A lot of you know that, before my current job as a daytrader, I was climbing up the corporate ladder at an engineering firm. Like most big companies, we had plaques and cards with grandiose mission statements on them. Something like: “We will provide exceptional value to our customers via superior technical solutions created with a sense of ethics and integrity.” Even just typing it makes my eyes roll. The associated list of “corporate values” were just as sad (and they only ever talked about them just before ISO:9001 audits so we’d know what to say…. but that’s another story).

Only a room full of high-salary business people could produce a mission statement so worthless. Of course they meant well, but in the end they just didn’t know what they were doing. Unfortunately, when I talk to traders about what they want to achieve, I hear equally well-intentioned yet equally useless statements. My background in business helps me keep a straight face (figuratively, since the exchange is always over e-mail or instant messaging), but I’ve been meaning to write an article about this topic for quite a while.

Your trading business is just that: a business. Let’s think a little about how we can treat it like one.

Defining the Concepts of Mission and Values

What exactly is a mission and a value, in terms of a business endeavor? Let’s ask Jack Welch, former CEO of General Electric:

… a good mission statement and a good set of values are so real they smack you in the face with their concreteness. The mission announces exactly where you are going, and the values describe behaviors that will get you there.

That quote is from his 2005 book, Winning. I thought it was one of the better non-technical books on management that I’ve read.

Good mission statements are so difficult to write because they are both high-level and specific. Ok, so no more lip-service to a laundry list of virtues. Of course, instead of “ethics” and “integrity,” traders usually cite “consistently profitable” and “only taking the best setups.” Yawn. Wake me up when they get past the part about not pulling stops… Obviously you need those, but what are you really going to do to succeed in your trading business? As Jack says (ibid.):

In my experience, an effective mission statement basically answers one question: How do we intend to win in this business?

From 1981 to 1995, GE’s mission was to be the most competitive enterprise in the world by fixing, selling, or closing every business unit that could not achieve No. 1 or No. 2 status in its market. For another example, here’s Google’s mission statement: Google’s mission is to organize the world’s information and make it universally accessible and useful.

The “values” are just behaviors that flesh out the mission statement, and I’ll give some examples below.

My Trading Mission Statement

A few months into my trading career, I gave some thought to what I really wanted to achieve, and came up with a mission statement. I’m not saying this is the best mission statement, or the most original, but it’s what I came up with:

I will generate the smoothest equity curve possible, using the smallest bets that still cover my living expenses.

When I say “smooth,” I mean no big losses and no big wins either. Having recently read Fooled by Randomness, and experiencing the ups and downs of novice trading, I had a few specific ideas floating in my head:

• You can’t tell the difference between luck and skill in the short run, and I am still in the learning stage of the game.
• People like the concept of expectancy, because it tells them it’s ok to only win 40% of the time… but I’d rather minimize my risk of ruin as long as I’m making enough to get by
• Living month-to-month, I don’t want to wait an unspecified time for a windfall gain… I want a stream of steady small wins
• Given a liquid enough instrument, leverage is a knob you can turn any time you want to “magnify” your wins and your losses.
• Returns with shallow drawdowns can be safely magnified the most. So, once I have some mastery of trading, I should be able to easily shift my focus towards becoming a seriously wealthly mofo

You can see my thinking in-progress in my posts from that era, which focused on pitfalls of focusing on expectancy and relative danger of trading different account sizes, and the like.

The secret to success seemed to boil down to generating the smoothest equity curve possible. I think, as a mission statement, it does at least answer the basic question how do I intend to win this daytrading game? The vague long-term goal was to enjoy steady small returns (not depending on big wins and not suffering big losses), and then start increasing leverage after a sufficent track record had been established. I’m still using that plan, today.

The associated values that flesh out this mission statement include things like:

• Increase profits by making more trades rather than bigger trades (this also improves consistency, see my article on the topic)
• Do not specialize in any one trading system (see articles about the ideal discretionary “Type 3″ trader, and numerous others about various approaches I’ve incorporated into my trading)
• Focus on win rate, then profit factor, then expectancy, in that order
• Minimize per-trade risk (every time my trading reaches a new level of profitability, I decrease my normal position size. I used to be able to live on 5R of profits a month… now I need more like 20R per month to live). This usually implies ‘minimize leverage’ as well

Hopefully it’s obvious how these values are in alignment with my overall mission. They are the “hows” that compliment the mission’s “what.” Once again, you can probably figure out other values by reading through the articles I wrote last year.

