Trading psychology and risk management: your mind as a trading tool

What trading tools do you use? You probably have a computer, some software packages, and databases. You probably visit several trading-related websites and may have a shelf of trading-related books. If you think that these electronic and physical objects are all the tools that support your trading, you overlook a hugely important trading instrument.


Your mind is a much more important tool than any computer or book.

Your emotions, hopes, and fears have an immediate and lasting impact on how you trade. If your computer freezes while you’re doing your homework or if your Internet connection goes dead in the midst of a busy trading day, you’d immediately recognize those events as severe obstacles to trading. Meanwhile, what goes on inside of your own head has a greater impact on the success or failure of your work than any technology.

Your mind is constantly at work, but it is humanly impossible to process all the signals that enter it from all directions. The input you receive through your eyes and ears is so immense that your mind must do a lot of automatic filtering to save itself from being flooded, overloaded, and shutting down. With a waterfall of sensations coming at you from life in general and from markets in particular, your mind must automatically sort out what to see and what to filter out. Most people are unaware of this filtering process. In fact, what you think are the objective signals from the markets tend to be highly filtered messages.

Once you become aware of this largely unconscious filtering process, you can see that most traders respond not so much to the markets but to the contents of their own heads. When people trade on the basis of their fears and fantasies instead of the reality of the markets, the results are likely to be poor. This explains why so many traders lose money and wash out of the markets.

To illustrate this unconscious filtering process, let us step away from the markets for a moment and take a look at what happens at the highest levels of the government.

The President of the United States has virtually unlimited sources of information—but there is no way one person can process everything available to him. He ends up depending on trusted assistants, such as cabinet ministers, to process the data in their area of expertise and give him their summaries. Those ministers, in turn, depend on their assistants in the narrower areas of expertise to process information and feed it to them. It is a logical system, designed to work well. It fails when the man at the top tells the men below what information he believes is correct. This influences them to serve up the information that confirms his preconceived notions.

For example, think of Iraq—instead of true information percolating up from the field, intelligence agencies were told to look for weapons of mass destruction. As it turned out much later, those did not exist, but overeager agencies produced enough flimsy “evidence” for the President to authorize the invasion. We are still dealing with the consequences of that highly flawed decision-making process.

What can we do as traders to avoid fabricating our own evidence? How can we avoid the trap of buying or selling because we “see” something that we want to see in the markets, when it is not actually there?

Much of this book is dedicated to the recognition of good trading signals. Before we proceed, I want you to recognize the hugely important fact that your mind is a part of the decision-making process. Your fears, wishes, and fantasies have a greater impact on your trading than all moving averages and trendlines combined. You have a great capacity for deluding yourself—but your success depends on seeing the truth.

If your mind is a trading instrument, we will need to set up a system for processing information. Your decision-making process must be transparent and unbiased. Then you will be able to learn from your experience and become a better trader going forward.

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