The Daily Trading Coach

by Brett N Steenbarger

  LESSON 29: MAXIMIZE CONFIDENCE AND STAY WITH YOUR TRADES

  A great deal has been written about risk management and the importance of stop-losses. A stop-loss, ideally, is that point that tells you that your initial trade idea is wrong. Traders establish firm stops that are closer to the point of entry than the price targets and help ensure a favorable risk/reward profile to each trade. You can generally tell a professional trader by the way she closes out a losing trade. The exit is automatic, not a cause for consternation. Loss is an accepted part of the game. The good traders learn from those losses and use them to revise market views. A losing trade, as a result, can set up the next winning trade.

  Much harder for many traders and far less remarked upon is something we might call stop-profits. Traders who religiously adhere to stop-losses can find it difficult to let profits run on winning trades. They stop those profits out prematurely, reducing the reward portion of the risk/reward profile. Over time, these traders have trouble succeeding, because their winning trades end up being not much larger than their losers—and sometimes smaller.

  There are a few reasons that traders tend to cut profits short. One reason is that they fail to identify profit targets as clearly as stop-loss points. Such targets may be based on a number of factors, such as the market’s overall volatility, the presence of distinct support and resistance levels, and the time frame of the pattern being traded. Many of my trades, for example, are based on historical analyses of the probability of hitting particular price levels (previous day’s high or low; pivot point levels based on the prior day’s high-low-close); those levels then serve as targets for setups. It is much easier to stick with a trade when there is a firm target in mind, just as it’s easier to get work done when you have a clear goal in mind. Without a predefined target, it’s easy to get caught up in the tick-by-tick ups and downs of the market, acting on fear and greed unrelated to the initial trade idea.

  Another culprit in those stop-profit scenarios is a lack of confidence in one’s trade ideas. One of the important advantages of testing one’s trading setups is that you can estimate the historical odds of a market acting in your favor. That knowledge can provide the security necessary to see the trade through to its ultimate target. When trade setups and patterns are borrowed from others without prior testing (either through one’s own paper trading or through historical analysis), it is difficult to have a deep, inner sense of confidence in the ideas. As markets experience normal retracements on the way to a profit target, those adverse excursions become difficult to weather. Instead of seeing them as potential opportunities to add to the trade at good prices, it’s easy to perceive them as threats to paper profits.

  Finally, a trader’s risk aversion may play a role in prematurely stopping out profits. Suppose you have a choice between taking a sure $1,000 profit versus a 75 percent chance at $1,500 and a 25 percent chance at $500. Over time, taking the 75 percent chance will make you more money. Nonetheless, at any given point in time, a person may feel that it’s foolish to walk away from a sure $1,000. In such a situation, the decision is made as much for the trader’s peace of mind as for overall profitability. Similarly, traders may set stop-profit levels to achieve a sense of certainty, not to maximize returns.

  Seeing a trade through to its target requires an unusual degree of security and ability to tolerate uncertainty. As the trade moves further in your favor, you have more money in paper profits that you’re exposing to future risk, even if the risk/reward picture remains favorable. This ability to sit through a trade’s uncertainty as profits accumulate requires particular confidence in the initial trade plan. Ironically, it takes more confidence to stay in the trade as it goes in your favor than if it remains in a narrow range, simply because more paper profits are at stake.

  It usually takes more confidence to sit in a winning trade than to enter it.

  So how does one achieve the level of confidence needed to sit through good trades? Often it’s not the loss of the paper profits per se that are the real threat for traders. After all, if a trade moves your way and you prudently raise your stop-loss level to breakeven, you’ll never get hurt by a sudden, unusual adverse excursion. As disappointing as it may be to lose a paper profit, it’s hardly, in itself, a threat to one’s account.

  Rather, the threat to traders lies in how they would process such a retracement. In many cases, their attitude would become quite negative in the face of lost profits. They might criticize themselves for the missed opportunity or lapse into an uncomfortable state of frustration. Instead of viewing the reversal of a gain as nothing lost—simply a scratched trade—they treat it as a situation calling for blame. It’s the self-blame and the discomfort of second-guessing that traders are avoiding, not the (paper) dollar loss itself. “You’re never wrong taking a profit,” is an attitude that speaks more to this psychological reality than to the logical necessity of taking larger winners than losers.

  Traders often think they’re managing a trade when they exit prematurely, when in fact they’re managing their thoughts and feelings about that trade.

  A large part of confidence is trust. You have confidence in your marriage because you trust your spouse. You have confidence in your driving because you trust your ability to maneuver the car under changing road conditions. If you don’t act on your trade ideas—that is, by not seeing them through to their planned conclusion—you actually undercut your confidence by never allowing yourself to develop trust in those ideas. Just as mistrust of a spouse cannot lead to security in a marriage, a failure to trust your time-tested ideas cannot bring confidence to your trading. You can only endure the uncertainty of the trade that moves in your favor by seeing—in your own experience—that the discomfort is indeed endurable, and that you gain far more than you lose by sticking with your planned trades.

