Saturday, January 31, 2009

Taking Heat on Your Trades

The odds of selling or buying a market at the precise top or bottom are pretty slim. What that means is that even the best trades will take some heat, i.e., some adverse price movement. Indeed, distinguishing between normal heat--random price movement around an entry--and just plain being wrong on the trade is an important component of trading expertise.

The recent post on emotionally intelligent trading is highly relevant to the issue of taking heat on trades. The emotionally intelligent trader uses the feelings generated by adverse movement to become more market focused, absorbed in the details of how and why the market is moving. If the heat on an S&P trade occurs on a modest TICK reading, for example, and is not confirmed by similar moves among small cap stocks and leading sectors, the trader may well conclude that it is merely noise. Conversely, if a leading sector moves opposite one's trade and the broad market follows, the heat may represent an important shift in short-term sentiment and warrant a quick exit. The emotionally intelligent trader neither ignores the heat nor overreacts to it. Instead, it becomes a prod to revisit one's trade and trade assumptions.

One of the common reactions I observe among traders is that they react to heat with frustration and a venting of emotion. This creates distraction and a lapse in concentration. Lacking emotional intelligence, the trader takes the heat personally rather than as fresh market information. When reactions are personalized in this manner, it is difficult to make decisions that are not impulsive.

A great way to deal with heat is to anticipate it. When traders react personally to adverse movement, it's often because they didn't expect to take heat. If you check out the posts on hot and cold emotional states and using imagery to accelerate behavior change, you'll see that mentally rehearsing expectable heat (and one's desired reactions to the heat) can very much instill sound trading behaviors. When we vividly imagine adverse movement and what we would do under various scenarios, the heat becomes familiar to us; it loses its threat value. Heat on a trade doesn't have to make us hot-headed. Once we expect adverse movement and have rehearsed how to handle it, we can channel our discomfort toward greater focus, awareness, and planning.


Globetrader said...

It might be time to revisit your copy of "Reminiscences of a Stock Operator" from Edwin Lefevre.
Livingstone tested the markets before he went in with a full position. And while he tells you quite strongly not to add, if the market proves you wrong, he never said, you shouldn't scale into a trade.
Make it part of your pre-trade analysis to define the levels where your trade-signal might still be a go and where you are proven wrong and should better stop yourself out.
Enter 25% or 50% of your position now and then place add-on orders into your stoplevel. Also be prepared to add, if your trade starts going your way.
That trade approach makes market heat part of your trade entry strategy, actually the trade which nearly stops you out before going your direction will prove the most profitable, while on the other hand saving you money in case you are stopped out, as you did not ride a full position from the first entry into the stop.
The emotional risk you take with this approach is, that you might override your internal red flag as you program yourself to welcome market heat instead of objectively looking for signals that a real market shift has happened and you have been proven just plain wrong.
Also you should adjust your stop if the market first goes your direction, hitting your add-on order(s) before reversing on you. Now you have a bigger position with a worse entry and the market momentum better carries you on or you just leave the trade at breakeven. There is always another trade signal waiting to be taken.


adan said...

geez, how timely enough does this article have to be for me that even the word verification below is one letter from spelling my last name, geez :-)

also very much enjoyed globetrader's comment

thanks ya'll....

Brett Steenbarger, Ph.D. said...

Great advice, GlobeTrader; thanks much--


The Stock Speculator said...

A note to Globetrader: Livermore also only traded oversized positions. so a 1/2 position for him might have been 100% of his principal or 50% of a fully margined position. When he was right he did make a fortune, but he was wrong often. he bankrupted himself 1/2 a dozen times. He became so depressed from trading that he stuck a shotgun in his mouth and took his life. Livermore is not always the best example. Just my take.

Stick Hansup said...

"Livermore is not always the best example."

...which is why you take the good parts and leave the rest alone. I guess the shotgun thing shows that Jesse Livermore needed to work more on his exits:-) He was either all-in or all-out both in life and in trading.

I also very much appreciate Chris's comment.