By M. William Scheier, a futures trader and analyst in the E-mini Index contracts*
Posted: November 14, 2008

No matter how clever your trade entries are, successful trading is mostly a mental game. This treatise on trade psychology is appearing in a series of installments (and modified for use on this site) and has been excerpted from chapters of the book Pivots, Patterns and Self Recognition. The excerpts appear here by permission of the publisher, valhallafutures.com .

This is the eighth installment in this series, whose purpose is to examine the internal decision environment the trader faces within his mind. On the assumption that a better understanding of the mental conflicts we face will improve our trading results, the three modes of conflict are personified in separate "voices" inside of us. These are the Trader, the Accountant and the Analyst.

Chapter Seven
Fatal Assumptions

It is law also to obey the command of just one. Heraclitus

If the Analyst in your head gets you into a position that doesn't materialize the way the pattern model suggested, he is very likely to attempt avoiding defeat by retaining the position under the guise of new analysis. He sees his old position now justified by a new pattern as the chart unfolds.

He just loves to use his tools. He just loves to demonstrate his skill at pattern recognition and technical analysis. And, at no time is he more eager to prove his skills, than at a time when his current pattern isn't working. You don't hold it against him personally because you now understand his sense of being threatened. Fending off the truth, he goes into denial. His only motive is to prove himself right.

In some ways, the better the Analyst has become at listening to the market, the more tools he has to transfer the losing position to. But, that's a slippery slope, once you're on it during a trade. And, although the new pattern he comes up with might seem an equally valid reason to continue committing funds to a losing position, be aware that he'll probably find another if this one doesn't trigger either, and so on until it finally stops you out of the trade anyway.

Usually, it pays to ignore him immediately if the parameters of the original pattern are violated. For one, you have a better chance of reducing the loss earlier, and, for another, you resist the Analyst habitually digging himself into a hole where the well of his credibility is drained. With as much good cause as there is already to find irritation in this guy, there's nothing more pitiful than to see him beat his head against the wall.

Take him out earlier, and he'll handle the recovery better. You'll be doing him a favor, saving him from himself, as it were. Better that than to let him go through his gymnastics trying to save the trade. Remember: The Analyst only has one directive in life — the glory of being right. He can't help himself. The Analyst, you see, assumes he is right — always and at all times — simply because he can't admit he's wrong.

If left unchecked, the Analyst will exhaust himself trying to prove this condition. If you catch yourself in the midst of a trade, wandering through a maze of mental gymnastics as rationale for holding a bad position, shake it off and assume the podium. The Analyst has been in control.

The best weapon against your Analyst's control is a rule:

Each trade shall have a well tested model. Each model shall have a specific description as to what it should look like before the trade and how it can behave afterwards. If after you've taken the trade, the trade does not behave as the model describes, you must exit the trade immediately, all the more so if it is still a good distance from your stop.

This rule puts the Analyst on call from the get-go and separates him from the act of the trade. It forces him to cough up the parameters by which a pattern is both triggered and violated ahead of time and outside the activity of real-time trading and, thus, keeps him at a distance from the outcome.

Define the rules as specifically for each pattern as possible. Yes, the rules for the model can evolve as your trading skill progresses, but not without considerable empirical proof, and never in the middle of a trade. Rely on your rules as you have developed them thus far. At the moment you need them most, you'll be the most tempted to abandon them. That's why you have them.

Any reason that occurs to you to rationalize further commitment at those times when a trade is going sour is the Analyst's voice in your head. Welcoming him into your head at this stage of the trade is self-indulgent and will extend your financial risk excessively.

If only you could just hear the Accountant's voice about this time should the Analyst take control of the trade. "No, that's not what you promised. You said that, if the trade failed, we'd get out. Now, get out, you idiot." And then half under his breath, "I told you so," just to get in his digs. This would be good for the Analyst to hear, but he doesn't. He can't hear anything but himself — not when he's in control of your voice.

And, don't expect the Analyst to do anything else but be himself. His mission is singular: To affirm his existence in the glory of being right, no matter how much it costs to get there. Read the rules out loud in your head. The rules restore your voice to the Trader. The Trader will then take command. The rule of law is the command of the Trader.

*Reprinted (and modified) with permission from M. William Scheier and the publisher, valhallafutures.com