The Deutsche Nationalbibliothek

Lists this publication in the Deutsche

Nationalbibliographie; detailed bibliographic
information is available online at http://d-nb.de.

1st edition 2015

© 2015 by FinanzBuch Verlag

an imprint of the Münchner Verlagsgruppe GmbH,
Nymphenburger Straße 86
D-80636 München
Tel.: +4989 651285-0
Fax: +4989 652096

Original Edition copyright © 2006 by FinanzBuch Verlag.

All rights reserved. The original edition has been
published in 2006 under the title »Die Kunst des
erfolgreichen Tradens: So werden Sie ein Master Trader!«.

All rights reserved. No part of this publication may be

reproduced, stored in a retrieval system, or transmitted,
in any form or by any means, without the prior permission
in writing of the publisher, nor be otherwise circulated in
any form of binding or cover other than that in which it is
published and without a similar condition including this
condition being imposed on the subsequent purchaser.

Translation: Jadwiga Boroboska

Editing: Shelley Steinhorst
Proofreading: Hella Neukötter
Coverdesign: Judith Wittman

ISBN Print 978-3-89879-720-7

ISBN E-Book (PDF) 978-3-86248-410-2
ISBN E-Book (EPUB, Mobi) 978-3-86248-381-5

Further informations are available at

www.finanzbuchverlag.de
Please visit our other publishing houses at
www.muenchner-verlagsgruppe.de
 TABLE OF CONTENTS

Acknowledgements
Foreword
1. Chapter 1
1.1 Find out what you want
1.2 Ask yourself what values do you strive for in your life
1.3 Condition yourself for success! Only those who reward
themselves directly for good performance will be in a position
to repeat this performance
1.4 Formulate your goals properly! Important rules that you
should observe when you formulate your goals
2. Chapter 2
2.1 Take 100 percent responsibility
2.2 Focus on those things that you can really control
3. Chapter 3
3.1 The function of a business and trading plan
3.2 How to prepare a comprehensive plan
3.2.1 Establish a connection with your mission
3.2.2 Provide an overview of your trading style and your
history
3.2.3 Comment on the products and markets that you want to
trade
3.2.4 Specify how you organize your trading and what
equipment you need for this
3.2.5 Compare yourself with the competition
3.2.6 State your strengths
3.2.7 Comment on your weaknesses
3.3 The trading plan
3.3.1 Every strategy is based on a philosophy
 3.3.2 Decide on an analysis technique
3.3.3 Develop an entry strategy
3.3.4 Develop a low risk idea
3.3.5 Accurately describe the transaction process
3.3.6 What’s your exit strategy?
3.3.7 How do you organize the daily and periodic follow-ups
for your trading?
3.4 An example of a business and trading plan
3.4.1 Overview
3.4.2 Business description
3.4.3 Competitors
3.4.4 Financial information
3.5 My trading plan (excerpts)
3.5.1 My philosophy
3.5.2 My analysis technique
3.5.3 The entry
3.5.4 Waiting and watching
3.5.5 Action
3.5.6 Exit
3.5.7 Re-entry
3.5.8 Mental prerequisites
4. Chapter 4
4.1 How does our brain function?
4.1.1 Information is discarded
4.1.2 Information is generalized
4.1.3 Information is distorted
4.2 Belief systems determine our behavior
4.3 There is no reality - Only an internal mental representation of
the world
4.4 How beliefs affect our actions
4.5 Beliefs in trading
4.5.1 How they block us
4.5.2 How belief systems provide us with support
4.6 How to find belief systems that will support you
 4.6.1 Trading problems arise from unproductive or limiting
belief systems
5. Chapter 5
5.1 Moods determine our behavior. If you can handle your
emotions, you can handle trading.
5.2 How do moods arise? There’s a link between an event, our
internal mental representation of this event, the mood that
arises from this internal mental representation and our
behavior
5.3 Discipline
5.4 Steps to discipline
5.4.1 Step 1 - You have to know yourself
5.4.2 Step 2 - Use your mental resources
5.4.3 Step 3 - Observe yourself
5.5 How to develop a behaviora compass
5.5.1 Steps to discipline
6. Chapter 6
6.1 The states and modes of existence of traders
6.2 The optimal mood for every trading step
6.3 Excellence through mood control
6.3.1 Commitment/vocation
6.3.2 Passion
6.3.3 Demand more of yourself
6.3.4 Belief systems that provide you with support
6.3.5 Trust in yourself
6.3.6 Intuition
6.3.7 Don’t fight, but trade
7. Chapter 7
7.1 Market analysis and its significance
7.2 The risk/reward ratio
7.3 Criticism of the risk/reward ratio
7.4 The hit rate and the payoff ratio
 7.5 The expectation value
7.6 The risk of ruin
7.6.1 Staying in the game is a trader’s most important goal
8. Chapter 8
8.1 The entry
8.2 The random entry
8.3 How to plan your entry
8.4 The philosophy
8.4.1 Long or short? First specify the direction of the trade!
8.5 Assess the market’s psychological state
8.6 When do we make our entry? Clear objectives and specific
criteria
8.7 Implement your rules rigorously - Even in loss-making phases
8.8 Where should you enter, or this is how you wait and watch for
the optimal entry
8.9 Poker strategy
8.9.1 Immediate buy
8.10 The opportunity factor
8.11 The steps you have to take
8.12 What to bear in mind for every entry
8.13 For every entry you should also already plan the re-entry
8.14 Be aggressive with the first position and reload as soon as it
runs in your favor
8.15 Don’t enter too frequently
8.16 Avoid an entry prior to important economic data
8.17 Is there a smart entry and what would this be like?
9. Chapter 9
9.1 The fundamental law of trading and why so many exit
strategies contravene this law
9.2 Are you finally ready to gamble your profits?
9.3 The turkey trap
9.4 My exit rules
9.4.1 The first interval - R1
 9.4.2 The second interval - R1
9.4.3 The third interval - R1.5
9.4.4 The fourth interval - The target zone
9.5 How to find your perfect exit strategy
10. Chapter 10
10.1 The Kelly Criterion
10.2 Optimal F
10.3 How to evaluate a system’s risk of ruin
10.4 Maximum rate of return
10.4.1 Sample matrix
11. Chapter 11
11.1 What’s the difference between a simulation and
backtesting?
11.2 How to simulate your system
11.3 How to develop a simulation in Excel
12. Chapter 12
12.1 Single-lot traders trade suboptimally
12.1.1 Single-lot traders
12.2 Position sizing - The turbocharger for your performance
12.3 How to develop an optimal money management algorithm
12.3.1 Fixed bet size
12.3.2 Percentage bet size
12.3.3 Percent volatility model
12.4 The rules of position sizing
12.5 Never reduce the price
12.6 Never increase your initial risk
12.7 Never overtrade
12.8 Be disciplined
12.9 How to pyramid
12.10 Psychological considerations when setting up a pyramid
12.11 An example of a pyramid
13. Chapter 13
 13.1 Rule 1: “Stay in business”
13.1.1 Traders overextend themselves
13.1.2 Traders produce negative moods that hinder optimal
decisions
13.1.3 A polarity of having and not having develops
13.1.4 Trading systems aren’t implemented consistently
anymore and trading rules are flouted
13.1.5 The perspective becomes restricted to the next trade
and to profits
13.2 Rule 2: “Don’t ask why, ask how”
13.3 Ways out of the crisis
13.4 Immediate measures
13.4.1 Take a short break from trading
13.4.2 Take a dissociative view
13.4.3 Change your perspective
13.4.4 Keep on reducing your risk until you realize a winning
trade
13.4.5 Increase your risk slowly back to the usual size
13.5 General measures
13.6 External control
13.7 Internal control
14. Chapter 14
14.1 Trading tactics
14.2 Trading tactic 1: Gamble your profits
14.3 Trading tactic 2: Only reduce your risk in the case of a loss
14.4 Trading tactic 3: Don’t try to maximize the profit from one
single trade but, instead, maximize the profits from the sum of
all the trades
14.5 Trading tactic 4: Use mixed strategies
14.6 Trading tactic 5: Always gamble if the expectation value of
taking a gamble is positive
14.7 Trading tactic 6: As traders, we always have to incur a risk
and it should be incurred as early as possible
14.8 Trading tactic 7: Careful planning brings benefits in
uncertain situations
14.9 Trading tactic 8: Those who have an advantage shouldn’t
give it away again
14.10 Trading tactic 9: Never stagger the realization of your gains
14.11 Trading tactic 10: Take a break from trading
 ACKNOWLEDGEMENTS

I’d like to express my thanks to my beloved wife Christina, who not

only worked for hours proofreading this book but who also shows
a great deal of understanding for the huge amount of time that my
profession requires.

I’d also like to thank my parents who brought me up to believe that

freedom and justice are important values. I became a trader not
least for this reason.

I’m also indebted to my friend Karsten who, with his helpful daily
support in my trading operation, provided me, among other things,
with the freedom to write this book.
 FOREWORD

The quest for the key to financial freedom through trading -

successful investing and top performance - leads most people to
embark on a long, expensive and frequently endless odyssey.
Dozens of trading strategies are tried out, widely varying indicators
are tested, gurus are consulted and research reports are carefully
studied. Naturally, this aimless wandering also includes the search
for the holy grail, for “the” method or for “the” trading system that
promises reliable and long-term gains.

Only a very small number of traders realize their goal of

generating top performance continuously. Many drop out along the
way. Maybe they run out of funds, maybe they lose interest or the
belief that it will ever be possible to achieve this goal. Studies
show that only around 5 percent of all futures traders achieve
long-term success.

Why is it that there are so few winners in this game of games? Is

successful trading a question of talent, perhaps? Is it maybe just
the luck of the draw if, year after year, someone earns millions by
trading on the capital markets of this world? Or could it really be
the case that these chosen ones have discovered a secret trading
system that turns them into super traders?

It’s nothing of the kind. Experienced traders and investors know

that neither talent, nor luck nor the trading system is the key to
financial freedom, to top performance.

The sole determinant of a trader’s success is the priceless ability

to implement INTERNAL CONTROL and to manage risks.
Internal control is the equivalent of checking the status, which is
also known as discipline. This is the key to infinite profits.
Discipline is not the ability to follow rules. Discipline means more.

Discipline is the ability to put yourself, at any time, in an optimal

productive mood for tackling the task at hand. Here’s an example:
Each of us knows the traffic regulations but we frequently break
these rules. Why? Because we just happen to be tired, not
concentrating, angry, aggressive, nervous or in some other
unproductive mood. It’s the same with trading. We know exactly
which rules lead us to success. However, frequently, we’re not in a
position, or in a mood to follow these rules. We’re anxious, greedy,
impatient, nervous and, thus, not in an optimal state for the task
ahead of us. Anxious traders, for example, will take profits too
quickly when they’re trading.

Those who are in a position to put themselves in any desired

mood, at any time, will always be able to create the ideal
conditions for tackling the task at hand. It’s only when we’re in the
right mood that we can also achieve the best possible output when
solving a problem.

Imagine that you have to hold a speech in front of important

people. What would be better: holding this speech in a nervous
mood or with confidence? The answer is obvious.

For each task that has to be tackled there are productive and
unproductive moods. The art is to put yourself in the optimal
productive state before you tackle each task. With trading there
are various tasks that have to be accomplished during the different
phases. In this book, I’m going to show you which tasks you have
to accomplish when you’re trading and how you can put yourself in
an optimal productive mood for every second of your trading.
Up to now, many traders have assumed that they don’t have
control over their moods and that their state of mind is, thus,
determined by external events or randomly. In the following
chapters you’ll learn that precisely the opposite is the case. It’s we
ourselves who have control over our moods.

For example, a trader is in a bad mood and aggressive because

he’s had to take the sixth loss in a row. After so many setbacks
you can’t blame him for not being in a good mood. Nonetheless, it
will be clear to everyone that the trading outcome will suffer
considerably as a result of this aggressive state. Instead of being
aggressive and bad tempered the trader could also put himself in
a confident, relaxed state. The impact on his trading behavior and
trading outcome would be huge.

An aggressive trader will tend to fight the market constantly. He’ll

increase his risk and only profits will be able to appease him in his
anger. By contrast, those who are confident will be able to
continue trading in accordance with their trading rules.

In order to understand how we can control our moods and our

state, first of all, I’m going to talk about how moods come about. In
my seminars, I keep on meeting people who, initially, wonder what
all of this has to do with trading.

I’m going to show you that in trading there are various problems
that need to be solved. You have to develop a trading idea (a low
risk idea), you have to complete a mental ability test and you have
to monitor your trade as well as many other things.

Each of these tasks requires a different mood. The better you can
put yourself into a state that you determine, the better will be the
outcome of the problem that needs to be solved. If you solve all
problems in an optimal state then you’ll easily achieve your
objective of excellent trading.
People fail at trading because they attach great importance to
external control. With external controls it’s a matter of tackling
problems such as the question of when is the best time to open a
position, or what is the best trading system, or the best method of
analysis.

In this book, I’m going to show you that external control doesn’t
help us in our trading. External control is an illusion, to a large
extent, and can even hinder us in trading.

However, there is one issue that we can and have to control

externally. This issue, which no trader can get around, is risk
control. Besides internal control, it’s the only factor that will make
you a successful trader. The words “risk control” are the best
definition of trading. If I’m asked what it is that I do in my job, I
usually reply that I manage risk.

In order to be able to control risk we have to know what

possibilities and instruments are available for this. Here, it’s not
just a matter of stops but, instead also, for example, money
management functions. Money management is a crucial factor in
trading. Money management doesn’t mean “where do I set my
stop?” but, instead, how much money should I risk with this-
position, hence, what size should the position be?

Despite having a successful strategy you can still ruin your

account if you don’t practice any, or the wrong sort of money
management. In my seminars, I let the participants trade in a
simulation with a predetermined trading system. Here, the entry
into and exit from a position are determined by the system. The
traders only have to decide how much money they want to allocate
to the position. Do they buy 100 shares, 1,000 shares or some
other number? After some of the simulations we compare the
account balances. Every participant has a different account
balance. Some have halved their accounts, others have doubled
then, although all of them applied the same trading strategy. The
only difference between their approaches was through money
management.

There are typical human behaviors that result in us increasing our

risk when we’re making losses. Humans have a natural affinity for
risk with regard to losses and are risk-averse with regard to profits.
In keeping with the old adage that a bird in the hand is worth two
in the bush, we’re too mean when it comes to profits. However, we
also say: “Hope springs eternal”, so that we’re frequently too
generous if we have to accept losses. In this book, I explain which
human instincts encourage this behavior and how you can protect
yourself from them.

When it comes to trading, we always have to bear in mind that

human nature and human instincts are frequently of no help to us
in trading but, instead, hinder us. In short, this book is about two
things, therefore: self-control and risk control.

Self-control means mastering the right way of communicating with

your own subconscious, the ability to know what you want, how
you can achieve this and how to put yourself into an optimal state
for this. First off, you’ll be thinking that this is no easy task.
However, it’s a task that many successful traders before you have
already mastered. This book will help you to achieve trading
excellence.

Risk control is the ability to develop money management

strategies and to implement low risk ideas, which will enable you,
day by day, month by month and year by year, to generate
outperformance and to earn multi-digit returns. In this book, I show
you my strategies that have helped not only me, but also many
other investment professionals and super traders, to achieve
absolute success in trading. You’re going to learn what
distinguishes a low risk idea and how you can develop these
yourself.

Birger Schäfermeier
 1.
CHAPTER 1

What traders really want and how they achieve it. Find out the
purpose behind your goals and decide what you want
specifically.
 1.1 Find out what you want
Bunker Hunt, a Texan oil millionaire, was once asked how can you
attain success.

He said that there was a simple answer to that. “First, you decide
what you want specifically; and second, you decide you’re willing
to pay the price to make it happen, and then you pay that price.
Success is that simple.”

Most people are unsuccessful because they’ve already omitted the

first step to success. They simply don’t know what they want. The
same can be said of many traders. When I ask, “What do you want
to achieve with your trading?” time and again, I get the reply:
“Quite a bit. Earn lots and lots of money.” Most of the time, I then
say to these individuals that they should imagine that they’re now
going to get a lot of money from me, let’s say Euros 1,000.000,
however, only on condition that they have to spend all of it again.
For this they have one minute to write a list of all the things that
they would buy. The only rule here is that they’re not allowed to
invest the money, nor are they allowed to buy real estate with it,
thus, it has to be spent entirely on consumption. I hand over a slip
of paper and a pen to them and most of them start to write avidly:
a luxury car, Armani suits, a gold watch, expensive electronic
devices, a luxury trip and so on. Hardly anyone manages to spend
the million. After the first three or four wishes the writing frenzy
grinds to a halt. What else would I need, what do I want and what
for?

The traders quickly realize that “a lot of money” is a very

unspecific goal that doesn’t help them because they don’t know
what they want to do with the money. However, in order to be
successful you have to decide what you want specifically. Money
is a product that is generated in trading but it’s not your real goal.

That’s why I ask the traders another question. They should

imagine that they have as much money as they could wish for.
What would they do with it? Would they buy a house with it, or a
sports car, all the same? If they want to buy a house, then why
exactly a house? Maybe so that they never have to pay rent
again? Why are they concerned about paying rent? Do they feel
more secure if they own a house that has been paid off? If they
want to buy themselves a sports car, I ask them why it has to be a
sports car precisely and not an antique car. Maybe because fast
driving is fun, or because the car provides them with a young and
successful image?

I try to find out what the traders really want. And actually, it’s not
goods that they’re after but, instead, values such as security,
recognition, fun, independence and freedom. These values
determine our actions. Nobody wants a sports car because it can
get him or her from A to B. In fact, behind this wish is a yearning
for a feeling. The goal is to achieve the experience of this feeling.
Behind every goal there’s a purpose, which needs to be identified.

If you don’t know exactly what you want, then it will also be
impossible for you to attain your goal. Or, would you set out on a
journey without a destination? Without knowing it, the probability of
you landing up at the destination that you wanted to reach is very
low. It would be a lucky coincidence. However, we don’t trade in
the hope of a lucky coincidence but, instead, in order to achieve a
very specific goal. Yet, frequently, we haven’t figured this out.

Already as a little boy, I had the goal of becoming a millionaire, at

the latest, by the age of 30. I achieved this goal much earlier. I
made my first million at the age of 22, while I was still studying.
Although, I didn’t have a clue as to why I wanted to be a millionaire
and I certainly didn’t know what I wanted to do with the money. So,
I left the money in my account and continued to trade. I was a
millionaire but the feeling of happiness at having achieved my goal
only lasted for a few days. After that I was somehow dissatisfied
even though I had so much money in my account.

This dissatisfaction grew stronger day by day and, at that time, I

didn’t know why. I was now a millionaire and I had achieved my
supposed goal. However, as the money was still in my trading
account and I didn’t indulge myself with anything at all really (why
should I, I wanted the money for money’s sake and had no idea
what I wanted to use it for, or how I wanted to feel), after a few
days already, the money had no significance for me anymore. It
was only a number.

I was living in my student house share, in a small room with a coal

stove and an unheated bathroom. The million was just a number in
my account. The money didn’t provoke any feelings in me and
that’s why it was meaningless for me. I didn’t appreciate it
because what else could this million give me? In my
subconscious, like anyone else, I was striving for particular values.
Among other things, I eagerly wanted to have a feeling of fun and
excitement. If you act in a very disciplined way, then fun and
excitement are the last things that you’ll feel. That’s exactly what it
was like as I arduously made the first million. But I wanted to have
fun.

Now, what’s the best way of generating fun and excitement with a
million when you’re not aware of this yearning and the
subconscious has taken over command? It’s really simple - aged
22, you call up your banker and buy a short term DAX option for
an amount that is ten times this man’s annual salary. Every one-
point change in the market now means multiples of Marks 10,000.
Your account begins a roller coaster ride. In the space of minutes
you earn or lose amounts that are the equivalent of the price of a
luxury sports car.

I was now having my fun and the excitement that I had wished for.
However, this wasn’t good for my account. Within just three
months the entire million was gambled away and I was back to
where I’d started - with zero!

It was only much later that I learned why I had lost the hard-
earned money again so quickly. I didn’t know what my goal was; I
hadn’t decided what I wanted specifically. It wasn’t until I became
aware of this that I was also in a position to earn money
continuously and to use the profits that I generated to achieve my
goals.

You can be certain that you will never achieve lasting success as a
trader if you don’t really know why you’re trading, what goal you’re
pursuing and why you want to achieve this goal at all costs.
Knowledge of your goal is crucial information in order not to let
your journey turn into an odyssey.
1.2 Ask yourself what values do you strive for in your
life
Trading will determine a large part of your life. It’s only when your
value concept is reflected in your vocation as a trader that you’ll be
in a state in which you’ll be able to achieve top performance in the
long term.

As a trader you have to decide what feeling and what values you
strive for. This will be different for each person and changes over
the course of life. When I was in my early 20s, I wasn’t interested
in values such as security. What I wanted was fun, recognition and
excitement. Ten years later - when I’d started my family - security
was a very important feeling for me, which I wanted to experience
in order to be contented. As you can imagine, you’ll display
completely different behavior if you’re striving for security, or for
recognition and excitement. Those who strive for security as the
ultimate goal will buy a house, those who strive for recognition and
excitement will prefer a sports car.

Of course, we always strive for several values. Nevertheless, there

is one value that dominates our actions, one value - if we had to
choose - that we would prefer over all the others. You can find this
out really easily by writing down all the values that are important
for you, one below the other, in a list. Next, search for priorities
among the values that you would like for your life. You do this by
comparing two values in your list in terms of which one is more
important for you. The best way is to imagine that in your life you
could only achieve one of these values. Which one would you then
give up in favor of the other?
Your list could include values such as: harmony, success, health,
honesty and security. Now, ask yourself what’s more important for
you: harmony or success? Let’s assume that the answer is
success then, after that, compare success with health. If health is
more important, then compare this value with honesty. If health is
more important to you than honesty and also security, then you’ve
found the value that is at the top of your scale of values.

In order to find out the further sequence, you should now do the
same again, as described above, with the remaining values.

As soon as you have compiled your scale of values, for each value
you should ask yourself the question how will you be able to tell
that you have attained this value. What would your life be like if it
was completely in accordance with the desired value? What would
your environment have to be like? What would be the course of
events of a so-called perfect day?

This exercise is very time-consuming and can take several days,

but it helps you to identify your personal goal. And that’s
necessary in order to be able to achieve it at all. Remember the
Texan oil millionaire: “First, find out what you want.”

It’s only when you know what your personal goal is that you can
prepare a plan of how trading can help you to achieve this goal. In
the course of this, you could also come to the conclusion that
trading won’t help you much to achieve your goal. In that case,
you should think very carefully about whether or not you do,
indeed, want to continue risking your money, your time and your
nerves in the markets, every day, if this doesn’t enable you to
enhance your wellbeing. In that case, trading isn’t your vocation.

In order to trade successfully you have to know what you want.

When you know your goal it’ll be easier for you to achieve this
goal. Your brain, the consciousness and the subconscious, will
now know what you want. We know from psychology that with the
help of our brain we can achieve almost anything that we want.
But it’s only when we realize what we want that we can undertake
the necessary steps in order to achieve it, too. To trade-
successfully is a big challenge for each of us, which we can only
solve successfully if we know why we trade and what goals we’re
pursuing in this way. Knowing your own goal is one of the most
important things that you have to find out in order to be successful.
However, as most traders have never explicitly asked themselves
this question, they’re unsuccessful, or at best average, but never
excellent. Super traders know which goals they want to realize
with their trading. Because they know this, trading is their vocation.
 1.3 Condition yourself for success! Only those who
reward themselves directly for good performance will
be in a position to repeat this performance.
You can only be successful in the long term if you’re willing to use
the money that you earn with trading for your personal goals.
What’s the point of having money in your trading account if you
don’t put it toward your goals? It’s important to reward yourself
continually so that your brain knows why it’s making all that effort.

We know about this stimulus from psychology under the keyword

“conditioning”.

If fun is among your preferred values, thus, if the goal of fun is

right at the top of your list then, after a successful trade, you
should indulge yourself by having some fun. Withdraw a part of
your profits from your trading account and experience an amazing
day when you treat yourself to everything that you enjoy. Splurge
some of the profits. You’ll notice that you’ll earn the money again
more quickly and more easily because by rewarding yourself you
learn that you can achieve your goals by trading. Your brain needs
feedback that it’s done everything correctly.

After I’d lost my first million again, I vowed to myself not to make
the same mistake the second time around. I realized what I
actually wanted, namely, fun. So, from time to time, I would go and
withdraw a larger amount from my account, even though I still had
a long way to go before I reached the million again, and I would
spend the money within one day. For example, I flew to Sylt for a
day [an island in northern Germany], hired a luxury suite and
enjoyed the day.
The experience reinforced my conviction that by trading I was
doing the right thing. Most of the time, I earned back the money
that I’d spent on my fun within a few days already. I developed a
completely different attitude to money and to trading and I learned
that “realizing your own goals” doesn’t mean spending all your life
working toward a goal but, instead, enjoying your life and that
means realizing some of your goals immediately.

By realizing your goals already while trading you condition your

brain for success. Conditioning is nothing other than action and
reward. Our brain functions in accordance with this simple
principle. Once it has learned how it can get its reward, thus, once
the conditioning has taken place, then, through action it can help
itself to obtain a reward over and over again.

That’s why you should learn to program your brain for success.
That’s the only way that you can be successful in the long term.
Otherwise, you’ll share the same fate of many traders who earned
a lot of money once, but then lost it again and were never able to
earn a lot of money once more. Star traders earn money
continuously because they have conditioned themselves for
success.

In practical terms, this means that even if you’re dreaming of

owning a sailing yacht and, for this reason, you keep on
accumulating more money in your account, it’s better to withdraw
money intermittently and, for example, to charter a yacht for a
week. In this way you reward yourself and condition your brain.

Most traders think: Why should I withdraw money from my trading

account? The less money I have in my account, the higher my
returns have to be in order to achieve my goal.

Mathematically speaking that’s right, but in terms of psychology it’s

wrong. An important element of successful trading is rewarding
yourself even for small successes. My experience and that of
many traders has shown that continuous rewards enable you to
reach your target faster.

So, firmly resolve to condition your brain for success. For this, you
have to know what you want and set interim goals that can be
achieved quickly. Every time that you achieve an interim goal you
should reward yourself. Be sure that the interim goals are not too
difficult to achieve. It’s absolutely fine to reward yourself already
after the first successful day, or the first successful week.
 1.4 Formulate your goals properly! Important rules
that you should observe when you formulate your
goals
When you set your goals and your interim goals you should
observe a couple of rules. It’s important always to write down your
goals. That way you have to use more specific language and you
determine what you really want more precisely. It’s only when we
have a clearly defined goal that it’s easier for our consciousness to
make slight, to take corrections, if we move away from our goal.

Next to each goal, make a note of why you want to achieve it. The
purpose of every goal is usually a value, such as fun, recognition
or security.

Goal Purpose Why

Earn 40 % per year To buy a sports car Prestige and recognition

Never formulate static goals, but, instead, dynamic ones. When

you formulate static goals you install a barrier in your mind. What
happens when you’ve earned a million?

It’s important that all the goals that you set yourself are
measurable. That’s the only way that you’ll be able to know
whether or not you’ve achieved your goal, or how far away you still
are from achieving it and, thus, how much effort you still have to
make in order to attain your goal. If your goal is restricted to
earning a lot of money, this isn’t exactly precise and it certainly
isn’t measurable. For some, Euros 20 is a lot of money, for others,
it’s Euros 10,0000.000. This can lead to huge problems because
you’ll never know whether or not you’ve earned enough money in
order to reward yourself.
Ideally, you should formulate a target return for your trading, such
as, for example, a monthly average increase in capital of 5
percent. This target is measurable, dynamic and specific.

Moreover, according to a basic rule of goal setting, you should

always formulate positive goals. In your check list of goals there
shouldn’t be any negative phrases such as “lose money” or “make
small losses”. It’s better to say “maintain capital” instead of “lose
no money”, or “low level of fluctuations in the performance curve”
instead of “low level of losses”.

Just say what you want to achieve instead of expressing what you
want to avoid. For us humans, it’s easier to achieve positive things
than to avoid negative ones. So, if you formulate positive goals
this helps you to achieve your goals more easily.

The final rule might appear to be a little strange initially. It’s about-
ensuring that your goals are desirable and advantageous for your
personal environment. Every goal, in fact, will have different
effects on your life, which could lead to deterioration in some
areas. Imagine that in just one year you earn Euros 2,000.000.
How would your environment react to this, your partner, your
parents and friends? Many people are not aware that if they were
to achieve their goal the reaction within their environment would
not necessarily be positive. Perhaps you can deal with the
success but your partner isn’t able to. He begins to buy expensive
things for himself, to throw money out of the window and to have
fun. However, you wanted to earn the money because you would
like to have security in the future. You don’t want to move into a
luxury apartment, but would prefer to buy two rented apartments
as an investment. This leads to constant quarrels, you lose your
partner and with him, perhaps, your child for whom the partner has
been awarded custody. Was that what you wanted?
Of course, this is a very extreme example but it’s supposed to
make the point that your goals, even if they are consistent with
your values, are not always positive for your environment, too.
Therefore, in order to be successful in the long term, you have to
make absolutely sure that your goals are positive and
advantageous for your personal situation.
 2.
CHAPTER 2

There are two basic things that you have to accept before you
set out to become a Master Trader.
 2.1 Take 100 percent responsibility
When you create your checklist of goals you’ll already be way
ahead of the majority of investors and traders who don’t even
know exactly what it is that they want. Of course, there’s more to
achieving a goal than knowing what it is, however. You have to be
able to take responsibility for your goals.

No doubt you, too, know people who aren’t able to achieve their
goals simply because others prevent them from doing so. They
find thousands of reasons why they’re not successful or couldn’t
be successful, all of which have nothing to do with them
personally. Such a person will never be successful.

Success and, in particular, trading success, implies that you take

100 percent responsibility for everything that happens to you. At
my seminars, I always ask the participants what things are
arguably essential for successful traders. In the subsequent
brainstorming they come up with keywords like: experience,
capital, trading system, discipline, know-how, good software,
market knowledge, risk management and the like. Afterwards, I go
through every single point and I ask which of the things that were
mentioned could we influence 100 percent. We quickly realize that
we could influence everything. Because this is the case, we’re 100
percent responsible for our trading success - even if we suffer a
total loss because our software wasn’t working properly. After all,
we could’ve chosen different software, or backup software.

I point out to the traders that the minute they seek to pin
responsibility for failure on anyone other than themselves and on
anything other than their own actions, they run the risk of
repeating this failure. It’s because if you believe that you’re merely
the victim of unfortunate circumstances then, in the future, you
won’t be inclined to make any changes. That’s why the same
misfortune can befall you again.

Therefore, you have to decide - do you want to play the role of a

victim or do you want to be pro-active in your life? As a victim you
won’t have any power to make a difference, or to bring about
changes. What you achieve will be the result of good fortune or
bad luck, but it won’t have been within your power. You can go to a
gambling casino with such an attitude but not into the market.
Successful traders are active players. They determine what it is
that they want to achieve and they’re responsible for this. If they
don’t achieve something then they make the necessary changes in
order to achieve their goal nevertheless.

If you accept 100 percent responsibility for everything, then in the

event of a failure you will ask yourself: What do I have to change
so that this never happens to me again? What did I do wrong? You
ask yourself this question only because you believe that you share
the responsibility for this failure.

There’s a nice example taken from crime statistics. You’d think that
people who’ve fallen victim to an investment fraud would never
again experience this in their lives. Unfortunately, you’d be wrong.
Crime statistics show that it’s precisely those people who’ve been
the victims of investment fraud once who, frequently in their life,
will be victims of the same crime again. Here, of course, the
question arises of how something like this can happen.

The answer is simple - because these people see themselves as

victims. Of course, in both a legal as well as a moral sense they
are victims, but this attitude doesn’t help those concerned, instead,
it leads to them becoming victims a second time. If they hadn’t
viewed themselves as victims but, instead, had accepted 100
percent responsibility for what had happened to them, the same
thing certainly wouldn’t have happened to them again. They would
have asked themselves: What did I do wrong, and not: What did
the others do wrong? They would’ve most likely realized that they
had acted too carelessly, that they had been too gullible or greedy
and that they should’ve made enquiries about the person who had
made them the offer. Instead, they simply saw themselves as
victims.

You have to ask yourself whether, in your life, you want to be a

victim or an active player. As a successful trader, the best
hypothesis that you can put forward for yourself is that you’re 100
percent responsible for everything. I know that this is a very harsh
statement. Of course, there are things that we would call
unfortunate circumstances. But it’s only when we go through life
with the conviction that everything that happens to us is 100
percent our responsibility, that we’ll be inclined to make changes.
Otherwise, our ego will tell us that, well, it’s not we who are to
blame for a failure but, instead, Mr. X who told us that we should
buy position Y.

Currently, there are thousands of small investors in Germany who

think that it wasn’t their own fault that they lost money on the stock
market. They blame their bank, or their broker or the management
board of the company whose stocks they bought. All these
investors will make losses in the future, too, because their
approach doesn’t allow them to be able to make changes to their
strategy.

Naturally, a company’s management board is to blame if it falsified

financial statements or published wrong forecasts, but the
investors are also to blame. Why didn’t they have a risk model
that, after an initial fall in value of 10 percent would have triggered
the execution of a stop-loss order? Instead, they’re still stuck with
their worthless stocks and are looking to get compensation from
some court or other. By contrast, successful investors put the
blame on themselves and they would realize, for example, that
they had failed to manage their risks. In future, they’ll work with
stop orders.

As soon as we seek to pin just 1 percent of the responsibility for a

failure on others, our ego will make us believe that it was precisely
this 1 percent that was also responsible for the failure and not us,
even though we carry 99 percent of the responsibility. That’s why a
basic prerequisite for successful traders is that they have to be
prepared to accept 100 percent responsibility for everything.

Once they’ve resolved to do this, in future, in the event of failure

they’ll ask themselves: What will I have to change next time in
order not to suffer a failure again? How do I have to organize my
trading in order to be successful?
2.2 Focus on those things that you can really control
Everyone, basically, wishes to exert control over their environment.
Those who are confident that they have control over themselves
and of a situation are able to take their lives in their own hands
and actively create them. In the absence of such convictions we
feel at the mercy of everyday life and of professional requirements
and develop a fatalistic view of life. The desire for control is a
human social construct; it’s the wish to make a positive difference
and to be able to act autonomously.

This desire also has an impact in trading. A trader would like to

control everything if possible. Even though we understand
intuitively that we’re not able to influence the market, nevertheless,
many trading beginners, in particular, believe that they can find a
method that will allow them to predict future market movements.
This desire to control is also reflected in the belief that it’s possible
to forecast the outcome of a single transaction.

Yet, it’s impossible to know whether the next transaction will be a

winner or a loser. There are thousands of unimportant matters to
which we can direct our attention and in which we can find an
instrument that satisfies our desire for control. However, in trading,
control is only meaningful with respect to two things:

Self-control and risk control. These are the only issues on which
we should and, indeed, have to concentrate. These are two things
that we can truly control.
 3.
CHAPTER 3

Develop a plan that works! All beginners know that they need a
plan, however, Master Traders won’t develop just any plan but,
instead, ones that are customized to fit their personalities.
 3.1 The function of a business and trading plan
As soon as you’re aware of what you want and you know what your
goals are, you have to develop a plan of how you can achieve these
goals. Every journey begins somewhere and, so, every plan has a
starting point. The starting point is the status quo, the point where
you are now. What resources are available to you and what do you
need in order to achieve your goal?

In order to find the appropriate measures for achieving your goal, it’s
crucial that you understand what your status quo is like. In fact,
depending on the starting point, you’ll have to take different
measures to achieve your goal.

The more detailed your plan, the more it will help you in your trading.
The really exciting thing when developing a plan is identifying issues
that you’ve never thought about. This is because, in the course of
developing a plan, the many pitfalls on the road to success become
apparent to traders and can, thus, be removed.

So, for example, a friend of mine, who trades stocks and derivatives
- although he was trading successfully - discovered that he was
running the risk of actually losing money, or even going bankrupt on
account of the tax regulations. This trader was trading stocks and
futures, namely, and in Germany, they’re treated differently for tax
purposes. Capital gains from stocks are taxable at only half the
appropriate tax rate, while capital gains from futures are taxable at
the full rate.

As long as he continues to make profits with stocks and futures he

doesn’t have a problem. However, as soon as he makes profits in
the futures area and losses in the stocks area, he runs the risk of
driving his account to ruin because of these tax regulations. For
example, if he earns money when trading futures (let’s say Euros
1,000,000) and he makes losses when trading stocks (for example,
Euros 800,000), at the end the year, he would have a pre-tax profit
of Euros 200,000. However, as he can only deduct 50 percent of the
capital losses from stock trading (i.e. Euros 400,000) from his entire
capital gain from futures, he has to pay tax at a rate of 50 percent on
Euros 600,000. Thus, his tax liability is Euros 300,000. However, as
his net gain was only Euros 200,000, after tax he even has a loss of
Euros 100,000. (Translator’s note: The above example makes
reference to the tax treatment of capital gains prior to 2009 when, in
Germany, the tax rules changed.)

You can be certain that there are not only tax pitfalls but also
emotional, social, financial as well as many other ones. The aim of a
plan is to explain and examine as many aspects as possible that will
both help you and hinder you.

When developing a plan, inevitably, gaps will appear that have to be

filled and issues will emerge that you hadn’t thought about before
but that still have to be clarified.

For instance, many traders lack an answer to the question of what

they should do if they’ve been stopped out and then the market
moves in “their” direction after all. What are your re-entry rules? Or,
what would you do if you suddenly came under a great deal of
emotional pressure, for example, if you were told that you have a
disease, if your parents were to have an accident, or if your wife
wanted to divorce you?

I had a client who, as a trader, lost his entire capital in six hours
because, one morning, after his positions had been opened he
found out that his brother had been in a car accident. Naturally, he
drove straight to the hospital but he forgot about his positions and
his open limits. The market moved against him the whole day and,
of course, the trader didn’t waste any time at all on the market - nor
could you blame him for that. However, as he didn’t have any rules
for such an emergency, he lost all of his capital.
When you start trading you’re sure and certain that you’ll make
gains. But what happens if you don’t? At which point should you
stop trading: at a loss of 20 percent or of 50 percent, of 80 percent,
or never? When will you make changes to your strategy? I know
many traders who have been unsuccessful for years because they
keep on changing their strategy at irregular intervals. Brimming with
optimism, they start with a new trading system and during the first
drawdown phase they begin to make changes to the system.

These traders have never been aware of the extent of a typical

drawdown of this system and the normal duration of its loss-making
phases. When you develop a trading plan you should think about all
these issues. You have to know what sort of drawdown your trading
system usually leads to and what you would do if the normal limits
were to be exceeded. Imagine that you’re making a living from your
trading, but you know that loss periods of three to four months are
quite normal for your trading style. How will you ensure that, during
this time, you’ll have enough cash available for your living
expenses? How will you be able to deal emotionally with such lean
times?

From these questions you see that, above all, a plan will help you to
consider many aspects before you start trading. This will be of
valuable help.

The plan that you develop can be compared with a business plan for
a company. Every successful company has a business plan that
describes in detail which goals are supposed to be achieved and
with what funds and resources.

With a plan you pursue several goals.

For a start, a plan serves as an operational support. It shows you

what steps have to be undertaken, at any given time, and in what
sequence in order for your business to develop successfully. It
sounds so simplistic that you might think that developing a plan is a
sheer waste of time. After all, you know what has to be done. So
what’s the point of writing down the things that we perform day in,
day out?

In particular, the plan should help you to keep track of things.

Trading is a job that demands all the resources within us.
Frequently, because of our trading activity we’re so close to the
market that we lose sight of the big picture. In day-to-day business,
small losses, which have been taken into account in the plan, vex us
and they cause emotional stress that is greater than necessary. We
can get carried away and possibly do something stupid. Yet, even in
difficult situations, here, it’s absolutely essential to keep track of
things and to make the right decisions for your own business.

Excellent traders have the ability to take a step back, to see things
from the right perspective, to know, at all times, where they are in
their plan and what the next step is now going to be. This is the only
way that they can achieve an optimal emotional state and they are
then in the right mood for tackling the task at hand. There’ll be more
on this in Chapter 5.

Consider carefully the following: When you draft a plan make sure
that you have enough time as well as peace and quiet and ensure
that you are in an optimal emotional state in order to be able to
weigh up alternatives and to define the best steps for achieving your
goal. A plan helps you to identify optimal decision alternatives for
every situation.

In the hurly-burly of day-to-day business you don’t have the

necessary peace and quiet and you can quickly lose sight of what’s
important. Then, if you don’t have a plan that provides suggestions
of how you should proceed, you run the risk of being pulled in a
particular direction into the maelstrom of events and that leads you
away from your goal instead of bringing you closer to it.
In your plan, for example, you’ll set daily limits for losses, as well as
measures that have to be taken once these limits have been
reached. I’ve come across traders who lost their entire account in
one day because they’d never decided on what action they should
take in the event of a loss of 5 percent, 10 percent or 50 percent.
However, for example, I only trade with one contract if I’ve lost a
particular amount in one day and if I hit another limit I completely
reorganize my trading.

Moreover, with a plan you’ll be able to make faster decisions.

Imagine that you’re in a building, which is totally unfamiliar to you

and a fire breaks out. What do you do? What’s the fastest way for
you to exit the building? The way that you got into the building is
already blocked. If you’d been able to memorize the layout of the
building beforehand, you’d know where the appropriate escape
route was because everything that your brain has already figured
out, in advance, it can retrieve in a matter of seconds.

Therefore, people with plans can make faster decisions. Every

second can mean thousands of Euros for you. Traders who were
long on September 11th had to act quickly. Every second that they
hesitated cost them dozens of DAX points and, thus money. Traders
who had a plan knew what had to be done. Working with only a
stop-loss was not sufficient in this case. Without disaster plan you
would have been completely disorientated on September 11th.
Traders who were long in S&P were not necessarily stopped out but,
instead, still had another five minutes to close their positions before
the market closed for four days and then opened 100 points down.

A simple plan that provides that, in the case of extraordinary events,

all risky positions have to be exited immediately would have spared
many traders from enormous losses. Thus, a plan includes all
aspects of the business of trading. The more detailed your plan, the
more successful the development of your trading will be, too.
 3.2 How to prepare a comprehensive plan
Now, what does such a business plan look like and what points
should it include? Of course, you can develop this plan completely
freely according to your individual requirements. Nevertheless, there
are a few key points that are covered in all business plans and
which are discussed on the following pages.

3.2.1 Establish a connection with your mission

It’s important for your business plan, right at the beginning, to
establish a connection with your mission. Your mission will consist of
the fundamental values and goals that you strive for in your life.
Without this mission, you’ll be lacking the essential link between
your trading and your life and, hence, the inner motivation to use
those resources for your trading, which will enable you to be
successful.

That’s why, in your business plan you should, first, define how you’re
going to fulfill your mission through trading.

Of course, besides the description of your mission, you have to

include the goal of earning money. Money is, ultimately, the link
between trading and your goals. With the money that you generate
from trading, bit by bit, you’ll be able to achieve most of your goals.
If you are, indeed, one of those people for whom money has no
meaning, as you’ll be able to achieve your goals even without
money, then you should look around for a hobby that suits you better
than trading.
 3.2.2 Provide an overview of your trading style and
your history
This point doesn’t have to be long, but it should provide you with
information about how far you’ve advanced in your trader “training”.
At this point, you have to decide whether or not you should invest
some more in your training.

These investments can be of a financial nature such as, for

example, seminars and books, or else they can be in the form of
time. Perhaps you still need some time in order to test and evaluate
additional trading systems.

The most critical question that you have to answer at this point is:
Have you already paid all your dues to the markets, or are you
willing to pay even more? You have to clarify this question
otherwise, in the future, you’ll very quickly be inclined to gloss over
trading losses and see them as simply paying your dues. You
wouldn’t believe how many traders trivialize their continuous losses
as simply paying their dues. This carries on until, one day, they
withdraw from the game of games because they’re ruined. However,
you want to earn money, therefore, like any business owner, you
have to be clear about what the maximum amount of money is that
you want to invest in your training.

Then, you won’t be able to regard your trading losses above and
beyond this amount as “paying your dues” anymore.

