Searching for the holy grail

Let's be honest: All traders are secretly looking for the perfect strategy, the much-cited holy grail (the dream of guaranteed success on the stock exchange, in other words.) That’s why traders invest so much energy into sophisticated forecasting models and complicated calculation models.

The holy grail strategy originated in the United States with Linda Bradford Raschke, known the world over as one of the best commodities and futures traders. In the mid-1990s, she developed a set of trading setups — strategies that were supposed to predict the optimum entry point during clear trend movements to maximize profits and minimize risks. The defined trading signals were supposed to enable an optimum risk-reward ratio. These classic trend-following systems, however, require stable trends to work. They lose their halo in volatile sideways markets. According to the Arthurian legend, the original Holy Grail disappeared and its secret was never discovered. In the trading world, the search for the grail continues unabated. (It’s a wistful goal, in my humble opinion.)

In retrospect, the holy grail has achieved notoriety by way of its name rather than its track record for producing profitable trading strategies, but that doesn't mean that Linda Raschke’s holy grail strategy doesn't deserve a closer look. In my opinion, her "legendary" trading approach provides three valuable fundamental principles that are worth remembering for newbies as well as experienced traders:

• Insisting on consistent risk minimization and loss limitation with every single trade
• Developing systematic and structured trading processes
• Opening a trade only if it has clearly identifiable chart patterns

Seeing why a market analysis isn’t sufficient

Why would I even suggest that an in-depth analysis of the markets isn’t sufficient for success? The answer is quite simple: because the human factor comes into play on the stock market. The trader’s psyche is the weak link in the process chain. Technical and fundamental preparation is just as important as mental preparation for what happens on the market. Your mental constitution and your attitude determine whether you will benefit from your technical expertise. Experience shows that it’s much harder to implement a tested strategy according to the rules than it is to find a new profitable strategy — apart from the fact that, unfortunately, there are no perfect consistently profitable strategies.

Don’t allow yourself to be fooled by the dubious promises of some self-appointed experts: “Guaranteed dream returns with my XYZ system” remains a pipe dream and serves only one purpose: to extract money from your pocket.

Doing self-analysis instead of market analysis

What is the correct procedure? First off, you need to shift your focus. Rather than focus exclusively on market analysis, devote more attention to self-analysis. Emotional stability, as well as the knowledge of your personal strengths and weaknesses, may offer significantly higher potential returns than crunching the numbers. In practice, there will always be more profitable strategies than profitable traders. Let me assure you: You need mental strength to implement your own strategy consistently — always based on your own pre-defined rules, in other words.

Self-analysis requires the willingness to engage in some introspection. You need to learn how to recognize your thought and behavior patterns as well as your emotional patterns early enough for it to be useful. Write down all anomalies immediately — because memory can deceive you after some time has passed.

Experience has taught me to write down patterns of any kind in a trading journal the moment I notice them, and I strongly suggest that you do the same. Otherwise, you give your ego time to correct unpleasant truths as it sees fit. At the end of the day, you can evaluate the entries in peace and reflect on them. (See Chapter 5 for more about trading journals.) Such reflection often leads to some useful insights, such as the ability to

• Identify harmful patterns and their impact on profitability
• Recognize useful patterns that you were not even aware of

Adopting the position of a neutral observer who is only documenting facts can be the best way to recognize your own strengths and weaknesses. That is the prerequisite for positive change and further development.

In Chapter 3, I go into detail about the various forms of pattern recognition.

The inability, or in some cases the unwillingness, to be introspective is a reason that many traders stagnate from the beginning and then give up after some time. Almost every trader has problem patterns. The art is to recognize these patterns and break through them.

With the right mindset, you can turn every trading day into a positive experience. You can't prevent loss days, and you’re unlikely to make money on the stock exchange every day. It’s therefore important that you refuse to identify with the losses, or you'll end up feeling like a loser.

If you focus on your strengths, implement your trading plans according to the rules, and limit your losses at an early stage, there’s no reason to doubt yourself. Just continue to learn and develop your strategies.

