book will show you how to manage emotions in trading. I discovered this method while practicing psychiatry. It greatly improved my trading, and it  can help you too. 

Part Two will focus on crowd psychology of the markets. Mass behavior is more  primitive than that of individuals. If you understand how crowds behave, you’ll be  able to profit from their mood swings instead of being swept up in their emotional  tides. 

Part Three will show how chart patterns reflect crowd behavior. Classical technical analysis is applied social psychology, like poll-taking. Support, resistance, break outs, and other patterns reflect crowd behavior. 

Part Four will teach you modern methods of computerized technical analysis.  Indicators provide a better insight into mass psychology than classical chart patterns.  Trend-following indicators help identify market trends, while oscillators show when  those trends are ready to reverse. 

Volume and open interest also reflect crowd behavior. Part Five will focus on  them as well as on the passage of time in the markets. Crowds have short attention  spans, and a trader who relates price changes to time gains a competitive advantage. 

Part Six will focus on the best tools for analyzing the stock market as a whole.  They can be especially helpful for stock index futures and options traders. Part Seven will present several trading systems. We’ll begin with the Triple Screen,  which has become widely accepted, and then review the Impulse and Channel trading systems. 

Part Eight will discuss several classes of trading vehicles. It will outline pluses and  minuses of equities, futures, options, and forex, while blowing away the promotional  fog that clouds some of these markets. 

Part Nine will lead you into the all-important topic of money management. This  essential aspect of successful trading is neglected by most amateurs. You can have a  brilliant trading system, but if your risk management is poor, then a short string of  losses will destroy your account. Armed with the Iron Triangle of risk control and  other tools, you’ll become a safer and more effective trader. 

Part Ten will delve into the nitty-gritty of trading—setting stops, profit targets,  and scanning. These practical details will help you implement any system you like.

3. THE ODDS AGAINST YOU 5 

Part Eleven will guide you through the principles and templates of good record keeping. The quality of your records is the single best predictor of your success. I’ll  offer you free downloads of the templates I like to use. 

Last but not least, this book has a separate Study Guide. It asks over 100 questions,  each linked to a specific section of the book. All questions are designed to test your  level of understanding and discover any blind spots. After you finish reading each section of this book, it’ll make sense to turn to the Study Guide and answer questions  relevant to that section. If test results turn out to be less than excellent, don’t hurry,  reread that section of the book, and retake the test. 

You are about to spend many hours with this book. When you find ideas that  look important to you, test them in the only way that matters—on your own market data and in your own trading. You will make this knowledge your own only by  questioning and testing it. 

■ 3. The Odds against You 

Why do most traders lose and wash out of the markets? Emotional and mindless  trading are big reasons, but there is another. Markets are actually set up so that most  traders must lose money. The trading industry slowly kills traders with commissions  and slippage. 

You pay commissions for entering and exiting trades. Slippage is the difference  between the price at which you place your order and the price at which it gets filled.  When you place a limit order, it is filled at your price or better, or not at all. When  you feel eager to enter or exit and place a market order, it’s often filled at a worse  price than prevailed when you placed it. 

Most amateurs are unaware of the harm done by commissions and slippage, just  as medieval peasants could not imagine that tiny invisible germs could kill them. If  you ignore slippage and deal with a broker who charges high commissions, you’re  acting like a peasant who drinks from a communal pool during a cholera epidemic. 

The trading industry keeps draining huge amounts of money from the markets.  Exchanges, regulators, brokers, and advisors live off the markets, while generations  of traders keep washing out. Markets need a fresh supply of losers just as builders  of the ancient pyramids needed a fresh supply of slaves. Losers bring money into the  markets, which is necessary for the prosperity of the trading industry. 

A Minus-Sum Game 

Winners in a zero-sum game make as much as losers lose. If you and I bet $20 on  the direction of the next 100-point move in the Dow, one of us will collect $20 and  the other will lose $20. A single bet has a component of luck, but the more knowledgeable person will keep winning more often than losing over a period of time. People buy the industry’s propaganda about trading being a zero-sum game, take  the bait, and open accounts. They don’t realize that trading is a minus-sum game. 

6 INTRODUCTION 

Winners receive less than what losers lose because the industry drains money from  the markets. 

For example, roulette in a casino is a minus-sum game because the casino sweeps  away between three and six percent of every bet. This makes roulette unwinnable in  the long run. You and I can get into a minus-sum game if we make the same $20  bet on the next 100-point move in the Dow through brokers. When we settle, the  loser will be out $23, and the winner will collect only $17, while two brokers will  smile on their way to the bank. 

Commissions and slippage are to traders what death and taxes are to all of us.  They take some fun out of life and ultimately bring it to an end. A trader must support his broker and the machinery of exchanges before he collects a dime. Being  simply “better than average” is not good enough. You have to be head and shoulders  above the crowd to win a minus-sum game. 

Commissions 

Commissions have become much smaller in the past two decades. Twenty years ago,  there were still brokers who charged one-way commissions of between half a percent  and one percent of trade value. Buying a thousand shares of GE at $20 a share, with  a total value of $20,000, would have set you back $100 to $200 on the way in—and  again on the way out. Fortunately for traders, commission rates have plummeted. 

The extortionate rates haven’t completely disappeared. While preparing this  book for publication, I received an email from a client in Greece with a small account whose broker—a major European bank—charged him a $40 minimum on  any trade. I told him of my broker whose minimum for a hundred shares is only $1. 

Without proper care, even seemingly small numbers can raise a tall barrier to  success. 

Look at a fairly active trader with a $20,000 account, doing one round trip trade  per day, four days a week. Paying $10 one way, by the end of the week he’ll spend  $80 in commissions: $40 for entries and $40 for exits. If he does that 50 weeks per  year (if he lasts that long), by the end of the year he will have spent $4,000 on com 

mission. That would be 20% of his account! 

George Soros, a top money manager, delivers an average 29% annual return. He  wouldn’t be where he is if he paid 20% a year in commissions! Even a “small commission” can build up a major barrier to success! I’ve heard brokers chuckle as they  gossiped about clients who beat their brains out just to stay even with the game. 

Shop for the lowest possible commissions. Don’t be shy about bargaining for lower rates.  I’ve heard many brokers complain about a shortage of customers—but not many customers  complain about the shortage of brokers. Tell your broker it is in his best interest to charge you  low commissions because you will survive and remain a client for a long time. Design a trading  system that will trade less often. 

In my own trading, I maintain one major account with a broker who charges me  $7.99 for unlimited size trades and another with a broker who charges a penny a  share, with a $1 minimum. When I trade expensive stocks, where I buy fewer than 

3. THE ODDS AGAINST YOU 7 

800 shares, I give that order to the penny-a-share broker; otherwise, I go with the  $7.99-per-trade broker. A beginning trader, making his first steps, should look for  a penny-a-share broker. Then you can trade your 100 shares for a dollar. A futures  trader can expect to pay just a couple of dollars for a roundtrip trade. 

Slippage 

Slippage means having your orders filled at a different price than what you saw on the  screen when you placed your order. It is like paying 50 cents for an apple in a grocery  store even though the posted price is 49 cents. A penny is nothing—but if you’re  buying a thousand apples or a thousand shares with a penny slippage, it’ll come to  $10 per order, probably greater than your commission. 

There are two main types of orders: market and limit. Your slippage depends on  which of these types you use. 

A limit order says—‘give me that apple at 49 cents.’ It guarantees the price, but  doesn’t guarantee a fill. You’ll pay no more than 49 cents, but you may end up without the apple that you wanted. 

A market order says—‘give me that apple.’ It guarantees a fill, but doesn’t guarantee the price. If the prices of apples are rising when you place your order, you may well  pay more than you saw on the screen when you pushed the buy button. You may get  hit by slippage. 

Slippage on market orders rises with market volatility. When the market begins to  run, slippage goes through the roof. 

Do you have any idea how much slippage costs you? 

