Saturday, March 24, 2007

Psychological Risk Management

Not too long ago, a trader indicated to me that he was having difficulty controlling his emotions when trading. At times he would become paralyzed by fear, missing opportunities. Other times, determined to not be caught in the headlights, he would lurch into markets and refuse to cut his losses. It became a cyclical process: he would lose money, reduce his size and trading frequency, become frustrated with missing out on opportunity, jump into positions out of that frustration, and then lose money again. Interestingly, this happened even if he was trading so small that the losses could not hurt him financially. Indeed, he found that he was trading emotionally even when he was placing "paper" trades in simulation mode.

The problem was that, even though he was trading small size and controlling his risks financially, when it came to his emotions, he was "all in". As he described it to me, he *needed* trading to work out for him. He saw no alternate future in another career and, indeed, dreaded the possibility that he might have to seek a "regular job". He also had experienced disappointment in love and had few friendships to fall back upon when things got tough.

In short, he was counting on trading for most of his self-esteem. It didn't matter what his financial risk was: his psychological risk was always sky high. His cyclical attempts to make profits and pull back from markets were not real trading strategies: they were coping strategies to manage his feelings about himself.

What we *need* controls us, and when the eggs of our needs are placed within a single basket called "trading", the performance pressures are simply too great to bear. Diversification of our positions in the market will matter little if we lack diversification in our sources of gratification and self esteem. The want for success is very different from a need for success, and the desire for success is different from the need to not be a failure. A rich and full life outside of trading is the best form of psychological risk management. The inevitable periods of drawdown in trading are far easier to bear when we are collecting dividends from the rest of life.