Observe your own behaviors carefully, ask the right questions, work on your trader personality, and develop mental strength rather than look for the holy grail.

Learning from experience: Small steps, big impact

As most everyone knows, no one can predict the future — you can only be prepared for certain likely developments. As a result of your thorough preparation, you’re sure to regularly make good and rational decisions — decisions that, despite their goodness and rationality, will turn out to be completely wrong. The best models don’t protect against wrong decisions.

According to a well-known trader adage, “If you set out to be smarter than the market, then you have already lost.” The trader who can realistically assess their abilities, however, still stands a chance.

The market holds up a mirror to you every single day. This may disrupt your self-image, but the market doesn’t care. The market immediately punishes personal weaknesses, emotional reactions, and a lack of preparation.

It’s a mental challenge to design your development as a trader in such a way that all your trading experiences — whether good or bad — take you to the next level. You’ll know you’re on the right track when you manage not to take personally any errors or setbacks, but rather to constructively analyze such errors and setbacks and draw the right conclusions from them. However, blaming yourself isn’t constructive — it leads to you focusing on your weaknesses rather than your strengths, and can leave you feeling incompetent and cause your self-confidence to suffer. (For tips on how to build your self-confidence and boost your self-esteem, see Chapter 6.)

A good way to strengthen your self-confidence is to think in small steps. Many experienced traders report that setting many small, achievable goals has proven to be a tremendous help. Two strategies make sense here:

• Time frames: Set daily, weekly, or monthly goals.
• Process levels: Set task-oriented goals associated with implementation strategies, trading setups, and trading plans.

If you decide to keep a trading journal (see Chapter 5), expand your focus beyond your weaknesses and errors. Watch out for balance. Successful setups and successful trades are worth entering. Always pay attention to which mirror you want to look at.

Set yourself some subgoals as well. The resulting step-by-step approach, which is immensely motivating, creates regular experiences of success. Psychologists say that this is the breeding ground for mental strength and self-confidence. Studies show that achieving small, planned successes has a greater impact than the normal, positive experiences someone has in everyday trading life.

Working with positive stress

Stress isn’t generally detrimental to your health — it’s quite a natural response to perceived stressful situations (those times you feel under pressure, in other words.) Stress sharpens the senses and inspires performance. You can cope better with challenges. The output of the stress hormone adrenaline provides for increased attentiveness and muscle tension. Positive stress mobilizes the body and mind, without causing damage. From an evolutionary point of view, a minimum level of stress and excitement is necessary for survival.

Winning is a rush. It triggers a shot of adrenaline in all traders and puts them in a joyfully excited state. Winning is sure to motivate you and increase tremendously your willingness to perform.

Stress and fear of loss of control

That adrenaline rush can definitely be positive, but it can also be dangerous if the feeling of stress continues and turns into a fear of losing control. Negative stress can easily throw you off track. If the psychological strain of trading becomes overpowering, you'll lose your emotional balance and make mistakes.

In research, a distinction is made between two types of stress: positive stress (known as eustress) and negative stress (known as distress). Positive stress occurs when you’re highly motivated; successful moments work to drive you. Negative stress occurs as a result of frequent overtaxing or threatening situations. Over a longer period, the physical and psychological consequences of negative stress are sometimes so serious that they can lead to burnout syndrome.

Stress is a social phenomenon. According to surveys, an overwhelming majority of the workforce suffers from stress symptoms.

You can probably imagine that trading contains numerous stress triggers. After all, you’re risking your own money in an unpredictable market environment. If this isn’t fertile ground for negative emotions and stress factors, or stressors, what is?

The need to be in control in trading (the desperate need to get a grip on the markets, in other words) may emerge when you have lost control in other areas of life. The sense of powerlessness triggers negative stress. Subconsciously, you want to compensate for this loss of control. However, the markets are the worst place to do it.

Letting go of false beliefs

Sometimes, you may put pressure on yourself with false expectations or unrealistic ideas of trading. You have probably never consciously thought about it. Typical stress triggers are, for example, the following convictions I often hear in my practice:

• Only a day with wins is a good trading day.
• I must trade a lot to be successful.
• I must earn money with trading every day/week.

