Saturday, November 21, 2009

Learning to Shift Emotional Gears as a Trader

A worthwhile blog post written by Richard Friesen describes what happens to traders when their brains downshift into flight or fight responses. In the post, he suggests a breathing and visualization exercise to achieve control of both body and mind. As I noted a while back, an effective way to prevent yourself from going on tilt in your thinking and trading is to exercise physical self-control.

Still another way to exercise self-control after a difficult trading period is to strictly control your trading size and the risk taken per trade. Large increases in position sizing magnifies the variability of profit/loss swings, which in turn magnify our emotional responses. The drama created by the increased risk creates potential trauma emotionally; once we're scarred from negative experiences, we end up trading scared.

A little while ago, I hit a high water mark in my yearly P/L and then took a full-sized position in a longer-term trade idea. Now, of course, we can increase the risk of trading not only through position sizing, but also through holding periods: the longer we hold a position, the greater the variability in returns. After all, the market moves up and down more in a week than in a day; more in a day than in a 20-minute period.

By trading full size over a much larger time frame (my average bread and butter intraday trade lasts less than 30 minutes; this one was a hold for several days), I increased my risk significantly. I felt justified in doing so, because I was confident in the trade idea.

Was I emotionally prepared, however, for a possible 20 point ES futures swing against me? Not at all. Instead of thoroughly thinking through that scenario and making sure I could live with it, I allowed my confidence to blind me to the possibility of being wrong.

And wrong I was. I took my largest loss of the year in a couple of days, erasing the gains of the prior two weeks.

Worse still, the experience left me frustrated and wanting to get back to my high water mark. The next day, eager to get back into the market, I forced myself to sit and watch. When I returned to the market, I limited myself to a single trading setup (a variation of my trusty transition pattern) and my short-term (intraday, under one hour holding time) framework. My trading size was kept moderate, so that potential losses would be entirely manageable.

Within a week, I recouped the loss and returned to my high water mark. I did so by chipping away at the drawdown, focusing only on my highest probability trades. The key was turning the frustration of the bad trade into a doubling-down of my determination to trade well. To accomplish that doubling-down, however, I needed to shift gears emotionally. Hitting the sidelines for a day and lowering my risk per trade were central to that effort. Had I tried to trade while I was hot, using size to recoup my losses all at once, I surely would have dug myself a deep hole.

Even though I've traded since the late 1970s, and even though I'm a psychologist who works with traders and all too familiar with trading pitfalls, I make the same mistakes--and am subject to the same biases and faulty decision making--as everyone else. No psychological techniques eliminate bias and bad trading. The best we can do is learn to shift gears, control risk, stay emotionally intelligent, and play to our strengths. That's what builds a trading job into a long term career.