As we saw in the last post, the starting point for addressing psychological problems in trading is making sure that the methods you are utilizing really do provide you with positive expected value. I recently spoke with a frustrated trader who was making money, losing it, making it, and then losing. He couldn't understand why he couldn't sustain his gains. It turned out that he was making use of trendlines that were promoted by an online trading service. The guru running the service pronounced that there was a "strong edge" in placing trades based upon these lines, but when I questioned, the trader acknowledged that he had not independently verified this edge. When I conducted a quick backtest, the signals based upon the lines displayed random forward returns. The trader's problems had nothing whatsoever to do with psychology. The psychological discomfort was the result of the problem, not the cause. All the attempts in the world to stick to his plan, improve his mindset, listen to his feelings, control his feelings, etc, etc, etc would not have helped him. This should always be the null hypothesis--the base case--for a trader experiencing distress and behavioral problems, especially if those do not show up in his or her non-trading life and if an edge had not been soundly established previously. The first hypothesis is that there is no edge--and you need affirmative evidence to reject that hypothesis. It is your methods, not your psyche, that need working and reworking. Only after establishing the soundness of what you're doing should work on psychology and performance take front stage. An analogy would be a golfer who runs into a string of poor scores. If the mechanics of the swing and the mechanics of putting have not been mastered, there's little sense in using visualization exercises to foster a winning mindset. A related hypothesis is that the edge that once was present is now no longer operative or has changed. If the golfer is playing in rainy conditions, that may dictate a change in swing and a change in each approach to the hole. If traders find themselves in low volatility conditions, that may dictate a change in the trading of momentum-based patterns. Edges are dynamic, requiring frequent adjustments by traders. Once you have identified and verified patterns in markets that capture your understanding of what makes markets move, any problems you might have in implementing the trading of those patterns might be psychologically driven. Here, the key is determining whether problem patterns in your implementation are caused by emotional or behavioral factors that show up as problems in other parts of your life, or whether the problems affecting your trading are indeed unique to the trading context. Many problems that impact trading are not specifically trading-related. For example, a person with fragile self-esteem or a person with poor emotional self-control will find these problems impacting their family lives and personal relationships, not just their trading. In such cases, work on those problems needs to occur outside of trading and well as during trading hours. There are research-backed psychological techniques for the great majority of these issues, as I lay out in the Daily Trading Coach book and in many blog posts. Trading problems that won't seem to go away are usually trading problems not being properly addressed. By looking deeply into the root causes of poor returns, we can figure out what is going wrong--and that's the first step in setting things right.
In a remarkable interview, Professors Marcos Lopez de Prado and David H. Bailey explain that much of what we think we know about financial markets is just plain false. When we look for so many patterns in markets and finally hit upon one that "works", the odds are great that what we've discovered is a false positive: the one finding in 20 that happens to test as "significant". What many traders don't recognize is that traditional in-sample/out-of-sample procedures for determining whether a finding is "overfit" or legit are inadequate. When computing power allows us to test thousands upon thousands of combinations of multiple variables, it is not difficult to find one permutation that tests "significantly" out of sample as well as in-sample. What many discretionary traders don't recognize is that they are equally subject to the biases of false knowledge. Traders will hunt for dozens and dozens of "setups" at various time frames and across many different stocks and trading instruments. They finally find something that "works" and decide that they have figured out their "edge". When future results fail to live up to expectations, these traders become frustrated and hire trading coaches who tell them to stick to their discipline. You just can't make this sh*t up. A daytrader who places many hundreds of trades in a year will, by pure chance, have runs of five or more consecutive winning or losing trades. Interpreting these runs as meaningful, the discretionary trader will increase or decrease risk taking solely on the basis of randomness. Imagine the trader who trades every day of the week and is ecstatic after achieving five consecutive days of profitability. He increases his risk-taking based upon his trading "progress" and quickly loses everything he had made. After five consecutive days of losses, he pulls back his risk taking only to see trades win with smaller size. All with no objective edge whatsoever. What a waste of life. So what is the answer to this problem of false knowledge from large data samples? I encourage you to check out the interview with Professors Lopez de Prado and Bailey. Links to articles explaining how to compute the odds of backtest overfitting are included. Also, Professor Lopez de Prado explains a much more basic flaw in what systematic and discretionary traders are doing: using the same tools to generate ideas as to test them. He emphasizes:
Backtesting should not take place before a theory has been formulated.
In other words, before we can determine whether or not we have an edge (in systematic or discretionary trading), we need to establish knowledge. A theory explains how and why something occurs. Testing of historical data can help us conduct limited, targeted tests to determine whether our theory holds up in practice. Before we test, we must formulate a plausible hypothesis. There is no theoretical or practical rationale why many strategies in technical analysis, fundamental analysis, or random combinations of quantitative variables should be valid. This is a perspective you won't find in most writings in trading psychology. It isn't good for business to tell people they likely have no edge and are not engaged in processes that can objectively capture edges in markets. Now more than every, however, the tools are available to help us truly determine whether what we're seeing is random or meaningful. For traders and investors interested in understanding what they're doing--not simply gambling on market moves--this is a most exciting and promising development.
