Trading Psychology – What’s it all about?
If you’ve read any other Stickies or FAQs on T2W, you’ll have gathered by now that there are very few absolutes in trading. In other words, there are very few things about which most traders – let alone all traders - agree. One such absolute is trader psychology. If your head is in the wrong place, the chances of you screwing up increases exponentially. Ultimately, screwing up tends to result in one or two things, sometimes both: failing to realise a profit and/or taking a loss. (Please note that losing trades are not necessarily ‘screw ups’ and, by the same token, it’s possible to make a right pig’s ear of things and still exit a trade with a profit.) Then there’s the question of scale. Minor screw ups are to be expected, especially amongst novices. These are fine, necessary even, to teach the trader important lessons about themselves and about the markets. Major screw ups are best avoided, not least because few traders can afford to have very many of them. The goal of this Sticky is to equip you with the basic information required to ensure that all your future screw ups are minor learning experiences, not major disasters from which you may never recover. To achieve that, let’s start with the first of the three mental functions and behaviours mentioned in the opening post: confidence.
Confidence
As a trader, you are engaging in a performance activity. In this respect, you are in the same arena as actors, musicians, athletes and other sports men and women. Top sports stars have to have confidence in their abilities. Watch any sport, whether it’s a team game like football or an individual game like tennis and you can usually see who’s playing with confidence and who isn’t. In the final stages of the Wimbledon tennis championships, you will often hear commentators say things like:
‘S/he’s having to dig deep to find the winning shots when it really matters’ or
‘It’s all about who wants it the most’. The point is that, arguably, there isn’t much difference in terms of sheer ability between the top 10 players in the world. Yet, Federer, Dvocovic and Nadal repeatedly divvy out the major trophies between them. To a greater or lesser extent, what separates these three champions from the other seven top ten men is confidence.
As a trader, especially when you’re starting out, you’re competing against professionals at the top of their game - right from day one. There are no junior markets where you can practice and gradually work your way up to the senior circuit. There is no ‘newbie friendly’ kindergarten market where your broker will give you your money back if everything goes pear shaped. The best you can do is to paper trade on a demo account and, when you make the transition to trading real money, start trading with the smallest size possible. It is often said that the worst thing that can happen to a novice trader is that they start on a winning streak. If you took up tennis and, only having played the game for a few months, somehow found yourself in a competitive match against Federer – you would lose. That’s a no-brainer, obviously. The only way you could possibly win would be if Federer sustained an injury and retired. Ironically, the same thing does
not apply to trading. You can win from the get go and then you’re likely to suffer from the one thing that’s even worse than having no confidence at all – being over-confident. Make no mistake, the minute you start to think you’ve got the markets sussed and it’s just one great big personal ATM machine, you’ll get your ar$e handed to you on a plate. And that comes with an official T2W guarantee!
So, what is required then is balance; confidence without being over-confident, based on knowledge, acquired skills and experience. Hollywood actors can fluff their lines, famous musicians can hit bum notes and pro’ footballers can score own goals. However, whilst all these things can and do happen, most top performers in these professions are confident that they’ll do well most of the time, based on their training and dedication to their craft. And so it is with traders. However, unless you’re taken on by a bank or proprietary trading firm, getting to the stage at which you can justifiably be confident in your own abilities is likely to take longer than you think. Much longer. To be able to consistently take profits out of the markets over the medium to long term as a retail trader, is akin to taking up acting with the view to making a living doing it. It could happen, but probably not overnight. Or learning to play the guitar with the view to becoming session musician. Or taking up football with the aim of playing for a team as a salaried player. Some people will say that trading really isn’t as difficult as any of the above. Maybe they’re right. However, one thing is for sure. Most novice traders start off by being over confident, fuelled by hope and fantasy, without any real idea of the scale of the challenge that lies ahead of them. Having read this far, you no longer have that excuse.
Gaining confidence is a slow process and will reflect the time and effort you put in to acquiring the necessary knowledge and honing your trading skills. To do this efficiently, you will need to structure your learning. Think about the top musicians and sports men and women mentioned earlier. To a greater or lesser extent, the quality of their performance when they’re under the spotlight is dictated by the study and practice they put in when they’re away from it. That study and practice isn’t arbitrary or random; it’s highly organised. You must try and manage yourself with the same sort of mindset that a great manager like Alex Ferguson uses to manage Manchester United. Brett Steenbarger refers to this as being ‘process-driven’. To acquire real confidence, based on true ability, you’ll need to become process-driven. Here’s how he explains it:
“Sports teams practice their plays again and again so that they can execute automatically and flawlessly in games. A surgeon has a research-tested process for conducting a delicate surgery; an artist has a process for training an apprentice. When traders are process-focused and process-driven, random needs, impulses, emotions, etc. are less likely to interfere with trading. Equally important, the process can ensure that traders are as consistent as possible in doing what they do best.”