At this point, depending on what conclusion you arrive at, potentially,

you might have to include further measures, in your trading plan,
which are aimed at rounding out your training. If you realize that
your training has been completed, then there won’t be any more
excuses why you shouldn’t earn money continuously - unless you’re
a trend-follower and the markets are moving sideways. That’s
precisely why it’s important, in your business plan, to provide an
overview of your trading style. Are you a trend-follower, scalper, day
trader, long-term investor, or another type of trader? There’s an ideal
market for each trading style. As in any other business, you have to
know what the optimal qualities should be for the market that suits
your trading style. Only then will you be able to select the right
markets and products for trading.

3.2.3 Comment on the products and markets that you

want to trade
Here, you should examine the products and markets in the following
terms: liquidity, leverage and experience, commission charges as
well as stock market rules.

Many traders make the mistake of not opting deliberately for a

particular market. They’d rather leave the choice of which market
they trade to chance. For example, some prefer the DAX over the
Euro Stoxx because the DAX is more well-known - even though,
given the size of their accounts, they’d be better off trading the
smaller and more liquid Stoxx. Such a random choice then has an
impact on your trading opportunities. For example, the Euro Stoxx
has a significantly lower degree of slippage than the DAX.

Is the market sufficiently liquid for your trading strategy? What

slippage do you have to contend with? Different issues will emerge
here depending on the trading strategy. Sometimes, despite a
fivefold commission charge, it can be an advantage to trade five
small E-Mini S&P contracts instead of one large S&P contract. So,
are the products that you want to trade appropriate for your
account?

For example, if you only have Euro 15,000 available for trading, then
it could be that the DAX is not the right market for you, even though
you’ve developed a functioning trading strategy for this market. If
your risk management rules, for example, stipulate that your
maximum acceptable risk per trade is 3 percent - which, in this case,
would be Euros 450 - then your trading capital would be simply too
low for the DAX. Euros 450 do not even correspond to 20 DAX
points, so that you would have to work with a very narrow stop-loss
margin.

Different exchange rules apply to the various markets. You have to

know these rules and understand the advantages or disadvantages
that each rule entails for you personally. For example, in 2001 on
one particular day, the DAX fell by more than 1,000 points in three
minutes and then went up again. The majority of the transactions
were cancelled but not all of them. It so happened that many traders
were not fortunate as regards the execution of their orders with entry
stops or stop-losses. By contrast, in the S&P there’s a so-called
“limit down rule” according to which trading is suspended if price
movements that are too strong occur within a short period of time.

Why do you believe that the products and markets that you’ve
chosen are ideal for achieving your business goals? What
advantages do these markets and products offer compared to
others? What are the drawbacks and how, potentially, could these
be eliminated?

3.2.4 Specify how you organize your trading and what

equipment you need for this
The most important point with respect to office equipment will surely
be capital. Many traders underestimate their cash requirements. For
example, how much money do you need every year to cover living
expenses and how much additional cash do you require (for the
Internet connection or an office) in order to keep up your trading
business? Let’s assume that you start with capital of Euros100,000
and that you need Euros 40,000 per year to cover your living
expenses and then an additional Euros 10,000 for your trading.
Therefore, you have to earn 50 percent per year in order to stay in
business. What would you do if, at the start of the year, you already
have a drawdown of Euros 25,000? You’d then have to earn 100
percent in order to be able to carry on. Such a situation is not
unusual but it would probably put the average trader under
considerable pressure.

However, traders who have a trading plan are prepared for such
situations as well as for similar ones.

How do you want to manage your trading business? Tax is the

biggest cost that every successful trader has. Yet, your tax bill
depends, in particular, on the legal form of your business
organization. Therefore, which organizational form you should
choose is an important question and should be answered before you
begin trading.

Should you set up a trading firm as a corporation or as a

partnership, or should you trade as a private individual? In this
connection, you have to consider in which country you want to set
up your trading firm and how you can repatriate the money to your
home country in a way that is both tax efficient and legal.

It would be beyond the scope of this book to provide a detailed

comment on this issue, but you understand how important it is to
focus on this problem in good time.

What equipment do you need for your trading? Will a PC with an

Internet connection be sufficient, will you need a dedicated line,
what’s your ideal trading software, which brokers and how many
brokers will you use?

Most successful traders have at least two brokers in order to have

an alternative option.
Can you, for example, place telephone orders, too, quickly and in an
uncomplicated way? Do you have backup systems?

Here, you should also think very carefully about your equipment so
that you’ll know what costs you’ll have to cover with your trading
earnings.

How will you manage your time? Bear in mind that many markets
are open for a period of eight hours a day. It’s not possible for
anyone to keep their concentration at a high level over such a period
of time. So, when are you going to take breaks, how long will you
trade for?

3.2.5 Compare yourself with the competition

At this point, you should explain about your competitors in the
market. After all, you’re not alone but, instead, you’re faced with
tough competition from all the other market players. In the area of
futures, in particular, competition with other market players is a
prominent feature because, as you know, futures transactions are a
zero-sum game. When someone wins something, someone else
loses. Thus, your success is not only determined by your abilities
but also your abilities are compared with those of the others. If
you’re good but the others, for whatever reason, are better, then
you’ll be the loser.

However, it’s not only in the area of derivatives that you need an
advantage over other market players in order to be successful in the
long term. If you don’t have any specific advantage over the other
traders, then the question arises of how do you expect to win the
battle for performance? Your advantage could be, for example,
many years of experience, or the ability to make fast decisions.
Whatever your advantage may be, it’s only when you’re able to
specify it and are aware of it that you are able to prevent trading
from becoming a game of chance.
 3.2.6 State your strengths
You yourself are, thus, part of the competition, therefore, in a
business plan you have to include an objective self-observation.

Imagine that you have to apply for a job as a trader, or that you have
to persuade someone to acquire an interest in your trading
business. You would, of course, try to show yourself in the best
possible light and would explain what you’ve already done in the
past, in order to present yourself as a successful trader.

That’s precisely what you should also do in your business plan in

order to bolster your self-confidence. Bear in mind that you’re not
writing this business plan for it to be filed away, but, instead, so that
it will help you in your operations. It’s precisely during periods when
you’re trading isn’t going so well and you need encouragement that
reading this part of the business plan would be a highly appropriate
way to give you renewed energy and motivation.

3.2.7 Comment on your weaknesses

Frequently, the reason for losses, particularly for big losses is that
many traders vastly overestimate their abilities. All traders, no matter
how successful, also have weaknesses. Only those who know their
weaknesses are able to identify and circumvent the pitfalls that
result from them. That’s why you should pay particular attention to
this part of the business plan.

Do you tend to be impatient? That can be just as damaging as

hesitating for too long. Are you too optimistic or too pessimistic?
Which of your character traits could hinder or be detrimental to you
in your trading? Find this out in order to protect yourself against this.

There’s nothing more convincing than a business plan in which there

is a complete and honest listing of a company’s weaknesses - or in
our case, a trader’s - and where the author of the plan has already
detailed possible ways that s/he can be successful despite his/her
weaknesses. That’s why you should find ways to solve any problems
in your trading that could result from your weaknesses.

For example, one of my biggest weaknesses is that I’m a very

impatient trader. Frequently, my impatience makes me enter into a
position too quickly, or else to build up positions that are too big. I
want to achieve my goals very quickly. I know that the best way that
I can overcome this weakness is with the help of my trading plan.
There, I’ve defined a money management algorithm that
automatically determines the size of a position, irrespective of my
state of mind. For all my positions, also for my discretionary
decisions, I automatically determine the optimal position size on the
basis of the risk and the account size. As long as I keep to this rule I
can’t overtrade my account out of impatience.

However, what happens if, on account of my mood, I’m not able to

follow rules?

In order for me to be able always to keep to the rules, I’ve learned

how I can put myself, at any time, in a state - in a mood - of my
choice. Whenever I feel impatient, I use my acquired ability to
control myself and I put myself in a calm and relaxed state. For this,
I simply change my posture and the internal mental representation.

Therefore, I have at my disposal effective weapons with which I can

combat the impatience from which I am also unable to free myself. I
can overcome my weakness through my understanding of discipline
(discipline means being able to induce the mood/emotion that is
most productive for tackling the task at hand). You’ll learn more
about this inner control later on.
 3.3 The trading plan
The trading plan is part of the general business plan. With the
business plan you’ve organized your trading, which you’ve
connected with your mission and, in this way, you’ve integrated it
into your life. Besides many general considerations - why you trade,
what you trade, what qualifies you and what hinders you - in a
business plan, of course, you also have to make detailed statements
about your trading. This is the role of the trading plan. Here you’ll
address all the issues that are related to your trading strategy.
Furthermore, you’ll create a plan of procedure for all the steps
involved in trading.

3.3.1 Every strategy is based on a philosophy

Every successful strategy is based on a philosophy about the
markets, thus, a highly generalized set of beliefs about how markets
function and hypotheses that justify the choice of strategy.

For example, you may believe, as economists frequently do, that the
markets move only randomly. This means that, ultimately, every
change in the prices is merely the result of random events. With
such a hypothesis, you would encounter difficulties when developing
a trend-following strategy. Trends can hardly be reconciled with
random movements.

Let’s assume that you support the hypothesis that prices already
reflect all the available information. In this case, you would find it
difficult to become a follower of fundamental analysis because your
view would imply that all the known fundamental information
available in the market is already reflected in a fair price. However,
technical analysis would be of great interest to you as prices give
you all the information that you need.

You could also assume that the markets move in certain formations
and that these formations generate patterns that occur time and
again. If that’s what you believe in, then technical analysis is an
excellent instrument on which you can build your trading strategy.

Your philosophy of the markets will be the foundation stone of your

trading strategy. That’s why you have to be aware of your set of
beliefs with respect to markets and price formation. Everything is
built on the basis of this conviction. It determines all the subsequent
steps, your limits and your opportunities.

In the same way that anglers pick out what they believe to be the
perfect bait from among the favorite foods of their prey, so, traders
also have to select their strategies so that they match their
philosophies.

Many beginners fail because they don’t have a philosophy about

how markets function and how prices are formed. They simply try
out some strategy or other, which they believe will be able to make
them successful. Every strategy will feature phases when there is a
“slump”, a so-called drawdown. During such times, if investors are
not confident in their philosophies, they’ll automatically become
anxious during periods in which their strategies lead to temporary
losses.

Imagine that you’re sailing with Columbus, in 1492, and you set out
on a journey to “India”. You put out to the open sea because
Columbus is convinced that the earth is round and that you’re not
going to fall off the edge at some point but, instead, merely discover
a new, shorter sea route to India. Here, the calculations of the Italian
astronomer Toscanelli were very influential. According to his
calculations the earth was smaller, by a quarter, than previously
thought and consisted mostly of land. Thus, the distance between
Europe and Asia and, hence, the new planned sea route would be
significantly shorter, too. Of course, this held the promise of trading
advantages.

Accordingly, Columbus’ philosophy is: “The earth is round”. His

strategy is: “If the earth is round then I can also reach India by
crossing the Atlantic.”

Your voyage starts on August 3rd, 1492, in Palos de la Frontera,

Spain. You sail across the open sea for the whole of August and the
whole of September and, according to the original calculations, you
should actually have got to India a long time ago already. Columbus
is convinced that the earth is round and has no doubt that, sooner or
later, he will reach his target. By contrast, when you set off on your
voyage you were unconcerned about any belief about the shape of
the earth. You’re a merchant and you wanted to sail with Columbus
in order to reduce the cost of your business transactions through
shorter transit routes.

How will you be feeling after two months on the high seas?
Definitely not as well as you felt in the Spanish port, when, obsessed
with the thought of saving money and thus increasing the profit
margins in your Indian business, you light-mindedly wanted to
accompany Columbus on his voyage. You’ll be frightened and
insecure, moreover, you’ll reproach Columbus for having taken you
with him on this odyssey. If you could, you’d break off your voyage
immediately and take no further risks.

Your strategy for earning more money was to reduce transport costs
and to obtain trading advantages from a shorter sea route to India.
Definitely a coherent strategy. However, you didn’t have a
philosophy. You simply trusted Columbus, an acknowledged
navigator who had the support of royal authority and was well known
for his expertise.
And now, your shrewd cost-saving strategy appears not to be
working. If you could, you would now definitely swap your cost-
saving strategy and choose another one. Perhaps you’re also
beginning to think that, possibly, the earth isn’t round, after all. At
this moment you know that you’ve lost. You’re going to die because
the food supplies will run out during the long return trip, or you’ll
simply go down with the ship as it tips over the earth’s edge.

Fortunately, as a trader you won’t have to die if your strategy doesn’t

work. You’ll only lose money. As a trader you can discard your
strategy at any time and try out a new strategy. However, if you don’t
have a philosophy on the markets you’ll never be able to develop
the confidence in your strategy that is necessary to adhere to this
strategy during loss-making phases, too, as well as to perfect it.

If Columbus hadn’t had a philosophy, perhaps he would still have put

out to the open sea - but always only so far so that he’d still have
had enough food supplies for the return trip. He would have tried out
different see routes (strategies) but, this way, he’d have never
discovered America. He’d have always had to turn back in the
middle of the Atlantic. However, he firmly believed that the earth was
round and this belief made it possible for him to follow through on
his strategy, even during difficult phases.

Successful traders have a clear philosophy on markets and price

formation and this alone makes it possible for them to follow their
strategies in the long term. Without a philosophy, at the first bigger
drawdown you’ll discard your strategy and look for a new one.

Perhaps you’re now wondering what’s wrong with swapping a

strategy, which currently isn’t resulting in profits, for a new one. After
all, your goal is actually to make money.

If every time you enter into the loss-making zone of a strategy you,
subsequently, look for another one, then it’s guaranteed that you’ll
continue to be a loser in the market.
Let’s assume that you start with Euros 100,000 and that you make
money for two months but then, in the third month, you lose
everything completely once again.

In the fourth month, your account balance even drops to minus

Euros 3,000 and you decide that your strategy is unsuitable.

With the remaining Euros 97,000 you now try out a new strategy
that, once again, after a while, leads you into a loss-making zone.
The losses unnerve you and you decide to make another change to
the approach. Now, with your account down to, let’s say, Euros
92,000, you follow a third strategy, which after initial gains, pushes
your account down to Euros 85,000.

You understand that with such losses you have to come up with a
new idea and you choose another trading system that immediately
generates a further loss of Euros 7,000. The only way of getting
away from this loss-making spiral is to find a strategy that will never
have a particularly large drawdown and with a continuous upward
trajectory. Unfortunately, it’s very unlikely that you’ll find such a
strategy. In fact, periodically, every successful strategy typically also
has drawdowns. During these phases, if you change your approach
each time then you’ll ensure that your losses will continue.

Therefore, as a successful trader, you only need one strategy that is

underpinned by your set of beliefs and your philosophy. As long as
this strategy has a positive expectation value you shouldn’t change it
but, instead, perfect it.

Therefore, you should clarify what your philosophy is and then

decide on a strategy that is suited to this.

3.3.2 Decide on an analysis technique

Closely linked to the philosophy is the analysis technique - your
choice of trading strategy. Chart technicians believe that there are
patterns that keep recurring in the market. That’s why they look for
particular patterns on a chart such as, for example, head and
shoulders formations, triangles or double tops.

Elliott wave technicians believe that there are certain wave

structures that underlie all market movements and trends. That’s
why their technique consists of breaking down the market into
separate fragments and then deriving a price forecast from this.

Fundamental analysts presume that price formation in the market is

not efficient in the short term but that in the long term the market will
fluctuate around its fair value. For this reason, their strategy consists
in identifying undervalued stocks on the basis of different variables
and then buying these stocks.

Other fundamental analysts believe that the latest news affects the
markets. That’s why, with their strategies, they concentrate on
interpreting news items.

Of course, there are also traders who integrate various techniques

into their strategies. For example, they only buy if the fundamental
data suggest that undervaluation exists and there is a particular
pattern on the technical chart.

3.3.3 Develop an entry strategy

In this part of your trading plan, you should determine all the
conditions that have to be met so that you can open a position.

Selecting an entry strategy is a problem for only very few traders. In

the relevant literature, you’ll find thousands of helpful items that
recommend entry strategies that work. For example, these can be
based on technical or fundamental analysis. There are strategies
that generate signals on the basis of indicators, or ones that include
unusual entry conditions, such as particular constellations of stars
and planets.

However, there are also strategies where the exact parameters of

the entry conditions remain hidden from the trader. They may be
unclear because a neural network in the black box of a computer
predefines them.

Entries can be cyclical or anti-cyclical, or determined on the basis of

“magic numbers” such as the Fibonacci sequence or Gann cycles.

Last but not least, an entry strategy can be based on a combination

of fundamental, technical and other conditions. The sky’s the limit
when it comes to entry conditions and my list certainly isn’t
exhaustive. There is no rule that restricts the choice and
constellation of the parameters.

Ultimately, you have to decide how meaningful a particular strategy

is for you. While a lot of attention is focused on the entry strategy,
nevertheless, I believe that it only has a very small impact on the
trading outcome.

The reason for the great interest in entry strategies can be

explained, to a large extent, by psychology. It’s for the same reason
why people prefer to select their own lottery numbers and to mark
the crosses on the lottery ticket themselves instead of just drawing a
ticket with a particular number. Selecting parameters for the entry
strengthens the feeling of actually having control over whether an
individual transaction will be a success or a failure. However, this is
an illusion. The outcome of a particular transaction, thus, whether
we win or lose, depends on the market and not on our decision. It’s
the same as with the lottery where the probability of winning also
doesn’t increase just because the players have personally chosen
the numbers.
Nevertheless, many people believe that they can improve their luck
by putting a cross, on the lottery ticket, on their favorite numbers,
dates of birth, wedding anniversaries, or similar. Statistically
speaking, the probability that a very specific, pre-selected
combination of numbers will be drawn in a lottery is always the
same.

Entry signals give us the feeling of having control over the market
because when we decide to open a position because of a signal, at
that moment, the market behaves exactly as we expect it to.

For a better understanding of this, imagine that you’re part of a team

of traders and that you always have to take over the position of
another trader after s/he has selected the entry. However, you don’t
know when this trader made his/her entry. Your gains and losses are
determined solely by the changes in the market from the point in
time that you take over the position. You don’t know if, previously,
the position was in profit or loss and profits or losses that have
already been run up won’t be credited to your account. There are no
transaction costs.

Now, before you continue reading, you should pause briefly and
decide whether you would be able to trade successfully under these
conditions, or if you would be more successful if you were allowed to
open the position yourself. Furthermore, ask yourself if you feel
more secure and more comfortable when you determine the entry
and exit yourself or when, as described above, you have to continue
trading an existing position.

Most people, including me, clearly prefer to look after their position
from the start, therefore, they also prefer to determine the entry
themselves. Yet, there is no difference between this approach and
the model in which you had to take over a position because, if you
hadn’t liked it you’d have been able to exit it immediately and at no
cost, i.e. no loss.
Despite this, we believe that we’re able to influence our success if
we also determine when we enter the market. Thus, we succumb to
the illusion of having control.

Nevertheless, we can’t dispense with an entry strategy. That’s

because without a clearly defined entry strategy the outcome of our
trading is random and, thus, can’t be reproduced. We can’t expect to
be able to repeat trading outcomes, which we generated in the past
through random decisions, with a particular degree of reliability.

Another argument in favor of committing yourself to an entry

strategy is that without clear guidelines, when we want to open a
position we quickly allow ourselves to be led by our feelings. This
harbors the risk that we’ll enter into a position simply because we
want to satisfy a particular feeling and not, however, on account of
suitable market conditions. Our actions are then determined by
greed, fear, a desire for distraction and excitement, impatience or
many other emotions.

It’s not unusual for a trader to watch the market begin to go up

sharply and, because s/he’s afraid of missing out on something,
quickly and simply to buy a couple of stocks or contracts. There’s no
strategic motivation for such a purchase, instead, it’s the result of
feeling greedy.

However, if trading decisions are based on a strategy, there will be

specific conditions that have be fulfilled for traders to build up their
positions. These conditions should be specified and described in
your trading plan. The aim of using entry signals is to develop a “low
risk idea”, i.e. one where the opportunity is proportionate to the risk.

What is appropriate will depend on your hit rate. The hit rate shows
the percentage of all your transactions that are profitable. In Chapter
7 “Market Analysis and its Significance” you’ll find more information
on the subject of the low risk idea.
Therefore, you have to stipulate specific conditions that have to be
fulfilled so that the opportunity will be proportionate to the risk and
also define parameters on the basis of which an entry time will be
proposed.

This is the purpose of an entry strategy.

There are two types of investors: discretionary traders and

systematic traders. Both of these types require an entry strategy.

Systematic traders follow a clearly defined trading system. All their

entry decisions are determined by the parameters in the system.
The trading system generates their entry signals for them
automatically, for example, this can be based on certain indicators
reaching thresholds. In principle, because of the clearly defined
parameters, these traders can also allow their trading decisions to
be made by a computer, as they don’t have any leeway as to
whether or not to follow the entry signals generated by the system.

By contrast, discretionary traders decide on a case-by-case basis.

Thus, some subjective leeway underlies their decisions. Whether or
not they enter into a position depends not only on particular
parameters but also on them, too. Nevertheless, discretionary
traders don’t make arbitrary decisions either. In fact, they constantly
compare current market situations and parameter constellations with
patterns from the past with which they’re familiar. So, they make use
of their experience.

Discretionary decision strategies are used, for the most part, when
economic data and news or chart patterns have to be interpreted.
Frequently, there are so many different factors involved in
interpreting the data that a systematic trading system would be too
rigid and inflexible to give the appropriate weighting to all the data
and to process this. The use of neural networks for generating
trading signals is nothing other than an attempt to allow a simplified,
artificial computer replica of the brain’s activity to make the
discretionary decisions of a human. In the same way that humans
learn from experience, the computer is also supposed to give
optimal weighting to all the data that it receives as input.

It’s not clear to what extent a computer can incorporate a trader’s

experience. Unlike a chess computer, a neural network doesn’t only
have to receive the positions of 32 chess pieces on the playing
board as data input but, instead, it has to assimilate and weight a
much higher number of variables.

As you can already see from the differences just described not every
trader is qualified to make discretionary decisions. In fact, it requires
a high level of experience.

Added to this, discretionary traders have to exercise more self-

discipline than systematic traders. They have to ensure that every
trading decision is motivated by market movements and not by their
moods.

Nevertheless, something that both types of traders have in common

is that their decision-making procedures are based on an array of
data that the traders are consciously able to define. These can be
indicators, chart patterns or news items. In your trading plan you
should record precisely the values that your selection of parameters
would have to show in order for you to enter into a transaction.

A systematic trader who bases his trading decisions, for example,

on moving averages, in his trading plan, notes which moving
averages he watches and when he would open a position in the
market. For instance, he could open a long position if the 38-day
average crosses over the 50-day average.

A discretionary trader who bases his purchase decisions on Elliott

waves, in his trading plan, writes that he always enters into a
position if he believes that a corrective wave 2 or 4 has terminated,
for example.
Furthermore, for your entry strategy, you have to determine the unit
of time that your trading decision will be based on. Do you use a
one-minute chart, a five-minute chart or an hourly chart, or do you
look at your entry parameters on the basis of daily closing prices
only?

Try to be as precise as possible in your description of which

variables you use as the basis for your decision-making. Include
everything that contributes to your decision-making. At the end of
this chapter, I’ve added my own trading plan as an example for you.

3.3.4 Develop a low risk idea

The second part of the entry strategy is the development of a low
risk idea. Once you’ve decided on a system or a method that will tell
you when you should build up a position, you still have to check to
see if this particular signal meets the requirements of a low risk idea.

The key criterion for a low risk idea consists in the opportunity being
proportionate to the risk.

To this end, you first have to know your planned level of risk. For this
reason, the first step when developing a low risk idea is to “draw a
line in the sand”, thus, to find a point at which you would decide to
terminate your trade even if this entails making a loss.

This point can be determined on the basis of your chosen technical

analysis tool, or alternatively, based on your exit strategy. In any
case, you will need a price, however, at which you would end the
transaction at all events. This price will be your so-called initial stop.

The difference between your entry and the point, which you have
defined as the “line in the sand” is your planned degree of risk.
Whether or not this degree of risk is appropriate depends on two
additional factors.

First of all, you have to check if the planned degree of risk is

compatible with your money management rules. Thus, this question
concerns itself with whether or not the degree of risk is proportionate
to the size of your account. Professional traders know that what’s
important is not just finding a strategy with a positive expectation
value, but also selecting a risk level per transaction so that the
positive expectation value of a strategy can truly be achieved
without going bankrupt beforehand in the short term. This would be
conceivable if a trader were to risk an excessively large portion of
his account per transaction. If you were to risk one tenth of your
account per transaction and lose just six times in a row you would,
thus, already halve your account.

Therefore, your money management rules are ones that define the
maximum percentage of your account that you can risk per
transaction. They’re an important part of the entry strategy, as
transactions where the planned degree of risk (the difference
between the entry and the stop) is too big would automatically result
in you not executing them.

This means that there’ll also definitely be some signals that your
trading system produces that you won’t realize because your money
management rules exclude such risks.

The second factor that plays a role in risk planning doesn’t relate to
account size but, instead, to the opportunity that presents itself to
the trader.

Most successful traders are only willing to take risks with which they
can earn a multiple of their degree of risk. Therefore, the
appropriateness of the risk also has to be viewed in relation to the
opportunity that presents itself. This is the second important step
when developing a low risk idea.
First, you have to make a statement on the opportunity that has
presented itself. This task is not quite so simple because, here, you
have to make an objective and realistic assessment of how much
money you’ll be able to earn with the planned transaction.

You have to set a target zone that you consider to be a minimum

target for the generated signal. You should then compare your
potential profit with the planned degree of risk by putting them in
relation to each other. You will then obtain a number that shows your
risk multiple.

Only in cases where your risk multiple exceeds the minimum value
for your risk/reward ratio, which is set by you in your trading plan,
would a transaction be permissible in accordance with your trading
plan.

Therefore, in short, there are two conditions that can be used to

assess whether or not a risk is appropriate. Firstly, your trading plan
has to have a money management rule and, secondly, you have to
show the minimum risk multiple that you want to earn per
transaction. If it emerges that, according to your money
management rules, a transaction is already not permissible then the
question of the proportionality of the risk with respect to the
opportunity will be superfluous.

3.3.5 Accurately describe the transaction process

Once your trading system has generated a signal you have to
implement this in the market. In your trading plan, it’s important to
describe all the details and steps involved in the implementation of
the signal.

At first, this might sound like a lot of unnecessary work because

actually, as a trader, you know everything that has to be borne in
mind when you enter into a transaction. Furthermore, entering
orders is part of a trader’s routine and shouldn’t cause any
problems.

However, trading is a business. Imagine that you’re a business

consultant. When you want to optimize the workflows in a company,
first of all, you break down all the procedures into lots of small work
processes. Next, you check to see if there’s any possibility of
generating better business results by changing the work processes.

In the trading plan, it’s precisely this function that your description of
the transactional process is supposed to fulfill.

Begin your description at the point where your trading system has
generated a signal and, in your opinion, the degree of risk for the
transaction is appropriate.

The first question that you should ask yourself is whether, after the
signal has been generated, you want to buy immediately “at market”,
or whether you’ve introduced procedures into your workflow that
should enable you to achieve an optimal purchase price.

Such procedures could include, for example, consulting the order

book to determine the optimal moment of entry, or using minute
charts or tick charts while you await the most favorable entry time.

In your trading plan, you should also describe the moment of action
and how you intend to monitor your position. During my trading I’ve
had to suffer some big losses that arose because I insufficiently
monitored my positions or was careless in the way I went about this.
There’s nothing more annoying than discovering, at the end of the
day, that you’ve forgotten to cancel a limit or a stop and this order
has now been executed and is on the books with a big loss.

At what time intervals do you check your transactions and your

executions? Once a day, hourly or only after the order has been
placed?
 3.3.6 What’s your exit strategy?
This is possibly the most important part of your trading plan. Only
very few traders have clear rules about exactly when and in what
way they should exit a position, irrespective of whether it’s profitable
or loss-making. Often, the exit simply happens when the trader
thinks that s/he has gained enough, or s/he becomes afraid that s/he
will have to give up some of his/her gains once more.

Frequently, the decisions to exit are guided by feelings. Without

clear exit rules we won’t be able to free ourselves from being forced
out of our positions by our feelings. It goes without saying that, most
of the time, this doesn’t lead to the best possible outcomes.

That’s why it’s important that the exit rules in the trading plan are so
clearly described and well defined that someone else would be able
to choose how to exit a position on our behalf. That’s the only way to
ensure that we generate outcomes that can be reproduced and that
we don’t allow ourselves to be guided by our feelings.

In trading, nothing affects our feelings as much as the fear of losing.

You could say that it’s a natural instinct. We humans have learned
that taking risks can be worthwhile. Many millennia ago, when our
ancestors roamed the forests and headed off to hunt a mammoth,
they had to incur a deliberate risk and, in the short term, had to
overcome their fear of losing their lives. They were usually rewarded
for the risk that they’d incurred.

In trading, too, we have to incur short-term risks. At the point in time

when we make an investment, we consciously have to overcome
our fear of losing money and we hope for a reward in the form of
profits.

Now, if there’s an imminent danger that our reward will be taken

away again, because the market seems to be turning against us,
very quickly, we become afraid that the efforts will have been in vain
and that we could lose our reward entirely. That’s why we usually
end the speculation quickly with a small profit. While this behavior is
very understandable, nevertheless, it prevents us from becoming a
successful trader. As traders, we have to find rules that allow us to
let our profits run. Subjective feelings that we haven’t earned
enough for this risk or that transaction don’t help us.

Therefore, objective exit rules are an essential feature of your

trading plan.

3.3.7 How do you organize the daily and periodic

follow-ups for your trading?
An essential tool for your daily and periodic follow-up procedure
should be your trading journal. I can only recommend that every
trader should keep a trading journal.

Therefore, in your trading plan, you should specify how you’ll

organize your trading journal and at what intervals and when you’ll
make the entries. If your trading allows you enough time for this
then, immediately after each transaction you should record all the
important information about your trade in the trading journal.

Otherwise, your trading plan should define precisely when you’ll

perform this indispensable task. For example, have you put aside for
this one hour an evening after the market has closed, or are you
going to make these entries during trading hours, at times when
turnover is weak, such as the lunchtime market?

It’s imperative to set a specific time for your entries in the trading
journal. Because if you don’t do this, what will happen to you will be
the same thing that happens with so many things in life that you
intend to do but for which you don’t schedule an appointment. You
keep putting them off until it’s too late. After all, there’s always
something more important. However, a trading journal will only be of
use to you if the entries are complete and if they’re made regularly.

It’s also important to evaluate periodically the information that has

been entered into the trading journal. That’s why, in your trading
plan, you should also note the dates and intervals for such a regular
process.

Following up on your trading on a regular basis frequently yields

valuable pointers that can be used to improve your trading strategy.
 3.4 An example of a business and trading plan

3.4.1 Overview
This business plan helps in the operation of my electronic day
trading business. I’m the sole beneficiary of my trading business but
I have an assistant for the so-called day-to-day business. As a well-
trained trader, I’m sure that my day trading business is profitable.
Not only do I have sound practical experience of the markets in
which I’m active (more than 15 years), but also the mental abilities
required for this business. Both together constitute my specific
advantage over many other market players.

No further investments in the business are required and, right from

the start, the day trading business will result in positive cash flow.

3.4.2 Business description

Mission

In order to lead a well balanced, happy and contented life I try to

live, to the greatest possible extent, according to my concept of
values. The most important values, besides health, a zest for life
and security, are freedom, justice and success. Trading is a
business in which many of these values are reflected and it
promotes these values. I’m free to make my own decisions and I,
myself, determine what I do as well as when and how I do it. I have
no customers in the business so that I don’t have to take anyone
into account if I give myself time off, or if, during the course of the
day, I decide that I’ve traded enough for one day. Nobody is able to
make a subjective assessment of my performance so that my
success depends solely on me. From the profit and loss statement I
can understand objectively whether I’m doing well or badly in my
business. There are no unjust decisions or performance evaluations
with respect to trading.

My business is day trading. This activity produces substantial profits

and cash flow for me. That’s why trading also leads to financial
independence for me. Profits help me to achieve my goals gradually.
These goals are closely linked to my concept of values.

Overview and History

I have an extensive background in trading, which is based both on

many years spent studying the markets (since the age of 14 years)
and on my psychological knowledge of the behavior of other market
players as well as of my own psychology. Moreover, my degree
course in economics and business studies supplied me with further
fundamental theoretical principles that provide support in my trading.
I’ve attended various investment seminars and I keep a trading
journal that helps me to develop and improve continuously.

Products and Special Skills

The special skills that benefit my trading have already been clearly
defined under the keyword “mission”. However, others also benefit
from my trading because, as a day trader, I provide an essential
service by generating liquidity for the markets. For example, I
contribute to the functioning of and optimal price formation in the
world markets.

I trade DAX Futures and Bund Futures, primarily, as well as E-Mini

S&P contracts. From time to time, I also enter into positions in the
Euro Stoxx. All the markets that I trade are electronic exchanges so
that I can expect the order executions to be fast and fair.

Business Processes
1) I work from home and, in addition, I have an external office. Both
workplaces are ideally equipped. Here, the most important elements
that are worth mentioning are several computers with backup
computers, flat screens and a secure Internet connection as well as
a second standalone line for emergencies. Furthermore, in the
office, I also have dedicated lines to the nearest ISPs.

2) My day trading is based on momentum trading strategies and is

trend oriented. Precise statements about the trading are to be found
in the trading plan.

3) Time management - In the morning I trade the DAX at the

opening from 9:00 up to around 11:00 and, then, I travel to the office.
There, depending on the market and my mental state, I trade until
22:15. I have a break between 17:30 and 19:00. Generally, I trade
five days a week apart from holidays. The preparations for the
market (test of mental ability and development of low risk ideas) and
the follow-up (trading journal and a review) are made on the way to
the office and during sport. The written documentation is dealt with
during trading hours.

4) Emergency Plan - There’s an emergency plan for technical

failures, such as telephone/Internet and also one for any unexpected
stressful situations that could occur. In case of technical failures, I
always have a backup line available such as, for example, through
my mobile phone. Should unexpected situations occur, for example,
an accident in the family, or huge errors, then trading would be
suspended immediately and only resumed once the source of the
stress has been eliminated.

5) Organization - I make trading decisions on my own (please see

Chapter 3 “The Trading Plan”). The so-called record keeping and
monitoring of orders is done by an employee so that I can
concentrate completely on the trading.
 3.4.3 Competitors
On the futures exchanges, besides institutional traders, around 5
percent are retail customers. Only a very small percentage of them
(around 15 percent) are successful. As a day trader, with my horizon
of experience, I have no disadvantages in relation to the
competition. I have quick and secure access to the exchanges and I
don’t trade on any pit-based or floor-based exchanges. With my
Ninja Trader (trading platform) I have the same possibilities to
access electronic exchanges as institutional traders.

Many of my competitors have a bigger budget, however, this isn’t an

advantage for day trading. With this type of trading, in many
markets, it’s difficult to place or withdraw large amounts quickly
without affecting the market itself.

1) My strengths are fundamental knowledge about the functioning of

the markets that I trade and the willingness to make fast decisions
and, moreover, to follow through with these decisions and to
implement them. I’m flexible and that’s why I tend not to make
generalizations. This doesn’t mean that I don’t have any principles,
but that I know when it’s better to concede a point. I’m organized so
that not only can I develop a plan but I can also follow it with the
flexibility that is required. I’ve learned that my emotions are
controlled solely by me. My biggest advantage in relation to the
other market players is that I have the power to control my emotions
and, within a very short space of time, to create a productive state
for the task that has to be tackled.

2) My weakness is my impatience and, linked to this, being too goal

oriented. This combination quickly leads me into a state of “wanting
to have” (I want xy profit). The polarity of “having”, namely “not to
have” in the case of losses, promotes unproductive emotions. I’m
able to overcome this weakness through my understanding of
discipline (once again: Discipline means being able to induce the
mood/emotion that is most productive for tackling the task at hand.)
However, to date, I’ve not found a way to eliminate this weakness
generally.

3.4.4 Financial information

1) Trading budget

I have the following fixed costs

office rent
data feed
trading platform Internet connection
telephone
...

Furthermore, I plan to increase the budget for

seminars
computer programs conventions
...

2) Cash flow statement

net income
expenses (see budget)
net cash flow

3) Profit and loss statement

4) Balance sheet
 3.5 My trading plan (excerpts)

3.5.1 My philosophy
There are many different players in the capital markets. I believe that
the biggest influence on the markets emanates from the
psychological patterns of crowd behavior of these players. In the
market, these behavior patterns always lead to similar
configurations. Therefore, there is a system in the market. All the
available information is already reflected in the price formation.

As psychological phenomena always produce the same behavior

patterns among the market players, so the same configurations
emerge in the markets, over and over again. My task is to identify
these patterns and, based on them, to derive a price development.

The basis for all my trading decisions is the Elliott Wave Theory, the
essence of which is that the market moves in specific wave
structures. This theory distinguishes mainly between impulse waves
and corrective waves. It presumes that the movements have a
natural order.

I trade both corrective waves as well as impulse waves, although I

usually follow a pro-cyclical approach.

3.5.2 My analysis technique

I monitor the markets on candlestick charts and try to identify Elliott
wave patterns. The time settings on the charts vary, however, as a
day trader, I mainly use five-minute charts, nevertheless, at the
same time, I also take into consideration 60-minute charts and daily
charts. I try to trade with the trend, therefore, I determine the trend
on the 60-minute chart as follows:

higher highs and higher lows = upward trend

lower lows and lower highs = downward trend

Several anti-cyclical movements, so-called secondary trends,

interrupt each primary trend on the 60-minute chart. I try to
speculate with the trend within these secondary movements that are
directed against the main trend. I build up my position as soon as a
secondary movement comes to an end, by coming down in a
support zone, or if a complete corrective Elliott wave structure
exists. When I make the entry I run through the steps described
below.

3.5.3 The entry

The investment decisions are discretionary and are based on
technical analysis and market intelligence. The most important
principle is to trade risk/reward ratios greater than 1.5 only, that
means that a position will only be entered into if the reward (the
difference between the target price and the purchase price) is 1.5
times as big as the risk (the difference between the purchase price
and the stop price). This strategy is based on the assumption that by
using a stop price, in the long term, a hit rate of less than 50 percent
will be sufficient in order to generate a positive performance. If the
investment manager, on average, generates twice as much for each
winning trade as for a loss-making trade, then he’ll already break
even with a hit rate of 0.33 percent. This means that even if only one
third of all transactions are successful, nevertheless, no losses will
occur because with each gain twice as much will be generated than
will be lost with a loss-making trade. I perform the following steps
when I make an entry:

Develop a belief in or an attitude toward the preferred calculation

Stipulate a point at which this calculation would no longer be
sustainable
Specify the target that results from this calculation
Work out the risk multiple
Consider/determine alternative calculations that have the same
trend, draw a “line in the sand” here, too

Before the position is built up I await the best entry. The size of the
position is determined by a special money management algorithm
(for this see Chapter 12 later on).

3.5.4 Waiting and watching

Monitor the market until it moves into the target zone
Place a buy limit order below market price
Break down the time units, for example, into one minute (from a
five-minute chart previously) and perform the calculation
Buy when the wave structure is complete
Distinctive features in the order book
 Break out
Buy limit below market price

Then follows the phase during which I enter the market.

3.5.5 Action
With market orders watch liquidity very closely!

Check order
Send order
Check fill
Place stop
Check stop

3.5.6 Exit
As soon as the entry has been executed, my exit rules now
determine how I should get out of the position again. For this I have
to monitor the trade. The main tasks when monitoring are:

Adjust stop
Terminate trade

a) Two techniques are used for the stops:

No. 1: The time stop - If the position is not in plus territory after a
maximum period of four times the selected time unit (with five-
minute charts this would be 20 minutes) I start to scale out of the
position. Furthermore, by the end of the day, the position will be
closed.

No. 2: The stop keeps trailing in relation to the highs/lows. If the

trade reaches its target zone, an aggressive stop is used or limited
depending on the market phase/time and strategy. (The exit will be
described in detail in Chapter 9).

b) A trade will be terminated immediately if

an error occurs
the trading environment changes significantly

3.5.7 Re-entry
A possible re-entry only occurs if a good risk/reward ratio is
generated again.

3.5.8 Mental prerequisites

No trading takes place if there are stress factors or if there is time
pressure. Feeling has to remain unconnected with trading success.
External control of feelings through discipline.
 4.
CHAPTER 4

Belief systems are opinions or guiding rules that control our

behavior. Productive beliefs open up significantly more
potential for Master Traders.
 4.1 How does our brain function?
As you read these lines, how much information do you think is
streaming at you?

Reflect briefly on this.

There are thousands if not millions of pieces of information. The

color of the paper, the weight of the book that you’re holding in
your hand, the phrases, letters, words, the brightness of your
environment, whoever happens to be in the room with you - and
so on and so forth. There are thousands of pieces of information in
our environment, however, it’s only when we concentrate on these
that we’re also consciously aware of them.

Studies show that people only actually notice 1 to 2 percent of

visual information. Well, what are the mechanisms, then, that
control which pieces of information we consciously notice and
which ones we leave out? Clarifying this question will help us to
better understand ourselves and our trading mistakes.

Our brain uses three mechanisms to process the available

information.

4.1.1 Information is discarded

Most information doesn’t even make it through to our
consciousness in the first place. All the information streaming at us
is filtered before we become consciously aware of it. Only a
fraction of the information makes it through and the rest is
discarded. With this mechanism we reduce our environment to an
amount of information that is small enough for us to find our way
around.

If you believe that the market is going through a bear phase, you’ll
mainly absorb information that supports your opinion. If then, for
example, economic data are published that are contrary to your
argument - such as a sharp increase in new job creation in the
labor market - there’s a risk that you’ll leave out this information
when you form your opinion and you’ll view the figures as a one-
off blip.

While the process of discarding helps the brain to process the

flood of information, nevertheless, it also robs us of possible
alternative courses of action because, frequently, we spot new
developments too late. It’s highly likely that you’ll ignore a lots of
buy signals if you believe that the market is going through a bear
phase. Possibly, you might not even notice the buy signals
because they’ll be filtered out unconsciously.

4.1.2 Information is generalized

Another mechanism that ensures that the information streaming at
us is easy to deal with is the process of generalization. This
means generalizing the information that we become aware of.
Information is simplified so that it can be more easily absorbed by
our consciousness.

We make such generalizations, for example, if we believe that

speculative short selling is more dangerous than long trades
because of the inherent infinite risk. After all, at most, an asset can
become worthless, thus its value could go down to zero. However,
with speculative long positions the value of the assets can double,
triple or increase tenfold.
This generalization, “Speculative short selling is more dangerous
than long trades”, will ensure that you’ll frequently perceive
opportunities for short selling to be too risky and you’ll give
preference to the long side.

4.1.3 Information is distorted

The third mechanism that plays a part in the processing of
information is a series of actions that distort information in such a
way that it will conform to a pattern that is familiar to us. It’s easier
to squeeze information into our personal pattern of thinking then to
conduct a detailed analysis of it, which could, perhaps, result in us
having to change accepted opinions or thought patterns. It’s easier
to adapt information to a pattern of thinking then to change the
pattern in order to incorporate new information. This is because,
frequently, patterns of thinking are associated with other thought
patterns (for more on this see also the next section about beliefs).

With trading, for example, you always distort information when you
interpret published economic data differently from the market. For
example, you believe that the stock market is in a bull market
phase. However, after an interest rate cut the market barely goes
up and indeed, after a while, it even goes down. For you, the
interest rate cut is a positive sign. However, it’s actually a
reflection of the poor economic situation - the central bank wants
to stimulate a struggling economy. You don’t know whether or not
this will work, you’re simply distorting the information by
interpreting the interest rate cut as something positive.

The process of discarding helps us to hold on to our

generalizations.
 4.2 Belief systems determine our behavior
So, there are three mechanisms that ensure that information is
filtered, distorted and generalized. But what criterion is used to
filter this information? How does our brain decide whether it should
discard the information, whether we will distort it or, possibly,
generalize it?

Belief systems determine what information our brain receives and

in what form. Belief systems are convictions. They’re formed
through our environment, knowledge, expertise, reference
experiences and the power of our imagination.