There is only one way to find out: write down the price at the time you placed a  market order, compare it with your fill, and multiply the difference by the number of  shares or contracts. Needless to say, you need a good record-keeping system, such as  a spreadsheet with columns for each of the above numbers. We offer such a spread 

sheet to traders as a public service at www.elder.com. 

You’ll be reading “record this” and “record that” throughout this book. Remember  that good record-keeping is essential for your success. You have to keep an eye on  your wins and an even sharper eye on your losses because you can learn much more  from them. 

Here’s a shocking number, which you can confirm by keeping good records: an  average trader spends three times more on slippage than on commissions. Earlier we talked about commissions raising a barrier to success. The barrier from  slippage is three times higher. This is why, no matter how tempting a trade, you need  to avoid buying “at the market.” 

You want to be in control and trade only at prices that suit you. There are thousands of stocks and dozens of futures contracts. If you miss a trade due to a limit  order, there’ll be countless other opportunities. Do not overpay! I almost always use  limit orders and resort to market orders only when placing stops. When a stop level  gets hit, it becomes a market order. When a trade is flaming out, it’s not the time to  economize. Get in slow but get out fast.

8 INTRODUCTION 

To reduce slippage, trade liquid, high-volume markets and avoid thinly traded stocks, where  slippage tends to be higher. Go long or short when the market is quiet, and use limit orders to  buy or sell at specified prices. Keep a record of prices at the time you placed your order. Demand  your broker fight the floor for a better fill when necessary. 

Bid-Ask Spreads 

Whenever the market is open, there are always two prices for any trading vehicle—a  bid and an ask. A bid is what people are offering to pay for that security at that moment; an ask is what sellers are demanding in order to sell it. A bid is always lower,  an ask higher, and the spread between them keeps changing. 

Bid-ask spreads vary between different markets and even in the same market at  different times. Bid-ask spreads are higher in thinly traded vehicles, as the pros who  dominate such markets demand high fees from those who want to join their party.  The bid-ask spreads are likely to be razor-thin, perhaps only one tick on a quiet day  in an actively traded stock, future or option. They grow wider as prices accelerate  on the way up or down and may become huge—dozens of ticks—after a severe drop  or a very sharp rally. 

Market orders get filled at the bad side of bid-ask spreads. A market order buys at  the ask (high) and sells at the bid (low). Little wonder that many professional traders make a good living from filling market orders. Don’t feed the wolves—use limit  orders whenever possible! 

The Barriers to Success 

Slippage and commissions make trading similar to swimming in a piranha-infested  river. Other expenses also drain traders’ money. The cost of computers and data,  fees for advisory services and books—including the one you are reading now—all  come out of your trading funds. 

Look for a broker with the cheapest commissions and watch him like a hawk. Design a trading system that gives signals relatively infrequently and allows you to enter markets during  quiet times. Use limit orders almost exclusively—except when placing stops. Be careful on what  tools you spend money: there are no magic solutions. Success cannot be bought, only earned.

PART 1

PART 1 

Individual Psychology 

■ 4. Why Trade? 

Trading appears deceptively easy. A beginner may cautiously enter the market, win a  few times, and start feeling brilliant and invincible. That’s when he starts taking wild  risks and ends up with bad losses. 

People trade for many reasons—some rational and many irrational. Trading offers  an opportunity to make a lot of money in a hurry. Money symbolizes freedom to  many people, even though they often don’t know what to do with it. 

If you know how to trade, you can make your own hours, live and work anywhere  you please, and never answer to a boss. Trading is a fascinating game: chess, poker,  and a video game rolled into one. Trading attracts people who love challenges. 

It attracts risk-takers and repels those who avoid risk. An average person gets up in  the morning, goes to work, has a lunch break, returns home, has a beer and dinner,  watches TV, and goes to sleep. If he makes a few extra dollars, he puts them into a savings account. A trader keeps odd hours and puts his capital at risk. Many traders are  loners who abandon the certainties of the routine and take a leap into the unknown. 

Self-Fulfillment 

Many people have an innate drive to achieve their personal best, to develop their  abilities to the fullest. This drive, along with the pleasure of the game and the lure of  money, propels traders to challenge the markets. 

Good traders tend to be hardworking and shrewd people, open to new ideas. The  goal of a good trader, paradoxically, is not to make money. His goal is to trade well.  

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10 INDIVIDUAL PSYCHOLOGY 

If he trades right, money follows almost as an afterthought. Successful traders keep  honing their skills as they try to reach their personal best. 

A professional trader from Texas invited me to his office and said: “If you sit across  the table from me while I day-trade, you won’t be able to tell whether I am $2,000  ahead or $2,000 behind on that day.” He has risen to a level where winning does not  elate him and losing does not deflate him. He is so focused on trading right and im 

proving his skills that money no longer influences his emotions. 

The trouble with self-fulfillment is that many people have self-destructive streaks.  Accident-prone drivers keep destroying their cars, and self-destructive traders keep  destroying their accounts. Markets offer vast opportunities for self-sabotage, as well  as for self-fulfillment. Acting out your internal conflicts in the marketplace is a very  expensive proposition. 

Traders who are not at peace with themselves often try to fulfill their contradictory wishes in the markets. If you don’t know where you are going, you’ll wind up  somewhere you never wanted to be. 

■ 5. Reality versus Fantasy 

If a friend with little farming experience told you that he planned to feed himself  with food grown on a quarter-acre (1,000 square meters) plot, you’d expect him to  go hungry. One can squeeze only so much from a small piece of land. There is, how 

ever, a field in which grown-ups let their fantasies fly—in trading. A former employee told me that he planned to support himself by trading a $6,000  account. When I tried to show him the futility of his plan, he quickly changed the  topic. He was a bright analyst, but refused to see that his “intensive farming” plan was  suicidal. In his desperate effort to succeed, he’d have to take on large positions—and  the slightest wiggle of the market will quickly put him out of business. A successful trader is a realist. He knows his abilities and limitations. He sees  what’s happening in the markets and knows how to react. He analyzes the markets  without cutting corners, observes himself, and makes realistic plans. A professional  trader cannot afford illusions. 

Once an amateur takes a few hits and gets a few margin calls, he swings from  cocky to fearful and starts developing strange ideas about the markets. Losers buy,  sell, or avoid trades due to their fantastic ideas. They act like children who are  afraid to pass a cemetery or look under their bed at night because they are afraid  of ghosts. The unstructured environment of the market makes it easy to develop  fantasies. 

Most people who grow up in Western civilization have several similar fantasies.  They are so widespread that when I studied at the New York Psychoanalytic Institute,  there was a course called “Universal Fantasies.” For example, many people have a  fantasy in childhood that they were adopted. This fantasy seems to explain the un 

friendly and impersonal world. It consoles a child but prevents him from being aware  of a reality he’d rather not see—that his parents aren’t that good. Our fantasies influence our behavior, even if we aren’t consciously aware of them.

5. REALITY VERSUS FANTASY 11 

In talking to hundreds of traders, I keep hearing several universal fantasies. They  distort reality and stand in the way of trading success. A successful trader must identify his fantasies and get rid of them. 

The Brain Myth 

Losers who suffer from the “brain myth” will tell you, “I lost because I didn’t know  trading secrets.” Many have a fantasy that successful traders have some secret knowledge. That fantasy helps support a lively market in advisory services and ready-made  trading systems. 

A demoralized trader may whip out his credit card to buy access to “trading  secrets.” He may send money to a charlatan for a $3,000 “can’t miss,” backtested,  computerized trading system. When that system self-destructs, he’ll pull out his  almost-maxed-out credit card again for a “scientific manual” that explains how he  can stop losing and begin winning by contemplating the moon, the stars, or even  Uranus. 

At an investment club we used to have in New York, I often ran into a famous  financial astrologer. He often asked for free admission because he couldn’t afford to  pay a modest fee for the meeting and a meal. His main source of income remains  collecting money for astrological trading predictions from hopeful amateurs.  

Losers don’t realize that trading is intellectually fairly simple. It is nowhere near  as demanding as taking out an appendix, building a bridge, or trying a case in court.  Good traders are shrewd, but few are intellectuals. Many have never been to college,  and some have dropped out of high school. 