Use Your Mission Statement

The great thing about an effective mission statement and associated values, is that you can actually use them. Every time I make a decision, I can think back to my mission, and make sure I am in alignment with it. Here are just a few examples:

• At least once a month someone asks me if I daytrade futures or currencies. It certainly sounds exciting, but it doesn’t fit with my current mission at all.
• Every so often people leave a comment on the blog saying I’m making a mistake by not “swinging for the fences” with my profit targets. It can get frustrating, but I try to explain that I have different goals than they do. Plus, they rarely seem to grasp how you make the same money winning $.10 on 2000 shares as you do winning $1.00 on 200 shares.
• It’s taking me a long time to get into the options game for longer-term trades (which I had planned to do by now), because the increased leverage and wide spreads are at odds with my current mission. I am still investigating strategies, and hoping that penny option pricing helps me out to some degree.
• I have some interest right now in doing a better job of choosing profit targets for my scalps, so I don’t leave so much money on the table. But, that is taking a back-seat to things like learning how the fibonacci traders trade, since adding more trading styles is in-line with one of my core values.

The list goes on and on..

Having an overall idea of where you are going as a trader clarifies and shapes your goals for each month. It keeps you focused on what’s really important. If you are mired in a bunch of vague near-term goals like “make $x by y” or “obey my own rules,” then you might benefit from creating a framework for all those tasks in the form of a mission statement for your trading business. It need not be anything like mine, especially if you have different goals for your trading career, or a different personality, or whatever. Hopefully, I’ve made the concept seem less hokey than most businesses make it.

“I need a drink.” And I didn’t mean water… Breathing quick and shallow breaths, I made futile attempts to massage out the tension in my neck and shoulders. My shoulder muscles in particular were burning from the prolonged strain. My fingers were tapping nervously on the table almost as fast as my heart was pounding nervously in my chest. As I hunched forward, the pin-point stinging in my eyes told me I had forgotten to blink for too long. Was I diffusing a bomb? At gun-point? Nah… just tradin’ some stocks.

This is the third installment of the Evolution of a Trader series. It’s a series about important learning experiences I had while developing as a trader. I spent a lot of money on these lessons… I hope you don’t have to! If you are new to the series, you might want to check out the other entries.

The Ideas
The opening paragraph is no exaggeration. I used to be a real mess during my trades. Around November of 2005, when I used to hang out in trading chat rooms, we all used to joke about the stress of trading. We’d say “looks like the markets are calling for the hard liquor today,” or the classic “looks like I picked the wrong week to stop sniffing glue.” At least, I hope we were all joking. It was fun to chat about, but the stress was very real, and clearly not healthy.

As soon as I put on a position, I would immediately grow tense and fixated on the chart. Even when the stock had moved in my favor, I was just sick watching for any sign that I should get out. So, I started looking for ways to counteract the problem.

I’m not ever content to just theorize… I prefer to try things out, even if they seem ludicrous. Some ideas I tried include:

• Stretching and light aerobics before trading. This way, at least my muscles were loose and relaxed prior to the stress onslaught. After a few minutes, though, that benefit was long gone.
• Stretching and light aerobics during trading. I had some success with this, but it kept me from doing any real typing while trades were on, which hurt my productivity. Also, I was still under the same amount of stress; I was just channelling the energy a bit.
• Moderate alcohol consumption… as in a couple glasses of wine early in the trading day. What can I say… I guess we joked about it until it started to sound like a good idea! I found that I could get just as worked up during the stressful times, so it didn’t really help. Worse, during the boring times, my attention would drift. (an aside: I had this cabernet last night, and thought it was pretty good)
• Meditation. I did this already, but at night. I tried fitting in some meditation before the trading day, to see if that would help. Like pre-trade stretching, this helped me go into the day nice and relaxed, but the effects wore off pretty quickly.
• Listening to music during trading. I tried a variety of styles, with no discernable benefit. During a stressful trade, I was tuning the music out. During the boring times, it was a distraction. Also, a big part of my trading style back then was watching the tape, and getting in synch with the action. I found that music interfered with my ability to do that, because I would inadvertantly correlate the ebb and flow of prints with the rhythms in the music!
• Trading in a massaging chair. I found that, when stressing out over a trade, the little massaging motors were more painful than soothing. But, when not trading, I love that thing.
• Trading on more sleep, and less sleep. The ideas were “I’ll be fresher,” and “I’ll be too tired to care,” repectively. Wrong, and wrong.