  As your own trading coach, it’s important that you instill both trust and confidence in your trading. This can be accomplished in two ways:• Instill the confident mindset. Before trading starts, you want to mentally rehearse how you would talk to yourself in the event that you have to scratch a trade after having a paper profit. Specifically, you would rehearse a mindset of “nothing ventured, nothing gained”—it’s okay to scratch a smaller percentage of trades if that allows you to let a larger percentage run—rather than a self-blaming, frustrated mindset. Prepare yourself in advance for adverse excursions so you remove much of their threat value.

  • Build on small change. A useful brief therapy principle is to start making large changes by just starting with small changes. If you do just a little of the right thing, you will provide the feedback and encouragement necessary to expand those efforts. In the case of trading, this is easy: even if you take much of your position off ahead of a planned target, leave a small piece of the position on to either hit the target or scratch out. This preserves profits and assuages risk-aversion while it enables you to have the firsthand experience of seeing your ideas through to their conclusion. Over time, you can leave on larger pieces and build performance that way.

  Confidence is not just a function of how you think, but also how you act. If you act in a way to trust your judgment, you’ll have the opportunity to see your judgment work out—and that will build confidence. The stop-profit scenario, unfortunately, is a stop-confidence one as well. If you act with confidence—even in small measure—you coach yourself to self-trust and a deeper internalization of that confidence.

  COACHING CUE

  The flip side of the impulsive trader is the perfectionist. I’ve seen many traders come up with great trade ideas, only to never participate in them because the market never came to their desired entry levels. Coming up with a big, winning idea and then seeing it work out without you on board can be supremely frustrating. Don’t let the perfect become the enemy of the good. If you have a fantastic idea—for instance, you see a market break out and enter a trending mode—get on board with at least a small piece of your maximum position size. If it’s a good trend, you
can always add to the position later on countertrend moves; if it’s not a good trend, you can exit with a modest loss. But always try to let your trading positions express your convictions: you always benefit psychologically when you act on your confidence.

  LESSON 30: COPING—TURN STRESS INTO WELL-BEING

  We have seen that stress does not need to become distress if it is balanced with generous amounts of well-being. People can endure high levels of challenge, pressure, and uncertainty if their work is meaningful to them and they experience rewards tied to their efforts.

  We can think of coping as a set of strategies for handling stressful situations so that they don’t become distressful. By coping effectively with the risks and uncertainties of markets and the demands of the learning curve, traders can go a long way toward maintaining a favorable emotional balance.

  Psychological research tells us that there is no single most effective coping strategy. Rather, people with different personalities and needs employ different coping patterns to best handle situations. When you are your own trading coach, it is important to know how you cope best with trading stresses, so that you can activate these strategies on demand.

  This knowledge is especially crucial because, at times of greatest stress, we often lapse into old, well-worn coping patterns that may have worked at one time, but may not be appropriate to the current situation. An avoidant coping pattern may have worked in past work situations involving interpersonal conflict, but would be disastrous if employed in the middle of a losing trade in a fast-moving market. Doing what comes naturally is not necessarily the best strategy for handling stress. As we will see in Chapter 5, those past, overlearned modes of coping are often what keep us locked into cyclical problem patterns.

  One example that I commonly encounter involves traders who utilize highly confrontive coping strategies. Many traders have aggressive personalities and succeed by facing challenges head on. This can work quite well in situations where one must negotiate a business deal or handle a piece of bad news. In the markets, however, the aggressive response is not always the best one. When facing a series of losing trades—something that happens to all of us—traders can become more aggressive and confront the situation by trading more and larger. This way of handling frustration leads a trader to take maximum risk when he is seeing the market least clearly—a virtual formula for catastrophic drawdowns.

  You can often recognize failed coping strategies when you look back on your actions and wonder what could possibly have led you to behave that way.

  So how can you know which coping strategies work best for you in particular situations? Below is a checklist that will help you sort out your different ways of handling trading problems. For this lesson’s exercise, I’d like you to think back to several situations in which you’ve handled trading problems effectively and several situations in which you’ve handled them poorly. Next to each coping strategy, place a checkmark if it’s a mode of coping that you utilized when trading well. Then, next to each item on the list, place a circle if it’s a mode of coping that you utilized when trading poorly. Here we go:1. I reached out to others for ideas or feedback _.

