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This post was originally published on See It Market as part of the Market Masters series. The original post can be found here.]

I am a quantitative-discretionary trader. I have made it one of my life’s goals to understand how financial markets move, to understand how to predict those movements, and to understand the limits of what can be predicted. Much of what I write focuses on these ideas and the reality of the marketplace, and I have often been very critical of much of traditional technical analysis and on trading methods that just don’t work. Today, though, I want to focus on a different aspect of trading: on the journey that every trader must undergo, from rank beginner to experienced trader. Let’s think about why that path is so long and hard, and maybe we can come away with some ideas to help bridge the gap between knowing and doing.

Understand the marketplace

First, we should spend a few moments thinking about how financial markets really work. There are many theories. On one level, we can easily understand that buyers and sellers meet (face to face, through proxies, or electronically) and figure out what the market value for an asset is. We can also go another step further and see that rational buyers and sellers will quickly process any new information, and it should be reflected in those market prices pretty quickly and efficiently. (This is the lesson of the academic theory of market efficiency.) However, there is more going on here—psychology and human behavior play a pivotal role in the inner workings of markets.

Any decisions humans make are based on a combination of rational analysis and emotion—we can try to understand and control the contribution of emotions to the decision process, but we cannot eliminate it. A revolution in understanding comes when we realize that the financial markets are truly driven by these behavioral factors. As I wrote in The Art and Science of Technical Analysis:

Part of the answer lies in the nature of the market itself. What we call “the market” is actually the end result of the interactions of thousands of traders across the gamut of size, holding period, and intent. Each trader is constantly trying to gain an advantage over the others; market behavior is the sum of all of this activity, reflecting both the rational analysis and the psychological reactions of all participants. This creates an environment that has basically evolved to encourage individual traders to make mistakes. That is an important point—the market is essentially designed to cause traders to do the wrong thing at the wrong time. The market turns our cognitive tools and psychological quirks against us, making us our own enemy in the marketplace. It is not so much that the market is against us; it is that the market sets us against ourselves.

More and more people recognize the importance of these behavioral factors, both in academia and in practice. Working traders are often amazed to see themselves repeat the same, seemingly silly, mistakes over and over. We know that these behavioral and psychological factors drive prices, and we also know that prices can influence behavior. Because of this, many traders and writers have focused a lot of attention on trading psychology, but there might be another way to attack the problem.

“Trading psychology” might not be the answer

You are nervous about your entries, make impulsive trades, or just aren’t having the success you want? The traditional answer is work on your psychology, visualize yourself succeeding, etc. Cynically, we could point out that, by focusing on psychology, developing traders can often ignore some critical issues. Consider some common reasons traders fail:

• Not having a method that works. You cannot escape the laws of probability, at least in the long run. If you don’t have an edge in the market (and most methods do not), then you will lose.
• Not being prepared for how long the learning curve can be. For most traders, figure 3-5 years.
• Being undercapitalized. You can’t learn to trade on a shoestring budget.

Unless these things are right, there can be no enduring success, and overemphasis on psychology may be emphasis on the wrong things. For instance, many psychologists trivialize the difficulty of finding a trading method that works, basically saying anything works as long as you are “properly aligned psychologically”, when, in fact it seems to be very difficult to find a methodology that has an edge in the market. Working on our psychology may make us more relaxed and happier while we bleed money into the marketplace, but it won’t make us winners if we aren’t doing what we need to win. A happy loser is still a loser.

Understanding the true nature of the market – that it is an environment that has evolved to encourage us to make mistakes – starts to make many of the traditional psychological problems fall into place. Cognitive biases, emotional decisions, fear and greed – these are all simply part of the market. That uncanny inclination you have to sell an asset in desperation at what turns out to be the absolute bottom of the decline, and to repeat a similar error over and over? It’s not strange; it’s actually those emotions, en masse, that create the bottom. Understanding the nature of the market is a good start, but there still might be something we are missing about the process of becoming a trader. Maybe we misunderstand the journey.

Patterns to profits

There are patterns in markets. My work, which I won’t belabor here (as I have already belabored it at great length elsewhere on my blog and other writings), has focused on finding patterns in prices that have predictive value, but there are also patterns in fundamental information, sentiment, etc.—and all of these patterns can be a source of a trading edge. This is why there are so many approaches to trading and so many different trading styles, but no matter how we trade or invest, we’re really looking for these patterns that show us where an opportunity might exist. There are, however, a few problems with trading these patterns.