Intelligent and hardworking people who have succeeded in their careers often feel  drawn to trading. 

Why do they fail so often? What separates winners from losers isn’t intelligence  or secrets, and certainly not education. 

The Undercapitalization Myth 

Many losers think that they would trade successfully if they had a bigger account. People destroy their accounts either by a string of losses or a single abysmally bad  trade. Often, after the loser is sold out, unable to meet a margin call, the market  reverses and moves in the direction he expected. He starts fuming: had he survived  another week, he would have made a fortune instead of losing! 

Such people look at market reversals that come too late and think that those turns  confirm their methods. They may go back to work and earn, save, or borrow enough  money to open another small account. History repeats itself: The loser gets wiped  out, the market reverses and “proves” him right, but only too late—he’s been sold  out again. That’s when the fantasy was born: “If only I had a bigger account, I could have  stayed in the market longer and won.” 

Some losers raise money from relatives and friends by showing them a paper track  record. It seems to prove that they would have won big, if only they had had more 

12 INDIVIDUAL PSYCHOLOGY 

money to work with. But even if they raise more money, they lose that, too—as if  the market were laughing at them! 

A loser is not undercapitalized—his mind is underdeveloped. A loser can destroy  a big account almost as quickly as a small one. An acquaintance of mine once blew  out over 200 million dollars in a day. His broker sold him out—and then the market  turned. He sued the broker and said to me: “If only I had a bigger account….” Ap 

parently an account with $200 million wasn’t big enough. 

A loser’s true problem is not account size but overtrading and sloppy money management. He takes risks that are too big for his account size, however small or big. No matter how good his system may be, a streak of bad trades is sure to put him out of business. 

Amateurs neither expect to lose nor are prepared to manage losing trades. Calling  themselves undercapitalized is a cop-out that helps them avoid two painful truths:  their lack of a realistic money management plan and lack of discipline. 

A trader who wants to survive and prosper must control losses. You do that by  risking only a tiny fraction of your equity on any single trade (see Section Nine, “Risk  Management”). Learn from cheap mistakes in a small account. 

The one advantage of a large trading account is that the price of equipment and  services represents a smaller percentage of your money. The owner of a million dollar fund who spends $5,000 on classes is only ½ percent behind the game. The  same expenditure would represent a deadly 25 percent of equity for a trader with a  $20,000 account. 

The Autopilot Myth 

Traders who believe in the autopilot myth think that the pursuit of wealth can be  automated. Some people try to develop an automatic trading system, while others  buy systems from vendors. Men who have spent years honing their skills as lawyers,  doctors, or businessmen plunk down thousands of dollars for canned competence.  Most are driven by greed, laziness, and mathematical illiteracy. 

Systems used to be written on sheets of paper, but now they get downloaded on  a computer. Some are primitive; others are elaborate, with built-in optimization and  even money management rules. Many traders spend thousands of dollars searching  for magic that will turn a few pages of computer code into an endless stream of  money. People who pay for automatic trading systems are like medieval knights who  paid alchemists for the secret of turning base metals into gold. 

Complex human activities do not lend themselves to automation. Computerized  learning systems have not replaced teachers, and programs for doing taxes haven’t  created unemployment among accountants. Most human activities call for an exercise of judgment; machines and systems can help but not replace humans. 

Had there been a successful automated trading system, its purchaser could move  to Tahiti and spend the rest of his life at leisure, supported by a stream of checks from  his broker. So far, the only people who’ve made money from trading systems are their  sellers. They form a small but colorful cottage industry. If their systems worked,  why would they sell them? They could move to Tahiti themselves and cash checks  from their brokers! Meanwhile, every system seller has a line. Some say they like 

5. REALITY VERSUS FANTASY 13 

programming is better than trading. Others claim that they sell their systems only to  raise capital or even out of love for humanity. 

Markets are always changing and defeating automatic trading systems. Yesterday’s  rigid rules will work less well today and will probably stop working tomorrow. A  competent trader can adjust his methods when he detects trouble. An automatic  system is less adaptable and self-destructs. 

Airlines pay high salaries to pilots despite having autopilots. They do it because  humans can handle unforeseen events. When a roof blows off an airliner over the  Pacific or when a passenger jet loses both engines to a flock of geese over Manhattan, only a human can handle such crises. These emergencies have been reported in  the press, and in each of them, experienced pilots managed to land their airliners by  improvising solutions. No autopilot can do that. Betting your money on an automatic  system is like betting your life on an autopilot. The first unexpected event will make  your account crash and burn. 

There are good trading systems out there, but they have to be monitored and adjusted using individual judgment. You have to stay on the ball—you cannot abdicate  responsibility for your success to a mechanical system. 

Traders with autopilot fantasies try to repeat what they felt as infants. Their  mothers used to fulfill their needs for food, warmth, and comfort. Now they try to  recreate the experience of passively lying on their backs and having profits flow to  them like an endless stream of free, warm milk. The market is not your mother. It  consists of tough men and women who look for ways to take money from you rather  than pouring warm milk into your mouth. 

The Cult of Personality 

Most people pay lip service to their wish for freedom and independence, but when  they come under pressure, they change their tune and start looking for “strong leadership.” Traders in distress often seek directions from assorted gurus. 

When I was growing up in the former Soviet Union, children were taught that  Stalin was our great leader. Later we found out what a monster he was, but while he  was alive, most people enjoyed following the leader. He freed them from the need  to think for themselves. 

“Little Stalins” were installed in every area of society—in economics, biology,  architecture, and so on. When I came to the United States and began to trade, I was  amazed to see how many traders were looking for a guru—their own “little Stalin.”  The fantasy that someone else can make you rich is always with us. 

There are three types of gurus in the financial markets: market cycle gurus, magic  method gurus, and dead gurus. Cycle gurus call important market turns. Method  gurus promote new highways to riches. Still others have escaped criticism and invited cult following through the simple mechanism of departing this world. 

Market Cycle Gurus 

For many decades, the U.S. stock market has generally followed a four-year cycle.  The broad stock market has normally spent 2.5 or 3 years going up and 1 or 1.5 years 

14 INDIVIDUAL PSYCHOLOGY 

going down. A new market cycle guru emerges in almost every major stock cycle,  once every 4 years. A guru’s fame tends to last for 2 to 3 years. The reigning period  of each guru coincides with a major bull market in the United States. 

A market cycle guru forecasts rallies and declines. Each correct forecast increases  his fame and prompts even more people to buy or sell when he issues his pronouncements. A market cycle guru has a pet theory about the market. That theory—cycles,  volume, Elliott Wave, whatever—is usually developed several years prior to reaching  stardom. At first, the market refuses to follow an aspiring guru’s pet theory. Then  the market changes and for several years comes in gear with the guru’s calls. That is  when the guru’s star rises high above the marketplace. 

Compare this to what happens to fashion models as public tastes change. One year,  blondes are popular, another year, redheads. Suddenly, last year’s blonde star is no longer wanted for the front cover of a major magazine. Everybody wants a dark model,  or a woman with a birthmark on her face. A model doesn’t change—public tastes do. 

Gurus always come from the fringes of market analysis. They are never establishment analysts. Institutional employees play it safe—afraid to stick their necks out— and almost never achieve spectacular results. A market cycle guru is an outsider with  a unique theory. 

A guru remains famous for as long as the market behaves according to his the– ory—usually for less than the duration of one 4-year market cycle. At some point,  the market changes and starts marching to a different tune. A guru continues to use  old methods that worked so well in the past and loses his following. When the guru’s  forecasts stop working, public admiration turns to hatred. It’s impossible for a dis 

credited market cycle guru to return to stardom. 

All market cycle gurus have several traits in common. They become active in  the forecasting business several years prior to reaching stardom. Each has a unique  theory, a few followers, and some credibility, conferred by sheer survival in the advisory business. The fact that each guru’s theory did not work for a number of years  is ignored by his followers. When the theory becomes correct, the mass media take  notice. When a theory stops working, mass adulation turns to hatred. 