Belief systems grow out of the sense of certainty that we have

about a particular situation. With this certainty we internalize a
conviction and the process of selective perception begins.

We carry around with us thousands of convictions. We have sets

of beliefs about our environment, about our behavior, our capacity,
about our values, our identity and spirituality.

Our beliefs are arranged hierarchically like a pyramid. They’re

mutually dependent and build on one another. A belief on a higher
level has to be supported by a belief on a lower level. Right at the
bottom, at the base of the pyramid, are our belief systems about
our spirituality. Do we believe in God? Is the world good or evil?
Spiritual issues determine all the other belief systems.

Beliefs about our identity make up the next level. Are we winners
or losers, are we clever or stupid? Our actions will depend on how
we assess ourselves.
Likewise, our behavior is determined by belief systems about
values. For example, if we believe that money corrupts the
character and brings only bad things, at the behavioral level we’ll
never speculate and we’ll consider stocks to be an unsound
investment.

Another level in belief systems is the one for our capacity. If we

believe that we can swim then we’ll jump into the water. If we don’t
believe this, then we’ll take care not to go into the water without
swimming aids. If we believe that we’re speculative investors then
we’ll also trade futures, otherwise we won’t. Thus, the beliefs
about our behavior are actually generated by all the other levels.
The same is true of the weakest beliefs about our environment, for
example, that we’re of the opinion that candlesticks are a better
chart display than bar charts. Or that Coke tastes better than
Pepsi.

Beliefs about our environment are easily interchangeable. They’re

not deeply rooted but they have to be supported by all the other
levels. If I believe that I’m a conservative investor then I would
have great difficulty in arriving at the conviction that futures are
better than stocks. Most books and seminars about trading
attempt to change traders’ belief systems at the environmental
level because it’s relatively easy to do. System A is better than
System B - a speaker will be able to clarify this for the audience in
five hours. However, over the course of a seminar, he’ll hardly be
able to change the participants’ belief systems with respect to
identity or spirituality (that is, unless he brainwashes the
participants). Indeed, it’s much more difficult to facilitate real
changes in the behavior of the traders.

If we succeed in changing one belief system on one lower level of

the pyramid this would have consequences for all the levels higher
up. As a non-vegetarian, if I change my value concept and I now
believe that animal life is just as precious as human life, for the
capacity level this will mean that I won’t be able to eat meat
anymore, for the behavioral level that I’ll change my diet and for
the environmental level that a soya burger will taste like a
hamburger.

Our belief systems are constructed like a tin can pyramid in the
supermarket. If we remove one of the cans right at the bottom, all
the cans higher up will fall down, too.
 4.3 There is no reality - Only an internal mental
representation of the world
Belief systems are very strong as they can affect our behavior to
the point of self-abandonment. If we believe that there are 72
virgins waiting for us in heaven if we blow ourselves up with a
bomb in a crowd of people, in a so-called holy war, this belief
system will destroy our own life (and those of a number of
innocent others).

Belief systems control our behavior and our perception. Our

convictions create an internal model of the world. There is no
objective reality, as every person has different beliefs and,
therefore, perceives the world differently, too. Bandler und
Grindler, the founders of NLP (Neuro-Linguistic Programming),
phrased this as follows: “A number of people in the history of
civilization have made this point - that there is an irreducible
difference between the world and our experience of it.”

This process accompanies us in our trading, too. There is no

reality, there is only our personal notion of the market. Our actions
will depend on how we perceive this market.

Our personal reality is constructed and developed by generalizing,

discarding and distorting. This reality is like a map - it determines
our behavior. It gives us opportunities. The more strongly we
generalize, discard or distort information the fewer will be the
opportunities that will present themselves to you. That’s why it’s
important to ensure that you create a complex reality for yourself.
That’s because only then will you have a variety of alternatives.

A conviction or a belief differs sharply from a notion. You have a

series of notions that you still don’t really believe, however. Many
of you can perhaps imagine becoming a Master Trader but are still
not convinced about this. It’s only when you really have a sense of
certainty when you say this phrase to yourself that you are then
convinced about this.

Of course, notions can be transformed into convictions if, for

example, you’ve had reference experiences in which your trading
was excellent. Perhaps, you’re able to look back on an amazing
track record and you’ve already overcome several trading crises.
The more reference experiences you are able to bring in, the more
solid the basis of your conviction will be. These reference
experiences prompt you to believe. The more reference experi-
ences you have, the greater will be the certainty and the belief
system will be reinforced.

Internal mental representation

Every person experiences their own reality

The internal mental representation is like a computer program

that determines our behavior

People make the best choice from among the opportunities that are
available to them

We’re able to believe anything and everything if we have recourse

to enough reference experiences, or are able to create a very
intense mental picture. Frequently, we have both positive as well
as negative reference experiences with respect to a particular
issue. There surely aren’t any traders who haven’t made the odd
trading mistake, or who’ve lived through a loss-making phase that,
actually, didn’t reinforce their belief systems.

However, they’re certainly also able to provide examples of

positive experiences. The question now, however, is which of
these memories matter to them and will serve as reference
experiences for them.

The interesting thing is that what is really important for sustaining

us and helping us is not so much the things that we actually
experience but our perception of them. Which reference
experiences do you want to concentrate on - the good ones or the
bad ones? It’s your decision. If you focus on your bad experiences
then, most of the time, you’ll be scared. A conviction wants to
protect you from further bad experiences. Find out which
conviction wants to protect you.
 4.4 How beliefs affect our actions
Imagine that there are two traders with the same background.
Both of them trade stocks and, up to now, have been successful.
Now, they decide to be a little more speculative and they want to
buy their first option. Let’s assume that each one buys ten
Telekom call options with a strike price of 15 and a June expiry.
Immediately after the investment, the stock price goes down and
the option loses value. Added to this, there’s the loss in time value.
In the June of that year, the Telekom stock is at Euros 15 but the
option is worthless, as its quoted price is below its exercise price.

After this reference experience with options, Trader A is frustrated.

His goal was to earn money with options but he’s clearly fallen
short of this target. However, after reflecting for a while he also
sees the positive side of his first trade. He sees it as a valuable
experience and a sign that shows him that he still has a lot to learn
if he wants to trade options successfully. Therefore, he still
believes that he can earn money with options.

By contrast, Trader B is not only frustrated but he’s also

disappointed. He, too, has fallen short of his goal. He reproaches
himself for having traded options and he believes that he acted
imprudently and that options are not for him. His continuing
negative view of this reference experience leads to the conviction
that he won’t be able to earn any money with options. He
withdraws his goal of earning money with options and, henceforth,
believes that options trading is something for gamblers only.

While both traders had the same experience, nevertheless, on

account of their different beliefs, they drew different conclusions
from it. Successful investing results from our personal perception
of events and not from the events themselves. Thus, what’s
important isn’t the reference experiences in themselves but,
instead, our mental representation of these reference experiences
and the internal models that we develop on the basis of these.

Our two investors have each developed a different reality because

they perceived the loss from trading options differently and have
each made their own interpretation. According to the reality of
Investor B, in the future, there’ll be no more options as he thinks
options are useless and, the way he sees it, you can’t earn any
money that way. By contrast, Investor A has a more complex
reality. He now knows that options trading is different from stock
trading and that he still has a lot to learn if he wants to trade
options. However, he’s not going to exclude options trading in the
future.
 4.5 Beliefs in trading

4.5.1 How they block us

Successful trading means having complex internal mental models
and the appropriate productive belief systems that help you in your
trading. If we don’t have the appropriate internal mental
representations of events, then we won’t be able to trade
successfully either.

Many traders keep on repeating their mistakes because they lack

a suitable internal mental representation of the event that causes
the mistake. For example, there are many people who are
constantly trying to find reasons to justify a precarious situation.
The consequence of this is very large losses.

Why? It’s because the trader’s internal model tries to justify the
position by looking for reasons as to why this position is correct
after all. Such an internal model is not appropriate because it
produces behavior that continually breaks the golden rule of
trading - keep losses small. It’s also not productive because it
doesn’t create any other opportunities for finding a way of getting
out of the loss trap.

If you believe that there is a method that allows you to predict

market movements then you’ll expend a great deal of time and
resources to find this method. These resources will then no longer
be available for other tasks related to trading.

This belief system will limit you because it’s unlikely that you’ll be
inclined to look for different methods to earn money on the market
other than methods that forecast price movements.
If you believe that, in principle, you can earn more money on the
long side, then you’ll never be able to trade flexibly because your
internal model will give every short signal a poorer rating than a
long signal. This belief will rob you of a great number of short
selling opportunities. Many trading strategies that are very
successful will be out of the question for you. Anyone who
believes that futures are risky will find it very difficult to become
enthusiastic about this investment instrument.

It’s clear how the beliefs, listed above, create realities that hinder
traders. Many of the convictions that we carry within us limit our
opportunities. Find out which beliefs hinder you and develop
appropriate belief systems that will create a reality for you that
does not restrict you. There are no wrong belief systems. Every
conviction that you’ve internalized has fulfilled a purpose for you,
up to now.

For example, the trader who says: “I’m never going to trade
options again”, robs himself of the possibility of using this
instrument in the future. Nevertheless, his belief system also
serves to protect him from losing his money with options another
time.

However, if the trader replaces his belief, for example, in the

following way: “If I want to trade options then I have to be very well
prepared and, in any case, I’ll have to use a stop”, then this is a
belief that is helpful and productive.

4.5.2 How belief systems provide us with support

If you want to find belief systems that will support you, then you’ll
have to understand that most limitations ensue from a
generalization. “Options are the devil’s tools” is a clear
generalization. Anyone who challenges these generalizations will
acquire more complex beliefs, which will then help in the
development of a trading strategy.

Frequently, we don’t even notice how strongly inclined we are to

make generalizations. For example, if you believe that losses
should always be restricted, then the limitation that results from
this is not even noticeable in the first place. Should you always
really limit your losses? Aren’t there also investment opportunities
where a stop doesn’t make any sense, or isn’t even possible?

For example, what about an option that is way out-of-the-money?

Normally, such an option is quoted at just a few cents. Your
maximum loss would be the purchase price but you could gain a
multiple of this. If you always want to use a stop with these
options, then you won’t be able to buy this option because it’s
guaranteed that you’ll be continually stopped out given the narrow
price spread. Or, pre-IPO investments in companies - here, you’re
not able to limit your losses.

Likewise, all the convictions that you’ll find here in my book are
generalizations. I’ve selected these and not others because I
believe that for me personally they provide support in trading.

For example, if I say that the outcome of an individual trade is

random, then this belief helps me. If I know that, in any case, I
can’t exert any influence over whether a trade is a winner or a
loser, then I’m not going to put a lot of thought into the entry. That’s
why I’m able to make faster decisions. This decisiveness is an
advantage in relation to other traders.

Moreover, I won’t get disappointed or depressed if I do make a

loss because the outcome of an individual trade is, after all,
random. On the basis of this assumption, I’m only able to influence
the amount of profit or loss and so I’ll focus my resources on that.
As you can see, this belief helps me. It’s productive and not
limiting.

I also have beliefs that restrict me. For example, one of my trading
rules is that I only enter into risk/reward trades where I can earn
1.5 times my risk. There are many trading opportunities that I can’t
realize because I’ve imposed this rule on myself. However,
because I’m aware of this constraint it doesn’t pose any problem
for me. I know why I adopt it and what effects it has on my inner
reality.

Every person has thousands of convictions. What does the market

mean to you, what do profits, losses, a series of losses mean to
you? What do you believe about yourself, about trading and
speculating? Depending on how we formulate all these
convictions, they can help or hinder us.

Many traders believe that losses are bad. Frequently, this belief
has a very negative effect on the trader because is it at all possible
to avoid losses? Certainly not - losses will occur. Yet, the trader
will believe that s/he’s done something wrong if losses arise.

However, this thought undermines self-confidence. There’s then

the risk that a trader in this state will begin to have doubts and,
thus, rob her/himself of the ability to make good decisions.

People who believe that losses are bad will have difficulty in
realizing the losses. They’ll hope that they’ll still be able to avoid
this bad thing.

Yet, how would things look if, instead, traders assumed that losses
are the price for the next opportunity? This belief would help them.
Actually, the traders would ensure that the price paid for the next
opportunity is never too high. Therefore, they would be careful to
keep their losses small. Their self-esteem won’t be affected if they
make losses, as there isn’t any link between the belief and their
self-esteem.

Frequently, traders use categories such as “good” or “bad” to

evaluate events and they then connect these with feelings. An
example of this is the belief: “Profits motivate me”. However, there
is a polarity contained in this conviction. This is because it implies
that losses demotivate traders. However, such demotivation can
result in the trader getting into a loss-making spiral.
4.6 How to find belief systems that will support you
The first step toward finding helpful belief systems is to understand
your own belief systems in the first place. That’s why you should
set aside a long weekend and try to uncover as many of your
convictions as possible. In the course of this, you should always
ask yourself: What do particular events or situations mean to me
personally?

For example, if you think about the issue of losses, it is easy to

write that losses are an integral part of the business. But do you
really believe that, or have you simply adopted an adage from
some book or other? The more honest and precise you can be in
your efforts to uncover your convictions, the more helpful the
pointers will be that you receive from this experience.

In any case, you should write down your beliefs because this will
help you to be more precise. Once you’ve compiled your list of
beliefs, you should review each belief. How does this conviction
limit you, what purpose has it fulfilled up to now, what purpose
could be fulfilled if a different and, possibly, better wording is
used?

Do your beliefs contain any polarities? Polarities are often

dangerous because they have an indirect impact and the resulting
negative effect is frequently overlooked. They always occur when
you connect a particular state of mind to an event, for example,
“Profits motivate me”. This is because, in turn, this necessarily
implies that “no profits” demotivate us.

Furthermore, ask yourself whether or not the belief is productive.

This is because if the wording is actually too impersonal it won’t be
very productive for you.
In answer to the question: “What does the market mean to you?”
many traders reply that the market is where supply meets
demand. While this belief is correct, it’s hardly going to motivate a
trader. It’s not productive. Or, would you feel motivated, in the
morning, to grapple with the market where, as you know, supply
meets demand?

My belief about the market is that it’s the source of my

opportunities. This wording is motivating as a source has positive
connotations and I’m going to find opportunities there.

A good method for finding helpful convictions consists in, first of

all, “learning by watching” successful traders. For example, you
could read the book “Market Wizards”. It includes interviews with
top traders and talks about their belief systems, which could be
helpful for you, too.

A belief system will help you if it doesn’t generalize too much,

doesn’t limit you but, instead, expands your opportunities and
means that polarities are avoided. A belief system is always
productive when it provides you with support in your trading.

4.6.1 Trading problems arise from unproductive or

limiting belief systems
Beliefs are the key to why many traders aren’t able to use
successful trading systems. If you carry around a conviction with
you that is not appropriate to the trading system because, for
example, you believe that the stock market is in a big bull market
phase, well then if the system goes short you’ll have difficulty to
follow it.

As all market players use beliefs as a filter for their own

investment information, it’s absolutely ridiculous to assume that
traders are able to act objectively in the market. All traders have
their own reality and they trade within it. When you understand
how you personally filter information with the help of your belief
systems, then you’ll automatically improve your trading results. In
particular, if you’re able to ascertain which beliefs are not
productive or are limiting.

In order to find this out you should keep a psychological trading

diary and, there, carefully examine and make a note of your beliefs
for each trade. When you then analyze your diary, you’ll quickly
uncover which belief systems motivated you and which ones
blocked you.

What filters did you use to enter into the trade, and what are your
beliefs about your investment or about the market? What did you
feel about the trade? Do you feel bad when you lose and good
when you win?

Try to replace these beliefs with more productive ones. This

doesn’t usually happen overnight but, instead, it’s a process that
you have to work at. The more intensively you think about it, the
more successful you’ll be.

Serious trading problems usually arise through one or two

obstructive belief systems on the levels of identity or spirituality. In
particular, you’ll keep on making the same mistakes if you’re
inclined to look somewhere other than yourself to apportion blame.
You have to arrive at the conviction that you’re personally
responsible for everything that happens to you - it’s not fate, it’s
not other people and it certainly isn’t the market.

In trading, there are frequently problems related to self-esteem.

Unfortunately, it’s very difficult for us to make an honest
assessment of how self-assured we are. However, if we take
losses personally then that’s a clear indication that we have
problems with our self-esteem. Feeling bad when we lose and
good when we win is typical for ego problems. With such problems
we’ll never arrive at the level of being in trading but, instead, will
tend to linger in a state of doing and having.
 5.
CHAPTER 5

States and moods. Successful traders are not free of

emotions. We need emotions to generate top performance.
Knowing how to make use of widely varying moods -
including fear - effectively, in order to perfect our trading, is
one of the big advantages that Master Traders have.
5.1 Moods determine our behavior. If you can handle
your emotions, you can handle trading.
Do you know that feeling when everything seems to be going
smoothly? In trading there are phases in which everything works.
You make your trading decisions with almost uncanny ease and,
apparently, you do everything right. You quickly get out of your
loss-making positions, you push your profit positions and the
money just rolls into your trading account.

Unfortunately, you’ve certainly also lived through times in which

none of the things that you initiate in your trading actually work
out. Every decision is a battle with the market; you have problems
identifying the market cycle, you seem to be making only losses
and if you do make a gain the profits are irrelevant and small.

How is this possible? What’s changed? After all, you’re still the
same trader with the same strategies, tactics and experience?
Why do you sometimes achieve such devastating results and then
again, at other times, have such fabulous outcomes?

The difference lies in the state, also referred to as the mood that
you’re in. There are productive moods that help you and
unproductive moods that cripple you.

Perhaps, up to now, you’ve believed that there is no possible way

to control these moods and that moods are something external
that assail you and then disappear again. Yet, what if we did have
a method for getting ourselves into a productive mood at any
time? What peaks of performance could we then attain?

Why is it that when we’re in a certain state we can perform tasks

better than when we’re in a different state? The answer is
relatively simple - because we behave differently in each mood.
Thus, our behavior depends on the mood that we’re in.

Imagine that you’re in a nervous state. How would you behave if

you’ve entered into a position? It’s highly likely that you’ll be
anxious about your profits and that you’ll quickly exit the position -
frequently too quickly, so that your profits will be small.

The situation would be completely different if you felt confident at

that moment in time. You would be sure that with your strategy you
would win in the long term, even if you had to give up some profits
in the short term. That’s why you would be able to hang on to your
position and possibly even add to it. The same position, the same
market environment but just a different mood and, therefore,
different behavior.

So, it’s moods that determine our behavior. Without a mood we

wouldn’t be able to act in the first place. A mood precedes every
action. Moods motivate us to act. There are thousands of moods
and we have terms for many of them, but there are others that we
perhaps can’t even describe in words.

Most moods arise unconsciously. We see, hear or feel something

and react to it with a certain mood. People who, consciously or
unconsciously, manage to put themselves into a helpful and
productive state, and who can do this continually, are more
successful and achieve their goals more easily and earlier.

If, as a trader, you want to achieve top performance then you have
to be able to control your moods. For this you have to know how
states and moods arise in your brain. When you know this then
you’ll be able to exert specific influence on getting yourself into a
particular mood.
5.2 How do moods arise? There’s a link between an
event, our internal mental representation of this
event, the mood that arises from this internal mental
representation and our behavior.
How is the state that we’re in produced and why is a particular
behavior connected to every state? A state has two main
components, firstly, there’s our internal mental representation of an
event and, secondly, physiological processes, such as posture,
biochemical sequences, breathing as well as the contraction and
relaxation of muscles.

Some people use drugs to try to influence their biochemical

processes in order to get themselves into a different mood. When
you massage yourself, or take a hot bath your muscles relax and,
in this way, you get into a different state. Maybe you take a deep
breath before you meet a challenge. This, too, is an intuitive
attempt to affect the mood through breathing. Likewise, you use
your posture when you want to induce a particular state.

The definition of “internal mental representation”, which affects our

mood, is what you imagine in a particular situation, or what you
think about an event. Although, how you imagine something to be
also determines your state and your behavior. Here’s an example.

Imagine that you’ve suffered a very big loss. This event, in itself,
hasn’t affected your state yet. First, you have to give a meaning to
this event, an internal mental representation. What does this event
mean for you, what’s going on in your imagination?

You could say to yourself that this loss has moved you further
away from your target of attaining financial security. Even though
you made an effort, nevertheless, you weren’t able to realize your
goal and it has now receded far into the distance. You’ve achieved
a result that has thrown you far back on the path to accomplish
your goal.

It’s highly likely that this representation will induce a feeling of

frustration in you. You applied yourself but, nevertheless, you
didn’t achieve your goal. When people realize that they’ve missed
their goal their reaction is one of frustration.

However, you could decide to have a completely different internal

mental representation of this event. For example, you could
consider that a loss is no more than the price for the next
opportunity.

This time, you paid a high price for this opportunity. That’s why you
should pay particular attention to the next transaction.

This internal representation doesn’t focus your attention on the

failure but, instead, attempts to give a positive meaning to the
external event of a “loss” while not glossing over it. The state that
follows from this internal representation certainly isn’t one of
frustration. It’s more likely that you’ll get into a cautious mood.

Our internal mental representation of an external event is

extremely important because our mood depends on how we do
this. When we’ve learned how to find helpful internal mental
representations and to use these for all events that occur in
trading then we’ll be able to put ourselves into an optimal state.

An important question that we have to ask ourselves is: What

causes one trader to represent an event in a particular way and
another trader to represent the same event in a different way?
Once again it’s our belief systems, attitudes, values and
experiences that lead us to have an internal representation of an
event in a wholly individual way. That’s why it’s so important to find
helpful belief systems and to be aware of which convictions block
us. This is because our belief system has a significant influence on
the internal mental representation and if we want to master our
moods then we have to control over our internal mental
representation.

However, besides belief systems there is still another factor that

affects our internal mental representation. This factor is our
physiology and the way in which we use it. How do we breathe,
how tense are our muscles, what’s our blood sugar level, what
other biochemical processes are currently working in our body?

Our internal mental representation and our physiology form a

cybernetic loop, this means that both factors influence each other.
You’ll undoubtedly perceive the world in a different way if you’re
full of energy than if you’re feeling tired, harassed and stressed.
When everything appears to you to be difficult then you also feel
heavy, your muscles are tense, your breathing is shallow and you
get into a bad mood.

The interdependence between mood and physiology is very strong

and works in both directions. You’ve also surely had the
experience where you felt tired and lackluster and were able to
overcome this state simply by taking a lot of exercise, for example,
by going jogging. Suddenly, you didn’t feel tired anymore.
Although, all you did was to activate your muscles. When you’re
anxious, usually, your breathing is very shallow. As soon as you
begin to take deep breaths, you ease your anxiety. There are
many examples of how, through changes in your posture and
breathing, a different mood can also be induced.
Thus, besides your internal mental representation, moods also
arise from the posture that we adopt.

Now that we know how our moods are produced, we have a

starting point for changing them. With this knowledge we’ll now be
able to control our behavior. Our behaviors are very closely linked
to certain moods.

But why doesn’t everyone react in the same way when they’re in a
particular state? Trader A swears, perhaps loudly and thumps the
desk when he’s annoyed. Trader B starts to overtrade his account
in order to distract himself from his vexation.

As in a flow chart, our brain has various, highly individual behavior

patterns that are linked to certain moods. Frequently, these are
behaviors with which our brain, shaped by reference experiences
and belief systems, tries to alleviate or eliminate a mood
connected with pain.

Thus, Trader A has learned that he can vent his vexation by

swearing and thumping, which in turn gets him into a different
state. Trader B has learned that trading distracts him from his
unpleasant state.

The more frequently we react to a mood with a particular behavior,

the more pronounced this becomes in our brain. The brain learns
by using certain neurons over and over again - until this behavior
becomes routine and automatically follows on from a mood. Then,
in extreme cases, we know only one way to react to a particular
emotion.

This is most apparent in people who exhibit addictive behavior, for

example, alcohol addiction. Let’s assume that someone drinks
alcohol in stressful situations. He notices that he relaxes and gets
into a different state. The brain has a reference experience where
the unpleasant state of “being stressed” can be eliminated with
alcohol. Now, the more frequently the brain has this learning
experience, the more likely it is that, in future stress situations, it
will suggest alcohol consumption in order to eliminate an
unpleasant state. With every successful attempt at distraction, the
neural pathways in the brain become reinforced until, eventually,
hitting the bottle is automatically assigned to stressful situations.

It’s a similar situation with some traders. Certain harmful

behaviors, such as overtrading or incurring enormous risks,
distract traders from moods that are perceived to be negative.
These behaviors are always used by the brain when an
unproductive mood arises - with catastrophic results for the trading
account.

With a psychological trading diary, in which you make a note of

your moods, you’ll soon realize if there are behaviors connected to
specific moods and which ones. As there is a strong link between
mood and behavior, it’s very important to figure out this
connection. Self-observation is essential for this.

In the table below you can see how I behave in the market when
I’m in certain states.

Mood Behavior

Nervous Conflicted, stops that are too narrow, profits that are too small, a feeling
of having insufficient control, in an associative state

Relaxed In a dissociative state, more control, few actual trades

Anxious I miss opportunities, run after the market and get in too late, exit too
quickly and, thus, limit profits; I have difficulties holding a position in the
first place

Secure I know what I’m doing as well as how and why

Overconfident I incur huge risks and trade very aggressively; I ignore exit signals and
trade too much

Goal-oriented Very unemotional, straight, I know when I can push the market
Table - Mood and Behavior
 5.3 Discipline
Even beginners, after initial painful losses, will appreciate that
discipline represents a key factor for successful trading in the long
term. So, it’s all the more astonishing that only very few traders are
able to implement this realization in practical terms into their work.
A false understanding of the term discipline, among other things, is
to blame here.

It’s generally assumed that discipline is the ability to follow rules.

However, this definition is not very helpful when it comes to
trading. You might, perhaps, survive in the market if you follow
your rules, but you’ll never become an excellent trader who
generates above market returns consistently.

Actually, a trader isn’t a soldier who marches off to war, receives

and carries out orders but who, nevertheless, perhaps dies in the
battle. No, a trader stands behind the lines and doesn’t engage in
the fight with the market. Traders are the generals, they’re flexible
in their decision making and always prepared to adapt to new
situations. They make the rules, they gather the troops, and they
draw up a strategy and implement it.

Thus, it’s not about stubbornly following some rules. Successful

trading means behaving in an optimal way in widely varying
situations. However, our behavior is essentially controlled by our
moods. Therefore, anyone who wants to control their behavior has
to be able to control their moods.

It’s not enough then to be satisfied with the definition that

discipline is the ability to follow rules. Discipline is more than that.
Discipline is controlling a state. Understanding discipline as the
ability to control your own mood (state) in such a way that we’re
able to react in an optimal way to all challenges will be significantly
more helpful to us in trading then all the other standard definitions.

Discipline is the ability to find the optimal productive mood for

tackling the task at hand and to put yourself into this mood.
Therefore, traders with discipline have control over their state, or
mood at any given moment.

Discipline means having the mental strength to induce a mood

(state) that makes it possible for me to produce the appropriate
behavior for following my trading plan and, thus, the rules.

We all know the traffic regulations. Nevertheless, surely everyone

has broken these rules at least once. Why? If we leave aside
cases of willful breach of traffic regulations, there remain those
instances where we were distracted, which means that we weren’t
in the optimal state (mood) that is required in order to be able to
tackle the task at hand. We were perhaps tired, not concentrating,
nervous, frantic, impatient or angry - these are all moods that are
unproductive for participating in road traffic.

The same applies to trading. Here, too, there are productive and
unproductive moods.

It would be a big mistake to assume that a good trader is ice-cold

and unemotional. As with all complex tasks, so good traders are
also distinguished by the fact that they’re able to make targeted
use of a wide variety of moods productively (see also the The
Optimal mood for every trading step on page 105ff).

So, for example, fear can definitely be a productive mood if it’s

used at the right time. Actually, traders not only ask themselves
the question of whether or not they should execute a certain
transaction but also how much money they want to risk in the
process. When they’re making their decision, if they allow
themselves to feel fear at that moment, then they’ll get an honest
answer. If they don’t allow this then, because they’ve lied to
themselves about the true risk of the transaction, they might
possibly feel a surge of fear at precisely the wrong moment,
namely when they’re faced with the question of what they should
do: go ahead and buy or sell, or hold back the trade.

In such a situation, fear is a bad advisor and if, beforehand, the

traders have also lied to themselves about what amount they
should risk, then fear frequently leads to wrong decisions.

The traders sit in front of their monitors and, like rabbits

mesmerized by a snake, watch for a buy signal but, because of
their feelings of anxiety, they’re unable actually to bring
themselves to make the acquisition. They miss the opportunity and
can’t follow their trading system. Thus, profitable trading signals
are not followed up because, at the point in time when the
purchase decision should be made, an unproductive mood (fear)
hinders the decision-making process.

However, if when we’re making the decision about the amount that
we want to risk we allow ourselves to feel fear of losing money, we
would realize, for example, that a loss of Euros 1,000 is too big for
our risk profile and that we should buy fewer contracts or avoid the
trade. In this case, fear is a productive mood that helps us to
determine a position size that is proportionate to our risk appetite.

Our understanding of discipline is based on an important

assumption - that we’re able to control our moods. Moods are not
dependent on external factors, as many people believe, but
instead on our internal mental representation of the world.

In other words, moods are dependent on the instructions that we

give to our brain. Thus, our brain produces exactly the mood that
we’ve (mostly) subconsciously instructed it to do. We’re able to
produce any desired mood at command. Here’s an example:

Rob and Tim are day traders. Both trade the DAX according to a
relatively simple trend-following system; both have the same
account size and the same financial background. The market is in
a sideways range and, as a result, the trend-following system has
produced a number of false signals.

After the eighth false signal in a row and a cumulative loss of Euro
8,000 Rob is completely stressed out. His mood fluctuates
between vexation and anger. He’s in a very aggressive state. His
losses tell him that he’s a failure. This angry mood makes him
aggressive and he decides that, in the next trade, he’s going to
buy double the number of contracts.

By contrast, Tim remains calm; he’s confident and knows that the
system has a positive expectation value and that during sideways
phases there are false signals. Losses have nothing to do with him
personally but are, instead, part of the game.

At the next signal, Rob strikes a blow and does indeed buy double
the quantity of contracts. Tim, by contrast, continues to be guided
by his money management rules as regards position sizing. Right
from the start Rob’s trade runs up a minus once again and is not
very far away from being stopped out.

Rob looks at his profit and loss statement and can’t believe it. His
losses are now growing at double the previous speed. He’s never
lost so much. He gets scared and he decides to end the trade
even before he’s stopped out - so that the losses don’t get even
bigger. He sells everything. Shortly afterwards, the market turns
and picks up significantly. Rob can’t believe it. If he’d stayed in the
market he’d already have made a net profit by now.
Tim continues calmly to follow the movements of the market and
waits patiently for his sell signal. At the end of the day, when he
exits his position, he’s generated a net profit of Euros 9,000.

What’s the difference between Rob and Tim? Both have

experienced the same thing, the same thing has happened to both
of them, however, they reacted to it with different moods. Rob is
angry and annoyed. Tim is calm and confident.

As a result of the varying representations of the experience, as

expressed in each mood, different behaviors arise. Tim adheres to
his rules; Rob breaks them and overtrades his account. Rob
selected the mood that he wanted to feel, even if unconsciously,
by transmitting a message to his brain that he’s a failure. The brain
responds to this with the usual mood program of vexation and
anger. By contrast, Tim has signaled to himself that losses are part
of the game and simply go with it. This neutral message makes it
possible for him to remain not only calm but even confident.

However, we don’t always manage to control and filter precisely

the messages that we want to send to our brain. Frequently, in
such a case, we’re in a mood that we don’t consider to be
productive and we’d like to switch into a productive mood. A
characteristic shared by all successful traders is the ability to put
yourself into a productive state at the right moment. With a little
practice and the right know-how everyone can learn how to do
this.

The most powerful instrument that we can use in our trading is the
possibility, at any time, to consciously put ourselves into a
productive mood for tackling the task at hand. In the case of many
successful and experienced traders, this happens automatically
and more likely unconsciously. Nevertheless, in situations that are
specific to trading, they make use of the same behavior patterns
over and over again. There’s an optimal mood for every step and
for every task that we have to tackle in trading.

It’s very problematic if moods are designated, or identified as

being good or bad. There are no moods that are good or bad in
themselves. Even so-called good moods can be dangerous if, for
example, out of sheer joy we behave in a way that is overconfident
and reckless. Likewise, a mood such as fear that is perceived to
be bad can protect us when, for this reason, we refrain from an
action that, perhaps, might have had a harmful effect on us.

Rather than classifying moods into categories such as “good” or

“bad”, it’s better to assume that there are productive and
unproductive moods for tackling the task at hand. Here, we should
always bear in mind that all moods, productive as well as
unproductive, are signals from our body.

So, before we turn to the steps involved in getting ourselves out of

an unproductive mood and into a productive mood, we have to
realize that the current mood is a signal that wants us to become
aware of something. If we ignore this signal it will return but then,
usually, it’s stronger. Thus, the best method is to ask yourself what
does this signal (mood) want to tell me.

However, sometimes in trading, owing to a lack of time, it’s not

appropriate to concern yourself with your unproductive moods.
We’d like a method for putting ourselves very quickly into a
productive mood. That’s what the next section - “Steps to
Discipline” - is about.
 5.4 Steps to discipline
Discipline is the most important characteristic of a successful
trader or investor. Discipline means being able to control your
emotions, your moods as well as your state. Accordingly, discipline
is nothing other than being able to control your feelings.

Discipline shouldn’t be confused with money management. As a

trader you have to develop consistency. You have to follow trading
rules and a system that is customized to fit your personality. This
means that you have to know yourself and you have to know what
you want and where your problems lie. You have to know how to
solve your problems, where you want to go to and what goal
you’re heading for. Ultimately, this is only possible with continuous
self-observation.

5.4.1 Step 1 - You have to know yourself

There are two states in which you can undergo an experience: one
of association or one of dissociation. You have to be familiar with
both positions.

Both ways of experiencing the world are very useful. Usually,

people’s perception is stronger in an associative position. You’ll
never become truly acquainted with life if you don’t take up a fully
associative position. Traders who follow the ups and downs of the
markets with extreme emotional upswings and downswings are
mostly fully associated.

Dissociation is a very simple way to control this state. Dissociation

is also important in order to be able to make an objective
assessment of your own states and actions. Keep on asking
yourself: What am I doing right now? Be more realistic with
respect to your moods.

Perhaps you believe that some moods are useful and others
aren’t. That’s wrong. Every mood has a particular purpose.
Objectivity in relation to moods means understanding that the
purpose of a so-called negative mood is to send a message to you
personally. A part of you would like to tell you something really
important.

When you respond to this message, this mood will subside.

However, if you ignore this mood, on each occasion it will become
more intense - until you can’t ignore it any longer. If you only
eliminate the so-called negative moods in your head, together with
this you’ll also extinguish an important source of information. You
can control negative moods by becoming aware of the messages
that they’re presenting to you.

5.4.2 Step 2 - Use your mental resources

Most investment problems emerge from particular moods - from
impatience, fear, depression, disappointment, listlessness or
greed. Thus, the cause of the problem is that the investor is in a
mental state that isn’t productive for success.

You know that most people want a particular mood. People don’t
want money, they want satisfaction, peace and quiet. They want
the satisfaction of receiving money, or being able to do something
with the money. People undertake actions only because they want
to have a particular feeling or a state.

What people want is not a material good but, instead, the state
that they associate with it. Your discipline plan should focus on
controlling your state.
 5.4.3 Step 3 - Observe yourself
As soon as you’re able to observe yourself objectively and to
realize what your state is, you’ll be in a position to manage your
mental state at any time and to change it if it’s not working for you.
You only need one more step in order to be consistently
successful.

Observe yourself continuously. You’re working really hard to

change your state but it’s easy to fall back into old habits.
Therefore, permanently observe yourself before you fall back into
the old pattern.

In trading, just one relapse can mean a major loss, or even your
account being ruined. In this connection, the most important point
is keeping a trading diary. If you record your moods and actions in
such a trading diary they’ll reveal a pattern of thought.
 5.5 How to develop a behavioral compass

5.5.1 Steps to discipline

Observe yourself.
Work out what your mood is and what signal your body is
conveying to you.
Welcome the signal and try to find a response to it.

If there is no time for this process when you’re trading then use the
five possibilities for changing your mood.

Thus, it’s not trading systems that earn money but, instead,
traders. Trading systems are only decision-making strategy
shortcuts. You can only achieve trading excellence when you’re in
top condition.

There are four starting points for changing your behavior:

by changing your internal mental representation

a) For example, you can achieve this through belief systems that
are helpful for this situation (“A loss is the price for the next
opportunity”).

b) You could also simply change your perspective, however: “This

is one trade out of hundreds and, by next week, I’ll already have
forgotten about it”.

c) The final possibility is framing. Framing means viewing an event

in a different context. For example, not viewing a loss as a failure
but, instead, as feedback that shows something isn’t working
according to your plan.

By changing the internal mental representation you change your

mood and, consequently, your behavior. You should come up with
helpful internal mental representations for all the important events
in trading and, based on these, develop a behavioral compass. A
behavioral compass will show you which internal mental
representation leads to which mood and, thus, to which behavior.
This task is very time-consuming, as you have to find different
internal mental representations for each event (for example, profit,
loss, series of losses or a margin call) and formulate them in such
a way that they induce a particular mood for you personally.

A behavioral compass is always customized because every trader

has a different belief system and, moreover, has learned different
behaviors for particular moods.

You can find an example of a behavioral compass in the table

below. The same event is represented differently and, thus,
through various moods leads to diverse behaviors. When you’ve
developed your behavioral compass you’ll be able to induce any
desired mood by giving your brain the right internal mental
representation.

Event Internal mental Mood Behavior

representation

Huge This loss is an obstacle on the Frustrated I want to achieve my goal faster
loss path to my goal of “financial and I trade bad opportunities.
security”. Even though I’ve
applied myself I’ve moved away
from my goal and have produced
results that have thrown me
back.

Huge Losses are the price for the next Cautious I’ll examine the next opportunity
loss opportunity. This time, I paid a like a hawk and take a very
high price for this opportunity. selective approach.
That’s why I should pay particular
attention to the next transaction.
Huge This is a very rare event but it’s Confident I let profits run, I trade little but
loss part of the game and I can effectively.
remember earlier situations
where my loss was followed by a
huge profit.

Huge I’m grateful for the feedback that Analytical I check my trading system. Have I
loss something isn’t working according broken the rules? Has there been a
to my plan and that possibly crucial change in the market? Was
urgent changes are necessary. this loss a rare event but,
nevertheless, in the context of
probabilities a possible event? How
many such losses could I expect in
a month?

In order to develop your compass, you should proceed as follows.

The initial step involves generally finding new answers and

alternatives for a particular condition. To this end, first of all, we
have to find out what was our standard response, in the past, to a
particular emotion.

At this point, it’s important to emphasize that it’s essential to

identify your mood precisely and to label it. This is the only way
that we’ll be able to change the routine behavior that is triggered
by this mood.

Here, once again, the trading diary is our most important tool. For
all moods and events create a behavioral compass that will show
you with which mood, up to now, based on your internal mental
representation, you’ve reacted to particular events and to which
harmful behaviors this has led.

Once you’ve created the part of the behavioral compass that

describes your past, you should develop alternatives. For each
event that led to an unproductive mood you should imagine an
internal mental representation that would lead to a productive
mood. Think very carefully about which event in the past triggered
a mood and which had been productive in order, in the future, to
be able to give up the unproductive behavior and replace it with
one that is more suitable.

As the example shows, usually, there are several productive

moods for an event. The more you find, the more possibilities
you’ll open up for yourself. Keep on looking for new moods and
possibilities, as this quest can improve your ongoing trading.

Revise this compass over and over again. In the course of this, the
more precise you can be as regards the language you use, the
easier it will be, in the future, to notice which mood you’re in and
for what reason.

Put up this new behavioral compass above your desk, internalize it

and use it constantly.

through changes in posture

You’re also able to affect your behavior by changing your posture,

as there is a particular posture associated with every mood.
Ensure that you change not only your internal mental
representation but also your posture, as both factors together form
a cybernetic loop.

In order to be able to effect a stable mood change, your posture,

breathing, muscle tension and internal mental representation have
to be congruent. Otherwise, your brain will receive contradictory
signals and won’t know how it should react.

through new behavioral models

Another possibility consists in developing and acquiring new

behavioral models. In trading, when I’m in a blind alley, I can
always suspend this activity and undertake other things that
release me from my state of frustration.
Find alternative behavioral models for every state.

State/mood Alternative behavioral models

Frustration I suspend my trading immediately and write another chapter of my trading

book.

I suspend my trading immediately and telephone someone who I like very

much and talk to him about things that are pleasing.

I suspend my trading immediately and go out on the golf course, to the

fitness center or to the sauna.

However, as in every learning process, you can also train your

brain to strike a path that is different from the previous behavior
patterns. That’s a possible but difficult way to acquire discipline.

Once the brain has stored a response to a particular state, it’s

difficult to overwrite this memory. Addiction experts even assume
that it’s impossible to delete this response from the behavior
program of the brain, so that just one single relapse immediately
leads to addiction again. That would mean that even if you had
acquired new responses to states, you could quickly fall back into
an old unproductive method.

One method for teaching your brain new behavior patterns as

responses to particular states is the age-old principle of repetition.
Thus, through repetition you learn to reinforce what you’ve
acquired.

You embark on a long journey to rehearse and train new behavior

patterns. But it’s a worthwhile journey, as you’ll replace harmful
behaviors with useful ones.

by remembering or fantasizing

One last method for putting yourself into another mood and, in this
way, affecting your own behavior consists in thinking of reference
situations from the past, or if there haven’t been any, simply
imagining such a situation. Our brain can’t differentiate between
the past, present and future. If we want to generate a feeling, it’s
sufficient to think about particular things.

A request - please don’t underestimate the significance of

controlling a state. Not every top trader consciously makes use of
this method for controlling behavior. However, you can be sure
that these traders unconsciously make use of the right internal
mental representations, that is ones that are helpful. When I talk of
Master Traders I don’t mean average traders who earn their 10
percent over one or two years with trading system xy. I’m thinking
of excellent traders who produce top results - and not only once
but over and over again.

You’ll only be able to attain this performance when you find helpful
internal mental representations for controlling your state and when
you’re in a position to put yourself into top condition during trading.
 6.
CHAPTER 6

Productive moods for trading success. In trading there are

moods that are productive and ones that are unproductive.
For every task that you have to tackle in trading, figure out
which moods are productive and learn to control these.
 6.1 The states and modes of existence of traders
“One of the most indispensable qualifications to a trader in his
position is poise - that state of mental balance which enables him
to regard any situation calmly, and from an unbiased point of view,
uninfluenced by hope or fears. He possesses this desirable
characteristic to a most remarkable degree – was evidently born
with it and has highly cultivated it since.”

Richard D. Wyckoff and Jesse Livermore, “Jesse Livermore’s

Methods of Trading in Stocks”

Every trading beginner, to start with, has one goal - to earn as

much money as possible. This is a typical condition that
characterizes every beginner. S/he wants to have money.

This condition focuses solely on having and, therefore, we call it a

“state of having”. All motivation and energy stem from this state of
having. Traders also draw on this source to create their self-
esteem.

Success and money act as an endorsement of the traders and

enhance their self-worth. Losses, by contrast, will necessarily
lower self-esteem.

In a state of having, an extreme polarity becomes apparent. This is

because the traders only differentiate between having and not
having. While profits strengthen their self-esteem, nevertheless,
losses have such a destabilizing impact on them that, sooner or
later, they’ll lose their accounts. This is because it’s not possible to
trade without also making losses occasionally. Now, if a loss
occurs then the self-esteem of the traders is lowered and without
profits they never return to a state of poise.
Thus, they are dependent on an external factor (profits) in order to
stabilize their emotional state. Without profits, which from a short-
term view are just as much a product of coincidence as losses,
these traders are quite literally stranded.

Once an imbalance occurs, anyone in a state of having will no

longer be able to regain their poise through their own efforts.

