May 22, 2021 by Brent Donnelly
Introduction
The introduction highlights the challenging and dynamic nature of trading, describing it as a complex and constantly changing game played by intelligent individuals with sophisticated technology. The author emphasizes the difficulty of trading successfully due to the need for a combination of skills, knowledge, discipline, and rationality. The competitive nature of markets is likened to a battlefield where traders vie for financial rewards. The central question posed is how a select group of traders consistently outperforms while others fail. The answer, according to the author, lies in mindset, methodology, and mathematical understanding. The book aims to cater to traders of all levels by addressing the fundamental elements required for success in trading.
The book describes trading as a complex and dynamic game that requires a combination of skills, discipline, and rationality. It emphasizes the challenges faced by traders of all levels and the need for a strong mindset, methodology, and mathematical understanding to succeed. The author, drawing on personal experience and extensive research, aims to define the ideal trader and provides a practical guide with actionable information.
The book is structured into four parts:
Part One: Examines the equation for trading success, offering a brief overview of the general recipe for success.
Part Two: Delves deeper into the specific qualities of winning and losing traders, encouraging readers to identify their own traits and learn from presented strategies.
Part Three: Explores how to become an expert in trading, covering topics like microstructure, market narrative, technical analysis, sentiment, and risk management. It includes a detailed walkthrough of a real trade to illustrate the author's thought process.
Part Four: Focuses on maintaining a healthy mindset, discussing adaptation, continuous improvement, self-awareness, perspective, and metacognition.
The author encourages readers to take what resonates with them and reject what doesn't, recognizing that each trader's journey is unique. The overall goal is to help traders evolve into more successful and profitable individuals by being rational, self-aware, and continuously learning and growing.
PART ONE : WHY DO SOME TRADERS SUCCEED, BUT MOST FAIL?
Part One of the book is a brief exploration of success in general and, more specifically, success in trading. It begins with a self-evaluation, encouraging readers to assess their strengths and weaknesses as traders. Chapter 2 emphasizes the formidable challenge of achieving enduring success in trading. In Chapter 3, the focus shifts to an examination of research on success beyond the realm of trading. Chapter 4 then applies this broader knowledge to the specific context of trading, seeking to define the equation for trading success.
Throughout Part One, readers are prompted to consider their alignment or divergence from the Alpha Trader profile and are encouraged to take notes. The section aims to facilitate a thorough study, understanding, and definition of the factors contributing to trading success. The ultimate goal is to initiate an iterative process wherein readers continuously learn, plan, execute, analyze, and improve in order to achieve success in trading.
Chapter 1: Know yourself - Good traders are introspective and self-aware
In trading, the primary adversary is not external factors like luck, other traders, or market conditions. The foremost enemy is oneself. The quote from Sun Tzu, "Know the enemy and know yourself," is employed to underscore the interconnectedness of the trader and their own challenges. The author emphasizes that success in trading requires self-awareness and discipline, asserting that managing one's emotions, memories, history, knowledge, and biases is the central challenge.
The author contends that the most significant obstacle in trading is not the tactical aspects such as choosing assets, timing trades, or determining capital allocation. Instead, it is the management of one's own psychological and emotional state. Traders, despite their intelligence, can undermine their efforts through irrational and impulsive decisions.
To improve as a trader, the first step is recognizing and understanding oneself. The chapter introduces a quick quiz for readers to complete, serving as a tool to establish a personal baseline and inventory of their attributes. The quiz is designed to offer a snapshot of the reader's self-perception as a trader before delving further into what constitutes a successful trader. The author urges readers to take the quiz promptly, emphasizing its brevity with an estimated time of five minutes or less.
Chapter 2: If it was easy, it wouldn’t pay so well - Research shows success in trading is difficult to achieve and sustain
Trading for a living is likened to pursuing a career as a professional athlete, a renowned author, or a poker player, where there are few entry barriers, no specific credentials required, and the potential for substantial financial rewards. However, the book highlights that while intelligence and drive are crucial in many business endeavors, they are necessary but not sufficient conditions for success in trading.
Contrary to the belief that trading is a zero-sum game where one can succeed by simply being better than the competition, the author argues that trading is, in fact, a negative-sum game. The negative sum is illustrated by the observation that many traders, while grossly positive in some periods, end up net negative due to transaction costs, slippage, and other expenses.