When you recognize that a successful new guru is emerging, it may be profitable  to jump on his bandwagon. It’s even more important to recognize when a guru has  reached his peak. All gurus crash—and by definition, they crash from the height of  their fame. When a guru becomes accepted by the mass media, it’s a good sign that  he has reached his crest. The mainstream media is wary of outsiders. When several  mass magazines devote space to a hot market guru, you know that his end is near.  Mass psychology being what it is, new gurus will continue to emerge.  

Magic Method Gurus 

While cycle gurus are creatures of the stock market, “method gurus” are more  prominent in the derivatives markets. A “method guru” erupts on the financial scene  after discovering a new analytic or trading method. 

Traders always look for an edge, an advantage over fellow traders. Like knights  shopping for swords, they are willing to pay handsomely for their trading tools. No  price is too high if it lets them tap into a money pipeline.

5. REALITY VERSUS FANTASY 15 

A magic method guru sells a new set of keys to market profits—speedlines, cycles, Market Profile, etc. It may have an edge in the beginning, but as soon as enough  people become familiar with a new method and test it in the markets, it inevitably  deteriorates and starts losing popularity. Markets are forever grinding down each  method’s edge, and what worked yesterday is less likely to work today and highly  unlikely a year from now. 

Oddly enough, even in this era of global communications, reputations change  slowly. A guru whose image has been destroyed in his own country can make money  peddling his theory overseas. That point has been made to me by a guru who compared his continued popularity in Asia to what happens to faded American singers  and movie stars. They are unable to attract an audience in the United States, but they  can still make a living singing abroad. 

Dead Gurus 

The third type of a market guru is a dead guru. His books are reissued, his market  courses are scrutinized by new generations of eager traders, and the legend of the  dear-departed analyst’s prowess and personal wealth grows posthumously. The dead  guru is no longer among us and cannot capitalize on his fame. Other promoters profit  from his reputation and expired copyrights. One dear-departed guru is R. N. Elliott,  but the best example of such a legend is W. D. Gann. 

Various opportunists sell “Gann courses” and “Gann software.” They claim that  Gann was one of the best traders who ever lived, that he left a $50 million estate,  and so on. I interviewed W. D. Gann’s son, an analyst for a Boston bank. He told me  that his famous father could not support his family by trading but earned his living by  writing and selling instructional courses. He could not afford a secretary and made  his son work for him. When W. D. Gann died in the 1950s, his estate, including his  house, was valued at slightly over $100,000. The legend of W. D. Gann, the giant of  trading, is perpetuated by those who sell courses and other paraphernalia to gullible  customers. 

The Followers of Gurus 

A guru has to produce original research for several years, then get lucky when the  market turns his way. While some gurus are dead, those who are alive range from  serious academic types to great showmen. To read about scandals surrounding many  gurus, try Winner Takes All by William R. Gallacher. 

When we pay a guru, we expect to get back more than we spend. We act like a  man who bets a few dollars against a three-card Monte dealer on a street corner. He  hopes to win more than he put down on an overturned crate. Only the ignorant or  greedy take the bait. 

Some people turn to gurus in search of a strong leader. They look for a parent-like  omniscient provider. As a friend once said, “They walk with their umbilical cords in  hand, looking for a place to plug them in.” A smart promoter provides such a receptacle, for a fee. 

The public wants gurus, and new gurus will come. As an intelligent trader, you must realize  that in the long run, no guru is going to make you rich. You have to work on that yourself.

16 INDIVIDUAL PSYCHOLOGY 

Occasionally, when I give a talk or appear on TV, someone introduces me as a  “famous guru.” I shudder at those words and interrupt such introductions. A guru  is someone claiming to lead the crowds across the desert for a donation. No such  pitches here! 

I always begin by explaining that there are no magic methods, that the field of  trading is as huge and diverse as that of medicine, where one needs to choose one  specialty and work hard to become good at it. I chose my path a long time ago, and  what I do in front of a class is simply think out loud, sharing my modes of research  and decision making. 

Trade with Your Eyes Open 

Wishful thinking is stronger than dollars. Recent research has proven that people  have a prodigious ability to lie to themselves and avoid seeing the truth. Duke University professor Dan Ariely describes a clever experiment. A group of  people are given an intelligence test, but half of them are “accidentally” showed a response sheet, allowing them to look up correct answers before recording their own.  Needless to say, they score above the rest. Next, everybody is asked to predict their  grades on the next IQ test, in which there will be absolutely no cheat sheets—and  those who predict correctly will get paid. Surprisingly, the half of the group that  scored higher with cheat sheets predicted higher results for the next test. The cheaters wanted to believe they were very smart, even though their incorrect predictions  of success would cost them money. 

A successful trader cannot afford wishful thinking—he must be a realist. There  are no cheat sheets in the markets—you can see the truth in your trade diaries and  equity curves. 

To win in the markets, we need to master three essential components of trading:  sound psychology, a logical trading system, and an effective risk management plan.  These are like three legs of a stool—remove one and the stool will fall. It is a typical  beginner mistake to focus exclusively on indicators and trading systems. 

You have to analyze your feelings as you trade to make sure that your decisions are sound.  Your trades must be based on clearly defined rules. You have to structure your money management so that no string of losses can kick you out of the game. 

■ 6. Self-Destructiveness 

Trading is a very hard game. A trader who wants to win and remain successful in the  long run has to be extremely serious about his craft. He cannot afford to be naive or  to trade because of some hidden psychological agenda. 

Unfortunately, trading often appeals to impulsive people, gamblers, and those  who feel that the world owes them a living. If you trade for the excitement, you’ll  inevitably take trades with bad odds and accept needless risks. The markets are unforgiving, and emotional trading always results in losses.

6. SELF-DESTRUCTIVENESS 17 Gambling 

Gambling means betting on games of chance or skill. It exists in all societies, and  most people have gambled at some point in their lives. 

Freud believed that gambling was universally attractive because it was a substitute  for masturbation. The repetitive and exciting activity of the hands, the irresistible  urge, the resolutions to stop, the intoxicating quality of pleasure, and the feelings of  guilt link gambling and masturbation. 

Dr. Ralph Greenson, a prominent California psychoanalyst, has divided gamblers  into three groups: the normal person who gambles for diversion and who can stop  when he wishes; the professional gambler, who selects gambling as his means of  earning a livelihood; and the neurotic gambler, who gambles because he is driven by  unconscious needs and is unable to stop. 

A neurotic gambler either feels lucky or wants to test his luck. Winning gives  him a sense of power. He feels pleased, like a baby feeding at a breast. In the end, a  neurotic gambler always loses because he tries to recreate that omnipotent feeling of  bliss instead of concentrating on a realistic long-term game plan. 

Dr. Sheila Blume, director of the compulsive gambling program at South Oaks  Hospital in New York, called gambling “an addiction without a drug.” Most gamblers  are men who gamble for the action. Women tend to gamble as a means of escape.  Losers usually hide their losses and try to look and act like winners, but are plagued  by self-doubt. 

Trading stocks, futures, and options gives a gambler a high, while looking more  respectable than betting on the ponies. Gambling in the financial markets has a greater  aura of sophistication than playing numbers with a bookie. 

Gamblers feel happy when trades go in their favor. They feel terribly low when  they lose. They differ from successful professionals who focus on long-term plans  and don’t get particularly upset or excited over any single trade. 

The key sign of gambling is the inability to resist the urge to bet. If you feel that you are  trading too much and the results are poor, stop trading for a month. This will give you a chance  to re-evaluate your trading. If the urge to trade is so strong that you cannot stay away from the  action for a month, then it is time to visit your local chapter of Gamblers Anonymous or start  using the principles of Alcoholics Anonymous, outlined later in this chapter. 

Self-Sabotage 

After practicing psychiatry for decades, I became convinced that most failures in life  are due to self-sabotage. We fail in our professional, personal, and business affairs  not because of bad luck or incompetence, but to fulfill an unconscious wish to fail. 

