Tuesday, February 17, 2015

Best Practices in Trading: Scenario-Based Preparation

In trading, as in sports, the game is often won or lost before the competition formally begins.  It's the preparation for winning that leads to winning and the failure to prepare that prepares for failure.  Coach Bob Knight famously observed that many have the will to win, but not many have the will to prepare to win.  Elite performers love the preparation, not just the performance--and that's what enables them to move to ever higher levels of performance.

Reader Paul Landry contributes today's best practice:  a scenario-based preparation routine.  By anticipating a variety of possible market scenarios and how he'd respond to each, Paul helps ensure that he will not be surprised by market developments.  It is very difficult to emotionally overreact to situations that we have anticipated and prepared for.  In that sense, mental preparation is one of our best tools for emotional self-control.  Here's how Paul explains his routine:

"I come from a military background.  Before an operation, rehearsals are crucial to getting things right before we face decisions in the heat of battle.  I find I also need to conduct rehearsals before the trading day.  I rehearse seven possible scenarios with four parts for each one.

The seven scenarios are:  a bullish move that turns into a long trend upward; a bullish move that turns into a short trend upward; a bearish move that turns into a long trend downward; a bearish move that turns into a short trend downward; a return to the mean move where the market reverses; the most likely move that I could experience; and the most dangerous move I could experience. 

The four parts are:  the likelihood of each scenario; what the charts and indicators will show to identify each scenario; what is the likely near term direction for each scenario; and what my reaction should be when faced with each scenario.

The rehearsals help me in two ways.  First, the decision making is faster and of higher quality because I have been in the situation before.  Also, the second-guessing during and after the trade is minimized because the decisions were rehearsed beforehand, when trading stress was minimal."

Notice that Paul's preparation routine is really an exercise in open-mindedness.  He does not start the market day locked into any one particular scenario.  Rather, he rehearses and prepares for all likely situations, staying flexible as markets unfold.  During the day's session, certain scenarios will come to the fore and others will not play out, enabling Paul to focus on his preparation for the day's most likely outcomes.  

My experience with this kind of preparation is that detail is important.  It's not just visualizing a situation that is important, but concretely rehearsing the specific steps you would take in that situation.  Preparing through multiple modalities is more effective than through a single channel.  For example, visualizing a scenario and desired responses; talking out the scenario and responses; and writing them both out are different ways of processing trading plans.  Spending more time on the exercise--and drawing upon multiple ways of processing the plans--results in a deeper and more effective preparation.

"What if" planning is essential not only in military actions but in most competitive games and sports, from chess to football.  As Paul emphasizes, one cannot count on accurately and thoroughly processing a situation in the heat of battle.  Thoroughly planning actions before things heat up is a great way to make sure we trade well, regardless of curve balls the market may toss our way.

Further Reading:  Priming and Preparing Your Brain