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Sunday, September 04, 2005

The Basics of Analysis and Rational Trading (Advertorial 2)

For a number of years, fundamental analysis was considered the only real or proper way to make trading decisions. In the late '70s and early '80s, technical analysis was used by only a handful of traders. As difficult as it is to believe now, it wasn't very long ago when most of the financial experts, major funds, and financial institutions thought that technical analysis was a flawed and nearly useless tool.

Today the opposite is true. Almost all experienced traders use some form of technical analysis to help them formulate their trading strategies. Except for some small, isolated pockets in the academic community, the "purely" fundamental analyst is virtually extinct. What caused this dramatic shift in perspective?

The answer is simple: money. The problem with making trading decisions from a strictly fundamental perspective is the inherent difficulty of making money consistently using this approach.

In case you're not familiar with fundamental analysis, here's a brief explanation. Fundamental analysis attempts to take into consideration all the variables that could affect the relative balance or imbalance between the supply of and the possible demand for any particular stock, commodity, or financial instrument. Using primarily mathematical models that weigh the significance of a variety of factors (interest rates, balance sheets, earnings projections, supply and demand, and numerous others), the analyst projects what the price will be at some point in the future.

The problem with these models is that they rarely, if ever, factor in other traders as a variable. People, expressing their beliefs and expectations about the future, make prices move—not models. The fact that a model makes a logical and reasonable projection based on all the “relevant” variables is worthless if the traders who are responsible for most of the trading volume are not aware of the model… or don't believe in it.

As a matter of fact, many traders – especially those on the floors of the exchanges who can move prices dramatically in one direction or the other – usually don't have the slightest concept of the fundamental supply and demand factors that are supposed to affect prices. And, at any given moment, much of their trading activity is prompted by a response to emotional factors that are completely outside the parameters of the fundamental model. In other words, the people who trade (and consequently move prices) don't always act in a rational manner.

Ultimately, the fundamental analyst could find that a prediction about where prices should be at some point in the future is correct. But in the meantime, price movement could be so volatile that it would be very difficult, if not impossible, to stay in a trade long enough to make money.

Technical Analysis

Technical analysis has been around for as long as there have been organized exchanges, but the trading communities didn't accept technical analysis as a viable tool for making money until the late '70s and early '80s. Here's what the technical analyst knew that it took the mainstream market community generations to catch on to:

A finite number of traders participate in the markets on any given day, week, or month. Many of these traders do the same kinds of things over and over in their attempt to make money. In other words, individuals develop behavior patterns, and a group of individuals, interacting with one another on a consistent basis, form collective behavior patterns. These behavior patterns are observable and quantifiable, and they repeat themselves with statistical reliability.

Technical analysis is a method that organizes this collective behavior into identifiable patterns that can give a clear indication of when there is a greater probability of one thing happening over another. In a sense, technical analysis allows you to get into the mind of the market to anticipate what's likely to happen next, based on the kind of patterns the market generated at some previous moment.

As a method for projecting future price movement, technical analysis has turned out to be far superior to a purely fundamental approach. It keeps the trader focused on what the market is doing now in relation to what it has done in the past – instead of focusing on what the market "should" be doing based solely on what is "logical and reasonable" as determined by a mathematical model. On the other hand, fundamental analysis creates a gap between what should be and what really is. The gap makes it extremely difficult to make anything but very long-term predictions that can be difficult for a trader to exploit… even if those predictions someday are correct.

In contrast, technical analysis not only closes this gap, but also makes available to the trader a virtually unlimited number of possibilities to take advantage of. The technical approach opens up many more possibilities because it identifies how the same repeatable behavior patterns occur in every time frame — by the minute, daily, weekly, yearly, and longer. Technical analysis turns the market into an endless stream of opportunities.

Rational Analysis

If technical analysis works so well, why don’t more people consistently make money?

