The Psychology of Trading

by Brett N Steenbarger

  Most depressed traders identify losses as the source of their blues. They forget that many system traders lose money on half or more of their trades and endure occasional strings of multiple, consecutive losses. The difference is that the depressed trader has lost hope as well as money. The mechanical trader pushes forward precisely because losses are built into the system. With no mechanisms for anticipating or handling losses, the depressed trader sees no future and loses all motivation.

  Motivational suppression would be an accurate description for Sue's state of mind. School, her longstanding passion, no longer felt like the priority that it had been. The hopelessness that had no doubt engulfed her childhood friends was now descending on her. Why make efforts if they can go nowhere?

  "But why withdraw from school?" I asked Sue. "Do you really think this isn't the field for you? What are you going to do for a career?"

  Sue looked down, her voice barely audible. "Dr. Steenbarger," she said, addressing me as she might address a parent, "I have to go. I'm pregnant."

  The Enduring Pain of Self-Betrayal

  I valiantly tried to hide my shock.

  "I can't believe I let it happen," she said. "I was weak. Nana was gone, and this guy Kenny was really good to me. I felt I could trust him. And don't get me wrong. He's great. He says he'll go along with anything I want to do, and he says he loves me. But one night we didn't use protection, and that's it. I'm not getting rid of my child, and I can't be a mother in school. No way. I'm not going to do what my mother did. I'm going to be there for my child."

  I knew Sue's religion would dictate her response to the situation. She felt that she had committed one sin in her premarital pregnancy; she would not commit another by ending the pregnancy. But I had the feeling this was not the source of her greatest anguish.

  "You know," she sobbed, "when I found out, I felt so guilty. I thought to myself that it was good that Nana had died first. I don't know how I would have told her. I couldn't have stood to see the look on her face. She'd have been so disappointed in me. I can't believe how I've ruined everything."

  Loss is painful; guilt can be devastating. Worse than losing one's dreams is the knowledge that the loss was self-inflicted. Like many traders that have sought me out, Sue could overcome the dreams that had died, but not the ones she had killed.

  FINDING SOLUTIONS AMIDST PROBLEMS

  In the midst of experiencing problems, it can be difficult to focus on solutions. Guilt and shame were Sue's dominant emotions. Yet if ever she needed to draw on her skills as a survivor, it was now. Much of the change process in therapy consists of finding the solutions that lie between the problems. And Sue, I believed, possessed just such a solution in her love for her child. Was she contemplating dropping her education because she no longer wanted to be a doctor? Was she making the decision out of self-punishment?

  Of course not.

  Sue was going to leave school because she felt that it was the right thing to do for her child. She was pushing Kenny away because years of duress had taught her that men were not to be trusted. She wanted to be a parent like Nana, not a parent like her mother. And she would give up anything to avoid replaying her past—anything—which both creates her problem and opens the door to change.

  You see, the key to understanding Sue's dilemma lies in recognizing that her problem—her sudden desire to terminate her education and her rejection of the boyfriend who cared for her—is actually a solution. Sue survived a traumatic childhood by emulating her grandmother; Sue's way out of her misery was to adopt Nana's values and to please. Now, with a birth looming and her world shaken by the loss of her one supportive figure, Sue is doing the only thing she knows how to do: She is trying to be like Nana. Nana would not end a pregnancy; children were the priority in her life. Nana would not let a man ruin her life. This could only mean one thing to Sue: Her child must become the most important thing in her life. She must give up school for her baby. She must give up her man.

  This theme will be explored repeatedly in this book: Problems are solutions that have outlived their usefulness. Problems are patterns that were learned in emotional circumstances during one period of life and that now have taken an existence of their own.

  Take a concrete example: the trader who developed his methods during a long bull market. Buying dips consistently made him money. Now he finds himself buying weakness in a very different market. Those gaps and oscillators that seemed so reliable during the strong market now become traps for the unwary. Despite the indications that the trading methods are no longer working, the trader continues to do the only thing he knows. He adds to positions on the way down, only to be caught in a waterfall decline.

  Many times, outdated solutions replay themselves in a variety of life situations, leaving people mindlessly repeating their mistakes in work, love, and trading. The philosopher George Ivanovitch Gurdjieff taught that people are shockingly mechanical. Their repetitive patterns rob them of the free will that would otherwise be theirs. In a very important sense, the goal of therapy is the expansion of personal freedom, the capacity for self-determination. There can be no free will for people who are locked into patterns developed for past challenges.

  Sue, at the moment she was meeting with me, lacked a measure of self-determination. All she knew was that she had to be like Nana, regardless of the cost to her. Nana put children first; Sue had to put her child first. To do otherwise would be to defile her grandmother's spirit. At some level she realized that forfeiting her education would make it difficult for her to ever rise above the economic circumstances of her childhood. She even could see that continuing on the path of her medical education would make her a better provider for her child. And, deep inside, she knew that Kenny loved her.

