The Psychology of Trading

by Brett N Steenbarger

  How do some people work long hours each week, undertake multiple projects, and yet seem to have the time and the energy for social and family concerns? To an outsider, such a life seems exhausting. The answer, which is difficult to comprehend until you have experienced it, is that significant efforts release more energy than they consume. The breakthroughs at the second and third and fourth winds open you up to new wellsprings of vitality. Without the intensity of practice, however, those wellsprings remain closed.

  The bioenergetic psychologist Alexander Lowen has written extensively on the practice of having depressed patients lie on their bed and pound away on their mattress, hitting with their fists and kicking violently with their feet. During this period of at least 25 good hits and kicks, the patients are told to scream as loudly as they can whatever enters their minds. Many—especially those who have been mistreated—end up verbalizing considerable rage. After this exercise (which I invite you to try for yourself), it is not at all unusual for the patients to feel that their anxiety and depression has left them. Where they were once lethargic and caught in negative thinking, they now feel more alive and energized.

  Simply sitting in a chair and raising one's voice a notch cannot duplicate Lowen's exercise in the bed. It is the radical departure from your daily norms that breaks you out of old modes, opening the door to new ones.

  THE TRADER AS ADDICT: BREAKING STOPS

  Perhaps no trading situation so exemplifies the distortion of information processing wrought by emotions as the failure to honor stops. One web site for educating traders, Ken Wolff's Mtrader, has even compiled an Alcoholics Anonymous–inspired 12-step program for those who chronically violate their stops. This is quite insightful. The pattern of overconfidence, getting away from basics, falling off the wagon, and then facing guilt and remorse makes problem trading and recovery from substance abuse very similar.

  For active intraday traders and especially scalpers, it is rare indeed for a large gap to force an exit from a position. Most large losses begin as small losses that are allowed to magnify over time. Once those losses occur, they often are processed as failures, with accompanying emotional and physical arousal. Under the aroused conditions, the trader now becomes focused on winning back the lost money and undoing the failure. Instead of honoring his or her stop, a different set of priorities takes over.

  A significant proportion of traders with whom I have talked make the lion's share of their money from a relative handful of good market moves. Many of their trades are narrow winners, narrow losers, or total scratches. If, however, they fail to honor stops, those occasional big winners will be balanced by one or two large losers, which will undo many weeks of good trading. Although there may be room for a measure of discretion in entering trades, the use of discretion in honoring stops is a slippery slope that leads to trading ruin.

  The stress inoculation exercise mentioned earlier is tailor-made for rehearsing the honoring of stops. Indeed, I have found that a large percentage of my winning trades begin with a rehearsal of negative, what-if scenarios in which I mentally invoke my stop strategy. Conversely, I have found that my worst trades begin with an estimate of my potential profits. By mentally rehearsing stop strategies under conditions of relaxation and cognitive focus—playing movies in your head of experiencing a drawdown and honoring your stops—you can make the minimization of losses an automatic part of your behavioral repertoire. In a very real sense, you want to normalize the process of losing; making it so familiar that it is no longer threatening. Uncertainty is built into the market; losses are a cost of doing business. By rehearsing them and your responses to them, you can greatly dampen your emotional reactions over time.

  BECOMING MORE RULE-GOVERNED IN TRADING

  Recall the situation of the child who is experiencing attention deficits and hyperactivity. School becomes challenging in the face of these difficulties, so teachers typically try to structure the child's setting by emphasizing rules and expectations for behavior. Putting rules into verbal form allows the child to hang onto them and to call them to mind in otherwise distracting circumstances.

  Rules in trading serve a very similar purpose. By emphasizing and rehearsing trading rules, traders are more likely to bring them to mind during emotional, volatile times of trading. A survey of the major sites for live training of traders, including those of Linda Raschke and Ken Wolff, suggests that these sites develop explicit rules for traders, which are then reinforced through the presentation of multiple examples.

  The formulation of explicit rules for exiting trades is an especially powerful way of moderating the influence of emotional trading events on behavior. Generally, these stop rules fall into one of three categories:

  1.Price-based rules. These are the most common stop rules, often formulated as a fixed-dollar amount or a percentage that a trader is willing to lose on a given trade. The price-based rules may also be formulated on the basis of perceived support or resistance, in which a particular price target acts as the stop. This latter strategy can be dangerous in the S&P and the Nasdaq futures markets, which feature frequent false breakouts of obvious support and resistance areas. For this reason, I am least fond of price-based stop rules, utilizing them as last-ditch mechanisms for avoiding catastrophic losses.

  2.Indicator-based rules. These use levels of a market indicator, rather than price alone, to dictate the exit point. A hybrid indicator/price strategy might adjust price-based stops for the current market's level of volatility. If, say, the market moves against the trader by two standard deviations from its last X period average, this could be construed as a nonrandom (trending) move and trigger a stop.

