The Psychology of Trading
Behavior is patterned. Beginning with this premise, noted clinical psychologist and active trader Dr. Brett Steenbarger opens the therapist's door, demonstrating how traders can identify, interrupt, and change the problem patterns that interfere with successful trading. In The Psychology of Trading, Dr. Steenbarger draws upon real-life case studies and offers hands-on techniques for emotional change to assist traders in becoming their own therapists. Themes that set The Psychology of Trading apart include:
•"Trading from the couch" by utilizing emotions as valuable market data
•Identifying and building solution patterns that capture hidden trading expertise
•Techniques for assessing and trading against the emotions of market participants
•Methods for building focus and concentration for more automatic and trustworthy trading decisions
•Creating shifts in states of consciousness to rapidly exit anxious, impulsive, depressed, and guilty frames of mind
In an engaging manner that provides practical solutions to real trading problems, Dr. Steenbarger walks you through the most common cognitive and emotional tendencies that distort efforts at identifying and trading market patterns. He then describes specific skills derived from years of brief therapy practice to help you become an effective observer of these tendencies and gain control over them. By blending state-of-the-art research from psychology and cognitive neuroscience with detailed case studies. The Psychology of Trading provides you with the intellectual and emotional ammunition to face yourself and transform your approach to risk and reward.
BRETT N. STEENBARGER, PHD, is Associate Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, New York, where he also serves as the Director of Student Counseling. Dr. Steenbarger has published over fifty peer-reviewed journal articles and book chapters on topics related to brief therapy, including standard reference entries in The Psychologist's Desk Reference and the Encyclopedia of Psychotherapy. He teaches techniques of counseling and psychotherapy to graduate students in counseling, doctoral students in clinical psychology, and residents in psychiatry. An active trader who conducts his own statistical market modeling research, Dr. Steenbarger has written feature columns for MSN's money site (www.MoneyCentral.com), many of which are archived at www.greatspeculations.com.
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THE PSYCHOLOGY OF TRADING
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The Wiley Trading series features books by traders who have survived the market's ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional, or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future.
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Copyright © 2003 by Brett N. Steenbarger. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
Steenbarger, Brett N.
The psychology of trading : tools and techniques for minding the markets / Brett N. Steenbarger.
p. cm.—(Wiley trading series)
ISBN 0-471-26761-9
1. Stocks—Psychological aspects. 2. Speculation—Psychological aspects. 3. Investments—Psychological aspects. I. Title. II. Series.
HG6041.S76 2003
332.64'01'9—dc21
2002190744
10 9 8 7 6 5 4 3 2 1
For Margie,
who has made it all possible
Preface
In our debts to others, we find the true measure of our wealth.
If there is a single theme to this book, it is this: Trading is a microcosm of life.* In trading, as in life, we pursue values. In both trading and life, we manage the risks of those pursuits: lost opportunities and realized losses. How we seek values and manage the associated risks will determine our personal and professional success.
Many times, our responses to the uncertainty of outcomes interfere with the achievement of our goals. In careers, romantic relationships, and trading, we find ourselves enacting self-defeating patterns: cutting promising situations short and lingering in unprofitable ones. It doesn't matter that we are virtuous people, hardworking and otherwise successful. It doesn't matter that we have attended all the latest seminars, read the hottest books, and purchased all the best trading tools. If our coping with risk distorts our efforts at pursuing values, we will fail to attain the stature that can be ours—as traders and as human beings.
For the past 20 years, I have provided counseling and therapy services to approximately 130 people a year. Almost all of these people have been high-functioning individuals tackling demanding career fields. I learned during these years of practice that the problem patterns of physicians, executives, students, and traders are surprisingly similar. These patterns arise when strategies for emotional risk management—efforts to minimize pain and maximize pleasure—fail to make it possible to successfully navigate life's matrix of risks and rewards. Every problem pattern we experience is a once-successful coping effort that has outlived its value. Conversely, newly created patterns that meet life's
present challenges lead to success. We are best positioned to achieve our goals when we can extract ourselves from the mindless repetition of the past and fashion fresh life solutions.
