The ultimate challenge

The last few months have been extremely tough going for medium term active share investors. This has been exacerbated this past week with a rapid increase in volatility and the markets once again moving into a high risk phase. Events such as these are not un-common in the markets and as traders and active investors we must be prepared for events like these and accept that they are one of the many risks associated with engaging the markets. Anything can happen in the markets and the events of the past week serve to remind us that we have no power over the market and that seeking to predict and forecast what the market will do next is more often than not a futile exercise. As disciplined and focused traders and investors, our role is to REACT to the events that occur in the market and have a well researched trading plan that specifies what we MUST do in such circumstances. This will include the management of risk and money through appropriate exit strategies that we clearly define well in advance of such events occurring.

As traders and investors we are operating in an environment with an unlimited number of unknown participants and a limitless number of variables. At any one time any change to one or more of these variables can result in any number of unforeseen circumstances unfolding, often extremely quickly. Each price move is the result of an action by another market participant based on their belief as to what price will do in the future. This is what makes the market what it is – thousands of buy and sell parameters interacting to cause changes in price. It is these interactions that combine to present us with great opportunities to generate profits, just as they present us with the potential to generate losses. We have absolutely no way of knowing what these decisions may be or how the combined result of all these decisions will cause the market to behave. As Mark Douglas states, one of the 5 fundamental truths of the markets is that “every moment in the market is unique”.

We can really only know and understand our own decision making processes and ensure that we strictly adhere to the rules that we have put in place for us to follow. These are our entry & our exit rules and our risk & money management rules, in the timeframe in which we choose to engage the market. At any point in time we have no way of knowing if a trade we enter will be a profitable trade or a losing trade, in our chosen timeframe, because “there is a random distribution of wins and losses for given set of variables that define an edge.” (Another of Mark Douglas’s 5 fundamental truths). What we have are knowledge of the probabilities of the trading strategy we are using and the money management and risk management tools we will employ to minimise our losses by cutting out of losing trades, and to maximise the returns from our winning trades, in our chosen timeframe. This will provide us with our edge over the market over the long term and a large sample of trades.

There is always room to improve a mechanical or discretionary edge within the stated timeframe and stated edge objectives, as perfection in the markets does not exist. The research challenge is to affect modifications to an edge that improves the edge in certain market conditions but does not negatively affect it in others. The overall edge must not be diminished. This research must be conducted away from the heat of the market, i.e. don’t trade modifications that are in research on the fly or allow current market conditions to dictate trading decisions on a discretionary basis.

The ultimate challenge is to trust the edge that you are currently using, at all times, to achieve consistency and objectivity. Whist easier said than done – that’s why it is a challenge – it is the probabilities of the edge over a large sample of trades in which you need to trust as trust overcomes fear and consistency cannot be achieved whilst fear is in control. And you cannot fear and trust at the same time.

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