Trading is based upon the notion of recurring patterns in markets. These could be patterns of price behavior, patterns of response to world or economic events, or patterns that occur in the relationships among markets. A common trading pitfall is perceiving patterns where none truly exist. We can become anchored to recent occurrences and assume that these will recur. We can overemphasize dramatic market occasions, such as large drops in prices, and look for similar "setups" going forward. If we look at enough patterns, something by chance will appear to be significant. Not all "overfitting" is performed by quants.
Just as there can be patterns--and false patterns--in markets, these can also exist in our trading. One daytrader I worked with had flat results over several months. When we dissected the P/L, it turned out that certain hours of the trading day (early morning) were consistently profitable. Other hours were losers. The patterns being traded, which involved momentum, were more likely to occur during periods of higher liquidity.
I also met with a portfolio manager who was having trouble making money. When we examined his returns, it turned out that newly initiated positions were getting stopped out for losses unusually often. This was because, in a lower volatility market, he was waiting for strength before going long and waiting for weakness before selling. He kept stops tight and thus was whipsawed when the short-term price movement failed to extend.
There is tremendous benefit in dissecting your returns as a trader. Yes, we can overinterpret and perceive patterns that do not exist. Many times, however, there are rational explanations for why the returns are patterned. Perhaps we're trading differently after having made versus lost money. Perhaps we're trading differently as a function of market conditions. Perhaps we're trading differently as a function of how we have prepared for the day or week.
I find it again and again: Successful traders spend significant time not trading, studying their markets, and studying their performance. Successful sports teams review game films to prepare for the next contest. What is your review process, and how rigorous is it?
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Here's an important principle: Your attention operates like a magnifying glass. We program ourselves with our attention. What we focus upon, grows within us.
This is why our self-talk is so important. If we focus upon our shortcomings and berate ourselves for our mistakes, that is what we internalize. We recognize this with parenting. We realize that if we were to focus on every flaw in a child, we would damage their self-esteem. As I mentioned in a post a while back, we are what we eat--and we're always eating life experience. Our experiences are what we internalize. Ultimately they define who were are.
In trading, if we focus on rules and best practices, we make those our own. As young children, we had to be taught rules of proper behavior, such as thanking people who do good things for us. Now, as adults, we don't need to consult the rule or motivate ourselves to follow it. We naturally feel gratitude for good deeds and offer thanks. The trader who makes rules about risk management or about what constitutes opportunity consistently focuses on those rules and eventually they become internalized principles. They are no longer simply things to do; they are part of us.
Merritt Black recently reviewed the Principles from Farnam Street and applied those to trading. One of those principles is that "principles outlive tactics". A tactic is something we do in response to a particular situation. A principle is something that guides us across all situations.
Here's a great experiment: Quickly, write down the principles that guide your trading. Only give yourself a couple of minutes for the exercise.
If you can't enunciate your principles quickly, they are not an automatic part of you. It's when principles are front and center that they form the backbone of trading process. That can only happen when we focus on principles and keep them conscious.
What a great practice for developing traders: Writing principles on a card and consulting them before trading for preparation, during trading for execution, and after trading for review. After a month of such repetition, we become more consistent because we become more principled.
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A while ago, I wrote in an article that, "Perhaps the greatest mistake in managing our lives is to treat energy and willpower as finite resources." It is partly for that reason that a major theme in the book I'm currently writing is renewal. All of us lived new and fresh lives as children growing up. The challenge of adulthood is to re-new and rediscover that early sense of adventure and excitement.
One of life's great paradoxes is that we need routine to efficiently navigate through life--think how exhausted we would be if we had to approach each task as if it were our first time--but it is precisely that immersion in routine that makes life feel, well, routine. Renewal requires new-ness, the exiting of routine to partake in what we find enjoyable, meaningful, and energy-giving.
