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msg #50674
Ignore TheRumpledOne
3/25/2007 9:38:03 PM

Catching up on my email...

Wednesday, March 21, 2007

Psyched Up: The Critique

A winning attitude is not all it's cracked up to be. It can only go so far. How can I criticize holding a winning attitude? Well, a winning attitude is certainly better than a losing attitude. But many traders self-destruct because of an overly optimistic attitude, so I think some criticism of a can-do, winning attitude is warranted. Any forthright trading expert will tell you that a winning attitude must be tempered with caution. You can't blindly believe that a trading method is foolproof, or that you can profit using unreliable trading strategies. You can get psyched up, but if you don't have the talent and resources to back it all up, you're still going to lose. That said, as long as you don't believe that your strategy is foolproof or that you have a supernatural ability to forecast the markets, getting psyched up can't hurt you too much. Risk management is the key, though. Don't risk money you can't afford to lose and don't feed a method or strategy that is not working.

At what point should you abandon a strategy that is not working? Doesn't that contradict thinking in probabilities? Don't you have to think of the big picture, and make a series of trades to get the law of averages to work in your favor? Let's look at this matter more closely. Suppose that through backtesting, and by testing out a new trading strategy under current market conditions, you discover that it works 90% of the time. You then decide to use probability theory to estimate the odds of success. If the strategy were used an infinite number of times, under identical market conditions, we would expect the strategy to work 90% of the time according to probability theory. Although it's impossible to use the strategy an infinite number of times, one can use it at least 20 times and expect it to work 9 times out of 10. If the approach is abandoned prematurely, however, it may not work with that frequency; thus, one needs to be optimistic enough to stick with it a fair number of times to see if it works.

That said, one must also be cautious. A central assumption of probability theory is that the trading strategy must be applied under identical market conditions, and we know that is a hard condition to meet. For example, compared to last fall, market conditions have changed significantly in the past few weeks. Therefore, even when a strategy has a past track record of 90%, we should expect it to work less than 90% of the time in the future because market conditions change frequently. (It is also useful to keep in mind that if market conditions were identical at each execution of the strategy, since 20 times is much less than infinity, it's quite possible that the strategy will not work even at a rate of 1 out of 20 times according to probability theory.)

Because probability is merely a hypothetical theory, risk management is crucial. It's vital that you risk a relatively small percentage of your trading capital on a strategy or method. Thinking in terms of probabilities can put you in a positive state of mind, but unless you are careful you can lose a great deal of capital.

Psychologists are usually strong proponents of positive thinking. For example, many people get bogged down believing that traders are born and not made. While in school, some young children make the mistake of thinking that they can't learn very well, and so they do not even try. Although some people are more intelligent than others, there are many people who come from humble beginnings who work hard until they succeed. It's useful to believe that you can succeed with hard work and persistence.

That said, a belief that any talent can be learned can lead to disaster. Look at "American Idol." Some of those contestants on the pre-competition show can't sing, and even if they practiced day after day, they will never sing like Celene Dion. That's also true of trading. If a person does not have the aptitude, he or she will never trade like Paul Tudor Jones. So if you absolutely need to be one of the best traders in the world, and can't master it after ten years, it may not happen. Thinking optimistically, working at your own pace, and accepting whatever progress you make will get you psyched up enough to persist for years, but in the end, it will not guarantee success. Does it hurt to have a positive attitude? As long as you manage risk, and don't lose too much, it can't hurt. But it's also useful to make realistic plans. Getting psyched up can make you go a long way, but a winning attitude, no matter how optimistic, will not allow you to do the impossible.

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