The purpose of this book is to help you identify your patterns of success and failure and exercise greater control over these. My deepest hope is that the case studies, the research, and the ideas contained in these pages will provide you with the intellectual and emotional ammunition to face yourself and to transform your approach to life's risks and rewards.
The following pages can help you cultivate new ways of thinking, feeling, and acting; but they cannot perform magic. For the trader, no amount of psychological assistance can substitute for concrete trading plans that have been tested across a variety of markets. As Robert Krausz neatly stated in his New Market Wizards interview with Jack Schwager, self-help methods by themselves can no more make you a great trader than they can make you a great chess player or baseball star. You can only learn to master the markets by immersing yourself in the markets.
Indeed, there is a sense in which the process of developing and testing your market strategies is the best of all methods for cultivating a positive trading psychology. Many traders fail with mechanical systems simply because they cannot tolerate the inevitable periods of drawdowns or flat performance. When you create and test your own approaches to the market, you develop an inner knowledge of how those methods work. During periods when the market throws a curve ball, your confusion is more readily replaced by the sense of "been there, done that." Nothing substitutes for the confidence born of experience.
Still, it is difficult to underestimate the degree to which traders can utilize identical trading methods and arrive at wildly different results. Possessing the right tools is necessary, but not sufficient, for success. As Krausz observed, traders have an uncanny knack for acting out their repetitive and destructive emotional patterns in their trading. Such enactments will derail even the most carefully constructed and tested systems.
An important goal of this book is to help you approach trading the way a psychologist approaches his or her clients. I call this "trading from the couch," which means learning to utilize your thoughts, feelings, impulses, and behavioral patterns as market data. Trading from the couch entails an important shift from traditional thinking. Instead of trying to overcome or eliminate your emotions, this self-aware trading calls on you to learn from your reactions. Your goal is to turn yourself into a finely calibrated instrument for detecting and acting on the patterns of both the trader and the trading.
Note that cultivating such sensitivity does not mean simply going with your feelings in placing orders! As you will see in the coming pages, it often means the opposite: learning to use excess confidence and risk aversion as valuable contrary indicators. Surprisingly often—for the trader, as for the therapist—acting counter to one's initial impulses is the winning move.
In trading from the couch, you become your own psychologist. That is not an easy task in the markets or in everyday life. The rewards, however, are considerable. Trading, like competitive sports, is a powerful crucible for cultivating the emotional skills crucial to life success. In few arenas are the pursuit of values and the management of risk so tangible and immediate. Nothing so drives home lessons in self-understanding as brutal hits to one's bottom line.
Self-aware trading also presumes a vital symmetry: In mastering the markets, you can further yourself as a human being; and in developing yourself as a person, you can enhance your trading success. Once you are able to extract the information contained within your emotional, cognitive, and behavioral patterns, you will be better equipped to identify and to exploit the patterns that appear in the financial markets—and vice versa.
BRETT N. STEENBARGER
Fayetteville, New York
November 2002
*The term trading is used in this book to cover all active forms of managing one's financial investments. Anyone who attempts to time investments, whether over hours, days, weeks, or months, is a trader.
Acknowledgments
My appreciation for the emotional intricacies of trading expanded exponentially when I began writing trading psychology columns for a web site that was known as Worldlylnvestor and for MSN's Money site (www.moneycentral.com). In response to those columns, I heard from traders around the world who were experiencing difficulties strikingly similar to the ones I had encountered in my years of trading. Some of my correspondents were neophytes, trading by the seats of their pants, engaging in little more than gambling. But most were dedicated practitioners, who had dutifully read books, learned trading methods, and undertaken their own research. With remarkable frequency, I heard the plaintive refrain: Inconsistency was robbing them of profits and exposing them to occasional, debilitating losses. It is difficult to express how frustrating trading can be when success seems so tantalizingly close and yet remains ever so elusive.
How is it that we can know the right things to do—regular exercising, healthful eating, good parenting—and yet so often fail to follow through? What distorts our trading, preventing us from acting on the information clearly in front of our eyes? These are the questions that have haunted me for nearly two decades as a professional psychologist and market participant. My attempts to answer them have taken me from the literature on trading and psychology to philosophy and leading edge research in cognitive neuroscience. If I have accomplished anything in this book, it is in synthesizing contributions from these fields, contributions that are far worthier than my own.
