The Psychology of Trading

by Brett N Steenbarger

  •I was not consistent in my execution. I am a short-term trader, and I have always been best in that mode. When I reviewed my track record, however, I discovered a disturbing tendency to let losing trades turn into longer-term ones. Invariably this magnified, not rectified, my losses. Ironically, I was most apt to let the short-term trades run when my drawdowns were greatest, almost ensuring that I would wipe out many days of profit in a single, botched trade.

  •I was not consistent in my perspective. Very often, during trades that ended up as modest losers, I became so immersed in tick-by-tick action that I failed to pay attention to the larger trend. Many trades that would have become large winners were cut short this way. On the successful trades, I tended to work from the top down, aligning my shorter-term positions with the larger trend. At other times, amazingly, I became so caught up in the tick-by-tick action that I placed trades without having even looked at the big picture!

  • I was not consistent in my exits. On average, I spent far longer analyzing when I should get into the market than how I should get out. The absence of an explicit exit strategy for every likely market scenario left me rudderless at those times of drawdown when I most needed guidance. A significant proportion of my losing trades would have become winners had I followed a planned and tested exit strategy. With the exception of those occasions when I allowed short-term losing trades to become longer-term ones, I tended to be overly risk averse. I cut profits short and tolerated so little drawdown that positions did not have ample opportunity to move in my favor.

  The results of my fearless inventory stared me in the face. They could be condensed to a single word: consistency. Despite everything I had read about cutting losses, letting profits run, and preparing for each day's trading, I was inconsistent in almost every facet of my game. Worse yet, I hadn't realized I was so inconsistent. Somehow I had talked myself into believing that because I read a great deal about the market, collected megabytes of data, and poured over reams of statistics and charts, this meant that I was working hard and was well prepared. Nothing could have been further from the truth.

  But why? I am hardly undisciplined. If I can wake up at 5 A.M. each morning, teach my classes, conduct my counseling practice, amass 50+ professional publications, carry on my trading, and maintain a family, surely I can muster the energy and the focus to create and to adhere to a trading plan! No, something was getting in the way. Something was robbing me of the focus I needed. Like Sue, I had the nagging, guilty sense that when it came to trading, I was my own worst enemy.

  AN INVENTORY OF SOLUTIONS

  What followed was an intensive period of ruthless, real-time self-observation and evaluation. My goal was to isolate those factors most responsible for maintaining or for losing my trading consistency. I realized, in a humbling moment, that my problems were not unlike those of clients I saw in counseling, people who had difficulty sticking to plans to stop smoking or maintain a diet. Helping them with their problems gave me fresh perspectives on my own. The problem was not one of trading per se. It was more fundamental: a difficulty in sustaining effortful, purposive activity of any type.

  An important clue to the dilemma was the fact that my trading results were far better when I made small trades than when I made larger ones. When the trades were small, I was much more likely to tolerate normal drawdowns and let profits run. Because the amount at stake—and the amount to be gained or lost—was modest, I felt no need to micromanage the trades. On reflection, I also realized that I tended to place the smallest trades when I was first testing out new trading ideas. Those were the times when I was most immersed in my homework and in the markets. They were also the times when I had best followed the advice of Victor Niederhoffer and kept my trading methods simple, data-based, and direct.

  The fearless trading inventory was modesty inducing, to be sure. But it helped to be reminded that when I kept my positions small, my methods direct, and my head in the market, I was capable of placing some very good trades.

  That recognition led to a solution focus to my market woes. As we saw with Sue, it is often helpful for therapists to not focus exclusively on their clients' presenting problems, searching instead for exceptions to the problems. If a couple seeks counseling for marital disputes, it is worth delving into occasions when they do not argue. Eating problems? Depression? Solution-focused therapists take the path less traveled: They ask about times when the person does eat in a healthy way or about occasions when they are happy. Sue's collage was her exception: a healthy attempt to face her issues rather than to push them away.

  The solution-focused approach works because it utilizes a person's existing strengths as a lever, making weighty problem patterns easier to lift. Couples in counseling are often amazed to find that they go for lengthy periods without arguing. Depressed people have so taken on the identity of being depressed that they fail to appreciate the frequent intervals during a day or a week when they are not down. Once people can turn their mindset from a problem focus to a solution focus, they can identify the adaptive things that they are already doing and do more of them.

  This is a very important concept: You will not become a better trader by emulating a market guru. You will become a better trader by identifying the occasions when you are already trading well and then modeling your future performance on those. If you are struggling with your trading, thinking of hanging it up (like Sue), you need to identify your own collage—the things you are currently doing that break your problem patterns.

