Thursday, December 06, 2007

When Trading Performance Falls Off a Cliff

“I’ve been a successful trader, but lately I’ve been losing money. Nothing I try seems to work. What should I do?”

I’ve heard variations of this problem quite a few times in recent months. Good traders are struggling, despite volatile markets that—on the surface—should offer opportunity. It’s a frustrating and demoralizing situation.

So what should a trader do?

The important thing here is that the trader has been successful over a period of years, not just months. The problem is not simply one of inexperience. This is what makes the problem so perplexing: the trader knows he or she has skills, but it’s as if all that experience has flown out the window.

Let’s take an analogous situation: Suppose you’ve had good health for years, but now feel persistently sick and run down. You’re just not your old self. What should you do?

Clearly, you would seek professional help for a thorough and objective evaluation and for an accurate diagnosis of the problem. What you would not do is let the situation continue to deteriorate. You would also not simply assume that the problem must be “in your head” and immediately seek psychological assistance.

Similarly, the experienced and successful trader whose performance has fallen off a cliff should not let the situation fester and should not assume that the problem is psychological. If health has deteriorated, there’s most likely a health problem that needs to be identified and treated. If the health of one’s portfolio has deteriorated, there’s most likely a trading problem that requires similar assessment and intervention.

Having worked with traders across a variety of markets and strategies—from market making and prop desks at banks to global macro portfolio managers and Chicago prop traders—I’ve found three common sources of performance decline:

1) Diminishing Opportunity in the Trader’s Market – Perhaps you’ve been making markets or trading spreads and the bid-offer has narrowed significantly. Perhaps your market has entered an extended period of reduced volatility. The market has changed significantly and your old strategies no longer work.

2) Altered Market Behavior – Perhaps you’re a short-term trader who looks for advantages in short-term price/volume patterns or in shifts within the order book (depth of market); perhaps you depend on execution (buying bids and selling offers, entering long on pullbacks, short on bounces) for much of your profitability. The presence of new large traders in your market, including automated trading systems/black boxes, has shifted how markets trade in the short-run, disrupting the patterns you’ve counted upon for your profitability.

3) Shifting Market Regimes – Markets that used to behave independently now are more correlated. Countertrend patterns that once ruled markets now are giving way to greater trending moves. Enhanced intraday volatility is making it difficult to participate in longer-term market moves. We’ve seen a variety of changes in market trading patterns and it has been difficult for traders and investors to adapt to these.

Notice that these are variations on a single theme: markets have changed in some ways and what once worked is no longer working. It’s no wonder that struggling traders feel as though they’ve “lost it”. In a sense, they have.

Does this mean that trading problems don’t have a psychological component? Not at all. When markets change and traders are caught in the transitions, the usual outcome is frustration, then self-doubt. These emotional reactions can interact with the trading problems to create vicious downward spirals, both in mood and P/L. What begins as a trading problem can escalate into emotional one. Frustrated, reactive trading can undermine serious efforts at adaptation.

My advice for traders in a prolonged tailspin is severalfold:

1) Cut Risk – It’s that “above all else, do no harm” principle. If you don’t have a feel for the market, trade small while you regain your feel. Preserve as much of your capital as possible to lay the foundation for your recovery;

2) Focus on Your Strengths – It’s not unusual for frustrated traders to try to make all kinds of changes in their trading in a frantic effort to gain some traction. These efforts can compound difficulties by getting traders further and further from their strengths. During rebuilding periods, you want to focus on the markets and strategies that you know most about, that represent your strengths.

3) Reach Out – It’s especially helpful to reach out to traders who trade markets and strategies similar to yours. Are they also struggling? If so, this suggests that market changes, indeed, may be at the root of the problem. If the traders you contact are succeeding, try to find out what they’re doing differently from you. It may well be that a simple tweaking of execution, holding times, and risk management could turn your performance around.

4) Stay Constructive – You may well be in a rebuilding period. This happens to the best athletes and sports franchises. It doesn’t mean you’ve lost all talent and skill. Identifying the kinds of trades that are working for you is a start toward rebuilding: you want to find the common denominators behind your successful trades so that you can emphasize these going forward.

5) Work on Your Self-Talk – Hard as it is, it’s important to stay positive during a rebuilding period. The last thing you want to do is create additional interference by beating up on yourself and dampening your motivation. This is one of the areas where coaching can be helpful. Setting attainable goals and creating plans for learning new patterns and trading strategies can fuel optimism, determination, and focus.

6) Control the Budget – It very much helps to have a cash cushion to weather these rainy day periods. Living within one’s means also helps greatly. I’ve generally found that traders can adapt to shifting markets if they have enough time to make the transition. It’s when the pressures of bringing in money month to month add to the performance pressures of a drawdown period that turnarounds become difficult to sustain.

Perhaps the best advice, however, is preventive. Identify slumps early and control losses before they get out of hand. Perform regular inventories of your winning and losing trades, so that you’re always on top of what’s working for you and minimizing what’s hurting performance. During your best times, remember that markets always change and keep powder dry to weather the inevitable lean times. Ironically, the best way to master declines in trading performance is to embrace them early and turn them into prods for learning and development.

RELEVANT POSTS:

The Most Important Question to Ask When You're in a Slump

Common Sources of Trader Stress
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