Tuesday, October 14, 2008

The Two Trading Problems I'm Hearing Most About

The old saying indicates that fear and greed are the emotions that dominate markets. If the conversations and emails I've had with traders during the recent market crisis are any indication, I'd say that the dominant emotions have been fear and frustration. In behavioral terms, those have translated into failing to take trades and trading too much to recoup losses.

As I've emphasized in the past, eliminating emotion from trading is both impossible and undesirable. The "feel" for markets possessed by the best traders is a form of emotion; Antonio Damasio's writings on this subject are must reading. I recently talked with a therapy client who was angry with herself for not "trusting my gut" and leaving a bad relationship; as she recognized, that gut represents information.

When we become very anxious or frustrated, however, our assessments of risk and reward are impaired: that is the enduring message of behavioral finance research. Regional cerebral blood flows no longer activate those executive parts of the brain responsible for planning, judgment, and decision-making. Rather, we regulate our motor activity as part of "flight or fight". In the flight mode, we flee from risk and inhibit trading decisions. This leads to immediate safety, but also missed opportunity. In the fight mode, we confront risk and activate trading decisions. This leads to the relief of taking decisive action, but also poses increased possibilities of loss.

With market volatility at record levels, it's not unusual to experience outsized losses when trades are wrong. These losses place a figurative magnifying glass on our flight or fight responses, activating stress modes at exactly the times we want to be most deliberate and planful.

The answer to this dilemma is to work on self-observation, so that you can recognize when you're in stress mode *at the time the flight or fight responses are occurring*. You neither want to reflexively flee markets, nor leap into them after losses. Running away and taking revenge are not trading strategies. Instead, you want to switch your attention from markets to yourself and take constructive action to bring yourself back to a calm, planned mode of operation. Very often this will involve cutting trading size temporarily (to reduce risk and that magnifying glass effect), taking a break from trading, and implementing self-control strategies such as those described in my books: meditative breathing and imagery, biofeedback, sessions with sound and light machines, etc.

The key is not which stress management method you utilize, but rather cultivating the self-observing capacity to step back from crisis reactions and taking the time to re-enter planning mode. If that takes an entire day to achieve, it is time well spent. In short, you should be totally focused on markets when you're trading, except at those times when you find yourself focused on money. On those occasions, you want to focus on yourself and your state of mind, so that you can eventually re-enter your "zone". To the extent you're thinking of P/L, you're not focused on markets, and that's as risky a situation as any financial crisis.