Dorian Yates is a bodybuilder who won the Mr. Olympia title six consecutive times. During an interview, he shared this bit of wisdom:
“People are always asking me to break it down. How much of your success is due to type of training? How much is due to number of reps? How much is due to supersets, drop sets, negatives? How much is due to diet? What percentage would you attribute to each factor? My answer is always the same. It’s 100% everything. You have to be committed and disciplined in all areas. If you fail at any stage, you lose.”
Trading is 100% methodology and 100% psychology. It’s 100% understanding the big picture and 100% understanding the small picture. It’s 100% choosing the right product. It’s 100% getting your costs as low as possible. It’s 100% everything.
That said, methodology is not as cut and dry as psychology. Every book about trading has a section on psychology but that section rarely leaves an impact on new traders because it doesn’t make any sense to a person who has no clue as to why certain methodologies can work over time and other methodologies have no chance of ever working. I received the following email awhile back and it’s what prompted this blog post.
“I always read how psychology is so important in trading and I can see why that’s the case. However, I’ve found a plethora of information on psychology which all basically says the same thing. It’s been much more difficult to find information that actually contributes to developing a winning methodology. While your course material offers great insight into the psychological aspect of trading, it was the methodology sections which really helped me turn the corner. I finally get the ‘why’ behind it all. It’s no wonder so many people fail at this. It’s easy to tell people to cut losses. It’s hard to teach them what ‘low risk/high probability’ really means.”
If you’ve hit this page on my site, you’ve probably already determined that there is value in studying volume. The point of this post is to reiterate the idea that every factor in trading matters and also to elaborate further upon why volume should play a key role in your methodology. I will attempt to break it down as simply as I can.
Let’s say you and I are the only two participants currently willing to trade in a given market.
I’m bid 1000 at 10. You’re offer 200 at 11. I have my reasons for wanting to buy. You have your reasons for wanting to sell.
I buy your 200 at 11 and then bid 800 at 11. You now offer 400 at 12.
I buy your 400 at 12 and then bid 400 at 12. You now offer 400 more at 13 thinking that even if I buy it, I’m done.
I buy your 400 at 13 and then bid 1000 at 13. Oops.
You now sell 1000 more at 13 in an attempt to hold down the market.
I bid for 2000 at 14.
You can’t sell anymore because you are tapped on margin.
Another guy decides to join the party and bids for 2000 at 15.
Five other guys can’t stand it anymore and bid for 16.
You are now officially up the river without a paddle.
You bid for 17. You have to stop the bleeding.
I sell to you at 17 and now we’re both flat.
I made a profit. You took a loss.
That is what’s happening at the most pure fundamental level. The rest of it is just a variation on the same theme. This is why understanding order flow is so important. I don’t tell people that they have to be scalpers in order to make money. I don’t even tell them they have to study order flow to make money. I tell them that if they have made a million trading, they probably would have made 2 million if they had taken the time to study order flow.
Once you understand what you are seeing on the tape, it can only help you. Taking from the example above, once you are short 2000 and the market is bid 16, does it really matter if the chart says down or the trend line says down or the Fib wave is overextended or the market is overbought? Of course not. You can see from the volume and price action alone that you’re on the wrong side and so you exit…if you have a good methodology and good psychology. Perhaps you even reverse and try to make back a few ticks depending on the action.
A poor methodology may lead you to hold the trade longer because now the market is “overbought”. Poor psychology may lead you to hold the trade longer because a loss isn’t a loss until you book it and you can’t believe a (expletive deleted) like myself would bid the market up to these prices at this time of day and it has to come back into the range…right? Either way, the decision is not based upon reacting to what you are seeing on the tape and as a result, you do not exit at 17 and instead exit at 20 or 23 or 30 or when the broker calls you and tells you you’re debit.
You have to design a solid methodology which is based on logic and reality. Then you have to have the psychological discipline to adhere to that methodology. The two go hand in hand and consistent profitability cannot be achieved if either one of them is missing from the equation.