Tuesday, April 07, 2009

Trading Scared is Trading Scarred

A trader dropped me an email today to explain that he was "trading scared": missing out on opportunities because he was overly risk averse. As luck (or Freudian psychology) would have it, he spelled "scared" as "scarred". That little slip revealed considerable psychological insight.

Most traders who trade scared are also trading scarred. Normal losing trades and periods of drawdown are processed normally, as expectable--if somewhat disappointing--events. When losses are substantial, however, they can be processed as traumatic events. Instead of being processed through normal, explicit, verbal channels, they activate the flight/fight emergency mechanisms of mind and body, leaving their emotional imprint. Later, events similar to the traumatic losses--even normal ones--can trigger the emotional and physical reactions of emergency, including paralyzing anxiety.

Interestingly, our trader had an excellent March after losses in December - February. During those losses, he explains, "I basically got pretty close to running out of money in my bank account." He feels that he should increase his size after the good month, but instead he's trading even more scared than he did before the winning month. As he recognizes, the making of money in March has restimulated his experience of losing money in December through February following a profitable fall season. Because the earlier losses nearly bankrupted him, they weren't experienced as normal losses. They scarred him in a traumatic way, and now he's trading scared.

When traders need profits to make the next paycheck that will put bread on the table, that is too much performance pressure. I've commented in the past that the smartest thing I ever did when learning trading was to begin with a trading stake that I could afford to lose in its entirety without affecting my family's lifestyle. Having the cushion of a second income and/or a secure savings account as backup means that normal slumps don't have to turn into career-threatening events. I've worked with traders who felt that, if they didn't make money in the current month, they would not be able to cover their mortgage payments. Normal losing trades became extreme threats, and the traders traded scared as a result.

It's when the desire to profit becomes an acute need for profits that performance anxiety is likely to overcome efforts at prudent risk-taking. Any business, when it gets off the ground, has to be adequately capitalized, so that it can weather initial adversity. The lack of adequate capitalization leads many traders to take large risks (to make enough money to support themselves), but also to trade with large fear (due to the absence of any cushion in the event of loss). Our trader should not be thinking of ramping up size after only a month in the black. Rather, he should work on achieving consistency with the kind of trading that worked in March.

That will build his cash cushion, his confidence, and ultimately his ability to take risk in a secure manner. The links below outline methods that are quite useful in addressing psych issues related to trauma.