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LESSON 6

TRADING PSYCHOLOGY: EMOTIONAL CAPITAL

Many traders, whether they are brand new or have been trading for several years, always face the
question of the importance of trading psychology.

If we had just a few words to answer, we would say . . .

The important aspect in the marriage between the mind and markets is
how to control the emotions. One important element to remember is that
as humans, we are not wired to trade successfully and here’s what we
mean.

There’s an old saying, which is “cut your losses and let your winners run.”
Our reaction:
Great, but how do you do that?

As humans we all hate being wrong, whether it’s a losing trade or an

argument. So, when we hate to do something we tend not to do it. Every
losing trade you have taken or will take is just that: admitting you were
wrong. In many other businesses, it’s easier to admit you’re wrong, just
blame someone else. In trading, you get that thing called a statement every
night that places the blame front and center.

Real Life Examples

Problem
Let’s go back to the cliché, “cut your losses, and let your winners run.” What does it mean? When
you’re in a losing trade, how does it feel? How it feels might be subjective, but realizing that
“you’re not wrong until you exit”, isn’t, and that’s why most traders hang on to losers and many
add to them. All to avoid admitting we are wrong. How about “let your winners run”? Well, you’re
not right until you exit. So it’s easy to “get out” and potentially cut that winner short.

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Solution
Have a plan: by that, we mean a simple one. Know where you’re getting out before you get in.
At least have an idea! In this way, you create less surprise, which means less emotion. Being
wrong is much easier to swallow when you have expected it. In fact, if you’re not wrong, then
you’re not a trader -- you’re a spectator. Baseball players strike out, football players fumble, and
traders lose money. However, it’s about creating a level of certainty about “here’s where I’m
wrong, before I even get in.”

Risk management isn’t cutting your losses… it’s taking them. Once you are comfortable taking
them, you become better at cutting them. But, here’s the most important element to all this:
know what you’re doing. When you use the proper tools to create your bias, then you’ll use the
proper tools to recognize where and when you’re wrong. Many traders try to manage risk by
managing their psychology. We say the best way to manage risk is to know what you’re doing.

Some traders we’ve heard want to remain as calm as possible. While we understand the
concept of “calm in a storm”, you don’t want to ignore fear: as you sink deeper in a losing trade,
the calmer you are, the more delusional you become. Lack of a plan will often spin you in that
direction.

Problem
Adding to a loser: many do it, and some have a problem with it. Now, don’t confuse adding to
averaging. Some highly disciplined traders can average in a position (i.e., buy it at 10 at 8 at 6 so
you’re average is 8). However, that’s almost always a predefined strategy. Many will mask
adding and say they were averaging. To most it’s lack of a trading plan and trouble admitting
they are wrong!

A trader will buy it at 10, and when it doesn’t go their way, they buy more at 8, 6, 4. Now they
have many more contracts in the position than they are used to.

At some point, in this example, “skill turns to hope” there is no more order flow or properly used
market relationship techniques -- in fact, it reminds us of another one of our Edge-isms:

Edge-ism | Sometimes trading is like shooting fish in a barrel . . . and sometimes you’re the fish.

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Solution
Don’t add to a loser! Have an exit strategy with every entry. There’s no breathing technique that
a trading psychologist will give you that works when you’re in a losing position. Would you want
your surgeon to stop and start doing breathing exercises to calm down when you’re dying on an
operating table? Of course not, you want the surgeon to know what he’s doing.

That’s our job, and the best way to calm yourself down is to know what you’re doing. You want to
get to a point where your best trades are losers, because you cut them short.
Now, let’s move on to the more glamorous side of a trade, the winners!

Problem
As mentioned, we tend to chop winners because we aren’t proved right until we get paid and exit
the trade for a winner. So, there’s always anxiety that is filling us up and a voice saying “get out
now, take the money.” We tend to focus on what we lose if we don’t exit. For example, you have
a winning trade that has you up 10 ticks. We often think, should I get out now? But, then we think
what if it goes to a plus 20 tick profit. Our mind always seems to think in the negative, in this case
taking the +10 when it goes to a +20 means we lost 10 or left 10 ticks on the table.

Conversely, if we don’t exit for the +10 and it goes to a +5, we not
only regret not taking the +10, but we look at the trade as losing
5 rather than actually making the +5. Either way, the mind drifts
to the negative. Doctors and psychologists can write about why
this happens: We’ll write the solution of what to do. It doesn’t
include a breathing exercise.

Solution
Not everyone is wired to trade big size, so stay with us on this one. We do strongly believe
everyone is wired to trade more than one contract at a time. Our solution to this mental battle of,
when to get out of winners, includes a scale model, or as we call it in the Trading Room, “paying
for the trade”.