The text emphasizes the significance of having a substantial edge in trading not only to make money but also to exceed the various costs associated with the trading process, such as execution, technology, and operational expenses. The high bar for success in trading is underscored by the need to surpass the income potential of less risky professions, considering the inherent risks and uncertainties involved in trading. The overarching goal of the book is to guide readers toward becoming one of the very few who not only survive but thrive in the challenging world of trading.
Chapter 3: Understanding success - Success and high performance in the world outside of trading
This short chapter provides background information on the key factors contributing to success in various fields outside of trading. Recognizing trading as both a business and a skill-oriented pursuit, the chapter advocates for a quick examination of success in analogous domains before delving into trading specifics in Chapter 4.
The concept of success is acknowledged as subjective, encompassing diverse meanings for different individuals. The chapter identifies common frames for success in research, including income, educational achievement, and ranking or achievement in sports. While success can also be measured in terms of happiness, health, longevity, and avoidance of negative outcomes, the focus in this context will be on income, educational achievement, and sports-related achievements—outcomes that closely relate to trading. The subsequent discussion will explore various measures and personality characteristics that correlate with success in these areas.
Chapter 4: So you’re saying there’s a chance? - Why some traders succeed but most fail
This chapter explores the relevance of a quote by Warren Buffett to trading, emphasizing the extensive academic literature on the subject. The author delves into the diverse fields—finance, psychology, economics, statistics, and sociology—that find trading a compelling area of study. Having sifted through this literature, the chapter seeks to distill key insights into why some traders succeed while most fail.
Rather than providing a comprehensive review of the academic literature, the chapter offers the author's condensed interpretation of the research. The primary conclusion drawn from the literature is twofold:
Rationality: The human trait that best predicts trading success is rationality. Traders who exhibit rational behavior, avoiding hasty conclusions and mental shortcuts (heuristics), tend to be more successful. This characteristic can be quantified as a Rationality Quotient.
Overconfidence: On the other hand, overconfidence is identified as the human trait that most accurately predicts trading failure. Traders who overestimate their ability to outsmart the market often perform poorly.
The chapter aims to succinctly convey these critical traits, setting the stage for further exploration and explanation of their significance in subsequent sections.
PART TWO : THE ALPHA TRADER MINDSET
Part Two of the book takes a deeper dive into the characteristics that lead to either success or failure in trading. It explores the concept of being rational and unbiased—a mental state that may never be perfected but is consistently sought after. The author emphasizes the importance of being brutally honest about one's strengths and weaknesses, with the goal of enhancing positives, addressing weaknesses, and plugging leaks in one's approach.
The overarching message is that no individual possesses every positive trait or is devoid of negative aspects. The key is to honestly assess personal strengths and weaknesses, striving to improve positives, mitigate weaknesses, and address any shortcomings. Readers are encouraged to reflect on their own assets and limitations, take notes, and recognize that focusing solely on fixing weaknesses is not sufficient. Acknowledging and building on strengths are equally crucial.
Part Two is structured into three chapters:
Chapter 5: Strengths and positive traits: Examines specific positive character traits that enhance a trader's likelihood of success.
Chapter 6: Weaknesses and leaks: Explores areas of vulnerability and potential shortcomings in a trader's approach.
Chapter 7: Rational, unbiased trading: Discusses the importance of maintaining a rational and unbiased mindset in trading.
The section aims to guide readers through a comprehensive understanding of the traits that contribute to trading outcomes and sets the stage for further exploration of these themes in the following chapters.
Chapter 5: Level up - The traits and habits you need to succeed
The chapter underscores that successful trading involves a combination of diverse skills and traits rather than a single "x-factor." Referring back to the formula introduced in Chapter 4, an Alpha Trader is described as someone who is rational, intelligent, skilled, conscientious, and possesses calibrated confidence.
The author expands on these essential traits, presenting a comprehensive list of positive attributes that contribute to success in trading. The list covers cognitive and non-cognitive traits, highlighting that cognitive skills can be developed over time, while non-cognitive traits may be static or changeable. The importance of conscientiousness, which generally increases with age, is emphasized, with specific attention to skills such as organization, self-control, focus, and preparedness falling under this category.