Authors face a curious paradox indeed: With each intellectual debt accumulated, they are enriched manyfold. In that regard, I feel wealthy indeed, having benefited from the insight and the assistance of many inspiring influences.
My first forays into writing about the markets came through the Speculator's List, an online group of traders, money managers, academics, and accomplished individuals in the arts and sciences. I am forever indebted to Laurel Kenner, Victor Niederhoffer, and James Goldcamp for their role in establishing the List and for their kind encouragement of my many posts to the group.
When I needed to understand the dynamics that distinguished successful from unsuccessful traders, Linda Raschke was incredibly supportive, allowing me to study the many individuals who participated in her seminars. I quickly found that Linda was a worthy model of exemplary trading and an accomplished mentor. I am deeply grateful for her friendship and for her insights into the business and human sides of trading.
Some of my most important influences have been those who have pushed me to write with ever greater clarity and precision. Jon Markman, editor at MSN Money, has been a valued friend and colleague, as well as a role model for his trailblazing research. The book has greatly benefited from my editor at Wiley, Pamela van Giessen, whose humor, practical bent, and commitment to quality have carried me through the long writing process.
To be sure, none of this would have been possible without the salutary influence of my academic colleagues in the Department of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University, most notably Roger Greenberg, Mantosh Dewan, and John Manring. My good friends and trading correspondents Henry Carstens, Saurabh Singal, and Steve Wisdom have enriched this book with their inspirations and ideas. I am also indebted to Mark Mahorney for his excellent work on the Great Speculations site (www.greatspeculations.com) and to Frank and Kris Linet, Susan Niederhoffer, and Arnold and Rose Rustin for their warmth, humor, and insight. To Yale Hirsch, Andrew Lo, Sam Eisenstadt, and Jeff Carmen, my hat is off in salute and appreciation for their exemplary research and personal support.
Finally, I gratefully acknowledge my family for their ongoing love and encouragement. My parents, Jack and Connie, have been role models and inspirations for longer than they realize. The support of Marc, Lisa, Debi, Peter, Steve, Laura, Ed, Devon, and Macrae has meant more than I can express. But no single person deserves credit for this book more than my wife, Margie, who has taught me most of what I know a
bout life, love, and the navigation of risks and rewards. It is my greatest joy to dedicate this book to her.
A VIEW FROM TALL SHOULDERS
I count July 4, 2001, as a special day. That marked the completion of the first draft of this text. Until that day, I hadn't explicitly identified why I had written the book. Yes, I had wanted to share insights and ideas, but that wasn't the major purpose. After all, I had written the book with no publishing contract in hand. And although I wanted to see it published, it was clear to me that the writing held a personal significance beyond its status in the marketplace.
On July 4, sitting in a Seattle hotel lobby with laptop at my side, I suddenly recognized the source of that personal significance. Feeling the need to capture my insight in words, I took out the laptop and composed the following letter to my friend and mentor Victor Niederhoffer:
Dear Victor,
Nothing is quite so conducive to reflection as travel. The combination of distinctive scenery and breaks from normal, daily schedules helps us think in new ways, see things in a new light. What we vacate during vacation are our routine ways. It is during those breaks from the routine that creative impulses are most likely to find expression.
This was particularly evident to me during this past holiday, as I brought my book manuscript on a trip to the West Coast. I expected that the writing would find inspiration on the road, and I anticipated that the writing would be most enjoyable without the distractions of the workaday world. I was not disappointed in these respects. More surprising, however, was my emotional reaction to the writing. As I crafted page after page, I found myself experiencing a profound humility. I recognized, with a deep emotional certainty, the extent to which so few of my ideas were truly original. With each line I could recognize an inspiration from another source: a teacher or mentor, a book I had read, a piece of research I had studied, a personal hero. There was little on these pages that was truly my own. Instead, the writing was a synthesis of what I had absorbed from those greater than myself. At a profound level, I could appreciate Newton's statement that if he had seen farther than others, it was because he had stood on the shoulders of giants.
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