How I Overcame My Stress
As usual, though, I was taking completely wrong approaches. I was attempting to treat the symptoms, and not attacking the cause of the stress and anxiety itself. I guess, at that time, I felt like tension and stress were a part of trading that needed to be accepted. After all, one of the traders in Stock Market Wizards had an aneurysm, and Pit Bull recounts Marty Schwartz’s trading-related health problems. I could cite several more examples. However, I no longer think extreme stress is a necessity.

At some point early in 2006, I happened to notice that I was under a bit less stress than before. Something had obviously improved, and that was the catalyst that got me really thinking hard about what could have changed. I tried to go from there to identify the real root causes of all that tension. Here’s what I came up with (this is an actual text file I saved off on my hard drive, somewhat edited for presentation here):

1. Too much focus on reward, too little focus on risk. One bad trade could erase several days of profits. (I’ll be making a subsequent evolution post to cover this topic fully).
2. Not enough confidence in the setups I was trading.
3. Trading too much of the noise, and not enough of the bigger stock moves

The big stress-reliever that I had already experienced came from addressing issue #1. I had recently achieved a much firmer grasp of risk:reward ratios, and the concept of risking a fixed % of current equity per trade (for more on these topics, see articles such as this one and this one, among others). By controlling and understanding my risk better, I felt more in control of my trades. I felt like my perfomance was more predictable. Therefore, less stress.

Items #2 and #3 were other stress factors I thought up in my brainstorming. It seemed reasonable that if I could systematically address these, I could further reduce the problem.

So, to improve my confidence in my setups, I implemented a backtester, and also started keeping close track of my trading expectancy. It is soooo much easier to face a trade that’s going against you, when you have some reason to believe that you will make the money back (and more!) soon, trading the same way. Think about that… that’s powerful knowledge to have. I also did more thinking and reading about the chart patterns that are the basis for a lot of my trades. I tried to gain a deeper understanding of the market mechanics that make them work. I find it’s easier for me to trade against what I think market participants are doing, and harder for me to trade against what looks like a “head and shoulders” shape on a computer screen.

Over time, I came to realize that Item #3 (regarding trading noise too often) was a valid concern. Really, it’s a close relative of Item #1 (poor risk control). I still, even today wake up sometimes with the notion that I should throw some money at the opening volatility. I wake up literally imagining the killing I could make, in detail. I guess the memories I have of making $1200 in a couple seconds are just too sweet to kill. On the other hand, I have to look at my old trading records to remind myself that I lost $2000 or more just as often on the same silly trades. Selective memory is deadly! But, aside from that, I was making a lot of trades with a goal of picking up a few cents on a wiggly $90 stock. That’s a miniscule move on a $90 stock, and can happen at random, in an instant. It was too unpredictable, and too hard to control my risk properly. My expectancy record keeping made it clear that I had to stop making trades like this. Though they don’t spark my imagination like those opening-minutes trades, I still want to trade noise sometimes, too. But, I know better now, and I have the facts to back me up, so I can resist.

Making these adjustments, and working on my overall workflow so that it fits my personality better, has dramatically reduced my in-trade stress. I no longer feel like I am doing myself physical harm by trading. It’s also just a lot more fun, this way!

Summary
I think a lot of beginning traders feel like high stress is an unavoidable cost of doing business. To some degree, trading is going to be stressful, true enough. However, if you have a stress level anywhere near what I described above, you need not suffer through it. In my case, it took me a long time to realize that I could attack my stress, head-on. You don’t need to wait like I did. Get to the root cause of your tension, and address it. I would wager that in many cases it boils down to the same two issues I had: a lack of confidence, and poor risk control.