The chapter emphasizes the significance of understanding both fixed, innate characteristics and areas where improvement is possible. The goal is for traders, whether new or experienced, to reflect on their own profiles and identify areas for enhancement. Acknowledging that no one possesses every skill abundantly, the chapter encourages readers to work on weaknesses and elevate strengths by leveraging the methods and ideas presented in the subsequent chapters.
While the chapter discusses traits individually, it skips defining them, assuming familiarity with the terms, and focuses on illustrating the relevance of each trait to trading. The primary aim is to provide specific ideas and tips for readers to enhance their skills in each area.
Chapter 6: Kryptonite - Bad behavior, poor discipline, sloppy thinking, and leaks
In this chapter, the author explores the various bad habits, mistakes, unhealthy mindsets, and persistent errors that often lead traders to failure. The discussion focuses on common patterns of negative behavior in trading and outlines strategies to mitigate the impact of these detrimental traits. While building strength is crucial, the chapter emphasizes the need to minimize destructive and unprofitable behaviors.
The central point highlighted is that biased or bad thinking represents the most damaging form of trader kryptonite. Chapter 7 will delve into bias in detail, while this chapter concentrates on other factors hindering traders, excluding irrational and biased thinking.
The chapter begins by underscoring that trading is a negative sum game due to external and transaction costs that erode performance. The author shares personal experiences from trading during the NASDAQ bubble, illustrating how changing market conditions and transaction costs impacted profitability.
The discussion extends to the current landscape where stock market trading is theoretically "free" for many individuals, but hidden transaction fees and information and technology asymmetry still pose challenges. The author outlines common reasons traders lose money, including bad discipline, insufficient edge, overreliance on simple indicators, insufficient focus on risk management, and emotional decision-making.
Overall, the chapter emphasizes the importance of recognizing and addressing these pitfalls to enhance a trader's chances of success in the inherently challenging environment of trading.
Chapter 7: Smart people do stupid things - Rational, unbiased trading
In this chapter, the author shares a personal revelation about the tendency of intelligent individuals to make irrational decisions, leading to a greater understanding of both self and others. The focus is on exploring ways in which even the smartest traders can act irrationally and discussing remedies for these biased behaviors.
The chapter builds on the concept introduced in Chapter 3, where superior performance on the Cognitive Reflection Test (CRT) was identified as a predictor of trading success. It points out the conundrum faced by traders who need to make quick decisions (relying on System 1 and heuristics) while also avoiding behavioral biases, which are more prevalent in fast thinking. The author acknowledges the inherent conflict and explores ways to counteract these biases.
High-performing traders are portrayed as those who understand behavioral bias and are self-aware of how their biases can negatively impact decision-making. The chapter emphasizes that awareness alone does not make one immune to biases, drawing a parallel with optical illusions. The central idea is to internalize the fact that being aware of a bias is not enough to avoid its influence.
The chapter outlines various types of trader bias and presents specific methods to avoid or reduce their potential damage. It aims to provide readers with insights into the biases that can affect traders and practical techniques to address each bias, fostering a more rational and objective approach to decision-making in the complex world of trading.
PART THREE : METHODOLOGY AND MATHEMATICS
In Part Three of the book, the focus is on outlining the specific steps required to master the market as a trader. The author emphasizes the importance of becoming an expert in the product or markets one trades, advocating for a narrow and deep focus on one or two markets rather than a wide and shallow approach. This, the author argues, provides the best chance at establishing a sustainable edge.
The chapter introduces the concept that attention and time constraints are key factors, and spreading them thin reduces the likelihood of achieving mastery. The author shares personal experiences supporting the idea that traders who specialize in one area tend to succeed more often than those who dabble in multiple markets.
The upcoming chapters in Part Three will detail the three steps essential to becoming an expert in a market: understanding microstructure, comprehending the narrative, and grasping technicals, positioning, and sentiment. The author emphasizes the necessity of doing the work to master these areas for trading success.
Readers are encouraged to view the examples provided as starting points for their deep dive into their own markets. The chapters aim to teach important aspects, provide diverse perspectives, and inspire independent analysis and study of markets. The author stresses the importance of continuous improvement and lifelong learning, urging traders to build on presented ideas and develop their own innovative strategies.
