The Psychology of Trading

by Brett N Steenbarger

  These kinds of communications are difficult to handle. The person is increasingly experiencing the problem even as they attempt to describe it. The mounting tension can be contagious; it is a challenge for a therapist to maintain a calm, reassuring perspective in the face of such emotional frenzy. As long as that emotional tone persists, however, any reassuring words or helpful strategies will be lost. The person's mood will swamp any message that is offered. The first step, then, is to achieve a mood shift. That is the purpose of the pivot chord.

  I responded to Tom with a very even, slow, calm voice. I raised my eyebrow and said, "You have a dog at home? Tell me more about him."

  The abrupt shift of topic usually surprises people, but they rarely complain or even comment. Not infrequently, you can help yourself become unstuck in a life situation by changing your pace or by approaching a problem in a different key. At my shift, Tom simply smiled and reported, "She's a girl, a cocker spaniel, only several weeks old. I got her from an ad in the paper. Her name is Nipper."

  "How do you feel when you're holding Nipper?" I asked.

  Again, Tom smiled and now spoke with a somewhat slower, warmer tone of voice. This was a shift. "Nipper is about the only thing that calms me down. I hold her in my lap and she will let me stroke her belly. When she licks my hand, I feel warm all over."

  "Can you close your eyes for a moment and get an image of yourself and Nipper? Can you feel the softness of her fur, her warm tongue? Can you feel her body wriggling underneath your hands as you stroke her?"

  Tom nodded and opened his eyes. His look was far mellower now.

  It was time for the pivot chord.

  "When you wake up with your anxiety, how would you like to really experience a stroke?" I asked.

  A look of shock flashed across his face. "What?!"

  "A Nipper stroke," I quickly clarified. "When you are stroking Nipper, you're making that puppy feel loved and wanted, and that feels good to you. Suppose you could stroke yourself the way you stroke Nipper?"

  "Funny you should mention that," Tom said. "When I was with my last girlfriend, she used to stroke my face and hair when I would get upset. I calmed down right away."

  "Maybe you felt like Nipper," I offered. "What if, next time you get nervous, you think about giving yourself a stroke instead of a stroke? Suppose you close your eyes and imagine that you're there with Nipper and imagine what she's feeling like. Try to feel what it's like to be stroked and held. Imagine yourself petting your puppy and getting inside her head, how warm and comforted she must feel. If you're at home, maybe feel Nipper's soft fur and imagine that you're the one being stroked."

  Tom liked the idea of "giving himself a stroke." That became a theme for the next several meetings, as he learned to accept his stress and to use it as a cue to evoke nurturance rather than the mounting sense of catastrophe. Emotionally, he made a shift in keys, from the key of anxiety, fear, and negativity to the key of caring and loving. The "stroke" metaphor, delivered at a time of emotional upheaval and following a shift to a warmer feeling, was the pivot chord that made the shift possible.

  Moods cement messages. We see this cementing in advertising, we make use of it in therapy, and we can harness it in trading. Evoke an enhanced state, and a pivot becomes possible—a new melody, a new rhythm, life in a different key.

  BREAKING ROUTINES

  Moods and messages—these are the essential building blocks for psychological change. The research literature on the effectiveness of therapy suggests that people are most likely to change when they process information about themselves in new ways. That is why various approaches to therapy make use of role-playing, metaphors and storytelling, personal journals, and dream analysis. Each of these is a way that people can use to capture ideas about themselves in ways that are out of the ordinary. When researchers ask clients to identify the episodes that were most critical to their success in therapy, they invariably mention occasions in which new information and experiences were presented in a novel fashion. Routinely presented information is processed routinely. Novelty breaks routines.

  Ken regained his ability to study not because I talked with him about his problems, but because I set up an unexpected situation in which he would have to call his father to admit defeat if he did not study. Faced with that noxious scenario, he could not maintain his pattern of procrastination. The consequence of giving in to his father was much more undesirable than the consequence of failing the test. The novel shift of context allowed him to experience his problem in a different way. Had we simply talked about his fear and the probable consequences of not studying, it is likely that he would never have made it through the course. Changing his behavior required seeing his problem in a different light. Ken redefined "failure"; Tom redefined "stroke." When people change, they effect a translation, a shift in the meaning and the significance of their problem patterns.

  And yet, novelty alone will not generate change. The research on therapeutic outcomes suggests that people are most likely to alter their problem patterns when they are emotionally involved in the change process. A variety of therapeutic techniques are used to enhance the clients' experiencing; confrontations, role-plays, and relaxation techniques, to name a few. Each of these helps to shift an individual from one mode of experience to another. The counseling research suggests that people will process information more deeply and more enduringly when they are in such enhanced states. The moods anchor the messages.