Discipline
Confidence in ones abilities is the result of acquired knowledge and practical application of skills and experience. It takes time and lots of hard work to acquire. Even if you have good reason to be confident in your trading abilities, on its own, it’s not sufficient to ensure success in the markets. You need more. You need discipline. The good news here is that discipline is easier and faster to acquire. Indeed, you may already be a disciplined person and just need a few pointers about how to apply it to the markets. The bad news is that many traders fall at this hurdle, as it proves much harder to master than many of them imagine.
On paper, trading with discipline is straightforward. It’s simply a case of knowing what to do at any given time and then doing it. Or knowing what not to do and not doing it, as the case may be. To achieve this, you must have a trading plan that details everything relating to your trading life. Whatever the markets throw at you, you never want to be caught like the proverbial rabbit, frozen, starring into the headlights. Expect the worst and plan for it. Your trading plan will detail exactly what your edge is, how to trade it well and the positive expectancy that you’ll enjoy when you do. (For an explanation of the terms ‘edge’ and ‘positive expectancy’, please refer to the FAQ
Essentials Of 'First Steps' ) The challenge then is to trade your plan day after day, week after week, month after month. That ain’t easy. Somehow, amidst the highs and lows of daily life, you have to trade your plan consistently and methodically. All the while the markets, i.e. the people on the other side of your trades, are doing their utmost to part you from your money. This is one of the reasons why some discretionary traders turn to mechanical trading systems, as computers are a bit more level headed and consistent in their approach than their human operators.
Let’s return briefly to the tennis analogy. The commentators love their match statistics and, in the interval between games or at the end of the set, they look at the key stats of the competitors. Often, that’s all that’s needed to see why one player is doing better or worse than their opponent. Their first serve percentage has dropped from 75% down to 65% or their return of serve has dropped from 77% to 60% - or whatever. In other words, they can’t maintain their edge; i.e. play according to their game plan. Casinos don’t have this problem because their edge is in-built into their games such as the zero on a roulette wheel. Unfortunately for traders, performing at their best and executing their edge consistently is as tough for them as it is for tennis players. And, just like tennis pros, when you don’t trade well, guess what happens? Your confidence takes a hit too. Just to be clear, ‘trading well’ does not mean having lots of profitable trades, it means trading the way your trading plan dictates that you should. It’s entirely possible to trade well and have losing trades, just as it’s possible to trade badly and have winning ones.
Let’s just delve a little deeper into what a trading plan is and the role it will play in helping you to trade in a disciplined fashion. A trading plan is a complete set of rules that covers every aspect of your trading life. Many amateur traders do not have any sort of plan to trade by, and enter the markets with scant regard to their risk and profit objectives. Suffice to say, comprehensive risk and money management strategies lie at the heart of all good trading plans. Traders with a plan have the ability to monitor their performance. They can evaluate their progress continually, day-by-day, in a way that is objective and comprehensive. This enables them to trade without emotion and with minimal stress. The trader without a plan is not able to do this and their trading tends to rely upon gut feeling, hunches and tips etc. Trading for them is a nail biting, emotional roller coaster ride of stress that, inevitably, results in financial loss.
Obviously, a plan does not guarantee success; that would be too simple. However, if you trade with discipline and adhere to your plan, it will help to minimise losses and enable you to stay in the game a lot longer than traders who do not have a plan. In his book ‘trading online’, Alpesh B. Patel writes,
“While a plan cannot predict the future, it can lay down how you react to the possible outcomes. This is why a plan is essential. It is a list of strategic responses to events beyond your control. You control the only thing you can control – yourself”.