Once an investor learns to identify patterns and read the market, there are limitless opportunities to make money. But, as I'm sure you already know, there can also be a huge gap between what you understand about the markets and your ability to transform that knowledge into consistent profits and a steadily rising equity curve.

Think about the number of times you've looked at a price chart and said to yourself, "Hmmm, it looks like the market is going up (or down)," and what you thought was going to happen actually happened. But you didn’t actually make a trade, and you anguished over all the money you could have made.

There's a big difference between predicting that something will happen in the market (and thinking about all the money you could have made), and the reality of actually getting into and out of trades. The difference a mental gap that can make trading one of the most difficult endeavors you could choose to undertake – and certainly one of the toughest to master.

The big question is: Can trading be mastered? Is it possible to actually trade with the same ease and simplicity you feel when you’re only watching the market and having theoretical success, as opposed to actually executing trades? Not only can you, but that's exactly what this e-course is designed to give you: insight and understanding you need about yourself and about the nature of trading. So the result is that actually doing it becomes as easy, simple, and stress-free as when you are just watching the market and thinking about doing it.

This may seem like a tall order, and to some of you it may even seem impossible. But it's not. There are people who have mastered the art of trading, who have closed the gap between the possibilities available and their bottom-line performance. But as you might expect, these winners are relatively few in number compared with the number of traders who experience varying degrees of frustration, wondering why they can't create consistant success.

There are two types of traders: those who consistently make money, and those who don’t. Traders who have learned to be consistent make significant sums of money in the market every year.

Surprisingly, most of the trading industry’s failures are also bright and accomplished people. The largest group of consistent losers is composed primarily of doctors, lawyers, engineers, scientists, CEOs, wealthy retirees, and entrepreneurs. Furthermore, most of the best market analysts are the worst traders. Intelligence and good market analysis can certainly contribute to success, but they are not the defining factors that separate the consistent winners from everyone else. So if it isn't intelligence or better analysis, then what could it be?

The best traders think differently from everyone else.

That doesn't sound profound, but it does have profound implications if you consider what it means to think differently. To one degree or another, all of us think differently from everyone else. We may not always be mindful of this fact; it seems natural to assume that other people share our perceptions and interpretations of events. In fact, this assumption continues to seem valid until we find ourselves in a basic, fundamental disagreement with someone about something we both experienced. Other than our physical features, the way we think is what makes us unique, probably even more unique than our physical features do.

Let's get back to traders. What is different about the way the best traders think as opposed to how those who are still struggling think? While the markets can be described as an arena of endless opportunities, the markets simultaneously confront the individual with some of the most sustained, adverse psychological conditions a person can be exposed to. At some point, everyone who trades learns something about the markets that will indicate when opportunities exist. But learning how to identify an opportunity to buy or sell does not mean that you have learned to think like a trader.

The defining characteristic that separates the consistent winners from everyone else is this: The winners have attained a unique set of attitudes that allows them to remain disciplined, focused, and, above all, confident in spite of adverse conditions. As a result, they are no longer susceptible to the common fears and trading errors that plague everyone else. Everyone who trades ends up learning something about the markets; very few people who trade ever learn the attitudes that are absolutely essential to becoming a consistent winner. Just as people can learn to perfect the proper technique for swinging a golf club or tennis racket, their consistency, or lack of it, will without a doubt come from their attitude

Traders who become consistent and disciplined usually experience a great deal of pain (both emotional and financial) before they acquire the attitude that allows them to function effectively in a market environment. The rare exceptions are usually those who were born into successful trading families or who started their trading careers under the guidance of someone who understood the true nature of trading, and, just as important, knew how to teach it.

Why are emotional pain and financial disaster common among traders? The simple answer is that most of us weren't fortunate enough to start our trading careers with the proper guidance. However, the reasons go much deeper than this. Trading is filled with contradictions in thinking that make it extremely difficult to learn how to be successful.