Yet, profits can also destabilize, in particular, if a series of gains

leads to traders having excessive self-esteem. The consequence
of excessive self-esteem is that traders then lose touch with reality.
Traders lose all respect for the market and, because of this, incur
greater risks. If the risk turns against them and they lose, it’s no
longer possible for them to trade sensibly. Their subconscious
assesses the loss to be an attack on their self-esteem and
declares war on the market.

Traders in a state of having will rarely experience a state of poise.

They constantly swing back and forth between the poles of having
and not having and experience an emotional roller coaster ride.

On a conscious level, the goal of these traders is to have success

and to earn money. However, trading success and money are the
benefits of trading, which follow automatically when experienced
traders, in a state of poise and while taking into consideration
money management rules, engage in trading. Thus, the main goal
of traders cannot be success or money but, instead, has to be
focused on staying in business.

Frequently, traders realize that their job is a challenge. Then their

goal is no longer the attainment of success and money but,
instead, to meet challenges and, in this way, to strengthen their
self-esteem.
While behind the goal of “a challenge” no polarity, such as the one
described above, is concealed, nevertheless, serious trading
problems can also arise from this approach. Constantly seeking
challenges automatically leads to stress. Moreover, there are
market situations in which there is simply nothing to do. However,
someone who looks for challenges at any price is unable to
exercise patience and will begin to trade bad opportunities, or
they’ll continually try to improve their trading system in order to
find the holy grail of permanent profits. It’s because this activity of
searching produces a short-term feeling of satisfaction. Traders
are then not inactive and believe that, in this way, they’re able to
forge their own destiny.

Traders who look for challenges will also be inclined to incur huge
risks. Playing with risk will be viewed as a challenge.

In the subconscious, concealed behind this state, there’s

frequently a desire for a distraction from problems or
responsibilities that the trader is afraid to address directly.
Sometimes, it’s also simply a fear of boredom. That’s why the
traders are constantly trying to do something. We also refer to
such a state as one of “doing”.

Traders in a state of doing always have to be active in some way

in order to feel themselves as well as to be able to appreciate their
own person and in order to be able to exist. While this state,
viewed superficially, is very productive, it doesn’t help traders to
become poised. Stable emotional equilibrium only exists when the
traders are active (doing something). As soon as there’s nothing to
do they lose their balance and with it their ability to trade
successfully.

Traders in a state of doing have usually come out of the initial

beginner’s stage but, nevertheless, are still not able to generate
profits consistently. Instead, after small profit making phases, over
and over again, loss-making phases occur during which traders
are on the lookout for even better systems or signals, or also they
are simply too active in their trading.

The optimal state for a trader is one of simply existing. We refer to

this as a state of being. In this state traders accept themselves as
they are and know that they are important. Such traders have no
problems with their self-esteem. They have a calm approach to the
things in life without assuming the role of the victim here. They
know that they have to be 100 percent responsible for all the
things that happen to them and that not all outcomes can, or have
to always be positive.

These traders have found their trading style. They know about
risks but also about their abilities. They don’t have to demonstrate
their abilities to themselves or others on a daily basis. They are
aware that their greatest source of strength lies in their poise.
These traders live in a balanced state, neither profits nor losses
affect them emotionally in any way. That’s why trading results will
not upset them either.

Many traders believe that people can’t be like that and that’s why,
in trading, they prefer to trust in computer systems that can be
more rational in making decisions. However, it’s a fact that we
humans still carry around within us the biggest and best neural
network.

If we manage to live and trade in a state of “being” our trading

results will be excellent.

However, the most positive side effect of this state is true

satisfaction. The emotional balance that characterizes the state of
“being” has an impact not only on trading but also on all of life.
Some people might say that anyone who is satisfied is also
complacent and will have little inclination to trade. Anyone who
doesn’t set themselves goals will not be able to attain wealth
either.

While this certainly sounds like a logical argument, actually, it’s a

case of putting the cart before the horse. As I already mentioned,
it’s particular values that drive traders to achieve their goals.
Concealed behind the goal of wealth are values that control the
actions of traders. In all our actions we are mainly concerned with
attaining a state of satisfaction. If we link this state of satisfaction,
or of being, with wealth, then we quickly find ourselves in a state of
having once again.
 6.2 The optimal mood for every trading step
In trading we have to tackle various tasks. Each of these tasks
requires us to have a different mood. First of all, we’re going to
analyze what tasks traders have to tackle in the course of their
trading and then we’ll look for the optimal mood for performing
these tasks.

A trade begins long before the planning. This is because trading is

a competition with other market players. As in a sporting
competition, we would only want to compete if we’re truly fit.
Therefore, every day before you begin trading or immediately after
you get up, it’s advisable to perform a little self-check.

How fit are we today both physically and mentally, do we feel well,
what private matters could distract us from trading today? Are we
prepared for the trading competition? Are there things that could
hinder us? What needs do we have?

The purpose of this self-check is the optimal preparation of the

trading day. There will surely be days when we don’t feel so well.
You’ll have to decide whether or not you want to trade on such a
day. However, if you do want to trade you should know how to
ensure that you concentrate completely on the market.

If you’ve identified stress factors for the day then you should think
about if and when you’ll trade. Stress factors include all those
things that could distract you and prevent you from concentrating
completely on trading. These can be both business and private
matters. For example, if you know that, in the afternoon, you have
an unpleasant dental appointment, then when you’re doing your
planning in the morning you should decide already whether or not
you want to trade beforehand and what you’re going to do in the
afternoon with the open positions.

After the self-check there should normally be intensive

preparation for the actual trading. You have to check the current
news items, look at the charts, observe correlating markets and
check your system. A mental rehearsal of the trading day can also
form part of this preparation.

Already prior to the market opening, I try to imagine different

scenarios. What will I do if the market opening is firm or weak, if
the published economic data are better than expected or worse
than expected? What important market data should I take into
account? What will I do if the market breaks through particular
resistance and support levels? Which markets should I pay
particular attention to today?

After the intensive preparation I start to develop specific trading

ideas. In the course of planning these trading ideas not only do I
think about where I should set my initial stop, what target prices I
consider to be likely but also how big my position should be, how
many re-entries I should allow, whether I’m going to trade
aggressively or less aggressively and whether or not I plan to
pyramid (scale in) into my trades.

All the previous steps are ones that I perform already before the
market opening. Usually, I also try to write down the main thoughts
for the trading day in order to be able to analyze my actions better
in my trading diary, later on. Once the market opens the next
phase begins during which I await an entry for my planned trading
ideas. In this phase of waiting and watching, I observe the market
and try to become aware of all the information.

If I spot a trading opportunity then I initiate a trade. In the course of

this I have to ensure that I do everything right. The order has to be
submitted properly and I have to be very fast so that I don’t miss
the opportunity, nevertheless, I still have to be careful.

Once the trade has been initiated I check the fill. That’s important
because maybe I haven’t made a mistake but, instead, either the
order platform or my broker has. Once I’ve checked that my order
was executed in the way that I wanted, the trade moves into the
monitoring phase. In this phase, I try to follow my rules and let
the trade run. However, if unplanned things occur in the
environment of the trade I have to be careful and, perhaps, break
off the trade prematurely. Then as soon as the trade is ended,
once again, I check all the executions and enter it into my trading
diary.

At the same time, naturally, once again I wait and watch for a new
trading opportunity.

At the end of the day, I review my work once again and make an
analysis based on the charts and the notes in my trading diary.

I carry out this routine every day. Every step requires a different
mood. Of course, it’s possible to remain in the same mood for the
whole day. However, I doubt that this is productive. For every task
there’s an optimal mood as well as an optimal perspective. We can
adopt an associative perspective or a dissociative perspective.
The advantages of both perspectives have already been
described. In the following table there’s a list of the right
perspectives for each task.

Task Associative Dissociative Mood Focus

perspective perspective

Morning self-check No Yes Open, meditative Broad

Intensive preparation for the Yes Yes Concentrated, Broad

trading day analytical, imaginative

Development of a specific Yes No Creative, anxious or Narrow

trading idea cautious

Waiting and watching phase No Yes Calm, later on keyed Broad

up

Initiation of a trade Yes No Aggressive Narrow

Checking Yes No Critical Narrow

Monitoring of the trade No Yes Relaxed, calm Broad

Breaking off a trade Yes No Aggressive narrow

Keeping a record in the No Yes Pedantic Broad

trading diary

Daily follow up No Yes Critical Broad

For the self-check in the morning it’s important to adopt a

dissociative perspective. This is the only perspective that allows us
to make an objective assessment of our needs and our state. In a
state of association we would be dominated solely by a feeling.
We wouldn’t notice other possible needs that are overlaid by this
feeling. Our focus should be very wide - which is typical for a
dissociative mood - in order to become aware of as many moods
and needs as possible.

Our mood for tackling this task should be meditative. That’s how
we manage to listen to our inner voice. Unproductive moods, in
which you’ll hardly be able to tackle this task, are, for example,
stress or euphoria. You wouldn’t be able to carry out the daily self-
check successfully in a state of stress or euphoria because these
moods would block your ability to perceive.

Once you’ve successfully completed your self-check you’ll know

whether or not you’re going to compete with your trading rivals and
you’ll also know to which needs you have to pay attention, despite
a long trading day. Don’t neglect these needs, even if you’re
convinced that on this special trading day you’ve no time for them.
This is because the longer you push these needs to the back of
your mind, the more difficult it’ll be for you to remain in a poised
state over the course of the day.

In the next step, you devote yourself to the intensive preparation of

the trading day. For this, once again, it’s important to have a
dissociative perspective so that your focus is as broad as possible.
In particular, once again, you have to be very objective, which is
easier to do in a state of dissociation.

For the preparation of the trading day you should put yourself into
an imaginative mood. Try to imagine as many scenarios as
possible for the trading day and the development of the market.
The more scenarios that you’re able to imagine, the more flexibly
you’ll be able to react to events during the day.

Other moods that could help you to tackle this task are states in
which you are concentrated and analytical. It’s precisely when
you’re in an analytical state that you have enough distance from
the market in order to be able to carry out your planning more
objectively. Your focus should be broad so that you can let your
imagination run free.

Once you’ve prepared yourself generally for the trading day, now
follows the phase in which you plan a specific trading idea. This
phase is very distinct from the preparation of the trading day, as
you now have to narrow your focus. The best way to manage this
is in a state of association. Frequently, traders make the mistake
of adopting an associative perspective at the start of their trading
day. While this perspective makes it possible to have a high level
of concentration, nevertheless, because of the narrow focus the
result is that the trader becomes aware of too few things and,
mostly, doesn’t start the trading day particularly objectively.
It’s better not to adopt an associative perspective before you start
planning a specific trade. A very productive state for the optimal
planning of a trade is one of fear or caution. It’s because if, at this
point in time, you allow fear, it’s unlikely that this mood will disturb
you later on in your trading. Fear is actually a signal from your
body that’s supposed to protect you.

If you allow fear during the planning, you’ll be able to use that
signal in a meaningful way. Have you prepared yourself well? Is
the risk acceptable for you personally? Does the trade comply with
your trading plan and are you following your trading rules? You’ll
give honest answers to all these questions if, during the planning
of a trade, you put yourself into an anxious state for a short while.

A somewhat milder form of this is a cautious mood. It can also

provide you with productive support during the planning of a trade.

However, before you really begin your trading day, you should
ensure that you’re no longer in an anxious or cautious state. As
helpful as these states are at the planning stage, nevertheless,
during a trade their effects are harmful. Traders begin to have
doubts, they’re not bold enough to follow a signal, or they exit too
early from their positions. That’s why you should ensure that at the
start of the trading day you switch into a calm state.

In order to make sure that this switch happens, you should, in any
case, adopt a dissociative state for a short time and observe
yourself. You should then maintain this calm state. You should only
fall back into a keyed up state shortly before the market
approaches your entry prices.

In the course of this, think of a predatory animal that’s lying in wait

for its prey. The focus of the predator remains broad. It’s only once
the prey gets close enough that the focus becomes very narrow,
as it’s only then that the hunter can allow himself to focus all his
concentration on the prey.

At the moment when you want to enter the market, once again,
you’ll adopt an associative perspective. You should now switch
into an aggressive state. This is because now it’s important for you
to devote all your concentration on the entry. This works best in an
aggressive state.

For example, think of the pit traders in Chicago. They don’t have to
type in their orders but, instead, get their orders through in the pit
by shouting. Aggression ensures that the necessary decisiveness
is there because those who are aggressive don’t back off and it’s
easier for them to assert themselves. That’s why this is the optimal
state for this point in time.

The most difficult switch comes immediately after your order has
been executed and you’ve checked your fills. You have to switch
from an associative perspective right away into a dissociative one.
Otherwise, as is usual for an associative state, you’ll have a
greatly heightened awareness of your emotions. Usually, this then
leads to an emotional roller coaster ride, as the prices move for or
against your position.

If you don’t manage to get out of the associative perspective then

the trading day will be very strenuous for you and, after some time,
you’ll feel stressed. We can’t and nor do we have to maintain, for
the whole day, the level of concentration that we need during the
entry.

As soon as you start to monitor the trade, you should relax. For
beginners, in particular, this switch is very difficult. However, if you
have specific exit rules then there won’t be much more for you to
do now. All you have to do is simply follow your exit rules - you’re
not able to influence anything else. During this phase, you’re only
going to be able to relax if you’ve developed a high degree of trust
in your exit rules. If you manage to get into a relaxed state then
you’ll be able to enjoy your trading.

You’ll only return to an aggressive state and an associative

perspective when you break off the trade because, here, as in the
entry, you have to ensure that your order is executed quickly and
correctly.

If you trade several signals daily then, during the trading day, you’ll
constantly have to switch between an associative perspective and
a dissociative one. This switching has to become routine but it will
help you to manage your trading day better.

In order to write your notes in your trading diary you should put
yourself into a pedantic state so that you’ll document as precisely
as possible what you’ve traded and why.

When the trading day is over it’s advisable to carry out a critical
review of the day. What mistakes did you make? Can you avoid
making these mistakes in the future? What was good, what could
you have done better? You really should note down all your ideas
and conclusions in your trading diary.
 6.3 Excellence through mood control
Besides the above-mentioned moods there are, of course, other
productive states to help you tackle the necessary tasks. It’s
important for you to understand which states are productive and
which aren’t and that you make use of the resources available to
you in order to get yourself into a productive state.

It may well be possible to earn money in an unproductive state,

too, but how much more money would you have earned if you’d
been in a productive state? It’s only when we’re in productive
moods that we can make optimal decisions and generate top
performance.

Think of two athletes who have the same physical strength. The
athlete who’s able to get him/herself mentally into a better state
will win a race, in other words, the one who is able to get into peak
condition.

Trading isn’t just about a mechanical concept. You can only

achieve trading excellence, the true art of trading, when you’re in a
mental state that helps you. This is the only way that you can
actually use an unbeatable weapon in your trading. This weapon is
called intuition. The art of trading means constantly following many
routines but using your intuition at the right moment.

In the same way that a very good chess player, who knows and
uses hundreds of standard moves, can win a game by using his
intuition at the decisive moment, as a trader you have to know
when your intuition can help you. That’s the only way that you’ll
achieve a state of excellence.

How can you induce this state?

These are the principles that you have to follow in order to achieve
this peak condition:

6.3.1 Commitment/vocation
Making a commitment means devoting yourself to a task, or
having a sense of vocation (a calling) for a task. If you don’t have
a sense of vocation for trading you won’t be able to find sufficient
strength to endure setbacks. You’ll allow yourself to be distracted
by many things and you won’t do your utmost in order to achieve
your trading goals.

Imagine that you’ve got two weeks of free time and don’t really
know how you should spend your time. You plan a trip to the sea.
On the way, you stop at a rest and service area and order for
yourself a snack-to-go. You get back into your car and drive a few
kilometers further until you get to a quiet location in order to have
a picnic. As you unwrap the bought food you realize that it’s stale.
Quite rightly you’re angry.

As you’ve got nothing better to do you’ll probably drive back to the

rest and service area and complain. When your complaint is not
taken seriously you ask to see the manager. As he’s not there you
ask to be given his name and address, you keep the stale food,
maybe you show it to the other guests and ask them to act as
witnesses to your complaint and you gather evidence. Then you
drive home and you go to the trouble of writing a letter to the group
head office, another letter to the public health department and
possibly also one to the local newspaper. You spend a whole day
pushing through your grievance.

Now, let’s compare this situation with a story where something

similar happens to you. However, this time you’re not on leave but,
instead, on your way to an important business appointment. You
know that you’ll only be able to close the deal if you’re punctual.
As the journey is very long, you stop on the way to get some take-
out food. After you’ve paid for your purchases, you get into your
car and drive on. A few kilometers further, while you’re driving, you
unwrap the food and you realize that it’s stale. Quite rightly you’re
angry.

Will you turn back this time, too? Probably not. You wrap up the
food again and continue on your way in order to close your deal.
Nothing is going to stop you. When you arrive at your customer’s
premises you throw away the stale food. That was the last time
that you thought about it. That’s because on the way back you’re
so fired up by the deal you’ve just closed that you don’t want to
allow your good mood to be spoiled by an argument with the rest
and service area owner.

These two stories should demonstrate to you what it means to

have a sense of vocation. If you have a clear goal in mind then
you won’t allow yourself to be distracted by trivialities. In the
absence of this goal you won’t have all the resources available to
you, as you’ll be easily distracted and will then expend your
energy on other things.

Having a sense of vocation means wanting something with all your

heart, making no compromises and being able to set priorities. You
can’t just say: As from today, I have a sense of vocation for
trading. Commitment means subordinating all goals and plans to
the task for which you have a sense of vocation and organizing
your life in such a way that you can contribute all your resources
for this task.

6.3.2 Passion
Commitment and passion are very similar. You have to feel the
passion in yourself. You’ll only be able to arouse this passion if
trading is completely in accordance with your value concept.

Passion is a motivation that drives you on and releases

unimagined energy in you. It’s passion that, despite setbacks,
drives you on to continue accumulating experience and gaining
new insights. Without passion there is no excellence.

6.3.3 Demand more of yourself

What are you satisfied with? Do you want to earn some money on
the market, or do you want to be one of the best traders? Trading
isn’t a hobby or a leisure-time activity. Anyone who wants to be
average should, preferably, make a couple of long-term
investments and hope for a return of between 5 and 10 percent.
For trading, however, you have to use so many of your own
resources that a result of 5 to 10 percent wouldn’t motivate you to
give your all. Only those who constantly demand more of
themselves will be successful, excellent traders.

6.3.4 Belief systems that provide you with support

Many traders are passionate, however, they have belief systems
that limit them and prevent them from being truly successful. The
importance of convictions has already been discussed. Our belief
in who we are and what we’re capable of is key to what we can
accomplish. It’s only when we’re convinced that we can also make
intuitive decisions that we’ll become aware of intuitive signals from
our bodies and be able to act on them.
 6.3.5 Trust in yourself
For this it’s necessary for us to trust in our own strengths,
performance and experience. Self-confidence is a key ability of
successful traders. You won’t acquire self-confidence overnight.
That’s still why nobody’s born a Master Trader.

Self-confidence is acquired through experience. The more you

experience, the more confident you’ll become in your métier.
Please don’t believe that trading for six months, or even for two
years constitutes sufficient experience. No book or seminar can
relieve you of going through this process.

However, books and seminars show you helpful shortcuts to

acquiring experience. You can learn either through trial and error,
or by taking a look at the principles of traders who are already
successful. Yet, even experiences that you take over in this way
have to be internalized before you can trust in yourself sufficiently.

6.3.6 Intuition
Trading excellence means being able to make decisions intuitively.
Intuitive decisions are not made on a conscious level; they’re
decisions from the subconscious and, therefore, can be made
quickly. That’s why it’s important for you to learn how to deal with
intuitive decisions.

Frequently, they merely serve as an excuse for traders as to why

they’ve broken their rules. However, we know that the ability to
follow rules depends on being in the right state. That’s why it’s
important for you to be in a productive state if you want to follow
intuitive decisions.
If you’re stressed you won’t be able to make the right intuitive
decisions. The same applies if you’re too fixated on a goal. The
only state that allows you to make the right intuitive decisions is
one of poise. It’s a state of calm without any distractions and one
in which no pressures, whether financial or psychological, drive
the traders to make hasty decisions. Here, they’re in a state of
being and they can listen to their inner voice, uninfluenced by
hopes or fears.

That’s the reason why so many traders fail. They never achieve a
state of poise.

You can only acquire intuition if you already have a broad horizon
of experience. At some point in time, you’ll be able to make
unconsciously those decisions that you’ve made consciously a
thousand times.

Perhaps you can still remember your first driving lessons and the
difficulty that you had when you had to operate the gear lever and
engage the clutch at the same time. Frequently, you forgot to push
down the clutch pedal and stalled the engine. However, the more
frequently you drove the car, the more automatic the process of
engaging the clutch became - until you didn’t have to think about it
anymore. Now, the whole process happens in the subconscious
and doesn’t require any more resources.

It’s the same with trading. The more frequently you run through a
trading routine with the same pattern over and over again, the
easier it will become for you to make decisions.

Factors and patterns that you’ve very frequently been aware of -

perhaps without paying particular attention to them - have been
pieced together as a picture in your subconscious. Without being
aware of the exact decision-making strategy, you develop a sense
of what is and what isn’t the right time for a trade.
Intuitive trading doesn’t mean dispensing with rules. You still have
to adhere strictly to your risk and money management rules. Yet, it
often helps you to make decisions very quickly.

How can you encourage intuitive decisions? First of all, you have
to train and trade for a long time. You have to look at thousands of
charts and monitor market sentiment very closely.

Check your decisions constantly. What have you seen, heard and
sensed? A psychological trading diary in which you make a note of
your perceptions for each trade will help you in this.

However, the most important step is to develop confidence in

yourself and your own trading style. This also means no longer
carefully examining everything but, instead, taking things as they
are. Learn to deal with this. Don’t try to understand intuition but,
instead, try to trust it.

6.3.7 Don’t fight, but trade

“Hence to fight and conquer in all your battles is not supreme
excellence; supreme excellence consists in breaking the enemy’s
resistance without fighting.”

Sun Tzu, “The Art of War”

Frequently, traders view their task as a battle - a battle against the

market and a battle with themselves. Even if this view mobilizes a
lot of resources and motivates traders, yet in this way, they can
never attain a state of poise.

Those who fight have to exert themselves. While they’re

constantly doing something they still haven’t even found a path
toward achieving their goals. Think about the state of being. It
differs from those of “doing” and “having” in that the trader is
poised and doesn’t always have to be active.

Fighting means using a lot of energy. Traders who fight constantly

very quickly burn out, or their health suffers as a result.

Trading success has nothing to do with fighting but all the more
with personality. Only those who are open, flexible and poised and
have a high – without being excessive - degree of self-confidence
and are, thus, able to summon up self-assurance, will achieve true
excellence.

Losers are distinguished by precisely the opposite characteristics.

Just read the online message boards about trading. How many
traders there radiate only hatred, envy as well as malice and are
both intolerant and inflexible. Have you every wondered why these
so-called traders express themselves in such a scathing way?
They’re probably venting their anger at having lost the battle with
the market.

The moment you stop viewing trading as a battle you’ll be a

successful trader - or you’ll have ceased trading.
 7.
CHAPTER 7

How do I find out what’s a good bet? Traders are risk

managers. Nobody knows whether they’ve got a good trade or
a bad trade ahead of them, however, good traders always know
how big their risk is.
 7.1 Market analysis and its significance
Do you know anyone who’s able to predict the future for you?
Unfortunately, I don’t - although, for a long time, I believed that on
the stock market this had to be different. Indeed, I was convinced
that, like in the natural sciences, on the stock market there are laws
that describe a cause and effect process and that the movements on
the markets follow these laws. However, even if this were the case,
then we would still lack the instruments that you need in order to
look into the future to see what events would occur tomorrow or the
day after, which would then produce their effects on the market in
accordance with the laws.

If we’re unable to predict the future, we could at least assume that

future price changes depend, to a certain extent, on historical price
movements. Whether prices will go up or fall could possibly be a
function of previous price movements. Market analyses based on
this approach are usually referred to as technical analysis.

It’s frequently argued that even if there is no relationship between

historical prices and the future, it’s sufficient if simply enough traders
assume this, base their trading on it and, in this way, bring about the
occurrence of the results of technical analysis. We then refer to this
as “a self-fulfilling prophecy”.

Charts or indicators are supposed to give information about future

price movements. As appealing as this idea is, in trading, however,
such a belief can quickly become an obstacle. Most traders become
inflexible as soon as they arrive at a market opinion through their
analysis. Then, they’re neither willing to trade against their
assessment of the market, nor will they exit their positions before the
target price has been achieved. They’ll never let their positions run if
their target prices have already been achieved.
Through this inflexibility they eliminate opportunities for themselves.
Often enough they also think that a good analysis can compensate
for poor risk management.

The forecasting ability of individual indicators or chart patterns is,

generally, overestimated. In particular, the idea that markets can be
predicted steers traders down the wrong track when it comes to
developing a functioning trading system. A large part of the
development work is then concentrated on increasing the system’s
probability of a hit. Although, the probability of a hit is irrelevant.
Many successful trading approaches and trading systems are
effective with hit rates of less than 50 percent.

For the sake of simplicity, let’s assume that a system generates ten
trades per year. Seven of them are stopped out with a loss and only
three signals are successful. When the system gets it wrong, it loses
Euros 1,000 each time, when it wins it generates Euros 2,500. Even
though the system was successful in only 30 percent of cases,
nevertheless, a plus of Euros 500 still remains.

That’s why, in order to be a more successful trader, it’s not at all

necessary to predict price movements correctly.

At this point, it’s frequently argued that a system could be even more
effective if the large number of loss-making transactions could be
reduced.

Whether or not an individual trader will be a winner or a loser is a

process over which we have no control. If we were able to control it,
of course, we would only make profitable transactions and would
have a hit rate of 100 percent. If we know that we’re not able to
achieve 100 percent control of certain factors, then we shouldn’t
even attempt to control these factors in the first place. It’s because
this would then mean that we allow factors such as good fortune or
bad luck to play a role in our trading outcome.
Another argument as to why market forecasts could be problematic
for many traders is that in our heart of hearts (or rather our ego) we
want to be right. Once we’ve formed an opinion, whether it’s about
the market or something else, then it’s difficult for us to give up this
belief again. We defend our opinion with all the means at our
disposal - which, in the case of traders, can become a very
expensive business.

Worse than the possible losses is the emotional destabilization that

occurs when, after a series of losses, we have to realize that we
were wrong. Our society doesn’t tolerate losers and since going to
school we’ve learned that there is only “right” or “wrong”. Moreover,
doing something wrong doesn’t contribute to our wellbeing. With
every further trade, a trader feels worse and slides into a loss-
making spiral.

It should be noted that reliable market forecasts are not possible

because no one is able to predict the future and market analyses
can hinder traders as regards their flexibility and mood.

Yet, how should traders know whether they should go long or short if
market forecasts have no value for them? In order to answer this
question traders don’t have to make a forecast that is focused on the
future but, instead, look at what the market is doing right now.

Perhaps the following comparison will help you. Imagine that you
want to go for a walk outside and you’re thinking about whether or
not you should take an umbrella with you. To help you make your
decision you could consult a weather forecast that, like a market
forecast, is nevertheless uncertain, or simply look out of the window
and observe what the weather is like at the moment. If the sun is
shining then you’ll leave the umbrella at home, if it’s raining you’ll
take the umbrella with you. If the situation isn’t all that clear then
you’ll simply stay at home.
Precisely as in this comparison, as a trader you should simply look
at what the market is doing currently and act accordingly. If it’s going
up then you buy, if it’s going down then you sell and if you don’t
know exactly whether the market is going up or down then you
shouldn’t do anything at all.

In order to determine the state of a market it’s not necessary to

subject this market to a complex fundamental or technical analysis.
In fact, it’s sufficient to find the “path of least resistance”. Jesse
Livermore coined this term in his book “Reminiscences of a Stock
Operator” and even today this simple method is very effective.

Through careful observation all you have to find out is how the
market reacts to news items and movements in correlating markets
and with what momentum its movements develop.

In a bull market, good news should result in acceleration; the market

should show relative strength in relation to correlating markets and,
as a rule, breakouts will be dynamic. The market usually deals well
with bad news, or it even ignores it.

Put simply, traders should always trade with the market. If the
market is going up then they should buy, if the market is falling they
should simply sell. “Don’t challenge the market” or “The trend is your
friend“ are old trading adages that recommend exactly this
approach.

Of course, this method isn’t a guarantee that, just after we’ve

executed our transaction, the market won’t turn significantly and
exhibit behavior that is different than what we observed. In exactly
the same way as it can suddenly start to rain, even though just now
the sun had still been shining so, too, on the market there can be
swings in sentiment. Then, it’s our stop that ensures that we don’t
lose too much money.
Yet, doesn’t such an approach completely rule out anti-cyclical
behavior? Yes, at first sight, because my advice is to trade with the
trend. Nevertheless, it would be unwise if traders, through their entry
method, excluded the possibility of anti-cyclical trades.

The big money is not made with individual price fluctuations but,
instead, with trends. It’s the big market movements that make
traders rich. For this it’s not necessary to sell at the top and buy at
the bottom. It’s more important to recognize the momentum of a big
movement and to be able to exploit this movement to a large extent.
Thus, it’s not so important to buy low or to catch the high for a short
commitment but, instead, to trade consistently once a trend reversal
has already become apparent.

In this connection, the path of least resistance should be pointed out

once again. Prices dynamics always develop in the direction of least
resistance. Of course, this movement is not infinite and there will
come a point at which the movement will, firstly, weaken, will then be
slowed by resistances and, at some time, will again take the path of
least resistance and go in exactly the opposite direction. The prices
will then strike out on this new path. However, a patient trader will
wait until the market has indeed struck out on a new path, as
wanting to anticipate a movement in the market usually makes little
sense.

It’s impossible to determine, with a high degree of certainty, the point

at which a trend encounters so much resistance that it can’t continue
its movement anymore. That’s why I prefer pro-cyclical trading
strategies.

Although, in certain cases, it can make sense to bet on trend

reversals. Two conditions have to be fulfilled for this. Firstly, the
trader has to have developed a methodology that, at least, can
identify that the resistance to the current trend has become
significantly bigger. Please note that any observation related to the
path of least resistance is not focused on the future but, instead,
assesses past and current market activity. Thus, if traders speculate
on there being a trend reversal, they should already have observed
that resistance in the direction of the existing trend has increased
significantly.

The second condition is that the payoff ratio for the trade in relation
to the risk incurred should be very high. If you speculate on there
being a trend reversal then your goal shouldn’t be to earn a “few
points” on the market but, instead, a multiple of the degree of risk
incurred. Let’s assume that, in any desired market, the risk from the
purchase to the stop is 20 points. In such a case, if you enter into an
anti-cyclical trade, then your target price should make it possible to
generate a profit of at least 60 points (three times the level of risk).

Even though I use anti-cyclical trading strategies, I’d advise all

traders to concentrate mainly on trend-following strategies. This is a
much easier way to earn money (a lot of money) on the market.
Only once you’re able to trade successfully with pro-cyclical
strategies should you use anti-cyclical strategies, too, with a view to
expanding your trading repertoire.

The significance of market analysis has less to do with predicting the

direction of the market with a high probability of a hit. What’s more
important is being able to draft a complex map of reality with the
help of market analysis, in order to maintain an overview. Market
analysis isn’t crucial for success in trading. It’s not there to predict
price movements. It’s there so that you can evaluate your risk,
realize where the limits are and where the path of least resistance is
going. It should never be used to justify anything. Certainly not to
justify a position.

Use market analysis like a map on which various paths are depicted.
If you use market analysis in the usual sense of the term - in order to
predict the direction of the market - your map will only plot one way.
Maps on which you can see only one route are very primitive and
only help you if stay on that route. It’s because the map is never the
reality and that means that you lose your way as soon as you
deviate from a predetermined route.

Good traders use market analysis differently. Their goal is to draft a

map that is as complicated as possible, which although it can never
describe the reality, nevertheless, helps them to find their bearings in
reality. There are many routes charted on these maps. Resistances
and supports will also be found on such a map, in the same way that
you’ll find mountains and rivers on a geographical map. However,
neither type of map gives any indication that a particular obstacle
can be overcome. Instead, there will be pointers to the difficulties
that might be encountered on the route.
 7.2 The risk/reward ratio
If with the help of market analysis we’re not able to find out where
the market is headed, how then are traders supposed to be able to
determine whether the next trade does or doesn’t make sense for
them? They know that they have to place a bet but don’t know what
the probabilities are for a win with this trade.

Traders have to decide whether the bet ahead of them is a good one
or a bad one. As they don’t know anything about the probability of
winning they have to make an assumption. Let’s assume that the
trading result is as random as the outcome of flipping a coin, thus, it
would be advisable to assume a hit rate of 50 percent. In order to be
on the safe side and because we don’t want to make things too
difficult for ourselves on the market, let’s assume that our hit rate is
below 50 percent.

Yet, how can we be successful if less than half of our trades are
profitable, for example, let’s say 40 percent? This can only work if in
the cases where we do make a profit it’s significantly more than what
we lose in the case of a loss-making trade.

Here’s an example. Imagine ten random trades. Six transactions are

closed with a loss of Euros 100, two are stopped out at break-even
and only two transactions generate a profit of Euros 400. Even
though 60 percent of our transactions were negative, in this case we
win; overall, there’s still Euros 200 because the payoffs for those
times that we did win were significantly higher than the losses.

A wager is usually good when the payoff rate is significantly higher

than the risk. Unfortunately, we don’t know in advance what the
payoff (thus, the profit) of our trade will be. What we certainly do
know is our maximum loss per contract. The difference between the
entry and our initial stop is the maximum amount that we’re
prepared to lose. If you assume that there’ll be no slippage, this
amount is our risk.

Yet, how can we determine our payoff rate? The payoff rate can only
ever be known once the transaction has been completed. That’s why
in our calculations, instead of the payoff rate, we have to manage
this by taking into consideration a potential capital gain.

The difficulty here lies in making a realistic estimate of the price

potential.

That’s why, in order to make this estimate, you should answer the
following questions beforehand:

What’s the average duration of one of your typical trades: one to five
minutes, an hour or a day?

On the basis of what timescale do you make your entry decisions:

tick chart, five-minute chart, hourly chart?

The response to these questions will show you how long you
normally remain in a trade. Now, while taking into account the
current market volatility, you have to find out what were realistic
market movements within this time frame in the past.

Let’s take the example of a DAX day trader who usually executes
just one transaction and uses a trend-following approach.

He has to know what the average daily range of the DAX is (for
example, 60 points).
He has to know when it’s likely that the market will be able to
continue running even though it already has a large part of the
average range behind it (for example, in the case of new items of
market news, important technical breakouts, etc.).
He has to identify supports and resistances.
He has to know if, on the trading day, important economic data will
be published that could possibly further increase the volatility.
Taking into consideration the above-mentioned parameters, the
trader can define a realistic target price for his trade. The difference
between the target price and the entry represents the opportunity
that could result from a possible trade.

If the trader wants to find out whether or not the trade is a good bet
then he has to compare this opportunity with his risk.

The opportunity is the amount that I expect to gain if my target price

is achieved and the risk is the amount that I would lose if I’m
stopped out at the level of my initial stop.

A bad wager is always one where the loss ratio in relation to the
profit ratio is greater than the risk/reward ratio. For example, if I have
a loss ratio of 60 percent, then my risk/reward ratio has to be greater
than 1.5 for the trade to be acceptable and to represent a good bet
for the trader (loss ratio/ profit ratio < risk/reward ratio, thus 0.6 / 0.4
= 1.5).

I try to make my life as a trader easy for myself and I also want to be
successful if less than 50 percent of my trades end up in profit.
That’s why, for me, it would always be a bad wager if my risk/reward
ratio were below 1.5. I would only enter into a transaction if I could
earn at least 1.5 times my risk.

However, I only use this risk/reward ratio when I’m evaluating the
trade. As soon as I open a position then it doesn’t matter anymore to
me, as I believe that you can’t predict the market.
 7.3 Criticism of the risk/reward ratio
The concept that we should never enter into transactions unless we
can expect a profit that is, at least, 1.5 or two times, even perhaps
three times as big as the possible risk is surely one of the oldest and
most logical trading concepts and one that appears in many trading
books.

Nevertheless, at this point, I have to issue a clear warning.

Determining a target price is nothing other than an attempt to predict
the market. This concept assumes that if we correctly guess the
direction of the market then we can even predict the strength of the
movement. Yet, my philosophy implies that we’re not able to predict
the market. The future is uncertain and nobody can foresee where
the market will go and certainly not how far. Gaging the potential of a
trade goes beyond even market analysis, which is merely an attempt
to find out the direction of a future movement.

We know that we can’t make a forecast. Why then am I indeed

suggesting that the risk/reward ratio should be determined before
each trade?

It’s because monitoring the risk/reward ratio, usually, protects us

from doing something stupid. All too frequently, traders run after the
market even though a large part of the movement has already
happened and there is only minimal profit potential. Calculating a
risk/reward ratio usually leads to traders making fewer trades,
however, they think more about the transactions that they do make.
It’s not important whether or not the target price is actually realized -
the trade could possibly be stopped out with a profit beforehand
already, or possibly the market could massively overshoot the target
price. What does matter is for traders to have a criterion that, in
terms of both their trading concepts and of statistics, induces them
to trade rationally.
For example, speculating on a profit of five points with a risk of 20
points is irrational behavior.

The risk/reward ratio is a statistical concept that’s closely linked to

the expectation value of a trading strategy (see also the next-but-
one section “The expectation value”). The ratio is supposed to
enable traders to make a rational decision before opening a trade.
To this end, it has to be based on fictional quantities and
assumptions. With the help of the given assumptions (such as the
hit rate, risk and target price) it’s possible to determine, on a
mathematical basis, whether or not the trade makes sense (is
rational). Once the decision to go ahead with the trade has been
made, then the risk/reward ratio doesn’t actually matter anymore.

Thus, it should be noted that this method shouldn’t be used to

determine how far the market will go but, instead, only whether or
not it would make sense to enter into a trade if the market does run
to the specified target price. If traders calculate that, statistically, this
doesn’t make sense then they should abandon the trade.
 7.4 The hit rate and the payoff ratio
With the risk/reward criterion we’ve found an instrument with which
we can assess whether or not a trade is a good bet. Avoiding bad
bets helps traders to survive in the market and to enhance their
performance. However, as we don’t see into the future and can’t
predict the outcome of our wager on the market, the risk of losing
the bet remains.

However good the risk/reward that traders incur, if they continually

lose their bet then, sooner or later, they’ll go bankrupt. In order to
avoid ruin, traders have to have a total of three variables under
control. Some of these they’ll be able to control well, others they
won’t.

Most traders focus the largest part of their attention and

concentration on the hit rate. It shows what percentage of
transactions, executed by the trader, has been successfully
completed. Whether the success was only marginal, or whether a
huge profit was generated is not taken into account here. Traders
usually wish to have a high hit rate, as high hit rates affirm the ego of
every trader. Who doesn’t like to be right the whole time?

The simplest way to generate a high hit rate is to dispense with

stops and to realize every gain, however small, immediately. After
all, sooner or later, most trades will be profitable.

Only, the disadvantage of this method is that the few trades that
never make a profit produce such big losses that the trader would
undoubtedly go bankrupt. That’s why traders have to set stops in
order to limit their losses. However, once they’ve decided on a stop
price then they no longer have control over their hit rate. Now, it’s
the market that determines whether a trade will be stopped out or
whether the trader is able to end it successfully.
Of course, with the choice of a stop price, traders have a certain
amount of influence on the hit rate because the closer the stops are
to the market, the more often traders will be stopped out with a loss.
They simply have to set the stops further away from the market in
order to increase their hit rate; yet, this influence on the hit rate can
only be acquired at the price of bigger losses.

The hit rate is a statistical variable, which undoubtedly affects

performance and the risk of going bankrupt. The link between the
risk of going bankrupt and the hit rate is shown in the following chart:

The risk of ruin and the hit rate

As can easily be seen, the risk of bankruptcy increases as the hit

rate falls. Traders usually wish to have hit rates of more than 50
percent.
However, the hit rate, in itself, doesn’t provide any useful information
about the performance of a system. Frequently, it’s actually the
traders with high hit rates that are among the losers in the market,
as they generate only small profits and, now and again, big losses.
Most top traders have hit rates that are below 50 percent - despite
the risk of going bankrupt with falling hit rates.

The risk of going bankrupt can only be offset by another variable,

namely by the payoff ratio. This figure puts average profits in relation
to average losses. The higher the payoff ratio is, the higher the
average profits are in relation to average losses. As can be seen in
the following chart, the risk of going bankrupt increases when the
payoff ratio falls. The smaller the payoff ratio is, the more probable it
is that you’ll go bankrupt.

The risk of ruin and the payoff ratio

This can be briefly explained with an example. Imagine that, each

time, you make a loss of Euros 1,000, but when you’re in profit you
immediately realize Euros 100. Thus, your average loss is ten times
as big as your average profit, so the payoff ratio is 1 / 10 or 0.1.
Therefore, in order to compensate for a loss-making trade you need
10 profitable trades. The probability that you’ll have ten consecutive
profitable trades in order to be able to offset the loss-making trade
depends on your hit rate. However, even with a hit rate of 80
percent, the probability of ten consecutive profitable trades is only
8.5 percent. Thus, with a low payoff ratio, the risk of ruin is very high.

The situation is different if you always lose only Euros 100 but
pocket Euros 1,000 on average. While this payoff ratio of ten is not a
guarantee that you won’t go bankrupt, yet the probability is
significantly lower than in the previous case. For each profit, you can
even afford to make losses ten times without this pushing your
account into minus.

So, we note that the higher your payoff ratio, the less likely it is that
you’ll go bankrupt. Yet, how do we get a high payoff ratio? We have
to keep our losses small, thus limit them. We get a low payoff ratio
through narrow stops. However, as we’ve learned, narrow stops
reduce our hit rate. Thus, we see that an attempt to manipulate one
of these two variables - the hit rate or the payoff ratio - affects the
other variable. We’re not able to achieve an improvement in the hit
rate by placing the stops further away, without, in the process, also
reducing the payoff ratio.

When you recognize that there is this link then you come a great
deal closer to the secret of top performance.

In seminars, at this point, it’s frequently argued that I can indeed

improve the hit rate without doing anything to my stops, simply by
finding “better” signals. This line of argument assumes that you’ve
found a method that can predict, with a high degree of probability,
the future on the market. Naturally, the method with the best
prediction will also produce a better hit rate.
However, according to both my experience and my philosophy,
nobody can predict the market and, thus, every method that is
based on using clairvoyance to forecast future market movements is
an illusion. Even if there were such a method, it’s not worth looking
for it endlessly because there’s a simple way to generate profits
continually on the market, without having to predict what the market
will do in the future.

So let’s make it easy for ourselves. Let’s put our trust in a method
that will already bring us profits if we simply conduct ourselves
correctly in the market. This method isn’t based on high hit rates but,
instead, on maximizing the payoff ratio. Such a method makes more
sense than an attempt to predetermine where the market is going.

Unfortunately, in trading, we only actually have control over very few

variables and it’s only when we make effective use of this control
that we’ll manage to be successful traders.

Thus, unfortunately, we’re only able to influence the hit rate to a

certain extent by setting our stop prices closer or further away.
However, the unforeseeable development of prices on the market
still has a far-reaching impact on the hit rate. It’s simpler to control
the payoff ratio, which can be maximized if we find a method with
which we can keep losses small and let our profits run.

With the choice of an initial stop, the maximum loss per contract will
already have been specified. By using intelligent exit rules, the
average loss will even be significantly lower than the initial risk level.
Now, if we can also mange to exert influence over the size of the
profit, then we’ll have an effective way of controlling our
performance.

We can’t predict whether the next trade will be a winner or a loser.

Thus, the outcome of every individual trade is random. However, the
size of the profits or the losses in a trade isn’t random, as we have
influence over these parameters. What’s important is not the number
of losers or winners but the magnitude of the profits and losses.
That’s why the hit rate is of secondary importance, while the payoff
ratio is a key variable that should be given our full attention.

To put it another way: The hit rate of any system is determined by

the entry criteria and the exit rules. However, the size of the profits
and losses has nothing to do with the entry strategy but, instead,
solely with the exit rules and our money management algorithm.
Thus, it’s the exit rule that has the biggest influence on a trading
system. Optimizing it is the secret of top performance.
 7.5 The expectation value
The expectation value is a concept taken from statistics. Even if you
hate mathematics and statistics, it’s crucial for successful traders to
understand this concept.