“Ok, you wanna go up? Fine! Let’s go up!” It was December 29th, 2005, and I covered a losing short on Energy Conversion Devices, Inc. (Nasdaq: ENER) for a loss of $166. I had other losing trades in motion on Alkermes, Inc. (Nasdaq: ALKS) and Under Armour Inc. (Nasdaq: UARM), and the day was running out of trading hours. I needed to recover, and fast.

This is the second installment of the Evolution of a Trader series of articles. It’s a series about important learning experiences I had while developing as a trader. I spent a lot of money on these lessons… I hope you don’t have to! If you are new to the series, you might want to check out the introduction article, and the first installment.

Trading Loss Recovery Tactics

Continuing with the story from the first paragraph, I didn’t want to finish the day in the red. ENER had turned up as soon as I had gotten in short. It was especially hard to watch, because I had already pinned my hopes of making up for my other losses on this ENER trade. It wasn’t going to work! So, I reversed my position and took a $166 loss in the process. “Fine, let it go up,” I thought. “At least now it’s going in my direction.” Not only did I reverse the position, but I bought 5 times as many shares as I had sold in the short position. I should hardly need to tell you that it promptly started falling. I lost an additional $669 on the long trade.

It’s natural to want to end every day in the green, but like many beginning traders, I had all the wrong goals, and took all the wrong actions. That ENER fiasco was just one example, and unfortunately there are many in my early career. Here are some things I’ve done in the name of loss recovery, at one point or another:

• I held on to a winning trade too long because it had not yet made enough money to cover an earlier loss. “C’mon… Just a little more… I have $500 losses to make up for…” This line of thinking creates an irrational tie between the performance of one trade and the performance of another. It causes you to ignore your trading plan, and can not only reduce profits, but even turn winners into losers!
• I jumped out of a winning trade too early because it had made enough money to cover my earlier loss. “I can’t risk going red again for the day.” This is a variaton on the above irrational thinking. If the trade is still good, don’t alter your trading plan.
• I overtraded to make up losses by the end of the trading day. “This isn’t the best setup, but it’s almost 3pm, so…” If you get fixated on getting back into the green by 4pm, desperation can make bad setups seem good.
• I traded too large a size so that a trade’s likely reward would cover my losses. “Let’s see… I need to make $500, and I can maybe get 20 cents… so I’ll buy 2500 shares.” That’s ignoring the proportionally larger risk, of course. I don’t have to tell you how this turns out, do I? I did this in the ENER example above.
• I traded for revenge. “Revenge Trading” is when you trade the same stock that you lost money on, but you are so focused on “beating” the stock, that you lose some or all of your trading discipline. The hasty long/short reversal from the example is a kind of revenge trading.
• I associated new trades in my mind with the hope of making up my losses. From the start, this puts emotional ties on the trade, and it exacerbates all the other items on this list. Any book will tell you that “hope” is a four letter word in the markets, but I bet every trader in existence has fallen prey to this illness at some point in their development.

I’m sure a lot of aspiring or beginning traders will read through this list and laugh. Of course they would never do those things. When you read them in a list, they do seem like stupid thoughts to have at all, much less act upon. But, when you are down thousands of dollars, and you have bills to pay, and you know that so-and-so is going to ask you how the day went in a couple hours, and they obviously already think you are an idiot for trading stocks in the first place, and you’d really like to impress them… well, somehow your brain manages to blind itself to anything but the possible upside of plans like the ones above. If not, you are luckier than I was! On the other hand, if you do find yourself having thoughts like these, I hope they’ll seem familiar from this article, and you can avoid my mistakes.

The True Nature of Recovery

Eventually, I had a revelation. “Recovery” is not an action that you take. It’s not a course of action you can plan. It doesn’t even have anything to do with your account balance, or whether the markets are open. Recovery is a state of mind.

