Trading with Your Head and Heart

Every trader has an analytical part (head) and an emotional component (heart). A system that suits you will engage both aspects of your person­ality. When you start trading a system, you face two expectations. One is the statistical expectation, which we have discussed in detail. The other is your emotional expectation from the system. If the two expectations are not coherent, then you will not be happy trading the offending sys­tem.

This raises questions about why you trade. For many people, the only reason to trade is to make a profit. However, you could have many other reasons, such as the excitement of trading or the intellectual chal­lenge of competing with other traders. You should check to see if the following are consistent: your profit objective, trading horizon, mathe­matical expectations, and emotional expectations.

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If these are not consistent, then you may not have the mental edge. Probably fewer than 25 percent of traders have the mental edge, and perhaps only 2 percent can maintain the edge year after year.

There are many contradictions between mathematical and emo­tional expectations. The mathematical expectation covers 2 to 3 years of data, but the emotional expectation covers only 2 to 3 months. Emo­tional expectations can be complex, and they cannot be represented by a single number. In the worst case, a system could have a positive mathe­matical expectation but a negative emotional expectation. In this case your head and heart disagree, and the inevitable tension will make it im­possible for you trade this system.

Your emotional expectations may be based on an inaccurate or in­complete understanding of system test results. You should make it a point to study the evolution of each trade day by day. You should be comfortable with the dollar amount of the average trade, the winning percentage, and the length of the average trade. You should also be com­fortable with the dollar amount of the initial risk-control stop. If you understand the "signature" of the system, then each trade will reinforce your belief in the system. If you have unreasonable emotional expecta­tions, then each trade will diminish your faith in the system.

You may expect big successes, with few losing streaks and many ex­citing trades. The reality is that only 5 percent of the trades are big suc­cesses, you can have many losing streaks, and most of the trades are dull. You can use the "rule of two," as follows, to modulate your emotional expectations:

1. Expect half as many winning trades in a row as you project from your testing.

2. Expect twice as many losing trades in a row as your testing may show.

3. Prepare for half the expected profits.

Let us continue with the "head and heart" analogy. What you "think" you believe is in your head. What you "truly" believe is in your heart. Your head may be clear or confused. Your heart may be confident or fearful. If your head and heart disagree, and the stakes are low, then the head wins any conflicts. However, if the stakes are high, then the heart wins any conflicts. Thus, you can trade comfortably only if your head and heart agree. So spend the time and effort to understand system performance so that your mathematical and emotional expectations will agree. This is the key to long-term success.

252 A System for Trading