Becoming a better trader (or investor) involves much more than expanding your knowledge of markets.
While the vast majority of market participants may believe that it is, they are incorrect.
The secret to trading success does not lie in external knowledge, but internal knowledge.
It’s about understanding yourself, how you make decisions, how you react to adversity, and how you think about markets.
If you can gain enough mastery of yourself, trading success will follow.
This Collection will show you how.
The Dollar rallying out of its summer weakness is beginning to catch the attention of mainstream commentators.
Unfortunately, their focus isn’t on the Dollar per se, but rather the Dollar Index, which is not a very good indicator of USD performance at all.
What should you be looking at instead?
Before we take a look at the different methods of gauging Dollar strength or weakness, it is important to understand why we need to be looking at the USD at all.
Obviously, the USD is the world’s reserve currency and is thus of global importance. Everyone knows this, but they don’t really understand why.
The common belief is that the Fed controls the supply of Dollars around the world, because the Fed can print USDs at will.
However, this isn’t accurate.
The Fed controls the supply of USD denominated bank reserves, which, contrary to popular belief, are not really money. They are a settlement currency which can only be used by banks.
The clearest way to see that bank reserves aren’t money is to realize that banks do not lend them out when making loans.
In other words, the supply of Dollars is controlled by banks.
When they decide to loan more Dollars, the supply of USDs in the world increases, and when they do not, it stays the same or decreases (as loans mature).
Consequently, the USD is the world’s reserve currency because the banks in the global financial system have chosen to use it as such, which makes the supply of USDs around the globe the world’s de facto money supply.
This in turn makes the USD the most important market to watch, as its value directly tells us whether or not the world is being supplied with enough Dollars.
If it is, the global economy can keep growing, or at least hum along; if not, recession or crisis lies around the corner.
If you want to learn more about the USD’s importance to the world’s economy, as well as how the system works, check out our course on how to make money trading a crisis.
Unfortunately, observing the USD’s value is not as straightforward as one might think. As currencies are always quoted against another, this means that the Dollar has different values against different currencies.
There isn’t a single number one can look at which comprehensively tells us the value of the Dollar.
Which is why folks like to use the Dollar Index (DXY), as it provides the convenience of a single number that they can look at.
Unfortunately, the Dollar Index does a poor job of showing us the USD’s value versus its peers. This is because:
- It is comprised of only 6 currencies, the Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Canadian Dollar (CAD), Swedish Krona (SEK), and Swiss Franc (CHF)
- These 6 currencies do not represent a wide spectrum of the world’s economies
- It is too heavily skewed towards the Euro, which bears an index weight of 60%
Simply put, the scope of the DXY is too restricted.
In order to get a decent understanding of the Dollar’s performance versus the world’s currencies, we need to track its value against currencies which represent different types of economies, from all over the world.
A decent alternative to the DXY is the Broad Dollar Index (DTWEXBGS). This index is constructed by the Fed, and measures the Dollar’s value against more than 20 currencies.
While this makes it a much better alternative to the DXY, the DTWEXBGS isn’t calculated and made available on a real time basis; the latest reading of the index made public by the Fed tends to lag by a few days.
As such, the DTWEXBGS will give a much more accurate picture of what the Dollar is doing over a period of time than the DXY, but not a real time one.
On the other hand, the DXY can give us a real time snapshot of Dollar performance, but not a very broad one.
Of course, you could also follow a variety of individual currency pairs to gain your own view on Dollar performance. This method would give you the best of both worlds – breadth and a real time perspective, at the expense of ease and convenience.
If you want to learn how to use the Dollar’s strength, or weakness, as an indicator in a broader trading framework, we teach you how to do so in our course on how to trade global macro.
Ultimately, pick whichever suits your needs better, or use one in conjunction with the other.
Just make sure that you are following the USD!
While the disposition effect accounts for much of the emotional pitfalls we face when we have open positions in the market, it doesn’t account for the emotions we experience, and their effect on our decision making when we are out of the market.
If you are wondering how developing your emotional awareness when you aren’t trading can be important, consider the blackjack player who, in an effort to make back his losses, doubles down every time he loses a hand.
From an objective outsider’s perspective, it is clear that the gambler is playing with fire. His insistence on quickly making his money back is only exposing him to even larger losses, significantly increasing the probability that he will walk away from the table with nothing.