A trading strategy with a positive expectation value is a basic

prerequisite for a trading enterprise to have positive results. An
expectation value, generally, shows the average amount per
transaction that a trader can expect to gain. Therefore, the
expectation value has to be positive if a trader wants to be
successful.

Two variables are incorporated into the calculation of the

expectation value: firstly, the hit rate of the system or a strategy and,
secondly, the average payoff ratio. The formula for the expectation
value describes in a relatively simple way the interaction of the two
variables, namely, the hit rate and the payoff ratio.

If we multiply our hit rate (HR) by average profits and then, from this
amount, deduct the product of the loss ratio (LR) and the average
loss we, thus, get the expectation value.

Formula:

(HR x average profit) +

(LR x average loss) = expectation value

Even if you don’t like statistics very much, it’s worth taking a closer
look at this formula. The expectation value always goes up if either
the hit rate is very high, or if the average profit in relation to the
average loss is very big.
You should try this out by calculating the expectation value for a hit
rate of, let’s say, 80 percent with an average profit of Euros 400 and
an average loss of Euros 200 and then compare this with the
expectation value for a strategy with a hit rate of only 40 percent.

In the first case, the expectation value is Euros 280.

0.8 x 400 = 320

0.2 x (– 200) = – 40
Total = 280

For the second system we get an expectation value of Euros 40.

0.4 x 400 = 160

0.6 x (– 200) = – 120
Total = 40

Thus, the expectation value falls significantly when the hit rate
comes down. But be careful. This time, calculate the expectation
value when the hit rate falls, as in the above example, but with a
payoff ratio (average profit/average loss) that has gone up instead.
In the first example we had a payoff ratio of 2 (400 / 200). Now we
want to assume that we earn ten times as much as we lose.
Accordingly, our payoff ratio is ten.

This time, with a hit rate of 40 percent we get the following result:

0.4 x 1000 = 400

0.6 x (– 100) = – 60
Total = 340

The expectation value has gone up significantly, even though the hit
rate has come down. Despite a hit rate of just 40 percent, it’s higher
than in the first example where the hit rate was 80 percent. This
effect came about because, compared with the first example, the
payoff ratio had gone up significantly.
Thus, we see that with an increase in the payoff ratio we were able
to improve our expectation value and, thus, our performance. Even if
an increase in the payoff ratio is at the expense of the hit rate we
can overcompensate for this negative effect.

What does this mean in practical terms? Let’s assume that we

decide to improve our system by setting a more narrow initial stop.
Originally, we worked with a 20-point stop, now we want to reduce
the stop to ten points in each case. The impact of the narrower stop
will be reflected in the hit rate, as a narrower stop usually leads to
more frequent losses. Therefore, the hit rate falls, let’s assume, from
50 to 40 percent. With the same payoff ratio, the expectation value
would also be reduced; however, as our average losses likewise fall,
the payoff ratio goes up. Let’s assume that average profits remain
unchanged and let’s also assume that these are 30 points. While,
previously, the payoff ratio was 30 / 20 = 1.5, it now goes up to 30 /
10 = 3.

Expectation value before the adjustment of the stop

0.5 x 30 = 15
0.5 x (– 20) = – 10
Total = 5

Expectation value after the adjustment of the stop

0.4 x 30 = 12
0.6 x (– 10) = – 6
Total = 6

Thus, if traders want to improve their performance they have two

possibilities. Either they increase their hit rate, or they improve their
payoff ratio.

Once we’ve decided on an entry criterion, the influence that we can

exert over the hit rate is very small. Of course, we can test out any
number of entry criteria and select the method with the highest
probability of a hit.

The problem with this approach is that we have no control over the
hit rate. While for every system, we can determine a precise hit rate
for the past, yet, whether or not the system will behave in the same
way in the future remains a mere supposition.

Indeed, it appears that, sooner or later, most trading systems

undergo major changes in their accuracy. However, if we don’t want
to leave decisions that relate to our trading to chance and luck, then
we have to concentrate on the few things that we’re able to control.

For any given hit rate there’s a payoff ratio that leads to a positive
expectation value. If you manage to realize the required payoff ratio
then you’ll be a successful trader.

With a simple calculation trick you can determine how high your
payoff ratio has to be for any desired hit rate. All you have to do is to
divide the loss ratio by your hit rate and that’ll give you the payoff
ratio that is required in order for your trade to break even.

Let’s assume that the hit rate is 20 percent and, thus, the loss ratio
is 80 percent (100 – 20 percent = 80 percent). In this case, we divide
the loss ratio (80 percent) by the hit rate (20 percent) and we get a
payoff ratio of four. All this means is that if you want your trade to
break even then your average profits will have to be four times as
big as your losses.

Try out this calculation with other loss ratios and test your result with
the formula for the expectation value.

0.2 x 4 + 0.8 x (– 1) = 0

If we want to improve our system then we view the hit rate as a

given and we concentrate on the payoff ratio.
As traders, we have two instruments with which we can influence
the payoff ratio.

Firstly, with our exit rule we’re able, to a large extent, to control how
high both our losses as well as our profits are. Are we inclined to let
our losses run and to limit our profits, or have we developed
mechanisms that allow us to keep our losses small and let the
profits run?

The second important instrument for influencing the payoff ratio is

position size. How big is our position size when we lose? With what
position size do we generate profits? Note that the payoff ratio is
calculated per transaction and not per contract. That’s why position
size is a key factor in the calculation of our average profits and
losses.

Traders who want to improve their performance have to make skillful

use of two instruments: an intelligent exit rule and a professional
money management algorithm. In the individual chapters on exit
strategy and position sizing I’ve developed a few suggestions for
these rules.
 7.6 The risk of ruin
You’ve seen that the hit rate is largely insignificant, as long as the
payoff ratio is right. You know that the risk of going bankrupt
increases when the hit rate falls and the payoff ratio falls.

In particular, the payoff ratio is a crucial determinant for the risk of

ruin and I’d like to demonstrate this with the following example.

A trader has an unbelievably high hit rate of 90 percent, as he

always realizes his profit after a gain of three DAX points. In the
event of a loss, normally, he allows the trade to run until it’s in profit
again, however, if the loss gets to 30 points then he applies the
emergency break.

The expectation value for this strategy is

0.9 x 3 = 2.7
0.1 x (– 30) = – 3.0
Total = – 0.3

and is, thus, negative. Accordingly, sooner or later, this trader will go
bankrupt. The risk of ruin for this trader is 100 percent as the
expectation value is negative. Even the high hit rate can’t save him
from the bankruptcy of his account.

What suggestion would you have for this trader?

There are many possibilities for this trader to change his strategy.
He could set a more narrow stop, or increase his profits. Surely,
hardly anybody would suggest that this trader should increase his hit
rate.

With this extreme example, I wanted to demonstrate that it’s easier

to influence his payoff ratio. Let’s now assume that the trader sets
his stop at 20 points and that this does not affect the hit ratio.

0.9 x 3 = 2.7
0.1 x (– 20) = – 2
Total = 0.7

Now this strategy has a positive expectation value. Although, the

advantage amounts to only 0.1 points. This means that, on average,
the trader can expect to earn 0.1 points per trade. The longer the
trader trades, the more money he’ll be able to earn. The only
question is whether or not the trader will at all be able to realize the
positive expectation value of the strategy. In order to succeed with a
strategy, the trader actually has to trade long enough - he has to
stay in the game. Many traders use strategies with a positive
expectation value, however, they never realize this value because
they withdraw from the game before they’re able to do so.

Such a failure always occurs when a trader risks too much per trade.
The bigger the share of your account that you risk per transaction,
the higher the risk of ruin.

Traders are risk managers. Only those who manage to assess their
risks correctly will survive as traders. It’s not only important to make
a correct assessment of the risks, here, but also to develop a
strategy for managing the risks and, thus, to ensure that you can
survive in the market in the long term.

7.6.1 Staying in the game is a trader’s most important

goal
Interim losses and drawdowns are unavoidable. However, anyone
who withdraws from the game as a result, no longer has an
opportunity to recover these losses. That’s why, for a trader, the
“stay in business” rule has to be top priority. All other rules have to
be subordinated to this rule.
Before each trade, traders assess the risk and then decide for or
against the risk. Thus, traders behave like professional players.
They try to estimate probabilities, without being able to quantify
these precisely. However, traders are always able to determine their
risks exactly. In this way, they’re in a position to decide whether or
not the risk is acceptable for them personally. Both traders and
professional players know that even if the probability of the
occurrence of an event is 95 percent, it still remains uncertain.

With every trading system there’s a risk of losing money because

future events are uncertain. If series of losses pile up, then this can
lead to the ruination of an account.

The risk of ruin is the point at which traders have lost part of their
financial resources and because of this they’re no longer able to
implement their strategy.

Thus, the risk of ruin doesn’t mean a total loss but, instead, it
materializes when traders are already no longer able to implement
their trading strategies, for whatever reason. This could be because
the margin is now insufficient, or because trading capital was
depleted by losses and traders were no longer able to follow their
money management rules and, foolishly, had to set a stop that was
too close to the market. In both cases, the risk of ruin has already
materialized.

Theoretically, the risk of being unable to continue trading can never

be ruled out completely. However, traders are able to position
themselves such that the risk of ruin doesn’t pose a danger to them.
If they know what their risk of ruin is and respond to it with the
appropriate money management algorithm, then their trading will be
less emotionally charged than when they constantly have to fear that
they could completely lose the game of games.

It’s important to find out what risk of ruin is at the basis of your
strategy and then to find a level of risk that you can live with.
What level of risk of ruin is acceptable for you will depend heavily on
your aversion to risk. There are people for whom the risk of going
bankrupt in one out of 1,000 cases is acceptable, however, for this
worst case scenario others would like a maximum probability of one
out of 10,000 cases.

When you know and have mastered your risk of ruin, the huge
advantage for you will be that you’ll develop enhanced self-
confidence when you trade. In this way, you’ll keep fear under
control and will be able to avoid many mistakes, such as setting
stops that are too narrow.

Your trading system can be dramatically improved when you have

control over your risk of ruin. More trust and less fear will bring calm
to your trading and that will stabilize you emotionally.

To this end, you have to be able to answer two key questions. The
first is: “How do I, personally, deal with a series of losses?”, and the
second question is: “How can I determine what I can expect in the
market?”

The first issue can’t be solved with a mathematical formula because

everyone reacts differently to a series of losses. That’s why it’s
important for traders to know how they, personally, react to a series
of losses.

In the relevant specialist literature, in answer to the question

concerning the optimal position size, attempts have been made,
over and over again, to find a formula. Here, Optimal F and the Kelly
Criterion are the best know approaches.

However, these formulas can only help traders as they look for their
personal optimal position size. They don’t provide any useful
information about a trader’s personal risk appetite. However, the
best mathematical approach won’t help traders if, in the market, on
account of their risk appetite, they’re not able to manage the position
size that has been prescribed by the formula.

In order to be able to live with the risk of ruin, we have to be aware

of it and be able to calculate it. A simple statistical approach is
helpful here and, in the next section, we want to take a closer look at
this.

Let’s assume that you have an account with Euros 50,000 and that
your hit rate is 50 percent. If you win you get double your stake, if
you lose the entire stake is forfeited. Your point of ruin is an account
balance of Euros 40,000, so that you may lose a maximum of Euros
10,000. What amount should you risk?

Think for a moment how you would tackle this problem. I can assure
you that all the important information has already been included in
the question.
The question that you have to answer first of all is how probable is it
that you’ll lose xy times in a row. This is because the frequency with
which you can make consecutive losses, without winning, depends
on into how many parts you divide up your Euros 10,000 of risk
capital. If you divide up your risk capital into ten units, then you can
lose ten times in a row. However, if you divide it up into 20 units, you
can lose consecutively 20 times before you’re ruined.

As you know how likely it is that you’ll lose with a transaction (your
hit rate is 50 percent), you’re also able to calculate how probable it is
to lose xy times in a row. In statistics, you talk of so-called
“conditional probabilities”, they’re conditional because the
occurrence of an event depends on the condition that another event
has occurred previously. For example, with a series of two losses,
it’s necessary not only for the second trade to be a loss but also for
the first trade. The probabilities for each individual event in the chain
of conditions are multiplied in order to get the overall probability of
the occurrence.

In the table on the previous page you can find an overview of the
probabilities of loss for a series of xy losses with a hit rate of 50
percent.

Thus, the probability for a series of four consecutive trades is 6.25

percent. That’s a very high probability for traders, as over the course
of 100 transactions they’ll have to expect to suffer a series of four
consecutive losses more than six times. You can’t minimize the
probability of a series of four consecutive losses, as it’s
predetermined by your hit rate. The probability of a series of four
consecutive losses could only fall if your hit rate were to go up.

It’s very important for traders to know the probability of a series of

losses, so that they know, statistically, what loss series they can
expect in their trading. It has little to do with bad luck, therefore, if a
trader makes a loss four times in a row. In fact, these events are
statistically determined.

Even if there are no traders who like to hear this - there is also a
probability that we’ll lose ten times in a row. As can be seen in the
table, while the probability for this is only 0.098 percent,
nevertheless, a measurable probability for this event does exist and
we can’t ignore it. Bear in mind that it’s 14,000 times more likely to
have ten consecutive losses than six correct numbers in the German
lottery! 1

What does this mean for our risk management? From a statistical
point of view, we can’t prevent this event (ten consecutive losses)
from occurring at least once within 1,000 transactions. Thus, if we
have to reckon with it we should take strategic precautionary
measures so that we don’t go bankrupt if this unlikely but,
nevertheless, possible event occurs.

As we’re unable to avoid this event ourselves, we have to protect

ourselves against bankruptcy by still having enough money in our
portfolio after a series of losses. Thus, in each case, we risk only a
small amount. There is a simple formula for calculating the size of
this small amount: The sum of the amounts that have been risked in
a series of losses may not be bigger than the overall amount that we
may lose before we go bankrupt.

For our example this means: If we can afford a maximum loss of

Euros 10,000, then the sum of the losses in a series of, for example,
ten trades may not be greater than Euros 10,000. If we assume that
we risk Euros 1,000 per trade then, in the worst case, with ten
trades we would lose Euros 10,000.

Now, for the above example, we can calculate how much money we
should risk if our chance of winning is 50 percent, but the maximum
amount that we want to lose is Euros 10,000. While we can never
completely rule out the risk of ruin, nevertheless, we can set a
personal tolerance value.

If for us, personally, a probability of less than 0.1 percent is

acceptable - thus, in 1,000 cases we would go bankrupt in less than
one case - we may risk a maximum of Euros 1,000.

Once you know how probable it is for you to have a series of xy

losses for a given hit rate, then you have to ask yourself what sort of
risk of ruin could you live with. If you’re comfortable with the idea of
going bankrupt in one out of 1,000 cases, then you have to look up
in the aforementioned table at which point the probability of the
occurrence of a series of xy losses falls below one per thousand.
As can be seen in the table, this is the case with a series of ten
trades. The probability is just 0.098 percent and is, therefore, less
than one per thousand. Thus, from a statistical point of view, in
1,000 cases, we wouldn’t go bankrupt.

However, as can also be seen from this example, in 10,000 cases, a

series of ten losses will occur at least once. If you want to ensure
that, in 10,000 cases, you won’t go bankrupt then, once again, you
have to look up in the table when a probability of the occurrence of a
series of losses is so low that this event won’t occur in 10,000
cases.

A series of 14 losses is the first one that is so unlikely that it won’t

happen in 10,000 cases. The probability of a series of 13 loss-
making trades in a row is 0.01 percent and could, thus, occur once
in 10,000 cases.

With the search for a series of losses, which has such a low
probability that it falls within our comfort level for the risk of ruin, we
can now also determine our position size. As a series of 14 losses is
so unlikely that it wouldn’t even occur in 10,000 cases, we can afford
to divide up our risk capital into 14 units that we risk there. If, as in
the example, our risk capital is Euros 10,000, we can divide this up
into 14 units of Euros 725 (10,000 / 7 = 14 units). With this wager we
can be sure that even if we do suffer a series of losses it’s unlikely to
be at the risk of ruin.

The lower our comfort level is, the smaller our position size has to
be. Please note that, usually, the risk of ruin is not the equivalent of
a total loss because, before a total loss, you’ll have already been
forced to cease trading. Generally, you’d describe a strategy as
being unsuccessful if, for example, 30 percent of losses have
occurred. Thus, a drawdown of 30 percent already denotes your risk
of ruin. For an account with Euros 100,000, this would imply an
account balance of Euros 70,000. If we assume that we have a hit
rate of 50 percent and that we accept a risk of ruin of one in 1,000
cases, then with a stake of Euros 3,000 we could withstand ten
consecutive losses. In this example, this is the equivalent of exactly
3 percent of our starting account size.

At this point I wish to briefly talk about the excuse, which beginners
always like to plead, that money management isn’t possible with a
small account of, for example, Euros 25,000.

Let’s assume that a beginner, as opposed to a professional, could

lose his/her entire account because s/he is still in the learning phase
and that s/he has other income and, therefore, doesn’t have to live
off trading. S/he can then be compared with a trader who has an
account with Euros 100,000 and who has to make a living from this.
This trader is unable to accept a drawdown of more than 25 percent
as, every month, s/he has to withdraw money from the account.

With a loss of Euros 25,000, both types of trader achieve the ruin
level. Thus, in terms of the risk of ruin, both of them trade under the
same conditions. That’s why the same rules for avoiding the risk of
ruin, which apply to a professional, also apply to a beginner. Thus, in
absolute terms, the size of the bet remains the same, although in
this case, on a percentage basis, it’s four times as big.
 8.
CHAPTER 8

Beginners attach great importance to the right entry, although this is largely
inconsequential. Nevertheless, there are some things that you should pay
attention to.
 8.1 The entry
Beginners attach great importance to the right entry. Although, when
you’re experienced enough to be able to avoid certain mistakes, it’s
pretty unimportant.

I spent a great deal of time thinking about whether I should even

write a chapter on the entry, as the success of all good traders isn’t
based on their entry strategies but, instead, on their exit strategies
and on money management (position sizing). Yet, I was afraid that
some readers would then think that, by excluding this topic, I wanted
to keep from them the true secret of trading - which certainly isn’t the
case.

However, at the risk of repeating myself, I’d like to emphasize that

there’s nothing magical or special about an entry into a position. The
only reason that traders are always focused on the entry is because
they believe that, in this way, they’re able to gain control over the
trading outcome. Yet, as nobody knows what will happen in the
future this view is false.
 8.2 The random entry
Many traders find it hard to believe that the entry into a position can
be almost random. All too often, they remember situations in which
they knew exactly what the market was going to do. Possibly, they
might even have earned a lot of money in these situations. I’m not
claiming that there aren’t such premonitions, as I’ve also
experienced them myself many times. However, as traders we can’t
reckon with our hunches being as reliable as a crystal ball that can
look into the future.

It’s simpler and safer to assume that the future is uncertain. Even in
situations that appear to us to be clear - for example, the terrorist
attacks on the World Trade Center on September 11th, 2001 – we
can’t know how the market will behave.

You don’t believe that? Then please read the following example.

Imagine that a popular American president is murdered and you

knew this one minute before. So, you’re still able to react in the
market. The only condition is that you can only exit from your
position the next day.

Surely, nearly every trader would decide on a short position. As a

matter of fact, the shooting of Kennedy didn’t make much of an
impression on the stock market and anyone who exited from a
position the next day would’ve got out of the market with a loss.

Let’s take another example.

One of the biggest American cities experiences a complete blackout.

An overall power supply failure. Nobody knows whether this is
random, or if this is the work of terrorists.
The last time that there was such a big blackout in a major American
city the National Guard had to intervene in order to halt the looting.
Once again, you know about the event beforehand and are also able
to make an intra-day exit.

Here, too, this was not a cause that was followed by an effect on the
stock market. When the lights went out in New York, in 2002, there
was no panic. The stock market, which had just closed, was already
up at the opening of the night session that began 30 minutes after
the close of trading.

With these examples I want to convey that nothing has to happen on

the markets. There are only two things that we have to do: die and
pay taxes. Everything else is uncertain.

With a view to improving understanding, in the preceding few

paragraphs I’ve described situations in which items of news should
have moved the prices. However, you can also transfer these
examples to certain indicators or chart configurations. There’s no
such thing as a sure signal. On account of this fundamental
uncertainty, the entry allows us only very little control. Sometimes it
might work, sometimes it just won’t.

Would you get into a car where the steering works sometimes but
not all the time? Sometimes you have control and sometimes you
just don’t. That’s why the entry is not important - it doesn’t allow us
to have the control that we need in order to produce a reliable
trading outcome. We have to concentrate on things that are more
reliable.

There are only a few parameters that we can truly control. These
include, in particular, the position size and the exit strategy, which
always help us to exert influence on our average profits and losses.
That’s why, above all, we should pay particular attention to these two
factors.
If the entry is not important for a trading system or a strategy, then
why don’t traders simply roll dice every morning in order to decide
whether they’re going to go long or short?

There are some trading strategies that are based on random entry
and they’re successful. In the book “Trade Your Way to Financial
Freedom”, Van K Tharp together with Tom Basso showed that random
entries could also be successful.

I’m convinced that many traders have random entry strategies,

without knowing this. This is because, viewed objectively, it doesn’t
make any difference whether you wait to enter until certain criteria
are fulfilled, or until a certain face turns up on the die. For example,
you could buy every time that a bullish engulfing pattern appears on
a five-minute candlestick chart, or roll dice every five minutes and
buy each time you roll a six. In the same way that when you’re
rolling dice the probability of getting a six is 1 / 6, likewise, there’s
also a certain probability that a bullish engulfing pattern will occur.
This method will only be statistically significant if, in the long run, the
market does actually go up within a defined period of time after a
bullish engulfing pattern appears.

Significance means that this method is better than chance, thus, the
price does really also go up in more than 50 percent of cases. It’s
only in such a case that the entry would be “randomless” (not by
chance). It remains up to each trader to decide how much effort s/he
wants to expend on finding an entry that’s better than one that is
random.

The really important news for all traders is that they themselves
will be able to trade successfully with random entries if they
select exit strategies that are appropriate for these entries and
if they manage their position sizing correctly.

When developing an individual trading strategy, it’s important not to

concern yourself for too long with the optimal entry but, instead, to
specify a couple of simple, objective criteria for the entry and then to
find the optimal exit strategy for this entry as well as the appropriate
money management rules. Anyone who’s got this far and is earning
money will soon notice that it’s not worth fine-tuning your entry any
further. However, it’s highly likely that they’ll check their exit rules,
over and over again, for any possible changes in the markets and
make adjustments if necessary.
 8.3 How to plan your entry
In principle, an entry strategy has to provide the trader with three
answers: When, at what price and in what direction should I enter?
Although, I believe that the when and where are more important
than the direction because, as we know, nobody can look into the
future. Nevertheless, when we’re planning our entry, before we can
determine the optimal timing and the best price we first have to
answer the question about the direction. Yet, how is a trader
supposed to determine the direction for a trade in a market that is
possibly moving randomly?
 8.4 The philosophy
In the first part of this book, I already described how important it is to
have a philosophy on the market. We’ll only be able to trust in a
strategy that is based on a philosophy that we accept.

My model assumes a market where the prices move in random

patterns but where the individual movements are amplified, distorted
or shortened by the sentiments of the market players. Imagine that
the god of chance of the financial markets had a large die and rolled
it every day. There are performance points shown on his die so that
the market goes up or down randomly. However, if the sentiment of
the market players is good, then the market will go up by twice as
much as the number of performance points that were actually shown
when the die was rolled. For example, the god of chance rolls a five,
but the market goes up by ten points. Furthermore, if the sentiment
of the market players is good, then the market doesn’t fall by as
much as the number of negative performance points shown on the
die. By contrast, if pessimism predominates, the market will, for
example, only go up by three points even though the god of chance
has rolled a plus five, however, if he throws a minus one, then the
market will fall immediately by two points.

Thus, the sentiment of the market players becomes an important

influencing factor even though the prices movements tend to be only
random. This is my model of the stock market and/or the financial
markets.

Of course, there are still more ways of classifying sentiment than

just good and bad but, basically, this example describes my
philosophy. On the one hand, my model emphasizes that you can’t
predict the markets, as we don’t know what the next outcome will be
when the god of chance rolls the die. Secondly, it highlights that we
already have an advantage when we identify the sentiment of the
market players. Then, we can at least guess whether the movement
will be stronger or weaker than predetermined by the die.

With this knowledge we’re able to manage our entry more smartly
than a purely random entry. Although, we still don’t know whether
we’ll win or lose with the entry signal. However, if our assessment of
the psychological mood is correct we can make assumptions about
the potential of the trade. This is because if market sentiment is
positive and we bet on rising prices and if the god of chance has
rolled a plus five then the market should go up by twice as much.

Therefore, if we use trend-following strategies, we should make our

attempt on the long side. In principle, even though nobody knows if,
at the next roll of the die by the god of chance, the outcome will
actually be negative again, there’s no reason why we can’t go
short.2 However, in that case, we should select a quick exit, as in
view of the positive sentiment, the potential won’t be very great.

8.4.1 Long or short? First specify the direction of the

trade!
Once we’ve made our assessment of the psychological mood, then
it’s no longer a matter of chance whether we go long or short,
instead, this will depend on our evaluation of the potential of the
trade, in conjunction with the risk.

For example, when market sentiment is good we would expect

greater potential on the long side and little potential on the short
side. This criterion, in conjunction with the path of least resistance,
will determine the direction of the trade.

In order to be able to evaluate more precisely the potential of the

respective trend we’ll take a look at the chart based on various
timescales and we’ll search for resistances and supports.
Supports and resistances are distinctive market points, which can
frequently be identified by a series of trading ranges in the market.
Furthermore, daily highs, daily lows and other extreme points are
distinctive features that point to resistances and/or supports.

Trend lines are less appropriate because they’re only imaginary; this
means these did not constitute prices that are actually traded such
as, for example, a trading range. These lines only exist in the minds
of chartists and are frequently only identified retrospectively on the
chart.

Besides, trends are inclined to fan out. This means that while the
trend line is broken, however, the trend has not yet come to an end
but, instead, the development will be only somewhat flatter (see
chart).

In the search for supports and resistances, moving averages occupy

a hybrid position between trend lines and market points. As they
represent a smoothing of a line of price action they’re more real than
trend lines. However, there are so many possibilities for smoothing
price action (13, 21, 50, 100 days, moving average simple,
exponential, weighted, unweighted etc.), that I, personally, don’t pay
any attention to moving averages in this context.
I consider pivot points and Fibonacci retracements to be completely
irrelevant. These indicators are worthless and, at most, can be used
in the context of a self-fulfilling prophecy. As there are at least four
Fibonacci points and six pivot points, then the law of probability
alone would suggest that, in the course of a trading day with an
average trading range of 30 points, at least one of these ten points
would fall on an extreme point or a distinctive trading point.

If we then also permit a tolerance of plus or minus one point for

these magical prices then, with 30 possible points, we get to a
probability of 100 percent that, on any desired trading day, the
market will turn or will have reached an extreme at one of these
points.

The resistances and supports that we identify before we open a

position should help us to evaluate the potential of a trade. Usually,
we find several resistances and supports, which I number
consecutively in each case, starting with the current market price. I
label the next resistance level as R1, then follows R2 and so on. I do
exactly the same with the supports; I call them S1, S2 and so forth
...
Whether or not the market actually has the potential to go up to R1,
or even to R3, depends firstly on how strong the average upward
movement has been in the past days and secondly on whether
market sentiment is positive or negative.

If market sentiment is positive then I usually assume that, over the

course of the current trade, the market will also be able to exploit the
average price potential of the previous positive days. For example, if
the average movement on a positive day was 60 points, then I
assume that this will also be valid for the current positive day.

In this example, if the DAX is quoted at 4,200 with a daily low of

4,180 then I would assume that the market could still go up by a
further 40 points (we’ve already gained 20 points based on the daily
low). Now, if there were resistance at 4,240 then I would define this
as my target price. However, if there were no more resistance until
4,260 and before that at 4,220, then I would definitely accord
potential to the market of up to 4,260. If the resistance level were
already at 4,230 then I would reduce the potential to 30 points.

With short trades, likewise, I go through the same process by

calculating the potential on the basis of the average daily losses of
the past negative days while taking the support zones into
consideration.

When calculating averages there’s something that you should take

into account. For the positive price potential, in each case, I take into
consideration only those days when the market rose significantly.
The days on which the market was trendless, or it fell, don’t matter
here. As I’m a day trader, I also don’t look at any daily charts but,
instead, at hourly charts and I use the average from a normal rally
over the course of a day. I use only this to calculate averages.

As soon as I’ve determined the potential for a trade, I try to specify

the risk. For this, I usually look for an appropriate initial stop price
that isn’t set too close to the current market price but also isn’t too
far away from it. In the course of this, once again, I’m guided by
distinctive market points such as supports and resistances as well
as relative and absolute highs and lows. As soon as I find these
points then I can specify the risk of the trade per contract and put it
in relation to its potential.

If then there is a risk/reward profile that is attractive for me

personally, I enter into the trade.
 8.5 Assess the market’s psychological state
Ensuing from the market model described above, the question
arises of how can you monitor and determine the psychological state
of the market players.

Here, too, the easiest method is, once again, to look for the path of
least resistance. A market that’s trending very much in one direction
and exhibiting a strong momentum in the direction of the trend is the
best signal that the psychological state should also be interpreted as
being in the direction of the trend.

More complex methods are sentiment analyses or the Elliott Wave

Theory. Sentiment analyses study the mood of market participants
either on the basis of surveys or by monitoring the put-call ratio and
other sentiment indicators. My experiences with sentiment indicators
are that they are not particularly suitable for day trading, but they
definitely provide results that are useful for position trading.

Personally, I prefer to use Elliott waves in order to gain an

impression of the market’s psychological state. Please note,
however, that I don’t use Elliott waves to make price forecasts
because, as has already been mentioned, nobody can predict what
chance will bring on next. Nevertheless, Elliott waves are an
effective instrument for understanding the market’s psychological
state.

Even if experienced traders frequently manage to make a correct

assessment of the market’s psychological state, there will never be a
100 percent surefire method with which you’ll be able to determine
the condition of the market players.

The residual uncertainty, together with the uncertainty about the

future (what will be the outcome when the god of chance rolls his
die?), means that no trader can know whether s/he’ll win or lose with
the next trade. Naturally, everyone hopes to win, however, the risk of
losing still remains. That’s why the entry isn’t able to offer us the
type of control that’s required in order to achieve a stable
performance curve and continuous wins. Therefore, we have to
control our risk of losing and that’s the function of the exit.
8.6 When do we make our entry? Clear objectives and
specific criteria
Once we’ve determined the direction of a trade then the main
purpose of the entry strategy has already been fulfilled. The trade
will now be initiated as soon as the right trigger appears. Our entry
strategy has to define very clearly the criteria that have to be fulfilled
for us to enter into a trade.

A typical mistake that many traders make is not formulating the entry
criteria clearly enough. As a result, they enter into trades that
actually don’t comply with their strategy. Here, system traders
usually have things easier than discretionary traders because, in the
case of the former, the entry criteria have to be input into the trading
program.

Nevertheless, a discretionary trader also has to develop clear

criteria for his/her entry. In contrast to a mechanical system, a
discretionary trader has the additional freedom of not entering, once
in a while, even if the market conditions have actually been fulfilled.
A discretionary entry doesn’t mean entering simply when you feel
like it. Here, too, there have to be clear entry criteria. The rules have
to be formulated so clearly that a third person could objectively
understand the entry, or even be able to execute it in your place.

Entry criteria are one or more conditions that have to be fulfilled

before you enter the trade. This step happens once you’ve already
analyzed the path of least resistance and the market’s psychological
state. The direction of the trade is already specified, however, you
don’t enter until the conditions have been fulfilled.

Here’s an example. You believe that the path of least resistance is

heading upward and that’s why you decide to go long. However,
when you go long will depend on your entry conditions. For
example, your criteria could be that:

1. the 13 and the 21 unit moving averages have a positive slope;

2. the 13 unit average has to have crossed above the 21 average;

3. the price has to have closed above the level of both averages.

These conditions are objectively understandable.

At the same time, the entry criteria have to be specific, which means
not only objectively understandable but also formulated so as to be
measurable.

An entry criterion along the lines of: “The trend has to point upward”
is not specific enough. However, if we formulate the rule by
stipulating that, on a five-minute chart, there have to be at least two
high points and two low points and that the second high has to be
above the first high while, at the same time, the second low point
has to be before the second high and above the first low - this then
constitutes specific criteria.

It’s up to you whether you use one or several entry triggers at the
same time.
 8.7 Implement your rules rigorously - Even in loss-
making phases
The entry conditions that you select will be your personal decision. I
believe that there are thousands of entry criteria that work. What’s
important is that you, yourself, develop trust in your entry criteria so
that you’ll be able to follow these rules rigorously. A common
problem for many trading beginners is that they take entry rules from
other traders but don’t trust these rules.

As there is no method for predicting the future, with all entry

methods there will be false signals. If you have no trust in the
selected strategy, then if there is an accumulation of false signals
you’ll be disappointed and you’ll look around for a new method.
Then, once again, as soon as you get the unavoidable false signals,
you’ll turn to the next entry strategy until this one then fails,
supposedly.

Thus, you’ll never follow a strategy rigorously and you won’t be able
to develop perfection but, instead, you’ll forever be searching for the
holy grail.

That’s why you should find entry rules that are appropriate for you
and then perfect them. Find rules that are logically understandable
for you.

I’d like to illustrate this by means of an extreme example. One of my

clients believes very firmly in astronomical influences. He’s
convinced that the constellation of the stars exerts a strong influence
on our lives. His entry rule is based on price changes during certain
phases of the moon. For him, it makes sense for the market to
continue certain trends during particular phases of the moon.
By contrast, traders who consider astrology to be sheer nonsense
would never develop trust in these entry rules, irrespective of the
success that this method generates.

I, myself, believe that the movements of the markets are random, as

described above (chaos theory), and that their fluctuations are
amplified or distorted by crowd psychology phenomena. That’s why
my entries are based on the Elliott Wave Theory.
 8.8 Where should you enter, or this is how you wait
and watch for the optimal entry
If your entry trigger has output a signal then this doesn’t
automatically mean that you have to enter immediately. Your trading
plan can provide that you wait and watch for an optimal entry. For
example, if the entry trigger is the breakout from a trading range,
many traders wait for a retracement of the breakout movement
before they enter.

This waiting and watching for the best price has the advantage that,
as a rule, your risk will be smaller. During the retracement the
market comes back and you can buy or sell at a better price. The
difference between the entry and the stop will be smaller and with it
the initial risk, too. Another effect of waiting for a retracement is that
the price potential will get bigger - overall, the risk/reward profile of
the trade will improve.

As an example, the following is a typical trading situation. The

market breaks out of the 4,180 to 4,200 range. This is an entry
trigger for a trader who focuses on the long side. He now has the
possibility of buying immediately after the breakout (in this example
at 4,205) or, with a retracement, at 4,200. His stop is below the
range, at 4,180, his target price is 4,240.

If the trader doesn’t wait for the retracement, then his risk would be
25 points and his reward would be 35 points. If he waits, then the
reward increases to 40 points and the risk falls to 20 points. He can
make a bet with an overall risk/reward ratio of 2. That’s significantly
better than in the first case where the risk/reward ratio was only 1.4.

The disadvantage of this strategy - gambling on a better entry - is

that sometimes you’ll miss a movement. That’s why you should
develop a criterion for deciding when you should gamble on a better
entry and when you shouldn’t.

If your experience and your research show that, for the strategy that
you’ve chosen, it’s typical for the market to come back, once again,
after the entry trigger then, with the help of probability calculations
you can determine whether or not you should gamble on a better
entry.

To this end, you should proceed as follows. Let’s take a simple

breakout system that always buys when the market breaks out of
the range. Note all the cases from past or current trading situations
where the entry trigger generated a signal.

For the sake of simplicity, let’s say that you’ve identified 100 signals.
Now form groups according to the following scheme.

In first group are all the trades where the market had tested the
breakout level once again; in the next one are all the cases where
the market immediately rose further without a retracement to the
breakout level. In a third group note all the false signals, thus, the
cases where the position was stopped out at the initial stop.
 8.9 Poker strategy
Group Number Percent Average
gain/loss

Group 1 Retracement on 63 trades 71 % 25 points

Breakout

Group 3 25 trades 29 % – 20 points

False signals

Overall 88 trades

Group 2 (twelve trades) can be omitted because, here, the market

didn’t reach the entry level anymore. In the case of a false signal,
your calculation of the loss per trade is merely the amount of the
price difference between the entry after the retracement and the
stop, as, in any case, the market would have reached the buy limit
during the retracement. You calculate the average profit for each
group by dividing the results of all the trades in the group by the
number of trades.

8.9.1 Immediate buy

Group Number Percent Average
gain/loss

Group 1 75 trades 75 % 20 points

Group 2
Immediate buy

Group 3 25 trades 25 % – 25 points

False signals

Total 100 trades

In the poker strategy, the profit for groups 1 and 2 has to be less
than the profit of group 1, as you don’t make any changes to the exit
rule and haven’t waited for a retracement. Thus, you always enter
immediately at a higher price.

Now, once you’ve entered the values in a table, as illustrated above,

you can compare the expectation value of the poker strategy with
the expectation value of the immediate buy strategy.

The expectation value is calculated by taking the percentage share

of the winning trades and multiplying this by the average profit and,
to this, adding the product of the average loss and the percentage
share of the loss-making trades. For the poker strategy in our
example this is:

0.71 x 25 + 0.29 x (– 20) = 11.95

Now calculate the expectation value for the immediate buy without
waiting for a retracement. For this you have to multiply the average
profit from group 2 by the frequency percentage of groups 1 and 2
and generate the product of the percentage share of group 3 and
the average loss in group 3. Please note that you now have to add
the difference between the average profit from groups 1 and 2 to the
average loss in group 3, as after all, in the case of an entry without a
retracement you would have bought at a higher price. For the
immediate buy we calculate:

0.75 x 20 + 0.25 x (– 25) = 8.75

 8.10 The opportunity factor
Please note that it’s not always advisable to give priority to the
strategy with the highest expectation value. With the poker strategy
you should bear in mind that the “opportunity factor” - the possibility
to be active in the first place - is lower here.

While in the case of an immediate purchase after a signal, you’d

have had 100 opportunities to trade, however, only 88 trades arise if
you wait for a better price. In twelve cases the market runs away
from you. You only get the correct result when you multiply the
expectation value of a strategy with the opportunity factor.

In this example, in the poker strategy, in 88 cases you can expect to

earn an average of 11.95 points, thus, a total of 1,051.6 points.
However, if you don’t wait for a retracement, then you can earn a
total of only 875 points.

As you can see, the opportunity factor is important. Just to reiterate -

the strategy with the highest expectation value isn’t always also the
best one. If you have comparable strategies with different high
positive expectation values you always have to take the opportunity
factor into consideration.
 8.11 The steps you have to take
First of all, on the basis of the time unit that you trade, you should
gain an inkling about the direction that market wants to pursue.
Here, it’s helpful to find the path of least resistance. However, make
sure that you gain only an inkling and don’t form an opinion.

The reason why this differentiation is so important is that once

you’ve formed an opinion it’s very difficult to deviate from it, even if
the market shows you that your opinion is wrong. Nobody likes to be
told that they’re completely mistaken in their opinion. However, an
inkling about the direction of the market allows you to react more
flexibly to current events in your trading. You’ll also be able to veer
more quickly and more easily in the market direction that isn’t
favored by you.

Once you’ve formed your inkling about the direction of the market
this will already be linked to the direction (long or short) that you’ll
give your trade. However, at this point in time, the entry will not have
occurred yet. Usually, this is only carried out once your entry trigger
has been set off. The entry signals should be controlled by clear
criteria, otherwise you’re too easily inclined to simply enter into a
position without the market providing a specific reason for this.

If your entry signal recommends an entry to you, before you even

open the position it’s essential to check whether or not you’re
making a good bet. You shouldn’t actually open the position until you
have an attractive risk/reward ratio.

Before each trade, check to see if the trading idea does really make
sense and that it complies with your plan. You have to take the time
to do this.
Likewise, make sure that you always base your decisions on the
same time unit. Frequently, signals that have been generated on a
short-term time unit don’t actually apply to a longer time unit. If you
normally get your entry signals on the five-minute chart then, before
the entry, you shouldn’t look at the minute chart but, instead, only
enter once your signal has also actually appeared on the five-minute
chart.

Be consistent and rigorous in the way you make your decisions. If

the market provides a signal, then you should also follow this signal.
An entry strategy in which you follow only half the signals is
worthless. Discretionary traders do indeed have the freedom not to
follow individual signals, however, this should be the exception and
not the rule.
 8.12 What to bear in mind for every entry
Plan each trade exactly and develop an entry routine
Routines help you to act more quickly, as many processes and
decisions can be managed by your subconscious. Lists that can be
used for an entry are helpful for beginners, in particular. Like a pilot
performing a check before the start, you should carefully review all
the criteria before you act. If you plan your trade in advance then
this will help you to trade in a considered way. You’ll automatically
make fewer trades, which, nevertheless, should improve your result
significantly. Here, the planning shouldn’t be restricted to the entry
but, instead, should describe in detail all the phases of a trade.
 8.13 For every entry you should also already
plan the re-entry
At the planning stage, you should also already consider the
circumstances under which you would be willing to make a re-entry.
A re-entry means taking up a position again that was previously
stopped out. Those who plan their re-entry in advance will be able to
trade more sensibly if they’ve already been stopped out once with a
loss.

Frequently, traders fall into two extremes when they’ve been

stopped out. There are those who just don’t want to believe that
they’re wrong and immediately build up their position again with a
new stop, which virtually amounts to expanding the initial position -
but this time with a stop that’s further away. At the other extreme are
traders who are no longer able to go into the market if they’ve been
unfortunately stopped out once - even though the market then
continues to go in the direction that they presumed it would.

If you want to avoid these extremes you need to have a re-entry

plan ready before you enter into the first position. Moreover, you
have to imagine what will happen if you were to be stopped out.
Where will the market be then? When would you decide that you’ve
been simply unfortunately stopped out? In what cases will the
market view your position as wrong? Where is the line in the sand?
How many re-entries would you permit?

If you plan your re-entry already before your first trade, you’ll realize
whether it makes more sense to attempt several entries with one
narrow stop or to leave it at one attempt but, however, to provide it
with a bigger stop. You’ll be in a better mood, from an emotional and
a psychological perspective, if you plan your re-entry at a point in
time when you’re neither stressed nor affected by a previous
negative trade.

Always ask yourself about the reason for the trade

Are you trading because this constitutes a good bet or do other
motives exist? Frequently, day traders only trade out of boredom, or
because they believe that they should do something. It’s also risky if
the only reason that you enter into a trade is that you quickly want to
make up for a loss that you previously suffered.
8.14 Be aggressive with the first position and reload as
soon as it runs in your favor
Traders look for security and that’s why they frequently wait until the
market appears to show very clearly in which direction it’s going.
Unfortunately, the point at which a trend becomes clear for everyone
is usually the point at which the trend is over, for the time being.
Thus, many traders wait for a breakout from a range if they want to
go long.

Instead of waiting for a breakout it’s better to be aggressive

beforehand and to open a small, initial test position. If a breakout
then occurs, you can reload and enlarge your position during the
retracements. While it appears that you have greater uncertainty
before the breakout, however, this uncertainty will be offset by a
lower risk. If we then also take into account that the future cannot be
predicted then, in any case, an earlier entry is appropriate instead of
waiting for supposed security.

Only enter into a position if, before your opening, you’re able to
determine a meaningful stop for this position.

One of the most stupid things that a trader can do is to enter without
a predefined stop. In order to avoid making this mistake it helps to
set up a clearly defined trading routine. Thus, before opening a
position, traders will go though all the entry criteria and check to see
if they’ve thought of everything.

Frequently, traders believe that they don’t have any time for this and
that they can take care of the initial stop loss once they’ve entered
into a position. Theoretically this would even be possible, as the
initial stop is usually far away from the current price. The problem is,
however, that traders who jump into a position without thinking about
it, firstly, don’t know if they’re making a good bet - because they
can’t determine a risk/reward ratio - and, secondly, usually their
trading is more emotionally charged than when they thoroughly plan
their trade beforehand.

