The Daily Trading Coach

by Brett N Steenbarger

  One of my greatest failures as a trading coach occurred with a young trader who experienced early market success. He took the time to observe markets, learn short-term patterns, and track his own trading. He started trading small and learned the important lessons about waiting for good entry points, cutting losing trades, and letting his winning trades run to their target points. The trading firm was happy with his progress and gave him significantly greater size to trade. That was where I went wrong. I should have stepped in and demanded that the trader’s increase in risk be more graduated. Instead, armed with his new size, the young trader decided he would try to compete with the more experienced traders at the firm. He traded full size in his positions and his profits and losses swung wildly. Unprepared emotionally for those swings, he became impulsive and, one day, abandoned all discipline, blowing himself up on a single trade he allowed to get away from him. He never recovered from that loss and eventually had to start over at another firm.

  It is impossible to remain emotionally stable if you greatly amplify your P/L swings.

  When traders are undercapitalized and still hope to trade for a living, they too are impelled to take high levels of risk to achieve their desired returns. The result is that their portfolio swings wildly, with gains and losses that represent a large portion of total account value. These financial swings bring emotional swings, both positive and negative. The larger the financial swings, on average, the larger the emotional swings. The larger the emotional swings, the greater the potential for the development of learned, conditioned responses that disrupt future trading.

  When a trader undergoes an emotionally harrowing loss, many of the situational factors associated with that trade may become associated with the emotional pain. Some of these situational factors, from the trader’s physical state to the particular type of movement in the market, may be quite random. Nonetheless, they can trigger the emotional pain, much like sitting in a passenger seat triggered my anxiety following the automobile accident. A trader who consulted me about problems pulling the trigger on good trade setups experienced precisely that problem. He had lost significant money shorting the market during an uptrend, incurring several large losses. Subsequently, even when his trades were small in size, he felt fear whenever he tried to short the market. The feelings associated with his loss came back as a conditioned response, inhibiting his trading. This is the dynamic behind the flashbacks that occur during post-traumatic stress: stimuli associated with the initial trauma trigger memories and feelings from that painful incident.

  The problem may have been just as severe had this trader made large money on the initial trade instead of losing. The emotional impact of a windfall profit, like the impact of a crack cocaine high, would bring its own conditioning, leading him to pursue similar gains (and highs) in future trades. It is poorly understood by traders that, psychologically, outsized gains are just as problematic as outsized losses. The fat tails of returns threaten fat tails of psychological response, interfering with sound perception and decision-making.

  For this reason, when you’re your own trading coach, you don’t want patterns of extreme returns. Steady, consistent profits are far better for psychological performance than wild swings up and down, even though they may lead to the same ultimate returns. Stated otherwise, good risk-adjusted returns are better for the psyche than extreme patterns of returns. It’s not how much you make, but how much you make per unit of risk taken that will keep you in or out of the performance zone.

  Your assignment for this lesson is to track the variability of your returns as intensively as your overall profitability. By variability of returns, I mean the absolute value of daily/weekly changes in your portfolio value: how much your account swings up or down on average each day. As markets change in their volatility and as you shift in your level of conviction about trades, you’ll see changes in this variability. This tracking will tell you when you run more and less risk. On the whole, you’ll want greater variability when you trade well and have many solid ideas; you’ll want to cut your risk (lower the variability of returns) when you don’t see markets well and when good trading ideas and moves are scarce.

  Track the volatility of your returns, not just their direction. Volatility affects trading psychology every bit as much as winning and losing.

  When you track the variability of returns, you’ll also be able to see when your swings in profit/loss are outliers from your historical norms. This will be an excellent alert that your levels of risk may be sufficient to generate those large emotional swings that will produce unwanted conditioned responses. Traders tend to love volatility when they’re making money and hate volatility when they’re losing. Psychologically, it makes sense to keep the volatility of your returns within bounds: markets may possess fat tails, but with prudent position sizing, your returns can remain stable. You don’t want markets conditioning your learning: you want to be your own coach, directing your own learning.

  COACHING CUE

  The psychological research on trauma suggests that processing a very stressful event verbally—out loud or in writing—can be extremely helpful in making sense of that event and divesting it of enduring emotional impact. When we repeat something again and again, it becomes familiar to us and no longer evokes powerful emotion. If you encounter outsized gains or losses in your portfolio, double down in your use of the trading journal or in your conversations with peer traders to thoroughly process what happened and why. As noted above, this process is just as important following large gains as following large losses. When highly emotional events bypass explicit processing, that is when we are most vulnerable to the effects of conditioning.

  LESSON 66: THE POWER OF INCOMPATIBILITY

  Earlier we saw how much of what we learn is state-dependent. We associate particular outcomes with specific physical and emotional states. These associative links trigger unwanted behavior patterns when we enter those states. The classical conditioning mentioned in the previous lesson is an excellent example: if we experience overwhelming anxiety due to large losses, exiting the market may provide immediate relief. Subsequent experiences of anxiety in the market may trigger the same exiting behavior even when it would be in our financial interest to hold the position. The association between the anxiety and perceptions of danger may be so strong that it overwhelms our prior planning.

