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Correctly Applied Knowledge is Power: Bridging the Gap Between Learning and Application in Trading

Once again a reorg of this site has brought up a few gems that I'm taking to heart these days. This one came from a comment on my Death By Opinion article, one of my few that got some good attention thanks to our friend B. Ritholtz.

At one point this post had a slew of comments, but an old migration lost them, and I'm glad it did – it made me reread the only one that made it through. To get to the point, here's the comment:

I once read the quote ”knowledge is power” I later read a more solid quote that totally neutralized the first one, the quote was ” knowledge isn't power, correctly applied knowledge is power”.

…now whether or not this quote has entered cliche territory, I don't know, but he's absolutely right. I can't argue with this at all. I think of the number of times I've received things handed to me on a silver platter, only for a moment worth of poor judgement to step in and see it all go to waste.

Many times, we don't realize what we have in front of us. Other times, we're simply given poor information, which directs us down the path of bad knowledge = bad decision making. Today I want to focus on the former.

Good, core knowledge can be derived from a third party or simply, ourselves. How many times have we sat down at the computer and seen a perfectly profitable trade go to dust because we never took action? Or worse, we heard the knowledge screaming to us in our subconscious yet completely ignored it and went the other way? This is an intermediate trader dilemma, but like most other things, there is a solution.

There is something that happens from that moment of realization to the moment where we need to take action that acts as a natural cloud of smoke that gets us completely disoriented. Simply having someone tell you to “do it” won't fix the problem. There's something deeper there. Something that literally pushes our decision making from one choice onto the complete opposite.

Make it physical.

Your “gut”, literally, is an excellent barometer for good decision making. And I'm not at all talking about trading wildly with “gut instincts”.

Something happens to us physically in our guts that changes the landscape of the decision we are about to make. And that something is stress. Stress is there to tell us “slow down, buddy, you're moving too fast”. You can feel it. It's literally a physical stimulus that churns your stomach, causes discomfort and lets you know that what you're doing simply isn't good.

Now you might think that the best profits come from the most uncomfortable situations, where you're beating stress to death with your Forex battle axe and conquering your inner core. I'll disagree with this 1,000,000%.

All too many times I hear people say that trading is stressful and a quick way to lose your hair. My take on this:

You should be comfortable. You shouldn't be on edge. And this is where knowledge starts to kick in. I want to help explain here how to get your experience under control and use it to your advantage.

How are you applying your knowledge? Is it helping you or hurting you?

All too many times, our knowledge is used against us. Our “knowledge” of past, bad experiences serve as a catalyst for fear as opposed to doing constructive work, which is truly what it should be doing. Fear is just one way of us using our knowledge in an non-constructive manner. Fear prevents us from acting appropriately, if at all, and causes mayhem if we take action when it's around.

Stress is there to tell you that something is wrong, much like physical pain as if you were hitting your thumb with a hammer. When stress is present, your performance is almost always hindered in some way, shape or form.

Think of the number of professional athletes that “choke” in a high pressure situation due to stress. In their own brains, it could be insecurity, pressure from the cheering crowd and his or her thoughts about not being able to live up to their expectations, etc.

And this is where traders actually have a major advantage over stress. Because we don't have to do anything. We don't have to swing the bat at the ball. We don't have to catch the 30 yard pass. We can just as easily go ahead and pick up a book until we find ourselves in a better situation with our friend, the market.

But back to application. Progress needs to be made…

I'm a strong believer in “the more you know, the better you are”. I believe what many people view as “psychological” issues associated with trading are really just a facade for a lack of properly applied, correct knowledge, thus confidence in decision making.

This is true for just about anything, but it's not the end of the equation that solves all of our problems. A lot of “smart” people that want certain things in life can't obtain them because there's something else blocking the path. In rush the head doctors, and essentially what they do is provide a kick in the butt to take action on stuff that these people already know.

But of course, sometimes our core knowledge is flawed.

E=MC2 was a major breakthrough until people realized that there was no such thing as a mass – energy relation. Momentum was the missing ingredient, which Einstein recognized later in his career. You can't base an entire explanation for something on fundamentally flawed logic.

So our core knowledge should come first, and making sure that we're looking at the proper things. For me, that's a pretty short list:

1. Human reactions (reflected in price) to fundamental information (expectation versus reality – this is a forward looking market that is oftentimes slow-to-learn)

2. Price and bar patterns

3. Diagonal and horizontal support and resistance with confluence, and what happens when they break / hold (and there's a specific way to do this)

4. Market symmetry and other methods of price projection

As a recent example, I regularly use charts when I'm on the go or just on my Mac. There's a chat box in the navigation bar where traders can talk and I'm looking at a chart one day and this guy says “Euro is going to keep going down right here” as I'm staring at a bullish pattern developing at the base. Sure enough, Euro retraced and the guy is saying something to the effect of “aww shucks”. But did he see the pattern I saw? No. Did he know what to look for? Clearly not. And this thing was clear as the light of day to me.