A brilliant friend of mine had a lifelong history of demolishing his success. As a  young man, he was a successful pharmacist but lost his business; became a broker and  rose near the top of his firm but was sued; turned to trading but busted out while  disentangling himself from previous disasters. He blamed all his failures on envious  bosses, incompetent regulators, and an unsupportive wife.

18 INDIVIDUAL PSYCHOLOGY 

Finally, he hit bottom. He had no job and no money. He borrowed a quote terminal from another busted-out trader and raised capital from a few people who  had heard that he had traded well in the past. He started making money for his  pool, and as the word spread, more people invested. My friend was on a roll. At  that point, he went on a speaking tour of Asia but continued to trade from the  road. He took a side trip into a country famous for its brothels, leaving a very large  open position in bond futures, with no protective stop. By the time he returned  to civilization, the market had staged a major move and his pool was wiped out.  Did he try to figure out his problem? To learn? No—he blamed his broker! After 

I helped him get an attractive job at a major data company, but there he began to bite the hands that fed him and was fired. In the end, this brilliant man was  going door to door, selling aluminum siding—while others made money using his  techniques. 

When traders get in trouble, they tend to blame others, bad luck, or anything  else. It hurts to look within yourself for the cause of your failure. A prominent trader came to me for a consultation. His equity was being demolished by a rally in the U.S. dollar, in which he was heavily short. He had grown up  fighting an abusive and arrogant father. He had made a name for himself by betting  large positions on reversals of established trends. This trader kept adding to his short  position because he could not admit that the market, which represented his father,  was bigger and stronger than he was. 

These are just two examples of how people act out their self-destructive tendencies. We sabotage ourselves by acting like impulsive children rather than intelligent  adults. We cling to our self-defeating patterns. They can be treated—failure is a curable disease. 

The mental baggage from childhood can prevent you from succeeding in the markets.  You have to identify your weaknesses and work to change. Keep a trading diary—write down  your reasons for entering and exiting every trade. Look for repetitive patterns of success  and failure. 

The Demolition Derby 

All society members make small allowances to protect one another from the consequences of their mistakes. When you drive, you try to avoid hitting other cars, and  they try to avoid hitting you. If someone cuts in front of you on a highway, you may  curse, but you will slow down. If someone swings open the door of a parked car, you  

swerve. You avoid collisions because they are costly for both parties. Almost all professions provide safety nets for their members. Your bosses, colleagues, and clients will warn you when you behave badly or self-destructively. There  is no such safety net in trading, which makes it more dangerous than most human  endeavors. The markets offer endless opportunities to self-destruct. Buying at the high point of the day is like swinging your car door open into the  traffic. When your order to buy reaches the floor, traders rush to sell to you—to tear  off your door along with your arm. Other traders want you to fail because when you  lose they get your money.

 7. TRADING PSYCHOLOGY 19 

Markets operate without normal human helpfulness. Every trader gets hit by  others. Every trader tries to hit others. The trading highway is littered with wrecks.  Trading is the most dangerous human endeavor, short of war. 

Controlling Self-Destructiveness 

Most people go through life making the same mistakes decade after decade. Some  structure their lives to succeed in one area, while acting out their internal conflicts  in another. 

You need to be aware of your tendency to sabotage yourself. Stop blaming your losses on bad  luck or on others, and take responsibility for your results. Start keeping a diary—a record of all  your trades, with reasons for entering and exiting them. Look for repetitive patterns of success  and failure. Those who don’t learn from the past are condemned to repeat it. 

A trader needs a psychological safety net the way a mountain climber needs his  survival gear. I found the principles of Alcoholics Anonymous, outlined below, to  be of great help at an early stage of trader development. Strict money management  rules also provide a safety net, while the diary helps you learn from your mistakes as  well as successes. 

■ 7. Trading Psychology 

Your success or failure as a trader depends on your emotions. You may have a brilliant  trading system, but if you feel arrogant, frightened, or upset, your account is sure  to suffer. If you become aware of fear, greed, or a gambler’s high, close your trades. 

In trading, you compete against the sharpest minds in the world. Commissions  and slippage slant the field against you. Now, on top of that, if you allow your emotions to interfere with your trading, the battle is lost. My friend and partner in  SpikeTrade.com Kerry Lovvorn is fond of repeating: “It is hard enough to know what  the market is going to do; if you don’t know what you are going to do, the game is lost.” 

Having a good trading system is not enough. Many traders with good systems  wash out because psychologically they are not prepared to win. 

Bending the Rules 

Markets offer enormous temptations, like walking through a gold vault or through a  harem. They provoke great surges of greed and even greater waves of fear of losing  what we’ve got. Those feelings cloud our perceptions of market reality. 

Most amateurs feel like geniuses after a short winning streak. It is exciting to  believe that you are so good that all your trades are sure to be winners. That’s when  traders start deviating from their rules and damage their accounts. 

Traders gain some knowledge, win, their emotions kick in, and they self-destruct.  Most traders promptly give their “killings” back to the markets, which are full of  rags to riches to rags stories. The hallmark of a successful trader is the ability to accumulate equity.

20 INDIVIDUAL PSYCHOLOGY 

You need to make trading as objective as possible. Be sure to follow money management rules. Keep a spreadsheet listing all your trades, including commissions and  slippage. Keep a diary of all your trades with “before and after'' charts. At the early  stages of your trading career, you may have to devote as much energy to analyzing  yourself as analyzing the markets. 

When I was learning to trade, I read every book on trading psychology I could  find. Many writers offered sensible advice. Some stressed discipline: “You cannot let  the markets sway you. Don’t make decisions during trading hours. Plan a trade, and  trade a plane.” Others stressed flexibility: “Don’t enter the market with any preconceived notions. Change your plans when markets change.” Some experts suggested  isolation—no business news, no Wall Street Journal, no listening to other traders, just  you and the market. Others advised being open-minded, keeping in touch with other  traders, and soaking up fresh ideas. Each piece of advice seemed to make sense, but  they contradict one another. 

I kept reading, trading, and focusing on system development. I also continued to  practice psychiatry. I never thought the two fields were connected—until I had a  sudden insight. The idea that changed how I trade came from psychiatry. 

The Insight That Changed My Trading 

Like most psychiatrists, I always had some patients with alcohol problems. I also  served as a consultant to a major drug rehabilitation program. It didn’t take me long  to realize that alcoholics and addicts were more likely to recover in self-help groups  than in classical psychiatric settings. 

Psychotherapy, medications, and expensive hospitals and clinics can sober up a  drunk but seldom succeed in helping him remain sober. Most addicts quickly relapse. They have a much better chance to recover if they become active in Alcoholics  Anonymous (AA) and similar self-help groups. 

Once I realized that AA members were more likely to stay sober and rebuild  their lives, I became a big fan of Alcoholics Anonymous. I began sending patients  with drinking problems to AA and related groups, such as ACOA (Adult Children of  Alcoholics). If an alcoholic came to me for treatment, I insisted that he also go to AA  because otherwise he’d be wasting both our time and his money. 

One night I stopped by a friend’s office on the way to a party. We had two hours  before it began, and my friend, who was a recovering alcoholic, said: “Do you want  to take in a movie or go to an AA meeting?” I had sent many patients to AA but had  never been to a meeting, since I have never had a drinking problem. I jumped at a  chance to attend an AA meeting—it was a new experience. 

The meeting was held at a local YMCA. A dozen men and a few women sat on  folding chairs in a plain room. The meeting lasted an hour. I was amazed by what I  heard—these people seemed to talk about my trading! 

They talked about alcohol, but as long as I substituted the word “loss” for “alcohol,” most of what they said applied to me! My account equity was swinging up and  down in those days. I left that meeting knowing that I had to handle my losses the  way AA handles alcoholism.

 8. TRADING LESSONS FROM AA 21 ■ 

8. Trading Lessons from AA 

Almost any drunk can stay sober for a few days—until the urge to drink drives him  back to the bottle. He cannot resist as long as he continues to think and feel like an  alcoholic. Sobriety begins inside a person’s mind. 