  But all of that was intellectual. Emotionally, she could not countenance the idea of pursuing her goals. It wasn't what Nana did, and she had to be like Nana to survive. Sue's head told her to persevere in her studies and work things out with Kenny; her heart told her to give them up. Torn between priorities, wracked by learned helplessness—like a trader frozen in front of the screen—Sue could not take a step in any direction.

  ACCELERATING CHANGE BY DOING WHAT COMES UNNATURALLY

  My particular specialty is brief therapy: Instead of talking about issues and problems, which can take months and even years of weekly sessions, brief therapists seek to accelerate change by creating hard-hitting emotional experiences. The idea is that these experiences are processed more deeply than common conversation. As a result, they are readily internalized and can become the foundation for new patterns in day-to-day life.

  Years ago, I met with a young man who sought therapy because of his sense of loneliness and social isolation. He began the session by loudly declaring that he had no business in my office, that all therapists were fakes, and that counseling was a waste of time. I immediately leaped to my feet and expressed my joy that he felt the same way about the field that I did. There were too many unqualified, untrained therapists, I declared, and he was right to be wary of them. I then invited him to ask me any and all questions so that he could decide if I were qualified to help him. If I failed to answer his questions adequately, I told him, I would gladly refer him to a colleague who might have more to offer.

  I was not especially surprised when he only asked me two questions about my training and then dropped all protest. After all, I had passed his test by not responding defensively to his attack. It later came out in our meetings that he had been badly hurt in prior relationships. He had learned to avoid further hurt by pushing people away before they could reject him. But this solution had lost its value. It now left him lonely and isolated.

  By embracing the very behavior that was designed to push me away, I convinced him—in ways that words never could—that I would never reject him. To create that experience, however, I had to behave in a counterintuitive fashion. Was I put off by his abrasive attack? Of course! This repulsion, however, was my cue that I had to reach out to him. To b
e a good therapist, I had to be aware of my natural reaction so that I could act in precisely the opposite way. If I had shown him that I was miffed, I would have fallen into the same trap as everyone else, isolating him and destroying all hope for our work.

  Know what you're feeling and use that information to go the other way: Successful traders and therapists both learn to do what comes unnaturally.

  GOING AGAINST THE FLOW WITH SUE

  Of course, the natural response with Sue would be to try to convince her that she should continue on with her studies and bring Kenny into our sessions. However, she would hear this as a demand to betray her grandmother and would not only refuse, but possibly leave therapy altogether. No, the natural response would not do. It's like those situations we've all faced when a nice trend leaves the station and we're not on board. The market is moving, the trading pace is quickening, and every fiber of our being wants to pile on. But that's generally when a reversal is at hand. Once a trend is evident, the majority of players have made their move. It takes real discipline to notice your own urge to jump in and then use that information to wait, wait, wait for the retracement.

  That is what therapists do: They watch for those countertrend moves, the things that people do when they are not immersed in their problems. Few people are continuously dysfunctional; if they are navigating through life, they must have certain strengths and emotional capacities. It is valuable to focus on these: They are the foundation for solutions. A solution-focused approach to brief therapy is grounded in a simple understanding: The resolution to problems can be found in what people are doing when those problems are not occurring. If problems are the "trend" in counseling, the therapist waits for the countertrend move before making an entry.

  What is the natural thing to do when a person is crying in front of you, submerged in self-blame? Reassure them, of course. That, too, wouldn't work. Sue would toss aside comforting words because she wouldn't feel worthy of comfort. She has done wrong, and she must bear the consequences. But, remember, she would do anything for her child. That was Nana's way.

  "It's a shame you can't really be a parent like Nana," I said to Sue through her tears. "Nana enjoyed people; she loved being with you. You're not really enjoying this pregnancy are you? I bet if your baby knew how you were feeling, she wouldn't even want to come out of the womb."

  Sue's head jerked upward and she glared at me. "That's not true!" she insisted. "You don't know what I've been doing for my baby."

  "What have you been doing," I asked, "besides feeling that she was a big mistake?"

  Sue was unprepared for my tone of voice. I realized that if I were to reassure her, she would stay helpless, an object of pity. Under the lash of my criticism, however, she now sounded defiant, not depressed.

  "We've been making a collage," Sue sputtered.

  "A collage?" I asked in surprise. "What kind of collage?"

  "I want my child to know all about Nana," Sue stated with feeling. "We've been collecting pictures and letters and everything we can find of Nana's and putting them on a big poster board. When the baby's old enough, it's something we can look at together."

  My tone lowered a few notches. "That's beautiful," I said. "You're keeping Nana's spirit alive. And as long as your child learns that spirit and passes it along to her children, something of Nana will live on."

  I waited for a moment before asking my question in a near whisper. "Will your med school diploma be part of the collage? Will this be how you pass on to your child Nana's influence on your education?"

  Sue didn't respond. But neither did she argue.

  I picked my words carefully. "I love the idea of your collage. It will mean so much to your child. But I want to ask something of you. It's going to be very difficult, but you've got to do it for the baby."