This same emotional reflex, driven by the desire to quickly exit traumatic emotional states, affects traders as well.
This should sound familiar to you if you have even a little experience trading – just think of the times you exited a trade at a loss and felt the impulsive need to immediately get back in the market again.
The feeling is even worse if you have been on a losing streak.
The feelings of failure and anger, probably mixed with a little sadness, form a combustible emotional cocktail that can drag you into a negative spiral of knee-jerk trading, which will only compound your losses.
Needless to say, this is a spiral that you will want to avoid falling into.
The best way to avoid it is to, again, have a predefined process in place. One that has specific criteria setting out conditions which must be met before entering a position.
If for whatever reason you don’t have such a process in place, then you must, at the very least, be aware that your emotions can and will affect your decision to re-enter the markets after taking a loss.
This awareness will allow you to take the time to reassess market conditions and logically think of what to do next, instead of knee-jerking back into the market trying to recoup your losses immediately.
However, even having a process in place does not preclude you from making trading decisions which are fueled by emotion.
While a process can, to some extent, mitigate the disposition effect and knee-jerk trading, it can’t shield you from impatience and the feeling that you must always be doing something.
This feeling, and the discomfort it brings, either out of FOMO or the uncertainty of waiting, is particularly acute when you have just exited a position at a loss and are waiting for the next trading opportunity to present itself.
While acting out of impatience and putting on a trade in the absence of an optimal setup may not lead to a loss, it will have a reduced probability of success.
Considering that we have precious little control over the outcomes of our trades to begin with, we must do everything we can prior to entering a position to ensure the highest probability of their success.
This means waiting for the right time to trade, and not succumbing to impatience.
Ultimately, developing emotional self awareness only comes with experience, and experience in markets means losing money.
We all need to lose money in order to gain insight into ourselves, pinpoint areas in which we need to improve, and then not repeat the same mistakes in the future.
Think of the money lost in this endeavor as tuition, although paying this tuition does not come with a guarantee of future returns.
After all, most people don’t even make back the amount that they initially lose; they either give up and don’t participate in the markets again, or fail to learn their lessons and keep throwing money away in the markets.
The problem with trading emotionally isn’t so much that emotions are unreliable indicators of future outcomes, it is that allowing them to dictate our trading decisions is frightfully inconsistent.
The lack of consistency means that after a trade is complete (entered into and exited, regardless of profitability), the result cannot be evaluated in a way that provides insight into how to improve.
This is because there wasn’t an underlying process to the trades that were made, and as such, no areas of improvement which can be identified.
In other words, if we were to continue to allow our emotions to influence how we trade, we cannot improve as traders, and if we cannot improve as traders, we will end up being part of the 95% who lose money.
All of which begs the question, how do we keep our emotions from influencing our decisions?
Firstly, it is important to understand that we are only human and our emotional responses are natural. This means that, for the sake of your own mental health, don’t try to avoid feeling the emotions or suppressing them in some way.
Doing so presupposes that we can be robots, which we obviously aren’t, and hence will not help us to achieve our objectives.
What you need to do is to become very aware of how you respond to different situations when trading.
How do you feel when a trade moves against you and causes you to lose money?
How do you feel when a trade is profitable?
Of course, everyone’s answers to these questions will differ slightly. But, in general, the response to losing money will be fear tinged with hope and anger.
The fear stems from the uncertainty that more money may be lost, the anger from the fact that circumstances did not work out in a way favorable to you; and hope from wishing that you can recoup the losses quickly – if only the market turns.
The danger here lies in allowing the loss to grow larger by not exiting the position because of this hope, potentially resulting in an ultimate loss of catastrophic proportions.
On the other hand, the response to making money will be fear mixed with greed.
Fear in this case arises from the reluctance to lose those gains, and greed from the desire to see those gains grow larger. In this case, should you give in to fear and exit the position, you are giving up potential gains (cutting winners too early).
Conversely, if you were to hold on for too long, the market might turn against you and leave you with less profits, or possibly even a loss.
As such, the objective is to not allow small losses to snowball into large ones, while keeping positions open in the market for as long as possible in order to make the most amount of money possible.
