Saturday, May 02, 2009

Risk Management in Trading and Emotional Self-Control

In the recent post, I reflected on the fact that I find the psychological needs of high frequency traders to be different--and greater on average--than those of traders who make decisions on longer time frames. We've also seen how large increases in trading size and risk contribute to the emotional ups and downs of traders. The problem traders call "overtrading" is often the result of frustration and poor impulse control; less well appreciated are the ways in which overtrading--both in size and frequency--help to initiate and sustain emotional dysregulation.

It is axiomatic among the hedge funds where I work that, when you're not trading well, you reduce the risk associated with your portfolio. Very often, portfolio managers will take a little time away from markets, regroup and focus on areas of distinct opportunity, and then take limited risk in a limited number of positions. As markets begin to reward their views, they then participate more fully and gradually return to more normal risk-taking.

This psychological risk management strategy prevents traders from losing all their profits during a slump, but it also preserves the trader's psyche. Dampening P/L swings enables the trader to simply focus on markets and regain a sense for how markets are trading. Even among daytraders, it's not unusual to see the most successful ones take breaks in the trading day during difficult periods and stop trading for part of a day if losses are accumulating to an unusual degree.

One advantage of working at a professional trading firm is that there is at least one individual designated as a risk manager who, like a pitching coach, will come out to the mound and consult with you when you're not doing well. Sometimes the risk manager/coach will even have to take you out of the game for a while. This preserves mental capital as well as trading capital: the idea is to trade your smallest and your least when you're trading at your worst.

The independent trader has no dedicated risk manager and so has to rely on hard and fast loss limits, position sizing, and "time out" rules to regulate the psychological risks of trading. Mentally rehearsing these rules as part of pre-market preparation and post-market journaling helps cement them as habit patterns.

A lesson I've learned over many years of coaching and work as a trading psychologist is that poor trading practices can inflict considerable psychological damage. You can't sustain emotional self control if you don't have firm controls over how you trade.