And this is all what I call “static knowledge”. It's there, in my head, when I need it, I've had it for years and I know it well. And for the record, all I was looking at was a highly reliable bullish candlestick pattern. That's it. Definitely nothing fancy and was one of the first things I learned as a trader.

What I call “floating knowledge” leaves us open to interpretation and evolves as we undergo experience. It's in our heads, but barely. We might have read it somewhere or seen it visually represented, but it's floating in space as opposed to planted in the ground, so to speak. Thus, we question what we know, because we simply don't trust it or have the experience to back it up / reinforce it.

And this…

….type of knowledge is where we can just as easily gain our confidence as lose it (e.g. drive fear).  Seeing familiarities is what calms us down and turns floating knowledge into static knowledge. How we use it is what matters most and let's us decide on which side of the train tracks we're going to walk (constructiveness or fear).

Our instincts can turn our floating knowledge into stress and fear, moreso if we've been “burnt” in the past. This is why newer traders tend to perform well right out of the gate, while intermediate traders get punished, and experienced traders take the lead. Without bad experiences, newer traders don't have the fear that intermediate traders do. Intermediate traders have floating knowledge, which can lead to stress/fear if that floating knowledge isn't turned static. Advanced traders know what to expect, have static knowledge, and know how to keep it that way.

So here is what you need to do:  

First and most obvious, gain core knowledge. I've said many times on this site to get to know you basic price patterns, bar or candlestick patterns, draw your inner trend lines, etc. Don't miss a beat. These are all 101 basics and I would guess that 90% of retail traders don't know this stuff in and out. I've made the mistake in the past on this site of assuming that people cover these basics. Well, most don't. Period.

And when it comes time to trade, there are FOUR major things you need to ask yourself, and answer, every time you're about to do it:

First, “where am I getting out? How many ticks or % gain can I potentially score off of this trade?” This always comes first. Why is explained below.

Second, “Now that I know the potential yield, do I have an acceptable placement of my stop that would make the reward worthwhile over the risk?”

This step tells you whether or not you should even think about pursuing it, and it's all basic arithmatic. If there is simply not enough return versus potential loss, the trade is nullified, so stop right there and start thinking about what's next in your life. A clean equity curve demands good risk reward.

Third, “If 1 and 2 are acceptable and I'm “good for launch”, what could possibly happen to get me out?”

In other words, this step determines my “soft stop”. Step 2 tells me the worst case scenario, a hard stop getting hit, and it's all math. This step fills me in on “what would I see that would completely nullify this trade and tell me that I'm flat our wrong?” Usually, this entails price breaking through a price level and using it as support or resistance, against my intended trade.

Fourth, “what could happen from the point I enter to the point my intended area for taking profits gets hit?”

This is extremely important, and could be the mother of all stress subduers. It's because most of the time, price doesn't just simply reverse and go on its merry little way immediately to your take profit. Rarely happens. When it does, you feel like you just won the lottery, and that's because deep down you know that this is a rare circumstance. Literally visualize several scenarios in which you're waiting, waiting, waiting, for this trade to work out: price meandering for a a couple hours or days; price going right back up to your entry with the spread eating up my profit towards the top; price whipsawing until it breaks though a trend line and uses it as resistance or support, etc. There is a lot that can happen. Use your past experiences to “see” what it takes to get this trade to work.

And this is all about applying knowledge properly, not simply having it.

Steps one and two work from the knowledge you have that good risk reward is present, because this is what's required to maintain a clean equity curve over the long-haul. Step three works off of the knowledge that you have that price could indeed go against you, and what it takes to do so. Step four works off of the knowledge you have that trades rarely “work” immediately, and that instant gratification is not upon me.

And before I get too far, I am always asked this, so I'll answer it right now: the reason I start with a potential gain versus loss is due to three major factors:

First, you're in business to make money, not lose it. Find your realistic gain first and start off on a positive note. If it's just too small, why bother?

Second, starting by determining your stop could simply convolute your creation of a reasonable take profit. You create a larger threat of an impulse that would allow you to “stretch reality” in order to justify taking the trade. This stretch of reality goes against your knowledge of what happens in the market, or simply what you are capable of doing. You CAN'T do anything in life, at any time and at will. I don't care who tells you that. Our abilities are still limited to how much knowledge we have on any given subject and at what point in time we take action.

