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...