  Like Sue, Ken, and Tom, many people come to therapy already in a state of high arousal. They are upset about their problems and are already far from a normal, day-to-day state of consciousness. In the heightened state of crisis, they are much more ready to see their problem patterns differently than if they were not suffering. Crisis yields opportunity because it places people in a state where they are open to new life messages.

  Skilled therapists help to shift the experiencing of their clients through such simple means as alterations in their tone of voice and the use of shock and surprise. The therapists realize that in routine states of mind, people can only see things in routine ways and behave according to routine. It is when they shift their musical scores that they become able to process even the thorniest emotional patterns in new and constructive ways, opening the door to new behavior.

  BREAKING THE ROUTINES OF TRADING

  How can these change dynamics be applied to trading, harnessing the elements of change that benefited Ken and Tom? Here is a trading practice that, if it works for you as it has for me, will help eliminate a significant portion of your losing trading ideas before you implement them.

  Early in the morning, before the domestic markets open, get yourself in the habit of engaging in a vigorous exercise routine, such as jogging, swimming, martial arts, or aerobics. The only requirement is that it be an exercise regimen that challenges you, raising your heartbeat and respiration for a sustained period of time. My own routine incorporates stretching exercises with rapid series of sit-ups, push-ups, and other calisthenics. Invariably, I feel far more limber and energized after the workout.

  Once you're in your pumped-up state, review your trading plan for the day by talking it out aloud. This is important. Do not just look over your charts or computer printouts in the usual way. Talk them out aloud, as if you are delivering a commentary to another person. Your talk will describe the short- and long-term trends, the patterns in the market that you are perceiving, the anticipated points of entry, the proper stops, and so on.

  In my morning routine, I deliver my commentary shortly after finishing my workout, on the drive to my office. I cover every contingency I can think of: If the market opens lower, here's what I'll do. If it reverses and makes a new high, here's my plan. And so forth. The key is talking it out aloud in a normal speaking voice, as if you were addressing another person.

  The results are quite interesting. When you talk your trading ideas to yourself, you take both roles in a conversation. You are both speaker and listener, presenter and audi
ence. Hearing your own ideas—especially in a fresh, energized state of mind—allows you to evaluate them from a unique perspective. You hear your trading plans differently because you are processing them differently. Exercise is the catalyst that invokes a novel mindset. In a literal sense, you are running your trading ideas by a more objective, neutral party: yourself, in a different state of mind. As the research of James Pennebaker suggests, talking out emotional experiences is a powerful means for reprocessing them. When trading hunches are liberated from the confines of your skull, they are open for more neutral scrutiny.

  Incredibly, once they are given voice, many of your ideas won't fly. You'll have that sense of, "What am I thinking?!" That allows you to scratch a trade before even placing it. Ferreting out one's own faulty thinking is a powerful technique for building a sense of mastery in trading—and makes it more likely that you will not repeat the error on subsequent occasions. After all, as Yale and Jeff Hirsch point out in their 2002 Stock Trader's Almanac, "If you don't profit from your investment mistakes, someone else will" (p. 103).

  Conversely, you'll find that the best trading ideas sound good when you talk them aloud. They just feel right. And it is interesting that when you take a break from the screen and return to the charts in a different state of mind, you can actually see patterns in the market differently. What had looked like trendless, random action now appears as an important region of consolidation; a vigorous trend that makes you think of doubling down is suddenly reframed as a blow-off top and allows you to take profits. The messages of the market are there to be read, if you can access the proper moods.

  One of the problems I continually find with traders is that the frame of mind in which they analyze markets is different from the one in which they are actually making trading decisions. Most traders, like myself, use their late evening and early morning hours to download data, examine indicators, update overseas markets, scan news items, and the like. This is generally a quiet, routine activity. Once the markets open, however, the minute-to-minute price action is anything but routine. There are many indexes and markets to follow; an array of statistics to process; and sudden, unforeseen bursts of volatility to respond to. Under conditions of arousal, people process information very differently than during calm routine. The decisions and the analyses that were prepared in the calm of analysis rapidly fly out the window under the stress of trading, much as Ken's test material abandoned him during his pathology tests.

  This is a major reason why traders fail to sustain purpose in the markets. The action of the market elicits unintended pivot shifts, altering how traders process information about themselves and the markets. In a very real sense, the market acts as an antitherapist, shifting traders out of solution mindsets into a greater problem focus!

  One of my favorite techniques for handling the novel shifts that the market throws at us traders is to temporarily get away from the screen during periods of uncertainty and stress. During this break, I will quickly update my indicators, rerun my models, and scan the charts of various indexes and markets. This inevitably places me in a calmer frame of mind, similar to the state I am in during those early morning hours of preparation. Often, too, this fresh look at the data will clarify what had seemed uncertain.

  Recently, I noticed a nice upside breakout of the Standard and Poor's (S&P) and Nasdaq futures on a one-minute chart. The pattern followed a trade I had just closed, in which I had taken a profit on a short position. Now I was excited about catching a swing in the opposite direction.