So here's a great question: What one change in your daily routine will make the greatest difference: a) in your trading and b) in your life? How we live our lives shapes our habits and our mindsets. We cannot live one kind of life and expect to do a different kind of trading. If we live a life filled with drama or a life filled with inconsistency or a life filled with negative self-talk, that is what we will bring to our trading. It's also what we bring to our future. Who we are in the present and how we live right now shapes who we become. Each day is a practice session for our future. If we practice the right things, we develop the right ways. Too many traders mess up today and reassure themselves that it was all a good learning lesson. Bullshit. The learning comes from actively correcting the mess up--and then making that correction a regular part of your trading and your life. In some measure, be the person today you want to become in the future. That is climbing the ladder of development rung by rung. How we act shapes how we experience ourselves. Our routines create habits and our habits become part of ourselves. We don't have to impose discipline if we have developed the right behaviors as habits.
Too many traders focus on going fast--taking more trades, making more big trades--rather than build the consistency that can nourish a career. Consistency of outcome requires consistency of process. That means having a rhythm and routine for searching for opportunities--and researching them. It means having rules for position sizing and guidelines for when you add to positions and harvest profits in those. Consistency also means having risk limits and ways of operating within them. My experience is that consistent traders have consistent personal routines, both during and outside of trading. Bumping up your sizing/risk-taking makes sense if you have been successful and consistent. Bumping up your risk-taking without consistency is Russian roulette. But, watching people on the trading floor, I'm seeing one other element in trading success: teamwork in tandem. As in military training, developing traders buddy up with one another and dedicate themselves to each other's success. I describe this development in detail in my recent Forbes article: teams within teams provide a kind of mutual mentoring. That allows everyone to learn from each other, and it also provides the emotional and learning support that accelerate a trader's growth. It's a different take on "each one, teach one". When you learn one-on-one, you are always the teacher, always the student. The Forbes post explains how this accelerated learning occurs and why it's so powerful. When we put together consistency of process and intensity of learning, great things happen. Many, many traders fall short of their potential because markets change before they are able to adapt. Just as going to the gym with a partner can help you be more consistent in your workouts and do the exercises with proper form, trading with a teammate enables you to learn in an active--and interactive--mode. For many traders, this is a total game changer.
There's a great post from Merritt Black in which a video plays an ambiguous sound. If you think the sound is going to say "Brainstorm", that's what you hear. If you think the sound is going to say "Green Needle", then you hear that! It's the damndest thing..."brainstorm" sounds nothing like "green needle", and yet we can talk ourselves into hearing either one. How like markets that is, however! Two people look at the same chart and they come to radically different conclusions. We come in to a trading day with a particular expectation and, with just a little confirmation bias, we can find the evidence we need to put on the corresponding trade. It's yet another reason why trading with conviction is so dangerous. The same conviction that leads us to get large in a trade is the set of entrenched assumptions that shape our perception. We see what we believe. We expect what we believe most strongly. We act on what we expect. Merritt's post got me thinking about my school days. I took school seriously--my high school and college GPAs were between 3.8 and 3.9--but it was a certain kind of seriousness. I would have a test coming up the next day (or a paper to write) and that afternoon I would play baseball or basketball. I knew that I could pull a late nighter and get through the material, and that's exactly what I did. When I got to the test (or when I wrote the paper) I honestly can't recall wondering if I would get a good grade or not. I also can't recall thinking about what the teacher was looking for. When I got to a question I didn't know--or if I hit a block in writing the paper--I would put my pen down, relax my mind, and go with the first thing that came to me. I didn't think harder; in a sense, I stopped thinking and let the answer come to me. I knew that I had encountered the information. It was just a matter of letting it come to the surface. What I see among many traders--and what I've noticed in my own worst trading--is starting out with a view and then looking for trades that fit that view. More recently in my trading, I've begun the day with multiple hypotheses and then enter that open minded state to let the market tell me which hypothesis is playing out. It's like listening to a person from another country: you focus on picking up on their meaning, not imposing your own. The last thing a student is supposed to do before a final exam is hit the intermural building and play hoops with the gym rats. But that's what worked for me. I had already taken my notes, gone to my classes, and read my book chapters. By the time I was on the basketball court, all I needed was intensive review, not fresh learning. When I got to the test, I knew I had done the most intensive review possible. I didn't have to worry about what the instructor would ask, whether I would get a good grade, etc. It's all very relevant to trading. We do our preparation and our intensive review, but we don't let it become our lives. When we're not sure, we relax the mind and let markets speak to us. Eventually we'll make sense of it. The idea is to understand, not to trade. Perhaps this is why meditation is so helpful to many traders. It's not only a way to relax and focus; it's also a way to cultivate an open mind. We can see anything we're primed to see in markets. The key is getting past that priming. When we're actively prepared to see everything, we can quickly recognize when one scenario actually plays out. It's amazing what we can see when we come to markets with acceptance, not expectation.