These beliefs inevitably lead to negative stress. You’re emotionally dependent on winning days. If you believe that you need to earn money on the stock exchange, the market will take your self-esteem for a ride. Any unexpected market volatility inevitably causes a roller coaster of emotions. It’s well known that a loss of control leads to stress and anxiety. How will you be able to focus on the rule-compliant implementation of your trading strategy under those circumstances?

You can control neither the market nor your trading results. A good day is a day in which you successfully implement your strategy. Some days will bring wins, and some will bring losses. The number of trades doesn’t determine your success, either. In fact, it’s sometimes better to wait and observe the market until appropriate trading signals appear. You’re unnecessarily putting pressure on yourself if you think you need to trade frequently. And you’re bound to make mistakes. Don't let the market decide how you feel.

Mental strength also means being patient. Patience is a virtue that isn’t easy for traders to develop. Being patient means waiting and trusting that what you forecast will occur. It requires self-discipline and courage to endure the uncertainty, however the market develops. Patience requires a firm belief that your strategy is the right one and that the appropriate entry signals will come. When you develop mental strength, you'll be in a position to surpass yourself.

Be aware of your assumptions and expectations by writing down your beliefs. Consider carefully how realistic your goals are and be clear about what is actually important in trading in order to be successful. (Chapter 6 talks more about setting aside beliefs that are keeping you from achieving your goals.)

Reducing stress in a targeted manner

Here's the burning question: How can you relieve stress in trading? The usual stress management methods mostly aim at symptoms and their results. This isn’t enough. A sustainable form of stress management goes deeper and explores the reasons and causes. The goal is prevention instead of having to come up with a cure.

The following recommendations are derived from the flood of psychological self-help books on the topic of holistic stress management strategies. Let's start with the short-term measures:

• Take a break from trading and try to relax.
• Release the mental tension by physically reacting to it (maybe by letting loose a primal scream or two, pounding the table, or running around the block).
• Consciously distract yourself by concentrating on a completely different topic.

Now, for some long-term measures:

• Identify your stressors.
• Consciously avoid stressors by preventively correcting and adapting your trading.
• Change your attitude to the stressors you cannot change.

The short-term stress management measures are easier to implement than the long-term ones. To set the long-term measures in motion, you need regular phases of regeneration when it comes to your trading.

The truth is, you can't change most of the stress factors in trading — but you can preempt these and control your stress response more consciously by recognizing those triggers early on and assessing them more positively. This requires personal self-reflection. When you can consciously perceive your triggers, you can control your response. If you use this window of opportunity effectively, you can break old stimulus-response patterns. That's how you can avoid the stress trap.

The Austrian neurologist and psychiatrist Viktor Frankl (1905-1997) once stated: “There is a space between stimulus and response. This space gives us the freedom and power to choose our response. Our growth and our freedom lies in our response.” In other words, it’s up to us humans whether (and how) we respond. How you react is a mirror of your trading development. Stress responses start in your head. The thing you need to change is how you think. It’s possible for you to learn how to stop automated reaction patterns before they start. It's up to you to decide which response is appropriate in a given situation. Use your response space consciously and actively. As a result, you can maintain control. With the right attitude, you can develop your personal trading development potential. (You can also gain mental strength and resilience.)

Traders often follow way too many markets on too many screens. That practice is strenuous and distracting. The resulting sensory overload can cause stress. Stay focused and concentrate on the essentials. That way, you can stay on top of everything. The flood of information usually provides no added value, anyway. Also make sure you have a stress-free trading environment. It’s important that you can work undisturbed in a focused manner. Avoid unnecessary distractions.

You can try out a variety of relaxation exercises to relieve stress — yoga, meditation, autogenic training, or progressive muscle relaxation, for example. Special breathing techniques can also calm the nerves. Regular exercise reduces stress hormones and pent-up energy and has been proven to make people more stress-resistant. You can find out more about the benefits of exercise and other relaxation techniques in Chapter 6.

