The Psychology of Trading

by Brett N Steenbarger

  The beginning therapists could not help the Woolworth man because they were too focused on their own internal states—their discomfort with his irrationality and their fear of looking inept. The experienced therapist also felt uncomfortable with the Woolworth man; but he was able to step back, to observe this feeling, and to use it to initiate a contrary maneuver. If everyone is uncomfortable with the idea that the patient is a retail store, why not take the less-traveled path and ask what's for sale? What seemed most crazy was what most people wanted to avoid. It was also what was most worth pursuing.

  RULE-GOVERNED TRADING

  In Chapter 2, I mentioned the personality survey that Linda Raschke and I conducted with 64 active traders. Some of the findings from that research particularly illuminated the issue of emotions in trading.

  One of the survey instruments we administered was the "Ways of Coping" scale developed by Richard Lazarus and Susan Folkman. This scale assesses basic strategies for dealing with stress. Two of the most fundamental strategies involve problem-focused coping and emotion-focused coping.

  The person who utilizes problem-focused coping deals with threatening events by developing strategies for action. Investigating the situation, making contingency plans, and consulting others for advice are all problem-focused strategies. The person who employs emotion-focused coping deals with threatening events by expressing their feelings outwardly, by seeking support from others, and by turning their frustration against themselves. Everyone utilizes these different strategies at various points in his or her life. The question is which strategies dominate, especially during periods of high stress.

  It is not surprising that traders who scored high on the personality test for neuroticism also scored high in emotion-focused coping. They not only experienced a great deal of negative emotion in trading, but also tried to cope with the markets in emotional ways—venting feelings, blaming themselves or others, and so on. These traders tended to report emotional interference in their trading and poor trading results. This group was also poorly research-focused in its trading, relying much more on ad hoc decisions than on carefully constructed trading plans.

  Traders who reported greater success in the markets and less emotional interference with trading tended to score high in problem-focused coping. They experienced just as many setbacks and frustrations in the market, but generally they channeled these by becoming more immersed in their research and plans, more hands on in their setting and honoring of stops, and so on. These traders were also among the ones scoring highest in conscientiousness, as you might expect from the earlier discussion.

  Although traders are sometimes classified in a dichotomous way, as either discretionary (utilizing subjective judgment) or mechanical (automatically following research-tested trading signals), the survey of traders suggested a more complex reality. Traders vary in the degree to which they are rule-governed. Some approach the markets with intuition as their only guide, with few rules and explicit guidelines for entering and exiting the markets. Others, like myself, follow basic rules regarding trend and volatility direction, stop-loss levels, and so on, but they permit themselves a degree of discretionary judgment based on the results of historical testing. Other traders mechanize their signals and allocation of capital according to firm rules that are honored to the letter.

  My sense, having interviewed many of the participant traders, is that the net effect of emotion on trading appears to be a disruption of rule-governance. Most of the surveyed traders did have a set of trading rules to guide themselves, based on their reading of market trends, momentum, and the like. Under emotional conditions, however, their attention became self-focused to the point where they were no longer attentive to their rules. Often, it wasn't so much a case that under emotional conditions they doubted their rules; rather, they simply forgot them!

  Psychologists are accustomed to this phenomenon. It is observed most dramatically among people who experience a condition known as attention deficit hyperactivity disorder (ADHD). Often diagnosed among children, ADHD represents a chronic inability to focus and pay attention. It also is associated with impulsive behavior and difficulties in delaying gratification. Children with ADHD frequently need reminders from teachers and parents to pay attention to what they are doing and sometimes even need stimulant medications to help them achieve an adequate level of cognitive focus. Russell Barkleys research suggests that ADHD represents an interference with the ability to process and follow rules. With heightened distractibility, children cannot sustain attention to the rules that govern behavior and hence find themselves receiving frequent reprimands in school. It is at those junctures when rules have not yet been internalized—when they require active attention and concentration—that ADHD is most likely to prove disruptive.

  It appears that under highly emotional conditions of trading, at least temporarily, traders function in a mode similar to that of the child with ADHD. The high level of bodily arousal serves as a distraction, which diminishes attention and concentration. At the same time, the emotionality triggers negative patterns of thinking and behaving. The ability to plan and to foresee alternate outcomes is impaired as time becomes compressed, generating impulsive actions that fail to take consequences into account. Like the child with ADHD, the emotionally aroused trader becomes less rule-governed. If trading rules have not yet been internalized, this distraction may be sufficient to disrupt the enactment of the rules altogether. In short, under highly emotional circumstances, traders tend to behave more like the unsuccessful traders in the survey and less like the successful ones. Little wonder that traders want to eliminate emotions from their trading!

  The answer to the dilemma, however, follows the solution-focused model of change. If rule governance and conscientiousness in following rules is associated with market success, then traders want to use emotions to trigger greater attentiveness to plans and rules. This means creating associative cues between emotional arousal and the behaviors responsible for trading success. It is when traders—and markets—are most emotional that they want to become most planful in their approaches to trading.