If I had to mention one factor that accounts for the success of traders, it would be the intensity and consistency of their learning process. By supercharging our learning process, we can greatly accelerate our growth as traders. In a recent post, Mike Bellafiore mentioned the importance of developing and working within a "playbook". Once you have a collection of refined and tested market patterns, you now have a basis for evaluating your trading and working on the recognition and execution of trades related to these patterns. You also have a basis for examining how these patterns vary in different kinds of markets. Every day in the market, every trade placed, offers an opportunity for learning--and getting better. How you structure and implement your practice/learning process will shape your growth as a trader. On Tuesday, July 24th at the Traders Expo in Chicago, I will conduct a live seminar on strategies for accelerating our growth as traders. This will be an opportunity for group coaching and individual consultation, as I will be making myself available after the presentation. One of the things we'll discuss at the workshop are the elements that go into successful learning and practice. These include ways of reviewing our trading that literally re-view our trading and extract lessons that inform our subsequent decision making. When we turn every trade into a practical lesson, we greatly accelerate our learning. When we place more trades than we review and study, *that* is overtrading. What is the learning P/L of your recent trading? I look forward to meeting readers at the Chicago event! Brett
In the first post in this series, we took a look at the cognitive behavioral self-help techniques described in the new book by Dr. Seth Gillihan and how we can overcome our tendencies toward procrastination. The second post in the series examined the fear of missing out (FOMO) in trading and specific techniques for moving past that fear. This final installment deals with anger and frustration and methods for ensuring that these do not bias our decision-making. We typically feel frustrated when we are pursuing a goal and find our path blocked. If we want to reach a destination and we are slowed by traffic, we can respond to the situation with a flight-or-fight response, cursing the situation. When the situation becomes more personal--if we believe that someone stands in the way of our achieving our goal--the frustration can become anger and even rage. We most often experience anger if we believe our rights have been violated; that we have been mistreated or wronged. In the case of trading, our goal is to make money through our ideas and this goal is often thwarted by the adverse behavior of the market. We are faced with a loss instead of a gain and this can frustrate us. If we tell ourselves that other market participants are somehow cheating or gaming the system, our frustration can turn to anger. Once we're worked up in the flight-or-fight mode, we can make subsequent reactive decisions, turning one loss into many more. If a core skill of short-term trading is pattern recognition, then success hinges upon a high degree of focus and open-mindedness. When we lose peace of mind, we lose focus and openness and we trade what we want to see, not what we're actually seeing. Dr. Gillihan outlines several powerful techniques for moving past frustration and anger, including: 1) Know your triggers - Typically, there are a limited number of situations that have the power to set us off. If we are aware of those situations, we can mentally rehearse them and practice calming self-talk. For example, we can imagine ourselves losing on a trade, feeling frustrated, and then reminding ourselves that any edge in markets is only probabilistic and that losses are part of the game. This acceptance can help us regroup and generate the next idea. Self-awareness of triggers can also enable us to step back from trading temporarily when those occur, so that we don't allow frustration to impact our behavior. One especially powerful technique when a trigger occurs is to remind yourself of the costs of anger and how acting on the trigger has hurt you in the past. That way, frustrated behavior becomes the problem, not the triggering situation. 2) Relax and breathe with your anger - If you temporarily lost your faculty of vision, you would not blindly put trades into the market. The fight or flight response creates emotional blindness, so that you may no longer see yourself or the market clearly. If you use emotional arousal as a cue to relax and breathe more deeply and regularly, you practice self-control. Each episode of frustration thus poses an opportunity for you to achieve self mastery. You can actually engage your competitive instincts and look forward to losses as opportunities to beat anger. That way, every trade is a winning trade. You either make money or you build inner strength. 3) Practice acceptance - It is OK to lose as long as you exercise sound risk management in the sizing and management of your position. As we recently saw in a post on turning mistakes into trading successes, it is not uncommon for a losing trade to lead you to reassess your view and eventually generate a much better trade idea--often in the opposite direction. A sound trade that loses can provide useful information. By accepting the loss as a tuition for learning, we can move past frustration and gain from the lessons learned. I recently placed a good trade with high odds of taking out a prior market high. We moved toward the high, stalled, and then started to reverse on higher volume. I quickly got out of my trade at a small loss and flipped short, accepting that we had likely make the high for the day. The subsequent down move, trapping the longs, more than made up for the loss on the long position. We cannot prevent setbacks in life but we can ensure that we use these as sources of learning and development. Every day can be profitable if we're always using experience to make ourselves better. Once we realize that setbacks are opportunities, we can actually respond to them with gratitude. If life is a classroom, our setbacks are our lessons and we can give thanks for the opportunity to grow.
