Trading In The Zone

Trading In The Zone

Money talks. It says: “Goodbye.”

Groucho Marx

Has this ever happened to you? You notice a set-up on the Euro that fairly screams “go long” at you. Every indication is positive. You go through your routine: You check the Stochastics, the Moving Averages, the Momentum, the Relative Strength Index, and the MACD. You look at the Linear Regression and the Parabolic SAR. You do a quick Fibonacci analysis to get some idea of where you can expect the move to go. You run your trendlines. Everything says: “go long.” You check out Andrews’ Pitchfork and Murphy’s Blowtorch. The talking heads on Bloomburg and CNN all agree that the dollar is ready to crash and burn. Greenspan fell into the sewer on his way to testify before the House and broke his nose. Finally, you check Astara’s Astrological Journal to be sure that the Moon is in the Seventh House and Jupiter is Aligned with Mars because when that happens, peace will rule the planets and love will guide the stars. You rub your lucky rabbit’s foot, turn around three times and spit into the toilet for luck and you pull the trigger! And guess what? Of course. The trade tanks on you right from the get-go, sinks like the Titanic and hits your Primary Stop. And you bid a fond farewell to another couple of percent of your trading account!

How could this happen? It’s simple. All these fine indicators were perfectly correct. They just didn’t take into consideration the fact that last night the Angel Gabriel visited some Saudi Prince in his dreams and told him to sell Euros. So when he got up in the morning, after his ablutions and prayers, he trotted over to the petty cash box, withdrew a spare 15 or 20 million, wired it to his broker in Switzerland and told him to sell Euros with it. And his order hit the market just about ten seconds after you clicked the mouse button and opened your long! That’s what happened.

No matter what methods of fundamental or technical analysis we use, no matter what softwares we use, even if it’s the latest version of How To Become A Gazillionaire Overnight Made Easy, no matter how high the odds are in favor of our trade, we can never know for sure what is going to happen the minute we pull that trigger. Because the First Fundamental Truth of Trading is: ANYTHING CAN HAPPEN.

What is the solution to this conundrum? Mr. Mark Douglas has handed it to us if we have the foresight, intelligence and courage to grasp it: We must stop thinking in terms of the individual trade and start thinking in terms of “probabilities.” Mr. Douglas tries to get us to grasp this idea and adopt it: The successful trader has not merely a successful trading strategy but a successful thinking strategy working for him or her as well. The following quotations are from his masterful book, "Trading In The Zone," which I recommend very highly to all thoughtful traders. It has had a profound and helpful effect on my trading as well as my ability to sleep peacefully at night.


"What casinos and professional gamblers understand about the nature of probabilities is that each individual hand played is statistically independent of every other hand. This means that each individual hand is a unique event, where the outcome is random relative to the last hand played or the next hand played. If you focus on each hand individually, there will be a random, unpredictable distribution between winning and losing hands. But on a collective basis, just the opposite is true. If a large enough number of hands is played, patterns will emerge that produce a consistent, predictable, and statistically reliable outcome.


"It’s the ability to believe in the unpredictability of the game at the micro level and simultaneously believe in the predictability of the game at the macro level that makes the casino and the professional gambler effective and successful at what they do. Their belief in the uniqueness of each hand prevents them from engaging in the pointless endeavor of trying to predict the outcome of each individual hand. They have learned and completely accepted the fact that they don’t know what’s going to happen next. More important, they don’t need to know in order to make money consistently.


"Because they don’t have to know what’s going to happen next, they don’t place any special significance, emotional or otherwise, on each individual hand, spin of the wheel, or roll of the dice. In other words, they’re not encumbered by unrealistic expectations about what is going to happen, nor are their egos involved in a way that makes them have to be right. As a result, it is easier to stay focused on keeping the odds in their favor and executing flawlessly, which in turn makes them less susceptible to making costly mistakes. They stay relaxed because they are committed and willing to let the probabilities (their edges) play themselves out, all the while knowing that if their edges are good enough and the sample sizes are big enough, they will come out net winners.


"Traders who have learned to think in probabilities are confident of their overall success, because they commit themselves to taking every trade that conforms to their definition of an edge. They don’t attempt to pick and choose the edges they think, assume, or believe are going to work. If they did either of these things, they would be contradicting their belief that the “now” moment situation is always unique, creating a random distribution between wins and losses on any given string of edges. They have learned, usually quite painfully, that they don’t know in advance which edges are going to work and which ones aren’t. They have stopped trying to predict outcomes. They have found that by taking every edge, they correspondingly increase their sample size of trades, which in turn gives whatever edge they use ample opportunity to play itself out in their favor, just like the casinos."



This is by no means as easy as it sounds because I'll venture to guess that almost each and every one of us has trained ourselves from the very outset of our trading careers to obsess over the current trade. We hang on every up tic and down tic, we exult over profit gained and agonize over profit lost. It is very human to do this. But it is not winning trader psychology.


