The heart and soul of trading is neurobehavioral.  There is no way to deny this, as evidence continues to build that traders bring themselves and their brains into every aspect of trading.  With this comes irrationality and neuropsychological biases. 

The only way for a trader to succeed, i.e., perform in a consistently profitable fashion, is to have an edge.  Those of you who have coached or mentored with me for any period of time will recognize immediately that I continually stress three critical elements of trading: risk control, money management and edge.  What is an edge?

In simple terms, an edge is what separates the amateurs from the professionals.  An edge refers to that specific brain (synaptic) strategy that you have practiced until you are as familiar with it as breathing. (For more information on synaptic strategies, please see Dr. Dorn’s most recent publication in SFO Magazine: This Is Your Brain On Trading)   

The majority of traders lose.  This is the harsh reality.  Most enter the markets with ill-conceived beliefs and proceed to wipe out their accounts in a short period of time.  They are not trained and their behavior in the markets is somewhat akin to driving a race car blindfolded.  In essence, they might as well be throwing darts at the markets.  They have little to no strategy or planning.  Trading is a serious business and no businessman in his right mind would think about starting a business without a defined business plan.   It is no different with trading.  The saying is: Plan the trade and trade the plan.  This is simple, but not easy.  

The major reason traders don’t adhere to “plan the trade and trade the plan” is that they have not trained their trading brain to dampen down the emotional components which come rushing in as soon as real money is placed in the markets.   Everything changes once money is on the line.  First, there is the element of risk. Every time you have monies in the market, you are in the realm of risk, and it is your responsibility to control that risk by adhering to rigid practices of stops. If you do not have a strategy for risk control, you have no edge.  If you deviate from your strategy by giving yourself a “little slack” as regards stops, you have no edge.  If you enter a position without a clear stop and profit potential, you have no edge. If you turn a trade into an investment, you have no edge. 

Trading is a game of probabilities, not of black and white.  The worst thing that can happen to a novice trader is to win immediately. This is the winner’s curse because of the hubris and overconfidence it creates.  He or she will become overconfident and believe that he or she has it all figured out.  It won’t be long before the trader begins to take more and more risk, becomes careless and takes a big loss. 

Back to the edge.  Edges are statistical and represent some aspect of market behavior which you can exploit for your own profits.  This has some predictability and is likely to recur.  In trading, the best edges are those which relate directly to thinking (cognitive) biases. I will review a couple of these at the end of this article and introduce you to the neurobehavioral aspects of support and resistance.

For now, understand this:  In order to develop your edge, it is critical to find points of entry in the market where there is the greatest probability for success.  This means that it is your task as an edge trader to find those price points where the markets have the greatest probability to move in a direction which favors your position; and to avoid those price points where the markets have the greatest probability to move against your position.  Said another way, you want to enter with a target price point.  You enter with a target and a stop.  If the market moves in your direction, you take profits at or close to the target and you hold through until profit is reached.  If the market moves against you, you take the stop immediately.  There is no holding or hoping in losing positions.  Losing is losing, period. 

Edges exist at the price points where there is the greatest instability. These points are virtual battlegrounds between buyers and sellers.  The technical concept of support and resistance is one example of an instability point which I will discuss in detail over the coming weeks. The best traders laser focus on these areas, wait to see who is winning the battle, then jump in and ride the winning side. 

It is critical to grasp that the term “trading edge” is nothing more than the exploitation of recurring market inefficiencies.  There are edges (structural and methodological) everywhere in the markets for those who look beyond the ordinary to seek them out.  If you look diligently, you will find them and profit from them.  If you are able to consistently find and exploit edges, there is absolutely no limit to the amount of money you can make in the markets.  If you do not find and exploit edges, you are trading so-called efficiently priced assets and can only hope to profit if the information coming into the markets (this information is readily and instantly available to all!) is favorable to your position. This would be expected to occur with a probability of about 50:50.  That is not an edge or a probability that lends itself to the risking of your hard-earned assets. 

The July Trading Doctor Newsletter will examine the neurobehavioral aspects of the trading edge at points of support and resistance.  Specifically, it will discuss the role of the following cognitive (brain, thinking) biases in trading points of market instability at support and resistance:

1.  Anchoring.  This is the tendency for traders and investors to base perception on the most readily available information. 

2.  Recency Bias.  This is the tendency for traders and investors to place more importance on events that have happened recently. 

3.  Disposition Effect.  This is the tendency to cut winners short.

These are the three main cognitive biases that underlie the neurobehavior of imbalances at points of market instability such as support and resistance.  We will discuss these in detail in the next installment:  FINDING YOUR TRADING EDGE: Support and Resistance

Until next time,
Good Trading and Brain On!

Janice Dorn, M.D., Ph.D
Prescriptions for Profits
www.thetradingdoctor.com

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