Tuesday, May 16, 2006

Self-Inflicted Problems of Trading Psychology

I usually cover trading psychology topics on my personal site, but perhaps a heartfelt message on the blog will have a useful impact.

Many psychological problems I encounter among traders--professional as well as novice--are self-inflicted.

I say this, not to blame victims, but to call attention to the fact that two trading practices seem to lie at the heart of at least half of all the problems I see among traders:

* Quantum leaps in trading size - Traders increase their size in large proportional increments, creating P/L swings that feel large and that interfere with calm, rational decision making. It may not seem to be a large shift when you raise your size from five contracts to ten, but that doubling of size--and the resulting doubling of P/L swings--may feel much different than it looks on paper.

* Departures from prudent risk management - This occurs particularly when traders are up or down a great deal of money on the day. Traders become overly aggressive to get their money back, or they become overly risk averse when they're down. Similarly, when up money, traders become risk-seeking with house money or fearful of losing their gains.

Very often, these problems go hand in hand. Large changes in trading size lead to outsized gains and losses and departures from prudent risk management. These large emotional swings are processed by the mind in a manner similar to psychological traumas, creating very negative (and difficult to change) conditioned responses (different in degree, but not kind, from post-traumatic stress reactions).

My heartfelt message: Treat size with caution. Increase size incrementally, ensuring that trades don't feel different when you enter and manage them. The best treatment for trading psychology problems is preventive medicine.

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We've had a flat two-day period in SPY, a pattern which we recently saw leads to modestly bearish expectations.

Tomorrow AM, I'll begin posting on the topic of volatility and its relationship to near-term price change.

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