In the new book I describe a "principle of alternation" that helps us recharge: By arranging daily activities so that we draw upon different strengths, we rest one set of functions while exercising others. For example, I might alternate trading time with time spent helping people as a psychologist and then turn to immersing myself in family activity and finish the day reading a new book and listening to favorite music. The energy from each of these activities stimulates the next ones. We become like batteries continually connected to a power source: we don't run down.
That is an important part of living a truly diversified life. When we alternate activities that draw upon the best of us, energy and willpower are no longer finite resources. We spend much of our days facing the sunshine. That not only brightens our perspective, but lights our path.
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I work with many diligent traders who review their performance regularly, see what they need to improve, set goals for the next time period, and then move forward. It's a great process, but it misses one thing: vision. Rarely do goals in and of themselves truly motivate us to go beyond what we believe to be possible. That takes a vision that captures our imagination, challenges us, and becomes an overarching priority. Goals can help us implement our vision, but goals without a clear animating vision are little more than to-do lists.
In my latest Forbes article, I outline three strategies for getting to that all-important next level of performance. It turns out that the environment we create for our performance, the ways in which we pursue performance, and who we work with on our performance make all the difference in the world. But notice in the article that two of the performers I cite choose truly audacious goals driven by a vision. They seek something big. They seek something meaningful.
Without vision, we are blind. Without a vision of extraordinary achievement, we will always function within ordinary expectations. The three strategies I outline are effective precisely because they align our goal-seeking with our vision.
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Colin Wilson's insight is that we approach life as a spectator, not realizing that we are the ones in the control room. We experience pessimism when we believe we have little control over the important outcomes in our lives. If you examine successful people, you find they structure their time in ways that give them that sense of control. This is one reason living by goals and plans is so important. Only dead things go with the flow. Our job is to guide our lives. That means being in the control room.
Wilson also recognized that we tap a small portion of our potentials. This is partly because we tend to lead constricted lives. Think of our emotional states and how rarely we experience true unbridled joy, profound fulfillment, or even deep and heartfelt regret. Consider our physical states and how rarely we operate in modes that could bring us to our second wind. Reflect upon our intellectual states and how rarely we truly challenge ourselves with new ideas and challenges.
Constriction of life lays the groundwork for pessimism. It is difficult to remain negative if we experience varied emotional, physical, and intellectual lives.
Will you ever reach your true potential if you are planning, reviewing, and working on your trading while leading an unexamined, constricted life? If each day is an opportunity to stretch ourselves emotionally, physically, and intellectually, each day becomes an adventure--a journey into unexplored territory. Pessimism most often results when life is routine and we no longer experience fresh, shining vistas.
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The previous post highlighted distraction as a major source of trading problems. We have limited capacity for high-quality, focused concentration, and that shows up as limitations of willpower. Too often, we lose discipline in trading, not because we lack emotional control, but because we encounter limits to our capacity to sustain intentional action.
This helps explain why overtrading is so deadly. Trading requires mental capital, and after a while our cognitive bank account runs dry. When we overtrade, we almost guarantee that we will trade with suboptimal focus. Indeed, that's not a bad definition of overtrading: when our trading activity exceeds the capacity of our willpower.
An interesting corollary of the last post, however, is that perhaps we should *minimize* trading decisions and maximize the efficiency and depth of our information processing. What if we only traded when we had complete focus? How would that impact our results? Our trading psychology?
But, wait, here's an additional dimension to our challenge:
We can trade within the capacity of our willpower, but what if we need further willpower for the rest of our life outside of trading? I can tell you from personal experience that trading a full day in active decision-making mode leaves me pretty much like mush for the remainder of the day. Yes, I can perform routines and carry out normal social activity, but my capacity to sustain meaningful effort after a day of hard trading is severely limited.
That's not a great outcome for someone who has responsibilities outside of trading. If you hope to raise a family, deal with personal and relationship challenges, sustain physical fitness and optimal nutrition, expand yourself intellectually, and maintain a research program to adapt to markets and develop new sources of edge, you'll need to summon focus and willpower when you shut down the screens.