If you want to enter the market then don’t gamble but, instead,
always go into the market “at market”.

Frequently, traders gamble by placing a limit for their entry on either

the bid or the ask side. In this way, these traders often get in one tick
cheaper, however, they’re subject to the risk of the market being
able to run away from them without them having opened their
position. If all the conditions for an entry have been fulfilled you
should always buy at market. It makes no sense to be bullish or
bearish and to have no position.
 8.15 Don’t enter too frequently
With every trade, not only do you have to pay a commission but also
earn the bid/ask spread. That’s why the more frequently you trade,
the higher these costs will be. It’s better to concentrate on a couple
of good trades than trading too much. Usually, you’ll only make your
broker happy, however, your account will suffer as a result.

Many day traders feel useless if, over the course of one day, they
don’t trade but, instead, only observe the market. This feeling is a
result of our conditioning according to which only those who do
something are valuable. However, with trading, the output does not
depend on how much work you’ve put into the trade nor on how
frequently you trade.

My trading results are usually all the better, the less I trade.
8.16 Avoid an entry prior to important economic data
Anyone who already has a position prior to the publication of
important economic data shouldn’t necessarily close it, unless the
market becomes very illiquid so that high slippage is to be feared.
However, if you don’t have a position prior to the publication of
economic data then you shouldn’t enter into a new one either.

Trading through economic data is comparable with a game of

roulette. Nobody knows what the data will turn out to be. To open a
position based on luck is an absolute mistake. That’s why you
should hold back your entry until after the publication of important
economic data.
 8.17 Is there a smart entry and what would this be
like?
Nevertheless, is there such a thing as a smart entry? Contrary to all
statistics and criticism as to the forecasting capability of a system,
my entries, like those of many professionals, are based on market
experience. As in a game of football, there are indeed strategic
recommendations and standard situations during trading, however,
you will only achieve the level of a true Master Trader if you have
enough experience to manage situations that fall outside of the
standard repertoire. These experiences cannot be programed into
any computer with just a few rules. Moreover, I could’ve made this
chapter 1,000 pages long and it wouldn’t be of any help to you. It’s
because you have to accumulate your experiences yourself.

A smart entry, above all, means market experience. A strategy might

function in some markets but not in others. Strategies that I use in
90 percent of all cases will be omitted in the crucial 10 percent
because I believe that, in those cases, it’s right to break my rules.

This is a discretionary trader’s real advantage - using his/her

freedom to break his/her rules from time to time. With a computer
trading system this would mean the end of the system. There are
hundreds of exceptions and continuous changes in the market.

Ed Sakota has five rules for his trading (in his book “Market
Wizards”) The first is: “Follow your rules“, the last one is: “You must
know when to break your rules“. The complexity of the markets, the
continuously changing influences on prices in the markets and the
number of market participants suggest that you should give at least
some thought to your entry.

A smart entry is when the trader carefully gropes his/her way into
his/her position. This means not having his/her biggest position right
at the start but, instead, leaving room for further contracts that can
be taken up as soon as the market runs his/her way and, at the
same time, in the risk management, still leaving room for a re-entry
in case s/he’s stopped out.

Thus, a smart entry is a combination of money management and the

entry. As we’re unable to predict the future, it’s better to let the
market show you whether or not we’re right. Let’s assume that we’re
prepared to risk a maximum of 1 percent of our capital on one
position. In our account we have Euros 200,000, thus, Euros 2,000
constitutes the maximum risk. We assume that we buy at 4,200 with
a stop at 4,180. Accordingly, the risk per contract is Euros 500, thus,
we can buy a maximum of four contracts.

Now, instead of buying all the contracts at the same price, we can,
for example, buy half initially and, as soon as the market goes in our
direction, buy another contract. If the trend stabilizes for us, we buy
a contract once again insofar as the risk for the additional purchase
hasn’t become too great (that is, if we were to risk more than 1
percent of our capital overall for the trade).

This method has the disadvantage that, in part, we have to buy at a

higher price and the average purchase price goes up, however, in
return, we get confirmation from the market that our position is
correct.
 9.
CHAPTER 9

Exit strategies are the true secret of Master Traders. The simple
rule, which says that you should limit your losses and let your
profits run, can only be implemented with perfect exit rules.
9.1 The fundamental law of trading and why so many
exit strategies contravene this law
There’s nothing more fun than winning and, yet, most traders don’t
indulge themselves in this pleasure. Frequently, winning trades are
exited far too early. It appears that the emotional suffering
experienced during a winning trade is significantly greater than the
agony of losing. There can hardly be any other explanation as to
why, over and over again, day traders content themselves with small
profits. The rigor with which trades are exited too early and, thus a
limit is put on profits, is downright pathological.

According to an old trader adage: “Nobody ever died taking profits”.

That may be true, but anyone who takes profits too early will have
barely enough to keep body and soul together. These traders are
the typical fighters. They’ve developed a survival strategy but not a
winning strategy. Winners don’t restrict their profits. They prefer to
stick to the stock market rule, which says, you should “let profits
run”.

Yet, how do you develop a winning strategy? The outcome of every

trade depends on the exit. Even with a bad entry, a good exit can
frequently still save the trade. By contrast, a bad exit nearly always
leads to losses or, on account of profits that are too low, to a poor
trading outcome.

Bad exits always result in losses in cases where a trade was

stopped out too quickly because the stop had been set at the wrong
level and there had been no possibility for the trade to develop. For
the most part, as soon as the trader gets stopped out s/he sees the
market running away “in his/her direction”. These exits are
frequently the result of unproductive factors such as fear,
nervousness or financial pressure.
It’s relatively easy to spot these exits. They’re too close to the
market, within a zone that I call the “normal noise”. The normal noise
is the expression that I use to describe market movements that
occur randomly and that have no significance for the overall trend.

The noise of the market is not constant. There are times when the
noise is very powerful, and at other times the normal noise is so
weak that it goes largely unnoticed.

Experienced traders can easily spot these fluctuations in the noise

of the market, however, for beginners it’s frequently difficult to
distinguish between significant movements and noise. That’s why
my advice is to concentrate on underlying markets or underlying
securities in your trading, in order to acquire experience in these
markets, first of all.

However, I can also give beginners some clues as to how to identify

the noise of the market.

Trading ranges on charts are typical for noise movements. Between

the floor of a trading range and up to its ceiling all the movements
are mostly random, so that this range is a good indicator of how
powerful the noise is.

When identifying the noise, it’s important for traders to stick to the
time units that form the basis of their trading decisions, too, as the
noise on an hourly chart will be significantly higher than on a five-
minute chart.

Likewise, another good indicator for noise is the average size of a

bar or a candle in the time unit that is being monitored. For a more
precise calculation of the average you should disregard the three
biggest candles over the course of a day.

However, with this method, traders will only be able to determine the
minimum amount of noise in a market, while the noise within a
trading range (see above) frequently tends to give a measure for the
maximum amount only.

Exits in the form of stops should always be placed outside of the

normal noise. Suitable tools to help you move far enough out of the
zone of the normal noise also include significant points such as
supports, resistances or high and low points. Normally, a break in
these points will be of significance for the trend.

Another type of bad exit results from traders’ fears of having to give
up some of their profits again and this leads to profits that are too
small to cover the usual losses that inevitably arise in trading. Such
exits are common and, frequently, traders don’t notice that they’re
losing because of their bad exit strategy but, instead, they look for
the mistake in the entry. For these traders, a change in the exit
strategy would, for the most part, have an enormous impact on the
performance.

In these cases, bad exits limit the profits and don’t give the trade
enough room to develop. The result is a lot of little profits that, if
you’re lucky, will marginally exceed the sum of the losses after
trading costs, however, much more frequently they fall short of this
level.

The size of the profits has nothing to do with the entry. The purpose
of the entry is to get the trade to go in the right direction. However,
the sole determinant of how far the trade goes with the market in this
direction is the exit strategy. The more intelligent your exits are, the
bigger your trading success will be.

However, for this you have to be prepared to give an honest “yes” in

answer to the following question:
 9.2 Are you finally ready to gamble your profits?
It’s only when you play with your profits that you’ll be able to
implement the primordial law of trading - let profits run and limit
losses.

As in a poker game, it’s not about winning more often but, instead,
winning when the pot is at its biggest. Therefore, what will happen to
you is that you’ll leave some smaller pots (profits) lying on the table
and you’ll have to pass so that you can then strike at the right
moment. You won’t automatically earn more money with every trade
but, on average, your profits will go up significantly. You should learn
this art when you’re developing an intelligent exit strategy.

Here, the focus is on the following question: How much profit does
there have to be, how much is a trader allowed to and how much
should s/he take? Should we be like Scrooge McDuck and never get
enough, or is there a point at which it’s better to be content with what
you’ve got? When is it worth taking a gamble on the big pot and
when is it better to leave it? What is the optimal profit?

We can’t answer this question because profit is a future but

uncertain event. With the benefit of hindsight, it’s possible to
determine the optimal exit time for every trade by looking up on the
chart what were the maximum price movements after and before our
exit. Unfortunately, however, a follow up after the trade only ever
helps us to determine an optimal ex-post exit point.

Nevertheless, finding this theoretical optimal exit point could be

worth the effort, as in this way we’ll get an impression of what
percentage of a potential profit we weren’t able to cash in because
of the chosen exit strategy.
For this we simply have to compare our actual profit with the
hypothetical profit that would have come about if we had got out of
this trade at the optimal point. The number that we get provides us
with information about what percentage we were able to achieve
with our exit compared with the optimal exit.

Naturally, we’ll never achieve 100 percent but, possibly, at that point
in time we’ll already have realized that the exit strategy that we’ve
had up to now needs to be revised.

Yet, where is the optimal exit if, on account of the market

development, the result of the trade is uncertain? We have no
control over how far the market will go in our direction. Our influence
is restricted, firstly, to stopping the process of winning or losing at a
point in time determined by us and to realizing a particular profit or
loss.

Accordingly, our possible means of control are restricted to deciding

when we’ve won or lost enough. This decision appears to be
subjective at first sight. Ten profit points might be enough for some
people, while others won’t be satisfied possibly until they’ve got 20
points.

Yet, subjectivity has nothing whatsoever to do with the answer to this

question. It leads us astray because most people are risk-averse
with regard to their profits but are prepared to take risks when they
have to deal with losses. This means that we prefer to take a sure
profit rather than to gamble on a bigger but, therefore, more
uncertain profit. However, in the case of a loss, frequently, we prefer
to hope for a better exit and, thus, a smaller loss than to realize that
certain loss immediately.

Interestingly enough, many inexperienced traders have no exit

strategy and that’s why, over and over again, their answer to the
question about the optimal exit is intuitive. Exactly in keeping with
biologically programed behavioral patterns, they then react in a risk-
averse way in the case of profits and take profits much too early,
while losses frequently accumulate because the traders still hope to
make a better exit from the trade.

We can only solve this dilemma with a specific, defined exit strategy.
Although, before we get to this, I’d like to tell you a story.
 9.3 The turkey trap
Imagine that you’ve built a turkey trap. The trap works in the
following way: A large open bottom cage is hung above the ground.
At any time, using a piece of rope, you can lower the cage and, thus,
close the trap. Beneath the trap you’ve scattered some grains as
food and bait for the turkeys.

Now, all keyed up, you wait and watch from behind a bush, with your
hand on the rope for the cage and you’re hoping for fat prey. You
don’t know exactly how many turkeys are running around in the
area, however, based on your experience, you guess that currently
there are at least twelve turkeys on your hunting ground.

At the beginning, everything is quite simple. A turkey finds the bait

that you’ve put out and starts to pick at it eagerly beneath the trap.
Now, it would be easy to content yourself with the one turkey,
however, when the trap snaps shut you’d scare away all the other
turkeys. Yet, one turkey appears to be not quite enough for all the
effort that you’ve put into building the trap and that’s why you
continue to wait. Not long after, a second turkey already joins the
first one and starts eating your bait. Two are better than one, but
three would be even nicer, especially as you see that two more
turkeys are already approaching your trap.

Precisely at the moment when four turkeys are under the trap and
you’re thinking whether or not you want to make do with this prey,
the first two turkeys leave the trap again. You could’ve had four but
now it’s only two again. When will you let the trap come down? The
moment before yet another turkey escapes? Or are you hoping that
the two runaways will come back again? Perhaps you’re even so
hard-nosed and you’ll wait until even more turkeys are in your trap.
Before you’ve thought this through to the end, another turkey leaves
your trap. You already had four, now you’ve only got one left and
there’s a risk that this one turkey will, likewise, leave the trap.
Previously, you didn’t want to be content with one turkey, now, you’re
afraid that you’ll even lose this one, too, and you still want to secure
your mini profit, in any case.

Completely afraid of losing this one, too, you don’t even see that
there are six more turkeys making their way to your trap. You’re
thinking only about what you could lose and no longer about what
you could still gain.

When was the optimal time to close the trap? When would you have
closed the trap? With four turkeys? How were you supposed to
know that no more turkeys would run into your trap?

Our solution to the problem of finding the right time to snap shut the
trap can’t be based on feelings. It’s because our emotions will jump
around, back and forth, from fearful hope to greedy delight.

We’ll only be able to trade in a disciplined and unemotional way if we

have a clear rule about when we should let the trap snap shut.
Otherwise, we’ll be riding on an emotional roller coaster. With every
new turkey in the trap our delight would increase, however, every
time one ran away our disappointment would also grow. Turkey
hunting would be emotionally grueling. At some time we’d get to the
point where we wouldn’t behave rationally but, instead, simply would
want to stop riding the emotional roller coaster. Although, I doubt
that this point in time would also be the optimal one.

It’s only when we develop a fixed rule that we can solve this problem
- without hope, fear and other unproductive emotions. We could, for
example, have a rule that stipulates that as soon as more than two
turkeys have left the trap, but there are at least two turkeys still in
the trap, we snap shut the trap. We can expand this rule so that
when we have a certain xy number of turkeys under the cage we
snap shut the trap when already one turkey has left. When it comes
to developing an exit rule, the sky’s the limit. The only thing that’s
important is that an exit rule always has to be based on the basic
principle of let profits run and limit losses.

The turkey example is a very good comparison with the market.

Here, too, we don’t know how many additional points we’ll still be
able to earn. As this is an uncertain event that lies in the future, then
our decision will have to depend on how many points (turkeys)
we’ve already earned (caught) and how likely it is to snatch another
x + 1 point (turkey). We have to develop an exit rule on the basis of
this information.

This exit rule ensures that we’ll no longer be conflicted but, instead,
will be able to master the decision-making situation in a relaxed
manner. We have a fixed rule for the exit. The result will possibly be
sometimes smaller, sometimes bigger but it will have been the rule
that we complied with that will have produced the result and not our
feelings. Consequently, we won’t judge the situation anymore on our
emotions and, in this way, we’ll avoid low moods as well as those
damaging highs.

However, the question that still has to be answered is, for the entry
strategy that we use, which exit rule, on average, will produce the
highest output. In order to solve this issue we have to go back to our
basic knowledge of statistics.

Let’s start with the probability of gaining another x + 1 points. As the

size of the profits increases, so the probability of realizing x + 1
points falls because the market movement won’t yield this profit
anymore. Nevertheless, this doesn’t mean that we should focus on
small profits. It tends to be simpler to concentrate on bigger profits
than to try to generate your performance with lots of small profits.

Let’s make this clear for ourselves with an example from the DAX.
While the probability for a day trader to gain two points is still very
high, it falls significantly when it comes to generating a gain of 20
points.

Let’s assume that the probability of gaining two points is 85 percent

but the probability of gaining 20 points is only 30 percent. In order to
realize 20 points, we now have the possibility of earning ten times
two points or one times 20 points. The probability of realizing ten
times two points consecutively is 0.85 to the power of 10 = 19.69
percent and is, thus, significantly below the probability of realizing 20
points once.

You should bear in mind that this calculation was made without
taking trading costs into account. With trading costs it looks even
worse. Furthermore, we have to bear in mind that, irrespective of the
outcome of a trade, we need time and resources for each trade.
Here, too, a large profit is preferable to many small ones.

If we assume that the probability of generating a seven-point profit is

67 percent, we would thus only have to win three times in order to
achieve our 20 points. In this case, the probability of winning would
be almost the same (0.67 x 0.67 x 0.67 = 0.3). Yet, even in this case
we’re confronted by the problem of having to find an entry three
times, which means that, during the day, the market has to offer us
an opportunity three times compared with one 20 point opportunity.

We can see from this calculation and from the example that the
issue of the optimal profit size depends, among other things, on the
question of the probability of achieving a particular profit. Given that,
as profits increase it becomes ever more unlikely that x + 1 points
will be realized then, as profits get bigger, our exit rule has to
generate trading behavior that is different from the behavior used
with small profits.

Nevertheless, it should be structured in such a way that it is focused

on big profits and makes these possible. Accordingly, an intelligent
exit rule will give a trader different requirements for the various
trading phases.
 9.4 My exit rules
My first and most important exit rule is that, in an upward trend, I set
my trailing stop at the relative low and, in a downward trend, at the
relative high (see chart). In the next section I call this Exit Rule 1.

I, myself, distinguish four phases with my exits.

9.4.1 The first interval - R1

This first phase is the range between the entry and the stop. I call
this interval R1 as, in this phase, in extreme cases, I could lose the
entire amount that I’ve risked.

In this interval, the trading result is negative and I only have the
choice between the following alternatives: a) let the trade be
stopped out with a loss, b) wait and hope that the market does still
turn in my direction and that the trade goes beyond the break-even
point, and c) scale out part of my position with a loss.

As long as the market is in this loss-making phase, my initial stop

remains unchanged. Before I execute the trade I select this stop as
a meaningful line in the sand and I’m prepared to lose the amount
that I’m going to risk. Therefore, I don’t have to bring the stop any
closer to the market and, thus, risk being stopped out by the general
noise.

The initial stop is always placed behind significant market points, so-
called pivots, thus it lies outside of the zone of normal noise. As long
as the market doesn’t offer me any significant points behind which I
can place my stop, I set my initial stop at a predefined interval away
from the entry, so that the initial stop is further away from the noise
of the market, in any case.
However, for this phase, it’s important to develop one or more rules
about when to scale out your position, which means making partial
exits. The dilemma that exists, at this point in time, is that through
scaling out you achieve smaller losses, on average, but you’re
taking away upside potential for the whole position as well. That’s
why there should be clear reasons for scaling out.

When I enter a trade I think that I believe that I can get into profit
immediately, otherwise I would’ve continued to hold back the trade.
Thus, in any case, something has to have gone wrong if the market
has pushed my trade into loss. Here, once again, I distinguish
between pro-cyclical trades and anti-cyclical trades.

With pro-cyclical trades, I rarely tend to scale out of a position,

whereas with anti-cyclical trades, after a grace period, during which I
allow the market to get back into the break-even zone, I begin to
reduce the position rigorously.

Normally, I divide up the position into three thirds and, to begin with,
I sell one third of it. If the trade then continues to make further
losses, another third is sold and I retain only the last third. Rigorous
scaling out results in my losses, on average, being smaller than
usual.

With pro-cyclical trades, I usually only sell one third of the position if,
after a grace period, I’m still making a loss.

The exit rule for interval R1 is mainly a time stop for part of my
position.

At this point, the question arises as to why I don’t use a staggered

initial stop right away. Frequently, markets look for stops. Thus, over
and over again, we see sharp sell-out movements in a range, which
taken as a whole, however, have no significance. My initial stop is a
worst-case stop, which protects me from losing too much money.
That’s why it functions in the market as a so-called hard stop.
All other stops within the loss-making interval are not in the market
so that they can’t become victims of stop catchers. If I notice a sharp
sell-out without an immediate recovery then I attribute greater
significance to this movement than to the typical stop catcher
maneuvers that are mostly of an ephemeral nature. It’s only if I
deem the movement to be significant that I scale out part of my
position. Besides, I always want to give the trade some time to
develop, so that positions would only be scaled out after remaining
in the loss-making zone for a longer period.

Naturally, in this phase, my first exit rule already applies - in an

upward trend, I subsequently set my stop at the relative low and, in
a downward trend, at the relative high. It can happen that a relative
low/high falls within the R1 range and I can trail my stop to this point
and, thus, decrease my risk, without however, already being in a
market phase where my initial stop is zero.

9.4.2 The second interval - R1

After the R1 interval, the profit zone begins. In this range, where I
still haven’t earned my original risk (difference between the entry
and the initial stop), my behavior is neutral. The market has already
shown me that I’m right with respect to my position as it’s in profit.
Thus, there is no need to reduce the size of the position.

However, as soon as I’ve earned my initial risk (R1) then, at any

rate, I no longer want to get out of the market with a loss. That’s
why, the moment I’ve earned my risk, in any case, I’ll pull my stop to
break-even level, irrespective of the market movement.

Naturally, during the second phase, Exit Rule 1 is still in effect.

9.4.3 The third interval - R1.5

As soon as I’ve earned 1.5 times my risk, I use a stop that ensures
that, irrespective of any market movements, one third of my profit
has been secured. Therefore, I use a profit protection stop. For
example, if I were 21 points ahead, I would, in any case, secure
seven profit points. With 24 points the stop then goes to eight points
and so on.

9.4.4 The fourth interval - The target zone

When evaluating a trade from the point of view of risk, besides a
stop and an entry, I stipulate a target zone for each trade. As soon
as the market reaches this target zone my exit rule automatically
becomes more aggressive. Now, I’m still prepared to give up a
maximum of a quarter of my profit. Moreover, I now no longer
subsequently set my stop at the relative low on the five-minute chart
but, instead, I watch the relative lows/highs on a shorter-term chart,
such as a one-minute chart.

You should bear in mind that in the target zone, too, the profits are
not restricted by a limit. In fact, I let the market decide when enough
money has been earned by moving my stop successively behind the
market.
 9.5 How to find your perfect exit strategy
As the exit strategy will have a significant influence on your
performance, you should use all your energy and concentration to
develop an intelligent exit strategy for your trading system.

The entry strategy has already been found and merely serves to
give the trade a direction. Now, in order to filter out the best exit
strategy, once again, we make use of the concept of the risk
multiple, as here all the effects of position sizing will be eliminated.

Take an entry signal and ensure that clear criteria define the entry.
That’s important so that your results will have significance for the
future.

In the next step, find out what the maximum risk is that you’re
prepared to incur. The section on “The risk of ruin” will provide you
with invaluable help here.

Now, you will still have to know what is the normal noise of the
market that you trade, as your initial stop can never be in this zone.

I’ve already given you indicators for this. The more experienced you
become, the easier it will be for you to determine what the normal
noise of the market is.

Your optimal initial stop will be in the interval between your

maximum acceptable level of risk and the noise of the market.

Now test your entry rule with this one exit rule. In the course of this,
sort your loss-making trades into several groups. The first group will
include all trades where you were stopped out with a loss without
ever having been significantly in profit.
The second group of trades will be ones that were in profit at an
interim stage but, nevertheless, were stopped out with a loss
because the market had turned again.

What you call a significant profit will depend on the initial risk that
you incurred. As soon as the market has gone at least half way in
favor of your initial risk, I would then classify the gains as being
significant. Therefore, for example, if your initial risk is 20 points then
all movements that, at an interim stage, show a gain of ten points or
more will be of interest.

The next group of trades will include transactions that, at an interim

stage, were in plus to at least the extent of the initial risk. Create
another group for each risk multiple. It’s irrelevant here whether or
not, at the end of day or the period of observation, the trades were in
profit. The only thing that is important is that, during a period, the
trades in each group were at least once so far in profit.

After you’ve created the individual groups, look at all the groups with
trades that were not immediately stopped out with a loss. Now,
check to see how many of these trades would drop out of this group
if your initial stop had been one point closer to the entry. If, through
this, the number of losers doesn’t go up significantly, then you can
generally set a narrower stop than in the first test run.

Accordingly, using the same method, test a stop that has been
tightened by two points. Keep on reducing the initial until you
establish that significantly more transactions are being stopped out
with the initial risk without having been in profit previously.

Bear in mind that changing the stop by just one point can affect your
performance significantly. As a day trader, you’ll possibly enter into
two transactions per day on 250 days. With 500 trades, of which, for
example, half will be stopped out with a loss, a reduction in the initial
risk by one point per contract would mean an overall 250-point
improvement in annual performance.
Once you’ve found your optimal initial stop then deal with the group
of trades that showed a significant profit but, afterwards, were
stopped out with a loss.

Now, look for a rule for a trailing stop, which would reduce the losses
in this group. When you’ve found a rule then check to see the effect
of this rule on the other groups with R + 1 and multiple gains.

You can use this exit rule only if it doesn’t result in any changes in
favor of the losers in the other groups.

The next step involves a lot of work and calculations. The results in
the other groups are usually strongly affected as soon as you
develop a trailing stop rule for the group of R + 1 profits, this is
because the exit rule will mean that many trades from the R + 2 and
more groups will already be stopped out before they achieve their
theoretical profit.

For the most part, because of the new exit rule, you won’t be able to
prevent many trades from dropping out of the high profit groups,
therefore, you’ll now have to calculate which exit rule achieved the
best result.

When you’re looking for an exit rule, naturally, a computer with the
corresponding software can do a lot of the work for you. Thus, with
the help of software, exit rules can be backtested and optimized.

A computer can process a large amount of data, however, traders

then run the risk of over optimizing. Frequently, there’s a lack of
understanding for exit rules that are generated by a computer. I think
it makes a lot of sense to have various exit rules for the different
phases of a trade.
 10.
CHAPTER 10

The search for the “maximum rate of return“. The best system
is of no use if we can tolerate a maximum of three
consecutive loss-making trades but, frequently, have to
expect four or more loss-making trades in a row.
 10.1 The Kelly Criterion
We’ve already learned that it’s important to understand how we,
personally, can deal with a series of losses. Up to now, our risk
management approach has focused on not going bankrupt. The
optimal bet size was always selected in such a way that the risk of
ruin would be as low as possible. Let’s now look at the question of
the optimal bet size not from the point of view of risk but, instead,
let’s think about with what betting strategy could we expect to
make the biggest profits.

The Kelly Criterion is a progressive betting system according to

which the higher your chances of winning, the more you bet. It’s
also logical to bet more money if the chances of winning are
higher because the higher the wager, the higher the winnings will
be, too.

In trading, your wager is nothing other than the position size. For a
functioning trading system with a given amount of capital, should
you buy one or rather ten contracts, would it be preferable to
acquire 1,000 instead of 500 shares? These questions are
concerned with the position size.

Unlike risk management, the Kelly Criterion doesn’t determine the

wager that can be expected to have the lowest possible level of
risk for the portfolio but, instead, its focus is on the bet that will
lead to the optimal growth of the equity curve of a portfolio.

Here, the main consideration is as follows. The more likely it is that

we’ll win - thus, the higher the hit rate - the more we should bet,
too, because that’s the only way we can achieve the maximum
profit at the end of a series of trades. Thus, the basic rule that
applies is that the greater the likelihood of profit, the more we
should bet.

The Kelly Criterion calculates the optimal size of a bet exclusively

on the basis of the hit rate and the loss rate.

The formula was named after its inventor who, in 1956, developed
a solution for Bell, a telecommunications company, to the problem
of random and unpredictable background noises that are
associated with the transmission of telecommunications data over
long distances. Soon, this was applied not only in the
telecommunications sector but was also used to determine the
optimal size of bets in casinos and also in trading.

This is because the problem is always the same, irrespective of

whether it crops up in data transmission, in a casino or in trading.
The result of a process where data or money is input is uncertain.
Thus, the stakeholders don’t know if their input will in fact yield the
desired output. It’s not certain whether, in a telecommunications
system, the data transmitted over long distances will also arrive in
the form that a stakeholder wants, or whether they will also be
distorted by background noises. That’s exactly the same problem
that traders or gamblers have when they make a bet but can’t be
sure that this wager will lead to a win.

This was Kelly’s solution to the problem:

F = 2 x P–1

or

F = p – Q,

where F is the percentage of the capital to be risked,

P is the probability of winning and

Q is the probability of losing (thus 1– P).

Therefore, with a strategy that has a hit rate of 60 percent a trader

should risk:

F = 60 – 40 = 20.

This wager would lead to the best possible result. The Kelly
formula is very simple. In essence, it says that a trader should
always risk his/her advantage. The advantage is calculated as the
win rate minus the loss rate (you already know about the
advantage from the section on “The risk of ruin”).

The bigger the advantage, the more a trader should risk. With a hit
rate of 80 percent, a trader should already risk 60 percent of
his/her capital. This appears to be a great deal and contradicts our
considerations as regards the optimal bet in order to avoid
bankruptcy.

The aggressive wagers of the Kelly formula arise because, here,

it’s assumed that gains and losses are always equally big and,
moreover, it was designed solely to maximize gains. However, it’s
not possible for a trader to maximize gains and, at the same time,
to reduce risk. These two goals contradict each other. It’s only
possible to maximize gains if you also accept higher risks. If you
reduce your risk then you won’t be able to maximize your profit as
well.

While the Markowitz Portfolio Theory developed an approach in

which diversification means it’s possible to generate higher returns
with low risk, however, in a trading strategy for a single market
there’s no possibility to diversify. With a single trading system, you
always trade one market, for example the DAX, one stock or the
Bund and, therefore, you’re not able to diversify. Then again, while
a combination of trading systems enables diversification, however,
this is not possible within one trading system.

That’s why we’re confronted with a dilemma - you can either

maximize your gains or reduce your risk. The right answer would
be a compromise that takes your risk preferences into
consideration. However, the Kelly formula is so aggressive in
terms of maximizing wins that the risks for traders, who want
above all to stay in the game, are too big.

Indeed, in some series of trades, the Kelly formula would allow

you possibly to go bankrupt. The problem with the original formula,
which assumed that wins and losses are equally big, was solved
and resulted in the following modified formula:

F= ((b + 1) x (P - 1)) / b,

where b is the payoff ratio, thus the ratio of average winning trades
to average loss-making trades.

Let’s assume, once again, that a trading system has a hit rate of
60 percent and a payoff ratio of 2 (this means that, on average,
the trader wins twice as much as s/he loses), then the optimal bet
would be:

F = ((2 + 1) x 0.6 - 1)) / 2 = (3 x 0.6 – 1) / 2 = (0.8 / 2) = 40

Yet, even this result would certainly be too aggressive for most
traders. However, the Kelly Criterion could be interesting if, during
a certain period, you’re able to withstand a total loss of the capital
that is risked at that time.

For example, day traders, who are prepared to accept a maximum

drawdown of 5 percent of their trading equity as a daily loss, could
use the Kelly formula to determine what they should risk per trade
over the course of a day. In our example, where the hit rate is 60
percent and the payoff ratio is two, a trader should risk 40 percent
of his/her capital. Now, if his/her daily loss limit is 5 percent, then
s/he should bet 2 percent per position (40 percent of 5 percent is 2
percent). This would be the ideal wager according to the Kelly
formula, however, on some days, it would probably result in the
loss limit being reached.

In any case, the Kelly formula can only ever be a rough

approximation, as it was developed as a solution to a problem
where there are only two possible outcomes. The data were either
correctly transmitted (success) or distorted by background noises
(failure). The formula assumes a “Bernoulli distribution”; in
statistics, this is what you call an uncertain event that has only two
possible outcomes.

However, in trading there are more outcomes than just “success”

or “failure”. Gains and losses come in very many forms as they
can vary enormously in size. That’s why, in the 1980s, Ralph Vince
tried to develop another solution, which is known as Optimal F.
 10.2 Optimal F
This very theoretical approach to calculating the optimal size of a
wager was presented for the first time, in 1989, in a book called
“Portfolio Management Formulas“. In this book, Ralph Vince
developed a method for determining the number of contracts that
would optimize the capital growth of a portfolio. Optimal F is the
answer to the question of what share of the biggest loss in the
past constitutes the optimal bet size. Thus, the formula specifies
what the ideal percentage share of the capital that is risked in
each case should be in order to generate the best overall
performance with a given strategy.

The best performance is always achieved when the overall gain

for the account, which results from the sum of all trades, is at its
highest level. Therefore, Optimal F, like the Kelly Criterion, allows
you to maximize the profitability of a system. Depending on
whether a trader had speculated with a bet that was too high or
too small, there’s a risk that his/her winning trades were not big
enough, or his/her loss-making trades were too highly capitalized.
The result is a worse performance.

Optimal F is calculated by iterating the percentage share of the

biggest loss in the past and involves a considerable amount of
calculation that, these days, can easily be carried by a computer,
however. The formula actually calculates the size of the bet, which
fluctuates between one and 100 percent of the biggest loss to date
that would have generated the strongest equity growth.

This can be briefly explained with a simple example. Imagine that

there are just two trades in a series. One results in a gain of Euros
2,000 and the other in a loss of Euros 1,000. The sequence in
which gains and losses occur is not relevant for the problem.
Now, trial and error, or iteration (approximation) is used in order to
look for the bet that will maximize the output. The search for this
fraction is carried out independently of account size. The way this
works is that the bet is calculated as a fraction of the biggest loss
experienced in the past.

Thus, Optimal F doesn’t directly specify the percentage share of

the capital that should be used but, instead, the share that will be
risked as soon as the biggest loss is realized. In our example, the
biggest loss was Euros 1,000. Now, you try to see what the result
would have been if 1 percent of the biggest loss had been bet, 2
percent in the next step, then 3 percent and so on.

The solution to this problem is of an academic nature and doesn’t

help us with our real trading. The approach in this solution is
problematic because Optimal F can only carry out an optimization
of the bet on the basis of previous losses.

The use of this formula is nothing other than curve fitting as the
optimization is carried out on the basis of data from the past. As
soon as even small changes are made to the characteristics of the
data, the Optimal F will also change. Therefore, the calculated
value is very susceptible.

Optimal F will be different for each series of trades even if the

basic parameters, such as the probability of winning and the range
between the biggest gain and the biggest loss remain the same.
Thus, the optimal bet size will constantly change.

What does Optimal F show us? If the losses of a strategy are

small then we can nearly always bet 100 percent of the biggest
loss to date. For example, if the biggest loss were Euros 500, in
the case of an account with Euros 100,000 this would imply that
for every trade we should risk Euros 500, or 0.5 percent of equity.
Optimal F proves that the statement “The bigger my risk, the
higher my profit will be” is wrong. There’s a point of optimal risk
and if this point is breached then the output of a system falls.
Optimal F maximizes the output. The formula doesn’t provide any
useful information about the risk of ruin. Thus, the practical value
of this theoretically very fine approach to a solution is very low.

In 90 percent of cases you’ll be headed for a total loss if you

actually trade Optimal F. Nevertheless, from time to time, you
should calculate the Optimal F for your trading. It’ll show you how
far away you were, in the past, from the optimal position size and
how risky your trading is. For example, if Optimal F actually
suggests that you risk only 1 percent or 10 percent of the biggest
loss to date, then your trading strategy is very dangerous and
you’re probably incurring too much risk. However, if your Optimal F
is in the region of 80 to 100 percent, then this would suggest that
you’ve already gained a high degree of control over the size of
your losses and that your losses are small.

It’s generally assumed that you can expect to gain more, the more
you risk (see Kelly Criterion). However, Optimal F shows that this
interrelationship is not correct.

There is an optimal wager. When you exceed this then profits fall.
Thus, there is a point at which aggressive position sizing no longer
results in big profits, particularly when you trade leveraged
instruments such as futures. As soon as the position size becomes
too big, then the drawdown will be so strong that in the
subsequent winning phase it won’t be possible to compensate for
it.

Don’t take Optimal F too seriously. As it’s determined on the basis

of past trading series, a bigger drawdown or series of gains can
already lead to a significant distortion. Thus, Optimal F and the
Kelly Criterion are not sets of clear instructions as to what amount
you should ideally risk. While they maximize the output they give
little information about the risk. That’s why in our search for the
maximum rate of return we have to concern ourselves once again
with a system’s risk of ruin.
 10.3 How to evaluate a system’s risk of ruin
Some systems have an amazing performance, in particular, if the
system developer has made use of curve fitting. That’s why it’s
necessary to take a closer look at the individual trades in order to
be able to evaluate a system.

As an example, imagine a DAX trading system where, on average,

you earn 20 points and, in the case of losses, you lose 20 points.
As a first step, let’s consider how many consecutive loss-making
trades this system will withstand before a trader loses his/her
entire account of Euros 10,000. The trader could lose 20 times in a
row, thus his/her account can be divided up into 20 loss units.

Now, in order to calculate the risk of ruin, we still have to factor in

the probability of winning. Let’s assume that the system has a very
good hit rate of 60 percent. Thus, the loss rate will be 40 percent.
As in the Kelly formula, the advantage is calculated by deducting
the loss rate from the hit rate, and the result in this case 20
percent. Accordingly, the probability of the risk of ruin is 0.03
percent.

RoR = ((1–A) / (1 + A))c

A = the advantage (hit rate - loss rate),

C = the number of units that I can lose. 1 divided by the
percentage share that I’m risking. Thus, if you want to risk 4
percent, then you divide 1 / 0.04 = 25.

If the hit rate of the same system were only 55 percent, then the
risk of ruin would go up significantly. It would suddenly go up to
1.81 percent and, thus, would have got 60 times bigger even
though the probability of a hit would have fallen only slightly.
However, the formula assumes that we trade indefinitely.

What’s problematic about this formula is that it assumes that wins

and losses are always equally big. However, that’s precisely what
we don’t want in our trading approach. In fact, we would like our
profits to be considerably bigger, on average, than our losses.
That’s why this formula is only a rough approximation and can
significantly overstate the risk of ruin. The problem becomes too
complex for mathematical solutions as soon as varying levels of
payouts are taken into consideration. However there are
approximation formulas.

Even with the simple formula, it can be clearly seen that the risk of
ruin increases significantly as our bet gets bigger. You can
determine the risk of ruin for any desired bet for a given trading
system with particular hit rates and loss rates.

You can calculate the risk of ruin for your Optimal F bet. Usually,
this risk is not acceptable. If you select a bet that is smaller than
your Optimal F bet then your risk of ruin will fall, however, you’ll
then be trading a position size that won’t contribute to the optimal
growth of the portfolio.
 10.4 Maximum rate of return
The conclusion that can be drawn from the comparison of the risk
of ruin with Optimal F is that during phases in which our trading
approach works very well we should ideally trade Optimal F.
However, as soon as the trading approach encounters difficulties
in the market, then the selected position size should be small
enough so that there’s only a marginal risk of ruin.

To put it another way, a trader has to be able to recognize when

s/he can push the market and when s/he should exercise caution.
Constantly pushing the market (by betting Kelly, or Optimal F) will
lead to the loss of the account. By contrast, an overly cautious
trader, who doesn’t push the market during good phases, hinders
the capital growth of the portfolio by using a position size that is
too small.

Therefore, we have to find a method that allows us to achieve a

big position size quickly during winning phases but that will then
be reduced if we encounter the smallest difficulty.

Traders usually have their biggest position size after a series of

hits or wins and, as a result, traders will also embark on their next
series of losses with the biggest position size. This is because
naturally, at some time or other, a series of wins will be followed by
a series of losses, too. Here, if traders hesitate for too long about
reducing their positions then the start of the drawdown will be so
strong that a subsequent reduction in the size of the positions will
result in traders finding it difficult to achieve new capital highs in
their portfolios with the next series of wins. Their winning trades
will then be undercapitalized.
Frequently, traders want to avoid this problem and that’s why they
always trade position sizes that are too small. While this helps
them to withstand longer drawdowns, however, it’s suboptimal in
winning phases. In contrast, beginners usually trade position sizes
that are too big, which achieve fantastic growth during the winning
phases, however, in the loss-making phases these then steer the
account to the point of ruin.

Thus, the rule is: Push the market if the conditions allow this,
otherwise be as cautious as possible.

Let’s now specify what conditions have to be satisfied so that we

can push the market.

1. The trading approach should be ideally suited to the market

conditions. For example, if you use a trend-following strategy,
then the market should also be exhibiting strong trends.

2. Your results will be a pointer as to whether or not the market

conditions are favorable for your trading strategy. Both the hit rate
as well as the payoff ratio should be above average. If your hit
rate for all previous trades is, for example, 45 percent but if the hit
rate for the last ten transactions is 60 percent, then the market
conditions would appear to be favorable. The same applies to the
payoff ratio, or to your risk multiple. If the risk multiple that you
normally realize is 2.2 and, by contrast, if your last ten trades
resulted in a risk multiple of three, then you’re in a favorable
market environment.

3. Regardless of the market conditions, new highs in our equity

curve show us that we’ve come upon conditions that are
favorable for pushing the market.

4. However, it would be a mistake to push the market solely on the

basis of new highs in the equity curve because, naturally, after
 every drawdown a winning series will follow, however, after a
drawdown we’re not at a maximum point in the equity curve.
That’s why conditions will already be favorable when your equity
curve goes up significantly and steadily from any low.

When these conditions exist then it’s time you maximized your
position size. You can work out a formula for this, or alternatively
make discretionary (case by case) decisions as to when you want
to push the market. The advantage of a discretionary approach is
that it’s more flexible, thus, you can react more quickly to favorable
or unfavorable conditions. It also takes into consideration the
trader’s mood, as it’s only when you’re in a productive mood that
you should also push your position size.

Those who are capable of observing themselves closely and of

knowing themselves (a psychological trading diary will help you
here) can frequently recognize, long before this can be measured
statistically, that the market conditions are favorable for their own
trading approach and that it makes sense to increase the position
size.

With regard to position size management, good discretionary

traders will take into consideration not only the equity curve and
the market conditions in conjunction with the trading approach but
also their mood. After a series of wins, if they feel that they’re no
longer in peak condition, then they’ll immediately reduce the size
of the position.

The disadvantage of discretionary position size management is

that you have to be very disciplined. It’s usually only experienced
traders that achieve this level of performance. If you fail to notice
that, currently, you’re not in a productive mood then, inevitably,
you’ll slip into the next loss-making phase with a position size
that’s too big and you’ll experience a dramatic drawdown.
Personally, I manage my position sizing on a discretionary basis
but it was a long road to get to the point where, now, I intuitively
know what position size is ideal and when.

However, there are also algorithms for determining position size.

These are formulas that tell traders how big their position size
should be at a particular point in time. My discretionary approach
consists in consulting several algorithms and deciding, on a case-
by-case basis, when to use which formula.

In Chapter 7, I already gave you a few pointers about how you can
develop a position sizing algorithm. In the next section, we want to
continue with this approach and delve deeper.

“Push the market if conditions allow.” In order to provide some

input for this rule, we’re now going to put the conditions that have
already been specified above into simple formulas and develop a
position sizing matrix. We can use this matrix to look up what
position size we should trade and when.

Equity curve Hit rate Risk multiple Mood

Above average Increase Increase Increase Hold

Rising Increase risk Increase risk Increase risk Increase risk

Falling Reduce risk Reduce risk Reduce risk Reduce risk

Below average Reduce risk Reduce risk Reduce risk Reduce risk

The matrix not only makes a distinction between whether or not,

just now, the current performance is positive, but also whether
we’re above or below our average as regards important variables.
The average that you want to use will depend on how aggressively
you want to change your position sizes. The shorter the average,
the more frequently you’ll get signals that’ll tell you to increase or
to reduce your position size.
There are various situations in which it makes sense to increase
your risk. If you select a higher risk for a position, usually, the
position size increases. In a trading situation where, for example,
you use a stop of ten points in the DAX with a Euros 100,000
account, for a risk of 1 percent (Euros 1,000) you would trade four
contracts (1,000 / 250 = 4). However, if you want to accept a
higher risk, for example 1.5 percent, then you also have to trade a
bigger position size (1.500 / 250 = 6), which would be six contracts
in this case.

The cases in which you would increase your risk can already be
seen in the matrix but not, however, the factor by which you would
increase your risk. That’s why, for every case, you have to specify
how strong an increase you want for your risk.

Let’s say that your average position size is 0.5 percent. Now, when
your equity curve is above your average, it’s up to you to decide
whether you’re willing to accept a risk that’s twice as big or,
instead, only marginally to increase your risk.

Figuring out the amount by which your risk should be increased is

the function of your position sizing algorithm. For example, it can
stipulate that the risk should go up by 0.25 percent, or you can
specify that your risk should go up by 5 percent. In this case the
result would be 0.525 percent (0.5 percent x 1.05). You get a
specific instruction.