Seeing what constitutes a resilient trader

Here are some important traits and competencies of mentally resilient traders:

• Being solution- and goal-oriented (self-control)
• Accepting what comes your way and remaining calm (self-awareness)
• Fostering personal responsibility and control (sense of responsibility)
• Being (realistically) optimistic and having a positive self-image (self-efficacy)

These properties, the resilience factors, serve to protect you when adversity strikes, and they mutually reinforce each other. They act preventively, which is how they protect you against stress traps when dealing with markets.

What does this mean in practice? It means that resilient traders

• Practice non-attachment by not identifying with losing trades. (Think of the teachings of Gautama Buddha here.)
• Dissociate the outcome of a single trade from your self-esteem as a trader.
• Manage to cope better with difficult market conditions
• Avoid perceiving markets as threatening
• Act in a considered and controlled manner
• Maintain emotional distance (think non-attachment again) when monitoring markets
• Find appropriate coping strategies and trust that these strategies will be successful

Self-confidence in trading can easily lead to overconfidence. When it comes to markets, believing that you and you alone have control over your destiny quickly becomes an illusion of control. The reality is, you have no influence whatsoever on market price action.

Personality traits and characteristics remain largely stable throughout life. Even if more recent research has come to the conclusion that the human personality is more changeable than previously assumed, this doesn’t apply to the age group of 30- to 60-year-olds — which is where most traders will find themselves.

And none of this means that you can’t train yourself in ways that increase your resilience. Resilience is a dynamic process and, with the right challenges, humans are definitely capable of becoming more resilient.

Take a look at Dr. Eva Selhub's Resilience For Dummies (Wiley) in order to learn more about psychological resilience and inner strength.

Your trader personality influences how you perceive and assess what is happening on the market. You also need to factor in your personal experiences of the stock market. When you assess these two aspects together, it explains why traders with different personalities and different experiences have such varying experiences when it comes to markets.

Starting your training regimen

Scenario analyses are a useful method for training mental resilience. Each time you execute a trade, imagine how you might react if the completely unexpected occurs:

• Worst case scenario: The market turns suddenly against you, and you’re repeatedly stopped out in the shortest time with accumulating losses. Or a large price gap when the markets open forces the trade of a security you held overnight, leading to an unexpectedly heavy loss.
• Best case scenario: Your timing is perfect, and you hit a winning streak. Or you unexpectedly profit from a large price gap when the markets open.

The psychological trick is to truly imagine your emotional state for both cases in advance. If you can imagine both cases in concrete detail, you can already think through what your next steps should be. Admittedly, this strategy requires a goodly amount of empathy to simulate strong emotions, such as anger and resentment on one hand and greed and euphoria on the other, but it’s worth it.

The main benefit here is that it takes away the power of these emotions in the real-life situation. You have played through the emotions of the scenario; you’re therefore prepared, meaning it’s much harder to knock you off balance. And you have managed to write a script about how you will react before the event occurs, while still in a calm state. This is a good method for increasing your resilience in trading.

Traders often say that setbacks have made them more resilient. Resilience research confirms this observation. People who experience many setbacks and recover from them will know that things always pick up again. In my experience, you cannot completely avoid errors and losses in trading. If you have gained the inner conviction that you'll be able to weather any setbacks that come your way, you have the required emotional resilience for trading.

Successful trading requires mental strength and mental resilience. Resilience is a competency that you can learn and develop. Nowadays, you can find a multitude of training methods for increasing resilience. The exercises are primarily based on methods of behavioral psychology, positive psychology and neurolinguistic programming (NLP). I explore some of these methods in the next few sections.

The journey is the destination

The secret to good goal-setting is to boost your goals with positive emotional energy. That way, the goals become wishes you absolutely want to achieve. You won’t become a better trader just because you think it might be nice to be one. You need this yearning feeling in your bones compelling you to chase all your goals in a highly motivated way, no matter the consequences. Goals should always be formulated positively and build on your strengths.

Think about what you did best over the course of your most recent trading days. Is there a pattern that shows specific abilities or strengths? Can you derive a specific goal from this? Allow your competencies to become visible so that you can use them to drive your progress. (For more on leveraging your competencies, see Chapter 5.)