It's no coincidence that the majority of active daytraders I've worked with are single males. They are "passionate" about trading and expend their mental energy on placing trades and managing positions, but surprisingly often achieve relatively little off the trading floor. That is not a sustainable way to live life.
The bottom line is that most of us should be trading less. Much less. Activity born of true passion *gives* us energy. If you're finding yourself drained by the work of trading, you are probably shortchanging the rest of your life and jeopardizing your returns with the overtrading that results from lack of focus.
Not many gurus in the industry have a vested interest in telling you to trade less. Not brokerage houses, not trading coaches looking for your business, not prop firms that charge commissions from your activity or make hidden returns from selling your order flow, not hedge funds that seek nice returns but tolerate little downside, not firms that want to sell you trading software or advisory services, not "education" providers that promise the latest, greatest trading strategies, not vendors who will sell you whiz-bang overfit trading systems. They all benefit from you trading. Sadly, their livelihood depends on your overtrading.
With the idea that less can be more, I've constructed a trading approach that specifically minimizes trading decisions. It's really a framework for active asset management. Using ETFs with minimal management fees, I created a volatility-weighted portfolio consisting of fixed income, equity, and commodity returns. The specific ETFs were selected to minimize correlations among positions, maximize yield/dividend (carry), and maximize liquidity. I then studied the historical performance of the portfolio and identified the few times in a year when it would have been highly beneficial to institute a tactical hedge. The resulting quant model provides an on-off signal for an SPX hedge using three variables (time, breadth, volatility).
So that's it. Most the time, the portfolio does what it does, benefiting from asset strength and making a nice carry return during flat periods. Once in a while, when markets become turbulent and fragmented, the tac hedge kicks in and buffers the overall equity beta. The result is a framework for minimizing trading, but using trading insight for improving active investing. Less commissions, less wear and tear; more time for family, travel, community involvement, and other productive endeavors like book writing.
When I mentioned this framework to a few active traders, they responded with horror. It makes trading totally boring!!
Right.
No excitement. No drama. No gurus to follow or workshops to attend. No FOMO. Just diversification, portfolio construction, and informed hedging.
That's an important edge in itself.
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What if traders miss good trades and impulsively take bad ones, not because they are emotional, stressed, frustrated, or lacking in discipline, but because they are too distracted to maintain the focus needed for effective pattern recognition?
What if your trading environment not only does not bring out the best in you, but actively distracts you from what you need to be focused upon?
What if *how* you are working is precisely what prevents you from achieving your potential?
Some savvy traders have recently pointed me to a book called Deep Work by Cal Newport. The author refers to deep work as professional activities performed in a state of distraction-free concentration that pushes our information processing capabilities to their limit. The important idea here is that we need to be in a heightened state of focus to reliably formulate and execute plans and also to exercise our creative capacities to see opportunities others are likely to miss.
It is when we are in the heightened state of concentration that we find our cognitive second wind and enter into the flow state we sometimes call "the zone". Initially, concentration is taxing. It's easy to become fatigued and move to other activities. If we can sustain the focus, however, we hit that point of second wind where we're capable of doing deep work.
Multiple screens. Ongoing chats. Talk on the trading floor. Tracking indicators, markets, news...all of these contribute to distraction and keep us out of our zone. As Newport points out, the difficult truth is that we have to make friends with boredom if we are to enter and stay in our zones. This is why so much quality writing and artwork is performed in solitude.
How much solitude do you experience in your trading? In your life?
How deep is your work?
Perhaps the reason you're not finding opportunity in your trading is because you are not in the right cognitive mode. If you were to skim the surface in all your conversations, you would never build a meaningful relationship. Is our relationship with markets all that different?
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I recently went through the tweets under the #tradingpsychology hashtag on Twitter. It was interesting. The great majority of postings were relevant to beginning traders and pertained to emotions interfering with decision-making.