However, bear in mind that this step is performed after every

transaction. That’s why an upward jump in the risk that’s too strong
is very dangerous.

I prefer to allow a percentage increase in the risk, however, I

stipulate an upper limit. In the case of an “equity curve above
average”, I would opt for, for example, a 10 percent increase in the
risk, but up to a maximum of 3 percent of my capital. Thus, when
I’ve reached the 3 percent level then the risk won’t be increased
anymore, even if all the circumstances are favorable.

10.4.1 Sample matrix

Equity curve Hit rate Risk multiple Mood

Above average + 10 % max. + 5 % max. ± 0 % max.

3 % EQ 3 % EQ 1 % EQ

Rising + 25 % + 10 % +5% + 10 %

Falling – 10 % – 10 % – 10 % – 15 %

Below average – 20 % –5% –5% – 20 %

The matrix shown above now presents specific instructions. Let’s

assume that just now I’m trading a risk of 1 percent. Now, my
equity curve is above the average (+ 10 percent) and goes up (+
25 percent), the hit rate also goes up (+ 5 percent), but is still
below the average (– 5 percent), and my risk multiples are above
the average (+ 5 percent), but they’re not going up, instead they’ve
fallen (– 10 percent).

I should then increase my position size as follows:

1 percent x (1 + 0.25 + 0.5 + 0.5 – 0.5 + 0.5 – 1) = 0.01 x 1.25 =

0.0125 =
1.125 percent

The step from 1 percent to 1.25 percent appears to be little.

However, bear in mind that this calculation is carried out after each
trade. A small winning series of three trades under the conditions
that have just been mentioned would increase the risk by almost
100 percent (0.01 x 1.25 x 1.25 x 1.25 = 0.01953 = 1.953 percent).
Here’s another example: Let’s assume that, once again, we’re
trading a risk of 1 percent. However, this time, the equity curve
falls below the average (– 20 percent), with a falling hit rate (– 10
percent) and falling risk multiples (– 10 percent), which like the hit
rate (– 10 percent), are below their average (10 percent). It’s
advisable to reduce the risk by 60 percent. Instead of 1 percent we
would still trade only 0.4 percent of the equity. If the next trade
again generates another loss, so that the equity curve, hit rate and
risk multiple continue to fall, then the position size is again
reduced by 60 percent to 0.24 percent.

Please note that the data given here are only examples. The
values that it will make sense for you to enter in the matrix will
depend on your personal risk preferences and on your trading
style.

If your system generates a lot of signals, then the steps for

changing the position size should preferably be small. However, if
you get only a few signals in a year then you can change the
position size more quickly.

It’s important that you should be able to increase your position size
quickly when your equity curve goes up and, after the performance
peaks, at the start of a loss-making series, to reduce the position
size again just as quickly.

In order to be able to, in the first place, increase your position size
after a series of losses, the values have to be selected in such a
way that the risk will be allowed to increase even when your equity
curve is below the average but is beginning to rise.

If your equity curve is above the average but is falling, your

algorithm should help to stop your risk increasing further.
Therefore, you should always ensure that the algorithm follows an
anti-marginal principle. Actually, that’s the only condition for a
position sizing algorithm.

Be adventurous when you’re developing your position sizing

algorithm. Based on your past performance, try out various
position sizing formulas and check to see what type of position
sizing management is best for you.

Developing a position sizing algorithm involves a lot of work.

However, this point is more important than any forecasting method
and entry strategy. Use your energy to develop an optimal
algorithm.
 11.
CHAPTER 11

Monte Carlo simulations. Only those who simulate their trading beforehand
are prepared for everything. Monte Carlo simulations help us to understand
risk.
11.1 What’s the difference between a simulation and
backtesting?
When you buy a car, beforehand, you’ll undoubtedly go for a test-
drive in it? It’s because you want to know what it feels like to drive
this car. You want to know if the promises made by the sales
representative, or in the sales brochure are true.

In the same way that you test drive a car, you should also test your
system so that you know what to expect. Is a drawdown of more
than three months normal, or does it mean that your system isn’t
working? How serious could a drawdown be in your system? How
frequently should you expect a drawdown? What sort of capital
gains can you expect in a particular period?

You should have answers to all these questions before you opt for a
system.

We can’t predict the future, but we have to make it possible for us to

be able to take informed and realistic decisions. Quantitative risk
analysis provides us with the necessary resources for this. In order
to be able to form realistic expectations we have to simulate our
system.

Yet, what’s the difference between a simulation and backtesting?

Isn’t it enough if we test our system on the basis of past price data
series? This so-called backtesting is a possible way of finding out
whether or not a particular trading approach works.

However, the problem with backtesting, as opposed to a simulation,

is that it’s only possible to perform one test run with one historic data
series. Moreover, frequently, such a method of testing provokes a
trader into making changes to his/her system in order to enhance
the performance curve in such a way that the test with a historic
data series will generate very good values.

This so-called curve fitting doesn’t even have to happen consciously.

Frequently, it’s simply a few key pieces of information from the
historic price series (such as market volatility or trend
characteristics) that a system developer will use in order to optimize
his/her trading strategy.

The smallest changes to a system’s parameters can have a

dramatic impact on the performance. Thus, adjusting the initial stop
from 15 to 18 points, in a backtest, can already transform a loss-
making system into a winning system. Backtesting is playing around.
At most, it can give the trader an inkling as to whether or not the
system that’s used actually works.

It’s better to simulate the system than to backtest it. For this, there
are two possibilities: data simulation and system simulation.

With data simulation, a random number generator is used to create

an artificial price series, which is distinct from a real series but,
nevertheless, follows the same statistical pattern. The trading
system is then tested on the basis of this randomly generated price
series.

It makes sense to generate several price series, according to this

principle, in order to obtain different results from the simulation. By
analyzing the results of the simulation it’s then possible to make a
reasonably reliable estimate of how the system could behave in the
future.

The second possibility for testing the system is a system simulation.

You let a computer simulate everything that could possibly go wrong
and then you look to see if any of the results appear to be so
intolerable that you should reconsider the entire strategy. This
technique is called a Monte Carlo simulation.
In order to be able to simulate a system, some of the system’s
parameters have to be known. These are the hit rate (and, thus, the
loss rate) and the distribution of winners and losers according to
size.
 11.2 How to simulate your system
If you want to simulate your system then it’s sufficient if you
establish the risk multiples of the last 100 transactions and sort them
into groups.

Let’s assume that you had 100 transactions that led to an overall
result of Euros 5,820. In your trading diary, for each trade, look up
what risk you incurred and what multiple of your risk you realized.
You’ll have trades where you were stopped out at the initial stop.
These trades fall into the R1 group, as you lost your risk. Then
there’ll be trades where you, roughly, earned your risk, the R + 1
trades (these are trades where, for example, you risked Euros 500
and then won Euros 500).

You might possibly have trades where you gained two times, three
times maybe even four or five times your risk. Depending on how
much you gained, classify these trades as R + 2 or R + 3, R + 4 or R
+ 5 trades.

There’ll undoubtedly also be trades where your gain wasn’t exactly

double your risk but, instead, for example, 1.7 times (risk of Euros
500, gain of Euros 850). Initially, you should also write down these
trades as R + 1.7. However, later you should form groups in order to
simplify the simulation. For this, you could combine together, for
example, all the trades from R + 1 to R + 1.5.

However, when you form the groups make sure that your method is
consistent. For example, it would be a mistake to form groups at
intervals of 0.5, at the beginning, and then still another group for the
risk multiples above 5. That would distort the result and make it very
inaccurate.
After you’ve formed the groups, in principle, you can start the
simulation. The only thing that you still need for this is different
colored marbles and an opaque marble pouch. Assign a marble of a
particular color to each group.

Group Number of Color of Percentage Number of marbles out of 100

trades marble share marbles

R–2 3 Red 3% 3

R–1 47 Blue 47 % 47

R+1 33 Green 33 % 33

R+2 8 Yellow 8% 8

R+3 5 Black 5% 5

R+4 4 White 4% 4

Total 100

Now, fill the pouch with as many marbles of each color so that the
group percentage shares of the total result will be exactly recreated
through the distribution of the different colors of the marbles.
Therefore, if R–2 trades made up 3 percent then, in the case of 100
marbles, you should put exactly three marbles into the pouch to
stand for the R–2 trades.

So, now your trading system is in your marble pouch. If you take a
marble out of the pouch then this is no different to following the next
signal from your trading system. Here, it’s completely unimportant
whether the signal was a long or a short one. Whether you’re taking
out the marbles, or you’re in the market, either way you can’t look
into the future and so you don’t know whether your next trade will be
a winner or a loser.

Therefore, the first and most important trading law applies:

Whether a trade is a winner or a loser - it’s random.

Nobody in the world will have any influence on this until they’re able
to predict the future. It’s the same with the marble simulation.
Nobody can anticipate what the color of the next marble will be. Will
it be a winner or a loser? We don’t know that. What we do know is
that, in our example, with a 50 percent probability we can expect
that a trade will be a loser (R–1 and R–2 = 50 percent).

However, how much money will you earn if you take a particular
marble out of the pouch? The color of the marble only indicates what
risk multiple you will realize, which is why before you take out a
marble (trade) you have to determine your risk. In trading, our risk
(bet) is the difference between the purchase and the stop price
multiplied by the number of shares or contracts that we want to buy.
In the case of futures, we also have to multiply the result by the point
value of the future contract. Here’s an example.

If we want to buy the DAX at 4,000 and place our stop is at 3,990,
then the difference between the purchase and the stop is ten points.
Our risk per contract is ten points. As a contract is worth Euros 25 in
the DAX, the risk per contract is Euros 250. When we decide that we
want to buy ten contracts then the risk is Euros 2,500.

As soon as we’ve determined our risk (bet), after we’ve taken out a
marble, we can then specify what multiple of our risk (bet) we
would’ve gained. For example, if we take out a red ball then we
would’ve lost double our risk. With a risk of Euros 2,500 we would’ve
lost Euros 5,000.

We can now continue as in the example. Before each trade we

determine our bet (that’s our risk) and then we take out a ball. We
can then make a note of the result and add it to our trading capital or
deduct it from it - depending on whether it was a gain or a loss. After
a few dozen moves we get a performance curve for this simulation
run. It’s up to you how long you want to make your simulation run.
However, I would suggest at least 100 trades per simulation.
As you might already have guessed, this type of simulation is very
time-consuming. However, the advantage of determining the bet
yourself each time and of performing the simulation by taking out
marbles out of a pouch is that such a simulation also, frequently,
induces the emotions that are noticeably stirred up during trading.

Thus, traders are better able to assess how they would deal
emotionally with a series of losses. Ideally, you shouldn’t run just
one simulation but, instead, have several runs so that you get an
average simulation result.

This type of simulation will help you to understand what phases

you’ll have to focus on in trading and what you can expect.
 11.3 How to develop a simulation in Excel
Another possibility is not to simulate the trades with marbles but,
instead, with Excel or some other random number generator. In the
meanwhile, there are also a number of Monte Carlo simulation
programs available online. However, for those who don’t shy away
from putting in some effort into programming, they can very quickly
and cheaply put together their own Monte Carlo simulation with the
help of the random number generator in Excel. I’d like to present a
simple example in the following section.

In Excel there’s a data analysis function that’s called “random

number generation”. This data analysis function can be found under
the menu item extras. However, beforehand, likewise under the
menu item extras, you have to select the analysis functions and the
VBA functions for analysis in the add-ins manager.
As soon as you’ve installed these functions then you can use the
random number generator.

In the following section we want to simulate a simple trading system.

This trading system works anti-cyclically and tries to profit from false
breakouts. That’s why orders are placed above important
resistances and below support zones with the aim that, after a
breakout, the market will once again fall back below the resistance
level or run into the support zone. Every time the system has a
success it earns six ticks in the Bund. If the trade fails then the
losses will be realized after twelve ticks. Therefore, in this system
there are actually only two variants: either a gain of six ticks or a
loss of twelve ticks.

Backtesting has shown that this system has a hit rate of 80 percent.
Now, we don’t want to analyze this system by means of backtesting
but, instead, with a simulation. In the first phase of the simulation we
generate a random number series that results from 80 percent hits
and only 20 percent losses.

For this, you should call up the random number generation under
the menu item extras. There you’ll be prompted to specify the
number of variables. As we only know the factor success, or no
success, thus win or lose, we only need one variable. As the
quantity for the random numbers we select, for example, 1,000 for
1,000 trades.

After that we have to specify the statistical distribution, which the

random numbers should be subject to. For this, please select a
Bernoulli distribution. A Bernoulli distribution always has to be
selected if the variables reflect two mutually exclusive outcomes (for
example, success or failure).
Furthermore, you’ll be asked for the p-value. This value gives the
probability of success in terms of the test. Here, success doesn’t
mean an evaluation of the results, but, instead, merely presents the
observational aspect.

For example, in the context of quality control, if products are tested

as to whether or not they are defective, success in terms of a
Bernoulli distribution can be the defectiveness.

In our example, success stands for a positive trade (although, we

have defined it in this way). The random number generation then
creates 1,000 random numbers with the desired distribution either in
a new worksheet, or in an output area predetermined by us.
Therefore, we obtain a number series with 1,000 numbers, whereby
the number is either zero (for a loss) or one (for a gain).

Based on the results, once again, we’re able to prepare a

performance curve if we’ve previously specified what we’re willing to
risk. For the sake of simplicity, let’s say that we want to buy one
contract in each case and the tick value is Euros 10. Thus, for every
time the random number is one, we would’ve gained Euros 60 and
with a zero we would’ve lost Euros 120.

So that we don’t have to calculate our equity curve manually, we can

use a formula. For this, we select the formula editor and, here, a
function from the logical functions category. The function enables us
to analyze the content of an Excel cell and then, based on the result,
to specify particular values. We select that when the adjacent cell
has the value one, then the value 60 should appear in the current
cell. If the function is not true, thus, the cell does not contain the
value one, then the result should be –120.

We perform this calculation for each random number. In the third

column we then add together the results by entering a formula such
that the cell content comprises the value in the cell above and the one
to the left of it. We obtain a performance series.
This performance series is the result of a simulation. Now, we can
perform the simulation once again but, this time, using a worse win
ratio, for example, instead of 80 percent we take just 70 percent. The
area we select for the output of the random numbers is exactly the
same one where our previous random numbers stood.

The new performance curve reflects a simulation based on the

assumption that we would only win in 70 percent of cases. It‘s still an
amazing performance curve. However, take a look at the next chart –
would you want to invest in this system?

Surprisingly, it‘s the same system with the same conditions with a hit
rate of 70 percent, but this time there’s a different distribution of the
series of gains. The system still has a positive performance but a long
drawdown. The simulation shows what drawdowns are possible.

This is a decisive advantage over backtesting, which usually only

shows the drawdown based on one price series. The more
frequently you perform simulations, the better you’ll see how
drawdowns occur and what’s normal for the system. In the second
run, more than 750 trades were made that didn’t result in a new
performance peak anymore. Consider the following: In reality, would
you be able to follow such a system? How likely is such an event?

In order to find that out we have to run several simulations and make
a note of the results. For this, you could use a table like the one
pictured below. At the end of several simulation runs you can then
calculate what you can expect, on average.
Simulation High Low Longest Biggest End
drawdown drawdown

1 8,500 0 150 trades 1,800 8,300

2 2,700 – 80 750 trades 2,800 1,250

….

100 6,500 – 100 400 trades 2,400 3,600

Average 6,233 – 420 411 trades 2,200 4,500

The simulations described above were very simple. Of course, you

can set up a much more complex simulation. The more detailed the
simulation of the trading process in a trading system, the better
prepared you’ll be for the day-to-day business of trading. This
chapter can only serve as an introduction to this complex topic.

Please note that this simulation is not based on a money

management algorithm. However, a simulation is an ideal way to
test the effects of different money management strategies. It only
makes sense to test a trading system once you’ve also tested your
money management strategy.

It should be noted that simulations are indispensable if you want to

be ideally prepared for the day-to-day business of trading.
 12.
CHAPTER 12

Position Sizing. The probability that a single lot will be the

optimal position size is low. Master Traders vary their position
size according to the challenge.
 12.1 Single-lot traders trade suboptimally
Trading beginners, in particular, believe that they have to be
successful with one contract, first of all, before they can enlarge their
position size. Yet, in trading, position size is one of the few
parameters over which we have complete control. No area in trading
can be changed as easily as the position size.

Nevertheless, many traders forgo the possibility of exerting this

influence. Either because their account is too small and, therefore,
they don’t even have the possibility of trading more than one
contract, or alternatively because they lack the knowledge and the
courage to change their position size.

If your account is too small to trade more than one contract then you
should stop trading immediately, or select a market that will allow
you to trade at least two contracts. Position size is such an important
factor for good trading performance that no trader can afford not to
pay special attention to it.

It’s very unlikely that one lot (lot = contract) will be your optimal
position size, as your entries will normally be differentiated through
the initial stop sometimes being closer to the price and sometimes
further away. Sometimes, an opportunity might possibly present
itself to you to work with a ten point stop in the DAX, however,
sometimes, you’ll have to place the stop 20 points away. In such
situations, if you only ever buy one contract, then you’ll be weighting
your transactions differently. In the first case, for an unspecified gain
you take on a risk that is smaller than in the second case when you
use a 20-point stop. In the first case, your risk is Euros 250, in the
second one Euros 500 (in the DAX one point is worth Euros 25: (–
10) x 25 = 250).
Realistically, we have to assume that the probability of winning with
the next trade is always consistently high (consistently low). It’s
absurd to assume that there are situations that have a higher
probability of winning than others. It’s because this would mean that
we’re able to make forecasts about the future. However, nobody
knows whether, just now, they’ve got a good trade or a bad trade
ahead of them. That’s why it also doesn’t make sense to assume
that you’re able to determine the probability of winning for one
individual trade.

It’s only the probability of winning for a strategy (a series of trades)

that can be derived from the historic performance. However, this will
also only be the case if we assume that, in the future, the market will
behave in exactly the same way as it did in the past.

When the probability of winning is the same then, under normal

circumstances, it doesn’t make any sense to incur different risks. In
Chapter 10, we saw already that there’s an optimal bet size for a
given strategy and an investor’s risk appetite. The optimal bet size is
calculated on the basis of the risk of an individual trade, which is
comparable with a wager. Therefore, traders who don’t bet their
optimal wager are trading suboptimally.

For example, let’s assume that a trader always wants to risk one
percent of his securities account, which has Euros 100,000 in it.
With a ten-point stop in the DAX, he could buy four contracts (4 x
250 = Euros 1,000 = 1 percent of Euros 100,000). However, if the
stop is further away, for example, 20 points away, then he can only
buy two contracts. If he always buys only two contracts, then he’ll be
trading suboptimally in situations in which, according to his 1 percent
money management rule, he should have bought four contracts.

Imagine that you were in Germany and had to go from Düsseldorf to

Frankfurt city center. A large part of the route consists of a wide
expressway (an autobahn) but, unfortunately, not the entire route. It
also goes across highways with tight bends. If you were to travel
along this route in a car in which you weren’t allowed either to apply
the brakes or to step on the gas and, therefore, would have to opt
once for just one speed, then you would have to select a speed at
which you could drive everywhere without having an accident.
Accordingly, you would select a speed at which, on even the most
difficult part of the route, you could make it round the bend without
swerving. However, this speed is much too slow for the part of the
route on the expressway. Therefore, for a large part of the route
you’ll be driving at a suboptimal speed.

It’s similar with trading. If you don’t have the possibility to push when
things are going well for you and you lack a brake when things are
going badly then, for most of the time, you’ll be trading with a
suboptimal position.

Traders who only trade one lot have no possibility to apply the
brakes. Their only choice is to execute the trade with one lot or not
execute it at all.

However, you can’t win a race in which you get out when things
become a little more difficult. That’s why it’s important that your
average position size should cover more than one contract. That’s
the only way that you can steer things and, during difficult times,
apply the brakes, but during the good times you can then step on
the gas, full on, and exploit your advantage. Traders who aren’t able
to exploit position sizing management for themselves are inflexible.

Every trader knows that there are times when a trading approach is
ideally suited to the current market conditions and the strategy
appears to generate profits only. At such times, those who have the
possibility of increasing the position size are able to use their
temporary advantage. It’s important for traders to know when they
can push the market, when they have to step on the gas.

However, there are also times when, apparently, nothing works. The
strategies pursued by traders could have significant difficulties with
the market. For example, with a trend-following strategy you can
expect to get into difficulties during sideways phases in the market -
precisely because no trend develops. During sideways phases, the
performance of the system will suffer.

12.1.1 Single-lot traders

1. trade suboptimally

because it’s unlikely that one lot will just happen to be the optimal
position size;

2. trade inefficiently

because they evaluate each opportunity in the market as being the

same;

3. trade inflexibly

as they dispense with stepping on the gas when the trading is going
well and applying the brakes when the market proves to be difficult.

Here, if traders have the possibility of applying the brakes and

trading with fewer contracts then their average losses will be smaller
than if they constantly trade the same number of contracts.

The suggestion, which is frequently made in a sideways market, to

simply suspend a trend-following system and to trade on paper only
is not very helpful because traders will only know that a sideways
phase has finished once a new trend has already been formed. This
usually happens with a dynamic breakout from a trading range.

Missing out on this breakout (because the trader was only trading
virtually and had suspended his/her system) would significantly
damage the overall performance. It’s better to remain in the market
with a few contracts and then, in the event of a breakout, to pyramid
immediately. You’re going to see how this works later on in this
chapter.
 12.2 Position sizing - The turbocharger for your
performance
Two traders can follow the same trading signals and, nevertheless,
generate a different performance. This is the best proof that, in
trading, the entry strategy is of the least importance. Here’s an
example to illustrate this.

Let’s imagine a system that generated ten signals within one year.
The stop depends on the daily low (with long trades) or the daily
high (with short trades), on the day of the signal. In our example, the
following signals would‘ve been generated:

Number Signal Stop Risk per lot Result

1 + 4,200 4,180 20 + 140

2 + 3,800 3,750 50 – 50

3 – 4,500 4,530 30 – 30

4 + 4,500 4,475 25 + 50

5 – 4,800 4,900 100 – 100

6 + 4,300 4,290 10 80

7 + 4,600 4,540 40 – 40

8 + 4,900 4,860 40 – 40

9 – 5,100 5,140 40 – 40

10 + 4,900 4,860 40 20

Total – 10

At first sight, this trading system appears to be a flop. It’s because

anyone who always trades with a single lot, after ten transactions,
would end the year with a total loss of ten points.
However, what would happen if the trader were to use a money
management rule? His rule is: Always risk 1 percent of your equity.

Let’s assume that one point is Euros 10 and, in his account, he has
Euros 100,000. If he incurs a risk of 20 points, as in trade 1, he risks
losing Euros 200 per lot. As he wants to risk a maximum of 1
percent of his account, in the first trade, his risk will be a maximum
of Euros 1,000. Thus, he can buy five contracts for himself.

I’ve presented the results of using this money management rule in

the following table.

Number Risk per lot in points 1% of the account Gain/loss Account

Euros 100,000

1 20 1,000 5 x 1,400 = 7,000 107,000

2 (– 500) 1,070 2 x (– 500) = – 1,000 106,000

3 (– 300) 1,060 3 x (– 300) = – 900 105,100

4 25 1,050 4 x 500 = 2,000 107,100

5 100 1,070 1 x 1,000 = – 1,000 106,100

6 10 1,060 10 x 800 = 8,000 114,100

7 (– 400) 1,140 2 x (– 400) = – 800 113,300

8 (– 400) 1,132 2 x (– 400) = – 800 112,500

9 (– 400) 1,124 2 x (– 400) = – 800 111,700

10 40 1,160 2 x 200 = 400 12,100

Result Euros 12,100

By adapting his position size to the risk, from the risk aspect, the
trader has weighted each trade in the same way. Thus, the trader
always risks 1 percent of his account.

However, this rule results in different position sizes. Thus, when

traders trade the same trading system but use different position
sizes then they’ll generate different results not only in absolute terms
but also, frequently, in percentage terms. That’s why it may happen
that traders will replicate trades based on the signals of another
trader and one of them will earn money with this on account of
his/her variable position size, but the other one will lose money.

Position size is the key to success. As we already know, we can’t

look into the future and focus on the probability of the success of a
trade but, instead, we have to determine position size on the basis
of risk. However, besides risk there are also other indicators that can
help us to specify our position size.

The simplest possibility is to link the position size to the success or

failure of the account. This means that when things are going well,
then the trader should increase the number of contracts; if things are
going badly for him/her then s/he should reduce the risk and, thus,
the number of contracts.

This concept can be easily implemented if the trader always risks a

certain percentage of his/her account. This is because the better
his/her performance is, the higher the account balance will be and
the more risk s/he’ll have.

In the following chart you can see a simulation of a trading system.

The smoother line represents what the result of this system would
be if the trader never varied the number of contracts. The more
volatile line is the performance curve when the risk is 1 percent in
each case.
It can be clearly seen that as soon as the performance has
increased the equity, the one-percent rule has the effect of a
turbocharger because the system is automatically able to buy more
contracts. At the start of the system, only seven contracts had been
bought because, with a risk of Euros 130 per contract, the 1-percent
(= Euros 1,000) rule permits a maximum of seven contracts as the
position size, yet already after a few gains, the quantity of contracts
increases. The better the performance, the greater the number of
contracts that can be bought.

Of course, this rule also works in negative cases, however, it then

doesn’t work like a turbocharger but, instead, like a brake. The
worse the performance, the fewer the number of contracts that can
be bought.

A position sizing strategy that acts according to the principle of

raising the bet in the event of a gain and reducing it in the event of a
loss is called an anti-Martingale strategy. Perhaps you know the
strategy from the game of roulette where you bet only on one color
and in the event of a loss you simply double the bet. If this should be
followed by another loss then you continue to double your bet, as
the color that you’ve bet on has to come up eventually.

Let’s say that you decide to go for black and you bet Euros 5.
Unfortunately, red comes up and so, next time, you have to bet
Euros 10. If you win you’ll get Euros 20 and you’ll generate an
overall gain of Euros 5, as the sum of your bets was Euros 15. If red
comes up again, this time, you’ll have to bet Euros 20 already in
order to win Euros 5; with a further loss, Euros 40, then Euros 80,
Euros 160, Euros 320 and so on. After nine consecutive losses, you
would have to bet Euros 1,280 already in order to generate an
overall gain of Euros 5.

Naturally, as black will come up eventually, the casinos have

developed a strategy to protect themselves from this tactic. Every
roulette table has a table limit, a maximum amount that a gambler
can bet. That’s why this strategy, which works in theory, can’t be
implemented in practice. This strategy was invented by Martingale
who also gave his name to the principle of doubling in the event of
loss.

In trading there is no table limit so that, in theory, we could simply go

on increasing the risk with every trade until we’re in profit again.

However, in reality, there are two reasons for not doing this. Firstly, a
limit is set for us by our account and the margin requirements of the
stock exchanges. We don’t have an unlimited amount of money
available. Secondly, after ten consecutive losses, a trader would
usually be under such strong pressure that it’s unlikely that s/he
would have the mental strength required to double once again,
either.

All the traders I know who used a Martingale strategy, sooner or

later, were taken out of the game by the market and experienced the
risk of ruin of their accounts, frequently even, after having made
additional payments of large amounts, several times.
Martingale strategies don’t work. Sometimes, however, these
strategies are concealed behind a trading approach, so that traders
don’t even realize that they’re actually using a Martingale strategy.
For example, if you place staggered buy limits, in order to obtain a
favorable entry price, you’re already trading according to a
Martingale strategy, as the orders will initially be executed at the
highest buy limit. It’s only after you already have a book loss with
your first limit that you’ll then buy additional contracts.

Thus, in the event of a loss you’ll increase your risk - this is typical
Martingale. You’ll always have your full number of contracts when
the market is going against you and falling further, as all the buy
limits that were staggered downward will have been scooped up.

Unfortunately, if the market doesn’t go down to the lowest limit, then

your involvement will be restricted to a smaller number of contracts.
On average, when the market is going in your favor, you’ll have a
smaller position size than when you’re stopped out with a loss.
12.3 How to develop an optimal money management
algorithm
Now we know the principle that we have to follow when we’re
developing our money management algorithm. We have to ensure
that all strategies work according to the anti-Martingale principle.

As long as you take this principle into account then there are no
limits to your creativity. The money management algorithm tells you
how many contracts you can buy at a given point in time. Thus it
provides an answer to the question of position size.

There are a few standard variants, which are presented below.

12.3.1 Fixed bet size

With a fixed bet size the trader always “bets”, i.e. risks, the same
amount, for example Euros 1,000. It’s only once s/he reaches
particular break-even point values, for example, the doubling of
his/her account, that s/he also increases his/her bet.

12.3.2 Percentage bet size

I’ve already discussed this variant. The trader always risks a certain
percentage of his/her equity, for example, 1 percent.

12.3.3 Percent volatility model

This model works almost exactly in the same way as the percentage
bet size model, however, it takes into account the average volatility
of the trading market within a particular time period. As in the
percentage bet size model, the trader has a rule to determine how
much of his/her equity s/he’s willing to risk but s/he adjusts the
risked percentage amount for market volatility. This can happen in
two ways.

One possibility is that the stop, which the trader selects, depends on
the volatility. S/he calculates the average volatility for a particular
unit of time and then decides at what multiple of the average
volatility of this unit of time the stop should be placed away from the
market.

Here’s an example. A trader has calculated that the average hourly

volatility in the DAX is 20 points. He’s prepared to accept as his risk
a maximum of double the average hourly volatility. His stop is thus
40 points away. If this trader wants to risk a maximum of 1 percent of
his account and his equity is Euros 100,000, then he can trade a
maximum of one contract. 1 percent = Euros 1,000, 40 points =
Euros 1,000.

The other possibility consists in specifying a function that states the

percentage of his/her account that a trader will want to risk for a
given degree of volatility. S/he could, for example, specify that s/he’ll
always risk 2 percent of his/her account in a market that has
exhibited low volatility of 10 percent within a particular period of
time. As soon as the market starts to fluctuate by more than 10
percent, but less than 15 percent, s/he’ll only risk 1 percent. If the
volatility is between 15 and 20 percent then his/her risk will fall to 0.5
percent of the account, and above 20 percent, s/he’ll want to risk a
maximum of 0.25 percent per transaction only.

All of the methods, described above, have advantages and

disadvantages. Thus, many small traders follow the fixed bet size
model exclusively, as their account doesn’t allow any scope for other
rules. Too many trades would be refused for reasons of money
management. With the fixed bet size model, the advantages of
intelligent money management won’t come into effect, as the
automatic brake or the gas pedal only come into play at long
intervals, for example, if the account doubles. Usually, the brake is
built in only when the trader has already lost a significant amount.

That’s why it’s more dynamic to develop a money management

algorithm on the basis of the percentage method. Every loss or gain
is already taken into account in the planning of the next trade. If
things are going well, then more contracts can be bought quickly
and as soon as the situation starts to deteriorate, then the trader will
trade fewer contracts.

The disadvantage of this method is that it focuses exclusively on

own performance and not on the market. Both percent volatility
models offer a combination of a focus on the market as well as on
own performance.

As the stop is aligned with the volatility of the market, here,

movements in the market will be taken into consideration. Likewise,
with other percent volatility models - the more volatile a market is,
the less that is risked.

Naturally, you can take any anti-Martingale strategy for your

portfolio. However, the basic principles that have been discussed
can be optimized. With percent betting you already automatically
integrate the gas and the brakes in your algorithm.

However, it can also take a very long time before you’re actually
able to trade more contracts on account of good performance. For
example, let’s say you want to risk a maximum of 1 percent of your
portfolio and you trade in the DAX with a 20-point stop. Your account
size is Euros 100,000. According to this rule, you can trade a
maximum of two contracts (25 x 20 x 2 = Euros 1,000), as one point
is worth Euros 25 and you want to lose a maximum of Euros 1,000
with the first trade. In order to be able to trade a third contract you’ll
need an improvement in your performance of Euros 50,000, or 50
percent. So, it’ll be relatively late on before you can step on the gas
pedal.

That’s why I prefer rules that make it possible for the trader to step
on the gas quickly. For this, first of all, I determine my mean risk.
That’s the risk that I want to incur when my performance is
completely normal - let’s say, for example, 1 percent of my equity.

However, as soon as things start going well for me - thus, when my

strategy is managing well in the market and I’ve earned a certain
amount x in a predetermined period, then I’ll want to increase my
risk incrementally and I’ll up my risk to 1.5 percent.

If things continue to go well and, in the next predetermined period, I

earn an additional amount y, then my risk will go up to 2 percent and
so on. As soon as losses that have been realized drive down equity
from its peak by a certain amount z, then I’ll immediately trade only
my mean risk again, in this case 1 percent.

The algorithm works in exactly the same way on the negative side.
As soon as I’ve lost a certain part of my equity then I only risk 0.5
percent, then 0.25 percent and so on. If the situation then gets
better, once again, and I’ve earned a previously specified amount
then I’ll trade with my mean risk of 1 percent, again.

I call the amount that brings me back to my mean risk the “trigger
amount”. This trigger amount can be either a fixed amount (such as,
a gain of Euros 5,000 from the performance low), or alternatively it
can be a percentage (for example, 2 percent profit from the
performance low).

It’s important that the selected trigger amount shouldn’t be too big in
relation to the other stages. This is because if something is no
longer working according to plan, even in the event of a gain, then
the target should be to come back quickly to a normal risk. The
algorithm shouldn’t start to trade again with the mean risk after all
the gains have already been given up but, instead, when significant
performance still remains in the portfolio.

Here’s an example.

Let’s assume that, at the first stage, an amount x is Euros 4,000 and
an amount y is x + Euros 6,000. An amount z, which determines the
negative increments, is Euros 3,000. My trigger amount is Euros
2,000. The account starts at Euros 100,000.

Once an account balance of Euros 104,000 has been achieved, I

increase the risk by 0.5 percent to 1.5 percent. However, now as
soon as more than another Euros 2,000 has been lost, once again, I
trade with the mean risk of 1 percent. In the event of a loss, I reduce
my risk to 0.5 percent as soon as I get down to Euros 97,000, given
that an amount z = Euros 3,000 has been lost. The risk may only be
increased again to the mean risk once the trigger amount has been
earned.

The above-mentioned algorithm is simply an example. The

configuration of the stages and when you should go back to your
original risk depends very much on your trading strategy and your
risk appetite. However, what should be clear is that, in contrast to
the conventional models, which work exclusively with the same
percentage risk, here, it’s possible to step on the gas or apply the
brakes much more quickly.

Furthermore, day traders should think about whether or not they

should adjust their position sizing algorithm for the different trading
phases to take into account the trading periods. As you know,
volatility differs a great deal over the course of the day. While the
opening phase can be very frantic, at lunchtime the market tends to
be calm. When economic data are published, it then becomes frantic
again.
Whether you should increase or reduce the risk for the different
trading periods is something you can find out from your trading diary.
During which trading period do you most frequently make gains?

I, myself, normally trade with a small risk in the lunchtime market

and when there are economic data. I have my biggest risk at the
opening because, on the one hand, my opening trades perform
particularly well. On the other hand, however, also because I like to
go into the market aggressively at the start and then, if something
puts a damper on the situation, I reduce my risk.

As you can see, a good position sizing algorithm can be very

complex. It takes into account market volatilities, the account
balance, past short-term performance and trading periods. In
interviews with top traders, over and over again, you’ll find the
phrase: “A good trader knows when he has to push the market”.
 12.4 The rules of position sizing
Position sizing is very simple, yet time and again, the same
fundamental mistakes are made, unfortunately. That’s why you
should always ensure that you comply with the following rules:
 12.5 Never reduce the price
Any strategy where the price is reduced and even if this is only
because the trader staggers his/her purchases, follows a Martingale
principle. However, this principle will never result in our gains being
big, on average, and won’t keep our losses small.
 12.6 Never increase your initial risk
The initial risk is the maximum amount that you’re prepared to lose.
If you exceed this initial risk then you’ll be trading contrary to your
strategy. The only exception to this rule is if, from the beginning, you
plan to go into the market with a small position initially and then to
increase this to a particular size with a previously fixed risk if the
market develops in your favor.

Let’s assume that you want to buy a total of four contracts with a
stop at 3,980. The DAX is currently quoted at 3,995. If your strategy
consists in buying two contracts initially and another two if the
market breaks through 4,000 then this is neither a Martingale
strategy nor are you trading contrary to your plan.

It’s a different matter if traders increase their initial risk by

subsequently placing their stop further away. Such behavior implies
that you’re not employing strategic money management techniques.
 12.7 Never overtrade
Even if you only ever risk 0.5 percent of your equity, as a day trader
you’ll always be in danger of overtrading. If you make 20
transactions a day, each with a risk of 0.5 percent, then this can
mean an overall risk of up to 10 percent of your account. Smart
money management provides a maximum upper loss limit for each
day. This amount can be defined in absolute terms, for example, by
undertaking to lose a maximum of Euros 2,000 on a daily basis,
however, it can also be a percentage figure.

Plan your trade already before trading opens. If you want to lose a
maximum of Euros 2,000 and are prepared to risk 1 percent of a
Euros 100,000 securities account, then you could only make two
trades. That could be too few if, for example, you’ve been
unfortunately stopped out and want to attempt a re-entry into a
position once again.

Depending on your trading style, you should select your individual

position risk in such a way that you won’t reach your daily loss limit
too frequently on account of a few false signals. For example, if your
daily loss limit is 2.5 percent of your portfolio and you’re trading
three markets, then it would certainly be too much to risk 1 percent
per transaction. In this case, it could actually be that, once you
already have loss-making trades in each of two markets, you’ll no
longer be able to chose your desired position size for a signal in the
third market, as after two losses of 1 percent each you’ll have only
an 0.5 percent risk left over for the day.
 12.8 Be disciplined
Ultimately, the best position sizing rules will be of no use if the trader
doesn’t keep to his/her rules. Money management is the most
important area of trading. If you lose significantly more than usual
then one trade can already be enough to take you out of the game
for weeks. Breaking entry and exit rules is usually harmless, as long
as it doesn’t happen too often.

However, you should never break money management rules

because, frequently, a big loss is enough to destabilize you
emotionally and, mostly, this entails subsequent losses. You already
know how to remain disciplined.
 12.9 How to pyramid
Pyramiding is the art of higher level trading. It means enlarging your
initial position size during a trade. To this end, traders buy further
contracts at different stages. Purchases of further contracts are
made according to the same principles and rules as the purchase of
the initial position. Thus, traders have to comply with the same well
known rules for entry, exit and money management that are also
required for setting up their initial positions.

The principle of pyramiding involves adding to your winning

positions and, thus, increasing the average gains. This, in turn,
improves the payoff ratio and with it the expectation value of a
strategy. It’s important to note that it only makes sense to pyramid
winning positions. Augmenting loss-making positions through
additional purchases means, in practical terms, reducing your price
and, as has already been mentioned, is a huge trading mistake.

With a pyramiding strategy, typically, once the initial position is in

profit, as a next step, half the size of the initial position is purchased
in addition. If then the additional purchase is in profit, in the next
step, once again you purchase half of the size of the position that
was bought in addition.

For example, if a trader initially buys four contracts then, if s/he’s in

profit, by buying another two contracts his/her position is increased
to six contracts and then one more contract is added on top. S/he’ll
now hold a total of seven contracts. The strategy is called
pyramiding because, at every stage, the size of the additional
contract that is purchased gets smaller. The pyramid grows with
every stage (see the diagram).
There are also reverse pyramids where, at each stage, the size of
the position that is purchased in addition exceeds the one bought
previously in terms of the number of contracts. The problem with
reverse pyramids is that the average purchase price of all the
contracts is very close to the market. This is because the amount of
contracts that are bought last of all constitutes the largest number
and the last paid price, thus, has the strongest impact on the
calculation of the average price.

The probability of such a pyramid being stopped out is simply too

great for it to be able to be used in the long term. Nevertheless, in
practice, it can happen that because of favorable market conditions
a trader is able to set up a reverse pyramid without increasing
his/her risk in the course of this. However, in the field of day trading,
this is rather unlikely. In position trading, reverse pyramids are only
ever justifiable in very strong trend markets.
In order to pyramid in a way that makes sense, you have to
observe a few rules.

First of all, every additional purchase may only be made if the last
additional purchase, or the initial purchase, is already in profit.

Secondly, the initial risk may not be exceeded anymore.

Thirdly, at each stage, treat every entry separately as if you’re

dealing with a single, new position. All your entry criteria still have to
be satisfied.

Fourthly, the number of contracts should get smaller at each higher

stage of the pyramid.

The last rule isn’t something that has to happen but it’s advisable to
do so. Ultimately, it’s up to the trader if s/he wants to risk the trade
being more easily stopped out because of the nearness of the
average price.
Another question that will arise for traders is when should they set
up a pyramid in the first place? Generally, it only makes sense if the
market is trending strongly in one direction, thus, a powerful trend
can be observed. Furthermore, it has to be possible for you to buy
further contracts, after you’ve set up your initial position, without
exceeding the initial risk.
Before a trade, your risk is zero. As soon as you enter into a trade,
besides the entry price, hopefully, you’ll also have an initial stop. The
difference between the entry and the stop, multiplied by the initial
number of contracts, gives you your initial risk. At no point during
trading should this initial risk be exceeded. Therefore, in the
diagram, I’ve selected 100 percent for the scale in order to make it
clear that this is the maximum risk.

Of course, this 100 percent does not correspond to 100 percent of

your equity but, instead, 100 percent of the maximum risk that’s
acceptable for you. In accordance with your exit rules, as soon as
the market offers an opportunity to set a trailing stop then your initial
risk will fall.

I think it makes sense to wait until your initial risk has gone down to
zero before you set up a pyramid. That’ll always be the case if your
initial position can already be secured with a break-even stop. This
rule should protect you from overtrading. However, depending on
the trading strategy and the trading approach, there may also be
cases where you can already buy additional contracts before you
secure the initial position at break-even and yet not have a higher
overall risk for your pyramid than at the start of your initial position.

At stage one of the pyramid when the risk falls to zero via a break-
even stop you can then begin with the second stage of the set up.
Please note that, for the second stage, it makes no sense to select a
stop other than the break-even stop from the first stage. Therefore,
this means that the second position will have the same stop as the
first one.

If the stop were closer to the market then it would make sense also
to pull the stop for the first position closer to the current price. If the
second stop were further away than the stop from the first stage,
then the second entry would be more like a case of a multiple signal
than a pyramid, as the point of a pyramid is to expand a winning
trade further.
In order to secure a high average gain you should never make a
staggered exit out of your position (in this respect see also tactical
trading rule number 9 later on).

The stop price for stage two is already provided by the stop price for
stage one. The entry should be chosen in such a way that, once
again, you have a risk/reward ratio that, through your selected
trading strategy and the historic hit rate associated with it, results in
a positive expectation value for the trade. Only if the risk/reward
ratio remains attractive should you enter into a pyramid trade and
set up the second stage.

You can calculate the number of contracts you should buy, once
again, with the help of your money management algorithm. If you
haven’t developed any separate rules for setting up a pyramid, then
it may well happen that the second stage will be bigger or as big as
the first level. In theory, at any rate, you can buy as many contracts
again until, at most, you reach your initial risk.

For example, if the initial risk was 1 percent at the first stage, with a
20-point stop and if, at the second stage, the stop is just ten points
away then, at the second stage, you could buy twice as many
contracts if you wanted to set up your initial risk again. However, as
mentioned above, at every stage it’s advisable to incur a lower
percentage risk. In my opinion, at each stage, the risk should be
smaller than in the previous one. Therefore, if you risked 1 percent
for the first trade then, at the second stage, perhaps you should risk
just 0.75 percent, at stage three 0.5 percent and so on.

The number of levels that you’ll be able to add to the pyramid will
depend on how much longer you’ll still be able to trade with a good
risk/reward ratio with every further entry. If it should fall below your
desired value then you’ll have to refrain from setting up further
levels.
The exit from a pyramid happens in the same way as for a single
position. Your exit rule for the initial position will apply to all the
contracts during the entire pyramiding. Accordingly, you’ll exit your
pyramid in one go.

The entry for your pyramid should always be in a retracement, as

the additional contracts that are purchased increase the average
price of the position. The more you pay for the purchase of
additional contracts, the higher the average price will be. It’s logical
that we want to avoid high average purchase prices.