Think of your trading plan as a roadmap. It is quite literally the route that will take you from where you are now to where you want to be which, for most traders, is consistent profitability. In this analogy, consistent profitability is the destination. To embark on a car journey from, say, John O’groat’s to Land’s End without a good roadmap or SatNav would, probably, be unwise and the possible consequences of doing so are obvious. Similarly, to embark on trading without a clear idea of where you are going, and how you are going to get there will, almost certainly, result in increased stress, sleepless nights and financial loss - or all three. The question you must ask yourself is this: if you wouldn’t dream of driving from the north of Scotland to the most southerly tip of England without a detailed roadmap or SatNav, why on earth have you not got a detailed and clearly laid out trading plan?
A trading plan will make the act of trading simpler than it would be if you traded without one. It will limit your opportunity to make bad trades and it will prevent many psychological issues from taking root. It will help you to achieve these things because wherever you are on your trading journey, it will not only act as a roadmap, but also locate your position as well. Most importantly, if your trading is going badly, you will know it is down to one of only three possibilities: either the characteristics of the markets have changed, or something in the plan is not working or you are not adhering to the plan. If the plan is a good one and it is back tested and paper traded, (or forward tested with a very small amount of money), then the fault is likely to be your poor discipline in sticking to the plan. But, what if you are losing money whilst trading without a plan? It is virtually impossible to distinguish what you are doing right from what you are doing wrong. You have no way to evaluate your results, therefore the likelihood of being able to diagnose the fault and correct it is small and could take forever. A trading plan is your personal GPS device to locate your position and, if you have made a wrong turn, it provides the means to identify where you went wrong and how to get back on track. You are able to evaluate continually your results and, more importantly - your discipline - in a manner that is objective and comprehensive. It is another example of being process-driven and is extremely difficult to do if you do not have a plan.
A trading plan should take away much of the decision making in the heat of the moment. Emotional issues will become very powerful when real money is on the line and, as likely as not, force you into making irrational decisions. This is what markets do. They mess with your emotions. This is because they are predicated on two of the strongest and most basic human emotions of all: fear and greed. How to deal with these demons is what we’ll cover next.
Emotions
When you have knowledge, skill and experience; a thoroughly tested trading plan which you execute with discipline and confidence; your trading ought to be calm and stress free. However, this will take time and experience to achieve and, in the early days, there could be times when your stomach is knotted with fear or your head is spinning with $ signs. We are human beings after all; we are emotional creatures. Emotions and the markets are a very mixed bag. Emotions in others are, potentially, a source of opportunity for you as a trader. By the same token, your emotions could be a source of opportunity for the people on the other side of your trades and the cause of your undoing.
Lots of traders and investors lost money in the dot com crash in the spring of 2000. Companies that had next to no income – let alone profits – had ridiculously high valuations. The higher they got, the more people piled into them, motivated by fear and greed. Fear because they were worried they’d miss the boat when everyone around them was making easy money, and greed because they wanted some of that easy money for themselves. Then there were those who could see what was going on. They didn’t buy into the hype and the sky high valuations; they knew it was unsustainable and so they went short the markets instead. Even though they were correct, many of this group lost money as well. In the famous words of John Maynard Keynes,
‘The markets can remain irrational for longer than you can remain solvent’. How galling it must have been to be forced out of one’s short positions for a loss as the markets continued to rise, only to then witness a crash which would have made huge profits. This little lesson in recent history teaches us valuable things about the markets:
1. Taking trades based on strong emotions is rarely a good idea.
2. Trade what you can see is happening, not what you think might happen, as you can lose money even when you’re ‘right’.
3. Good timing is often essential – especially to directional traders.
Given the topic of this sticky, we’ll confine our attention to the first of these three lessons to examine why taking trades based on emotions is liable to result in financial loss. In his T2W article entitled:
Lessons from Behavioural Finance Lee Bohl writes:
“It should come as no surprise that people feel pleasure when they win and pain when they lose but what might surprise you is that the psychological impact of wins and losses of the same magnitude is not the same. According to research conducted by Nobel laureate Daniel Kahneman and Amos Tversky people feel the sting of a loss two and a half times more strongly than the pleasure of a gain of the same size. This phenomenon, often called “loss aversion”, is at the root of one of the most common of all trading mistakes- holding on to losers for too long.”
As a new trader, you’ll continually feel the pleasure associated with winning and the pain associated with loss. In time, the highs and lows should start to even out because you’ll know that any one trade is not important. It doesn’t matter whether or not your last trade was a winner or a loser and, just as importantly, it doesn’t matter if your next trade is a winner or a loser either. What matters is that you trade consistently well and that collectively, over time, your results produce a positive expectancy. ‘Trading well’ means trading with confidence, trading with discipline and, most importantly, trading in accordance with your trading plan.
