The Psychology of Trading

by Brett N Steenbarger

  Fortunately, through exploration with Dr. Kiev, Kurt observed that he was much more able to handle adversity in his golf game. When he made a bad shot—which happens to all golfers—Kurt would focus on the next shot, rather than immerse himself in what had gone wrong with the past shot. By invoking his golf-challenge state of mind during trading, Kurt was able to treat drawdowns and losing trades the way he handled errant shots on the golf course. He became more able to bail out of positions and to reenter them if conditions warranted, adding flexibility to his trading. Dr. Kiev observed that it is helpful to meditate on past success to cultivate a winning mind-set. As his case of Kurt illustrated, such a solution focus can be helpful even when these successes are drawn from spheres of life separate from trading.

  Dr. Kiev's astute observations with Kurt imply that anyone may experience a degree of vertical split in his or her trading. It goes back to the Gurdjieffian idea that people consist of many little I's, many traders running around with different needs and impulses. By focusing on past successes and by placing yourself in the mind-set of another domain in which you are successful (such as golf), you can select the I's that will dictate today's trading.

  A useful technique when a trading slump hits is to stop trading for a time and immerse yourself in something—anything—that you are very good at. This will invoke the state of mind associated with success, which then can carry over to your subsequent market forays. For me, writing is something that I enjoy and that has been associated with a measure of success. As a result, when markets make little sense to me, I review my charts and data and force myself to write a synopsis of my observations. Very often, as I am writing, an insight will come to me that had not been present while I was simply pondering the market action. The process of writing, for me, is like changing the glasses in Dr. Schiffer's office.

  Indeed, the dynamics of left- and right-brain hemispheres—and the notion that emotional patterns may be hemisphere-specific—helps to explain the psychological value of market preparation. A theme common to many of the most successful traders is planfulness. Successful traders are highly intentional in their approach to their craft. They treat their trading as a business and follow a careful business plan. They are purposeful with each trade, and they follow well-researched entries and exits. In his work with traders, Dr. Kiev emphasizes the importance of focusing on defined goals and of developing entry and exit strategies consistent with these goals. The very act of focusing appears to be helpful in activating parts of the brain that are responsible for problem solving and in suppressing those parts that process the world in emotional, visceral ways.

  I have had the privilege of observing several world-class traders in action and have been struck by the degree to which preparation has been a large part of their success. Victor Niederhoffer uses the term "counting," borrowed from the famous British scientist Francis Galton, to describe his empirical investigations into markets. Each day, Niederhoffer runs a number of studies to examine current market patterns and to see how these have been resolved in the past. Linda Raschke, the well-known Market Wizard interviewed by Jack Schwager, similarly stresses the importance of planning in market success. Here is an assortment of observations from her Trading My Way seminar manual:

  •"It is hard work to stay focused and push aside all the distractions that try to come between you and success. Concentration, routine, and ritual are the most powerful tools at your disposal to help ward off distractions and eliminate the emotions and anxieties that hinder good performance" (p. 3).

  •"A trader must have a plan, methodology, system, or program! Without a plan, the market already has you beat. The decision-making process can be so overwhelming you will either over-trade or be too conservative (hesitate), and sloppy mistakes will be made. Consistency is the only way to win, and a trading program is the only way to achieve this" (p. 6).

  • "Develop your own daily rituals. There is ultimately a freedom to be found in routine and rituals. They help free the mind from 'self-talk' and doubt. They keep one focused in the present and on the process. They add structure in an otherwise abstract environment" (p. 9).

  Notice the themes running through Raschke's observations: consistency, planning, rituals. Note Kiev's emphasis on focus and discipline. A problem-solving focus, I hypothesize, activates those verbal, analytic capacities typically associated with the left hemisphere. In suppressing the activity of your more emotional Mind #2, you make a crucial shift without the need for brain surgery, anesthetics, or taped glasses. In this sense, market research, plans, and preparation are more than a computation of probabilities for the next period's price action in the markets. They are valuable practice in generating and sustaining the quality of mental activity needed for market success.

  STATIONARITY AND THE MOODS OF THE MARKETS

  Clifford Sherry has made an important contribution to the trading literature by focusing on the issue of the stationarity of price changes in the markets. This concept is foreign to many traders, but it is a vitally important one.

