Trading Psychology - Dr. David Paul | Risk | Euphoria | Discipline | Probabilities | Position Sizing

Now.

I want you to use your wonderful imagination because in this vessel, we have a hundred one rand coins. Yeah.

See them? Right. Now, on every decision, on every trade, there's two decisions. One, is the damn thing going to go up or is the darn thing going to go down? Now, Barry alluded to the concept of. Of going short, which might be new to some of you, but you can take a bet that the market's going to fall, and if it does fall, you're going to make some money.

So.

That's the first decision. So the man in the green, heads or tails? Tails. Tails. Market's going to fall. The bear in the green.

We've got a hundred coins. The second decision, ladies and gentlemen, is how much do you want to bet? You can bet one coin, you can bet five coins. Or in the parlance of the commodity futures market, you can bet the farm. The whole bloody lot. Farmers love betting the farm. Okay.

So the man in the green says the market's going to fall. Tails. How many would you like to bet, madam?

1? 5? 20? 75. 20.

Okay, so let's trade. What we're doing is we're simulating a trading system that's right 50% of the time, that mixes twice as much when it's right as it loses when it's wrong. And I assure you that if you were a day trader in the Forex market, you would sell your granny for that system. Okay?

You're a granny. Because most intraday Systems will risk 30 to make 50.

And if that vendor is honest, it's not right that much more than 50% of the time. So the man in the green, are you feeling lucky, lads? Okay, don't take it too personally.

That's not a great throw. Not a great throw. Pound coined is much easier.

Sorry, mate. It's going up.

You lost. Sorry.

No, no, he bet. He bet was going to go down. So, 20 gone and we've got 80 left.

The man in the red, heads or tails? You, sir, you'll never wear that red pullover again.

Heads or tails? Pardon? Heads. We've got 80 coins left.

The man with a cold head with a cap on.

Remember John Wayne's last movie? He said to a guy coming in, he said, is your head cold?

We've got 80 coins left. How many would you like to bet? 40. Pardon? 40. He says, okay, this trade is totally independent of any other trade that you're ever going to take in your life. This is the first of the 10,000 trades that you're going to take between now and Death.

You said heads. Hey, man, let's see if I can get this right. That's an awful throw. Pound is much easier. That's better.

Heads is correct.

So we get 80. 80 and 81. 60. We're ahead of the game now, folks. The man in the red was lucky. Unfortunately.

What's the probability of a bad one?

Aha. Now, what's the probability of two bad ones in a row?

A quarter half times a half, which is a quarter. Now, in a 50% system.

Unfortunately, you get two bad ones every four trades.

Ladies and gentlemen, if you were to bet 50% of your coins on any one trade, you go bankrupt every four.

Do you understand? That.

Gets worse.

What's the probability of three bad wins in a row in a 50% gain?

A half times a half times a half, which is one over eight. That means throw a few coins when you get home. That means that in eight throws of the coin or eight trades, in a 50% system, you have a cluster of three bad ones in a row. That means, ladies and gentlemen, that if you were to bet a third of your coins on any one trade.

You go bankrupt every eight.

Okay? And most people go bankrupt because they bet far too much on any one single trade. Now, the bet size is the difference between your entry point and your stop loss, right? So if you buy a share at 10 rand and you've got a stop loss at 8:50, if it falls from 10 to 850, that's the bet size, okay? Am I correct, GT, gentlemen? I think I am.

So.

Unfortunately, there's a massive paradox here because you do the fundamental analysis, you do the technical analysis, and you're sure the damn thing's going to go up. Yeah. That's why you're putting the trade on in the first place. So if you're sure it's going to go up.

Why not have a big bet? Let's accelerate the process of wealth accumulation. So you decide to trade far, far too big. And then all of a sudden, you get a run of these bad ones. Now, if you don't believe me, here's what I want you to do. Tonight. Go to Monte Cassino. Who goes to Monte Cassino? Anybody? All right, you get to the casino tonight, lads. You go to the roulette wheel. It's a 50% game, equal number of blacks and reds. And there's a little white ball, which is GT's cut. That's the house edge, okay?

And you look at the scoreboard down at the end, and you're going to see long runs of red and long runs of black. Those clusters are real.

And it's this clustering effect that makes playing the game so difficult because you get long runs of good trades where you think you're God, and wrong runs, unfortunately, of bad ones where you feel like something that's under your shoe.

Okay? Now the first objective, ladies and gentlemen, is to live through the clusters, arithmetically, that you don't go broke in them.

Okay? Because you can quite easily have a cluster of five bad trains. Am I correct? Sure.

Five bad trades happen on a 50% system every 32, all right?

So if you were to bet 20% of your loot on any one particular trade, you go bankrupt every five.

And there is a big problem here. So there's a chap called Ralph Vince and he's written a long series of books called Effective Portfolio Manager for Traders. Thick, thick, thick, thick books. They've got them at Investec, they've got them at absa, but not bedtime reading, I assure you. And the gist of all of this is that you should not risk any more than 1 to 2% of your kitty on any one trade.

So if you've got 100,000 rand in your account.

And you're new to this, you should not bet, you should not risk any more than 1 to 2% of that in any one trade. So the maximum loss, ladies and gentlemen, that you ever have on any one trade should never be more than R2000 rand. And that will keep you alive.