  Other indicator-based rules may dictate exits when a market predictor reaches a predefined level. I have found, for instance, that if the NYSE Composite TICK makes a significant (two standard deviations) breakout from its two-hour average, the trend of the breakout tends to continue for the next five hours. Accordingly, I will stop any position after the TICK significantly breaks out of its range in a direction opposite my trade. Many times, the TICK breakout will occur prior to my price-based stop, allowing me to scratch an otherwise losing trade.

  Indicator-based rules can also act as profit targets to facilitate market exits. Very often, as I mentioned earlier, I will exit a trade on significant range expansion with high volume. Although I may miss the exact high or low with such an exit, I generally find that closing positions during panic buying or selling is a wise strategy. Similarly, a very high level of ticking action in the Dow Jones Industrial Average (the Dow) stocks (as measured by the TIKI—the cumulative total of upticks and downticks in the Dow industrial stocks) often occurs at short-term market extremes fueled by institutional buying and selling and can serve as a target for exit.

  3.Time-based rules. These are among my favorite stop rules because they are embedded in the very trades that I research. For example, suppose the market has made a steep two-hour decline on sharply negative TICK early in the morning. This has followed a flat day, breaking to a new low relative to the previous day. I will immediately query my historical database to see how similar markets have performed, say, five hours out into the future. If there is a significant directional bias (perhaps trend continuation, in keeping with the TICK breakout finding), I will then plan my strategy for selling rallies within the coming five hours. If, however, my position does not reach its target profit level in that five-hour period, I close out the trade—regardless of where price is located. To me, this is among the most rational of stops because it suggests that the edge that I had researched is no longer present.

  There is a more subtle reason why this exit strategy works, however. Let's say that I am anticipating downside trend continuation for the next five hours but only get a relatively flat move. In such circumstances, I have generally found that my research was right: The flat move was the downside trend continuation that I had anticipated. Because it was so shallow, however, I have a sign that the market may be strengthening. This may al
ert me to investigate breakout moves to the upside for a possible long trade. In other words, the failure of the market to live up to its historical tendencies can serve as a signal for a counter-trend trade.

  By grounding trading in explicit rules that address price, time, and indicator levels, the trader can rehearse concrete strategies even during the most turbulent trading times. If there is one winning strategy I can recommend wholeheartedly for dealing with emotional trading, it is becoming more rule-governed. The kind of historical analysis utilized by Jon Markman in his studies of monthly sector strength and weakness, by Yale and Jeff Hirsch in their research of calendar patterns of market trends, and by Victor Niederhoffer in his statistical analysis of past markets and prospective market moves is a powerful antidote to subjective, impulsive trading. It is in this sense that Niederhoffer's research admonition "Statistics on the table!" is also excellent therapy for the trader.

  USING EMOTION TO MAKE THE CONTRARY MOVE

  A useful perspective is that if you are feeling cocky or fearful about the market you're following, the chances are good that other traders are having similar feelings. If a downside move is unnerving you and you then notice a wide-range downside movement on the S&P E-Mini chart with a significant expansion of volume, you have real evidence that traders are bailing out of positions. At such times, I use my emotion as a cue to revisit my research, querying my database for all recent times in market history when a similar sell-off occurred and examining what happened subsequently. Very often, I will find a directional bias contrary to the direction of the market panic. This allows me to look for an opportunity to enter a long trade and to benefit from the group overreaction.

  During such market drops, I compare the expansion in the number of trades to the expansion in the number of contracts or shares traded. Very often the number of trades expands even more quickly than the volume does, suggesting that smaller traders are disproportionately represented among those bailing out. Those small (often undercapitalized) market participants are often wrong during such emotional selling occasions. I also like to look at the expansion of volume in the favorite daytrading vehicles, such as the QQQ and E-Mini indexes, compared to volume changes in the overall markets for evidence of speculative emotional extremes during downturns.

  This strategy of using emotional reactions to trigger your observing capacities lies at the heart of trading from the couch. However, it is a strategy that requires considerable practice. At first, the practice occurs outside of market hours, as you simply become adept at reaching the quiet state. In the beginning, it may take quite a few minutes to still your mind and your body. Over time, however, you can become quite skilled at meditation exercises or sessions with the sound-and-light machine, to the point of quieting yourself with a few deep breaths or a few seconds on the machine. This ability to rapidly transition to a calm, focused state is very useful for scalpers and floor traders, who cannot afford an extended exercise period while the markets are in full gear.

  I have found that the calm, focused state that facilitates the Internal Observer becomes associated with the stimuli utilized in the practice sessions, much in the manner of Pavlovian conditioning. For example, if you have been performing deep-breathing exercises while focusing your mind on a relaxing piece of music, the state of calm focus becomes associated with that piece of music. Through the associations built by repetition, you can then play that piece during the trading day, taking a few deep breaths and keeping your body absolutely still. This readily summons the Internal Observer, even on the heels of the most emotional trading events.