Third, most novice traders spend so much time worry about the entry, they completely put their exit techniques on the backburner. By making this the first step of the trade assembly process, you put emphasis on its importance.

All of the above of course assumes you've got your risk parameters in terms of equity% and position sizing scheduled well ahead of time.

A trade is so much more than just an entry point. You are essentially predicting a “chunk” of future price action. People seem to forget this very easily.

Visualizing this could might be very helpful here, so below is an example. My chart note taking became extreme so please refer to the text under the image for the full description:

EUR:USD 15 min chart

Line A and Line B setup the premise for entry. A=local resistance and B is used to pinpoint entry, which is a Triple Tap at these highs. Use the inner trend line (Line A) to find your hardest point of resistance (most historical hits).

Step1: Identify a reasonable profit target. Depending on your experience level this going to be either Point 1 or Point 2. Both are support levels derived from inner trend lines that show good strength from historical hits. Point 1 is also circa a spike base and Point 2 comes closer to completion of a 100% measured move from the base of the last flag.

Step 2: Hard stop. This is going to be right above the major resistance highs (Point 3). This allows us room in the event that orders are taken out above the highs, possibly creating a “Quadruple Tap” at the local highs. The risk / reward is worth it in both profit target scenarios, so we continue.

Step 3: What could happen to get me out of this trade, thinking it's a wash? A bullish bounce directly on Line A or a bullish bounce off of Point 3 highs. This is going to insinuate momentum at which point, your probability meter just went far against you. Essentially, looking for resistance turned support, and again, I recommend using inner trend lines. This market doesn't tend to honor major, peripheral trend lines as much on smaller movements.

Step 4: What can happen between entry and Point 1 or 2 being hit? A few things: price could dip, meander underneath Line B, come back up just ahead of the Triple Tap highs. Price could go as low as Point 1 lows, which fills the local gap, and then consolidate toward the highs. Price could start to get “lazy” and very, very slowly wean its way down to my profit target. Etc Etc Etc. The more of these you can come up with, the better. Preparing your mind for the “unforeseen” allows you act in a collective manner when any of these situations actually do occur, or situations, not exact, but very similar in manner.

Finally, when things go your way, a little more ease of mind. A backward bounce comes off of the Line C inner trend line. Another backward bounce comes off of the Line D inner trend line. And we're on our way. Two very positive signs that the right move has been made and sitting is your best strategy at this point.

As and an FYI – this example digs into some true nitty gritty. I'm selective though in terms of how I go about my day and like to see things with which I'm comfortable. This could work as easily over longer timeframes using different methods.


…there is simply an overwhelming amount of information that you're likely to absorb over time, but the best stuff typically comes from your own experiences. If I can steer you in the right direction, I would love to. Most people that write about trading techniques and tactics fail miserably in the department of getting his or her “students” to apply good knowledge in a productive manner.

Sometimes, it's pure laziness. Other times, it's because they are being fed knowledge that has never been applied correctly in the first place (and this is what educators most commonly attacked for, understandably). And even other times, it's because of the gap that exists, which we will call for the sake of simplicity “correct application”. And no matter what you learn over time, eventually you're going to end up trading in your own unique manner anyway, and that's because your knowledge and experiences are 100% special to you and you alone. You might know similar concepts as other people, but your built-in database of knowledge is drastically different than any other person on this planet.

My advice, and the ultimate purpose of this entire piece, is to apply the basics correctly. When price turns, FIND OUT WHY. Almost all of the time of the time it's because it's hitting historical or near-term horizontal or diagonal support or resistance. Get a demo account and some monopoly money and start doing the list above, and see if it's working.

If not, then knowledge is likely the issue, and you should be on the hunt for more experience or cleaner guidance. Like anything else, it takes time. Patience to learn, patience to act. But there are of course steps we can take for the more astute trader that can build confidence and put us back into familiar territory before any action is taken. Easing lethal distractions is what's necessary, and stretching your brain prior to any execution is one way to do it.


PS…This article is being posted now as opposed to later because going forward, I intend on getting more “mechanical” with the content on this site. The worst feeling in the world it a trader and opening a chart and not knowing what is happening in recent price action (what any of it means), where price is headed next, and can't identify turns in the market. But this happens all the time, and people simply trade very blindly. Your broker loves the fact that this happens, by the way.

But there is a lot you can do in the meantime, on your own. Basic bar and price patterns can tell us a great deal about future movements in price. Be curious, learn them all, and we'll see you soon with updates.

PPS…NBT has been taking a very long nap lately and could use your help. Sharing our articles whenever and wherever possible helps us out tremendously. Thanks as always,