Trading Psyche – Exuberance

Over the past several weeks I've been posting short articles that relate the psychological aspects of trading. Each post has focused on a particular emotion that we may encounter as traders, and that ultimately we need to deal with in a productive way. Today that emotion is Exuberance. In the words of Alan Greenspan, we might also call it Irrational Exuberance.

I hesitate to call this a rookie emotion, although I do feel that some amount of experience gradually helps us conquer the irrational aspects of this oh-so-good feeling. Conversely, any amount of experience doesn't remove it completely. The specific concern here is that traders might be overly optimistic about their chances for success.

Trading is a tough game. It's hard to be profitable. It's hard to compete with some of the most talented, smartest, and resourceful money managers in the world and do better; yet, that's what we try and do. I'm not trying to be negative, only to be realistic about the fact that trading is a business, and it's a tough one that requires a lot of determination and effort.
I'm not completely sure why this is the case, especially with new traders, but I've often thought that the financial education industry breeds it.

Do you remember the first (or last, or any) really good trading book you read? Do you remember closing the cover thinking, "I can do this!" Do you remember the seminar that you went to, coming away feeling confident that the method you just learned would work for sure? The financial education industry has to sell it that way, otherwise who would attend the seminars and buy the books? Have you ever seen anyone sell a seminar by saying, "This is really tough and we'll try to show you how, but most people will fail... sorry." That's not the way they sell them.

I'm not saying you shouldn't seek out and invest in financial education... you should. But we need to be realistic about what it is. Nobody walks away from a university with an MBA with the kind of optimism that comes out of a two-day seminar. I find that interesting. Bottom line: This is a business, and should be treated as a business. Yes - get an education and learn the business as you would any other. Practice and get experience, as you would in any other business. Here are a handful of things to put this idea in perspective:

• Start slow... Again, using the perspective of trading as a business, it's not typical for businesses to start out making money hand over fist. It does happen, but rarely. Plan to take some time. Learn and practice the craft of trading before you try to become a professional.
• Guard your cash... In any business, cash-flow is critical. When things aren't going well in a business, companies guard their cash. They cut expenses and reduce risk. It's not different in trading. Cash is part of your trading inventory and must be protected to stay in business.
• Have reasonable expectations... I've been in business for a long time and I have a pretty good idea when I look at a business plan whether or not it's reasonable. In most business growth comes slower than expected. We need contingency plans. Trading is no different. Have reasonable expectations about how long it will take to be profitable consistently, and about how much profit there will be. Can you make 15% in a month. Sure... on a single trade. I do it all the time. But to produce large returns on a portfolio over long periods of time is very difficult.
• Develop a business plan... Most good businesses have a business plan. Virtually all start-ups that want funding require it. Trading is the same... you need a plan. It should contain your beliefs about the market, your personal approach, specific strategies, money management, personal trading policies, and anything else that guides your trading. I have a well developed plan, but it remains a work in progress, and always will. Just like in any business, we are always learning, trying new things, and adapting to new market conditions.
• Review it frequently... Not only does my business have a good business plan, but we review it regularly and make significant updates. Likewise with trading... having a plan is crucial, but it's worthless if you don't use it. A trading plan is a map that will not guide you to your destination unless referenced. I personally review my plan in total monthly, right after each options expiration, and I refer to parts of it more frequently.
• Keep good records... Can you imagine a serious business that didn't keep good records? Actually, I can. I've seen them and it's not pretty. Poor record keeping and documentation is an indicator of a poorly managed company and ultimately failure. In trading, I log every single trade. I refer back, particularly to my losers, and evaluate the trade after the fact when I can see all the facts. This is invaluable in learning and improving.
• Strive to improve efficiency... Just like in business, trading gets better and more enjoyable as we become more efficient. For me, as a working stiff, it's also a requirement. Over a long time, I have been able to streamline many aspects of my trading exercises, but I am always looking to make it better. I want to spend as little time for as much profit as possible... not unlike any business.

I'm sure there are many more parallels to trading and business that we could learn from, but the main message here is, let's not get deluded into thinking that we can just follow some strategy we read in a book, put on a few trades and our pockets will be overflowing with money. That's Irrational Exuberance.

Good Trading...

Trading Psyche – Introspection

According to Wikipedia:

"Introspection is the self-observation and reporting of conscious inner thoughts, desires and sensations. It is a conscious mental and usually purposive process relying on thinking, reasoning, and examining one's own thoughts, feelings, and, in more spiritual cases, one's soul. It can also be called contemplation of one's self, and is contrasted with extrospection, the observation of things external to one's self. Introspection may be used synonymously with self-reflection and used in a similar way."