  To make such an approach work, it is first necessary to treat emotions as useful signals that allow you to begin your Observing. This flies in the face of the human tendency to want to eliminate unpleasant emotions. I vividly recall one trader, responding to a column I had written for a financial web site, begging me to show him techniques for "eliminating fear" in trading. You don't want to eliminate fear, I responded. Fear is important information, no less than the red light that shows up on your dashboard when you have engine trouble. The red light will make you uncomfortable to be sure; no one looks forward to its appearance. But the answer is not to cover it over with electrical tape. Too many traders want to rid themselves of "negative emotions," taping over their own, personal dashboards. Ignorance is bliss for a while—until the engine seizes and the problems multiply exponentially.

  It is understandable to want to rid oneself of fear in trading. Few experienced traders have not had the experience of anxiety during a drawdown, first hoping that their position will recover and then praying that it will do so. To see your position hemorrhaging minute by minute, while you are paralyzed with fear and filled with self-recrimination, has got to be one of the worst experiences known to humankind. At the moment when it seems most clear that your hopes will not be realized and your prayers will not be answered, there is nothing left to do but disgorge the position in a mixture of desperation and relief. Those feelings, however, quickly turn to regret as it becomes painfully evident that your sale has caught the worst possible exit point, almost to the tick.

  Painful as it is, this emotional script of hope, fear, and prayer does provide useful information. As you have seen, it often suggests that other traders might be feeling the exact same way and that this might not be the best time to liquidate. Among the many intraday indicators I follow and archive, the NYSE Composite TICK is one of my favorites. I am greatly indebted to Mark Cook and Linda Raschke for their insights into the TICK. When you see a TICK of –1000 or lower, signifying that a great plurality of stocks is trading on downticks, it means that people are fleeing the market indiscriminately. The TICK reading is the red light on the trading dashboard, lighting up when emotions are running high.

  At those times, the market will seem to make little sense. Even the best stocks, the companies with the brightest prospects, may be plunging, bar after bar after bar. If you can access the Internal Observer at such times, you will be better positioned to read the market's message. Instead of becoming intimidated by the market's craziness, like the graduate students with the Woolworth man, you will have the opportunity to ask, "What's for sale?" You the Internal Observer note the panic of you the Trader and turn that into market data—and a potentially profitable trade.

  CONCLUSION

  As I have shown, utilizing emotions as information is central to the work of therapists. Therapists experience feelings when they work with people; this is inevitable. The good therapists, however, utilize these as data, not as inconveniences, personal threats, or infallible guides to action. A classic example is a client who is overly dependent. He may express considerable fear about making a decision, emphasize the dire consequences of making a wrong choice, and express considerable anguish over his dilemma. He may even cry and ask the therapist for advice. At that point, it is only natural for the therapist to feel sympathy for the person and offer some guidance. That, however, is almost always the wrong course of action. Whatever advice is given will only reinforce for the individual that he was unable to make his own decision.

  Good therapists, therefore, activate their Observer, notice their feelings of sympathy, and think, "Hmmm . . . I wonder why I am feeling this way. I'm tempted to try to rescue this person. Maybe this is how other people feel toward him as well, which would help sustain his diminished confidence. Perhaps I should try the opposite approach and explore situations where he has been able to make successful decisions. Then he might be able to use his experience to make his own choice, rather than to rely on others."

  I cannot make the point strongly enough: Successful traders do not eliminate emotions. Indeed, they experience emotions fully, so fully that they become consciously aware of what they're feeling. At that point, however, they don't become lost in their emotional state. Instead, they adopt the vantage point of the Observer, standing apart from the feelings and making sense of them.

  It takes a while to find the exercises that work best for you in culti
vating self-observation. I have found biofeedback and the sound-and-light machine to be invaluable in my own work. Others rely on techniques drawn from self-hypnosis or meditation. One interesting variation on the earlier-mentioned movie exercise is to assume a comfortable seated position, slow your breathing, stay completely physically still, and use imagery to create a different movie in your head. In this movie, you vividly image yourself watching yourself as a trader becoming overconfident, panicked, greedy, and so forth.

  Notice the important wrinkle in the exercise. You are not watching yourself becoming overly emotional. You are watching yourself watching yourself overreacting to the market. Your identification is with the Observer: You can even create images of smiling and shaking your head, comforting and expressing pity for your poor emotional self, and so on. With practice, you, like the therapist, will be able to say to yourself, "Hmmm . . . I wonder why I am feeling this way." Once you cultivate the capacity to observe yourself, you create the freedom to do what doesn't come naturally.

  And, very often in the markets, that is the right move.

  There is a tendency for financial writers to cloak themselves in gurulike robes, in hopes of attracting the widest audience. I have to be honest with you, however: Dr. Brett is a rather poor trader. He too easily becomes absorbed in market action. Left to his devices, he would usually wind up fully invested at the peaks and troughs of his emotions. He's a lot like the Woolworth man, completely out of sync with the rhythms around him. Thank goodness, however, for the Internal Observer. He is able to make nice money for Dr. Brett's account by fading Dr. Brett.