Thursday, May 17, 2007

Risk Management and the Biology of Trading Psychology

Readers of this blog are probably familiar with Dr. Bruce Hong, who has graced many posts with insightful comments. He recently helped us understand how the adrenaline rush impacts trading in stressful circumstances.

I'm happy to report that Dr. Hong now has his own blog and is elaborating upon the biology of trading psychology. He offers considerable insight into the biological mechanisms of learning and how traders develop bad habits. His explanation of the role of the amygdala in learning under conditions of stress and the counterbalancing influence of the prefrontal cortex is the best, clearest account I've yet encountered.

A very important implication of Dr. Hong's work is that risk management is perhaps the preeminent tool of trading psychology. When we trade with excessive leverage, exposing our accounts to potential drastic drawdowns, we create the kind of stress-based learning that overwhelms the executive abilities of the prefrontal cortex.

There are many guides for risk management, but perhaps this psychological definition is simplest of all. You should always ensure that any loss you are likely to take in a position will not be large enough to generate an emergency response of mind and body. The size of your positions relative to the size of your portfolio will serve as a kind of magnifying glass for the stress responses of mind and body. Read Dr. Hong's posts carefully, and you'll understand why risk management is a biological--as well as psychological--trading imperative.


Psychological Risk Management

Self-Inflicted Problems of Trading