2. Working Harder at Trading Means Trading More Often. This assumption is that, if you trade more, you’ll learn more and build skills more quickly. The result is overtrading and a likely forfeiture of profits over time to market makers and brokers. Every trade starts as a loser. You’re losing the bid-offer spread if you buy and sell at the market, and you certainly lose a transaction fee. A loss of a single tick per trade due to execution, on top of a substantial retail commission, easily ensures losses of thousands of dollars to day traders who otherwise break even on their trades. As we trade more often without a distinct edge to each trade, our broker becomes richer and we become broker. Pointing and clicking to execute trades is a small part of the process by which traders develop expertise. The lion’s share of development occurs by tracking patterns in simulation and real time, practicing executing and stopping out trades on paper (and in simulation mode) prior to risking capital, and researching trading ideas. By expecting trading itself to generate learning, we ensure that our motivation for learning will lead to overtrading—and a loss of both capital and motivation.
3. Success Means Making a Living from Trading. Here is another expectation guaranteed to generate frustration and discouragement. No developing professional makes their living from their performances during the early years of expertise building. A golfer or tennis player may spend years on a college team and as an amateur before even starting the pro circuit. Star actors or actresses typically spend years in lessons and regional theaters before they see their names under the Broadway lights. Before surgeons make a living from their trade, they spend four years as a medical student, four more years as a surgical resident, and even more years in subspecialty training. Expecting to make a sustainable living from trading within the first years of exposure to markets is wholly unrealistic. More realistic expectations would be to keep losses to a reasonable level, cover one’s costs with regularity, and improve trading processes. There is no path to expertise that doesn’t first require time to develop mere competence. If you expect to make a living from trading much more quickly than people in other fields are able to sustain a livelihood, you are setting yourself up for frustration and failure.
An excellent antidote to these toxic assumptions is to write out your expectations as part of keeping a trading journal. This includes your expectations for each day of trading—your goals for trading well—but also your expectations for your development over time. My goal for my own trading performance is relatively modest: I want to earn more than the riskless rate of return after trading costs, and I want to do that by risking less than that proportion of my capital. In other words, I’m targeting positive risk-adjusted returns; that integrates my performance and process goals. I will be very happy if I average one percent returns on my portfolio per month by risking significantly less than that.
By focusing on risk-adjusted returns, not just absolute profitability, we blend process and outcome goals.
This may not be a realistic target for you, depending on your level of development and your risk appetite as a trader. What is important is not my target numbers, but rather the fact that I have developed realistic, attainable objectives for my trading. If I achieve my expectations, I feel a sense of pride and accomplishment. If I fall short, I can quickly identify that fact, pull back my risk exposure, and make necessary corrections.
A formula for positive trading development is: Always expect success, and always define success so that it is challenging, but attainable. Writing out your expectations for the day, week, month, and year—and ensuring that they’re doable—is a powerful lever over your emotional experience as a trader.
COACHING CUE
A great entry in a daily trading journal: “What would make my trading day a success today, even if I don’t make money?” That simple question leads directly to process goals—the things you can best control.
LESSON 13: WHAT CAUSES THE DISTRESS THAT INTERFERES WITH TRADING DECISIONS?
We become anxious and exit a good trade before it has an opportunity to reach its price target. We become frustrated and take a trade that completely contradicts our research and planning. We’re afraid of missing a trade and enter at the worst possible time. We’re reluctant to take a loss at our designated stop point and wind up with a much larger loss.
All of these are examples of trading behaviors for which all of us as traders can truly say, “been there, done that.” In trading, as in much of life, we learn by making the mistakes our parents and mentors try to protect us from. The key to longevity is making those mistakes early in your development, before you have too much on the line. Mistakes in dating can lead to a great marriage. Mistakes on a simulator can lead to solid real-time performance. Making your errors when your risk is lowest is a large part of success.
But what causes these mistakes, in which the arousal of distress interferes with prior planning and consistent, sound decision-making? Perhaps if we can figure that out, we can shorten the painful learning curve just a bit.
The fields of behavioral finance and neuroeconomics have illuminated how emotions affect financial decisions; check out references at the end of this chapter.
To hear traders talk, distress in trading is caused by markets. A market turns slow and range-bound: that is the supposed cause of a trader’s boredom and overtrading. A market reverses direction: that allegedly generates frustration and impulsive trades for the trader. Because their emotions are triggered by a market event, traders assume that the market must be responsible for their feelings. A moment’s thought, of course, dispels this notion. After all, if the market had the power to compel emotional reactions, we would see all traders respond identically in a similar situation. That, however, is not what happens. Not all traders respond to a slow market with boredom and overtrading; not all traders become frustrated and make impulsive decisions when a position reverses against them. There is more to the cause of our emotions than external events.
