Friday, October 17, 2008

When Good Trading Leads to Bad Trading: Breaking Problem Cycles

Consider the following scenarios:

1) A woman is motivated to lose weight and goes on a diet, losing 20 pounds over time. As she becomes more comfortable with her weight, she relaxes the diet and begins to put the pounds back on. Only after she has returned to her original weight does she reinstate the diet with renewed motivation.

2) An alcoholic attends AA meetings every day and remains sober for months. He tells himself he can become a social drinker and control his intake, only to relapse into his prior pattern of overdrinking and erratic behavior. When he is given another DUI citation, he is in jeopardy of losing his driver's license and returns to his AA meetings and prior sobriety.

3) A trader has gone through losses and trades smaller and more cautiously, planning out trades carefully in advance to maximize reward and minimize risk. As he makes money, he relaxes his trading criteria and takes a number of unplanned trades, resulting in losses. Once he loses the money he had made during his good trading, he returns to trading smaller and more carefully.

Each of these is a situation in which problems occur in cycles. The cycle involves strict, conscious, and motivated attempts at self-control followed by lapses of self-control. During the periods of self-control, the unwanted behaviors are contained; during the lapses, they spiral out of control and bring undesired consequences. Think about the eating patterns of a bulimic patient or the interaction patterns of spouses who repeatedly fight and make up. The problems are different, but the cyclical quality of the problems is constant.

Much of my book The Psychology of Trading deals with this problem of "multiplicity": how people can behave one way, in one state or frame of mind, and quite the opposite when those states shift. Reviewing cognitive neuroscience research, I conclude in the book, "People lose money in the markets because the person who places the trade very often is not the same person who manages and closes the trade. Quite literally, another self has taken over--another mind...People cannot sustain purpose in their lives--and trading is certainly a purposeful act--because they are fundamentally divided beings" (p. 79).

It takes the shock of significant consequences to change people's feelings and state of mind and shift them into the self-controlling mode. Once those consequences are not salient, the mind state becomes more relaxed, the urgency of maintaining control is reduced, and old behavior patterns come to the fore.

Conversely, when consequences are *always* salient, there is no problem maintaining desired behavior patterns. Most of us don't feel particularly tempted to steal merchandise from stores or drive at high speeds on the wrong side of the highway. We're quite aware of the consequences and following rules and doing the right things take no particular act of effort or discipline. Similarly, when a heart attack patient realizes his fragile health status, he finds it relatively easy to stick to a regimen of medications and proper diet. Salience of consequences promotes consistency in behavior: in classrooms, at work, and in day to day life.

The first step in breaking problem cycles of behavior is to become aware of those cycles as they are occurring and to focus attention on the likely consequences of those cycles. In practice, this means being very sensitive to the triggers that set the problem cycles in motion. For the alcoholic, the triggers are cravings or thoughts that it might be possible to engage in controlled drinking. For the trader, the triggers often are frustration and perfectionistic thoughts about how much money one should have made (or shouldn't have lost). If those triggers are accompanied by alarm--a concern for consequences--it will be relatively easy to interrupt the problem cycle and, in the case of trading, step back from the screen, calm oneself, and redouble efforts at careful, planned trading. The entire key is attaching that sense of alarm to those triggers.

I'll have much more to say about this in my forthcoming book on self-coaching, including specific techniques for sustaining self-control. Readers of the Trader Performance book might want to consult the chapter on "Behavioral Techniques for Enhancing Performance", which outlines, step by step, how to identify triggers and use exposure techniques to interrupt and reprogram them. In the exposure method, you use relaxation and guided imagery to vividly walk yourself through specific trigger situations, while you keep yourself physically calm and cognitively focused and mentally rehearse the concrete actions you want to take in those trigger situations: recognizing the trigger, reminding yourself of the dire consequences of repeating the problem pattern, and redoubling your efforts at cautious, controlled trading.

In other words, you want to respond to the trigger situations--the frustration, the thoughts of needing to trade to make money back, the overconfidence--the same way that you respond to losses of significant money. Instead of waiting until you lose money to become virtuous in your trading, you train yourself to become virtuous when you recognize the trigger situations and feelings that would take you out of your game. The more you mentally rehearse the trigger situations in the right state of mind and body, the more prepared you'll be to respond to them in a calm and focused way when they arise in real time.