Alcoholics Anonymous (AA) has a system for changing the way people think and  feel about drinking. AA members use a 12-step program for changing their minds.  These 12 steps, described in the book Twelve Steps and Twelve Traditions, refer to 12  stages of personal growth. Recovering alcoholics attend meetings where they share  their experiences with other recovering alcoholics, supporting each other in their  sobriety. Any member can get a sponsor—another AA member whom he can call for  support when he feels the urge to drink. 

AA was founded in the 1930s by two alcoholics—a doctor and a traveling salesman who began meeting to help each other stay sober. They developed a system that  worked so well, others began to join them. AA has only one goal—to help its members stay sober. It doesn’t ask for money, takes no political positions, and runs no  promotional campaigns. AA keeps growing thanks only to word of mouth and owes  its success only to its effectiveness. 

The 12-step program of AA is so effective that people with other problems now  use it. There are 12-step groups for children of alcoholics, gamblers, and others. I’ve  become convinced that traders can stop losing money if they apply the key principles  of Alcoholics Anonymous to their trading. 

Denial 

A social drinker enjoys a cocktail, a glass of wine, or a beer but stops when he feels  he’s had enough. An alcoholic’s chemistry is different. Once an alcoholic takes a  drink, he feels an urge to continue until he passes out or his money runs out. 

A drunk may say that he needs to cut down on drinking, but can’t admit that it’s  out of control. Try telling an alcoholic relative, friend, or employee that his drinking  is out of control and damaging his life, and you’ll run into a wall of denial. 

An alcoholic may say: “My boss fired me ’because I was hung over and came in  late. My wife took the kids and left ’because she had no sense to begin with. My  landlord is trying to kick me out of the apartment ’cause I’m a little behind  on the rent. I’m gonna have to cut down on my drinking, and everything will  be alright.” 

This man has lost his family and his job. He is about to lose the roof over his head.  His life is spinning out of control—but he keeps saying that he can cut down on his  drinking. This is denial! 

Alcoholics deny their problems while their lives are falling apart. As long as an  alcoholic believes that he can “control his drinking,” he is headed downhill. Nothing  will ever change, even if he gets a new job, a new wife, and a new landlord. 

Alcoholics deny that alcohol controls their lives. When they talk of reducing  drinking, they talk about managing the unmanageable. They are like a driver whose  car spins out of control on a mountain road. When the car careens down a cliff, it is 

22 INDIVIDUAL PSYCHOLOGY 

too late to promise to drive carefully. An alcoholic’s life careens out of control, while  he denies he’s an alcoholic. 

There is a stark parallel between an alcoholic and a trader whose account is being demolished by losses. As he keeps changing his trading tactics, he acts like an alcoholic who tries to  solve his problem by switching from hard liquor to beer. A loser denies that he’s lost control over  his trading life. 

Rock Bottom 

A drunk can begin his journey to recovery only after he admits that he is an alcoholic.  He must see that alcohol controls his life and not the other way around. Most drunks  cannot accept this painful truth. They can face it only after they hit rock bottom. 

Some alcoholics hit rock bottom when they develop a life-threatening illness.  Others hit it after being rejected by their family or losing a job. An alcoholic needs to  sink to a point so low, so deep down in the gutter, so unbearably painful that it finally  penetrates his denial. 

The pain of hitting rock bottom makes an alcoholic see how deep he has sunk. He  sees a simple stark choice—either turn his life around or die. Only then is an alcoholic ready to begin his journey to recovery. 

Profits give traders an emotional high and a feeling of power. They try to get high again, put  on reckless trades, and give back their profits. Most traders cannot stand the pain of severe losses.  They die as traders after hitting rock bottom and wash out of the markets. The few survivors  realize that the main trouble is not with their methods—it is with their thinking. They can  change and become successful traders. 

The First Step 

An alcoholic who wants to recover has to go through twelve steps—twelve stages  of personal growth. He needs to change how he thinks and feels, how he relates to  himself and others. 

The first step of AA is the hardest: to admit that one is powerless over alcohol.  An alcoholic must recognize that his life has become unmanageable, that alcohol  is stronger than he is. Most cannot take that step, drop out, and go on to destroy  their lives. 

If alcohol is stronger than you, then you can never touch it again, not even a sip,  for as long as you live. You have to give up drinking forever. Most drunks do not want  to give up that pleasure. They destroy their lives rather than take the first step of AA.  Only the pain of hitting rock bottom can motivate them to take that first step. 

One Day at a Time 

You may have seen bumper stickers that say, “One day at a time” or “Easy does it.” Those  are AA slogans, and people who drive those cars are probably recovering alcoholics. Planning for life without alcohol can seem overwhelming. That’s why AA encourages its members to live sober one day at a time.

 9. LOSERS ANONYMOUS 23 

The goal of every AA member is to stay sober today and go to bed sober tonight.  Gradually, days become weeks, then months, then years. AA meetings and other  activities help each recovering alcoholic stay sober, one day at a time. 

Recovering alcoholics receive—and give others—invaluable support and fellowship at these meetings. They are held at all hours, all over the world. Traders have  much to learn from those meetings. 

An AA Meeting 

One of the best things that a trader can do is go to an AA meeting. I especially recommend it to any trader on a losing streak. Call Alcoholics Anonymous and ask about  the next “open meeting” or “beginners’ meeting'' in your area. 

A meeting lasts about an hour. You can sit in the back of the room and listen carefully. There is no pressure to speak, and nobody asks for your last name. Each meeting begins with a long-term member getting up and speaking about his  or her personal struggle for recovery from alcoholism. Several other members share  their experiences. There is a collection to cover expenses—give a dollar if you like.  All you have to do is listen carefully, and every time you hear the word “alcohol,”  substitute the word “loss' ' for it. You will feel as if the people in the meeting are talking about your trading! 

■ 9. Losers Anonymous 

A social drinker enjoys an occasional drink, but an alcoholic craves alcohol. He denies that alcohol controls and destroys his life—until he reaches a personal crisis.  It may be a life-threatening illness, unemployment, abandonment by the family, or  

another unbearably painful event. AA calls it “hitting rock bottom.” The pain of hitting rock bottom punctures an alcoholic’s denial. He sees a stark  choice—to drown or to come up for air. His first step to recovery is to admit that he  is powerless over alcohol. A recovering alcoholic can never drink again. Loss is to a loser what alcohol is to an alcoholic. A small loss is like a single drink.  A big loss is like a bender. A series of losses is like an alcoholic binge. A loser keeps  switching between different markets, gurus, and trading systems. His equity shrinks  while he is trying to recreate the pleasurable sensation of winning. Losing traders think and act like alcoholics, except that their speech is not slurred.  The two groups are so similar that you can predict what a loser will do by using  alcoholics as a model. 

Alcoholism is a curable disease—and so is losing. Losers can change by using the  principles of Alcoholics Anonymous. 

The Urge to Trade 

Successful traders treat drawdowns the way social drinkers treat alcohol. They have  a little and stop. If they take several losses in a row, they take that as a signal that 

24 INDIVIDUAL PSYCHOLOGY 

something isn’t working: perhaps their system isn’t in gear with the current market  environment. It’s time for a break and a fresh look at the markets. Losers, on the  other hand, cannot stop—they keep trading because they are addicted to the excitement of the game and keep hoping for a big win. 

A prominent trading advisor who has since busted out wrote that to him the  pleasure of trading was higher than that of sex or flying jet aircraft. Just as alcoholics  proceed from social drinking to drunkenness, losers take bigger and bigger risks.  They cross the hugely important line: the one between taking a business risk and  gambling. Many losers don’t even know that line exists. 

Losers feel the urge to trade, just as alcoholics feel the urge to drink. They make  impulsive trades, go on trading binges, and try to trade their way out of a hole. Losers bleed money from their accounts. Most of them bust out, but some turn  to managing other people’s money after losing their own; still others sell advisory  services, like burned-out drunks who wash glasses in a bar. 

Most losers hide their losses from themselves and from everyone else. They keep  no records and throw away brokerage statements. A loser is like an alcoholic who  doesn’t want to know how many ounces of liquor he drank. 