In order for a market event to generate a negative emotional response, we have to view it as a threat. Let’s say that I’m a trader watching my market become slow and range-bound at midday. If I view that as an opportunity to update some of my ideas and prepare for the afternoon, the slow market will not trouble me in the least. Similarly, I may view the choppy, thin action as an opportunity to get away from the screen, clear out my head, and start the afternoon fresh. Again, the slow action affects neither my feelings nor my trading behavior.
If, however, I start my day telling myself that I must make at least several thousand dollars each day, then I’ll now perceive the slow market as a threat to my trading goal. The narrow, whippy action translates into lack of opportunity, which translates into lack of profit, which translates into lack of success. It’s easy to see, with that mental framework, how I could wind up viewing slow markets as threats to my career. It’s no wonder that the slow market would trigger my distress and overtrading.
But, of course, it’s not merely the slow market that is generating my negative mood and behavior; it’s my perception of that market. Perception is the filter that we place between events and our responses to events. If we place a distorting lens over our eyes, we will see the world in distorted ways. If we adopt distorted perceptions of markets and ourselves, we’ll experience trading in distorted ways.
Can we alter our perceptions? Chapter 6 deals with cognitive approaches to change that restructure thought processes.
So how do we change the filters that turn normal trading experience into abnormal events?
The rule is simple: if you don’t know your filters, you cannot change them. Becoming aware of the expectations and beliefs that shape your perception is essential to the process of shifting your perception.
Here’s a simple exercise that can aid you in becoming more aware of any distorted perceptions you might hold:
Every time you experience a distinctly negative emotional reaction to a market event, consciously ask yourself, “How am I perceiving the current market
as a threat?” This turns your attention to your perceptual processes, giving you a chance to separate perceived threat from real threat.
A simple example comes from my recent trading. I really wanted to finish the week on a high-water note in my equity curve and found myself with a nice profit on a Friday morning trade to the long side. As the trade moved my way, I moved my stop to breakeven. The trade continued to go my way a bit before making a small reversal. It then chopped around for a few minutes. I found myself becoming nervous with the trade, as if it were on the verge of plunging below my stop point.
I quickly asked myself, “Why am I nervous with this trade? Why am I perceiving the trade with so much uneasiness?” A moment’s reflection and review of the market told me that the trade was perfectly fine and progressing according to plan. It was my desire to end the week profitably (after an extended flat period of performance, I should add) that turned the potential reversal of a winning trade into a threat. If all the market can do after the run-up is chop around in a flat way, perhaps this is an opportunity to add to the position, I reasoned. I calibrated my risk/reward on the added piece to the position (and for the position overall, given my new average purchase price) and added a small portion to the trade. The added increment wasn’t large enough to dramatically affect the profitability or risk of the trade, but it was an important psychological step: I turned a perceived threat into opportunity.
The key here is to distinguish between actual threats—markets that truly are not behaving according to your expectations—from perceived threat. That requires reflection about markets and about personal assumptions. Once I saw that the trade was proceeding normally, I was free to challenge the filters that were leading me to become nervous with a good trade.
When you think about your thinking by adopting the perspective of a self-observer, you no longer buy into negative thought patterns.
After you identify a perception that turns a normal event into a threat, the next challenge is to find opportunity in that normal event. I might feel threatened by a difference of opinion with my wife, but that threat can be turned into an opportunity for fruitful communication and problem solving. We might feel threatened by a trade that starts modestly profitable but then stops us out, but that threat can be turned into an opportunity to flip our position or reassess our views of that market.
Identify the perceived threat; turn the perceived threat into an opportunity: that is a two-step process that addresses the true cause of emotional reactions that distort trading decisions. By keeping a journal specifically devoted to your thinking and perceiving, you can structure this two-step process and turn it into a habit pattern that you activate in real time.
COACHING CUE
When you talk or IM about the day’s trading, pay attention to how you describe the markets: good, bad, quiet, active. Listen especially for the tone of your descriptions. Many times, your tone and language will give away whether you’re in tune with markets or fighting them. If you become caught up in what you think the market should be doing, you’re most likely to fight it when it does something else.
LESSON 14: KEEP A PSYCHOLOGICAL JOURNAL
When I first began trading, I kept a journal in the form of multiple annotated charts. I looked for every major turning point in the stock market and then investigated the patterns of indicators and price/volume patterns that could have alerted me to the changes in trend. After a while, I found that certain patterns recurred. It was out of those early observations that I learned to rely on patterns of confirmation and disconfirmation among such measures as the number of stocks making new highs versus lows, the NYSE TICK, and the various stock sectors. Later, as I gained new tools, such as Market Delta (www.marketdelta.com), I added to those patterns. For me, the journal was a tool for pattern recognition. Only after an extended time of recognizing patterns on charts, could I begin to see them unfold in real time. It was also only after an extended period of real-time observation that I felt sufficiently confident to actually place trades based on those patterns.