In contrast to a separate position, tactically, with a pyramid you’re in

an advantageous position because even if no more retracements
take place in the market then you already have a presence with your
initial position. That’s why it’s appropriate to wait for a retracement.
12.10 Psychological considerations when setting up
a pyramid
As you’ve learned, it’s not actually difficult to set up a pyramid, at
least, if the trading horizon goes beyond the next few hours and the
trader also wants to follow a trend. It should be clear that, in day
trading, naturally we have few days on which there are such strong
trends that it’s worth setting up a pyramid. Nevertheless, you should
make use of the few opportunities that do present themselves.

However, most traders, whether they be position traders or day

traders don’t have the confidence to pyramid.

For the most part, these traders are still caught in a state of having
and they fear for the profits that they’ve already generated with their
initial position. These traders attach too much importance to the
result of an individual trade. In fact, what matters is the sum total of
all trades and, above all, the ratio of average profits to average
losses. Frequently, several attempts are necessary in order to set up
a pyramid. However, that’s not a problem, as you’ll never lose more
than the initial risk that you incur for every other trade. As I’ve said,
this is because one of the basic rules for pyramiding is never to incur
more than the initial risk. Thus, the average loss size remains the
same. However, when the pyramiding is successful then you’ll have
a huge number of contracts for a winning trade. Naturally, this will
have a very positive effect on average gains.

However, those who always only want to optimize the result of an

individual trade will never have the courage to pyramid. In order to
pyramid successfully, it’s absolutely essential to be in a state of
being. Anyone who is under financial pressure, who has to satisfy
targets or is determined to beat certain benchmarks, is rarely in a
state of being and won’t have the composure and emotional strength
to set up a pyramid.

If you want to pyramid then use the following beliefs in order to

develop the mental strength for this.

An individual trade has no significance.

I want to optimize average gains and not one individual trade.

Winners need home runs.

 12.11 An example of a pyramid
To conclude this chapter, I’d like to illustrate for you again, by means
of a trade, how a pyramid is set up, with the specific example of a
Bund position.

Bund Pyramid

The first ten contracts were set up at 123.20 with a stop at 20 ticks
(risk = 200 ticks). At the breakthrough below the support it was
possible to move the initial stop to 123.03 already, so that contracts
could be shorted, once again, at 122.80 with a stop of 23 ticks. (The
risk for the new contracts was 115 ticks). The entire position of 15
contracts was already securely in profit, as the average short price
was around 123.08. With a renewed breakout from the trading
range, two contracts were then shorted again. The risk for this
position never went beyond the initial risk and the pyramid was
selected in such a way that a loss wasn’t possible. Of course, this
was gambling with the profits in that an existing winning position was
further expanded.
 13.
CHAPTER 13

Handling a trading crisis successfully. Even Master Traders

sometimes get to a point where they get stuck in a loss-
making phase. However, they have special techniques that
help them to withstand crises and to recover quickly from
them.
 13.1 Rule 1: “Stay in business”
Trading crises are dangerous times for all traders. Nobody’s ever
developed a system in which you don’t have to withstand a drawdown.
During this phase of declining performance, traders will be under both
great financial as well as emotional stress. And yet, there’s a simple
trading rule for such a case.

“Stay in business”. Those who manage to follow this principle will

undoubtedly rank among the professional traders. The trading
maxim “stay in business” isn’t self-evident nor, here, is the cause
confused with the effect. What is meant by this rule is a realistic
target that enables a trader to act in an emotionally balanced way.

As an experienced trader and the owner of a brokerage, where I

was able to observe the careers of hundreds of traders, time and
again, I noticed that while this principle is so simple, logical and
self-evident, frequently, it isn’t given top priority. In times of crisis,
in particular, traders focus on other things, for example, on
avoiding further losses.

What’s the difference between the maxims “avoid losses” and

“stay in business”?

The maxim, avoid losses, is an impossible requirement. With

this, traders make unrealizable demands on their trading, as there
is no strategy where 100 of the transactions will be winners.

The consequences of this rigid requirement to avoid losses are

manifold.

13.1.1 Traders overextend themselves

By bowing to an unattainable wish (“no more losses”), traders start
to hope instead of engaging in proper crisis management. Hope,
however, is a bad advisor. Those who hope, frequently, don’t want
to let the market decide anymore whether or not a trade will be a
winner or a loser. That’s why hopeful traders dispense with stops,
or place them disproportionately far away. Traders who hope rely
on their luck. However, trading success doesn’t depend on luck
but, instead, on sensible risk management.

As traders will never be able to attain their short-term goal of “no

more losses”, during loss-making phases, not only will they feel
stressed but also disappointed. When traders have overextended
themselves and they’re in a state of stress they’re very prone to
irrational behavior.

In particular, this includes the tendency to make bad bets. Either

transactions are entered into at too high a risk, or alternatively,
during the trade, traders don’t focus on the market but, instead,
only on their goal of not producing any more losses. In such a
mood, they can’t let their profits run and, frequently, they’ll pocket
very many small profits and, in the case of losses, they’ll hope that
the market will again turn in their direction, after all. However,
many small profits are often not enough to compensate for big
losses, so that traders who’ve overextended themselves will get
further into a loss-making spiral.

13.1.2 Traders produce negative moods that hinder

optimal decisions
As we already know, one of the most indispensable qualifications
is poise. This state of mental balance, which enables the trader to
regard any situation calmly and to be uninfluenced by hope or
fears, is an essential prerequisite in order to be able to overcome
crises.

However, those who are stressed and have overextended

themselves will never have poise. If traders continually fail to
achieve their goals then this will result in negative moods. There’s
no need for long explanations to understand that when traders are
in a bad mood they make significantly worse decisions than when
they’re in a good mood.

Yet a trader’s main task is to make decisions constantly. When

should I enter into a position? With how many contracts? What exit
rule should I use and when? Where should the trade be ended?

A trader has to answer all these questions as well as many others.

However, in order to behave in the optimal way it’s absolutely
necessary to have the appropriate mood (for information about this
see the section on discipline on page 89ff.). It’s highly unlikely that
traders will be in a productive mood if they continually fail to
achieve their goal (“no more losses”). However, if traders opt for
the goal to “stay in business” then losses won’t necessarily lead to
a conflict of goals. It’s more likely that traders will be able to
remain in an emotionally stable state and will, therefore, make
better decisions.

13.1.3 A polarity of having and not having develops

Constantly thinking about profits and losses automatically leads to
a state of “having” when you enter into a loss-making phase. As
you already learned in the preceding chapters, this isn’t a very
productive state because concentrating on profits also means
focusing on their antithesis, namely, on losses.
As Wilhelm Busch, a German humorist and poet, phrased it (this is
loosely translated from the German): “What we want most of all is
precisely what we can’t have at all.”

In a state of having, it’s almost impossible for traders to follow one

of the best know trading rules - let profits run and limit your losses.
In order to let your profits run you have to give the trade enough
scope. This means that the market can make several significant
retracements during which book profits will decrease again.

If the stops are placed in such a way that they’re not triggered by
every natural retracement, then traders can follow a trend for a
long time and let their profits run. However, as soon as traders get
into a state of having, they become fearful for their book gains and
they’ll attempt to secure these very aggressively.

Frequently, this leads to profits being taken too quickly and stops
being placed too close to the market. Traders who most of all want
a large profit don’t get this at all.

Yet, frequently, when traders are in a state of having, the opposite

of this behavior is also apparent. While the traders let profits run,
they don’t secure them in any way because they’d like to have
even more profits. They become fixated on a target price that’s
very far away and aren’t willing to end the trade before this target
has been achieved. So that the trade won’t be stopped out
beforehand, the traders dispense with securing part of the book
gains. Therefore, frequently, the result is that, although the traders
were significantly in profit, they are then stopped out with a loss
because they failed to secure part of their profits with a sensible
exit rule.
 13.1.4 Trading systems aren’t implemented
consistently anymore and trading rules are flouted
This point is closely linked to the first three points. Frequently,
during a trading crisis, it’s not possible for a trader to follow his/her
plan because s/he’s in an unproductive mood. As s/he’ll be
pursuing the unrealistic goal of “no more losses” his/her behavior
will be different than usual and, thus, s/he’ll deviate from his/her
trading system.

This will be noticeable, in particular, in that s/he won’t follow all the
signals from his/her system because his/her confidence in the
trading system will have subsided. The lack of confidence is
usually the result of the emotional destabilization of the trader and
this is further encouraged by the fact that, as mentioned under
point one, given the unrealistic goals s/he will feel that s/he’s
completely overextended himself/herself. However, as already
described, a state of “wanting to have” also leads to a trader not
trading rigorously according to his/her system.

13.1.5 The perspective becomes restricted to the

next trade and to profits
However, in any trading crisis, the biggest problem is that,
frequently, the perspective is focused solely on the next trade. The
significance of one transaction becomes so huge that the trader
suffers from mental tension. The restricted perspective reinforces
feelings of hope and fear so that these feelings dominate the
trading.

All the above-mentioned points are so-called “losing attitudes”;

these are behaviors that will lead to the certain ruination of an
account in the long term. Nobody can definitely rule out that they
won’t fall victim to these behaviors. Many traders try to flee into
automated trading systems because they believe that, in this way,
they won’t be victims of wrong decisions that have been caused by
unproductive moods. However, usually, this only shifts the trading
problem to another level. Instead of no longer trusting individual
signals, during the drawdown phases, doubt is increasingly cast
on the own trading system. The trader then frequently decides to
suspend the complete system and will only resume trading once
the system shows positive results, on paper, again.

However, the consequences of this are the same as when

discretionary traders leave out individual signals. There’ll come a
point at which the signal that was left out would’ve generated a
very big gain. This gain would’ve improved the overall
performance of the system significantly. However, as this was only
a paper gain, the trader isn’t able to benefit from it.

I harbor great doubts that, during a drawdown, it makes sense to

trade on paper only until the system shows positive results again.
This is because in order for a system to show positive results it
has to have already run through a number of winning transactions.
Given that, up to the time when the system was suspended, the
negative trades were real but the positive ones, unfortunately,
won’t have contributed to the result if they only happened virtually,
it will be significantly harder for the trading system to get back into
the profit area again.

During loss-making phases, it’s better to reduce the position size

and, in this way, to “ease up on the gas”. Completely suspending a
system is merely a sign of a trader’s lack of trust in his/her system.

However, if a discretionary trader decides to take a break from

trading because s/he’s in a situation of emotional desolation, then
this has nothing to do with lack of trust in his/her trading system. A
recovery phase is important in order to be able to perform well
consistently.
 13.2 Rule 2: “Don’t ask why, ask how”
“When everything is going well, you can make wonderful decisions
… Unfortunately, however, in times of crisis even the right
decisions can be wrong.”

Winfried M. Bauer (*1928), German author of management books

The examples in this chapter have clearly shown how important it

is to formulate your goals properly. They should be drawn up in
such a way that, during trading, they’ll be of help and not a
hindrance to a trader.

However, asking the right questions is also of major importance for

trading. Unfortunately, we’re inclined to ask about the cause of a
problem, over and over again. Behind this is the hope that we’ll be
able to solve the problem more easily if we know its cause by, for
example, eliminating the cause. Asking about the cause of a
problem is asking why.

However, the most important question that has to be asked during

a crisis is not the question as to why but, instead, the question:
“How can I deal with this crisis?” Questions as to “why”, in
contrast to questions as to “how”, don’t put the emphasis on the
solution but, instead, focus on the issue of who or what is to
blame. That’s why, frequently, we don’t get the right “honest”
answers. As, often, it’s not the trading systems that are to blame
for the crisis but, instead, the traders themselves because they
behaved wrongly.

It’s very difficult to admit this failure to yourself. Instead of finding

an honest answer and accepting 100 percent responsibility for the
outcome, traders lay the blame for the losses on the market, or on
a trading system. That’s the reason that questions as to “why” are
very dangerous.

By contrast, questions as to “how” can be very productive, as they

present alternatives to previous behavior. Successful trading
implies being able to control behavior, which is why, precisely in
times of crisis, you should review your behavior. Frequently, there
are possibilities other than the ones that have been used
previously, which are more productive and will be better for helping
you out of the crisis. Ask yourself the question of how you can
increase your average gains, or how you can reduce your trading
mistakes.

It’s important to find alternatives to behavior in the past. The more

creative you are, the more options you’ll have. The more
possibilities you have, the better you’ll be able to perform.
 13.3 Ways out of the crisis
There are various possibilities for dealing with a crisis. However,
the most important goal is always to regain a state of emotional
balance. This is the ideal state that a trader should maintain, as
frequently and for as long as possible. In the following section, I’ve
presented immediate measures that should result in the trader
stabilizing his/her emotions and becoming calmer.
 13.4 Immediate measures
Five steps to calmness (poise):

13.4.1 Take a short break from trading

A break from trading is necessary so that you can step back from
the problem that needs to be resolved. Frequently, during a trading
crisis, your perspective will have narrowed significantly and you’ll
no longer be in a state in which you can distinguish the main
aspects. Often, a narrowed perspective leads you to start making
trading mistakes, which means deviating from your original trading
plan and concept.

13.4.2 Take a dissociative view

The best way to realize that you’re in a crisis is when you find it
difficult to take a dissociative view. A narrowed perspective is a
typical sign of an associative state. In such a state, we’re more
highly aware of our feelings and, thus, are more strongly led by
them.

It’s better to be in a dissociative state in order to be able to make

more objective decisions. In the first part of this book, I already
described how you can put yourself into a dissociative state.

13.4.3 Change your perspective

During a crisis, your attention is mostly focused exclusively on the
next trade and that’s why, mentally, this trade is assigned an
importance, which it doesn’t have.

As a day trader, you’ll probably make 500 to 2,000 transactions in

a year. Thus, from a statistical point of view, an individual trade is
of no significance. That’s why it’s also unrealistic to assume that
the next trade that you’ll enter into will be more important than the
trade before it or after it. When you change your perspective, it’ll
be easier to realize that an individual trade is of no significance for
your result.

13.4.4 Keep on reducing your risk until you realize a

winning trade
Probably the most important rule is to lower your risk continuously
during a drawdown. The fact that you’re losing money is the best
indicator that, currently, your trading approach is not compatible
with the market. It’s advisable to keep on reducing your risk for as
long as your trading style isn’t suitable for the current movements
in the market.

13.4.5 Increase your risk slowly back to the usual

size
As soon as you notice that you’ve regained confidence in your
trading approach and this is confirmed by improved results, you
should increase your risk again in order to get back to your usual
trading volume. Although, with respect to the size of your position,
you shouldn’t be guided exclusively by your trading results but,
above all by your self-confidence.
Personally, I trade my usual position size once again as soon as
I’ve regained my self-confidence. It’s only if there should happen
to be another setback that I start to reduce my position size again.

The steps to regaining poise, mentioned above, should be

internalized by you and performed automatically, in good time,
already before a trading crisis widens too dramatically. The better
you know yourself, the more effectively you can improve your
performance with smart breaks in your trading. Not because you’d
then be able to eliminate loss-making trades but, instead, because
you’ll be able to produce a top condition of poise for yourself more
frequently and for longer than other traders, without being
dependent on profits in the course of this.
 13.5 General measures
General measures that are important for overcoming crises
include the principles of internal and external control, which were
mentioned in the previous chapters. That’s why, in the next
section, only the main points will be briefly repeated.
 13.6 External control
Risk control is the only possibility for external control. We have no
influence over the result of an individual trade, or over the
movements of the market. While the entry into a position gives us
the feeling of having control it is, however, comparable with
somebody who plays the lottery and is the only one who believes
that selecting where to put his cross on the lottery ticket can have
an influence on his win.

As in the selection of lottery numbers, where we don’t know what

the result of the draw will be, when we select the entry point for
our trade we don’t know whether or not we’re going to execute a
successful transaction. The only thing that we can know is our
planned degree of risk, which is calculated as the difference
between the purchase and the initial stop (although, some
reckless traders don’t even know that). Linked to the initial risk is
the issue of position size (money management).

The initial stop and the position size determine the overall
risk of a transaction over which we have genuine control.

We only have supposed control over the exit from a position.

While we’re able to end a trade at any time, however, the question
is whether or not it makes sense to liquidate positions in a way
that breaks exit rules. By contrast, if we use an exit rule then the
market decides when our position should be ended and we have
no control over this.
 13.7 Internal control
Besides external risk control, we’re only able to control ourselves
(internal control).

“If you can handle your emotions, you can handle trading.“

If you can manage to control your feelings and moods you’ll also
be able to trade. In the section on discipline, we learned how our
feelings arise and how we can mange them.

Discipline isn’t only about following rules but it means more than
that.

Discipline is the ability to put yourself, at any time, in a

productive mood for tackling the task at hand.

It’s precisely in trading crises that you can see how important it is
to control moods because, during these times, it’s especially
important to make optimal decisions. However, we can only make
optimal decisions if we’re in a productive mood.

Two important tools for controlling our moods are available to us

as traders.

1. Keep a trading diary to identify behavior patterns.

2. Create a behavioral compass in order to discipline yourself.

If you manage to maintain internal control as well as to manage

your risk sensibly (external control) then, in the future, you’ll
master every trading crisis and will emerge strengthened from it.
With every trading crisis that you overcome your self-confidence
will increase and, in the future, it will be easier for you to overcome
further crises.
 14.
CHAPTER 14

Trading means thinking strategically. In order to make the right

decisions you need very specific tactics.
 14.1 Trading tactics
In trading, strategic ideas are usually extremely complicated on
account of the complex situation and the uncertainty about the result
(gain or loss). However, even simple errors in reasoning can already
lead to a dramatically worse performance because a trader has
made a suboptimal decision. Often enough, during trading, we don’t
even notice that there would’ve been a better option.

Imagine the following situation. In situation A, we’re about to earn

between 15 and 20 points because our stop has already secured 15
points of profit and we would sell at a profit of 20 points. In Situation
B, we could earn between 16 and more than 20 points (for example,
by subsequently moving the stop and setting a higher sell limit).

In this comparison, B constitutes the “dominant strategy”. A

“dominant strategy” refers to what is clearly the optimum from
among various possible alternatives. In our example, the clear
optimum is obvious. However, frequently, we don’t recognize
dominant strategies.

There are three main reasons for this.

The situation is so complicated that we can’t understand it.

We don’t know the simplest rules of statistics.
We run aground because of the imperfections of our thinking
habits.

Interestingly enough, frequently, we don’t find this optimum through

our intuition.

For example, what would your intuition tell you in the following
situation?
You’ve set up a short position in the Bund at 118.07. Your target
price is 117.98. The market gets to 117.99 so that, unfortunately,
your covering limit can’t be executed. You wait for a few minutes and
think about whether or not you should change your limit. In this time
the market has got back to 118.04. In the meanwhile, your stop is
118.08.

You now have the choice of ending the trade at the current price of
118.04 with three ticks of profit, or alternatively to let your limit of
117.98 work against the stop at 118.08. You estimate that the
probability of the market reaching your target price of 117.98 is as
high as the probability of being stopped out with one tick of loss at
118.08.

Intuitively, we would be inclined to take our profit. However, the

rational optimum would be to gamble the profit, as the expectation
value of this strategy is higher than the sure gain of three ticks. So,
we see that we don’t always recognize dominant strategies
intuitively. This is because, while our intuition follows rational
decision patterns and goals, these aren’t necessarily rational in
terms of trading for the maximization of profits.
 14.2 Trading tactic 1: Gamble your profits
Traders don’t want to let winning positions run into losses anymore
and that’s why they prefer to exit rather than to gamble their profit.
Even though, in a certain sense, they’re behaving rationally by
continually reducing their risk, nevertheless, they still don’t manage
to maximize their profit. The only appropriate behavior for traders
would be to gamble their profits. This is because the expectation
value for gambling is bigger than the profit that they would pocket if
they were to exit immediately.

Let’s check this quickly. If a trader were to gamble his/her profits

then the probability that s/he would earn six more ticks, or realize
four ticks less, is 50 percent in each case. The expectation value of
this “game” is 6 x 0.5 + (– 4) x 0.5 = 1 tick and is, thus, positive. As
long as we have a positive expectation value then it’s worth making
a bet.

To put it another way, a trader can realize three ticks, with certainty,
or gamble and, if the situation turns out positively, gain nine ticks, or
in a negative situation s/he would lose one tick. If s/he were to
gamble, then the expectation value would be 0.5 x 9 + 0.5 x (– 1) =
4 ticks and is, thus, greater than the three ticks of profit if s/he were
not to gamble. A day trader, who faces such situations time and time
again, can expect to earn more, on average, if s/he gambles.

The possibility of a winning trade ending up in loss unsettles many

traders and entices them to make wrong decisions. As a result, they
trade suboptimally.

But what if we argue that we don’t want to maximize profits but,

instead, we want to reduce our risk? In this case, wouldn’t we have
had to decide differently?
Maximizing profit and reducing risk are two mutually exclusive
strategies.

Maximizing profit means giving the trade room to develop and,

possibly, increasing the number of contracts; whereas reducing risk
is always associated with reducing the number of contracts through
to exiting the trade, or using a narrower stop.

In the case of an immediate exit out of a trade the risk falls to zero,
however, it stays at four ticks if the stop is placed, unchanged, at
118.08 and we use a mark-to-market valuation for our equity at all
times. Marking to market means that, at all times (effectively every
second), even unrealized profits or losses are added to or taken
away from our trading capital, respectively.
14.3 Trading tactic 2: Only reduce your risk in the case
of a loss
Under the objective of minimizing risk, the option of immediately
exiting a trade undoubtedly predominates, rather than being at the
mercy of the risk of profits get smaller again. Yet, does this mean
that, therefore, it’s the right decision to close a trade directly in order
to reduce risk?

No. As the strategies of “risk reduction” and “profit maximization” are

mutually exclusive, we have to decide when we should give priority
to which strategy. To this end, let’s look at the three possibilities that
we distinguish during a trade.

The trade can be either break-even, in loss or in profit. In the case of

a winning trade, if we were to pursue the goal of reducing risk, in
extreme cases, we would have to realize all profits directly, which
obviously makes no sense. In turn, this means that as soon as we’re
in profit with our trade our maxim is profit maximization. In the case
of a loss this is different. The market will show us that our bet is
currently going badly for us. If we wanted to maximize our gains at
this point in time, in extreme cases, we would have to buy additional
contracts, as this would bring our break-even point closer to the
current market.

However, we would, thus, increase our position, which is in any case

going against us. In this way, our average losses would tend to go
up. This is a strategy that obviously isn’t right. That’s why, in the
event of a loss, the goal of profit maximization is eliminated.

Instead, traders have to concentrate on risk minimization. In extreme

cases, this could mean exiting immediately out of the trade.
However, as we consider a small loss not to be of significance, we’re
not going to exit out of our position immediately every time there’s a
loss. However, in the event of a loss, it’s absolutely appropriate to
scale out of the trade gradually and, thus, to reduce the risk.

So, we see that a risk reduction strategy is an appropriate objective

in the event of a loss. However, as soon as we are in a profit
scenario, our maxim then has to be profit maximization.
 14.4 Trading tactic 3: Don’t try to maximize the profit
from one single trade but, instead, maximize the profits
from the sum of all the trades
As we don’t trade just once but, as day traders, we execute an
almost infinite sequence of transactions, our goal cannot be the
maximization of the profit from one single trade but, instead, we
have to try to maximize our average profits. As close as these goals
are to each other, nevertheless, they imply different behaviors.

However, a behavior that in one particular case would maximize

profit, could lead to the output of the sum of all the winning trades
not being maximized.

Here’s an example. Imagine that a trader always exits a trade at his

price target with a limit. Let’s compare this with the action of placing
an aggressive stop with a view to securing profit, for example, just
three ticks away from the market. With this type of behavior, a trader
will probably make less profit in 80 percent of cases, as he’ll earn
three ticks less.

However, if in the remaining 20 percent of cases he manages to

earn 15 ticks more, then this exit strategy has a higher expectation
value than the strategy of restricting profits with a limit.

Intuitively, a trader would rarely get to this possibility, as in eight out

of ten cases he would come off badly, thus, overall he would earn 21
ticks less. However, the two cases in which he comes off better
would compensate the eight negative cases. They would lead to a
higher average profit because the 30-point higher profit would more
than offset the income shortfall from the eight other cases. Thus, on
average, the trader would earn 0.9 ticks more per trade.
Is it worth being disappointed eight times for an average gain of just
0.9 ticks?

Most traders wouldn’t be able to endure such frustration. If we

assume that they have objectives such as composure, defined as
“Oh market, please don’t frustrate me”, then they’re even behaving
rationally in terms of their objectives. However, frequently, it’s
precisely such measures, which are supposed to make traders feel
better, that aren’t anywhere near to being rational and serving to
maximize profits.

How much would that good feeling of coming off better with your
trade in eight out of ten cases be worth to you? Euros 5,000, Euros
10,000 or Euros 20,000? In our example, this irrational behavior is
even more expensive for a ten-lot trader.

For a day trader who, for example on average, trades with ten Bund
contracts and who has two winning trades per day, rational behavior
means a performance difference of 0.9 ticks per contract – with 250
trading days this would mean Euros 45,000. Are you just a single-lot
trader? That’s not bad, this way you would still earn Euros 4,500
more per year.

These examples are supposed to show you that, frequently, we

behave wrongly in the markets because we don’t even know of an
optimal alternative option, or because, on account of intuitive
behavior patterns, we use the wrong objectives. For a trader it’s very
difficult to make the right choice between the mutually exclusive
criteria of maximizing profits and reducing risk for every situation.

Please bear in mind that, here, we’re not following a strategy based
on portfolio theory à la Markowitz where, because of diversification,
a combination of these goals is possible. A trader cannot diversify in
one trade, so that, in every phase of the trade, s/he has to choose
between profit maximization and risk reduction.
 14.5 Trading tactic 4: Use mixed strategies
Let’s come to another problem. How should we ideally behave with
every trade?

After we’ve entered into a trade, with every change in the price,
thus, effectively at every tick, we can choose from among four
options: hold, exit, reduce, pyramid. Thus, a trade is made up of a
chain of decisions.

The decisions can be aggregated into two categories of objectives:

either maximize profit, or alternatively, minimize risk. Although, at
any given time, it’s only ever possible to pursue one of these
objectives, as they’re mutually exclusive.

If you want to reduce your risk, you either have to reduce your
position size, or even reduce it to zero (that is, to exit), or
alternatively place a narrower stop subsequently. However, the
smaller your position, the smaller your profit will be, too. And the
closer the stop is to the market, the more likely it is that you’ll be
stopped out and the trade, thus, won’t be able to develop its full
profit potential. As has already been mentioned, that’s why you can’t
follow the maxims of risk minimization and profit maximization
simultaneously.

Similarly, if you want to maximize your profit, you have to either

increase the position size, or alternatively give the trade greater
scope to develop further (thus, to follow a trend for longer).
However, this rule is not in accordance with the objective that has
reducing risk as its guiding principle.

As traders, which rule should we now follow?

In the event stream shown in the diagram, you can see a trader’s
different optimal behavior maxims.

In the case of a loss, the risk always has to be reduced. In the

interval in which a trade is, in fact, in profit but the original risk has
not yet been earned, the trade has to be given the opportunity to
develop. Therefore, the sole objective will still be profit maximization.
Once the initial risk has been earned then the objective remains
profit maximization, however, the position shouldn’t lose any more
money than we were prepared to lose at the start of the trade. Thus,
here, the stop goes to break-even. Finally, when we reach our target
price, we have to ensure that we’re not maximizing the profit of an
individual trade but, instead, the sum of all the winning trades.

The key insight is that, frequently, an optimum is achieved not with a

sole objective but, instead, by amalgamating objectives and, thus
strategies. These mixed strategies are frequently more successful
than logically pure strategies.

For example, a pure strategy is the consequence of all individual

decisions made solely from the point of view of profit maximization
for the individual trade. Another pure strategy is risk minimization.

A mixed strategy could be as follows: Initially, we make our

decisions from the point of view of minimizing risk, however, then in
the next round of decision-making we change our tactics. If the trade
has already got into profit, then we prioritize profit maximization and,
later, not the profit maximization of the individual trade but, instead,
the sum of all the trades.
14.6 Trading tactic 5: Always gamble if the expectation
value of taking a gamble is positive
As traders, you have to know how to behave if you only just miss
your target prices. A typical situation is where a profitable trade is
approaching your sell limit or your target price. Let’s assume, to
begin with, that you had a limit in the market to sell a long DAX
position at 4,380 and the market gets to a quotation of 4,379.50. At
that moment, you’ll certainly still be hoping that your sell limit will be
cleared very soon. However, a little later you have to realize that the
market has come back by four points and you’ve missed buy limit by
0.5 points.

What do you do now? You have the choice of continuing to bet that
the market will still achieve 4,380, or else you can exit immediately.
As the market is currently trending at 4,376, four points below your
sell limit, not only do you have to decide whether or not to keep the
limit but also where your stop should now ideally be placed.

If you decide not to sell immediately then how much more of your
profit should you allow to be taken away? A decision to sell
immediately would give you a sure profit, however, gambling on your
sell limit would give you four extra points of profit per contract. That’s
why the expectation value of the option to gamble on higher profits
has to be at least as big as the profit that would be generated by an
immediate exit from the trade.

As you already know, the expectation value is calculated by

multiplying the probability of winning by the profit and adding the
product of the probability of losing and the loss. In this situation,
profit is defined as the additional profits from the gamble, while the
loss represents the amount of profit shortfall that features in the
scenario where we’re stopped out.
Unfortunately, the probability of being stopped out depends heavily
on how far away our stop is from the market. The closer the stop,
the more likely it is that we’ll be stopped out. The same applies to
our target price. The closer the market trades to the target price, the
more likely it is that the sell limit will be reached. Let’s assume, once
again, that the market moves randomly, so, if our price target is four
points away and we also place our stop four points from the current
quote, we could expect that the probability of achieving the target
price without being stopped out beforehand is, likewise, 50 percent,
the same as the probability of being stopped out beforehand.

If we were to estimate that the probability of our target price being

achieved is below 50 percent, we would consider the scenario to be
unlikely (worse than we could expect it to be randomly). In that case,
the best alternative would certainly be to exit out of the position
immediately at the current price. Thus, the probability of 50 percent
denotes the minimum expectation that we have to have in order to
gamble on our target price, in the first place. However, in this case
(50 percent), our stop may not be any further from the current
market price than our target price. This is because, otherwise, the
gambling strategy would have a worse expectation value than the
option of taking profits immediately.

If we’ve missed our target price and we now have to choose

between taking profits or gambling on the target price, then we’ll
have to change our stop subsequently so that it is at least as close
to the current price, so that the distance between the current price
and the target price is as big as the difference between the current
price/stop. However, this will only apply in the case where we
consider that it’s equally likely that the market will reach either point
first.

If we assume that it’s more likely that our price target will still be
achieved (for example, because the market is in a trend), then we
can even leave the stop still a bit further away.
 Probability of additional profits Minimum distance for the stop (rounded up)

5 10 15 20

10 % 0.56 1.11 1.67 2.22

25 % 1.67 3.33 5.00 6.67

50 % 5.00 10.00 15.00 20.00

70 % 11.67 23.33 35.00 46.67

But be careful. Our estimate as to why we consider it more likely,

although not certain, that the market will continue to go in the
direction favored by us, shouldn’t be simply based on wishful
thinking. It’s important that you have real grounds for expecting that
the probability of achieving the target price earlier is higher than for
the achieving the stop first.

If you’ve understood the logic behind the considerations discussed

above, then from this we can now develop a set of tactical
guidelines. For this, we again have to break down the trade and our
decision pattern into a multistage process.

When we developed the trade we defined a target price. We need

this in order to be able to discern whether or not the trade would be
a sensible bet. Now, if the market reaches this target price, we then
have the possibility of either realizing the profit or of gambling on an
even bigger profit. As you already know from the preceding
chapters, I prefer to gamble the profit. However, the expectation
value of gambling the profit has to be bigger than the profit that I
would realize if I were to exit immediately at the target price.

How great the expectation value is, in turn, will depend on the
probability of achieving another price gain of xy points.
On the left-hand side of the table, we’ve listed the probabilities for an
additional gain over and above the target price and, in the upper
row, various price gains.

For every combination of the price gain with a corresponding

probability, this matrix provides the distance of the stop point at
which the expectation value of the gambling strategy is as big as
that of realizing the profit immediately.

For example, if we expect that the probability of the market going on

for another five points is only 10 percent, then we would have to
place our stop at 0.5 points below the target price. In this case, it
would indeed be more practical to exit out of the trade directly at the
target price.

However, the table also shows that the stop can be five points away
if there is a likelihood of just 25 percent for our expectation that the
market will go up another 15 points in our direction. Therefore, if we
put our stop four points away, then we already have a dominant
strategy that, in the long term, will lead to a result that will be
superior to the one generated by an immediate exit.

Now for the tactic. Always gamble when the expectation value of
taking a gamble is greater than exiting immediately.

Once the target price has been achieved, if we assume that the
probability of another five point increase is 50 percent, then we can
move the stop to five points of our target price. If the market does
indeed go in our direction by another five points then, in the next
step, we have to think again. We assume that the probability of
another increase of ten points is only 25 percent, so the stop will be
placed at three points below the current market price.

If we’re still not stopped out, then, for the next increase, we’ll
assume a probability of only 10 percent, so that the stop will be one
point below the market level. So, we’re tightening the noose slowly
but surely without, however, depriving ourselves of all our
opportunities. Please bear in mind that this is, of course, only an
example.

Here, your trading experience will be very important, as it’ll help you
to find the correct probabilities of a further move in your direction.
Please bear in mind that we’ve always only ever assumed
probabilities of less than or, at most, 50 percent for the direction
favored by us. Even then it’s worth gambling.

When gambling, I consider it to be tactically unwise to rely on the

market going in your favor. That’s why the highest probability for a
positive scenario is a maximum of 50 percent, which corresponds to
a random movement.

Moreover, this tactic doesn’t suggest that we’re able to predict the
market because we assume, initially, that the result will be random
and then, in order to tighten the noose, we gradually assume ever
smaller probabilities.

When our target price has been achieved we should become more
aggressive with the stop. We already know this rule. The table
shows us how aggressive we should be.
 14.7 Trading tactic 6: As traders, we always have to
incur a risk and it should be incurred as early as
possible
Another important tactical rule is that we should always incur risks at
the earliest possible time. The further away we push this time, the
more difficult it will be for us if, contrary to our expectations, the risk
should materialize.

Here’s an example. As day traders, we always want to be flat at the

end of the day. Our position size fluctuates between 0.5 and 1.5
percent of our equity. When should we incur the highest risk?

We should always incur the highest risk in the morning. This is

because if we lose then we still have all day to recover the losses.

Here’s another example. The market is trading in a range. Your

trading strategy suggests a purchase. You now have the possibility
of buying either in the event of an upward range breakout or within
the range. As prices don’t move deterministically, thus, price x + 1
doesn’t depend on the previous price, a breakout wouldn’t provide
any additional information. That’s why we should make the decision
about the purchase already before the breakout and then implement
it. It’s only worth waiting if the breakout does indeed provide
additional information that reduces the uncertainty about the
outcome of the trade.

However, many traders prefer to wait because they believe that the
outcome of a trade will be that much safer, the more information that
they have. This attitude is based on the assumption that the result of
a trade can be determined.

However, in my opinion, the result is random so that hesitating or

waiting for a breakout won’t bring any additional information. That’s
why, in day trading, most breakout strategies don’t work.

It’s only worth waiting for the breakout if, in accordance with the exit
rules, a new stop point would emerge that would result in a lower
overall risk.
14.8 Trading tactic 7: Careful planning brings benefits
in uncertain situations
We’re unable to predict the future but we can prepare ourselves
optimally for certain trading situations. Many traders avoid the
opening because, here, frequently, the market appears to be frantic.
However, it’s a fact that it’s precisely at this time that a trader has the
possibility of carefully preparing himself/herself for a trade. The
same applies to economic data.
14.9 Trading tactic 8: Those who have an advantage
shouldn’t give it away again
When applied to trading this means that once an advantage has
been achieved, both in terms of an individual trade as well as a daily
gain or a period gain, it shouldn’t be given away again. Thus, as
soon as gains have reached a particular threshold or certain
significance then they shouldn’t be completely given away again.

This rule has nothing to do with the market. It’s a tactical

consideration that helps the equity curve to develop less erratically
and, thus, the trader won’t be emotionally destabilized.
14.10 Trading tactic 9: Never stagger the realization of
your gains
Traders like to reassure themselves by already realizing part of their
gains. To this end, they sell, for example, a third or half of their
position. As much as this behavior contributes to the trader’s mental
well-being, nevertheless, it isn’t particularly advisable.

For a start, you’ll always make a mistake with part of your position,
either the one that is exited too early or with the other one. You can
be certain that you’ll always make a trading error. However, such
behavior will also serve to make your average gains smaller than
they could be and, thus, your performance will be worse.
 14.11 Trading tactic 10: Take a break from trading
These days, I voluntarily take a break from trading if the market isn’t
developing in the way that I’d imagined. My experience has shown
me that, from time to time, it makes sense to pause and to reflect.
Voluntary breaks from trading have become part of my strategy.
During this time I gather my strength and reorganize myself. I
position my troops for the next assault, so to speak. It just doesn’t
make sense always to attack and to rush in headlong. An orderly
retreat opens up possibilities for a new, targeted assault.

However, I don’t only take breaks from trading after a series of

losses but also if my trading has gone particularly well and I notice
that I’m sailing almost a bit too close to the wind, not just physically
but also in terms of trading frequency and size. This voluntary
withdrawing helps me to gain an overview that makes me strong.
 Endnotes
1 The probability of six correct numbers in the German lottery is
around 0.000007 percent.
2 Please note that on the performance die there are no
preferences (higher probabilities) for either positive or negative
performance points.
Einfach traden
Schäfermeier, Birger
9783862485208
240 Seiten

Titel jetzt kaufen und lesen

Spätestens seit Ausbruch der Finanzkrise scheinen

die Finanzmärkte immer unberechenbarer zu
werden. Kursstürze von 30 Prozent und mehr sind
zwar nicht an der Tagesordnung, die Schwankungen
an den Börsen nehmen aber ständig zu. In einer
solchen Umgebung versagt jedes komplexe
Regelwerk, weil es nicht flexibel genug ist.

Birger Schäfermeier zeigt Ihnen die wichtigsten

Prinzipien, um in einem sich ständig wandelnden
Börsenumfeld als Trader weiterhin erfolgreich zu
sein. Wie geht der erfahrene Trader mit Angst, Panik
oder Euphorie um? Wie trifft er bessere
Entscheidungen unter Zeitdruck und wie geht er mit
Worst-Case-Szenarien um? Wie meistert er
schwierige Szenarien und verbessert beständig sein
Trading? Einfach traden bietet eine Roadmap mit
den wichtigsten Grundsätzen, um in
unterschiedlichsten Marktumgebungen erfolgreich zu
sein.

Titel jetzt kaufen und lesen

Cashflow Quadrant: Rich dad
poor dad
Kiyosaki, Robert T.
9783862486359
352 Seiten

Titel jetzt kaufen und lesen

CASHFLOW® Quadrant, der zweite Teil des

Bestsellers "Rich Dad Poor Dad" von Robert T.
Kiyosaki, deckt auf, warum manche Menschen
weniger arbeiten, mehr Geld verdienen, weniger
Steuern zahlen und sich finanziell sicherer fühlen als
andere.

Bill Gates, Steve Jobs und Richard Branson haben

die Schule ohne Abschluss verlassen und haben
dennoch extrem erfolgreiche Unternehmen
aufgebaut, für die viele der intelligentesten
Absolventen der Universitäten arbeiten wollen. Statt,
wie die meisten Angestellten, nur von einem Job zum
nächsten zu wechseln, rät Robert T. Kiyosaki, die
finanzielle Unabhängigkeit zu suchen und Geld für
sich arbeiten zu lassen – als Investor.

Dieses Buch beantwortet die wichtigsten Fragen zur

finanziellen Freiheit und hilft dabei, in einer Welt des
immer stärkeren Wandels tiefgreifende berufliche
und finanzielle Veränderungen vorzunehmen.

Titel jetzt kaufen und lesen

Die großen Crashs 1929 und
2008
Eichengreen, Barry
9783862486861
608 Seiten

Titel jetzt kaufen und lesen

Die Ursachen der beiden größten ökonomischen

Katastrophen in den letzten 100 Jahren – die
Weltwirtschaftskrise in den 1930er-Jahren und die
Finanzkrise seit 2008 – gleichen einander wie ein Ei
dem anderen. Beide entstanden infolge eines
krassen Kreditbooms, dubioser Bankpraktiken sowie
eines fragilen Finanzsystems. Und doch beriefen
sich die Entscheidungsträger auf die falschen
Lektionen, sodass die Krise nach mehr als sechs
Jahren noch immer nicht ausgestanden ist.

Barry Eichengreens Die großen Crashs 1929 und

2008 ist DAS neue Hauptwerk der
Wirtschaftsgeschichte und zeigt auf, welche
Schlussfolgerungen aus der Geschichte der Großen
Depressionen gezogen werden müssen, ehe
dieselben Fehler in der nächsten Krise erneut
gemacht werden. Kein anderes Werk erklärt die
Geschichte der zwei größten Krisen umfassender
und gibt weitreichendere Antworten. Ein
monumentales Epos von einem der einflussreichsten
Ökonomen der Welt.

Titel jetzt kaufen und lesen

Die wahre Geschichte von
McDonald's
Kroc, Ray
9783960920953
304 Seiten

Titel jetzt kaufen und lesen

Er ist der Mann hinter dem goldenen »M" und einer

»Vom Tellerwäscher zum Millionär"-Geschichte, die
ihresgleichen sucht: Ray Kroc, der Gründer von
McDonald’s. Nur wenige Unternehmer können
wirklich von sich behaupten, dass sie unsere Art zu
leben für immer verändert haben. Ray Kroc ist einer
von ihnen.

Doch noch viel interessanter als Ray Kroc, die

Businesslegende, ist Ray Kroc, der einfache Mann.
Ganz im Gegensatz zum typischen Start-up-Gründer
oder Internetmillionär war er bereits 52 Jahre alt, als
er auf die McDonald-Brüder traf und sein erstes
Franchise eröffnete. Was folgte, ist legendär, doch
kaum einer kennt die Anfänge.

In seiner offiziellen Autobiografie meldet sich der

Mann hinter der Legende selbst zu Wort. Ray Kroc
ist ein begnadeter Geschichtenerzähler und
unverwüstlicher Enthusiast – er wird Sie mit seiner
McDonald’s-Story mitreißen und inspirieren. Sie
werden ihn danach nie mehr vergessen.

Titel jetzt kaufen und lesen

CFD-Trading simplified
Schütz, Daniel
9783862486090
256 Seiten

Titel jetzt kaufen und lesen

CFDs – Contracts for Difference – sind nicht nur für

Sie als Trader, sondern auch für Privatanleger ein
vielversprechendes Instrument. Mit CFDs können Sie
überproportionale Gewinne erzielen und in
verschiedensten Assetklassen wie Rohstoffe, Aktien,
Indizes und Währungen handeln. Für Sie als Anleger
ist aber auch die transparente Preisbildung, sowie
die Möglichkeit interessant, mit kleinen Stückzahlen
zu handeln und die Option auch auf fallende Kurse
zu setzen.

Bei vielen Anlegern stoßen CFDs dennoch auf

Skepsis. Oftmals resultiert das schlicht aus
Unwissenheit. Daniel Schütz zeigt als erfahrener
Trader, wie Anleger die Vorteile von CFDs für sich
sinnvoll nutzen können, und erklärt anschaulich die
Grundlagen dieser spannenden Derivate. Nicht nur
das richtige Handeln beim optimalen Broker und ein
solides Risiko- und Money-Management werden
ausführlich erläutert. Sie erfahren auch alles über die
häufigsten Fehler im Umgang mit CFDs, das Traden
mit binären Optionen oder welche Rolle die
Psychologie des Traders beim erfolgreichen Handeln
spielt.

Mit Erdal Cene, Michael Voigt und Andreas Braun

geben zudem drei erfahrene Praktiker und Trader
Einblicke in ihre persönlichen Erfahrungen beim
Handel mit CFDs. Das Wissen der Profis – erstmals
gebündelt in einem Buch.

Titel jetzt kaufen und lesen