Friday, October 20, 2006

Understanding Lapses in Trading Discipline

These are the three legs of the performance stool: (1) your talents and interests, (2) your trading style, and (3) markets and their personalities. The meshing of your qualities with your trading style will help determine your ability to trade that style with consistency and discipline. The meshing of your trading style and the features of markets will determine the degree to which you have a performance edge in the marketplace. The ever-shifting features of markets ensure that traders who are adaptable will be most likely to sustain expert performance over the course of a trading career.

Enhancing Trader Performance

I recently received several emails from readers asking questions about that perennial problem: maintaining proper trading discipline. Sometimes the problem is holding losing trades too long or violating stop loss levels. Other times, it's breaking rules regarding position sizing or when to trade (and not trade). On yet other occasions, the problem is failing to take trades that set up or jumping into trades before they fully set up. Always, however, the problem is a failure to fully follow plans and intentions.

As the quote above suggests, my new book--due out at the end of the month--tackles the discipline issue from a different angle. Discipline problems, I maintain, are not the cause of trading woes. They are symptoms of other difficulties. Just as a problem maintaining the "discipline" of monogamy in a marriage is frequently the result of underlying relationship difficulties, failing to be faithful to one's trading plans is often a sign of conflict between the trader and those trading plans.

In the book, I review research that identifies several key personality traits that affect our decision making under conditions of risk and uncertainty. These include:

1) Neuroticism - Our tendency to experience negative emotion. When people show a tendency toward anxiety, depression, and anger, the volatility of the market--and the volatility of trading results--frequently sets off emotional volatility, interfering with sound decision-making.

2) Extroversion - Our tendency to be outgoing and oriented toward the outer, rather than inner, world. When people have many extroverted features, they tend to be risk takers; when extroversion is low, they tend to be more risk-averse.

3) Openness to Experience - Our desire for novelty and stimulation. When traders have a high degree of openness, they lean toward more discretionary, unstructured trading methods; when the openness is low, they prefer highly structured, rule-governed methods.

What happens when the plans we select for our trading don't truly mesh with our basic personalities? The result is that we continually find ourselves veering away from those plans.

A trader high in neuroticism will have difficulty following a trading system that puts a large percentage of capital at risk, that trades volatile markets, or that requires large drawdowns.

A trader high in both extraversion and openness will have difficulty following a patient trend-following system.

Frequency of trading? Placement of stops? Times of day to trade? Number of instruments to follow and trade simultaneously? All are impacted by our personality traits.

When traders who are normally disciplined find themselves breaking their trading rules, the lapses of discipline are a symptom of a lack of fit between who the traders are and what their rules demand. A fine system on paper is unprofitable if it cannot be followed by a trader. A trading method not only needs to be good; it needs to be good for the trader.

The answer is not to blame yourself for lapses of discipline or exhort yourself with motivational nonsense. Rather, keep a journal and truly investigate each of your lapses. Then view those lapses as information, not as problems. What do they say about you? Which rules do you find yourself breaking, and what inside you might conflict with those rules?

Now look at your trading successes. What came naturally to you? What rules and plans can be derived from those winning trades? Don't force yourself into a pre-made set of trading plans: identify what you do when you win and see how you can make *that* into your system.

Maybe, just maybe, breaking your rules is the first step in figuring out who you really are. A variety of trading psychology articles on my personal site might further that process.


WilyTrader said...

This is an excellent point of view that I had not considered. I am an MBTI: ENTP & on Big-5 score super low on N & C...This means that I'll likely need to fight harder to get and stay orgainized and should probably focus more on smaller timeframes as to not get bored & distracted while being better able to handle the stress than most.

In looking back over my results, this has in fact been the M.O. that, performs the best. Now it is all about harnessing this knowledge and putting my personality to work for my trading instead of fighting it!


Anonymous said...

Excellent observation Brett. I think another key to this topic is that most traders in general do not trust their strategy subconciously, therefore they veer from it at the worst time. Part of it surely comes from Trading a methodology at odds with their personality. You are correct that a Trader must be blatantly honest and design a system around their weaknesses and strengths. Should be a wonderful book and I look forward to reading it.


Brett Steenbarger, Ph.D. said...

Hi Wily,

Thanks for the interesting observation. I do think that we can learn a lot from our best performances. For a while, I tried to be more of an exclusive buy-and-hold trader and also a full time trader, but neither fit my cognitive strengths, my risk profile, or my personality needs. Frankly, when we're doing what we're best at and what comes most naturally, I don't find discipline to be a major issue.


Brett Steenbarger, Ph.D. said...

Hey DT,

You're right about that. If you're trading a method you've picked up in a book, seminar, or chat room, how could you truly trust it through downturns and drawdowns? There is much to be said for developing your own methods over time and practicing those to the point where they become second nature. The way to be consistent is to have routines, not to constant exhort ourselves to be disciplined!

Thanks for the note--


The Market Speculator said...

What about those of us that are the exact opposite of what you've concluded? For example, I am not an exrovert, but I constantly have to fight the battle of being a risktaker.


Brett Steenbarger, Ph.D. said...

Hi Paul,

Great question; thanks. The problem, typically, is not risk taking itself, but imprudent risk taking. Research out of the London Business School suggests that this is more a function of a personality trait called Conscientiousness than Extroversion. When this has been a problem, I have found that establishing firm trading rules and mentally rehearsing these prior to trading has been helpful. The key is the repetition of the rehearsals, so that the rules become internalized--second nature.


Arogant Trader said...

Hi Brett,

First of all I want to say thank you so much for writing two of the best books on trading psychology. The Psychology of Trading and Enhancing Trader Performance.

I am 30 and began trading at 28. All together I have been in front of the computer trading real money for exactly 22 months. I love trading and I am very passionate about it. I spent a lot of the last 22 months studying technical analysis and very little trading psychology, and as a result my trading results have suffered greatly. I don't have any problems with fear or not executing a trade at the right time. I have problems with not taking profits at exactly the right time, and not following my daily limit of capital to risk. I will say I am somewhat glad I didn't follow it in the past as placing over 4,000 trades in Equity Options, Forex and Futures Markets has taught me a lot more than an education at Harvard Business School could. Could you give me any suggestions on how I could create a better strategy to book profits and not overtrade my account? I am currently reading Mark Douglas's: The Disciplined Trader. I have many trading rules, and I keep a blog and document each trading day as well as review my trading rules multiple times a day. I think I am doing a lot of what I need to but trading discipline for me might just take more time to develop?
I am a volatile day and swing trader. I usually daytrade the Big Dow Stock Futures in an oversees account, which incredible leverage. I trade 0.30 on the first position and then add another 0.30 on the second position after I am in the money 25 points on the Dow. I then move up the stop on the first position to break-even. This would equal 0.10 size bigger than one U.S. Futures Mini Dow contract. I also trade the GBP/USD on swing trades and daytrade it just before a rate announcment(The Pound has one to be released around 3 a.m. PT). I also daytrade crude oil on days it moves, usually Monday, Tuesday and Wednesday. Sometimes I swing trade Gold, and I am practicing swing trading Cofee on my demo account.

Arogant Hollywood