from Trading from your Gut
“Intuition and concepts constitute…the elements of all our
knowledge so that neither concepts without an intuition in some way corresponding to them,
nor intuition without concepts, can yield knowledge.”
When I started trading, Richard Dennis trained me in methods he had carefully researched. Then he gave me a $2 million trading account to manage after only a month of trading a smaller practice account. I was lucky.
Most of you reading this book won’t be so lucky. You’ll have to develop your own techniques.
Don’t leave your left brain behind in this process. If you want to trade with both your intuition and your intellect, you need to pick trading strategies that work for your whole mind. Systematic intellectual traders who ignore their intuition are losing out on great potential benefit. So are discretionary traders who attempt to bypass or override their intellect—those who neglect to provide a firm rational basis for their trades.
Every trading method should be grounded in a firm intellectual framework.
Every trading method should be grounded in a firm intellectual framework. In this chapter, I show the basis for a specific method that I use as an example in the next several chapters. I like to start with the basics, such as the rationale for the method, and build my strategies from there. The first step in building a rationale is choosing a type of trading method that works for you.
Step by Step
When I resumed trading in 2001, I started an online trading discussion forum. Traders, and those who wanted to become traders, could post questions to more experienced traders. Many questions were directed to me. Some were specific questions about the methods we used as Turtles, which were easy to answer. Traders who wanted to emulate our success asked the more difficult questions. They wanted to be long-term trend followers.
I had to tell them the truth: For most people, long-term trend following is not a viable way to trade because
- Most people don’t have the necessary amount of money to have a reasonable chance of earning good profits.
- You can’t earn the 100% average annual returns I earned as a Turtle using the same methods we once used.
- Trading using a long-term trend-following approach requires the ability to stomach sizeable drawdowns, which most people don’t have the emotional constitution for.
Trying to trade with a system that you can’t get behind with your whole mind is pointless. You need to find a method that harmonizes with your whole mind and your psychological makeup. For most people, the old Turtle-style method is not that system.
So if trend following isn’t suitable for most people, what sort of trading is?
Is it swing trading, in which the trades last for days or a few weeks; or day trading, in which the trades last for minutes or hours? Fortunately, most traders can easily make this decision because the process of elimination leaves them with only one viable choice. For most traders, swing trading is the obvious choice.
Day trading requires that you devote the entire day to trading. This is not an ideal scenario for many traders who maintain a full-time job and trade a small account on the side. Most traders need an approach that won’t take up all their time—one that they can do part-time while supporting themselves with another job until they have honed their trading skills and built their trading account to the level required to earn a living from trading itself.
Day trading also requires quick judgment and decision-making skills. Many traders don’t possess these skills. Active traders have a hard time reacting quickly enough to make money while competing against professional day traders that have generally been trading 24/7 for years, if not decades. Some people like the speed of day trading. I don’t. From my personal perspective, it requires too much attention during the day and doesn’t leave me much time for other interests.
For these reasons, swing trading is the most viable option for most traders. You can trade with a smaller account, it won’t consume all your time, and it doesn’t require lightning-quick reaction. Swing trading also fits my personal lifestyle better. You can pick up trading for a while and then stop while you are doing something else. Because the trades normally last only a few days, you can start and stop more easily. During the day, you usually just need to wait for market alerts to fire, so you can be doing something else. I have many other interests, so this style suits me well.
Swing trading is also a type of trading that benefits from a whole-brain trading style. If you use your intuition, you will be able to find many more opportunities than you would if you use only one part of your mind. Swing trading benefits from both intellect and intuition.
The Source of Opportunity
If you want to be one of the few who reliably and consistently make money from the market, you need to find a strategy that gives you an advantage, an edge. To build such a strategy, you combine the building-block basics we learned in Chapter 4, “The Structure of the Markets,” in particular ways to extract profits. In this chapter, I put those building blocks together in a strategy that enables the left brain and right brain to do what they do best.
My rationale for this trading approach draws from the basics. First, recall that human psychology is the foundation upon which all successful trading is built. Markets are made up of large numbers of interacting
Homo sapiens, each with their own individual agenda. Even when they use computer networks and programs to execute their trades, somewhere behind the scenes for every trade is an individual trader who directed the computer to execute that trade using a specific set of algorithms. To beat the markets, you first need to understand these traders’ motivations, the impetus behind the direction and timing of the trades. Then you need to find times when the markets participants in aggregate have mispriced the market—when the market does not reflect the “right” price.
Many people, especially economists, are fond of saying that markets always reflect the “correct” price. This is one of the conclusions of the efficient-market hypothesis: Markets already reflect all known information, so they quickly respond to new information. Therefore, these economists believe that it is impossible to consistently win money by trading the market because the market already reflects all known information. They attribute any success by traders to mere random chance—the lucky monkey theorem.
Master traders know that Homo sapiens
are not completely rational. We have emotions, are sometimes afraid, are sometimes overconfident, and display cognitive biases. For these reasons, we sometimes overreact or
underreact. Therefore, the price is not always “right.”
The way to reliably make money from the markets is to identify repeatable psychological market phenomena in which market prices appear to
already reflect an overreaction or underreaction on the part of market participants, and
trade against that reaction or anticipate an overreaction or underreaction based on previous market behavior. You can make money from both overreactions and under-reactions, either by predicting them or by reacting to them. Predicting market prices themselves is very hard. Predicting human reaction to market prices is somewhat easier. But easiest of all is
detecting what has already happened and reacting to that existing market condition.
If the market overreacts, you can make money by anticipating a return to “correct” price levels. If the market underreacts, you can also make money by anticipating a return to “correct” price levels. In each of these respective scenarios, the meaning of “correct” is different. In the case of an underreaction of a price toward the upside, the “correct” price level is above the market price, so you can profit by buying at the market price and anticipating an eventual return to the “correct” price. In the case of an overreaction of a price toward the upside, the “correct” price level is below the market price, so you can profit by selling at the market price and anticipating an eventual return to the “correct” price.
About the Author: Curtis
Faith earned more than $30 million as a member of the legendary Chicago trading group, the
Turtles. Faith has developed a “whole mind” approach that gives traders at all skill levels the tools to become master traders.
Combining insights on trading psychology, managing risk, and trading methods, Faith delivers a method that is as much art as it is science and gives traders the tools to use all of the weapons at their disposal...namely, instinct and analysis. His most recent book is
Inside the Mind of the Turtles.