I think the thing that sets traders apart is their ability to go their own way. How many times do you hear about gut instinct and the like and wondered how you can possibly make a go of that, especially if you are new to trading? This thought has entered my head a number of times and it makes me think that gut feel is something of a learned behaviour that only comes through experience. However, this leads me to suspect that if we look closely at these moments in time we may be able to get some hints that can speed up our journey. The shame of it is that the psychological battle takes that much longer to come to terms with.
This is why you need patience – right now. What we need to think about is how testing and re-testing of ideas can start to give us insight. When you study carefully you start to notice things a lot faster than “a-ha moments” that occur after a lot of subconscious observation. Therefore we need to spend many hours trying out new methods on the charts to see what appeals and what appears effective.
First, though, I would like to go on the record and say I have met many traders who claim to work out their entire entry and exit strategy based on gut feel. Let me go on to say that I think that this is a purely lazy approach and one that I can’t imagine having any long-term likelihood for success. I would further suggest that this is the type of thing that can give a feeling of being successful during a rampant bull market but would give up the ghost in otherwise choppy market conditions. The reason that I make such a strong series of statements here is that I don’t want to be confused for suggesting that gut feel is all you need or that we are somehow inherently gifted with it because I don’t think that either of these factors are true.
When we look at the way we think about our experiences it is very important that we don’t get overwhelmed by the law of small numbers. This occurs when we make wide sweeping statements that are based on a small number of highly correlated events. For instance, if for the past three weeks you noticed that BHP shares rallied on the Friday you could come to the conclusion that BHP shares rally every Friday. This is a simple example and one that we can all see is flawed but a person could find something not too much more complicated that they believe to be golden. You may look at an oil stock and noticed that it has rallied the day after the oil price climbed in New York. This would seem logical. The fact is that week-to-week many oil companies are not that strongly correlated to movements of the oil price at all – so we need to be very careful about the conclusions that we make.
Naturally, just because a conclusion doesn’t work each and every time doesn’t make it entirely incorrect. Financial markets are a compilation of a vast number of opinions and events so the fact that an otherwise sound strategy doesn’t work sometimes is not the fault of the strategy but it being overwhelmed by several ancillary factors. In fact, this is an equally common and much larger problem for traders because in this case the trader has actually put in the effort to devise a strategy and may be about to drop it because of the law of small numbers. I suspect that this is particularly the problem if the trader goes from a winning streak and straight into a losing streak. It’s not surprising every trader enjoys making money but a real difference exists in the ability that the trader has in giving it back to the market.
If your response to a losing streak is to throw your hands up in the air and stop then you may fall into a bit of a problem category. The question that you would need to ask here is whether your strategy is at fault or is it just a market driven issue that you couldn’t have done anything about? It could be a combination of the two but the one thing that is unlikely to be a solution is to scrap your method and start from scratch. When it comes to technical analysis the basic concepts are really based around a limited number of central ideas which I would say relate to momentum or trend following. Of course there are masses of variations on these concepts but once you are on your 100th plan (hopefully not) you will notice that they will frequently fall into one of these two categories. The reason this is important is that simply scrapping an idea and starting again will unlikely produce the new start that you were looking for, so you will need to be a lot more subtle in your work.
The big problem that you get from scrapping plan after plan is that you will find it much harder to identify whether you are dealing with a successful strategy or just good luck. For instance, if I hung the share price pages on a wall and threw three darts at them, and you bought all three stocks which subsequently rallied you might say that the darts were magical – or you might say that it was luck – which would be correct. Imagine however that you put together a complex strategy and the first three positions all rallied, would that make it a winning strategy or simply lucky? Tragically you won’t know for a lot longer because you will need to deal with changing market conditions over a reasonable period before you can start to make any such assessment.
People often turn to computerised systems in order to carefully backtest the strategy they are planning to implement. The great thing about this is that it reduces the time that would be spent trying to determine the potential effectiveness of your strategy. It also allows you to get a good idea as to what making fine adjustments will do to the outcome of the trading strategy. I think that one of the overlooked benefits of this is not that it allows you to construct the most profitable strategy but that it allows you to see why finetuning is very important. Interestingly enough, finetuning to the nth degree is not effective either and is one of the reasons why backtesting sometimes gets a bad name. It occurs because people fit their testing to historical data so finely that it becomes ‘curve-fitted’. This means that it is almost perfectly suited to the data of the past but much less flexible to changing conditions in the future.
So by now you have a good idea why you need to be perseverant and not throw out your trading strategy after a bad run. Simply recognising this as a common characteristic of traders can be enough for you to recognise when frustration is getting the better of you – and in a choppy market like we are in now who would be able to blame you? To paraphrase one of my favourite trading authors, Frank Watkins, winning trades do not make you a good trader and losing trades don’t make you a bad trader – they are simply a by-product of the business that you are in. I think that the same can be said for the methodology that you apply.

A gutful

I think it’s likely that genuine gut-feel is a combination of study and practical experience – but we don’t have it built in. One of my personal ones (and pretty obvious) is the behaviour of strongly bull-trending stocks that start to break down on otherwise strong market days. I see this as a real warning sign that a stock is coming up for a rest period when it reverses early morning gains after recent strong movements in an otherwise bullish market. It doesn’t always seem to reverse properly that day or the next but I have noted how many times it’s a warning. Now I probably picked this up by thinking of a combination of candlestick patterns (like the shooting star) combined with staring at the depth screen of the markets for hundreds of hours. Its amazing how fast you learn as you curse the market when you are long a stock that doesn’t go up even when the rest of the market does – so this probably had something to do with it too.
These illustrations aren’t set in stone but the message that I would like to get across is that you need patience in dealing with changing market conditions. Particularly as we deal with a very erratic market, like we are seeing at the moment, you need to be very tolerant of fast changing conditions. As you study and learn though it is important not to let frustration to cause you to undo good work just because of a small number of failures. This type of irritation will affect everyone but having the patience to work through it (as always combined with conservative position sizes, stop-losses and risk management) can make all the difference.