Into the Hole 

A loser trades in a fog and doesn’t know why he keeps losing. If he knew, he would  have done something about it and become a winner. A loser tries to manage his trading the way an alcoholic tries to manage his drinking. 

Losers’ desperate hopes for magic solutions help advisors sell their services to the  public. They switch to new trading systems, buy more software, and look for tips  from new gurus. 

As losses mount and equity shrinks, a loser grows desperate and converts outright  positions into spreads, doubles up on losing positions, reverses and trades in the opposite direction, and so on. All of that does him no more good than switching from  hard liquor to wine can help an alcoholic. 

A losing trader careens out of control, trying to manage the unmanageable. Alcoholics die prematurely, and most traders bust out of the markets and never come  back. New trading methods, hot tips, and improved software will not help a person  who cannot handle himself. 

A loser keeps getting high from trading while his equity shrinks. Trying to tell him  that he is a loser is like trying to take a bottle away from a drunk. A loser has to hit  rock bottom before he can begin to recover. You have to change how you think in  order to stop losing and begin your recovery as a trader. 

Trader’s Rock Bottom 

Hitting rock bottom feels horrible. It is painful and humiliating. You hit it when you  lose money you cannot afford to lose. You hit it when you gamble away your savings. 

 9. LOSERS ANONYMOUS 25 

You hit it after you tell your friends how smart you are and later have to ask them for a  loan. You hit rock bottom when the market comes roaring at you and yells: “You fool!” Some people hit rock bottom after only a few weeks of trading. Others keep adding money to their accounts to postpone the day of reckoning. It hurts to see a loser  in the mirror. We spend our lifetime building up self-esteem. Most of us have a high  opinion of ourselves. Your first impulse may be to hide, but remember, you are not  alone. Almost every trader has been there. 

Many traders who hit rock bottom slink away from the market and never look  back. Many who trade today will be gone in a year, if not sooner. They’ll hit rock  bottom, crumble, and leave. They’ll try to forget trading like a bad dream. 

Some will lick their wounds and wait until the pain fades away and then return,  having learned little. They’ll be fearful, and their fear will further impair their trading. Fortunately, some traders will recoil from rock bottom to begin the process of  change and growth. For these individuals, the pain of hitting rock bottom will break  the vicious cycle of getting high from winning and then losing everything and crashing. When you admit that your personal problem causes you to lose, you can begin building a  new trading life. You can start developing the discipline of a winner. 

Trader’s First Step 

Just as an alcoholic needs to admit that he can’t control his drinking, a trader needs  to admit that he cannot control his losses. The first step of an AA member is to say: “I  am an alcoholic, I am powerless over alcohol.” As a trader, you have to take your first  step and say: “I am a loser, I am powerless over losses.” 

Recovering alcoholics struggle to stay sober, one day at a time. A trader can re-cover, using the principles of AA. Now you have to struggle to trade without losses,  one day at a time. 

You may say that’s impossible. What if you buy, and the market immediately declined? What if you sell short, and it turns out to be the bottom tick, and the market  immediately rallies? Even the best traders lose money on some trades. 

The answer is to draw a line between a businessman’s risk and a loss. As traders,  we always take businessman’s risks, but we may never take a loss greater than this  predetermined risk. 

For example, a storekeeper takes a risk every time he stocks new merchandise.  If it doesn’t sell, he’ll lose money. An intelligent businessman takes only risks that  will not put him out of business, even if he makes several mistakes in a row. Stocking  two crates of merchandise may be a sensible business risk, but stocking a full trailer  is probably a gamble. 

As a trader, you are in the business of trading. You need to define your business man’s risk—the maximum amount of money you’ll risk on any single trade. There  is no standard dollar amount, just as there is no standard business. An acceptable  businessman’s risk depends, first of all, on the size of your trading account. It also  depends on your trading method and pain tolerance.

26 INDIVIDUAL PSYCHOLOGY 

The concept of a businessman’s risk will change the way you manage your money  (see Section 9, “Risk Management”). The absolute maximum a trader may risk on any  trade is two percent of his account equity. For example, if you have $30,000 in your  account, you may not risk more than $600 per trade, and if you have $10,000, you  may not risk more than $200. If your account is small, limit yourself to trading fewer  shares, less expensive futures, or mini-contracts. If you see an attractive trade, but a  logical stop would have to be placed where more than 2 percent of equity would be  at risk—pass on that trade. You may risk less, but you may never risk more. You must  avoid risking more than 2 percent on a trade the way a recovering alcoholic avoids bars. 

A trader who blames high commissions on a broker and slippage on a floor trader  gives up control of his trading life. Try to reduce both, but take responsibility for  them. If you lose even a dollar more than your businessman’s risk, including commissions and slippage, you are a loser. 

Do you keep good trading records? Poor record-keeping is a sure sign of a gambler. Good businessmen keep good records. Your trading records must show the date  and price of every entry and exit, slippage, commissions, stops, all adjustments of  stops, reasons for entering, objectives for exiting, maximum paper profit, maximum  paper loss after a stop was hit, and any other data necessary to review and fully understand your trade later in the future. 

If you bail out of a trade within your businessman’s risk, it is normal business.  There is no bargaining, no waiting for another tick, no hoping for a change. Losing  a dollar more than your established businessman’s risk is like getting drunk, getting  into a brawl, getting sick to your stomach on your way home, and waking up in a  gutter. You would never want that to happen. 

A Meeting for One 

When you go to an AA meeting, you’ll see people who have not had a drink in years  stand up and say: “Hello, my name is so-and-so, and I am an alcoholic.” Why do they  call themselves alcoholics after years of sobriety? Because if they think they have  beaten alcoholism, they will start drinking again. If a person stops thinking he is an  alcoholic, he is free to take a drink, then another, and will probably end up in the gutter again. A person who wants to stay sober must remember that he is an alcoholic  for the rest of his life. 

Traders would benefit from our own self-help organization—I’d call it Losers  Anonymous. Why not Traders Anonymous? Because a harsh name helps focus attention on our self-destructive tendencies. After all, Alcoholics Anonymous doesn’t call  itself Drinkers Anonymous. As long as you call yourself a loser, you’ll focus on avoiding losses. 

Several traders have argued against what they thought was the “negative thinking”  of Losers Anonymous. A retired woman from Texas, a highly successful trader, described her approach. She is very religious, prays every morning, and then drives to  an office where she actively trades. Whenever the market starts moving against her,  she cuts her losses very fast because it would not please the Lord for her to lose His 

 10. WINNERS AND LOSERS 27 

money. I thought that our methods were similar. The goal is to cut losses due to some  objective, external rule. 

Trading within a businessman’s risk is like living without alcohol. A trader has to  admit that he is a loser, just as a drunk has to admit that he is an alcoholic. Then he  can begin his journey to recovery. 

This is why every morning before trading I suggest saying: “Good morning, my  name is so-and-so, and I am a loser. I have it in me to do serious financial damage to  my account.” This is like an AA meeting—it keeps your mind focused on the first  principles. Even if you take thousands of dollars out of the market today, tomorrow  you say: “Good morning, my name is so-and-so and I am a loser.” 

A friend of mine joked: “When I sit in front of my quote screen in the morning,  I say, ‘My name is John, and I’m gonna rip your throat out.’” His thinking generates  tension. “Losers Anonymous” thinking generates serenity. A trader who feels serene  and relaxed can focus on looking for the best and safest trades. When a sober man  and a drunk enter a race, you know who is more likely to win. A drunk may win  once in a while, but the sober man is the one to bet on. You want to be the sober  man in that race. 

■ 10. Winners and Losers 

We come to trading from different walks of life and bring along our mental baggage.  Many of us find that when we act in the market the way we do in our everyday life, we  lose money. Most of all, your success or failure depends on your ability to use intellect rather than act emotionally. A trader who feels overjoyed when he wins and depressed when he loses is at the mercy of market moves and cannot accumulate equity. 

To be a winner in the market you must act coolly and responsibly. The pain of losing  drives people to look for magic methods. At the same time, they discard much of what  is useful in their professional or business backgrounds. 

