The Golden Rule of Trading

You've heard it a thousand times.  "Cut your losses short and let your winners run."  So simple, so obvious... so why do so many find it so hard to obey "the golden rule of trading?"  Because it is so much easier said than done.  And most of the problem following the golden rule stems from something we can't ever escape--our human nature.  As I like to say, "your brain wasn't made to trade."

What I mean is that our brains evolved over millions of years for purposes that have very little to do with balanced, thoughtful, emotionless risk-taking.  What the human brain did inherit was a "fight or flight" response and hundreds of other neuro-chemical drivers that made it hyper-sensitive to danger, hunger, sex, and social acceptance.  When was the last time one of those priorities helped you in trading?

The result of our "priority drives" as I call them is that we find it hard to think logically and rationally when it comes to decisions involving abstract risk and uncertainty.  Avoid or evade a snarling predator?  Done.  Do whatever it takes to get food that day?  No problem.  Capture, or woo, the mate of our dreams?  100,000 years ago it was the Olympics everyday.  And finally, find a place of relative comfort and certainty in our clan of other hominids?  We will beg, lie, self-sacrifice, and cheat to be accepted and liked by our family and peers.

But, admit we are wrong again in a trade and take our 8th small loss in a row?  Or, have the awareness of and fortitude to fulfill our job of staying in the trade idea where we bought the breakout in British pound below $1.55 and now could be taking partial profits above $1.63?  How about ignore the voices of others who made a killing on that options or 2x inverse ETF trade while we plodded along in our boring, known market?  These tasks are overwhelming for our brains.

Part of it has to do with what emotion is originally for.  It's meant for high-powered motivation and explosive action, not quiet, lonely global-financial-empire building.  And part of it has to do with what a complex amalgamation our brains are.  They are amazing for sure, but they are also imperfect biological systems cobbled together over millions of years.  This means they have many interrelated and layered pieces that didn't necessarily evolve for the same reasons at the same time.  I call it your "multi-mind."  It becomes most evident in the feelings we often get when we say we want one thing, but we do the opposite.

Very complex and mysterious forces lie at the roots of human consciousness and to think that we are in total control of our thoughts and actions all the time is absurd.  Yes, nobody eats something that he or she couldn't have put down, and no one runs a red light that couldn't be stopped at by choice.  But there are hundreds of other actions and responses that fly under the radar every day and we are not even aware of them half the time.  The way we greet others, the way we eat, how we talk to our spouse, our boss, our kids.  If we could see ourselves the way others see us, we might be shocked and say, "That's not me--I don't do that!"

If you don't believe me, check with the neuroscientists.  They have been conducting experiments with sophisticated brain imaging technologies for over a decade now and the results are astonishing.  Here's one: they can watch your brain think and react and have found that sometimes people solve math problems with emotional centers of the brain, not those associated with logical, calculation function.  Or how about the behavioral finance researchers?  The guys and gals who don't even look inside your skull have been doing experiments with people for three decades that prove we are essentially irrational when it comes to money and risk.  We think we are logical, risk-calculating machines, but as a species we are actually pretty awful at it.

Or how about my own research that proves "your brain wasn't made to trade."  Ever since I set foot on a trading floor over 15 years ago, I made it a hobby of sorts to watch and study traders.  My fascination was not just with the super successful but with the spectacularly disasterous as well.  I loved to learn how they "blew up."  And most of the stories, whether of the pit trader or the hedge fund cowboy, had to do with what most of us would perceive as totally off-their-rocker decision making.  How could they think they were so smart as to take on that much risk?  Why didn't they just get out before losing 50% of their account became 150%?!  Why did they think they could get away with hiding those losses?  Who were they trying to impress?

Ah yes, emotion rears its beautiful, vital head again.  By this I mean that despite what you've heard your entire career about "eliminating" all emotion from trading, not only is that impossible, you wouldn't want to.  The brain scientists have proven that without emotion, you couldn't lift a finger, much less figure the risk-reward on a piddly $1,000 position.  So what is the solution for short-term traders?  Stuck with our inherited amalgamation of competing neural functions, driven by a "bag full of chemicals" between our ears, how do we get the most out of our brains so that we can do something as simple as follow the golden rule of trading?

In addition to the two themes I've already discussed here this week--(1) having a firm understanding of the mechanics of probability and risk, and (2) developing an approach to trading that takes into account your personality so you get a style-method match--you can simply accept the fact that trading is not an emotion-free business.  Nothing in life is, so get used to it.  Indeed, learn to use it to your advantage.  Listen to your thoughts and feelings on good trades and bad, before the execution and after the gains or losses are tallied.  Is your mind an aid to your trading, or a constant nagging, berating distraction?  That should tell you something about your approach and how much you are comfortable letting the probabilities of your system work.

Beyond these basics, I can't recommend enough that you learn to quantify your system in a formal way.  Some of the best traders in the world are mechanical for a reason.  They don't want to take any chances letting their brains interfere with a good thing.  I'm not saying that everyone should be an automated system trader.  Some are geniuses at discretionary trading.  But that isn't what we should aspire to.  They either worked very hard for a long time to develop that balanced skill set, or they are freaks of nature, idiot savants who can't be copied.  And there is no shame in not being "as good" as them.  In fact, trying to be so heroic is what gets most traders in trouble.

Besides, you'd be surprised how many supposed discretionary traders are actually following a rigid system of rules in their head.  That's a practice they have learned to cultivate.  It doesn't mean they don't deviate and kick themselves afterwards.  But they have enough balance in their risk-reward approach that a few violations wont' take down the ship.

Speaking of automated system trading, if you want to take advantage of the workshop "Building Automated Trading Systems with Confidence" with CTA and mathematician John Joseph in Chicago June 13-14, there are only 4 seats left.  Learning to  quantify your system doesn't mean you have to become a totally automated mechanical trader like him.  Just going through the steps with a master trader and teacher will add several times the value to your current trading campaigns.  And then you'll have that weapon in your arsenal, to use at will and maybe even con-currently in another market.  Ultimately, you will also make daily trading stress less of a factor in your results.

I believe that learning to quantify your system will actually improve it and your overall approach to trading.  It could literally save you tens of thousands of dollars, in either loss prevention or added profits.  And don't forget--if you join me in Chicago that weekend, I will give you, or a friend, a voucher to my Masters of PROP Trader Training (a $500 value that also will pay for itself several times over).  Go here to register or learn more: http://www.mirusfutures.com/NextD.htm

When you call Eliot or Karen at Mirus Futures, be sure to tell them that Cooker sent you! 

In Part 4 of this series on Thursday, we will explore a way to make sure your brain can follow the golden rule of trading.  It's an inside peak at my trader training Masters of PROP, which stands for Probability, Risk, and Optimal Profit.

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