Friday, October 20, 2006

Understanding Lapses in Trading Discipline

These are the three legs of the performance stool: (1) your talents and interests, (2) your trading style, and (3) markets and their personalities. The meshing of your qualities with your trading style will help determine your ability to trade that style with consistency and discipline. The meshing of your trading style and the features of markets will determine the degree to which you have a performance edge in the marketplace. The ever-shifting features of markets ensure that traders who are adaptable will be most likely to sustain expert performance over the course of a trading career.

Enhancing Trader Performance

I recently received several emails from readers asking questions about that perennial problem: maintaining proper trading discipline. Sometimes the problem is holding losing trades too long or violating stop loss levels. Other times, it's breaking rules regarding position sizing or when to trade (and not trade). On yet other occasions, the problem is failing to take trades that set up or jumping into trades before they fully set up. Always, however, the problem is a failure to fully follow plans and intentions.

As the quote above suggests, my new book--due out at the end of the month--tackles the discipline issue from a different angle. Discipline problems, I maintain, are not the cause of trading woes. They are symptoms of other difficulties. Just as a problem maintaining the "discipline" of monogamy in a marriage is frequently the result of underlying relationship difficulties, failing to be faithful to one's trading plans is often a sign of conflict between the trader and those trading plans.

In the book, I review research that identifies several key personality traits that affect our decision making under conditions of risk and uncertainty. These include:

1) Neuroticism - Our tendency to experience negative emotion. When people show a tendency toward anxiety, depression, and anger, the volatility of the market--and the volatility of trading results--frequently sets off emotional volatility, interfering with sound decision-making.

2) Extroversion - Our tendency to be outgoing and oriented toward the outer, rather than inner, world. When people have many extroverted features, they tend to be risk takers; when extroversion is low, they tend to be more risk-averse.

3) Openness to Experience - Our desire for novelty and stimulation. When traders have a high degree of openness, they lean toward more discretionary, unstructured trading methods; when the openness is low, they prefer highly structured, rule-governed methods.

What happens when the plans we select for our trading don't truly mesh with our basic personalities? The result is that we continually find ourselves veering away from those plans.

A trader high in neuroticism will have difficulty following a trading system that puts a large percentage of capital at risk, that trades volatile markets, or that requires large drawdowns.

A trader high in both extraversion and openness will have difficulty following a patient trend-following system.

Frequency of trading? Placement of stops? Times of day to trade? Number of instruments to follow and trade simultaneously? All are impacted by our personality traits.

When traders who are normally disciplined find themselves breaking their trading rules, the lapses of discipline are a symptom of a lack of fit between who the traders are and what their rules demand. A fine system on paper is unprofitable if it cannot be followed by a trader. A trading method not only needs to be good; it needs to be good for the trader.

The answer is not to blame yourself for lapses of discipline or exhort yourself with motivational nonsense. Rather, keep a journal and truly investigate each of your lapses. Then view those lapses as information, not as problems. What do they say about you? Which rules do you find yourself breaking, and what inside you might conflict with those rules?

Now look at your trading successes. What came naturally to you? What rules and plans can be derived from those winning trades? Don't force yourself into a pre-made set of trading plans: identify what you do when you win and see how you can make *that* into your system.

Maybe, just maybe, breaking your rules is the first step in figuring out who you really are. A variety of trading psychology articles on my personal site might further that process.