WHO'S THE MARK????

A key to making the rules work is an understanding of the psychology behind the
Rules, knowing where they work best, and knowing if that is congruent with our
personal trading style. The psychology behind the rule is what it is, in part,
because the psychology of the market itself is what it is. I don’t think we can
make our rules work at their best without a solid understanding of this
underlying market psychology.

Critical to that assessment is understanding our own personal psychology. No
matter where you personally are on the scale of trader evolution or your
application of your developing skills, you will eventually discover that your
own personal psychology is by far the single most important variable to your
lasting success as a trader. Indeed, only a trader who accepts this point of
view about his own psychology will be able to successfully make his trading
rules work—because the rules are self-created, self-enforced, and
self-defeating. Without a solid grasp of both market psychology and personal
psychology, your results will most likely be net losses, even if you have a
winning systematic approach and good rules.

Regardless of your current level of sophistication or trading background, there
is one indisputable fact about the underlying structure of trading markets that
you need to thoroughly understand before you place yourself at risk. Futures,
options on futures, and cash foreign exchange (FOREX), the markets most readers
will be trading are all zero-sum markets.

The price action and cash management take place in an environment where no money
is ever made or lost; gains or losses accrue as a cash debit or credit between
accounts on deposit after trades are cleared. In other words, a winning trade is
paid its cash credit from the exact opposite losing trade. The clearing
corporation of the exchange simply assigns a cash credit to the account with the
winning trade and assigns a cash debit to the account with the losing trade.

In the final analysis, it is the losers who pay the winners. You cannot accrue a
cash credit increase in your trading account unless some other trader (or group
of traders) somewhere, trading through the same exchange with you in the same
market, has lost the exact same amount. In order for you to make $10,000 from
your trading, someone else (or a group of someone elses) had to lose $10,000.
You can’t participate in Zero sum trading without accepting that risk.

It is the very nature of zero-sum transaction trading that makes using and
applying trade rules so critical to lasting success. If you personally don’t
know enough about what you are doing, or the risk you are really taking, you
will be the loser who pays some other winning trader. The market does not
function any other way.

Let’s take a look at the psychology behind price action. I believe this is much
deeper than the simple fact that for every winning trade there is a loser.
Zero-sum trading presents some fascinating insights into crowd behaviour and
what is really needed or required to exploit price action profitably.

Let’s start with the basics:

Buyer→ $2.33 ←Seller
You enter a buy order to open a position in corn at $2.33/BU. In order for you
to receive a fill on your buy order, it must be matched against a sell order at
that price. For the sake of illustration, let’s assume there is also a sell
order to open a position. Therefore, two separate traders have put themselves at
risk, and a new long position and a new short position are now active. What
happens next?

Another set of orders comes in, and those are matched, but if at that moment
there is an imbalance in the order flow, the market is requoted to reflect the
imbalance. In other words, if there are more buy orders left over after the sell
orders are matched, the market ticks higher and is matched with sell orders at
higher prices, if they are there. The remaining buy orders are then matched at
that new higher price. If there are more buy orders left over again, another
tick higher results.

Of course, this illustration is conceptual. As most traders know, those buy and
sell orders are constantly coming in and are combinations of stop orders, limit
orders, and market orders from both sides; the mix is always changing. What we
are concerned with is the pressure on the price as the net order flow is
processed from one moment to the next. If the order imbalance remains on the buy
side, the market will continue to tick higher until the imbalance is corrected
and the buy/sell orders are about evenly
matched again. If, at that point, the sell orders overwhelm the buy orders, the
market will begin to tick lower and will continue to do so until the buy and
sell orders again become about evenly balanced with the sell orders.

The ebb and flow of price action comes from these order imbalances, and what we
call an uptrend or downtrend is in reality a net imbalance lasting for some
period of time.

So let’s assume after a period of time, the net order imbalance for that period
of time has resulted in a new price for corn at that point:

→ $2.38/BU ←

Your open-trade long now has a profit of $0.05 per bushel. The open short from
your executed order (the other trader speculating) has an open-trade loss of
exactly the same $0.05 per bushel. If, at that exact moment, both of you choose
to liquidate your positions, and your orders offset each other at that point,
your account will be credited and his account will be debited the exact same
dollar amount (less any fees, of course).

This is all easily understandable, but there is a completely other world at work
in that process. That other world is the psychology of the traders involved and
how that creates their urge to action resulting in them placing the orders in
the first place.
What is not immediately apparent in price action is perception—how that net
credit or debit is affecting the account holder, what that account holder is
thinking, and what he must do next. What is certain is that at some point, both
traders must liquidate; no one can stay in the market forever.