Remember the tennis stars mentioned earlier? You often see them punching their fist in the air after a winning shot or looking up to the heavens in dismay after a losing one. However, the respective pleasure and pain they feel is very short lived and they quickly put it behind them to focus on the next point. They know that they’ll have lots of winners and losers throughout a match, so there’s little point expending too much emotional energy on any one of them. (Okay, the one exception is the point that wins or loses them the match!) They also know that their opponent could win more games than them, but that they can still win the match. And so it is with traders. Your win:loss ratio can be less than 50%, but you can still be net profitable because you win more on winning trades than you lose on losing ones.
So, what’s the bottom line with emotions? Basically, you have to monitor them and categorise them, knowing that some emotions are not conducive to trading well. Some of the traders who were stopped out of their short positions in the days and weeks leading up to the crash in March 2000 will have been a bit miffed – to put it mildly. Some of them may have tried to recoup their losses and shorted the market for a second time as it plummeted. They may or may not have got lucky. Either way, they weren’t trading well – as per the definition provided above. They were allowing their emotions of anger, fear and greed to dictate what, when and how they traded. In the months before the crash, there were loads of traders who had made some serious coin as the markets soared ever higher. It was easy. But they weren’t trading well either. They were motivated by greed, their (over)confidence was not based on knowledge or acquired skill and their trading plan – such as it was – comprised of going long only on tech stocks. True, many had experience, but it was only based on a bull market which, naively, many thought would just keep on keeping on.
Clearly, trading that’s based on emotions is potentially harmful to your financial health. As the examples above illustrate, some emotions can be categorised as being ‘bad’ for traders. Does this mean all emotions are bad? In his article entitled
Emotions, Decisions and Discipline Steve Ward puts forward the case of that some emotions are not only positive, but are essential in order to trade well. So the key then, is to know what you’re feeling at any given time and to think about how your emotions affect the way you trade. If you trade in the evenings when you get home from work and you’ve had a stressful day – give the markets a miss that night. If you’ve had a string of very profitable trades and you think you’ve got the Midas touch – be extra cautious. It’s about self-awareness and being sensible. Only allow emotions that have a positive impact on your trading to influence when, where and how you trade.
Summary
If you play roulette in a casino, the house edge is the white zero slot on the wheel. Wheels with a single zero provide the casino with a positive expectancy of just 2.70%. That’s small, but it’s enough to make fortunes for their owners and ensure that the pews at Gamblers Anonymous are always full. When you develop your trading methodology, you must identify what you think is your edge. When you paper trade it, it should result in a positive expectancy. If it doesn’t, you don’t have an edge. If it does, your next challenge is to transfer it to the live market trading real money. That’s the point at which the ideas discussed in this sticky will really come into their own. The light bulb will flick on. You’ll ‘get it’. Well, hopefully you will anyway!
You can have a brilliant methodology, based on exhaustive research with a brilliant trading plan to match. However, if you can’t trade it consistently well, then your P&L will yoyo up and down quite erratically. And if that happens – stop trading immediately and investigate why. Assuming you forward tested the plan and the results were consistent, then there’s unlikely to be anything wrong with the plan itself. That leaves two other possible explanations: either market dynamics have changed or you’re not following your plan. In most cases, the latter is more probable than the former.
Trading well is all down to you and is dictated by your confidence, attitude and how you feel about yourself and the markets. You’ll gain confidence by becoming a student of the markets, and by being process-driven in your acquisition of skills and experience. Discipline is about knowing what to do and when, regardless of what the markets throw at you. A good trading plan will include every conceivable scenario with your response in black and white. If you ever find yourself in a quandary, unsure of what to do next, then your trading plan isn’t robust enough and is insufficiently well thought through.
Lastly, some emotions may be beneficial to your trading but there are definitely some bad ones that have the potential to ruin you financially. You are who you are and how you respond to certain circumstances or events will be different to the next person. Therefore, there is no general ‘one size fits all’ prescription about what to do or not do in any given situation. You have to work that one out for yourself. But hey, the good news is that the person on the other side of your trade is in the same boat, but s/he probably hasn’t read this sticky (or anything similar) and, even if they have, they probably won’t act upon it. Unlike you of course. Hint, hint!
