Have you heard about the “Pain Trade” theory? It’s an intriguing Wall Street concept. It states that the markets will deliver the maximum amount of punishment to as many investors as possible from time to time. You can look at any given day on the stock market and try an interesting thought experiment. What will need to happen next – up, down, sideways movements, to punish the majority of participants?
Statistically, the majority of traders are repeatedly punished by the market. According to some brokers, as much as 90% of retail traders lose money. What is happening in the market on a daily, short-term basis is widely considered to be mostly random noise. This aligns with the academic Random Walk Theory, which posits that daily price changes are unpredictable, probabilistically isolated events, as all available information is already priced in. If you tossed a coin and landed heads 20 times, you would still have a 50% chance of landing heads again on the next spin, as history does not affect the outcome of future events. In this mostly random environment, it would seem believable that half of the participants would make money, while the other half would lose money, like in a coin flip game. But interestingly, only a few percent of traders make money, making the fact of being a consistent and profitable trader an anomaly. Why do so many fail at this game?
I view trading successfully as dancing with a monster. Picture a monster, maybe as the Shrike, the machine-creature in Hyperion, one of my favorite science fiction novels. For those who haven’t read it, the Shrike could be described as a horrible 3-meter chrome-like creature, covered in metal spikes, thorns, and blades. It’s a monster that can cut the flesh of poor humans as a hot knife can slice through butter. It’s a soulless machine that inflicts a lot of pain. You don’t want to fight this monster; it’s very much a lost cause.
Allow me to add a strange twist to this story: if you simply follow the monster's movements, you don’t get hurt by it, and something magical happens: gold coins fall onto you. And if you keep dancing in sync, the money continues flowing, as long as you dance.
I envision the market as a similar monster. You never want to fight it; it would otherwise tear you apart. Rather, you want to dance with it. Go with it, sense it flow, its movements, and follow it. You want to tune in to the moment, where nothing else matters, in order to sense the next move. The market doesn’t care about you; it has no soul, it doesn’t have feelings, it’s a machine that can never be wrong. You can only follow it, and whatever its next move is, it is the correct move.
And when you don’t follow it, you get hurt. It inevitably happens. You thought the monster was going in a specific direction, you jumped left, but it did the opposite. The monster’s blade cut through your arm, amputating it. You are surprised, bleeding, and in pain. Maybe you feel anger. It’s natural; something just hurt you. The reptile brain, buried deep under your neocortex and limbic brain, is directing a fight response, this time. Millions of years of evolution are directing a physical response to some abstract realities. Adrenaline pumps in your blood, all very real. You want revenge, you start to get aggressive. Maybe you want your arm back. Your loss is a blinking red light in your brain, which clouds your present judgment. Where is the monster heading next? You don’t think very clearly anymore; emotions of hate, despair, regret, or fear prevent you from being in the moment and making the optimal moves. If you don’t forget about your loss very soon and reset your emotional state, you might very well end up impaled by the monster and never dance again.