  TAKING YOUR EMOTIONAL TEMPERATURE

  An important step in creating links between purposeful behavior and emotional arousal is periodically taking your emotional temperature. During the day, people oscillate between relative states of underarousal (boredom, spacing out) and overarousal (anxiety, enthusiasm). They also move from comparatively positive emotional states (joy, contentment, affection) to more negative ones (stress, depression, anger). As a rule, repetitive behavior patterns lie at the intersection of a person's level of arousal and his or her propensity for action. In overaroused states, some traders will be more likely to be impulsive, whereas others will shut down. In underaroused states, a subset of traders will underreact to situations; others will push to force the action. Taking your emotional temperature periodically and observing your responses to moods will help you identify your own patterns and, when appropriate, target these for change.

  Similarly, moods are likely to affect someone's processing of information. Research by Alice Isen at Cornell University suggests that people who tend toward more positive mind frames are less likely to take risks than those who experience negative emotion. Because happy people are generally content with their current state of affairs, they are not as likely to risk a loss as people who are unhappy. In the markets, this could make traders risk-averse following gains (cutting profits prematurely) and risk-seeking following losses (holding losers in hopes of redemption).

  Taking your emotional temperature means periodically assessing whether you are overaroused, underaroused, in a positive emotional state, or in a negative one. This assessment in itself entails an activation of the Internal Observer. In taking your temperature, you remove yourself temporarily from the situation at hand, interrupt your normal flow of thoughts and activity, and observe the state of your mind and body at the time. The goal is to maintain self-awareness, even as you remain engaged in the flow
of market activity.

  Once you have noted your cognitive, physical, and emotional state, your first objective, following the physician's creed, is to "above all else, do no harm." Do not trade if you are in a bored, underaroused state; a frustrated, aroused state; or a mind-set of excessive optimism or fear. You want to use your mental and physical condition as a formal part of the setup for each trade. Just as you might wait for an upside breakout as a setup for a long trade, you wait to enter the correct mind-set prior to entering a market. Any deviation from your centered, focused state is telling you that something is amiss either in the market or in your processing of the market. And that is information.

  Very often, you will find that your off-center state reflects both an extreme in the market action and your processing of this extreme. Following a low-volatility market can be like watching paint dry. On more than one occasion, I have become bored with such markets and, unthinkingly, attempted to relieve the boredom by searching for short-term trades (i.e., action). These trades rarely prove profitable, as the size of the expected move relative to slippage, commissions, and just plain poor timing does not justify the risk. I don't often lose much money on such trades, but I still find them a distracting source of frustration once a trending movement commences and I need to have my wits about me.

  Similarly, I have found that my level of emotional arousal—especially fear and overcaution—is well correlated with the volatility of the markets. Because the highest-volatility moves tend to occur toward the opening and latter portions of trending days and especially during market downdrafts, I am prone to responding to my emotional state by becoming unduly risk-averse when I have a nice profit in hand. Indeed, I have left a great deal of money on the table in just such a fashion. "Any profit is better than none" does not hold if taking your money reinforces poor trading practices.

  Attend to yourself before attending to the markets. If you are not in your trading zone, you don't want to be putting your hard-earned capital at risk. Frustration after one or more losses or missed opportunities; eagerness after scoring a win; boredom and a desire for excitement; fear and procrastination at times of opportunity—these are some of the most common ways in which emotional shifts alter your perception and response to events and color your trading.

  Once you have taken your emotional temperature and find that you are running too hot or too cold, that is the time to temporarily remove yourself from the situation and perform your exercises to reenter a state of focused concentration. Closing your eyes, keeping your body still, slowing and deepening your breathing, and focusing your mind on a single object (music, an imagined visual scene, and so on) will help you return to your zone. After sustained practice, I have found that a quick-burst session with the sound-and-light machine, combined with the closed eyes and deep breaths, helps reset my emotional temperature. This is especially valuable for very short term traders who need to get back in the game rapidly. In the neutral and focused state, you are then better equipped to extract the information from your reaction and to formulate and follow your trading plans.

  Earlier, I mentioned the value of automating market research so that it is possible to rapidly shift from an emotional processing of market events to a more neutral analytic stance. With biofeedback, I have found that I can automate the readings of my emotional temperature as well, identifying significant deviations from my baseline. Very often the readings will deviate from their averages before I am consciously aware that I am tense, frustrated, or anxious. This invites a proactive response, dampening the reaction and shifting gears before the stress response has an opportunity to spill over into decision making.

  INOCULATING YOURSELF AGAINST STRESS

  The cognitive-behavioral psychologist Donald Meichenbaum introduced a technique that is very helpful in constructively handling emotional trading situations. He referred to the method as stress inoculation because it works on the principle of medical immunization. Just as a physician inoculates a patient against disease by introducing small amounts of a virus into the patient's bloodstream and thereby activating the body's natural immune responses, you can activate your desired coping responses for future trading challenges by introducing a small dose of a stressful situation.