  Before I could place my order, however, I talked my intentions out aloud and promptly interrupted myself, chastising: "That's not part of the plan!" My research compares current patterns of strength and weakness to similar patterns in past periods. By inspecting how the market moved subsequent to these past periods, I can identify possible future directional bias, which, in this case, had clearly called for a downward trend to the day. Rather than take the exciting, impulsive long trade, I updated the research to assess my earlier trading plan. Sure enough, the edge was to the downside. I let the short-term breakout play itself out (which it did rapidly) and was then better positioned to enter on the short side for the next swing.

  Many scalpers and very short term traders convince themselves that they do not have time for such research, that taking time away from the market action will cause them to miss opportunities. "You can't get a hit unless you swing the bat," they insist. They fail to realize that the best hitters protect the plate and, at times, will take a strike in order to wait for their pitch. The key to rapid trading is the automation of research, so that statistics and indicators update themselves in real time. I have dozens of Excel sheets dynamically linked to my real-time market feed, updating tables with preprogrammed formulas and displaying these in chart form. A scan through all of them rarely, if ever, causes me to miss a trade but often helps me avoid a bad trade by placing the tick-by-tick action in context.

  Such clarification of the market's context is only possible once arousal has been dampened. Activating analytical capacities is one of the most powerful strategies for suppressing excessive emotional processing of events. Well-known traders, such as Victor Niederhoffer, Linda Raschke, and Mark Cook, have written extensively on the value of market research. Less well appreciated, however, is that such research is also a psychological strategy. When people immerse themselves in research, they facilitate shifts in information processing that, as with Tom, open the door to new action patterns. The value of research lies not just in the information it imparts, but also in the frame of mind it cultivates.

  Behavior patterns are anchored to one's states of mind and body. As people randomly enter one state after another, they find themselves unwittingly enacting patterns that they would never consciously choose. This is how they fail to sustain purpose—in life and in trading. Once they learn the skill of shifting their emotional and physical states, they are free to create and to enact new patterns. Cultivating a calm, focused state during periods of market research—and then immersing oneself in research during the trading day—is a powerful strategy for interrupting the impulsive and emotional problem patterns that are elicited by volatile periods of price action. Many traders are so afraid of missing a possible market move that they dare not spend time refocusing on their trading plans. They fail to realize the far greater risk of losing sight of their plans and trading haphazardly.

  Your trading plan is your anchor; you most want to utilize it when seas are roiling. In developing and following your plans, even in those volatile seas, you extend your ability to act purposefully, and you gain a measure of mastery over yourself and the markets. The psychological antidote to greed and fear is planfulness, not calm or confidence.

  CONCLUSION

  Late in 2001, Linda Raschke invited me to two of her seminars for traders in order to conduct a survey of their personality traits and coping styles. Subsequently, I expanded the survey to include members of her trading chatroom and traders from the Speculators List inspired by Laurel Kenner and Victor Niederhoffer. The 64 traders who responded represented a variety of trading styles, experience, and levels of success.

  The personality questionnaire that I utilized was the NEO Five Factor Inventory derived from the research of Robert McCrae and Paul Costa. This assesses personality on five trait dimensions that have been found to be relatively stable across the lifespan:

  1.Neuroticism—the tendency toward negative emotions.

  2.Extraversion—an outward orientation toward people and life.

  3.Openness to experience—a desire for novelty, variety, and risk taking.

  4.Agreeableness—the tendency to get along well with others.

  5.Conscientiousness—the capacity to be reliable, steady, and trustworthy.

  The findings were eye opening. The traders who reported the greatest success (and who were willing to have me verify their success in case studies) tended to score high in conscientiousness. They were very steady and reliable.

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nbsp; The traders who reported the greatest problems with their trading tended to score high in neuroticism and openness. They were experiencing many negative emotions and tended to use trading for excitement.

  The conscientious traders tended to be highly rule-governed in their trading. There was little excitement in their trading. Instead, they very consistently developed their plans and followed them.

  The neurotic and risk-taking traders tended to make their decisions impulsively, without prior planning. They tended to revel in telling stories of their great wins and losses.

  The survey drove home one important lesson: Success in trading is related to the ability to stay consistent and plan-driven. Traders fail not because of their emotions, but because their emotions deflect them from their purpose. In developing their rules and systems, the successful traders had found a way to immunize themselves from the emotional effects of market volatility. Indeed, in many respects, the successful traders appeared to be every bit as fearful as the unsuccessful ones. It's just that the fears of the successful traders were not those of drawdown or missing a market move. Rather, they feared deviating from their plans. Dedication to purpose was the cornerstone of their success.

  Chapter Three

  The Woolworth Man

  We rise above what we observe.

  Experienced traders learn that the markets speak a language all their own. There are signature patterns for individual stocks, for indexes, and for commodities. A great part of trading success lies in deciphering the language of the markets.