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I call this process of inexperienced trend traders losing their position and/or missing a profitable trade the sideline regret/remorse syndrome. When it manifests as the relinquishing of a winning position, the decision to bank profits usually stems from a fear of those significant profits turning into small profits. As the market continues trending, traders feel regret and remorse, which can be alleviated only through the loss of discipline or participating in the trend irrespective of price risk management considerations. Often this throwing-in-the-towel mentality is pure crowd following and results in entry at the blowoff phase of the trend. Because reentry was triggered by emotion irrespective of risk, these traders tend to hold onto the losing trade until it balloons to the capitulation point. Then this failure can lead either to self-chastisement, lack of confidence, and trader paralysis (the inability to initiate new trades) or to a reckless gambler mentality that I call the breakeven syndrome.
The breakeven syndrome is one in which traders rationalize away prudent rules of price risk management as a temporary abandonment that they will return to once they break even. What I will say from years of experience is that once discipline is broken, only pain and failure will motivate us to resuscitate it.
Why does this loss of discipline/premature relinquishing of positions occur? Usually newcomers’ temptation to eliminate the outliers grows stronger after a large unrealized profit gives back a significant portion of potential gains. We can put these situations into perspective by remembering two things:
1. No one ever captures the top or bottom of a trend, and only with hindsight is a particular exit point apparent.
2. As trend traders, because a small percentage of all trend-following trades will make up a large portion of our profits, cutting off the outliers hampers our ability to financially weather the equity drawdowns that are inherent in any trend-following strategy and increases our risk of ruin.
If readers still are tempted by superior theoretical performance promised through cutting profits and are disciplined enough to adhere to the system irrespective of short-term pain/regret, I urge you to employ some mechanized methodology that forces you back into formerly abandoned trend trades once it is apparent that the dominant trend has asserted itself again.
PSYCHOLOGICAL PROFILE OF A TREND-FOLLOWING TRADER
Although this profile is by no means exhaustive, I believe it will give readers enough of an understanding of the trend trader’s personality traits to accurately assess their ability to implement these strategies successfully.
• Willingness to buy recent highs/sell recent lows. Unless traders adhere to this first premise, there is no point in reading on. Trend trading works because it is extremely difficult to buy highs and sell lows. Psychological reminders to help with this problem:
I If trend trading were easy, then everyone could do it and it would not be a profitable strategy.
| When feelings of uneasiness, fear, and apprehension arise in anticipation of buying recent highs (selling recent lows), reprogram yourself to associate these feelings with success and profitability. (Reinforce this reprogramming with a review of the backtested results shown in this chapter.)
• Willingness to give back a significant portion of unrealized gains. Remember that no one knows when the trend will end. Instead of attempting to anticipate the trend’s reversal, sit back and allow profits to accumulate.
MECHANICAL TRADING SYSTEMS
As we have been programmed to associate being right with success and being wrong with failure, it is only natural for us to remember and focus on those instances in which our intuition told us that we were at the top or bottom (therefore, not forced to relinquish a portion of profits) and conveniently forget times when our predicted market turns did not come to fruition. I call this phenomenon the psychic trader syndrome.
Psychological reminders to help with this problem:
• Participate, don’t anticipate.
• The market pays us handsomely for our patience. Regret over giving back a portion of one’s profits is only obvious with hindsight.
• Keeping a daily trading journal of your market forecasts will aid in abandonment of the psychic trader syndrome.
• Willingness to exhibit patience through numerous, consecutive small losses. Patience is the key to success as a trend trader. Psychological reminder to help with this problem:
• Backtesting and analysis of a mechanical trading system’s results will help in recognizing that sticking to the strategy after consecutive losses eventually leads to profitability. This historical trade evaluation process fosters the courage, fortitude, and discipline needed to weather such losses.
• Ability to blend discipline with flexibility. Discipline suggests sticking to the successful strategy; flexibility suggests abandonment of a strategy once markets have undergone a paradigm shift.8