When the losing position is liquidated at some point, the losing trader must do
an equal but opposite trade against himself. In other words, if I have bought
the market, and prices are moving lower, I must sell to liquidate my loss,
adding power to the dominant force in control of the market at that point. My
mental and emotional state is in direct conflict with my desire for a profit,
and my only choice really is to liquidate
now or risk a bigger loss. If I “wait it out” I am trying to anticipate the
market will reverse and eventually show a profit on the trade for me (thereby
making a loser out of the original short who initially had the open-trade
profit).

But all of this thinking or emotion is going on inside my mind and has nothing
to do with what is driving the market. In order for prices to advance or
decline, there must be more orders on that side of the market Prices can advance
only if there are more buy orders than sell orders at that moment. Prices can
decline only if there are more sell orders than buy orders at that moment. How
that order flow personally affects my account balance or my emotional state does
not concern the net order processing function of the market. In any attempt to
profit from any perceived opportunity in a zero-sum transaction market, you
simply must be on the right side of the eventual net order flow from that moment
forward until you liquidate. If you are on the wrong side of the net order flow,
you will have an open trade loss until you liquidate.

None of what happens inside the mind of the trader during that time can affect
the market in any way; it can only affect the net balance controlled in some way
by the trader in some way. This is why you must have rules and know how to
follow them. You cannot know for certain until later, after you enter your
position, whether you are on the right side of the net order flow.

The important thing to remember is that there is an emotional pressure at work
in most traders that will influence their perception of price action. They all
entered their trades expecting to win, but in most cases they will have to
consider liquidating at a loss. All of the emotional or psychological stress
involved in trading boils down to “When do I get out?”

Because the owner of the winning position has a lead on the market, he is under
less of this stress than the loser. In most cases, when the pain of holding the
losing hand gets too big for the losing trader, he will liquidate in the same
direction as the winning position. A simple example is a market slowly advancing
higher as more buy orders overwhelm the sell orders, until the market hits the
liquidating buy stops above the market placed by the sellers who are holding a
losing position. The market now
advances further on that buying pressure.

None of the above-described background to price action has anything to do with
market study, risk control, trading systems, or technical analysis. It has to do
only with the fact that if you are going to be in the market, you run the risk
that you will be on the wrong side of the order flow. What does that do to the
trader’s emotions? What will he do? What will you do?

Because you cannot profit consistently in a zero-sum market unless you are on
the correct side of the order flow, your entire analysis and trade plan must
take into consideration some way to identify where the order flow is and what to
do if you are on the wrong side of it. The issue of cutting losses is
essentially to have some method of negating any emotional conflict created by a
losing trade, in such a way that you will not hesitate to get out of the way of
the actual order flow if you are on the
wrong side of it. Part of how you participate on your trade, regardless of your
unique approach to finding a trade opportunity, must always answer the question:
“Where is the order flow?” Most of the studies done on net trader performance
come to the inescapable conclusion that around 90% of traders will close their
accounts at a net loss. None of those traders expected to lose, and yet they
did. Part of their losses came from the emotional conflict created in their
minds when the market moved against them, creating pressure on their execution.

Every trader has had the frustration of finally throwing in the towel and
liquidating his position, only to see the market reverse shortly thereafter and
prices move favorably, if only he had stayed in. All that really happened is
that the order flow dried up in one direction and then turned the other way. For
that particular trader it resulted in a net loss to his account. That particular
trader will now be tempted to “just ride it out” on
the next trade until prices eventually return. Of course, the one time this
doesn’t happen will result in a total loss in the account. It only takes one
“just ride it out” to ruin that particular trader.

To avoid being that trader, and to master the game of successful speculation,
you must know what you are really capitalizing on when you identify a trade
opportunity. You must accept and trade from the point of view:

“Where is the order flow?” and you must have a method of getting out of the way
when you are not on the right side of the order flow. All the analysis or study
you could ever do must answer these two central questions.

One assumption you can make to know your game is that most traders do not know
the game they are playing. About 80 to 90% of price action is simply the losers
liquidating their losing trades. When you begin each day, and before you place a
trade, ask yourself this question: “Where is the loser?”

In the final analysis, the game you are playing is “Beat the Loser.” The great
trader J. P. Morgan said it best: “Anyone who is unaware of the fool in the
market probably is the fool


Trading Rules That Work: Trading Rules That Work: The 28 Essential Lessons Every
Trader Must Master (Wiley Trading), by Jason Alan Jankovsky (Author)




Regards,

Patrick Stockhausen, BA (Hons), MPNLP, BPNLP, DHE, NHR

http://ultimatetradingpsychology.com/sales1.php