When we keep a psychological journal, the learning principles are not so different. At first, the journal is simply a tool for recognizing our own patterns as traders. These include:• Behavioral patterns—Tendencies to act in particular ways in given situations.
• Emotional patterns—Tendencies to enter particular moods or states in reaction to particular events.
• Cognitive patterns—Tendencies to enter into specific thinking patterns or frames of mind in the face of personal or market-related situations.
Many of our trading patterns are amalgamations of the three patterns: in response to our immediate environment, we tend to think, feel, and act a certain way. Sometimes these characteristic patterns work against our best interests. They lead us to make rash decisions and/or interfere with our best market analysis and planning. It is in such situations that we look to a journal (and other psychological exercises) to help us change our patterns of distress.
For more on keeping trading journals: http://traderfeed.blogspot.com/2008/03/formatting-your-trading-journal-for.html
But why do such patterns exist? Why would a person repeat an unfulfilling pattern of thought and behavior again and again, even when she is aware of the consequences? Sometimes traders are so frustrated with their repeated, negative patterns that they swear that they are sabotaging their own success. This pejorative labeling of the problem, however, doesn’t help the situation. It only serves to blame the frustrated trader, magnifying frustrations.
As I stressed in my Psychology of Trading book, maladaptive patterns generally begin as adaptations to challenging situations. We learned particular ways of coping with difficult events and those, at first, may work for us. As a result, these patterns become overlearned: they are internalized as habit patterns.
A good example is the tendency to blame oneself when there are conflicts with others. A child in a home fraught with arguing and fighting might adapt to the situation best by blaming himself for problems rather than risk conflict by blaming others. Later in life, with that pattern ingrained, even normal conflicts may trigger self-blame and depressed mood. Such a person, for example, might spend more time and energy beating up on himself after a losing day than learning from his losses.
When we repeat patterns in trading that consistently lose us money or opportunity, the odds are good that we are replaying coping strategies from an earlier phase of life: one that helped us in a prior situation but which we’ve long since outgrown. The task, then, is to unlearn these patterns—and that is where the psychological journal becomes useful.
Just as I used the trading journal to become keenly aware of market patterns, our psychological journal can alert us to the repetitive patterns of thinking, feeling, and acting that interfere with sound decision-making. Such a journal, like the annotated charts that I mentioned, begins with observation: we want to review our trading day and notice all of the patterns that affected our trading. The initial goal is not to change those patterns. Rather, we simply want to become better at recognizing the patterns, so that we’ll eventually learn to identify their appearance in real time.
The psychological journal is a tool for developing your internal observer: learning to recognize what you’re doing, when you’re doing it.
A favorite journal format that I use divides a normal piece of paper into three columns. The first column describes the specific situation in the markets. The second column summarizes the thoughts, feelings, and/or actions taken in response to the situation. The third column highlights the consequences of the particular cognitive, emotional, or action patterns.
The first two columns help us recognize the situational triggers for our patterns. This makes us more sensitive to their appearance over time. The third column emphasizes in our mind the negative consequences to our patterns. Those negative consequences could include emotional distress, losing money on a trade, or failure to take advantage of an opportunity. When we clearly link maladaptive patte
rns to negative consequences, we develop and sustain the motivation to change those patterns. That third column should spell out in detail the costs of the recurring pattern: how, specifically, the pattern interferes with your happiness and trading success. The clearer you are about the pattern and its occurrence and the more strongly you feel about the costs it imposes on you, the more likely you’ll be to catch the pattern in real time and be motivated to interrupt and change it.
For now, however, your goal should be to identify your repetitive patterns and their consequences—not to try to change those patterns all at once. You cannot change something if you’re not aware of it. The psychological journal is a powerful tool for building that awareness and understanding what is generating your distress. Keep the journal for 30 consecutive days to help you see just about every variation of your most common patterns. It will also begin the process of turning self-observation into a habit pattern—a positive pattern that can aid you in your personal life and in your trading.
COACHING CUE
Begin your psychological journal by tracking your individual trades and focusing on those situations in which your mindset took you out of proper execution or management of those trade ideas. In other words, these will be instances in which you failed to follow your trading rules, not ones in which you followed the rules and just happened to be wrong on your ideas. Replay these trades in your mind—or, better yet, consider videotaping your trading and observing those trades directly—and then jot down what set you off (Column A); what was going through your mind (Column B); and how it affected your trading (Column C). Zero in on how much money that trigger situation cost you. With practice, you’ll build your internal observer and start noticing these situations as they are occurring. That will give you an opportunity to create a different ending to the script.
The Daily Trading Coach Page 7