Financial and emotional disaster are common among traders because many of the perspectives, attitudes, and principles that would otherwise make perfect sense and work quite well in our daily lives have the opposite effect in the trading environment. They just don't work. Not knowing this, most traders start their careers with a fundamental lack of understanding of what it means to be a trader, the skills that are involved, and the depth to which those skills need to be developed.

Here is a prime example of what we’re talking about: Trading is inherently risky. No trade has a guaranteed outcome; therefore, the possibility of being wrong and losing money is always present. So when you execute a trade, can you consider yourself a risk-taker? Even though this may sound like a trick question, it is not.

The logical answer to the question is, absolutely, yes. If you engage in an activity that is inherently risky, then you must be a risk-taker. This is a perfectly reasonable assumption for any trader to make. In fact, not only do virtually all traders make this assumption, but most traders take pride in thinking of themselves as risk-takers.

The problem is that this assumption couldn't be further from the truth. Of course, any trader is taking a risk when he executes a trade, but that doesn't mean that you are correspondingly accepting that risk. In other words, all trades are risky because the outcomes are probable — they aren’t guaranteed. But do most traders really believe they are taking a risk when they execute a trade? Have they really accepted that the trade has a non-guaranteed, probable outcome? Furthermore, have they fully accepted the possible consequences?

The answer is no. Most traders have absolutely no concept of what it means to be a risk-taker in the way a successful trader thinks about risk. The best traders not only take the risk, they have also learned to accept and embrace that risk. There is a huge psychological gap between assuming you are a risk-taker because you make trades and fully accepting the risks inherent in each trade. When you fully accept the risks, it will have profound implications on your bottom-line performance.

The best traders can make a trade without the slightest bit of hesitation or conflict, and just as freely and without hesitation or conflict admit it isn't working. They can get out of the trade — even with a loss —and doing so doesn't create the slightest bit of emotional discomfort. In other words, the risks inherent in trading do not cause the best traders to lose their discipline, focus, or sense of confidence. If you are unable to trade without the slightest bit of emotional discomfort (specifically, fear), then you have not learned how to accept the risks inherent in trading. This is a big problem, because to whatever degree you haven't accepted the risk is the same degree to which you will avoid the risk. Trying to avoid something that is unavoidable will have disastrous effects on your ability to trade successfully.

Learning to truly accept the risks in any endeavor can be difficult, but it is extremely difficult for traders, especially considering what's at stake. What are we generally most afraid of? Certainly, losing money and being wrong both rank close to the top of the list. Admitting we are wrong and losing money in the process can be extremely painful, and is certainly something to avoid. Yet as traders, we are confronted with these two possibilities virtually every moment we are in a trade.

Now, you might be saying to yourself, "Apart from the fact that it hurts so much, it's natural to not want to be wrong and lose something; therefore, it's appropriate for me to do whatever I can to avoid it." And that’s true – to a degree. But it is also this natural tendency that makes trading extremely difficult.

Trading presents us with a fundamental paradox: How do we remain disciplined, focused, and confident in the face of constant uncertainty? When you have learned how to "think" like a trader, that's exactly what you'll be able to do. Learning how to redefine your trading activities in a way that allows you to completely accept the risk is the key to thinking like a successful trader. Learning to accept the risk is a trading skill — the most important skill you can learn. Yet it's rare that developing traders focus any attention or expend any effort to learn it.

When you learn the trading skill of risk acceptance, the market will not be able to generate information that you define or interpret as painful. If the information the market generates doesn't have the potential to cause you emotional pain, there's nothing to avoid. It’s just information telling you what the possibilities are. Seeing information and events objectively is your goal; you can’t be objective if you’re afraid of what is or isn’t going to happen.

I'm sure there isn't one trader reading this e-course who hasn't gotten into trades too soon — before the market has actually generated a signal, or too late — long after the market has generated a signal. What trader hasn't convinced himself not to take a loss and, as a result, had it turn into a bigger one; or got out of winning trades too soon; or found himself in winning trades but didn't take any profits at all, and then let the trades turn into losers; or moved stop-losses closer to his entry point, only to get stopped out and have the market go back in his direction? These are but a few of the many errors traders make time and time again.