  This works well in the markets because, although price changes from one time frame to another tend to be uncorrelated, volatility does display significant serial correlation. Volatile periods in the market tend to be followed by other volatile periods, and vice versa; you can roughly estimate the volatility of the next period by observing the previous one.

  This information is useful, in that it can help prepare you for the next period's trading landscape. You can observe if volatility is high or low, expanding or contracting, and thereby anticipate how the markets are likely to affect you emotionally. In low-volatility markets, you are likely to encounter underarousal: boredom, distraction, and frustration with lack of trading opportunities. In high-volatility markets, conversely, you are apt to experience the classic fear, greed, and overconfidence responses.

  By mentally rehearsing the trading landscape you may face prior to the market open, you can achieve a measure of stress inoculation. Once you have closed your eyes, focused on a stimulus, and slowed and deepened your breathing, the key is to begin playing a movie in your head. Your movie will consist of vivid imagined scenarios that you are likely to face in the market, your emotional responses to those scenarios, and the ways in which you plan to deal with those emotional responses. So, for example, on the heels of a downtrending day with expanding volatility, you might imagine yourself, in rich detail, encountering a sharp market drop where the Standard & Poor's (S&P) futures hit a support level on very negative TICK with sharply increased volume. (The New York Stock Exchange [NYSE] Composite TICK is the cumulative total of advancing and declining issues at any moment.) You would vividly imagine yourself feeling your hesitance in entering such a market, fearful of being caught in the downdraft.

  At that point, you will imagine yourself performing the activities for focusing your attention (through breathing, and so on) and interrupting your cycle of fear and procrastination. You will then picture yourself in your movie implementing your trading plans and following your trading rules and/or systems. In short, your movie will feature you encountering and coping with the challenges you most anticipate for the coming trading period.

  At any point during the movie when you find yourself feeling uncomfortable, simply freeze the image in your mind, continue your deep breathing with eyes closed, and then resume the movie when you are calmer. Your goal is to play the movie in your head many times without needing to freeze the images before you actually enter the trading arena. By that time, you have extinguished much of the stress reaction, and you will be primed to enact the right trading maneuvers when your feared scenarios actually unfold.

  Stress inoculation works because of counterconditioning. By activating feared scenarios in the context of a controlled state of mind and body, you are training yourself to respond less emotionally and impulsively in those situations. Psychologists utilize this technique to help individuals overcome phobias and performance anxiety problems, such as nervousness in public speaking. The normal human response is to want to not face such unpleasant situations. By pushing yourself to face the situations again and again, under controlled conditions, you gain an inner sense of mastery. When the difficult trading situation arises, you can respond with the knowledge that in your rehearsals you've "been there, done that." Such familiarity breeds confidence.

  EFFORT AND EMOTIONAL CHANGE

  Techniques such as stress inoculation depend not only on the frequency with which they are performed, but also on the intensity. When traders attempt to utilize methods such as meditation, brain wave entrainment, desensitization, and the like, they often give up after a cursory effort, failing to make the essential breakthrough. It is this breakthrough—the concentration of effort—that is largely responsible for the success of these methods.

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bsp; A good example can be found in the field of bodybuilding. The late trainer and champion Mike Mentzer discovered that building one's physique does not require constant effort in the gym. Instead, he found that relatively short, intense workouts interspersed with days of rest produced the greatest results. Mentzer indicated that the final repetitions in any lifting sequence produced the largest gains because they placed maximal demand on the muscles. This demand forces the body to devote a greater than normal share of resources to the muscles under load, engorging them with blood and nutrients and facilitating their rapid growth. Mentzer discovered that the rest between the intense training episodes was as important as the lifting, as growth occurred during the period in which the body nourished the taxed region.

  In an analogous way, the intensity of psychological exercises pushes you to develop extraordinary resources. A single marathon session of deep breathing and imagery accomplishes far more than several briefer sessions performed in succession. Immersing yourself in vivid imagery and real-life situations that evoke fear desensitizes you far more effectively and efficiently than less emotionally immediate exposure. It's back to that principle of the second wind. By exerting yourself beyond the comfort zone, you develop your cognitive and emotional "muscles," much as bodybuilders develop themselves. If the exercise is not taxing you, the chances are great that you are performing the equivalent of bench-pressing 20 pounds. Such exercise could go on for years with no observable development.

  This brings up one of the greatest enemies of self-development: time. Most people lead busy lives. Good trading, with its research and planning demands, is a time-consuming enterprise. Add that to home responsibilities, romantic relationships, and family obligations, and the mix can make a trader feel overwhelmed. This stress makes it especially difficult to take extra time out of the day to make supreme efforts. The natural human tendency is to use whatever free time exists for rest and relaxation.