Friday, August 12, 2016

Trading in the Zone - and some recent setups

While away for a recent holiday my reading material consisted of two classics by Mark Douglas - The Disciplined Trader and Trading in the Zone. For many Trading in the Zone this is the book that brought trading psychology to the masses.

A critical part of becoming truly 'in the zone' is allowing yourself to accept certain concepts and to treat the movements of the markets for what they are.

The books can appear to be quite deep for people new to the topic, and will require some thoughtful reflection, honesty with yourself and work if you want to learn how to understand how you can improve your mindset - which will ultimately improve your performance, regardless of your style of trading. They are a treasure trove of information and wisdom, and are I believe essential reading for anyone who wants to develop their mindset.

An important point he talked about was being able to accept that, while the performance of a single trade is totally random, if you have an edge that you are able to identify and trade often enough, you will come out ahead. 

As trend followers, we have a clear idea of when to enter a new position based on a set of entry parameters which have helped us (along with our other rules) obtain a positive expectancy in our trading. We do not know what will happen when we accept the risk in opening a new position - we are simply using our 'edge'. It is a probability or odds game.

In Trading in the Zone,  Douglas gave us the following five fundamental truths about trading that we have to develop to be truly accepting of, and which will allow us to be 'in the zone':
  • Anything can happen;
  • You don't need to know what is going to happen next in order to make money;
  • There is a random distribution between wins and losses for any given set of variables that define an edge;
  • An edge is nothing more than an indication of a higher probability of one thing happening over another;
  • Every moment in the market is unique.
I was reminded of these again as, refreshed and back in front of the charts, I constructed my watchlist for this week.

A number of stocks, which all met my criteria, I kept an eye on, and indeed I have taken a few trades this week, while respecting my own risk parameters and controlling my overall level of portfolio heat (read this and this for some ideas on how I control my portfolio heat). 

This meant that I could not take all the signals that were presented to me - I took them as an when they came along, and if my rules relating to risk meant I had to pass on some signals, so be it.

As it happens, I've taken more trades this week than in the previous three months! Not difficult I know when you look at my trading activity, but perhaps reflecting a positive change in market conditions.

It is probably typical that, of those stocks on my watchlist, those I have opened a position in have progressed very little, whereas some of the others that I didn't take the entry signals have progressed much better. Such is trading. I can accept that - could you?

I've shown some of the charts below of stocks that were on my watchlist and have broken out, but which I didn't take the trade. 

As Mark Douglas says, you have to be able to truly accept what happens after you have (or have not) pulled the trigger. 

Even though I have seemingly missed a couple of nice breakouts here, and regardless of whether my own trades generate a profit, I am happy to see that breakouts in general appear to be holding better - and that is certainly a change compared to the last few months where seemingly every breakout I watched quickly failed.

What I DID do (and all I could do) was participate in the market based on what I saw, accept that anything can happen (including seeing my own trades fail), while remaining faithful to my own rules for controlling my overall exposure and portfolio heat.

To me, the underlying positive from what I am seeing is that potentially the market 'state' is becoming more favourable towards my own style of trading. 

But I also need to bear in mind that the typical win rate for trend followers is below 50%, so I should still expect at least half (if not more) of my trades to fail. You also don't know in which order the winning and losing trades will arrive. I gave an extreme example here of the random distribution which a trend follow potentially could go through.

However, I know that at some point, if I keep taking signals as they are presented to me, I will get into one or more profitable trends - which may include a big one, that will cover a bunch of small losses and leave some profit left over.

Here's hoping for a nice run for the rest of the year!


  1. Great article. Thank you for sharing. My copy of Trading in the Zone is covered in notes. Best book ever.