Realistic and achievable goals are the foundation of success. Goals you have achieved create self-confidence and motivation.

So, what is the determinative factor when it comes to your success? Decisive here is that your goals should aim to improve the trading process rather than focus on boosting your profits. Why? It’s very simple: You can design and control process goals, but you can’t control the achievement of profit targets. Too many incalculable factors beyond your sphere of influence determine your profits. Focus on what you can control. Those are your processes, the implementation of your trading plans, and your strategies.

Do you want to improve the timing of your trade entry points? Simply adjust your setups and select an entry with half of the planned position size, and then buy the other half after a predefined time. Depending on how the price moves, you'll have either lowered your average purchase price or doubled your position in profit.

Your focus should always be on the continuous improvement of your trading strategies. Each experience brings you one step further. The learning process is the path that leads you to your goal. A good strategy implemented according to the rules is automatically profitable over time.

Every trading day turns into a positive learning experience if you focus on your strengths and consistently implement your trading plans. It’s not about making a profit every day. That is unrealistic. It’s about optimizing processes and strengthening your confidence in your competencies.

Accepting emotions as a source of information

Emotions are the formative part of your personality and character; they determine how you perceive the world. Can you exert any influence on your perception of the markets and how you react emotionally? I'm here to tell you that you surely can. Admittedly, you can’t change the core of your personality; your character traits will remain broadly stable for the rest of your life. But you can learn how (and in what form) your emotional personality comes to the fore.

Neuroscientific experiments with brain-damaged test subjects have proven that humans are unable to make decisions or act without emotions. As paradoxical as it sounds, if someone has lost access to their own memory of past emotional experiences, they no longer have a rational strategy for action. Traders get tangled up in weighing all the options, leading to an infinite loop. Brain researchers say that humans lack freedom of will at a conscious, rational level.

Who else remembers Mr. Spock, the emotionless Vulcan from the starship Enterprise, who always acted rationally? It’s a pipe dream, as everyone knows today.

It’s impossible to use the mind to get a grip on emotions, and it’s most certainly impossible to suppress them. In fact, it works the other way around: When you become angry about losses or errors, lightning-fast biochemical processes occur in your brain that don’t give reason a chance. The adrenaline boost, depending on someone's temperament, favors the kind of outbursts that have led to the destruction of quite a few keyboards and monitors.

As long as your emotional state is at equilibrium, you have full access to your logical and analytical mind. This state of equilibrium is the key to your cognitive performance.

How can you manage to maintain this condition while trading? The decisive step is not to try to suppress or block out emotions but rather to consciously observe and accept them as valuable information you can use to inform your trading. Are your emotions telling you that you need to adjust your trading strategy?

Accept your moods. Take away the hold that negative emotions have on you and you won't lose control so fast. By consciously perceiving your subliminal feelings, you can achieve a change of perspective and take a more constructive point of view.

Psychological studies confirm that it’s helpful to speak about your own emotions or to write about your emotions in a journal. In this way, you can observe your behavior from an observer perspective and reevaluate it.

Use your own emotional reactions as important additional information. You can use in trading much of the implicit knowledge in your emotional world. The rational mind has no access to the emotional treasure that lies hidden in your subconscious mind. This treasure has immense significance. Brain researchers have concluded that the area in human memory devoted to preserving emotional experiences is many times larger than all other areas for memory storage combined.

Your intuition, or your gut feeling, sometimes produces valuable information — results that cannot be achieved by the rational mind alone. You can find out more about this sixth sense in Chapter 3.

An inexplicable internal quiver, a grumbling in the belly, a tense neck, and pressure in the chest are often cited as physical warning signs that have saved many a trader from making a bad decision.

Even experienced traders react emotionally from time to time, but they never let emotions take control. They stay disciplined and stick to the rules. You can learn about maintaining emotional equilibrium in Chapters 7 and 8.

You can't lock away your emotions in a deep, dark dungeon when trading. The best strategy for dealing with your emotions is to consciously perceive, accept, understand and (where appropriate) take them into consideration.