Saturday, October 14, 2006

Losing Your Money Begins With Losing Your Focus

If you have a valid trading methodology, the role of psychology is to aid your executing it more consistently and effectively. One of the most important points I made in the Psychology of Trading book is that trading performance is not so much a matter of controlling emotions as controlling your focus and concentration. If you treat your emotional responses as market data--information, not problems to be covered over--you'll find that focusing on your experience (not getting lost in it) can pay off handsomely.

Let's take an example. The market has bounced off a price level a couple of times, and you're noticing reduced volume as we test those lows. The third time we approach the lows, you decide to buy the market. We bounce higher, stall, and then a large local begins to put large offers in the book, capping the buying. Within seconds, locals (perhaps that very same local) pulls bids and the market whooshes lower, breaking the recent support by a couple of ticks. Your trade is under water.

Does a trader feel fear or frustration at those moments? Of course. The question is not whether you have those emotions, but whether or not you lose your focus and blindly act upon them. As the slide above notes, to lose your focus is to become undercontrolled--impulsively putting on "revenge" trades--or to become overcontrolled, frozen with fear like a deer in the headlights.

A better alternative is to become an observer to those emotions. Perhaps, if you are becoming concerned about your position, other traders are as well. That prods you to increase your focus: look harder at what's going on in the market. When you notice that there are very large bids just below the market, you realize that large players are pushing the market into those bids. Your fear and frustration are what will make you hit their bids and get them out of their positions. Volume, after all, has not expanded on the move down: the running of stops was the result of a vacuum caused by strategies played out in the order book. Within moments, the market is back trading where you bought it.

There are good reasons to stay in a trade, and there are good reasons to exit and stop yourself out. The question is whether your decision is the result of enhanced focus--using your emotions as warning signals that alert you to important market changes--or the result of attention that has been shifted toward your P/L fears and frustrations. As any competitive athlete or soldier knows, emotion can be your friend or foe: it can make you focus harder on your circumstances, or it can distract your focus. It's much easier to maintain your focus when you have a well thought-out trade idea to focus upon. Much loss of focus (and resulting emotionality), I find, is simply the result of trades that lack a firm grounding.

Free psych resources for traders are available on my personal site. Trading, at its best, develops us as it develops our skills.