Paying for the trade consists of a trading size of greater than one contract. For instance, 2
contracts, or even better, 3 contracts. Later, we discuss a sizing plan to help get you to a 2 or 3
contract trading size.

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When you’re trading 2 or 3 contracts, you’re now able to trade out of the position in halves or
thirds. With this comes not only flexibility, but most importantly, a solution to the biggest mental
struggle of all: getting out. When you trade 1 contract you’re on the team. When you trade more
than one, you’re on the field!

Emotional Capital

Many traders get caught up in the sex appeal of a chart. Let’s say a market moves sharply higher, 5 ES
points or 20 ticks. A novice thinks “Wow, with a ‘one’ lot/contract, I could have bought it ‘here’ and sold it ‘there’
and made 17 of that 20 tick move”.

People tend to think backwards when introduced to this business. They think of the maximum amount of
reward with the minimum amount of risk. While you certainly don’t want to think in terms of maximum
risk, minimum reward, you have to find the sweet spot.

The sweet spot is defined by the average move for the market you’re trading. Sweet spot of risk is both
the size (number of contracts with which you open a position) and how many ticks you are willing to risk.
The size you trade is covered in more detail in the Sizing Plan section.

Let’s stick to the ES for now. While 15, 20, even 30 ticks of rewards are possible, they are also hard,
remember there’s a difference between charts and reality.

Looking at a chart and a market that moved 20 ticks and wanting to capture most of that seems (and
looks) easier than it is.

Problem
A trader gets long 1 contract at a fictitious price of 12. His profit target is 20 ticks, so in this example, he is
looking to exit at 32. The market goes 10 ticks his way. He feels good, but not out of the trade yet. The
market then goes all the way to 31, one tick from his 20 tick winner. However, it doesn’t fill him and
retreats all the way back down to 12, which is break even.

How do you think this trader feels? How would you feel?

Not good, is our answer. We don’t take to kindly to near winners. But, in fact, this is the reality of going all
in for bigger winners. While in this example, this trader did not lose real capital, he or she lost quite a bit
of what we call Emotional Capital.

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Solution
Scaling
As discussed earlier in this section, not everyone is wired to trade big size, i.e., 20, 50, 100 contracts at a
time. However, we feel everyone is wired to trade more than one at a time. In the problem above, there
is no flexibility to scale out and take advantage of being right to the tune of 19 ticks. Not only has this
trader suffered an emotional capital loss, but s/he also hasn’t made any money even though they made
a great directional prediction. All markets differ regarding their sweet spot or average move. Most of the
time, traders are always outside that sweet spot and spend a lot of emotional capital “swinging for the
fences.”

A good scaling technique, for example, of buying it at 12 and exiting at 18 and 24 on 2/3’s of the position
would have allowed this trader not only to “feel” better, but, also profit from being right. Now he or she
would have made +6 ticks on a third +12 ticks on a third and can now be flexible. You don’t have to start
trading 3 contracts, nor are we advocating it, but when you only trade one contract there is a bit of a
disadvantage.

Edge-ism | Realize that trading successfully isn’t less contracts and more ticks it’s slightly more contracts
and less ticks.

Pay for the Trade

“Pay for the Trade” is one of the most important phrases we use to
help others stay in profitable trades.

What does it mean?

It’s the first part of the scaling we spoke about a moment ago.

Problem
When the previous trader got long at 12, the market eventually went to within one tick of his target.
However, before that, other emotional moments may have occurred. Maybe it went 8 ticks his way, then
back to break even, then 10 ticks his way, then back to break even. At that point a trader will just take the
small winner or break-even /scratch only to see it go the distance up to his/her target. Why? Because we
can only take so much emotion.

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LESSON 6

Solution
“Pay for your trade” consists of taking a small profit, maybe on the first third of your trade to reduce the
emotion. Therefore, increase your comfort and focus. Even if you’re a 1 contract trader, you can practice
getting out early for “the sweet spot” exit.

Psychology II
Do not marry your trades whether or not you’ve read this in a trading psychology book or not we can
sum up in a sentence what many write in a book:

Edge-ism | A successful trading career will consist of thousands and thousands of trades, so then why
would anyone trade be that important.

Reduce emotion by knowing when you’re wrong, pay for it by scaling, and devalue the importance of any
one trade.

Many individuals feel that real capital is the only risk, when actually an element of emotional capital
always exists.

How hard do your winners feel? No matter how much money you make, if it feels like you’re walking
through a minefield each day, then it will be near impossible to sustain the effort. Reduce your emotion
by reducing the surprise. Know your exits before your entries. Don’t try to take too much out of your
winners and be perfect.

Edge-ism | More money is made by increasing your size, not your profit targets.

WATCH THE VIDEO FOR THIS LESSON

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