If we take Mark Douglas’s advice – really take it – I believe we will experience a liberation the like of which we have not yet known while trading.It has certainly had that effect on me. We will stop obsessing over the current trade. Instead, we will take the long view. We will see our trading in terms of blocks of trades, dozens of them, perhaps hundreds of them and our focus will be on our results at the end of the game, not in the middle of the game. Read the following observations very, very carefully if you have enjoyed Mr. Douglas's insights up to now.


"Here’s what makes thinking in probabilities so difficult. It requires two layers of beliefs that on the surface seem to contradict each other. We’ll call the first layer the micro level. At this level, you have to believe in the uncertainty and unpredictability of the outcome of each individual hand. You know the truth of this uncertainty because there are always a number of unknown variables affecting the consistency of the deck that each new hand is drawn from. For example, you can’t know in advance how any of the other participants will decide to play their hands, since they can either take or decline additional cards. Any variables acting on the consistency of the deck that can’t be controlled or known in advance will make the outcome of any particular hand both uncertain and random (statistically independent) in relation to any other hand.


"The second layer is the macro level. At this level, you have to believe that the outcome over a series of hands played is relatively certain and predictable. The degree of certainty is based on the fixed or constant variables that are known in advance and specifically designed to give an advantage (edge) to one side or the other. The constant variables I am referring to are the rules of the game. So, even though you don’t know and couldn’t know in advance (unless you are psychic) the sequence of wins to losses, you can be relatively certain that if enough hands are played, whoever has the edge will end up with more wins than losses. The degree of certainty is a function of how good the edge is.


"Traders who have learned to think in probabilities approach the markets from virtually the same perspective. At the micro level, they believe that each trade or edge is unique. What they understand about the nature of trading is that at any given moment, the market may look exactly the same on a chart as it did at some previous moment; and the geometric measurements and mathematical calculations used to determine each edge can be exactly the same from one edge to the next; but the actual consistency of the market itself from one moment to the next is never the same.


"For any particular pattern to be exactly the same now as it was in some previous moment would require that every trader who participated in that previous moment be present. What’s more, each of them would also have to interact with one another in exactly the same way over some period of time to produce the exact same outcome to whatever pattern was being observed. The odds of that happening are nonexistent.


"It is extremely important that you understand this phenomenon because the psychological implications for your trading couldn’t be more important. We can use all the various tools to analyze the market’s behavior and find the patterns that represent the best edges, and from an analytical perspective, these patterns can appear to be precisely the same in every respect, both mathematically and visually. But, if the consistency of the group of traders who are creating the pattern “now” is different by even one person from the group that created the pattern in the past, then the outcome of the current pattern has the potential to be different from the past pattern. It takes only one trader, somewhere in the world, with a different belief about the future to change the outcome of any particular market pattern and negate the edge that pattern represents.


"The most fundamental characteristic of the market’s behavior is that each 'now moment' market situation, each 'now moment' behavior pattern, and each 'now moment' edge is always a unique occurrence with its own outcome, independent of all others. Uniqueness implies that anything can happen, either what we know (expect or anticipate), or what we don’t know (or can’t know, unless we had extraordinary perceptual abilities). A constant flow of both known and unknown variables creates a probabilistic environment where we don’t know for certain what will happen next."

This is a very subtle point coming up but very crucial because I think it has happened to all of us at one point or another and explains why we can read tons of good advice and never act on it. We may understand something intellectually but that doesn't mean we are capable of necessarily acting in accordance with our understandings. Dig it.


"Being aware of uncertainty and understanding the nature of probabilities does not equate with an ability to actually function effectively from a probabilistic perspective. Thinking in probabilities can be difficult to master, because our minds don’t naturally process information in this manner. Quite the contrary, our minds cause us to perceive what we know, and what we know is part of our past, whereas, in the market, every moment is new and unique, even though there may be similarities to something that occurred in the past.


"This means that unless we train our minds to perceive the uniqueness of each moment, that uniqueness will automatically be filtered out of our perception. We will perceive only what we know, minus any information that is blocked by our fears; everything else will remain invisible. The bottom line is that there is some degree of sophistication to thinking in probabilities, which can take some people a considerable amount of effort to integrate into their mental systems as a functional thinking strategy. Most traders don’t fully understand this; as a result, they mistakenly assume they are thinking in probabilities, because they have some degree of understanding of the concepts.


"When you’ve trained your mind to think in probabilities, it means you have fully accepted all the possibilities (with no internal resistance or conflict) and you always do something to take the unknown forces into account. Thinking this way is virtually impossible unless you’ve done the mental work necessary to “let go” of the need to know what is going to happen next or the need to be right on each trade. In fact, the degree by which you think you know, assume you know, or in any way need to know what is going to happen next, is equal to the degree to which you will fail as a trader.


"To think in probabilities, you have to create a mental framework or mind-set that is consistent with the underlying principles of a probabilistic environment."

Quotations from “Trading In The Zone” by Mark Douglas.