Specifically, it’s the state of mind you were in before the loss. Think about it… If you have a positive expectancy (and a reasonable win rate), you will make back more money than you lost before long. At least, the odds are overwhelmingly on your side. And you don’t even have to do anything special. The only part of the bargain you have to hold up, is you have to trade the way you did when you measured that positive expectancy. When you focus on the loss, or attempt to take an action that you think of as “recovery,” you are making adjustments that put you in a state with unknown expectancy. The type of changes a beginning trader is likely to make will almost certainly lower his or her expectancy, if not make it negative. And off they go down the spiral of further losses and more urgent recovery “plans” and “attempts.”

In Jack Schwager’s The New Market Wizards: Conversations with America’s Top Traders, Linda Bradford Raschke says “It never bothered me to lose, because I always knew that I would make it right back.” If you measure your performance, and you have a reasonable system with a positive expectancy, you could make the same statement.

So, in a very zen way, the moment you stop trying to recover is the moment you will succeed. I can now say I’ve recovered from my latest loss without having made back a dime yet. Sometimes I need to take a walk. Sometimes I need to take the rest of the day off. I don’t trade again until I’m mentally back to where I was, pre-loss. Over time, it has gotten much easier to get there.

An Aside: Mental Discipline

A lot of the pitfalls that Type 1 and early Type 2 traders fall into really boil down to a lack of mental discipline. The thoughts I listed above may lead to counterproductive trading behavior, but they are all rooted in perfectly natural human emotions and dispositions. For me, they key has been to stay aware of my thoughts. That way, when I have counterproductive thoughts, I can recognize them for what they are and dismiss them. They still pop into my head today when I’m trading in the red. For instance, during my trade on United States Steel Corp. (NYSE: X) this week, I found myself watching the dollars of profit, waiting for it to surpass my earlier loss on CSX Corporation (NYSE: CSX). I quickly noticed and forced my attention back to the quality of the price action. Problem averted.

Reading trader blogs, I’ve noticed that several of us are into meditation, and I don’t think that’s a coincidence. A lot of people think meditation is for relaxation or spirituality, but first and foremost it’s about mental discipline. At the beginning, it’s actually really hard work! Being able to observe your own thought stream passively, and stay entirely focused on one thing for minutes on end, are excellent skills for any trader. I recommend that all traders try it.

Summary

That number on your trading platform screen isn’t labelled “Profit/Loss/Drawdown/Recovery,” is it? Of course not. Actions you take only result in profit or loss, plain and simple. Everything else is really just your mental picture of your equity’s health. If you let that picture alter your trading decisions, you are entering a zone with unknown expectancy, and will probably suffer for it.

Stocks Mentioned In This Article
Stock	Links
ENER	| |
ALKS	| |
UARM	| |
X	| |
CSX	| |

“I am a genius!” I was salivating over all the money I was about to make. This was the first trading idea I had put together on my own. Didn’t see it in a book. Didn’t see it in a magazine. Nope. This one was mine!

You are now reading the first in a series of posts I’m going to make about important learning experiences I had while developing as a trader. I spent a lot of money on these lessons… I hope you don’t have to!

The Idea

I had just opened my large trading account, and was getting my feet wet in the daytrading arena by trading two days a week (I arranged the time off with my employer, and still gave them over 60 hours a week, regardless). I knew traders were supposed to trade high-volume stocks, for their liquidity, so I was studying their charts. A certain class of stocks in this group caught my eye.

Think of stocks like Sun Microsystems (Nasdaq: SUNW), Sirius Satellite Radio Inc. (Nasdaq: SIRI), and Lucent Technologies Inc (NYSE: LU). These are all very low priced, very high volume stocks. As a result of their low price (with correspondingly small trading range) and the relatively huge number of shares changing hands, you tend to see this a lot:

That’s a pattern from today on SIRI, covering over one and a half hours of trading time. Some days, the pattern held for much longer. The bid and ask were practically static, one cent apart, and the prints were bouncing back and forth between them. Can you guess my brilliant plan?

1. Wait for the pattern to develop
2. Buy 10 or 20 thousand shares at the bid via limit order
3. Immediately sell the shares at the ask via limit order (gain $100 to $200)
4. Repeat until rich beyond wildest dreams

That’s it. Simple. And, if you look at the picture, you can see that I thought that a drop in the bid would mean selling at the ask to break even.

How Did It Go?

