Sunday, May 21, 2023

The Greatest Challenges of Trading Psychology - I: Trauma


There is a common assumption among traders that if they are falling short of their performance expectations, it must be because of their mindset.  If only they can maintain a positive mind frame, the thinking goes, they will be able to succeed.  There is an element of truth of this, and there is an important sense in which it is seriously misguided.

Research suggests that, when we are in our best frames of mind--and especially when we are operating with optimal well-being--we will be more productive and also more creative.  We will engage in our best trading when we are trading consciously, with what I have called a high mental Sharpe ratio.  The right kind of trading interests us, gives us energy, and doesn't deplete us.  The positive mind frame is both a contributor to good trading, and it is also the result of good trading.  Importantly, the proven change methods of psychology can help us find, not only positive emotional experience, but a deep spiritual fulfillment.  That can help make trading personally as well as financially rewarding.  In that sense, trading is not simply about making money.  It is one among many paths toward becoming the greatest person we can be.

It's a logical fallacy, however, to assume that because positive mindset is necessary for optimal trading, then trading success will necessarily follow from improving our mindset.  Negativity can interfere with the performance of an elite athlete, but reaching that elite status requires far more than a positive mind frame.  Mastery is a complex combination of inborn talents, available opportunities, and skills acquired through deliberate practice.  No amount of positivity can substitute for the experience required to gain mastery in any performance domain.  Trading the right way is just as likely to generate positive emotional experience as positivity will help our trading.  

Notice that, in any performance field, the process of gaining mastery is separate from the process of professional performance.  That is, a basketball team will practice offense and defense during the week before playing a weekend game; a singer will practice with a coach before performing in a concert; military troops will practice maneuvers before entering the battlefield.  One of the greatest challenges of trading psychology is that market participants spend relatively little time in pure practice mode and instead hope to gain their experience by putting their capital at risk.  They even justify this by claiming that practice modes cannot duplicate the pressure and stresses of live trading.  Can you imagine battlefield commanders or professional golfers foregoing practice because the stresses are not the same as in actual performance?  It is precisely by cultivating skills through deliberate practice under increasingly realistic conditions that we develop our mastery.

What happens psychologically is that traders who put their capital at risk too quickly encounter losses and P/L volatility that they are not prepared for.  These are experienced as dangers and threats to one's trading successes.  When we take risk too quickly and when we take too much risk in search of high returns on capital, we create emotional upheaval.  This turmoil does not just go away because we tell ourselves to be disciplined and to have a positive mindset.  It is the nature of trauma to stay with us and to be triggered by future experiences similar to those past losses.  I've described this as the dark side of trading:  with unrealistic expectations of profit and premature risk-taking, traders expose themselves to significant emotional turmoil that ultimately unhinges their future performance.

Because market conditions change frequently, even experienced traders need to revisit their learning curves and gain fresh mastery.  If they continue to trade aggressively and with large size based upon past success, they will be vulnerable to significant drawdowns when market themes, trends, and volatility change.  The most successful traders maintain their high mental Sharpe ratios by quickly detecting market changes, avoiding losses, and returning to a mode of observation and practice to gain mastery in the new regime.  If our overriding need is to get bigger and bigger and make more and more money, it's only a matter of time before we traumatize ourselves.  

The best way to learn is to fail fast.  The best way to fail fast is to fail small.

Further Reading: