Kirk at The Kirk Report summarized ten steps to a trading edge from George Fontallis (author of The Stock Market Course and The Options Course) and – while I will not list all ten (visit his site!), I wanted to expand on a few of them that are pertinent to trading psychology.
1. Understand the psychology of the trade: never believe you are smarter than the markets as the markets will always win.
I was glad to see this as rule #1! Every trade you enter MUST have a guiding purpose based on a valid market principle/observation you have tested, and that you understand. It is often wise to step back before entering a trade and know not only the reasons for entry, but the logic on your side of the trade AND the logic or emotions of the trader(s) on the other side of your trade.
Realize that when you enter a position, someone is giving their shares to you (or taking the opposite side of your trade. Do you think they do so with anticipation of losing money? No, they are betting on the opposite result that you are anticipating (this is true for short-term trades – not for investments). I like to describe it as the “Western Cowboy Theory” which envisions two gunmen at a duel with guns pointed at each other, betting on a specific outcome with high stakes on the line. One will win; one will lose.
Now envision you are a fade trader and there is a clear channel or range in price occurring. When the market reaches the upper edge of the channel, you enter short, playing for a retest of the bottom of the channel. At the exact same time, another trader (or group of traders) are entering early, anticipating a breakout of the range. Price has reached a “technical decision node” and will either break-out, or fail and (likely) fall back down to the bottom of the range. Either way, one of you will lose and the other will win. Odds and probability help place you on the right side… but the MARKET ultimately determines which side will win or lose (and shockingly it is not always the side which has the odds in their favor….)
2. Acquire the knowledge on how the markets truly work then test and retest your ideas and concepts until you feel confident.
This is big on my list and has helped me in my developing career. Knowledge is critical for success in the game. Period. Knowledge can be gained from books, articles, blogs, websites, etc OR it can be gained from personal trading experience. The two kinds of knowledge are distinct and critically different. You must apply the knowledge you have learned or it is worthless; also, you must obtain knowledge before attempting to trade or else it is likely you will suffer sustained and large losses early.
Knowledge is not enough. Markets change character as the masses ‘catch on’ and close inefficiencies. Volatility cycles. Trend dynamics change. Economic factors become more or less important depending on where we are in the business cycle. Classic chart patterns which worked for a while are popularized and their odds for success diminish.
There are certain timeless concepts in the market (such as “cut losers short and let winners run”), yet the exact application of these concepts through strategies varies as the years progress. The market does change character. There is no magic indicator, formula, or mechanical system. There never will be. All we can do is quantify what works and abandon what does not. This can lead to endless frustration… or excitement due to the thrill of the challenge of trying to solve an engaging puzzle which has many shifting solutions.
8. Integrate fundamental, technical, and sentiment analysis into a real world trading approach that enables you to best understand market performance.
I could speak for hours for this point, but suffice it to say that the best longer term trades (and even short-term trades) develop from a correct reading of economic conditions, place in the economic/business/market cycle, and a fundamental “story” develops. From this ’story,’ technical decisions (entry points, stop-loss points, and possible profit targets) arise which fine-tune entry into a rising stock or sector in a rising/expanding economy. Finally, sentiment indicators (over optimism or over pessimism/fear) help warn of possible turning points in the market. It may seem counterintuitive, but when everyone is bullish, prices WILL fall (and sometimes will fall hard). Also, when everyone is selling their shares and cursing the stock market, prices WILL rise. Learn to read possible extremes in sentiment. A proper trading strategy that works long-term certainly is difficult to develop, yet it will contain elements from these three approaches to market analysis.
Of all these, perhaps reading market psychology is the only one which is stood the test of time (in that mass euphoria leads to market tops and vice versa). Unified continuation of thought can carry price far beyond any proper fundamental valuations (or far below fair market value at capitulation bottoms) and beyond any technical indicator can read.
9. Specialize in one sector and one strategy at a time.
Remember, you are developing and you have your whole life ahead of you. Don’t try to do it all at once; you’ll get overwhelmed. Remember the acronym K.I.S.S. and “keep it simple.” This keeps psychological stress and frustration to a minimum and prevents you from being overwhelmed by the vast amount of information out there.
10. Give yourself the winner’s edge by always continuing to actively pursue the learning process.
The final point echoes earlier point about education, application, and constant exposure to the market. There are few successful passive traders (yet there are various passive investors). As a trader, you must be active and honing your edge. There are no shortcuts and there is no easy way to do it. Passion, love of the game, and a constant desire to learn more both about yourself and the market will keep you through the rough times and in this game for the long haul.
Thanks to Kirk for bringing out these helpful observations from George Fontallis!