  When you learn to trade from the couch as a psychologically sophisticated market participant, you don't become a different trader. You become more of the trader that you already are in your best moments. In a very real sense, every trader who has done his or her homework has at least two selves: the one capable of entering the zone and executing his or her strategy; the other so filled with inner urges, fears, and conflicts that the trader winds up trading less in the zone than the ozone. It is interesting that by the time frustrated traders look to psychology for help, they are more in touch with their destructive patterns than with their competencies. The most helpful part of a fearless trading inventory is the firsthand recognition that, even amidst failure, one does indeed harbor the seeds of success.

  ENACTING THE SOLUTIONS

  You know streak shooters in basketball? Unfortunately, I tend to be a streak trader. I can go through periods of incredible feast and withering famine. At the time I am writing this, I am on a particularly hot trading streak, with about three-quarters of my trades profitable and a net average of several Standard & Poor's (S&P) points per trade. It is at such times that it might seem that keeping a trading journal is least necessary. The solution-focused mindset, however, suggests just the opposite. It is when you are enacting exceptions to problem patterns that you most want to be mindful. If you are meeting with consistent success, the odds are good that you're doing something consistently right. Psychologically minded traders create models of themselves at their best and then consciously strive to embody those models. A great man, Nietzsche once remarked, is only the play-actor of his ideals. That is a wonderful formula for life and market success—to become the play-actor of your own highest strivings.

  At first, it does indeed feel like play-acting. The fearless trading audit raised my awareness of many subtle factors associated with successes and failures. For example, the physical comfort of my back and my right hand was highly correlated with the eventual success of trading positions at those times. When I placed high probability trades with proper preparation, I generally felt comfortable with my decision and sat comfortably in my chair, occasionally clicking on different charts and tables to monitor the progress of the trade. When I placed trades for the wrong reasons or with improper preparation, however, I found myself prematurely concerned about their success. I leaned forward in my seat and began furiously clicking charts in a frantic attempt to bolster my confidence in the trade. Eventually, my hand and my back hurt from the hunched-over mouse action. Our
bodies often know how our trades are faring more quickly than we do!

  Play-acting entered the picture when I consciously adopted a relaxed position when preparing and entering trades. Over the daily course of trading, one can create a powerful association between state of body and state of mind. Entering a facilitative physical state is one of the quickest ways of placing oneself in a winning frame of mind. This principle is well understood by basketball players or major league pitchers who perform little routines before taking a foul shot or delivering a pitch. The ceremonies of religion are similarly filled with such rituals and symbols, as are such formal social occasions as weddings. Once a state of mind has become anchored to a ritual, we need only invoke the ritual to summon the desired state.

  Particularly powerful results can be achieved if you can develop rituals out of the patterns you observe during your most successful trading and avoid those patterns associated with trading failures. Once again, think of Sue and the way she was able to expand her collage to include her education and her relationship with Kenny. Even the solution that seems the smallest can serve as an anchor for life-altering change. Here are a few "solution" rituals that emerged from my self-observation:

  •Taking breaks from trading. Active traders tend to balk at taking vacations. Vacations entail time away from the markets, which means lost opportunities. Nothing is more frustrating than a big move that occurs while you're away from the action, oblivious to the markets. Nonetheless, I have found that trading is especially successful after an extended break. The change of routine allows you to return to trading with a fresh perspective and to perceive patterns that would otherwise not have stood out. Many active traders take breaks around midday (when the markets are least volatile), indulging themselves in activities that are highly noncognitive, such as physical exercise. The renewed energy becomes critical in those later-day situations in which it becomes necessary to sustain concentration for extended periods.

  •Immersing oneself in what-if scenarios. My audit found that the amount of time spent in pretrade preparation was positively correlated with the success of trading. It appeared to be the quality as well as the quantity of time spent that mattered for success. As a result, I initiated a daily ritual of looking over the past several years at all days that were similar to the current market. Statisticians refer to such occasions as "nearest neighbors." If today's market declines on high volatility following three days of flat, low-volume market action, I will scour my database for all occasions when this pattern occurred in the past. I will then print out one- and five-minute charts of each of those occasions and review patterns that emerged in subsequent market action. This qualitative exercise primes my mind for things to look for in the coming trading session. As Yale and Jeff Hirsch note in their Stock Trader's Almanac, drawing on Pasteur, "Chance favors the informed mind."

  •Playing loose. I have found that if I am loose during the day, I am most likely to be flexible in my thinking and quick in responding. It is when I am tense and take things far too seriously that I am apt to freeze up and compound a situation that has gone sour. One of my trading colleagues, Henry Carstens, frequently marvels over what a great "game" trading is. It is not surprising to me that he is successful: He plays with trading ideas as spiritedly as he plays with his little son, Everett. Another trading colleague consistently describes trading as a battlefield. It is not surprising that he seems to experience post-traumatic stress with each loss, setting him—and his equity curve—back for considerable periods. Many successful traders learn to keep loose at the trading station in the same way that boxers or ball players stay loose before and during their contests: with uplifting music, banter with friends, and pregame warmup drills. I have recently begun using biofeedback for this purpose.