  A stationary price series is one that is generated by a single process. If cards are drawn at random from a deck in a game of blackjack, the distribution of cards selected will show evidence of stationarity; that is, they will follow a stable, predictable distribution over time.

  If, however, the dealer at the casino shifts from using a single deck of cards to using a shoe of several decks, the distribution of cards selected will change. The distribution will now show evidence of nonstationarity—there will be significant differences in the frequency of cards coming up using many decks versus one.

  Stationarity is important to traders because every so often the markets switch the number of decks from which they're dealing. The market will meander in a given direction with low volatility for a while and then suddenly zoom off on high volatility. If you look at the statistical distribution of price changes, you can see evidence of nonstationarity.

  Such sudden shifts in market outcomes are not the exception but the rule. Mornings are generally more active and volatile than midday hours in the equities markets. And on average, late afternoons also display more radical price movements than the lunchtime periods do. Preholiday trading is often thin and nonvolatile; trading around periods in which options and futures are expiring is often more hectic, with larger price jumps. Summer months have gained a reputation for doldrums; October has a reputation for violent, downward action.

  One of the greatest weaknesses of the methods utilized by many traders I have interviewed is the failure to assess stationarity and factor it into their decisions. Instead of identifying the type of market they are in and trading methods specific to that kind of market, they adopt mechanical signals and uniform chart or oscillator patterns to apply to all markets. As long as the market works from the same number of decks, their methods may produce profits. Once the changing cycles described by Niederhoffer change the decks, however, the formerly useful methodologies will produce substandard results.

  Any single set of trading rules or methods is vulnerable to breakdown if repeatedly traded across nonstationary periods. Why is this? Why do markets swing irregularly between trending and nontrending, volatility and quiescence? It may be because of the very same dynamics that have been observed in cognitive neuroscience research. Just as traders shift from one mind state to another, tossed about by their little I's, perhaps markets also shift from state to state. Markets, like people, have their personalities that, like Schiffer's patients, process information in wildly different ways.

  If this is so, the ramifications for trading are substantial. Instead of seeking holy grails—methods that can be traded across all markets over all time frames—it may be more fruitful to develop "personality" profiles of markets and to detect when shifts are occurring from one state to another. In my own trading, I integrate several important market variables—price change, acceleration, volatility, and relative strength—into a single composite statistic that I refer to as Power. A market with h
igh Power is one that is strongly trending upward; one with low Power is strongly trending downward. Power readings near zero are associated with nontrending markets.

  When I conduct my historical analyses, I only investigate those historical market periods that are similar in Power to the present market. Power, as a measure of trend direction and volatility, captures the market's personality at a particular point in time. Shifts in the Power variable signify changes in that personality—and they trigger remodeling on my part to see how the new personality fared in subsequent price action. As the market shifts from upward trending to consolidating to downward trending, the expectations for future price action shift accordingly, making research an ongoing part of the trading process. This embedding of research into the flow of trading is extremely helpful in keeping trades grounded in the logical needs for profit, rather than in competing psychological needs.

  Yet even within this quantitative focus, there is a role for intuition and feeling. If you engage in quantitative research, you will start to notice that attentiveness to your own state shifts will provide information regarding those of the market. I encourage you to keep tabs of the direction and volatility of both your moods and the markets you are trading. You may be surprised at the ways in which shifts in your state alert you to shifts in those of the markets. More than once my statistical remodeling of the market has been triggered by a shift in my own state in sympathy with the streaming market data.

  It is this intricate interplay between the experiential and the analytic that makes trading so challenging. As you shall see shortly, your emotional, right hemisphere holds the potential both to subvert your analyses and to provide the first, implicit cues for when those analyses are going awry. The image developed by V. S. Ramachandran and Sandra Blakeslee in their book Phantoms in the Brain is particularly apt. The left hemisphere of the brain acts like a general during wartime, making executive decisions about the deployment of your capital. The right hemisphere serves the function of scouts and sentinels, feeding fresh information to the general for the updating of strategy. Hysterical scouts and negligent generals are two of the great saboteurs of trading.

  CONCLUSION

  I have just begun to touch the surface of evidence that the most typical challenges faced by traders are not a function of emotional disorders, but instead are grounded in the very architecture of the brain. The division of labor between the brain's hemispheres, especially in the processing of verbal/conceptual information versus emotional/spatial experiencing, helps create those shifts in information processing that undermine trading discipline.