Okay?

That will keep you alive. But there's a big problem because.

We have runs of good ones and runs of bad ones. Now, between your ears, there's a thing called the pituitary guide.

And that pituitary gland pumps out muti. When I'm in England, I have to tell them what muti means. That pumps out all sorts of hormones into your bloodstream. And these hormones are actually responsible for every.

Emotional state that you have. So when you fell in love with that young lady of yours, those hormones were just pumping around your system, alright? When I leave the gym, I'm no longer 63, I'm 17 again and back in the Royal Marines, and as I say, can be quite stroppy when I leave the gym, okay? Now, similarly, when you have one good trade.

Two good trades, three good trades, the pituitary gland is hard at work, okay? And it's pumping this muti into your bloodstream and you change completely. I know people that after one good trade, they're a different person, okay? Certainly after two, after three winning trades, they're in the bar buying drinks and the souls have never bought a round in their life.

What happens is that after a series of winning trades, we become euphoric.

And if you look in the Oxford Dictionary, the definition of euphoria is invincible. So what happens is that you say, sort all that position sizing, let's have a big bet. And risk managers in the City of London are actually taught these days by the FCA to, in fact, that's the equivalent of the FSB here, to actually look at the traders under their control and assess their susceptibility to euphoria. Now, you're going to find that once you get the 1 or 2% into your head, it's in fact not the runs of bad trades that cause you to go broke, it's the run of good trades. Because in a run of good trades, you actually trade far, far too big.

So just be careful about euphoria.

Now.

Our job is to find an edge in markets. Barry's analysis of all you need is one pattern. That's all. You just need one pattern to be successful. The head and shoulders pattern could be your pattern. He put a chart up of lots and lots and lots of patterns. I love my wedges, falling wedges and rising wedges. Those of you who are trading forex, there's a textbook falling wedge in the Euro 1 daily chart at the moment. I also am very fond of my fib levels and harmonic patterns, which are my own personal edge in both the stock market and the forex market. But you need one little pattern. You need to practice really, really good money management. And that just means not losing any more than 1% of your LUT or at the very most, 2% of your Lute on any one trade. And then the third thing is to build the discipline to just do it over and over and over again. Many of you will see those ghastly adverts that Alan Gray put out. Do you know those long, boring adverts, Alan Gray are great. They've got a process that Alan Gray was taught by Old Templeton a lifetime ago and they do the same thing over and over and over and over again. I went to one of their lectures the other night in London where it's Orbis across there, where they actually put on a case very similar to your case, where they justify, fundamentally based on value, that Honda was a much better buy than Tesla. Okay, wonderful presentation. But they've got a process and they stick to that over and over and over and over again. And your process doesn't your Trailing edge does not have to be complicated at all.

Finding a share that's undervalued, that's growing it, growing earnings aggressively and safely, that's in the throes of a good trend. I like always for a share to be above an 89 day moving average. 89 works for me. And then you need some little pattern to finesse the entry. Could be a triangle, could be an ascending triangle. There's a heap of them. And a simple book on charting will get you most of the way. And then don't lose any more than 1 or 2% in any one trade. And then you need to build the discipline. Now, ladies and gentlemen, can discipline be built or is it God given?

Of course you can. Why was an old man like me in the gym this morning at half past six? Why.

Twice a day?

Okay? Did it take any discipline to get me to the gym this morning?

None. None whatsoever. The paradox is that when you've got it, you don't need it. You okay?

All right.

That's the paradox. So.

To build discipline, folks, you're going to have to grit your teeth and stick to the process. So the first step would be to sit down with one of these guys, sit down with usy, put together your trading plan, a simple mechanical plan. The more mechanical the better. And then my challenge to you folks is to follow that plan without deviation for a batch of somewhere between 20 and 30 trades.

That's going to take quite a bit of doing. It is a rite of passage. Now, I'm not a psychologist. I've had psychologists in my classes and they still don't know why this happens. But to build a habit, okay, any habit, you've got to grit your teeth and do it. And then all of a sudden you actually build this neural pathway between your ears.

By doing it, you're going to find that sticking to the rules for the first few trades is difficult. But I've done this with many, many people over the years. When I used to do one on one mentoring, I don't do it anymore.

Somewhere between five and 13 trades, you build the pathway.

And you'll find that the discipline to stick to the rules is no longer required.

Because that's what you do.

So my challenge to you all is out of this. Get busy. Make a nuisance of yourself. Get yourself to a point where you've got a written plan that suits you. It should not be more than one page.

Think about position sizing. There's a good book on it by a guy called Van Tharp. It's called Trade youe Way for Financial Freedom on position sizing.

And then the real exercise is to focus on perfect execution of that plan for somewhere between five and 20 trades. Now I personally build a habit very easily and many of you will say that's great but it also means that you can build a bad habit very easily.

So.

The one thing that I can say which, which is positive that everybody in this room is 8 to 13 trades away from the trader you want to be. That's all.

But very few people get there because they don't adhere to the one system until that neural pathway is built. So that's the process and you want to be successful folks. Sit down, put together a fairly simple system, adhere to 1 to 2% position sizing and then the rail work starts of being able to follow that system through thick and thin and you're only about 8 to 13 threads away from being able to do that. That's all.

Thank you very much.