Like an Ocean 

The market is like an ocean—it moves up and down regardless of what you wish.  You may feel joy when you buy a stock and it explodes in a rally. You may feel  drenched with fear when you go short but the market rises, melting your equity  with every uptick. Those feelings have nothing to do with the market—they exist  only inside of you. 

The market doesn’t know you exist. You can do nothing to influence it. The ocean  doesn’t care about your welfare, but it has no wish to hurt you either. You can only  control your behavior. 

A sailor cannot control the ocean, but he can control himself. He can study currents and weather patterns, learn good sailing techniques, and gain experience.  He can learn when to sail and when to stay in the harbor. A successful sailor uses  his intelligence.

28 INDIVIDUAL PSYCHOLOGY 

An ocean can be useful—you can fish in it and use its surface to get to other  islands. An ocean can be dangerous—you can drown in it. The more rational your  approach, the more likely you are to get what you want. On the other hand, when  you act out your emotions, you cannot focus on the reality of the ocean. 

A trader has to study trends and reversals in the market the way a sailor studies the  ocean. He must trade on a small scale while learning to handle his account. You can  never control the market, but you can learn to control yourself. 

After a string of profitable trades, a beginner may feel he can walk on water. He  starts taking wild risks and blows up his account. On the other hand, an amateur  who takes several losses in a row often feels so demoralized that he cannot place an  order even when his system gives him a signal to buy or sell. If trading makes you  feel elated or frightened, you cannot fully use your intellect. When joy sweeps  you off your feet, you will make irrational trades and lose. When fear grips you,  you’ll miss profitable trades. 

A sailor whose boat is being battered by ocean winds battens his sails—reduces  sail area. The first remedy for a trader battered by the market is to reduce the size of  his trades. Trade small while you’re learning or when feeling stressed. 

A professional trader uses his head and stays calm. Only amateurs become excited  or depressed. Emotional trading is a luxury that nobody can afford. 

Emotional Trading 

Most people crave excitement and entertainment. Singers, actors, and professional  athletes command much higher incomes than such mundane workmen as physicians,  pilots, or college professors. People love to have their nerves tickled—they buy lottery tickets, fly to Las Vegas, and slow down to gawk at road accidents. Emotional trading can be very addictive. Even those who drop money in the markets receive a fantastic entertainment value. 

The market is a spectator sport and a participant sport rolled into one. Imagine  going to a major-league ball game in which you are not confined to the bleachers.  Pay a few hundred dollars and be allowed to run onto the field and join the game. If  you hit the ball right, you’ll get paid like a professional. 

You would probably think twice before running onto the field the first few times.  This cautious attitude is responsible for the well-known “beginner’s luck.” Once a  beginner hits the ball right a few times and collects his pay, he is likely to get the idea  that he is as good as the pros or even better and could make a good living from the  game. Greedy amateurs start running onto the field too often, even when there are  no good playing opportunities. Before they know what hit them, a short string of  losses destroys their accounts. 

The market is among the most entertaining places on the face of the Earth, but  emotional decisions are lethal. If you ever go to a racetrack, turn around, and watch  the humans instead of horses. Gamblers stomp their feet, jump up and down, and  yell at horses and jockeys. Thousands of people act out their emotions. Winners em 

brace, and losers tear up their tickets in disgust. The joy, the pain, and the intensity of  wishful thinking are caricatures of what happens in the markets. A cool handicapper 

 10. WINNERS AND LOSERS 29 

who makes his living at the track does not get excited, yell, or bet the bulk of his roll  on a single race, or even in a single day.1 

Casinos love drunks. They pour gamblers free drinks to make them more emotional and gamble more. Casinos also throw out calm and intelligent card-counters.  There is less free liquor on Wall Street than in a casino, but at least here, they do not  throw you out for being a good trader. 

In Charge of Your Life 

When a monkey hurts its foot on a tree stump, he flies into a rage and kicks the  piece of wood. You laugh at a monkey, but do you laugh at yourself when you act  like him? If the market drops while you are long, you may double up on your losing  trade or else flip and go short, trying to get even. This is acting emotionally instead  of using your intellect. What’s the difference between a trader trying to get back at  the market and a monkey kicking a tree stump? Acting out of anger, fear, or elation  destroys the chance of success. You have to analyze your behavior instead of acting  out your feelings. 

We get angry at the market; we become afraid of it and develop silly superstitions.  All the while, the market keeps cycling through its rallies and declines like an ocean  going through its storms and calm periods. Mark Douglas writes in The Disciplined  Trader that in the market, “There is no beginning, middle, or end—only what you  create in your own mind. Rarely do any of us grow up learning to operate in an arena  that allows for complete freedom of creative expression, with no external structure  to restrict it in any way.” 

We try to cajole or manipulate the market, acting like the ancient emperor Xerxes,  who ordered his soldiers to horsewhip the sea for sinking his fleet. Most of us aren’t  aware of how manipulative we are, how we bargain and act out our feelings. Most of  us consider ourselves the center of the universe and expect every person or group to  be either good or bad to us. This does not work in the market, which is completely  impersonal. 

Leston Havens, a Harvard University psychiatrist, wrote: “Cannibalism and slavery  are probably the oldest manifestations of human predication and submission. Although  both are now discouraged, their continued existence in psychological forms demonstrates that civilization has achieved great success in moving from the concrete and  physical to the abstract and psychological, while persisting in the same purposes.”  Parents threaten their children, bullies hit them, and teachers try to bend their will  in school. Little wonder that most of us grow up either hiding in a shell or learning  how to manipulate others in self-defense. Acting independently doesn’t feel natural  to us—but that is the only way to succeed in the market. 

1 I carry in my wallet a free lifetime pass to New York’s Belmont racetrack that belonged to my late  great friend Lou Taylor. It looks like an employee card, but on the “position” line it says—winner.  He won many handicapping championships and continued to take money from the racetrack until a  few months before he died.

30 INDIVIDUAL PSYCHOLOGY 

Douglas warns, “If the market’s behavior seems mysterious to you, it’s because  your own behavior is mysterious and unmanageable. You can’t really determine what  the market is likely to do next when you don’t even know what you’ll do next.”  Ultimately, “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.” He adds, “The  traders who can make money consistently...approach trading from the perspective  of a mental discipline.” 

All of us have our own demons to exercise on the journey to becoming successful  traders. Here are several rules that worked for me as I grew from a wild amateur  into an erratic semi professional and finally into a calm professional trader. You may  change this list to suit your personality. 

1. Decide that you are in the market for the long haul—that is, you want to be a  trader even 20 years from now. 

2. Learn as much as you can. Read and listen to experts, but keep a degree of  healthy skepticism about everything. Ask questions, and do not accept experts  at their word. 

3. Do not get greedy and rush to trade—take your time to learn. The markets will  be there, offering more good opportunities in the months and years ahead. 

4. Develop a method for analyzing the market—that is, “If A happens, then B is  likely to happen.” Markets have many dimensions—use several analytic methods  to confirm trades. Test everything on historical data and then in the markets,  using real money. Markets keep changing—you need different tools for trading  bull and bear markets and transitional periods as well as a method for telling the  difference (see the sections on technical analysis). 

5. Develop a money management plan. Your first goal must be long-term survival;  your second goal, a steady growth of capital; and your third goal, making high  profits. Most traders put the third goal first and are unaware that goals 1 and  2 exist (see Section 9, “Risk Management”). 

6. Be aware that a trader is the weakest link in any trading system. Go to a meeting of Alcoholics Anonymous to learn how to avoid losses or develop your own  method for cutting out impulsive trades. 

7. Winners think, feel, and act differently than losers. You must look within yourself, strip away your illusions, and change your old ways of being, thinking, and  acting. Change is hard, but if you want to be a professional trader, you have to  work on changing and developing your personality. 

In order to succeed, you need drive, knowledge, and discipline. Money is important, but less so than any of those qualities. If you have enough drive to work through  this book, you’ll acquire much knowledge, and then we’ll close the circle by returning to the topic of discipline in the final chapters.

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