TRADING FUNDAMENTALS - PART 1: Accepting Constant Market Changes and Uncertainties

Most traders have a limited knowledge of trading’s fundamental rules, either from a psychological or a methodological point of view. This can lead to increasing loss probabilities on the markets, as well as deep and constant psychological damage.

Recent studies have proved that professional trading has a lot in common with professional sports activity and competition. In fact, sport coaching and training experience can be replicated and implemented to train financial traders. In any kind of sport, a series of fundamental exercises, which should be learned and practiced regularly, are necessary to reach competition level and become successful. For example, in basketball, some fundamental exercises to work on would include: rebound, left shot, right shot, dribble, pass, shot in suspension, etc.

Trading fundamentals are:

• Market

• Mind

• Method

• Money Management

To be successful in trading, it is necessary to understand and learn these fundamental theories and, at the same time, learn a method of thought which will help implementing them in trading activity.

The knowledge and implementation of these 4 fundamentals is probably what makes the difference between successful and unsuccessful traders. Traders who make profits continuously and in the long run, have consciously or unconsciously:

1. understood their market and the effects that it could have on their mind;

2. eliminated, or learned how to cope with the negative effects of trading;

3. found a methodology - often through a thorough, long lasting research, and demanding practice - which gives them a probabilistic edge on the market. Generally, successful traders have found a method which is adapted to their personality and best capabilities (to use a marketing term: they have found their own trading niche);

4. implemented money and risk management strategies which allowed them to reach point 2 (eliminate the negative effects) and contributed to generate profits on a regular basis.

The objective of this series of articles is to explain the fundamentals of trading and how to implement a training program which will highly increase the probabilities of success, to anyone who has a passion for trading and wants to be successful at it.

In this first article, we’ll start by analyzing the market and its specific characteristics. We will see how the implementation of certain mental strategies, which usually lead us to success in our every day life, can be dangerous in the trading activity.

In any financial market, the creation of a market price occurs through the confrontation between buy and sell decisions. It is made of individual decisions (billions of them), which generate a continuous and collective decisional stream. This stream is what defines the price of a specific market instrument at a specific time. As traders, we have the possibility to continuously make multiple decisions (based on expectations) about: the market direction, the amount of invested capital, loss limit levels, the duration of a trade, etc., with the possibility to modify our decisions any time.

These decisions aren’t only based on rational elements (as developed in the theory of Efficient Market Hypothesis or EMH) but, also on irrational and unconscious elements, which continuously invite us to change our mind, sometimes very rapidly.

Therefore the market is always moving, always changing. It has no defined structure and offers high profit and loss opportunities. In a fraction of a second markets can go from apparent quietness and stability to extreme speed and turbulence. This specific market characteristic is often ignored or underestimated by traders. But having to cope with a completely unstructured, fluid and ever changing environment is not something that we are used to. It’s like being projected into a world without laws, similar to the motion of atoms in a quantum mechanics system.

Let’s take for example, a very simple activity such as sitting down. In a world regulated by quantum mechanics rules, this simple action could become extremely complicated and risky, for anyone used to living in our “normal” world. What would happen if I sat down? Sometimes the chair would remain in the same position, both in terms of space and time. Sometimes the chair would disappear and
reappear in another place at an unexpected time. So the simple action of sitting down, could actually become very difficult if I continued to refer to my usual model of thought. So to be able to sit down in a world regulated by quantum mechanics, I’d have to learn a completely different way of thinking and acting. Otherwise, I’d be very inefficient.

As human beings, one of our main purposes is to create mental structures for ourselves which will bring us security and stability. And this is the main problem that traders have when confronting the financial markets.

We are not used to interacting
with an environment which is mainly ruled by change and uncertainty. An environment where the mental and decisional processes of all market participants are constantly changing.

Traders’ search for the Holy Grail- in other words the indicator or the theory which will systematically forecast market movements - is actually only an attempt to eliminate constant market uncertainty.

Therefore the first fundamental rule of the market is to accept changes and market uncertainties (in other words accept RISK). There is no other way to survive the financial markets than to accept this obvious rule. And it is a fundamental rule precisely because it is obvious. Easy to understand from a theoretical point of view, much more difficult to put into practice.

Accepting change and uncertainty doesn’t mean having a confused or insecure mind-set and attitude. On the contrary, understanding that fluctuations depend on mental processes and decisions, which can vary depending on an infinite number of unpredictable factors, allows us to eliminate all the mental mechanisms which generate pain (these will be developed in subsequent articles).

The absence of pain changes our perception and gives us the possibility to be objective and rational. Objective perception is fundamental in trading, as traders have to recognize market patterns. Therefore, a rational and objective mind set will help us develop a rational decision making model, which is not based on emotions. Acknowledging the fact that markets are unpredictable and accepting trading risk is - according to me - what makes the difference between a successful and unsuccessful trader.

This state of mind is an ability (or SKILL) which any trader should reach before he/she can start becoming profitable constantly and in the long run.

Author : Rodolfo Festa Bianchet