  Boredom, for many active traders, can be as noxious as strong anxiety. It may be associated with failure to make money, or it may have much earlier negative associations: being lonely or feeling abandoned as a child. If you get into a trade—particularly a risky one—you immediately relieve the boredom, but you create a new trading problem. In such cases, the trading behaviors triggered by the state are more psychological in their origins than logical.

  If trading is associated with an aversive state, we tend to do what is necessary to alleviate the state, even at the expense of our portfolios.

  One of the simplest behavioral techniques for breaking these bonds of conditioning is to place yourself in a state that is incompatible with the one that triggers your problematic trading. Thus, for instance, if you find that anxiety triggers hasty and ill-timed market exits, you would work on placing yourself in a calm, relaxed physical condition that is incompatible with anxiety. If boredom were your nemesis, you would cultivate activities that hold your interest during slow markets. When I am fatigued, I find that a round of vigorous exercise not only makes me more alert, but also triggers positive action patterns, as I tackle work that had previously seemed overwhelming. If you’re not in a state that supports sound decision-making, your self-coaching focus turns from the markets to yourself and doing something different to shift your state.

  Two of the methods I have found particularly helpful in maintaining states incompatible with one’s triggers are controlling breathing and muscle tension during trading. When I focus on the screen and breathe deeply and slowly while I follow the market, I minimize the physical manifestations of any form of overexcit
ement—from overconfidence to fear—and stay in a highly focused mode that I have learned to associate with good trading. When we slow ourselves down through deep, rhythmical breathing, it is difficult to be simultaneously speeded up and excited. The careful breathing thus acts as a dampener on extreme emotion. It reinforces self-control and discipline at the most elemental level.

  In my own trading, I’ve found that problematic trading tends to occur when I am physically tense, especially when I tense the muscles of my forehead. I rarely knit my eyebrows and wrinkle my forehead when I am comfortable in a situation. Conversely, I am prone to headaches and associate forehead muscle tension with tension headaches, which can pose a considerable distraction. By purposely keeping my forehead relaxed—widening my eyes slightly and going into a temporary stare—as I maintain the slow, deep breathing, I can sustain a state incompatible with the ones that occur when I’m on edge. Instead of waiting to become tense or nervous and then performing exercises to reduce these feelings, I proactively pursue and maintain an incompatible state before problematic trading occurs.

  Control the arousal level of the body as a powerful means of controlling the arousal level of the mind.

  I can often recognize my physical level of tension by my seating position. When I am comfortable, confident, and relaxed, I sit in the chair firmly, with my lower back and behind flush with the seat back. When market events trigger a stress response, however, I find myself leaning forward, with my seat near the end of the chair. Over time, this position gives me a backache in my lower back. I know that I’m not comfortable with my trading or with the markets when I feel that pain. Often, I’ll readjust my seating, reorient my breathing, and find it easier to view the markets from a different—and more promising—angle.

  The principle of incompatibility can also extend to thinking behaviors. Cognitive-behavioral work treats thinking as a discrete behavior that can be conditioned and modified just like any muscular behavior. If we tend to engage in negative thinking during trading, we can enter a mode of thinking that is incompatible with negativity before trading problems occur. I frequently have one of my cats sitting beside me as I’m trading, usually Gina. It’s nearly impossible for me to become consumed with negative or angry thoughts when I am petting Gina. She alternates between licking me and rubbing her face against mine, all the while purring loudly and making kneading movements with her front paws. Stroking the cat helps me stay in touch with loving, caring feelings that are incompatible with the nastier emotions that can emerge during frustrating market periods.

  One of the states that is most disruptive to my trading is what I would call a chaotic state, in which I feel as though I’m a step behind markets, not really understanding what is going on. It’s a confused state, but also a frustrated one, as I don’t feel in control in the situation. I’ve learned that if I place myself in environments that are incompatible with chaos, I am in a much more balanced frame of mind. Such environments are ordered and well organized—my notes and materials are readily at hand—and they are designed to evoke positive feelings. Music is particularly effective for me in this regard. It is also harder for me to feel chaotic if I have gone through a routine of research and track markets prior to the New York stock market open. I organize my ideas in advance to help me feel more organized, settled, and in control.

  You can structure your trading routines to make them incompatible with stress and distress.

  When you are your own trading coach, you have wide latitude in modifying your environment—inner and outer—so that it does not trigger states that are associated with poor trading. One trader I worked with loved trading in a room with other traders (he joined a prop firm) because, in the social setting, he was too embarrassed to engage in behaviors he might lapse into on his own. He found that he was much more prudent about risk-taking and much less emotionally volatile when he was accountable to others. The key is to find a state or situation that is incompatible with the triggers for your worst trading and then build that into your normal trading routine.

