Monday, October 15, 2007

The Role of Regret in Trading

Cognitive researchers emphasize that our emotional responses are mediated by appraisals: judgments about ourselves and the world. Two people might take the same examination. One feels capable and prepared; the other assesses himself to be incapable of passing. It’s the latter student who will be likely to experience test anxiety.

In that sense, emotion is an experiential barometer that connects us to our evaluations of events and situations in real time.

One of the most fundamental appraisals we can make is whether we have been right or wrong in our decisions and actions. When we deem that we have acted properly and effectively, we experience satisfaction and pride. When we perceive that we have fallen short in our actions, the result is frustration and regret.

When we experience regret, we act as our own judge and critic. For most people, this makes regret an aversive state. The desire to reduce or eliminate regret thus becomes a powerful motivation.

Consider the trader who exits a trade and takes a small profit, only to have the position move further in his direction. Although the trader has taken a profit, the dominant perception may be, “I should have held the position longer.” Topmost of the mind is not the amount earned, but the amount left on the table.

Our trader is in a situation in which he may very well use the next trade to reduce his regret. Perhaps he will chase the market to get in on the move. Perhaps he will fade the market’s move in hopes of undoing the missed opportunity. In either case, his trading decision is colored by his need to reduce his aversive state. It will not be a decision made solely on the basis of opportunity.

Some of the most painful trading incidents of regret occur when a trader misses a top or bottom in the market and then refuses to get into an indicated trade, hoping that the market will pull back and provide another opportunity for the perfect entry. Many times this leaves the trader on the sidelines for an extended move that had been anticipated, magnifying regret many times over.

Perfectionism is the close cousin of regret. When we set perfectionistic goals, we set ourselves up to fall short. This leaves us with plenty of opportunity for regret. It is difficult to experience confidence in trading when our self-appraisals chronically tell us that we're falling short.

Because we are fallible and markets are not perfectly predictable, there will always be opportunities for regret in trading. We will take profits too early and miss moves; we will hold on for large gains and see our paper profits eroded. At best we will take pieces of moves and participate in only a fraction of the moves generated by markets. Every trader must learn to live with a certain amount of regret.

That is not necessarily a bad thing. Regret can be a positive motivator as well as an emotional trap. When we look back on mistakes we make or opportunities we miss, regret can lead us to learn from those experiences so that we will not repeat them.

Regret is one of the prime motivators behind my position size management, which often has me scaling out of trades. It’s not uncommon that I will have both a near-term price target for my trades (perhaps the midpoint of a trading range that we’ve re-entered) and a longer-term target (the opposite range extreme or the prior day’s high or low). I’ve learned to take a portion of my profits at the initial target and leave a small position for the more extended move (with stop moved to breakeven).

What this accomplishes is the opportunity to be paid out when I’m right on a move and also the opportunity to benefit from the larger move. I avoid the regret of losing paper profits by waiting for the larger move and having the market reverse on me, and I avoid the regret of missing out on a larger move. My position management thus becomes a tool for maintaining psychological equilibrium.

If I experience a strong degree of regret during the trading day, I almost always shut my trading down. I’ve learned from hard-earned experience that trades tinged with regret rarely work out. When I’m trading well, I’m focused on the market and what it’s doing. When I’m trading with regret, it’s about me and “getting even”. Indeed, when I find “should have” entering my thoughts, that’s become a cue for me to step back from the screen.

There’s a time and place for “should haves”, usually during after-action reviews of the day’s trade. Regret can be an effective prod to examine and improve trading, but it makes a poor rationale for placing trades.


The Role of Appraisal in Stress and Coping