In two words you might summarize the above paragraph as: know yourself. In the world of trading, introspection refers to knowing yourself well enough that your trading style, strategies, and practices are in alignment with your beliefs, limitations, and other constraints that might come as part of our emotional baggage.

Part of taking control of one's psychological edge in trading is to find this alignment. Without it you are working against your very nature. It's a bit hard to explain, but let me try with an example. I know myself well enough to know that I simply can't stomach large losses. Huge draw-downs can be taken in stride by some, but not me.

When I have experienced large losses I found that it was so discouraging that I wanted to give up. It caused me to throw away all of my trading guidelines and policies and things just went from bad to worse. This is when the negative characteristics of Fear come into play. Consequently, I try to develop systems that don't trade that way. I use conservative strategies that produce a good number of wins compared to losses, and losses, while never welcome, are kept at a tolerable level.

Here's another one... I also know that I can't tolerate lots of losses, even if they are small ones. It just doesn't fit my makeup. I'm an optimist and I like my optimism to be fed by lots of victories. I have developed several nice trading approaches that have about a 50/50 success rate, but they work because winners are much larger than losers. I don't like them. If I don't see 65-75% winners (or more) it's just not fun! So, I use approaches that have a high frequency of winners.

Hopefully those examples help with the ways you might know yourself; and here are a few other things to think about as you self-reflect:

• Know your trading style: This refers to the examples I gave above. What can you tolerate? What do you like to see? What causes your stomach to churn?
• Know your strengths and weaknesses: Some people are great technicians. Others aren't. Some are great money managers, or have great intuition.
• Know your physical limitations: I have mentioned many times (it’s the theme of this blog) that I work a full time job. I can't day trade. I need to be able to enter order after hours, and can't even do that too much. Swing trading and Theta positive trading fit my constraints nicely.

There are many other topics on which to self-reflect... these are just a few. The point is, everyone is different when it comes to their psychological makeup and how it's applied to trading. People bring different beliefs and experiences to the table. Knowing yours will help tremendously so that you trade in alignment with those beliefs and experiences, rather than against them.

Good Trading...

Trading Psyche – Confidence

In this installment exploring the Psychological Edge of trading, I want to briefly discuss the role of Doubt, or said in a negative light – Doubt. In some ways, Doubt is a predecessor to Fear. It seems to touch all of us, and in time will grow into a level of Fear that will cause us to behave differently.

As a retail trader - a working stiff just trying to invest his money wisely - it's VERY easy to think that the Wallstreet guys are smarter than I am. After all, they're making the big money, living in the big city and cruising around in their yachts on the weekend. But the truth is they're not. If you doubt that, just check out the results of most hedge fund and money managers for 2008. The vast majority got completely trashed in that difficult year.

The only reason I bring this up is that the slightest wrinkle in my performance will sometimes cause me to doubt my ability to return a consistent profit. The irony of this is that a little inconsistency in performance may cause me to change my trading approach. In other words, one inconsistency leads to another and the vicious downward spiral begins.

What to do: I hate to harp on this subject yet again... well... but here I go. In my view, it's crucial to have a trading plan with a very clear and actionable set of rules. It must have a quantifiable edge. I know that this series of posts is about our psychological edge, but one edge improves when the other improves. Without confidence in our system and approach we will spend way too much time second guessing ourselves, rather than just trading the plan.

Your psychological edge needs a foundation on which to rest that cannot be shaken. Whenever I doubt myself I always go back to the foundation - the plan. I do the math. I review the edge, I evaluate the execution. Did the plan fail me or did I fail the plan? If things aren't working it's usually the latter.

Without the solid foundation of a sound trading plan you have no guidelines when Fear and Doubt come into play. In other words, if I'm going to be Confident, I need something to be Confident about.

Doubt also leads to confusion. It keeps us questioning our approach and constantly looking for the next great trading system. Commit to a philosophy and proven trading plan and stick with. Only by doing this will you master the approach and build the confidence that leads to what I call GrinVesting.

Good Trading…

Where does the market go from here?

If I were a serious technical analyst this chart might look really interesting… or scary.  The ES (SP500 Futures) has clearly moved into a new trading range, with increased volume supporting it. We are tapping on the pink line of resistance, but the volume has become unimpressive as price has moved up.

Interestingly, if you look at the longer term view, we are now trading in the range where we spent most of 2010.  Should we break below the grey box… look out below!  It’s a long way down.

This morning I entered the market with only short positions, and quite a few at that.  It wasn’t because of this picture, but this sure makes be feel better… and today was a pretty good day.