The chapter concludes by highlighting that expert-level knowledge of a specific market, coupled with a rigorous execution and risk management process, constitutes the two greatest sources of edge in trading. Part Three promises a detailed study of the methodologies and mathematics necessary for achieving these goals, with the next chapter diving into the fascinating topic of market microstructure.
Chapter 8: Understand microstructure - Step one towards becoming an expert in your market
In this chapter, the focus is on the significance of understanding market microstructure and having an in-depth knowledge of the traded products to excel as a trader. The author provides insights into how to become an expert in microstructure and leverage this expertise for increased profitability in trading.
The chapter begins by likening trading to one of the most complex and competitive games globally and emphasizes that having expertise in a specific product is crucial for success. While some traders may specialize in a particular strategy applicable across products, the general trend among successful traders is narrow and deep knowledge—becoming product experts.
The recommended approach to becoming an expert involves reading, observing, and studying. To illustrate, the chapter presents a scenario where a trader, struggling with trading success, decides to focus exclusively on day trading Tesla (TSLA). The pros and cons of trading TSLA are outlined, highlighting factors like liquidity, volatility, daily opportunities, and the participation of non-professional traders.
To become an expert in TSLA, the chapter suggests studying its microstructure, observing price action, identifying key players, and asking detailed questions about its trading patterns, liquidity, and volatility. The author provides sample questions related to microstructure, and a detailed explanation is given to guide readers in asking the right questions in their respective markets. The microstructure of a market is described based on the types of participants, liquidity, intraday activity patterns, and volatility, setting the stage for a deeper exploration in the following sections.
Chapter 9: Understand narrative - Step two towards becoming an expert in your market
In this chapter, the focus is on explaining how to study narrative and fundamentals and leverage this knowledge to enhance the ability to forecast short-term market direction. The author emphasizes that excellent traders possess expert-level knowledge of the primary narrative and competing sub-narratives driving their market. They are adept at understanding the market's story, recognizing when it changes, and distinguishing common knowledge from less-known information.
The chapter suggests that after gaining an understanding of the microstructure of the market and the basics of who influences it and how, traders should focus on understanding what moves the market and why. The author cautions that explanations in the financial press are often oversimplified, and gaining experience reveals the complexity behind market movements.
The narrative is described as the story the market tells itself to explain price movements, with a main plot and subplots. Traders are advised to prioritize understanding the main arc, as markets typically focus on one storyline at a time, but they should also be prepared for the emergence of new narratives that can replace the existing one.
Chapter 10: Understand technicals, sentiment and positioning. - Step three towards becoming an expert in your market
Success in trading, likened to a complex game or puzzle, requires both intelligent strategy and effective tactics. This chapter emphasizes the significance of tactics, often overlooked but just as crucial as strategy. It delves into technical analysis, sentiment, and positioning, highlighting how a superior understanding of these subjects provides a significant tactical edge. In the context of trading, strategy pertains to generating trade ideas, while tactics involve the execution and implementation of those ideas.
The author shares that the majority of their trade ideas originate from microstructure or narrative, not from chart analysis, sentiment, or positioning alone. Trade ideas typically commence with fundamentals or microstructure and may involve additional factors for refinement. While technical analysis, sentiment, and positioning are used as timing tools, they are not relied upon for trade selection. The author's perspective on this has evolved over the years, driven by market changes and the observation that technical analysis alone does not provide a source of alpha or edge, emphasizing that charts are not reliable forecasting tools.
Chapter 11: You feeling lucky, punk? - Data collection, risk management and variance
In this chapter, the focus is on risk management, emphasizing its paramount importance in trading. The author highlights that risk management is the most crucial skill in trading, surpassing all other aspects. While acknowledging the complexity of risk management in trading businesses with intricate strategies, large portfolios, correlated assets, illiquid markets, and non-linear derivative products, the chapter aims to provide a robust framework for risk management. For short-term directional traders in liquid markets, establishing appropriate risk management rules is deemed relatively straightforward, with the real challenge lying in consistently adhering to them. The essentials of risk management, though potentially extensive, are condensed into this chapter, offering insights for both novice traders and experienced professionals.