The most important issue is that these patterns offer only a slight edge. If we use the typical “fair coin” analogy, we might have patterns that show us when the coin is 55/45, instead of 50/50. Too many traders look for 80/20, and those types of edges simply do not exist on timeframes that human traders can trade. This is an adjustment that most developing traders eventually have to make: Yes, there are patterns, but they are slight. It is not easy to find them. It is not easy to trade them, and it is certainly not easy to trade them properly. Simply put, the game is much harder than most people would have you believe it is—the lights that guide our way on the metaphorical journey are not quite as bright as we might wish they were, nor is the path as clear as we’d hoped.

The problem of randomness

Humans are really bad at dealing with randomness, as study after study has shown. Some of the things we do best, like pattern recognition, actually work against us in a highly random environment because our brains, finely-honed pattern recognition machines, will happily create patterns, even where none exist. This is a fundamental aspect of human cognition; it’s a part of the way we think, and we cannot change it.

For developing traders, this creates many problems. The marketplace is highly competitive, and whatever edges we find are very small. This means that randomness will confound our results; we do not know if we lost money on a particular trade because we did something wrong, or simply because the (slightly weighted) coin happened to come up against us, purely due to chance. Even worse, we don’t know if our big winning trades were the result of simply getting lucky, or that we did something right.

In this highly random environment, we have to first act with consistency. This is why trading discipline is so important; you can’t even begin to understand your results if you are always doing something different every time. We also need tools to analyze and understand our results statistically. It’s not enough to look at big winning trades, or even to study our losers. We have to understand how our edge works over a large sample size, and constantly remind ourselves that we are doing something that is difficult, unnatural, and goes very much against our instincts.

Why traders struggle

We’ve considered a number of things that make trading a real challenge, but most traders discover that it somehow is harder than it seems like it should be. Based on my personal experience, and my experience guiding, teaching, and mentoring hundreds of traders, I think there is another aspect of learning to trade that is often ignored. Many authors have correctly pointed out that trading is not really about knowledge. Though there is a lot of subtlety, most of the knowledge needed to trade could fit in a very, very small book. There is a lot of thinking today about trading as a performance discipline, but this does not fix everything. I think I know the reason why: Trading is not about knowledge, and it’s also not about skill. If you want to trade, you must become a trader. Successful trading is really about transformation, about making yourself into something that you were not before.

I think a useful model of transformation can be found in Joseph Campbell’s work, which sees many of the stories told in human myth as variations of one single, great story. One of the most important aspects of this story is the Hero’s Journey, which ties together human experience and narrative from religion to Greek epic poems to Disney movies—they are all different versions of this one story. Now, this is far more than a simple academic theory. In fact, one way Campbell suggested we might think about it is that these stories, even pure fiction, are “more true than factual stories” because they say something true about who and what we are as humans, and there is power in that truth.

The Hero’s Journey

The Hero’s Journey follows a path in which the aspirant begins in the normal everyday world, receives some kind of call to adventure, finds a mentor or guide, passes into an unknown mysterious world (there are often parallels with the Underworld here, or, in many cases, an actual journey underground), meets many challenges along the way, receives some kind of aid, and returns, victorious, to the everyday world with a boon—new powers to live in and to change that world. First, think through the basic pattern with the stories you may know: The Odyssey? Beowulf? Star Wars? The Lord of the Rings? Yes, all of the above (and many more) are basically the same story told in different ways.

The trader’s journey

I propose that there are also parallels here with the trader’s experience. How many of us have trading histories that look something like this?

• A grand call to adventure. Who would not want to make a pile of money working from the comfort of your own computer screen?
• Finding a mentor. Good mentors matter! Few of us who have succeeded would have done so without some help.
• Crossing over into an “unreal” world. Markets are crazy. When we look deeply into markets, maybe we become a little crazy ourselves, and we certainly become disconnected from ordinary reality.
• Facing dire challenges. The emotional highs and lows of trading can be extreme. Is there a trader alive who hasn’t been awake at 4am wondering if they can ever do this, why they ever tried in the first place, how they could be so stupid to make the same mistakes over and over, and what they were going to do tomorrow? (This is probably not the time to mention that we only write stories about the heroes that complete the journey! A lot of dragons feasted very well, for a very long time.)
• Failure somehow, perhaps almost miraculously, is transformed to success.
• We figure out how to incorporate our trading activities into the everyday world, and discover that things probably weren’t quite as exotic or difficult as we had thought.