  A simple way to get started is to complete the following sentence:

  I trade my worst when I

  Once you write your answer, your assignment is to create the incompatible situation. For example, I would complete the sentence with “don’t do my homework.” I know that my day’s preparation for the trade has a huge bearing on my odds for success that day. I also know that I’m least likely to do my homework diligently if I oversleep or am fatigued. When I build stretching and physical exercise into my early mornings, I enter an energized state that prepares me for the homework: I’ve learned to associate the vigorous, energetic state with being prepared and engaging in my preparation. After you observe the differences in your states when you trade your best and worst, you’ll be able to construct similar activities that proactively keep you in an optimal trading mode.

  COACHING CUE

  I mentioned above how chaotic feelings are a trigger for my worst trading. If markets aren’t making sense to me, my mind feels scrambled and trading seems rushed. I’ve learned through hard experience that a powerful way to create a state incompatible with that chaos is to temporarily lower my trading size until I regain a feel for markets. With much less at risk, I don’t feel pressured and yet can stay actively engaged in markets. When we control our risk we can control our emotional reactions to markets: it’s tough to panic when you have little on the line. Markets seem to move slower—and our feel for them returns—when we’re not distracted by emotions triggered by risk and uncertainty.

  LESSON 67: BUILD ON POSITIVE ASSOCIATIONS

  In the cognitive-behavioral framework, we can utilize imagery as a stimulus to evoke desired responses, triggering our own positive, learned patterns. Making use of imagery in this fashion can help us create positive associative links, triggering our best trading behaviors.

  Let’s say we have a trader who anticipates an early-morning entry into the market based upon a researched setup. Before the market opens, she visualizes the setup and her execution, noting the feelings of satisfaction from making a good decision. This positive mental rehearsal acts as a preparation for the actual trade, as she follows the behavioral pathway she has laid down in advance. I call this anticipatory reinforcement: by imagining the positive benefits of doing the right things, we strengthen positive associative links and make it easier to act on our learning in real time.

  Many traders conduct anticipatory reinforcement in reverse: they dwell on negative outcomes and feared scenarios, undercutting their own sense of efficacy. This, in essence, is anticipatory punishment, and it leads traders to miss opportunities or to not act on them. I’ve found over the years that much of what separates the excellent traders from the average ones is not so much their ideas, but what they do with those ideas. Two traders will have positions go their way and then pull back a bit. The first trader, anticipating punishment, fears losing his gain and takes a quick, small profit. The second trader, anticipating reward, adds to the position on the pull back and reaps large gains. Same idea, different outcomes, all as the result of conditioned patterns of thinking.

  Our ways of thinking can reflect conditioned responses; that’s how markets can control our minds.

  When we reinforce positive patterns, we not only strengthen these but also begin the process of extinguishing negative patterns. In behavioral theory, a stimulus-response connection is extinguished over time if it is not reinforced. The animal that was given food each time it performed a trick will eventually stop performing the trick if food is not forthcoming. Behavioral patterns, in this way, not only have to be learned but also actively reinforced to find active expression in our trading. We can unlearn negative behavior patterns simply by withdrawing their reinforcement and by introducing more powerful rewards elsewhere. This is a powerful principle.

  One common learned pattern among traders is the connection between anger/frustration and aggression. When traders become frustrated by market conditions—say, a chopp
y, directionless trade—they react out of anger and lash out by placing trades to get even with the offending market. This pattern—relieving anger by lashing out—may make traders feel better for the moment (negative reinforcement), but it leads to poor decisions and losing trades.

  How can we use positive associations to unlearn this pattern of revenge trading?

  Suppose a trader engages in a thorough examination of his trading during the choppy markets of the past month. He investigates charts to identify the choppy periods and then reviews all his trades from these periods, pulling out the most successful ones. What he may find is that his successful trades in choppy conditions are more selective (fewer in number); that they are placed near the edges of trading ranges; and that they are held for shorter periods of time to capitalize either on breakouts/false breakouts or on moves back within the range. His losing trades, on the other hand, tend to be placed in the middle of the range and are held for longer periods, reversing before they can hit distant price targets.

  Armed with this bit of self-coaching information, the trader now can view the choppy period as one of opportunity, not threat. When he notices a trading range going into the day’s trade, he can use imagery to rehearse calm caution when the market is trading near the center of the range. He can also mentally rehearse entries near range extremes, including his placement of modest price targets. When he rehearses these trade ideas, it is with the feelings associated with his prior winning trades. Over time, with repetition, he learns a positive association with range-bound, choppy markets. His prior behavior pattern, built on frustration and its removal, is no longer reinforced. It faces gradual extinction, as he builds the more constructive associative patterns.

  Find the market conditions that are most challenging for you and then identify how you trade them best. This process turns threat into opportunity.