There were a couple things I didn’t count on in terms of execution. If you look at the Level II quotes on these stocks, you’ll see how large the size on the bid and ask are. This means that a limit order to buy tens of thousands of shares at the bid and sell at the ask can take quite a while to go through. Also, I wasn’t considering the time it takes to modify and cancel orders when the stock starts moving against you. It can mean the difference between a 1 cent loss and a 5 cent loss!

Still, the first two or three trades I made worked just as intended. I was thrilled. And then, the next one didn’t. Worse, my beautiful plan to get out at break even did not pan out. You see, because the bid and ask are so deep, it’s easy for the bid and ask to keep dropping before you get filled, even though lots of shares are trading hands at each level. So, you give up on limit orders and issue a market order, during which the bid can drop even further.

Put all this together, and it appeared that I would have to win at least 4 times as often as I lost, and even if I pulled that off it’s just not that profitable (you end up trading 100,000 shares to make $200 net profit!).

I kept trading, and kept getting similar results. Up $300, down $400. Up $400, down $300. Then, I had it move five cents against me, and like many beginning traders, I became irrationally confident that the stock would go back up. I’d be sorry, I reasoned, if I got out now for a $500 loss. But, it kept falling, and I closed out a couple agonizing hours later, down $1500 for the day.

What Did I Learn?

Let’s ignore that last part, about not being able to take a loss. This was just one of many examples of that particular problem from early in my trading. It was certainly a costly mistake, but tangential to shortcomings I want to expose in this story.

In formulating and executing this idea, I made several beginner mistakes:

• I only looked at the areas of the charts where this system would work. It’s a human trait to find a couple cases that work, and overgeneralize from them. It’s also a human trait to assume a repeating pattern will continue to repeat.
• I had capped my upside by immediately selling. If the stock tried to run up, I would still get filled at 1 cent of profit. However, it’s hard to truly cap the downside to 1 cent because of the issues described above. So, I had locked in a reward smaller than my risk.
• I gave no thought to the overall trend of the stock, or the health of the market. In other words, I was making trades with no context.

From these mistakes, I learned (or at least started to learn) the following:

• You have to control your enthusiasm. Make a conscious effort to look for the cases that don’t work, and see how bad they are. If you don’t set out to find the failure cases, your brain will have a tendency to gloss right over them. Be aware of the ways human cognition can fool you. The brain is wonderful at spotting patterns in data, even if it has to fill in data that’s not actually there!
• Even if you don’t perform a full historical backtest, always at least try to estimate the expectancy of your plan. That is, given your expected gains and losses, what kind of win rate will you need to make the plan pay off? Can you achieve that rate? Always factor commissions and slippage into your plan. For some reason, I have always been good about accounting for commissions, but I used to always assume my fills would be immediate and pristine. Now I allow for some error.
• Trades should not be taken in isolation. A stock’s trend (or lack of one) today is happening in relation to longer term trends (or lack of them) in the same stock. Also, stock motion is happening in relation to the overall market. It was after this failed experiment that I spent time learning about TICKs and TRINs. Since then, I’ve found really no use for the TRIN–I can’t derive anything useful from it. The TICKs for both NYSE and Nasdaq, on the other hand, are always on my screens now.
• It’s dangerous to trade on a scale that is essentially just price noise. Trying to catch 1 cent up, and get out at breakeven if the bid drops 1 cent, is relying on a certain amount of order inside that noise. That order doesn’t exist, by definition. Your brain just makes you think it does, when you look at time and sales data that’s already past.

Could this scheme be improved enough to be viable? I think not. If you disagree, I’d love to hear your ideas.

Stocks Mentioned In This Article
Stock	Links
SUNW	| |
SIRI	| |
LU	| |

I’m going to start writing a series of articles that I call Evolution of a Trader. In it, I’m going to dredge up some boneheaded thought process I used to employ, tell you how it worked out (I’ll give you one guess since I just told you it was boneheaded), and tell you what I learned from it. I think it may save beginning traders a lot of money. It may make experienced traders think back on their past and smile.

