Monday, October 29, 2007

Views From the Trading Penalty Box

At 10:50 AM CT, I placed myself in the penalty box. What that means is that I'm done trading for the day.

Actually the day started out just fine. I hit a new equity curve high last week and felt I was seeing the market well. My first trade Monday morning was a classic false-breakout, fade-the-strength trade and resulted in a several pt winner in ER2. My second trade pressed the downside in NQ and escaped with a half-point winner as the downside follow through never materialized.

That last trade should have told me that the downside was limited and warned me about continuing to sell the market. Moreover, what the hell was I doing fading NQ when the semiconductors were catching a bid and the Russells were still leading the downside? Worst of all, I didn't ask those questions before launching into my third trade: selling ES a little after 10 AM CT.

The market moved smartly against me, but I was seeing volume slow down and no outstanding sector strength, so I hung in there. One point against me. Two points. Then three. To say I was disgusted with myself would be an understatement. Not only had I failed to ask the right questions before entering my trade; I also left my stop fuzzy--not something that got me making the money in the first place.

I had a strong sense that, if I covered, I'd be buying the highs, so I established a firm catastrophic stop and waited the market out. Fortunately I got a retracement and managed to get out with a one-point loss about 50 minutes later. Much longer than I should have held a trade like that.

All the while, as the market moved back my way, I told myself that my trading day was done. It was in the penalty box for me. That was just an ugly trade.

I bring up this episode because it illustrates several lessons:

1) You never stop working on your discipline - I don't care how many letters you have after your name or how much you're up on the year. You stop executing the fundamentals and doing what got you where you are and you'll pay a price.

2) Overconfidence kills - It's when things are going well and I'm feeling good about trading that I tend to be sloppiest. The key, for me, is to always trade as if I'm down money. That keeps me sizing positions reasonably, waiting for good entries, defining my stops clearly, and being selective in my trades. Fear and greed may get top billing, but overconfidence is one of the greatest trading challenges.

3) The penalty box works - There was a time when I only entered the penalty box when I went through decent-sized drawdowns. Now just one bad trade can take me out of the trading day. That may seem harsh, but I can't tell you how much money and anguish it has saved me. I spend the rest of the day identifying what I did wrong and making sure it doesn't carry over to tomorrow. In August, I entered the penalty box after a couple of good trades that lost me money. The market wasn't doing its usual thing; my ideas weren't working well. By shutting down my trading for a little while, I came back when I had a feel for the market and was able to add to a profitable year.

I've been trading since 1978. I have a doctoral degree in psychology and work with traders professionally. I average well over 100 trades a year and have read most the major trading and trading psychology books.

Still I make the mistakes. Still I learn from experience. Still I visit the penalty box.

Sometimes it seems as though the only progress I've made in decades of trading is that I enter the penalty box a helluva lot quicker than I used to.

But that has made all the difference.


Understanding Overconfidence and Underconfidence in Trading

The Most Common Trading Problem


John V said...

Dr. Brett:

Thanks for this post. It lets me know I have distinguished company when making mistakes. In entering the "penalty box" it seems you do not distinguish between a 'bad trade' that goes against you and a 'good trade' that does the same. That is, if you followed all your rules and still the trade lost money, should you go into the penalty box? That seems unfair. I go into my penalty box for all 'trash trades', which are those where I did not follow my rules. But, if I follow my rules, I continue trading, while making sure I do some follow up analysis on those losing trades.


John V.

Ziad said...

Very nice post. i think it helps every trader to remember that even the most experienced in this field still make mistakes. But I do have a question for you. Some days I notice that my trading is off (usually when the market has some decent volatility to make me interested but is still trading in a choppy manner). During such days I see one seeming opportunity after another, but they chop me up to pieces because they're not really opportunities given the overall environment. After a couple of seemingly good trades go wrong quickly, I notice the environment is not conducive to my trading and decide to stand aside. However I always seem to be lured back in by what now seems to be finally a really good unmistakable opportunity. Of course they rarely are, and a slightly bad day turns into a really bad day after I keep trying to pull off a good trade. But what makes it hard to really stay away is the fact that the market on such days operates on a "variable reinforcement schedule". i.e. it will sometimes give you a good trade even in that environment that will make up for all the bad trades you made that day. Given this, standing aside becomes much harder because you keep thinking objective opportunity could present itself and give you a nice trade, and it feels foolish to sit there and watch it go by without acting.

The logical solution is simple: if overall you end up down on such days even when you factor in the rare good trades, then you should stand aside. But doing so is extremely hard since it's not as simple as being patient and standing on the sidelines during a dead range bound day with no set-ups. Here you have the constant potential for set-ups and it takes incredible will power to stay away, especially if one such set-up can turn a losing day into a winner.

Do you have any advice gained over the years about how to make yourself enter the penalty box despite there seeming to be opportunities around? What usually works well for me is cognitive reframing, but any suggestion would be appreciated.



abel said...

Do you think about how your downside bias may in part be a residual belief from your earlier post, referring to the margin debt spelling a possible bull market peak?

I personally find that waht I currently believe may extend, and carry-over, a little longer than may be useful for a trade, or a little earlier than it usually manifests into a trade, usually the latter.

The point I am trying to make is that, how a belief, or market outlook, possibly especially if written, may extend even after/and or evidence to the contrary surfaces.

Happens to me quite regularly.

F-Trader said...

Dr. Brett,

I think I posted about the failed trade you mentioned, except I took the opposite side in ES.


Brett Steenbarger, Ph.D. said...

Hey John V.,

You raise a good point; when you make good trades but hit the sidelines because you've hit a daily drawdown limit, that's not really a "penalty box". That's just risk mgt. But if your rules stop working, which can happen as markets shift volatility and respond to emerging intermarket themes, it makes sense to hit the sidelines as well. Not as a penalty, but as a means of preserving capital. Thanks for the observations--


Brett Steenbarger, Ph.D. said...

Hi Ziad,

Great questions. I distinguish between volatility (market movement) and opportunity. If the market is following patterns and themes, there's opportunity. But movement is not opportunity if it's not following the patterns you trade. If my themes aren't working, I stand aside regardless of the "opportunity" that might seem apparent on charts. It's not *my* opportunity.


Brett Steenbarger, Ph.D. said...

Hi Abel,

Great point. In my case, the bearish bias was a hold over, not from my prior post, but from my successful first trade of the AM. It's easy to get locked into ideas!


Brett Steenbarger, Ph.D. said...

Hey F-Trader,

Do pass along URLs for posts if you think they might be educational for readers; thanks & congrats on the good trade!


Jeff said...

thank you for this post, Dr. Brett.
Following Ziad's comment, I'd like to ask, do you ever try paper trading (or simulation) after you remove yourself to the penalty box?
And if you do, are you tempted back to live trading if your simulated trades work?

Brett Steenbarger, Ph.D. said...

Hi Jeff,

I mainly use paper trading (simulation) for testing out new strategies. When I'm in the penalty box, I'm away from the screen. I don't deserve to sit in the seat. No temptation at all; just a determination to earn my way back into the seat the next day.