What are key trading psychology issues that experienced traders deal with? Here are three that I've recently worked on with portfolio managers and traders:
1) Teamwork - How to build a team by hiring the right kind of junior professional; how to team up with other experienced traders in a way that offers quality for all; how to get more out of conversations with traders.
2) Creativity - How to process market information in new and deeper ways to see patterns and relationships that otherwise would go unnoticed. How to better integrate information at different time frames and/or across different markets. How to better blend intuition and rigorous analysis.
3) Self-Development - How to renew energy at the end of difficult days in the market; how to better review one's trading to identify what is and isn't working; how to more rapidly update views and adjust to market changes.
If I had to generalize, I'd say that beginning traders turn to psychology to deal with frustrations. Experienced traders turn to psychology to hone performance. At its best, psychology is a tool for learning from experience, not just a salve for emotional wounds.
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I've read hundreds if not thousands of journal entries during my years of working with traders. One pattern shows up among the traders who make greater success:
Their performance journals are highly focused.
The trader surveys his or her trading and identifies one big thing to work on that will make the greatest difference to the bottom line. They sustain that single focus until they have demonstrated significant progress. Then they move to another "big thing" goal to work on.
The lesser successful traders recount everything that has happened in their trading and what they need to do better next time. Lots of good intentions, not many concrete goals.
It is difficult to sustain a sense of urgency when working on many things at one time. When there are many goals, it's easy for a priority at one time to distract from efforts at other priorities.
When I see the progress of traders with many goals, it is difficult to pinpoint where they have made dramatic improvements. The more successful traders seem to be working on fewer things but they actually get more accomplished.
Here's the framework I'm using for my own trading: one prioritized goal per month. Each day I have a specific plan for working on that goal and each day I review my recent work on the goal and modify my plan. If there are roughly 20 trading days in the month, that means that I have at least 20 reps in my workout, 20 trials in my deliberate practice. The reality is that I have more than that, because I take midday breaks in my trading and treat morning and afternoon as separate trading "days". So that means 40 reps, working on just that one goal.
Then a new goal the next month.
And the next month.
By the end of the year, the idea is to have 12 big things that you've accomplished, each making you better. That's a big outcome, and it springs from a small beginning: a single important thing to work on that will make a positive difference in your trading. Keeping a report card on your trading is huge. Focusing that report card takes it to the next level.
What's your One Big Thing?
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Here's a trading psychology lesson from my own trading today. Twice today I had positions that went my way, only to reverse: one for a loss, one for a scratch. Since those were trades that normally work well for me, I began digging into the reasons they didn't work out.
My first hypothesis, always, is that I have missed something in the market. I don't automatically attribute my losses to psychological factors. These were trades that have worked very well for me in the last two weeks and something felt different today. I trust that sense of "something different".
To provide some background, I tend to enter trades actively (I'll pay the market price) and exit passively (I'll work an order to exit). The exit is a function of the expectable move in a particular holding period. In my case, the holding period is 60,000 ES contracts traded. I know from my research that, over a 60,000 contract horizon, we can expect moves of a given size.
Today, the two trades I had that didn't work out came close to my targets, but failed. Yes, that could be due to chance, but maybe something else was at work...
Notice the ES and SPY volume for today's session. According to my stats, the SPY volume in the afternoon was running at about half the expectable level for that time of day. On normal days, we might get 60,000 contracts traded in 25 minutes' time. Today it took more than an hour. Everything slowed down.
Except for my expectations.
In other words, per the above quote, my internal relations (my expectations) did not adjust to the the external relations (the volume and volatility of the market). I placed my take-profit exits at one level and that level didn't get hit in the time frame expected. That is because I was calibrating by chronological time when I know to calibrate in volume time. Had I let the trades run for the hour rather than a 20-ish minute time horizon, I would have made money on both.