The Three Types of Traders

Why do I pick that word evolution? I don’t know if all occupations have this concept, but before I traded I worked in software engineering. And in that realm we often talk about three classes of engineers, referring to various stages of their professional development. For this discussion, I’ll translate the description to talk about traders, and I think you’ll agree that the three stages apply well to them:

• The Type 1 Trader is just getting started. They either already know or will soon know one or two ways to trade. This is the proverbial hammer that makes every problem look like a nail. A typical trait of a Type 1 Trader is overconfidence. They tend to ignore or be entirely unaware of strategies besides their own, and are totally blindsided when their plan doesn’t work. They aren’t equipped to adapt to unknowns. When their one true way stops working, they tend to drop it and find the next one true way. Typical Type 1 questions are broad, like “Is this a good stock here?” or “Do you think it’s done going down?” Typical Type 1 assertions are also broad, like “Short selling is too risky.” Many aspiring traders never make it out of this phase.
• The Type 2 Trader has a few trading chops down, and is making at least some money in the markets. They’ve probably been burned a few times during their Type 1 phase, so many early Type 2 traders can be overly risk sensitive. The primary characteristic of the Type 2 trader is self-education. They have seen enough to know what they do not know. Type 2 traders often get trapped searching for the “holy grail,” making constant small adjustments to their styles looking for the magic combination of indicators. A Type 2 question sounds more like “Do you think there’s enough support at that round number, or would a volatility stop make more sense with an entry above the high of the fourth candle?” A lot of good Type 2 Traders make their living trading, and though they’ve gotten out of the “holy grail” rut, many never make it to the next level. In fact, some claim they don’t want to be at the next level.
• The Type 3 Trader… is a bit of a mystery to me, since I am a Type 2 Trader, going by my definitions. However, I was a Type 3 Software engineer, so here I will try to infer what a Type 3 Trader is probably like. The primary Type 3 characteristic is to be on the plane above “systems” and “methods.” The Type 3 Trader effectively creates successful approaches to match market situations on the fly. In the eastern thinking sense, they “are” the markets. You won’t hear a Type 3 Trader say things like “I don’t trade options expiration days,” or “I’m hanging back until the effects of the Fed announcement cool down.” Those are Type 2 statements. Type 3 Traders often have trouble explaining their methods to a Type 2 Trader, because Type 2 questions are senseless to them. “What indicators do I use? It depends on what I want to see at the time.” A lot of their explanations hinge on that phrase, “it depends,” but a Type 3 Trader has trouble articulating exactly what it depends on. I would guess that a combination of experience and depth of understanding gives them subconscious clues that one could call “intuition” of a sort.

What’s weird is that, while there are lots of Type 3 Software Engineers, I don’t see a lot of Type 3 Traders. Maybe one reason is that you can be an unsuccessful programmer for a long time before it all “clicks,” but traders must be successful or they get wiped out. I think that fear of wiping out is what keeps a lot of traders at Type 2. They are profitable, and don’t want to mess too much with a good thing. Nevertheless, I think Type 3 Traders do exist. I’m thinking of people like Marty Schwartz. In his excellent autobiographical book, Pit Bull: Lessons from Wall Street’s Champion Day Trader, you don’t see him just stick with a few systems he likes to follow. No, he saw on the news one night that the 90’s Iraq war started, and ran into his office to put on a combination of trades in futures and commodities that was tailored for what he sensed was likely to happen in the markets. He was urgently opening overseas accounts in the process to put on the exact trades he wanted. Do you have that kind of confidence or insight? Do you think he read how to do that in a book?

Even though I can say I am a Type 3 Software Engineer, unfortunately that doesn’t give me much insight into how the heck I managed to get there. So, I similarly have no real insight into how you make the jump into Type 3 Trading. I just know that the level is there, I know it’s a leap above Type 2 rather than a simple step-wise progression from Type 2, and I know I want to be there. Maybe, given time, that will be enough…

Back to the Point…

All that explanation just so I could make the following distinction: I’m not going to categorize these Evolution of a Trader posts as “Mistakes” in my blog, as I’m reserving that category for current mishaps and faulty thinking. Rather, the evolution series will be primarily about Type 1 and early Type 2 Trader mistakes that I made. I don’t mind if you laugh at them. I can laugh at them, too. And feel free to share your own, if you want.