  "What?" Sue asked quietly.

  "You've got to let Kenny contribute to the collage. I know you might not stick with him. That's your choice. But he is the baby's father, whether he's in your life or not. Your child deserves to know her story, where she came from. And maybe it will also be a way for Kenny to understand Nana and why you're making your decisions."

  Sue stayed silent for a long time. I could tell she was deep in thought. "Maybe," she finally said. "Maybe."

  FINDING SOLUTIONS

  With Kenny's help, Sue finished the collage. I know because they brought the finished product to me in a joint session. It was a true work of art.

  The process got Sue and Kenny talking. Sue wouldn't lower her guard for a man, but she would do it for her child. And once Kenny showed an interest in Nana, the two of them really began talking. Suddenly the relationship wasn't such a betrayal of Sue's upbringing. It could even become an extension of it.

  And, yes, Sue left space on the collage for her medical school diploma. Nana valued education; there was no getting around that! So Sue and Kenny would somehow have to make a good home for their child, even with the demands of work and school. Together they were determined to make it work. There was no more learned helplessness.

  A simple collage formed the basis for a solution. In the middle of her problems—pushing away love and education—Sue had hit on the idea of leaving her child a memorial to Nana. The key was extending this memorial to Sue's entire life. Sue, after all, would do anything for her child—even finish her education, even break down the walls and allow herself to love.

  Sue came to me focused on her problem. When she left, it was not with a solution that I had given her. Rather, it was with the realization that she had initiated a solution before we ever met.

  The problem with many traders is not that they have problems, but that they are focused on their problems. It is this problem focus that prevents them from appreciating what they are doing right, that blinds them to solutions already under way.

  THE FEARLESS TRADING INVENTORY

  In the introduction, I mentioned my debts of gratitude for the ideas contained in this book. If the truth is to be told, some of the greatest debts are to my trading failures. When I began as a trader, I believed that what I needed most of all were clean data, a reliable online connection, a good computer, and some well-crafted and well-researched indicators. I obtained all of those and more. I compiled a multiyear database of intraday data for backtesting short-term trading strategies. I obtained decades of market data for examining longer-term market patterns. Not satisfied with normal statistical analysis, I purchased the finest modeling software to ferret out nonlinear patterns in market time series. I read the gurus and compiled an enviable library of books on trading.

  And I lost money.

  Consistently.

  It was a sobering experience. I am a reasonably bright individual, with two advanced degrees to my name. It was humbling, but I had to acknowledge the truth: State-of-the-art tools and IQ points were not going to make me into a trading success. I had the raw materials for success and occasional flashes of promise, but something was getting in the way of making the most of them.

  I have the greatest respect for individuals in Alcoholics Anonymous who undertake a "fearless moral inventory." It takes considerable courage to stand in front of a group of people and announce, "My name is Brett, and I am an alcoholic." Even greater courage is required when it comes time to review one's life and the many hurts and wrongs that have been inflicted due to one's addiction. Such a moral inventory is a look in the mirror with eyes wide open. Not many people can tolerate speeding up their personal production process and, like those Japanese automakers, tackle their shortcomings.

  I knew, however, that unless I conducted my own fearless trading inventory, I would never take my market game to the next level. So I reviewed my trades, one by one, the winners as well as the losers. I searched for patterns: What did my winning trades have in common? What were the repeated elements in my losing trades?

  It was not a pretty sight, but it was educational.

  What I found was that my actual trading methods did not differ wildly across the winners and
losers. I tended to utilize the same market indicators and to piece them together in similar ways. I maintained a core data set and largely relied on this for my trading decisions. These methods had worked well for me in historical backtesting and in paper trading. That suggested an important conclusion: I could succeed or fail with the methods I was using. Developing new and more intricate methods was not necessarily the answer.

  The patterns I detected among the winning and losing trades supported this impression. Several conclusions jumped out from my diaries, as I inspected the assembly line of my trading.

  •I was not consistent in my position size. Too often, I increased my size after a series of successful trades, only to take a large hit when the inevitable losing trade occurred. As well-known trader Mark Cook noticed early in his trading, it is possible to have a respectable overall batting average but still fall short if the size of the losers relative to winners is badly askew. When I placed small trades—so small that the profits and losses almost didn't matter—my percentage of winners was quite respectable. My batting average was painfully lower on large trades.

  •I was not consistent in my preparation. The single most outstanding feature differentiating my successful trades from my unsuccessful ones was my state of mind during the trade. Winning trades tended to follow from hours of immersion in market data, accompanied by active rehearsals of what-if scenarios. Losing trades were made much more impulsively, without either the focus or the preparation of the winners. Perhaps this sounds mystical, but when I was immersed in the market and my research, winning trades came to me. I wasn't looking for the trade; it simply appeared to my conscious mind with a deep, inner feeling of certainty. The losing trades were trades that I attempted to impose on the market. Once I had made my mind up that I was going to trade that day, I found it easy to talk myself into all sorts of patterns and rationales for entering and exiting positions.