  •Achieving nonattachment. There is a Buddhist principle that states that suffering comes from one's attachment to the things of this world. As soon as you need something, or need something to occur, it gains control over you. For traders, a most deadly scenario results when they need trading results to bolster their self-esteem. My audit convinced me that I was at my best when I didn't need the trades to work out. Indeed, my best trades were ones that were so small that it didn't really matter all that much (in the financial sense) whether any particular one was successful. One of Jack D. Schwager's market wizards, Larry Hite, observed that he had no war stories to tell his colleagues. Every trade represented no more than one percent of total equity, and every trade was like every other one. That is a worthy model of trading psychology: Do a few things well, and perform them often and consistently. Confidence does not result from positive thinking; it results from the ability to face defeat with equanimity and to avoid attachment to market outcomes. Like sex, trading is most enjoyable and fulfilling when participants are immersed in the process rather than concerned about outcomes.

  • Creating symbols. A symbol is an object that acquires meaning through its association with something significant. The flag is a symbol of one's homeland and crystallizes all that that represents. Depending on one's philosophical proclivities, the dollar sign is either a symbol of the root of all evil or the source of the accomplishments that emerge from personal initiative. Successful traders create their own symbols, immersing themselves in the mindset of success. One practice I have found especially helpful in this regard is to periodically withdraw a portion of profits from the account and use the proceeds to purchase something special for myself or for loved ones. This may be a prestige or a luxury item on which I would not normally splurge, but which is associated with achievement. Some may deride such accumulation as mindless materialism, but this criticism fails to appreciate the psychology of the symbol. Your surroundings are both a mirror of and a contributor to your mind-state; by surrounding yourself with the earned rewards of effort, you transform your very environment into a celebration of self-efficacy.

  As you conduct your own fearless trading inventory, you may discover different solutions associated with your trading successes. Trading from the couch challenges you to alter the problem focus and to examine what you're doing when you're not trading poorly. Like Sue, you might just discover that you are creating a work of art without even recognizing the fact!

  CONCLUSION

  Perhaps you picked up this book because you are not content with your market results. If so, that is good. The research literature in psychotherapy suggests that people with moderate levels of distress are most likely to benefit from help. Too much distress leads to shut down; too little pain takes away the incentive for change. Your failures are there for a reason; like those carmakers, you have something to learn when your efforts fall short of expectations. Such a celebration of defeat best positions you to identify your strengths—the solutions you may be enacting without your conscious awareness.

  David Bowie once sang of being heroes just for one day. Perhaps Norman Mailer was closer to the truth when he described every person's "15 minutes of fame." No matter: A single enactment of greatness can set a template for a lifetime. The first step in transforming yourself as a trader is conducting the most honest, fearless inventory possible, assessing each and every defeat and victory. Examine your patterns: What were you doing wrong in the losing trades? What worked in the winning trades? Each of these patterns has a purpose: to teach you something about your trading, something about yourself.

  This fearless inventory will require an extensive trading journal that you can review at the end of each week. The journal should include the trades you made, the research-based rationale for the trades, your profit targets, your stop-loss parameters, your frame of mind during the trades, and the outcome of the trades. Each week you will grade yourself on how well you actually followed your trading plans, and each week you will conduct a review of what you did right and what you did wrong. The goal is to create a feedback loop of continuous quality improvement in your trading.

  Note that in keeping such a log, the focus is not whether each trade made or lost money. Rather,
the emphasis is whether you did your homework and followed your trading plans. Good percentage trades can lose money; occasional impulsive trades can be winners. You cannot control whether the next trade will win or lose. All you can do is tilt the odds in your favor through solid research, formulate plans that utilize that research, and place enough trades for the odds to work in your favor over time. In a very real sense, your goal is not to make money. Your goal is to be faithful to your trading plans. If they are solidly grounded, the money will come. If your plans are not solidly grounded, this too will emerge in your trading journal and can prompt you to re-search for your edge.

  Find the exceptions to your problem patterns—the times you are doing things that bring you closer to your goals. Then turn those exceptions into solutions by doing more of them. That is the solution focus. Sue was able to love by building on her one loving act: the collage. Traders will be able to trade by building on their successes, becoming more of who they already are at their best.

  *The names and identifying details of all clients and characters in this book have been altered to protect anonymity and confidentiality. To further protect my clients' privacy all of the cases and incidents described are composites of actual counseling cases. I have endeavored to preserve the essence of those cases, even as the creation of composites introduced elements of fictionalization into the accounts.