Problem and Solution Patterns

Breaking Trading Slumps

Top Reasons Why Traders Lose Discipline

Understanding Lapses in Trading Discipline


ivanhoff said...

"People lose money in the markets because the person who places the trade very often is not the same person who manages and closes the trade."

I believe that the said above might have a positive effect on trading. When the person who closes trades literally (physically) differs from the person, who initiates trades, the result would be much more disciplined trading: strictly following of stop losses and not putting good money after bad. I believe this is how most banks and hedge funds trading desks should operate.

mr rolfsson said...

This is sooo much me! I make a few good trades and feel like king of the world. Next trade Im all in and the trade goes against me. Im sure Im right so I keep it running and loose all my profits and are deep under when I close it. This almost always happend when I have decided to stop trading for the day and I see this golden opportunity that I cant miss. It almost always leads to a loss. But will a book change my trading personality?

Globetrader said...

It doesn't matter how bad your screw-up was, if you recognize it as a screw-up, if you are able to see, why it happened, you are already on your way out of the woods.
Losing 30% of your account in one day? With the recent turmoil in the markets it can happen and has happened to more than one trader I know.
But the question is, what do you do next? Why did it happen? Was it your system, which made you consistently money in the past, only to be lost within a few bad bad trades, or did you change your own behavior, your own responses to the market.

Certain trading techniques work great in a ranging or slightly trending market. But if the range/trend goes 500 points as you see in the YM recently only to reverse within the next 30 minutes, any trading method designed to scale into a trade, when it is at a loss, might not work, because the range is just too high. It worked in calmer markets, but it does not work right now, as you can't afford the risk involved.

Did you ever try to swim in the ocean, when the waves are between 1 and 2 or 3 meters? When they go beyond? If you are not careful and a wave breaks over you, and you are pressed under water, struggle to come up, only to have the next wave break above you again, you might feel real panic. Only by calming yourself and diving below the next wave instead of tumbling around, will you reach the surface again and be able to swim to shore.

Using trading methods, which worked for years will kill your account in this environment. But the problem is not your trading approach, your trading rules. They are most likely still sound, even if we have very high volatility.
Good trading rules work on small intraday timeframes as well as on daily charts. The only difference is, that the risk and the possible reward increase the higher the timeframe becomes.
Currently we see daily or weekly ranges made within minutes and hours. But that doesn't mean, you won't get good trade entry signals.
But your money management rules, they need adjusting!

Why are you a daytrader? I know, why I'm a daytrader. I can't afford the risk associated with holding overnight. My targets are smaller and the risk I take is smaller, as I place the stop nearer. But right now -as we all know- we see daily ranges within minutes. That means you need to adjust your stop or you get stopped out a lot more often than you are used to. Most of us trade with targets. If the Internet connection breaks down, at least a stop and a target order are placed. But did you adjust your target to the higher volatility, to compensate for the wider stop?
Most likely not, because you trained yourself to be content with 10 or 20 points even if the market ran another 100 points after you exited. Adjusting this is very difficult, as you need to overcome your fear of losing paper profits.
And, at least I, can sit calmly in a trade in the red, as long as my stop is not hit, waiting for it to return to green, while sitting in a green trade for a longer time always urges me to take profits now, instead of waiting for the next leg and the continuation of the trend.
Adjust your maximum position size. If you scale into a trade adjust the levels at which you scale in. be prepared to go out in a moments notice, if the trade does not work, because some moves just don't stop at the moment.

If you lost high, do what you always do, see where you failed and continue trading your signals. You can't climb out of a 30% loss in a day. But if you have a sound system, it will work in this environment, if you adjust your money management rules. And once you made it back, don't relax, continue doing what you did to climb out of the hole, so you can start the next leg up in your account.

Brett Steenbarger, Ph.D. said...

Thanks for the comments on the post. Very good point, Ivanhoff: by controlling your state, you can also promote positive decision making. Mr. Rolfsson, you're right: a book can't change trading personality, but it can outline exercises and techniques that help us change our thought and behavior patterns. Finally, excellent, excellent points about adapting to the volatile environment, GlobeTrader. Thanks much.


kltrue said...

If you stop trading like a gambler, you stop having all these justification of reasoning to your recent losses. The deeper you dig a hole the deeper you get stuck in it. So stop digging.

"Never try to earn back your losses by how you made your losses..."