More than two decades ago, Van introduced me to the concept of “parts” of our personality—roles that compete for our attention and influence over our decision-making. If you’re not familiar with that concept, this is a psychological construct that I’ve found quite helpful for understanding how we make decisions.
You may have a safety part, a joy-seeking part, a big spender part, and a pleaser part—all acting from their perspective in our own best interest. While perhaps not a clinically exact description of personality, it is a useful model.
Under this model, it’s easy to imagine that one of our parts enjoys emotional extremes. And from there it’s not a stretch to imagine this part of us wanting to feel those emotional extremes when we trade—the exhilaration of winning or the disappointment of losing. I could get philosophical here and dig into how our need to feel any emotion is not very discerning between these two extremes, but as many of you know, I’m much more practical than that!
So let’s talk for just a moment about emotions and trading at an applied psychology level. Many say that we need to trade without emotion. But such a generalization is not accurate. As humans, we are going to feel emotions, and trying to stifle them is counter-productive for most people. A more useful concept for traders is to minimize the effect emotions have on our decision-making.
Trading Systems Help Us Manage Emotions
A systematic trading approach provides a decision-making process that can reduce or eliminate emotional distractions if implemented properly. And, in order to make decisions in an objective manner, we need to provide a framework that covers all aspects of a trading system. In brief form, here are the individual components that make up a trading system:
- Beliefs about the system: This is the part of the system that tells us why the system has an edge in the first place.
- Market conditions where the system performs at its best and worst: This can be viewed as a subset of the system beliefs, but is important enough to warrant its own heading. It is important to understand the market environments where the system should perform well and when lower performance is expected.
- Set-up: This is the part of the system that tells us that conditions are ready to trade.
- Entry: The component of the system that tells us to pull the trigger now.
- Stop Loss: The parameter that tells us when to exit the trade if it moves against us.
- Profit-taking exit: This part of the strategy describes how and when we exit profitable trades.
- Position sizing: The part of our system that answers the question, “How many units to trade?”
Once we have all of these bases covered in a systematic plan, we can make objective decisions at every point in the trading process. And here’s the bonus: We are free to feel our emotions during the trade…as long as we stick to the plan. The emotions can even be useful in the system design and development phase of trading. Trading those strategies that cause you to feel particularly good in the development stage can add to your confidence in following the plan.
That’s Pretty Generic, D.R. How About a Specific Example?
Digging into strategies and trading them is one of my favorite activities. I’ve had the pleasure of doing it for household names in the trading industry, as well as for traders and investors just getting started.
Van and I often debated the importance of the entry component and how to gain an edge with that aspect of system design. As many of you know, Van wrote about a long-term strategy in his first book, Trade Your Way* that worked with a random entry, showing the importance of a well-designed exit component.
But, I’ve found that a well-crafted entry can add a considerable edge to an already good system. And there’s one entry strategy that has paid bigger dividends in strategy design for me than all of the others. I love it because it’s truly effective and beguilingly simple.
It’s All About the Direction
This particular concept for gaining an edge with your entry works in a system that is looking to play a continuation in the direction of the trend, after a pause, a counter-trend move or even in a complete reversal. And, the entry concept is wonderfully straightforward: Require the market to move in your direction before entering. Some readers may be thinking that this is too simplistic. But my research and practice have shown that this isn’t the case. Let’s look at some proponents of the practice and some examples of when and why it works.
First of all, Van did a study on this concept that he published in our book, Safe Strategies*. Van looked at a series of reversal trades that our co-author, Dr. Steve Sjuggerud, recommended in a newsletter. With no entry criteria (other than the fundamental set-up), the picks were quite good, averaging a gain of 2.5 times the initial risk.
However, when an entry condition was added for these long-term trades, that required the stock price to move up for one month before entry was allowed (price has to be higher than five weeks ago), the trades returned a whopping 6.4 times the initial risk.
We felt that this entry strategy was so compelling that we made it one of the “six keys to investment success” that were presented in the book.
And it doesn’t only work for longer-term trades like Steve’s, but also in short time frames. The 10-Minute Trader strategy is an intraday system that was also reviewed in the Safe Strategies book. It produced such good results over many years of use in large part because of an entry requirement: Simply, that price move in the direction of the trade on an intraday basis before a trade could be initiated.
As with almost all system trading concepts, there are tradeoffs. Waiting for confirmation of a price move in your favor means that stops have to be a bit bigger (further from entry). But my research shows that for most cases, this downside is more than made up for by avoiding strong momentum against the trade. It basically ensures that you’re not trying to catch a falling piano (wait for it to bounce first!) for long trades or step in front of a freight train for short trades.
A well-designed entry is just one part of a good system design. And R.J. Hixson has been teaching the How to Develop Winning Trading Systems That Fit You Workshop that’s coming up next week for over a decade. I plan on attending some of his sessions to see where his latest system design upgrades could help my ongoing study.
I’d love to hear your thoughts and feedback on using systems to manage emotions or about system design in general at drbarton “at” iitm.com. Until next week…
Great trading and God bless you,
D. R.
could you please give an example for this?