Sunday, January 31, 2016

Mental and Emotional Preparation for Trading

An important implication of the recent post on how to avoid bad trading decisions is that it is not enough to plan trades, write in a journal, or review performance.  If we make decisions in cognitive, emotional, and physical states that are different from the ones we occupied during our preparation, we're likely to find that the decisions we plan won't always be the ones we act upon.

Experienced traders don't just create a plan for a trade; they often plan a variety of possible scenarios for their positions based upon how markets behave, news that comes out, central bank decisions, etc. By anticipating a variety of events, these traders enable themselves to respond quickly in the face of surprise.

This mental preparation is most effective if it is also emotional preparation.  In other words, we want to not only anticipate a scenario, but also the thoughts, feelings, and physical states likely to accompany that scenario.  If a market is topping, for instance, and my short position starts to go my way, I know that I may feel uncomfortable on a bounce, and I know I'll have thoughts about stopping out of the trade.  I also know, however, that if it's a weaker bounce consistent with the broader topping action, it could be an attractive level for adding to my position.  If I plan the trade mentally but not emotionally, I increase the likelihood that I could act on the feelings and impulses of the moment and scratch out of a trade just when I really should be adding to my risk.

When we anticipate the thoughts and feelings that can nudge us from our best intentions, we make ourselves more resilient.  We're more likely to respond to stress with "been there, done that."  The idea is to make our planning as broad as possible so that we're anticipating a wide range of scenarios--and responses to those scenarios.  If there's one thing we want to minimize in trading, it's surprise.  Surprise--whether positive or negative--will shift our states and nudge us from trading plans.  When we prepare for a wide range of scenarios in which positions go our way or against us, we take the surprise out of market events and keep our responses more stable.

We cannot--and should not--eliminate emotion from trading, but that is also not necessary.  Preparation puts emotion into perspective; we gain control, not by staying Zen, but by anticipating situations that are likely to take us out of calm focus and preparing our responses to those.

Further Reading:  How to Trade Your Plans Once You've Planned Your Trades