See? Trading is not truly about learning patterns. It is not about learning some math. It is not about skill development, and it is not even about risk management. All of these things are important, but the real work of trading is work on ourselves.

Institutional shortcuts?

As an aside, one of the interesting questions you might ask is why this is not true for institutions. Certainly, when the banks had big prop desks, they did not hire traders and expect them to go through some mythical journey, not get eaten by a dragon, and eventually make money, right? How about prop firms today? Guys on the floor did not spend a lot of time thinking about transpersonal psychology. If learning to trade really is such a journey of transformation, there should be no shortcut. Does the story break down here?

It does not break down; the same idea and rules apply, even within an institutional framework. A few things to consider: the success rates, even in prop firms, are extremely low, often a fraction of a percent. There’s no magic there. In a hedge fund or the old bank prop model, a trader would essentially be hired as an apprentice and spend a lot time watching experienced traders work before ever taking the reins themselves. This allowed learning to take place in a controlled and structured way, and many traders could make transitions to other roles if they discovered they were not cut out to manage risk. Furthermore, there are many types of trading, within the institutional framework, that are not quite the same thing. For instance, there are desks that hedge and lay off risk in derivative products. A trader doing a job like this (or working as a market maker) deals with risk in a different way than our fledgling discretionary trader—it’s not quite the same task of conquering the market. In general, the institutional framework provides useful guides and constraints, and we can replicate some of these structures for the private trader.

Taking the journey

So, what are the lessons here and who are they for? I think these lessons primarily apply to the independent, self-directed trader who makes and is responsible for the consequences of her own decision. (A few points: this trader may (and probably should) work in a team, and we have not addressed funding. This trader may trade her own account, or she may trade clients’ money; in either case, the key fact is that she is making the decisions.) There are probably also applications here for traders who are in the process of switching styles, or maybe even for institutional traders who are striking out on their own. (I saw many traders leave the floor and go through some variation of this journey, for better or worse. Sometimes the dragon wins.) So what are these lessons?

First, realize that learning to trade is a journey. It is a long and painful journey, and it will test you in ways you did not expect. Most people say that trading is the hardest thing they’ve ever done; in terms of constant second guessing and self doubt along the way, I could agree with that statement. Sometimes the journey is dark and the path is anything but clear. I don’t tell you this to discourage you, but rather to prepare you. Many of the traders I have seen who have failed were actually doing just fine, but they maybe weren’t prepared for how long and difficult the road was going to be.

Second, you really have to have a method that has an edge. You have to have confidence in that method. I’ve created a pretty extensive completely free (really, truly completely free with no upsell or “member’s area” or anything like that) trading course that might help set you in the right direction, and that will definitely emphasize the importance of doing your own testing and work to verify your edge. Get this wrong, and nothing good will happen in the end—you gotta have an edge.

Third, structure your experience. Work toward building a process that covers everything you need to do. Pay attention to your learning and your evaluation of your results, but also work on developing a process for trade selection, management, and review. Yes, create a trading plan and a business plan, but also work on fitting that into your life plan. It all has to work together.

Last, be open to the experience and to change. Trading is going to change you, and, as the Buddha said, much suffering comes from trying to hold on to impermanence. Don’t fight the change. I think there is great value in practices such as journaling, introspection, meditation, and perhaps even letting some of your energy bleed over into a creative outlet. You may find new intellectual areas that interest you, and you definitely must be open to new experiences. You are going to grow and you are going to change, so do what you can to shepherd that growth, and, above all, don’t be afraid of it.

I think this is a different perspective on the process of becoming a profitable trader, and the parallels with the Hero’s Journey offer some exciting new avenues for thought and research. No matter how hard and long the journey, it is worthwhile. Find your path, and take those first steps—even the longest journey begins with that single, first step.