Saturday, March 24, 2007

Psychological Risk Management

Not too long ago, a trader indicated to me that he was having difficulty controlling his emotions when trading. At times he would become paralyzed by fear, missing opportunities. Other times, determined to not be caught in the headlights, he would lurch into markets and refuse to cut his losses. It became a cyclical process: he would lose money, reduce his size and trading frequency, become frustrated with missing out on opportunity, jump into positions out of that frustration, and then lose money again. Interestingly, this happened even if he was trading so small that the losses could not hurt him financially. Indeed, he found that he was trading emotionally even when he was placing "paper" trades in simulation mode.

The problem was that, even though he was trading small size and controlling his risks financially, when it came to his emotions, he was "all in". As he described it to me, he *needed* trading to work out for him. He saw no alternate future in another career and, indeed, dreaded the possibility that he might have to seek a "regular job". He also had experienced disappointment in love and had few friendships to fall back upon when things got tough.

In short, he was counting on trading for most of his self-esteem. It didn't matter what his financial risk was: his psychological risk was always sky high. His cyclical attempts to make profits and pull back from markets were not real trading strategies: they were coping strategies to manage his feelings about himself.

What we *need* controls us, and when the eggs of our needs are placed within a single basket called "trading", the performance pressures are simply too great to bear. Diversification of our positions in the market will matter little if we lack diversification in our sources of gratification and self esteem. The want for success is very different from a need for success, and the desire for success is different from the need to not be a failure. A rich and full life outside of trading is the best form of psychological risk management. The inevitable periods of drawdown in trading are far easier to bear when we are collecting dividends from the rest of life.


AnaTrader said...

Hi Brett

Just as you caution traders to trade and not miss out, Dr A Elder of Come into my trading room, cautions traders to trade less..

Clearly, there are times to enter bullish trades, times to enter bearish trades, and times to go play golf or go fishing or do something other than trade, or do nothing.

Guess trading is a balancing act of probabilities in our favour.

Jeff said...

So was that trader successful in obtaining a rich and full life outside of trading? How do you go about doing that, if you actually do need trading to work out for you?

procol said...

Just the other day, I commented on some chat that the best trading comes when you don't give a ****.

Now, I understand that may be a crude way of putting what you describe, but it is succinct.

Of course, I didn't mean that you should not care about what you are doing, or the outcome, but meant exactly what you are saying.

The more emotion and ego invested in the trade, the less effectively you will manage it.

For many , myself included, this is easier said than done, but at least we know where the goalpost is.

bhong4664 said...

An insightful analysis. Lack of emotional resources, a paucity of interpersonal resources and a restriction in coping skills/styles. Sounds like a borderline personality disorder.

You can't leave us hanging like this. You must give a follow-up report on whether this trader could be helped. And, if so, what techniques were used to help him.

I think all of us (traders) can fall into the trap of focusing too much on the cpu screen - much as children can become enraptured by television. Sometimes, someone has to tell them to get off their duff and go outside and play!

Brett Steenbarger, Ph.D. said...

Hi AnaTrader,

Good point; I think it's easier to be selective with trades when there isn't a *need* to trade--


Brett Steenbarger, Ph.D. said...

Hi Jeff,

I encourage any trader in that situation to set goals--and concrete steps toward those goals--for non-trading aspects of his/her life, including cultivating relationships, hobbies and other productive interests, spiritual life, etc. If someone *needs* trading to work out, it suggests to me that they don't perceive career alternatives. That's a vulnerable situation. I'd recommend developing those alternatives, perhaps with part-time education, so that all the eggs aren't in one basket.


Brett Steenbarger, Ph.D. said...

You said it better than I did, Procol: the less ego and emotion in the trade, the easier it is to manage the trade. Great synopsis. When there's lots of ego in the trade, it's just as emotionally draining as when there's lots of dollars in the trade!


Brett Steenbarger, Ph.D. said...

Hi Bruce,

I don't take private clients (individual traders), so all I can tell you is the advice I gave to the trader regarding diversification of life interests. As I've written elsewhere, a major problem with such diversification is when traders show addictive patterns in their trading--


Michele said...

Great stuff here. I saw myself in it, having succumbed to that particular trap, as well as most of the others in your book. In two years of doing this essentially full time, I've found that success comes in two stages.

At first I tried to learn how to make money. But I found that before I could do that I had to learn how not to lose money (and they're two really different things).

I've also observed that I'm a LOT more successful trading my paper account, and I'm in the top 6% of the CNBC challenge. But my real account is still pretty much treading water. I don't lose much, I don't make much. It's frustrating.

One thing that has helped me is to work on my trading program. Writing computer code automatically enforces discipline on your emotions. In fact, I'd call the computer the ideal trader - it never gets greedy OR fearful, and it doesn't give a hoot when it has a bad day.

There's even a paradox here. I believe that psychology is the key to successful trading, but a computer program in psychology-free. Go figure.

Brett Steenbarger, Ph.D. said...

Hi Michele,

That is *such* a good point; thanks for the comment. Learning to make money and learning to not lose money are *very* different things. I also like what you say about writing computer code as a way of enforcing discipline. I find research has the same effect for me--


Caravaggio said...

Excellent article Brett. So good in fact, that I've added the final couple of paragraphs to my trove of market related quotes.

I've spent too long in this chap's shoes, looking to trading to give me so much more than I had a right to ask. The result was that everything was taken away.

Michelle - Trading seems to be filled with paradoxes! Another one is the advice paradox - that so much valuable trading advice only really resonates once it's too late i.e. after you've been put through the mincer.

Marc Eckelberry said...

I have a recommendation for most (future's) traders in a funk. Find a trade in a sector you think should go up, i.e. take a long somewhere, quit trying to short something (how many of you went long copper today, instead of being blown out of your NQ short?). That already increases your odds of success. It gives you a focus with the added benefit of learning about different sectors. Shorting is a full time job, regardless of the sector you are hitting. Pros like it because it's fast, but conservative traders know that the steady money is finding longs that run a few days or a week. As an example, the better trade ahead of the Feds was to go long gold instead of risking a short in equities (or even a long). Gold had a win/win set up. The same with oil, once we were done with contract rotation (crack spread was a huge heads up). Once you get your rhythm back, play both ends of the game on the index you know well, but you will find that the discipline of finding a long makes you a more rounded future's trader. Find the bull somewhere. Once you have money in the bank, you will have the guts to do the only short trades that works: hitting bounces and rallies, which is not easy to do when you are scared.

Brett Steenbarger, Ph.D. said...

Hi Caravaggio,

Thanks for the comment and thanks also for your excellent post with the quotes. Much appreciated--


Brett Steenbarger, Ph.D. said...

Hi Marc,

Great point; given the equity market's risk premium, the longer your time frame, the more it makes sense to embed a long bias into your trading. Thanks for the comment--


Max said...

Good post by Marc. As an intermediate term trend trader in the stock market, I use end of day data. I find that if I maintain my stop loss discipline (40%+ of my trades are losers), the winners will take care of themselves. Since my work begins after the close of the market and takes no more than 45 minutes, I have plenty of time for those outside activities that help keep me balanced.

The most difficult thing is fighting the temptation to "do something".


Brett Steenbarger, Ph.D. said...

Hi Max,

Well said; thanks! Sometimes the hardest thing is to do nothing--