Chapter 12: Bringing it all together - The lifecycle of a trade, from idea to execution to exit
In this chapter, the author consolidates the diverse topics covered in the preceding chapters by guiding readers through the real-world thought process and detailing the lifecycle of a trade from inception to conclusion. Drawing on the questions often posed, such as the origin of trade ideas and the overall process, the author emphasizes the integration of multiple disciplines to filter and refine ideas. The trade ideation primarily relies on fundamentals and microstructure, with subsequent steps involving technical analysis, sentiment analysis, and cross-market analysis to enhance and optimize execution. The chapter provides a visual representation outlining the essential steps of the author's trading process, emphasizing that it serves as a general framework subject to variations based on experience and market conditions. The "Ready, Aim, Shoot" analogy is introduced, with the acknowledgment that in certain scenarios, especially reacting to headlines, the process may shift to "Ready, Shoot, Aim" for swift execution, followed by a retrospective alignment with the remaining steps to ensure sound logic and risk management. The presented table, along with explanations, serves as a guide for readers to understand and apply these principles in their trading endeavors.
PART FOUR : ADAPTATION AND ATTITUDE
The author emphasizes the critical role of mindset in trading success, asserting that even with a thorough understanding of methods and strategies, a poor mindset can lead to bad trading. Drawing on their experience as an experienced trader and author of two trading books, the author acknowledges personal struggles with periods of poor performance, attributing it to a negative attitude or mindset. Despite expertise, wily veterans are not immune to challenges such as poor adaptation, sluggish mental energy, sloppy trading, and frustration. The chapter underscores the detrimental impact of a rigid mindset, negative mental loops, and low energy on well-planned processes, strategies, and tactics. It highlights the necessity of the right attitude for sustained success in trading. The upcoming chapter will delve into the importance of adaptation, followed by final thoughts on the significance of maintaining a healthy attitude in Chapter 15.
Chapter 14: Adapt or die - Stay flexible and achieve long-term trading success
The chapter underscores the importance of adapting to changes in market conditions and microstructure for sustained trading success over the years and decades. It criticizes the idea of latching onto a single style or methodology and advocates for flexibility. Successful traders are portrayed as those who recognize shifts in market dynamics, such as the diminishing returns of trend following in the 1990s or the entry of algorithms in the mid-2000s, and adapt their strategies accordingly. The narrative emphasizes that no market regime lasts forever, and profitable strategies attract more participants, leading to shrinking profits and the eventual demise of those strategies. The chapter encourages traders to study and adapt to ongoing changes in market structure, recognizing that markets are in a constant state of evolution. It identifies significant structural changes every 5 to 7 years and emphasizes the importance of real-time adaptation to continual changes in the market. The chapter concludes by highlighting key markers of market structure and offering insights on how to adapt to them effectively.
Chapter 15: Thank God it’s Monday! - It is impossible to succeed without the right attitude
The chapter begins with a Chinese fable about a farmer, illustrating the unpredictability of life's events and the importance of maintaining a balanced perspective. It emphasizes the role of variance in shaping one's journey and advises against getting overly influenced by short-term outcomes. The chapter aims to explore the elements needed for cultivating and sustaining a healthy mindset throughout a lengthy trading career. It acknowledges that while it's easy to be enthusiastic at the start of a trading career, maintaining the right mindset over decades is a different challenge. The author proposes exercises to actively engage readers in self-reflection, emphasizing the importance of not just skimming through the content but actively participating in the learning process.
Conclusion
The book concludes with a summary of key takeaways for traders, emphasizing the importance of avoiding catastrophic losses, maintaining rationality, accepting the inevitability of being wrong at times, and navigating through the variability inherent in trading. The author encourages readers to find the fun in trading and shares six fundamental points to remember. Additionally, readers are prompted to revisit the questionnaire from Chapter 1, identify areas for improvement, and set realistic goals for incremental changes. The author shares a personal anecdote about facing challenges in trading and ultimately persevering, highlighting the resilience needed in the trading profession. The book closes with a motivational message urging traders to play the long game, continue improving, and never give up despite difficulties.
Alpha Trader: The Mindset, Methodology and Mathematics of Professional Trading Paperback – May 22, 2021
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