Those are not market-generated errors. Those are not errors that come from the market. The market is neutral, in the sense that it moves and generates information about itself. Movement and information provide each of us with the opportunity to do something, but that's all. The markets don't have any power over the unique way in which each of us perceives and interprets this information, or control of the decisions and actions we take as a result.

Here’s the biggest difference between consistent winners and everyone else: The best traders aren't afraid. They aren't afraid because they’ve developed attitudes that give them the greatest degree of mental flexibility to flow in and out of trades based on what the market is telling them about the possibilities from its perspective. At the same time, the best traders have developed attitudes that prevent them from getting reckless.

Ninety-five percent of the trading errors you are likely to make — causing you to consistently lose money — will be due to your attitudes about being wrong, losing money, missing out, or leaving money on the table.

Now, you may be saying to yourself, "I don't know about this: I've always thought traders should have a healthy fear of the markets." Again, this is a perfectly logical and reasonable assumption. But when it comes to trading, your fears will act against you in such a way that you will cause what you are afraid of to actually happen. If you're afraid of being wrong, your fear will act influence your perception of market information in a way that will cause you to do something that ends up making you wrong.

When you are fearful, no other possibilities exist. You can't perceive other possibilities or act on them properly, even if you did manage to perceive them, because fear is paralyzing. Physically, it causes us to freeze or run. Mentally, it causes us to narrow our focus of attention to the object of our fear. This means that thoughts about other possibilities, as well as other available information from the market, get blocked. You won't think about all the rational things you've learned about the market until you are no longer afraid and the event is over. Then you will think to yourself, "I knew that.

Why didn't I think of it then?" or, "Why couldn't I act on it then?"

It's extremely difficult to see that the source of these problems is our own inappropriate attitudes. Many of the thinking patterns that adversely affect our trading are a function of the natural ways in which we were brought up to think and see the world. These thinking patterns are so deeply ingrained that it rarely occurs to us that the source of our trading difficulties is internal, derived from our state of mind. It seems more natural to see the source of a problem as external, in the market, because it feels like the market is causing our pain, frustration, and dissatisfaction.

Obviously these are abstract concepts and certainly not something most traders are going to concern themselves with. Yet understanding the relationship between beliefs, attitudes, and perception is as fundamental to trading as learning how to serve is to tennis, or as learning how to swing a club is to golf. Put another way, understanding and controlling your perception of market information is important only to the extent that you want to achieve consistent results.

We say this because there is something else about trading that is as true as the statement we just made: You don't have to know anything about yourself or the markets to make a winning trade, just as you don't have to know the proper way to swing a tennis racket or golf club in order to hit a good shot – occasionally. The first time you played golf, for instance, you might have hit several good shots throughout your round, even though you hadn't learned any particular technique; but your score was still probably well over 100 for 18 holes. Obviously, to improve your overall score, you needed to learn technique.

The same is true for trading. We need technique to achieve consistency. But what technique do we need to learn? If we aren't aware of, or don't understand, how our beliefs and attitudes affect our perception of market information, it will seem as if it is the market's behavior that is causing the lack of consistency. As a result, it would stand to reason that the best way to avoid losses and become consistent would be to learn more about the markets.

This bit of logic is a trap that almost all traders fall into at some point, and it seems to make perfect sense. But this approach doesn't work. The market simply offers too many — often conflicting —variables to consider. Furthermore, there are no limits to the market's behavior. It can do anything at any moment. As a matter of fact, because every person who trades is a market variable, it can be said that any single trader can cause virtually anything to happen.