To use an analogy, the music on the dance floor slowed way down and I was still in my faster dancing mode. I needed to adjust to the pace of the music, not my accustomed pace. Institutional participants really moved away from the market today, and it traded a helluva lot more like a 10 VIX market than the 15 VIX we've seen recently. I didn't adjust, and that becomes my job tomorrow: to be prepared if relative volume comes in low once again.
Folks, this is real trading psychology from real time trading. Not the pronouncements of some self-appointed guru who tells you to control your emotions, listen to your emotions, keep yourself mindful, trade your plan, etc, etc. Market participation changes daily, and the balance of buyers and sellers changes daily. Our job is to recognize and adjust. Sure I can calm myself and trade with confidence. If I don't recognize how the market is behaving differently right here, right now, however, I'll simply lose money calmly and confidently.
When markets change faster than we adapt, bad things happen to P/L. Our job is to adjust our internal expectations to the external realities of the market.
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Think of working out in the gym. There is time when you work the muscles, and there is time when you rest them. The cycle of workout and rest increases blood flow to those muscles and enables them to grow in a sustainable fashion. If you only rested, you would never build your muscles. If you only worked, you would overtax yourself and break yourself down. Growth occurs over multiple cycles of work and rest.
This is an important lesson of the Sabbath in the world's religious traditions. After a period of creation, we rest and renew.
Some traders fail because they work too hard. Others fail because they hardly work. Performance is achieved when we effectively alternate effort and renewal. Growth occurs in the cycles of doing and reflecting that comprise deliberate practice.
Thanks to a savvy portfolio manager who passed along this article on how the Golden State Warriors make use of their halftime to dominate the third quarter of their games. It is fascinating to see how the coaches plan for the halftime during the game, collecting videos that will help the team build their confidence and focus on the right things in the second half. The period of rest during halftime becomes an integral part of improved performance for the remainder of the game.
Mike Bellafiore, in a recent blog post, notes that this same dynamic occurs on the trading floor. Traders keep running "playbooks" of their best trades and use breaks during the trading day to review their plays and share insights with other traders. When I worked at Kingstree in Chicago, traders would formally divide their trading day into morning and afternoon sessions, with a break in between. They allocated separate risk (loss limits) to the two sessions, effectively creating two trading "days" in one. Midday served as a halftime, a period of rest when they could learn from what they did right and wrong, update market views, share insights with colleagues, and rejuvenate.
What are your halftime drills? How are you utilizing periods of rest in your trading? In your life?
When we increase the frequency of cycles between "performance" and "halftime", we speed our deliberate practice and development.
How we rest is as important as how we work.
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The most unappreciated element in success in any area of life--trading or otherwise--is the capacity to sustain effort. We can think of this capacity as intentionality: the ability, over time, to exercise free will.
For much of daily life, we follow routines. This is efficient, allowing us to get the most done with the least effort. A great example is driving a car. Being able to do that automatically enables us to carry on conversations, listen to music or podcasts, etc. The problem occurs when we become so immersed in routine--so wedded to getting the most done with the least effort--that we are unable to sustain the efforts that generate distinctive performance.
Important research from the psychologist Mihalyi Csikszentmihalyi identified a "flow state" in which people become capable of high levels of creativity. The flow state results from being immersed in efforts over time--a kind of hyperfocus. In that state of superfocus, we become capable of processing information in new ways, seeing patterns and solutions that escape us in our normal state of awareness.
In our ordinary state of mind, we can only achieve ordinary things. All success comes from the ability to transcend routine. But that requires effort and the capacity to sustain effort. Successful people have developed routines that exercise intentionality: that build the capacity to sustain flow states. They sustain those efforts by pursuing their strengths: what they are good at and what speaks to them. We achieve hyperfocus when we are hyper-interested in what we are doing. If you need discipline to get things done, you know you are not operating in the sphere of your strengths and passions.
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