Tuesday, October 16, 2007

Emotional Resilience in Trading: Three Keys

I can think of no psychological characteristic more important to long-term trading success than psychological resilience. Resilience has been defined in a number of ways, sometimes as a process, other times as a trait. In all cases, resilience presumes exposure to stressful conditions and an ability to maintain high levels of social, emotional, and vocational functioning throughout this exposure.

My experience with traders suggests that even the most successful ones go through periods of drawdown. Sometimes these drawdowns are extended, either in time or in the amount of money lost. Some traders bounce back from these losses; others don't. Here are three factors that seem to distinguish the most resilient traders:

* Flexibility - The resilient traders, interestingly, seem well aware that there will be dry periods in their trading. They realize that slumps happen and that market conditions change. This anticipation enables them to respond swiftly when their good ideas are no longer panning out. They reduce their risk, cut back on their trading, and wait to get a feel for things again. This prevents them from drawing down too deeply--even the most resilient trader will have difficulty coming back from a loss of half or more of their capital. The flexible mindset also enables the resilient trader to not take slumps and losses personally. By adopting a mindset that anticipates dry spells, the trader achieves a kind of psychological inoculation.

* Problem-Focused Coping - The resilient traders, when losing, delve deeper into themselves and deeper into the markets. They gain motivation to figure things out. Lesser traders become mired in discouragement and frustration, spinning their wheels by venting (or acting out) their emotions or by avoiding trading altogether. I find that a competitive spirit is a key part of this resilience: the successful trader uses this drive to draw upon motivation during slumps. Many traders, surprisingly, are not competitive at all: they're drawn to trading because of a perceived easy lifestyle. These are among the least resilient traders. As soon as it becomes clear that trading out of a hole means real work, they lose motivation and interest.

* Prevention and Preparation - I consistently find that traders who live on the edge financially--including those who ratchet up their lifestyle as they make money--are among the least resilient traders. It is stressful enough to go through a trading slump; to have to worry about making mortgage payments or supporting a family is too much pressure. The resilient traders prevent the pressures from becoming too great by maintaining healthy cash reserves for those dry periods and by having secondary sources of income wherever possible. Conversely, when the trading losses become a source of stress in the home life, this impairs resilience.

Stresses that are anticipated, on average, will generate less distress than those that come out of the blue. Each individual losing trade can be a psychological preparation for larger drawdowns when a trader engages in problem-focused coping and manages risk proactively. It is in this sense that resilience is a process, not just a quality that people either have or lack. By rehearsing elements of resilience with each trade, it is easier to find emotional reserves during those more extended drawdowns.


Assessing Your Coping Style as a Trader