  2. I took steps to make sure I didn’t overreact _.

  3. I stepped back from the situation and figured out what to do next _.

  4. I tried to not make a big deal out of the problem _.

  5. I looked for what I could take away from the situation that would help me in the future _.

  6. I made a concerted effort to tackle the problem there and then _.

  7. I recognized my mistake and took action _.

  8. I decided to stop trading for a while and regain perspective _.

  Once again, the key is not to figure out the right and wrong coping strategies, but rather the ones that have worked best for you—and the ones that have been associated with problem patterns in your trading.

  One important dimension of coping is action/reflection. Some people benefit most by taking prompt action to own and address challenges; others step back, get themselves under control, put things in perspective, think through plans, and/or consult with others. Another key dimension is problem-focused versus emotion-focused coping. Some traders respond best to situations by first venting and getting things off their chest, reaching out to others for input and support, and working actively to dampen negative emotions. Other traders fare best by putting feelings aside, analyzing situations, and engaging in active problem solving to address problems.

  Often traders run into problems when they fail to enact their best coping strategies. The analytical trader can get hurt when he finds himself venting emotion and confronting problems without prior reflection and planning. The trader who thrives on social support and feedback from others is unlikely to cope effectively if she becomes discouraged and isolates herself from valued peers.

  If you contrast your best and worst coping—the times when you’ve handled trading problems most and least effectively—you identify what you need to do to sustain a favorable balance between well-being and distress.

  When you track how you cope when you are trading well, you create a mental model of your best ways of handling trading challenges. This model can then become a script that you can draw on during times of difficulty. Make a coping checklist a part of your daily journal; it will alert you to behavior patterns that you can build on for the next market challenge.

  COACHING CUE

  Think of your best and worst coping patterns as being sequences of actions, not just isolated strategies. Thus, for instance, when I’m coping well, I first take steps to calm myself and get focused; then I engage in concrete problem solving. I best cope with losses by analyzing them to death—figuring out what went wrong—and then drawing positive learning lessons from those. When I’m coping poorly, I don’t calm myself, and blame myself instead, adding a second bad trade to the first as a way of making up for the loss. In my poor coping mode, I don’t analyze my losers, instead turning my attention to more promising markets, instruments, or setups. That ensures that I’ll learn nothing from my loss—and that my error will repeat itself at some juncture. Think of coping as sequences of behaviors, so we can develop mental blueprints for the actions we need to take in the most challenging market conditions. This helps ensure that trading stress does not generate performance-robbing distress.

  RESOURCES

  The Become Your Own Trading Coach blog is the primary supplemental resource for this book. You can find links and additional posts on the topic of stress and distress at the home page on the blog for Chapter 3: http://becomeyourowntradingcoach.blogspot.com/2008/08/daily-trading-coach-chapter-three-links.html

  One of the early texts summarizing research into positive psychology is Well-Being: The Foundations of Hedonic Psychology, edited by Daniel Kahneman, Ed Diener, and Norbert Schwarz and published by the Russell Sage Foundation (1999). Another worthwhile reference work is the Handbook of Positive Psychology, edited by C.R. Snyder and Shane J. Lopez and published by Oxford University Press (2003) and, by those same authors, Positive Psychology: The Scientific and Practical Explorations of Human Strengths (Sage Publications, 2006).

  How our emotions affect our health and well-being is the topic of James W. Pennebaker’s edited text Emotions, Disclosure, and Health, published by the American Psychological Association (1995).

  A number of free articles covering topics of stress, coping, and emotions in trading can be found in the section “Articles on Trading Psychology” at www.brettsteenbarger.com/articles.htm.

  CHAPTER 4

  Steps toward

  Self-

  Improvement

  The Coaching Process

  Success does not consist in never making mistakes but in never making the same one a second time.

  —George Bernard Shaw

  What are the core processes of self-coaching? What concrete steps can we take to make changes in our trading to improve performance? These are some of the topics we’ll tackle in this chapter. Much
of this chapter comes from research over the past several decades that has illuminated common effective ingredients across all counseling and therapy approaches. An interesting finding from that research is that all of the major approaches to counseling appear to be more effective than no counseling at all, but no single approach consistently shows better results across a range of people and problems. Not only do the major modes of helping seem to work equivalently, they also seem to work for many of the same reasons. Those reasons capture the essence of what creates change—and what can fuel our efforts to become our own trading coaches.

  LESSON 31: SELF-MONITOR BY KEEPING A TRADING JOURNAL

  Self-monitoring refers to methods that you use to track your own patterns of thought, feeling, and behavior over time. Self-monitoring is the foundation for many of the other self-coaching techniques described in this chapter, because it tells us what we need to change. We can’t alter a pattern if we’re not aware of its existence. Very often in brief therapy, the first homework exercises involve self-monitoring. Just as observing market patterns precede our ability to trade them, becoming aware of our own patterns is the first step in changing them.