Since your emotions will change as your profits and losses fluctuate with the market, the only way to accomplish this is to have a predefined process.
To be concluded…
If you want to become a better trader, you will have to become intimately acquainted with yourself.
You need to know how you react emotionally to both losing, and making money.
More importantly, you need to know how those emotions affect your decision making.
Understanding your emotional reactions and how they color your trading decisions is important because most trading mistakes are made when traders act on their emotions.
This is easily observed through the disposition effect, where traders sell out of profitable positions too early, and hold on to losing positions for too long.
While this sounds like, and is, a foolish thing to do, traders do it all the time! Inexperienced traders are especially susceptible to it, even though when they first read about it they may scoff and think that they won’t ever do such a thing.
Why is this the case?
Simply because reading about trading doesn’t involve our emotions, but actually trading does.
When a position goes in our favor and starts making money, we feel afraid that those profits will disappear if the market turns against us, causing us to feel like closing out the position; not just to keep hold of whatever profits we’ve made, but also in order to stop feeling afraid.
On the other hand, when we are losing money on a position, we tend to hold on to them in the hope that the market will turn in our favor, allowing us to at least break even on the position.
Making matters worse is the fact that trading is a dynamic exercise, meaning that our emotions change as the market changes.
Should we hold on to a losing position and be fortunate enough for the market to move back in our favor, getting us back to even, we are then faced with a new decision, and hence a new emotional reality.
Having told ourselves that we would exit a losing position if it gets back to even, and actually exiting if it gets back to even are two completely different states of mind.
Because when the position gets back to even, greed starts to kick in and we begin to think: “if the market already moved in my favor and turned a losing position into a winning one, who’s to say that it won’t keep going in my favor?”
Consequently, we may end up continuing to hold on to the position simply based on how market fluctuations are making us feel.
Considering that markets fluctuate all the time and never move in a straight line, it is easy to see that allowing our emotions to dictate our trading decisions is not an effective strategy, and will at some point lead to financial disaster.
To be continued….
About 95% of retail traders lose money.
While the statistics are daunting, it doesn’t mean that trading/investing is a fool’s game. What it does mean is that it is extremely difficult to do well in markets.
Which begs the question, how do we become better traders?
Even though a lot of people use the statistic as a means to discourage or scare new and inexperienced traders/investors from participating in markets, the truth is that at some point in our lives, we have to make our money start working for us and earning some kind of return in order to fund retirement.
This means taking some kind of financial risk through trading or investing. That is, participating in some kind of market; stocks, bonds, currencies, real estate, cryptocurrencies, etc.
Which brings us back to the 95% number.
If most of us don’t have a choice and must invest our money at some point, viewing the 95% number as a scare tactic isn’t very constructive.
Instead, we can think of it from a far more useful perspective: If 95% of retail traders lose money, then we must not do what they are doing.
Put simply, the 95% statistic tells us that we need to look at how the majority thinks and acts, and then do the opposite (or at least something different).
The first, and arguably most important concept we must understand is that trading is not a battle between us and the markets. Rather, it is a battle between us and ourselves.
While this perspective runs counter to popular belief , remember the whole point of this exercise is to identify concepts, opinions, and beliefs which most people hold to be true, and then figure out if the opposite is actually true.
The easiest way to see that trading is a duel with ourselves is to recognize the shortcomings of our human minds in relation to the activities central to trading and investing; taking risks, making losses, and managing gains.
These natural shortcomings are known as cognitive biases, which naturally lead us to behave in ways that cause us to become unprofitable traders, as clearly illustrated by the high rate of failure.
As a matter of fact, the 95% statistic itself demonstrates a key cognitive bias that plagues traders, called the optimism bias.
Any novice trader/investor who bothers to do even cursory research into the field will quickly come across articles and studies that show that the majority of retail traders end up losing money.
Yet more and more folks keep signing up for new brokerage accounts. Why?
Simply because most of them believe that the statistic applies to everyone else, and not themselves. Of course, this blind optimism never works out and they end up being in the 95%!
This is also the best place from which to begin your journey on discovering how to be a better trader – knowing that the odds are severely stacked against you, and that the greatest struggle in trading and investing is not against the market, but against yourself.
As such, the first step is to get to know yourself.
To be continued…
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