Friday, March 21, 2008

Denial as a Trading Motivation

Back in the day, I used to meet with a number of couples in counseling. Not infrequently, infidelity was a major issue bringing them to see me. In a surprising number of cases, the signs of infidelity were present long before the affair was caught. Indeed, many times there were explicit warnings from others who saw what was going on. Still, the spouse didn't want to believe the worst...made excuses...turned the other way...until evasion was no longer possible.

Denial is a powerful human motivation. We have a drive to know the world around us; less commonly appreciated is our capacity to sustain ignorance. Many times, we just don't want to know the truth, whether it's what happens in a military prison or what keeps our spouse out so late.

One particularly uncomfortable truth for traders is that their lack of profits is simply due to trading randomness. It's not a lack of discipline, a lack of trade planning, or a lack of tweaking the right indicators that create losses--all of those are relatively easy to address. No, losses are caused by trading strategies that simply do not work, and that's not so easily remedied.

It's pretty threatening to think that what you're devoting time and money to has no grounding in reality. It's much easier to simply not think about it. Like the spouse who manufactures one excuse after another in the face of a partner's erratic behavior, we construct all sorts of explanations for our shortcomings.

Or we just put the blinders on. When I started working with traders some years back, I asked them to indicate their profitability over the past year. I was shocked that most could not give me (or would not give me) a response other than a hesitant, "I'm coming close to break even." Many had simply stopped looking at their account statements. The idea of actually drilling down into their trade data and extracting information about what they were doing right and wrong was quite threatening for them.

Sadly, there are plenty of willing accomplices in this denial. Coaches eagerly assure you that "psychology" is the difference between winning and losing in markets; gurus promise you hidden market secrets that will enable you to unlock your potential; publishers crank out books on how you can succeed at trading. But no one solicits trading magazine articles, workshop presentations, or books on the topic of *lack* of edge. No one wants to hear all the first-hand stories I can tell about lives and relationships harmed and even destroyed by false hopes and promises.

That's too uncomfortable. No one can make money from it. So we don't look at it; we choose to not know. But I'm telling you truthfully: I've seen just as many lives hurt or ruined by trading as enhanced.

A while back, I was asked to submit a proposal for a workshop hosted by one of the major financial exchanges. I thought a real public service would be to present research and first-hand observations pertaining to addictive patterns among day traders: how to recognize trading addiction, and what to do about it.

The idea was shot down immediately. As it turns out, it wasn't the conference coordinator that pulled the plug, but the corporate sponsor of the event. Sponsors don't make money when people don't trade or when they trade in a more controlled fashion. People, after all, come to hear about trading as a dream, not as a nightmare.

A little while back a trader begged me to talk with him over the phone and help him with his "self-defeating" emotional patterns. In an unguarded moment, I agreed. He told me about his anger and frustration during trading and how those had led him to violate his risk management rules.

I asked the trader to give me examples of what was going on during these periods of frustration. Many of the occasions boiled down to times when he was profitable on trades, but then saw those profits reverse. I drilled down further to get examples of those trades and discovered that, even though he called himself a daytrader, many of his reversals occurred on positions held overnight. Indeed, he proudly told me his rule that limited his overnight exposure to only his most profitable daytrades.

A bit skeptical, I asked him what he based the rule on. How did he know that profitable positions intraday would become further profitable if held into the next day?

He seemed stunned that I asked. I guess we're all supposed to know that "the trend is your friend" and that you should always trade with the trend.

I quickly got on the computer, downloaded daily open-high-low-close data for the S&P 500 Index (SPY) going back a little over a year (to the start of 2007) and threw together a spreadsheet that looked at returns following up days and down days. There was no programming or advanced Excel techniques to what I did; it took all of a few minutes.

To recreate what I found: When SPY was up on the day (N = 159 trading days), the next day's open averaged a loss of -.02% (79 up, 80 down). Similarly, when SPY was up on the day, the next full trading day averaged a loss of -.13% (75 up, 84 down).

When SPY was down on the day (N = 146), the next day's open averaged a gain of .03% (86 up, 60 down). When SPY was down for the day, the next trading session as a whole averaged a gain of .11% (85 up, 61 down).

So, in other words, the trader's rule had absolutely no grounding in reality. If anything, he would have been better off fading the prior day's direction. He was becoming frustrated and angry because he was losing his profits. He was losing his profits because he was trading a setup that had no validity. Frustration wasn't causing his trading problems; his bad trading was generating (understandable) frustration.

But, for me, the eye-opener was that he had never thought to check out his rule. Even if he didn't want to crack an Excel primer and learn how to find answers for himself, he could have simply kept records of his overnight trades vs. his intraday trades and seen what was working and what wasn't.

But he didn't do that.

That's when it hit me: He didn't *want* to know.

My caller was not happy with my analysis and did not seek me out further. I didn't deliver what he wanted. He wanted a self-help psychological technique to keep him disciplined, so that his rules would make him money. He didn't want someone pointing out that his rules were invalid and that following invalid rules with discipline will simply lead to ruthless consistency in drawdowns.

As our conversation wound down, he defensively explained that he had plenty of other patterns that he traded that were valid. One of his favorites were opening gaps. Long story short, I examined the spreadsheet and told him that this, too, was coming up blank. To recapitulate, upside opening gaps led to 83 wins and 82 losses for the coming trading day; downside gaps led to 71 wins and 69 losses. There were no significant differences in the sizes of winners and losers. There was no edge there at all.

"But that's for the S&P," he said. "The gaps work for the stocks."

"Which stock would you like me to run the data on?", I asked. He said no thanks; he didn't need the data.

But the analysis wasn't the point. The point was that he was trading a belief in an edge, not an edge that he had independently validated. His entire trading strategy rested on (blind) trust in these patterns. He didn't *want* to know if the patterns were good, because that--like the spouse's actual discovery of an affair--would necessitate facing unpleasant realities and making difficult changes.

I recently started work with a trader who wrote to me in elaborate detail of recent trading losses. He immediately offered to share his account statements with me so that I could help him change what he was doing. No denial. No defensiveness. No willing blindness. Just an open kimono. I confidently predict that this trader will be successful. He's doing the hard work right now: he's facing shortcomings with eyes wide open. By owning what's worst with his trading, he'll discover the best within him.


A Cardinal Trading Virtue

The Dual Path to Trading Success