Good Trading…

Trading Psyche – Volatility

In my recent series of blog posts on the psychological aspects of trading, I've addressed several specific emotions that traders experience - such as Fear, Patience, Resignation, Greed, etc. While Volatility isn't actually an emotion, I'm using it to refer to the vector and velocity of our emotions, rather than the markets. Are they up? are they down? How are those trading mood swings?

Managing the direction and extremes of our emotions is a critical part of the trader's psychological edge. Specifically, I'm talking about the things that cause us to have up days and down days. What are those things? What are the things that cause us to feel good about our trades or bad about our trades? More importantly, what influences do those feelings have on the next trade?

For me to be successful, I need to be somewhat in control of how my emotions effect my trades. Below I've collected some items that are food for thought. These items might be warning signs, or at least things to consider if they influence your trading at all.

• Does the market determine your mood? We live in a world where very few people manage their money actively. Most are content to hand it over to a money manager, or just put it into the "recommended" 401k fund. As a result, their balance ebbs and flows with the markets. When they markets up, they are geniuses for entering that fund. When it's down everyone feels bad about it. What to do: As active traders, it helps to simply recognize that we play by a different set of rules. We actively manage our accounts and the market makes little difference to us.
• Does the market influence your trading strategy? Ah... now were getting to a little more practical question. Are we listening to the market pundits, seeing big rallies and plunges, and altering our strategy? Movements, big and small, are a part of the market dynamics and they will happen. I think you could drive yourself crazy if you adjust your trading strategy after every rally or pullback. More importantly, you could end up chasing the market movements which is a sure strategy for losing. What to do: At this point I have to hearken back to what I've said so many times... It's crucial (at least for me) to have a set of trading rules and strategies that you can have confidence in. In other words, I need to trust my trading plan in good times and in bad. I admit it's not easy - that's why this part of trading is so important - but it's important to see each new trade as "just another trade".
• Do recent wins and losses influence your strategy? It's very easy to let the most recent series of events influence our trading execution. When things don't go well we want to "tweak" the system. When things go too well we want to "tweak" the system. I'm not saying that trading plans never need refining, but we don't do it in the heat of battle. As I write this, I'm experiencing this right now. I'm having a down day and wondering if my strategies are right. Deep down, however, I know they are right and it's easy for me to quickly dismiss those feelings (although, ask me again after a series of these days) What to do: As I said above, when you have confidence in your approach, a losing trade is "just another trade"... same with a winning trade. If you find yourself gloating over winners and complaining about losers, you may soon find your trading influenced by these recent events. Losses are rarely as bad as they seem, and gains are rarely as good as they seem.
• Does the news influence your trading choices? This is a tough one, a there are really important news events that one might think hard about before making certain trade choices. Then of course there's Cramer, Fast Money, and the rest of the talking heads spewing a continuous stream of recommendations. What to do: How you handle news depends on your trading plan. Personally, I am a technical trader and I completely ignore it. There have just been too many times that a horrible news report sends the market into a big rally, or a seemingly good story causes it to drop. I have developed a plan that is simple to follow and is purely based on a set of technical rules. That, however, might not be part of your trading plan. If news is important in your trading plan I give this advice: See if you can figure out a way to quantify it. If you can't do that then decisions become very subjective and it's hard to know when to take what action.
• Do you let the market determine your trading "style"? This of course follows closely to the points above... the point is that we should be cautious of changing our approach based on recent events in the market. One of the common ways to get whipsawed in the market is to chase trades and to trade according to different rules after up and down days. For example, you might lift a hedge after a couple of good up days - only to see it followed by a down day. Or you might remove that "insurance" Put you have on a condor after a little rally, only to see it pull back. What to do: The above examples are signs (to me) of discretionary trading. There are a handful of people in the world that have enough intuition to be discretionary traders, but I don't believe it's the rule. The rest of us need a time tested trading plan with a group of strategies that we have confidence in.

I know I've repeated this theme of "trading rules" a dozen times in this series, but it really is one of the greatest ways to conquer emotional trading. When it doubt, follow your time tested rules. When you feel like things aren't going well and you don't know what to do, just follow the rules.

I will close by sharing a rule from my trading plan. I have a list of what I have labeled "Policies and Practices" in my plan that includes a number of things that support by beliefs about the market. One of them is this: "Never change the rules while a trade is on." It's simple, but critical. Changing the rules in the middle of a trade is tantamount to discretionary trading, and I don't have that ability. If I question one of my trading strategies I will stop trading it, do a thorough evaluation and then determine if I should continue to use it.

Good Trading...