That means no matter how much you learn about the market's behavior, no matter how brilliant an analyst you become, you will never learn enough to anticipate every possible way that the market can make you wrong or cause you to lose money. So if you are afraid of being wrong or losing money, it means you will never learn enough to compensate for the negative effects these fears will have on your ability to be objective and your ability to act without hesitation. In other words, you won't be confident in the face of constant uncertainty. The hard, cold reality of trading is that every trade has an uncertain outcome. Unless you learn to completely accept the possibility of an uncertain outcome, you will try either consciously or unconsciously to avoid any possibility you define as painful. In the process, you’ll subject yourself to any number of self-generated and costly errors.

Now, we’re not suggesting that you don't need some form of market analysis or methodology to define opportunities and allow you to recognize them; you certainly do. However, market analsysis is not the path to consistent results. It will not solve the trading problems created by lack of confidence, lack of discipline, or improper focus.

When you operate from the assumption that more or better analysis will create consistency, you will be driven to gather as many market variables as possible into your arsenal of trading tools. But what happens then? You’re still disappointed and "betrayed" by the markets because of something you didn't see or give enough consideration to. It will feel like you can't trust the markets; but the reality is, you can't trust yourself.

Confidence and fear are contradictory states of mind that both stem from our beliefs and attitudes. To be confident while you’re functioning in an environment where you can easily lose more than you intend to risk requires absolute trust in yourself. However, you won't be able to achieve that trust until you’ve trained your mind to override your natural inclination to think in ways that are counterproductive to being a consistently successful trader. Simply learning how to analyze the market's behavior is not the only skill you need.

You have two choices: You can try to eliminate risk by learning about as many market variables as possible. Or, you can learn how to redefine your trading activities in such a way that you truly accept the risk and you're no longer afraid.

When you've achieved a state of mind where you truly accept the risk, you won't have the potential to define and interpret market information in painful ways. When you eliminate the potential to define market information in painful ways, you also eliminate the tendency to rationalize, hesitate, jump the gun, hope that the market will give you money, or hope that the market will save you from your inability to cut your losses.

As long as you are susceptible to the kinds of errors that are the result of rationalizing, justifying, hesitating, hoping, and jumping the gun, you will not be able to trust yourself. If you can't trust yourself to be objective and to always act in your own best interests, achieving consistent results will be next to impossible. Trying to do something that looks so simple may well be the most frustrating thing you will ever attempt to do. The irony is that, when you have the appropriate attitude, when you have acquired a trader’s mind-set and can remain confident in the face of constant uncertainty, trading will be as easy and simple as you probably thought it was when you first started out.

So, what’s the solution? You’ll need to learn how to adjust your attitudes and beliefs about trading so you can trade without fear… but at the same time keep a framework in place that keeps you from becoming reckless.

The successful trader that you want to be is something you have to grow into. Growth implies expansion, learning, and creating a new way of expressing yourself. In order to become a better trader, you’ll have to change. This is true even if you're already a successful trader and are reading this book to become more successful. Many of the new ways in which you will learn to express yourself will be in direct conflict with ideas and beliefs you presently hold about the nature of trading. You may or may not already be aware of some of these beliefs. In any case, what you currently hold to be true about the nature of trading will argue to keep things just the way they are, in spite of your frustrations and unsatisfying results. These internal arguments are natural. Your willingness to consider that other possibilities exist — possibilities that you may not be aware of or may not have given enough consideration to — will obviously make the learning process faster and easier.

"What Takes Some Successful Traders A Lifetime To Achieve Could Take You Just A Few Days... Or Less!"

Get these reports for free

Advertorial 1 - Introduction
Advertorial 2 - The Basics of Analusis and Rational Trading
Advertorial 3 - Basic Principles
Advertorial 4 - Characteristics of Successful Traders
Advertorial 5 - Playing to Your Strenghts, Overcoming Your Weaknesses
Advertorial 6 - Winning Psychology
Advertorial 7 - Avoiding Common Pitfalls
Advertorial 8 - Sound Money Management
Advertorial 9 - Trading Systems
Advertorial 10 - Final Words


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