  A major implication of the ideas presented thus far is that traders who are living for their trading will have difficulty trading for a living. Since writing the trading columns, I cannot begin to count the number of desperate traders who have sought me out for advice, beginning their pleas with a statement of how trading is the most important thing in their lives. I am obliged to point out to them that this may be their very problem.

  If it is true that much bad trading represents a spillover of unmet needs and desires, any failure to meet those needs invites future interference. The trader who lives for his or her trading may be neglecting basic drives for security, stimulation, affection, recognition, and spirituality. These are valid and important needs, but not ones that should be driving entry and exit decisions in the stock and futures markets. Rather than neglecting these needs, it is important to find constructive outlets for them so that they will not color moods and interfere with trading decisions.

  I recently spoke with a trader whose lapses in the market were almost entirely attributable to adopting astrological and other mystical patterns as a rationale for trades. Most of the time, he was relatively disciplined in planning and implementing entries and exits. Every so often, however, he would become absorbed in calculating astrological configurations and various numerical patterns in the markets. Hearing him talk about these approaches in reverent tones, it was clear that the very mysticism of the methods—their hints of an underlying meaning and order—was what held his interest. It did not surprise me that he was not inclined to religion or philosophy; his fascination with universal order served to channel these interests. I firmly believe that the best thing he could have done for his trading was to cultivate a creative, spiritual life outside of the markets. With those needs properly addressed, he would have been free to stick to what had been working for him in trading.

  Online chatrooms and bulletin boards are filled with lonely, frustrated traders who live for their trading and have precious little to show for their lives if their trading falls short of expectations. Successful traders don't need to trade to be successful; their trading success is an extension of—and is permitted by—their other life accomplishments. The markets can be challenging, rewarding arenas; but they are not life and they cannot fulfill the panoply of legitimate human needs. To pursue one's development as a trader at the expense of one's personal development is to court the very emotional interference that generates inconsistent, substandard results.

  Chapter Five

  Mary, Mary, Quite Contrary

  Every change begins with the interruption of a pattern.

  We have seen how problem patterns in our personal and trading lives represent well-intended efforts to cope with emotionally stressful situations. These efforts become overlearned and then take on a life of their own when new stressors emerge. People often come to therapy hoping that talking out their problems or immersing themselves in positive self-talk will break these patterns. Change rarely occurs this way, however. More often, people change because they undergo powerful emotional experiences that challenge their old ways and help to cement new patterns. It is not so much that you will trade better once you feel better about yourself, but that you will feel better once potent emotional experiences undermine old ways of trading and contribute to a new set of solutions.

  In this chapter, we will explore how therapists help to create these powerful emotional experiences in the context of short-term therapy, utilizing—and even generating—crises to accelerate change processes. We will then map out ways in which traders can accomplish this for themselves, employing emotional arousal as a tool for undermining destructive patterns.

  GETTING INSIDE MARY'S JOURNAL

  When Mary came to me for her first appointment, I was immediately struck by her attire. Unlike most students, she was wearing a tailored outfit: a silver gray jacket and skirt that would pass muster in any corporate office. Her light brown hair was pulled back away from her face, homely wire-rimmed glasses evoking the look of an elderly English teacher. This struck me as incongruous, because she was actually quite young and attractive.

  Mary was holding a large envelope and kept it clutched in her hands as she talked. In a reserved tone, she described how she was unhappy in her relationships with men. She found herself always being the one to give. She felt taken for granted, used. That made her feel very bad about herself. She came to counseling at this time because a relationship with a man had just ended. Despite her best efforts to make it work, he didn't seem to care. He saw her when it suited him, which she suspected meant that he had no other woman to sleep with that night. Nonetheless, she found herself depressed at the loss of this relationship.

  "I don't know why I should feel this way," Mary lamented. "I know he doesn't care about me. Why should I care about him? I feel weak. I hate myself this way."

  You can learn much about a person from the first few minutes of a therapy session. Counseling is a completely unnatural process. You are asking a vulnerable person to emotionally undress in front of someone they barely know. Only a reasonably secure person—or a completely overwhelmed person—would do that. On the one hand, when people begin their first session in a very guarded mode, it says something about their level of distrust and fear. This in turn probably says a great deal about their experience in previous relationships. On the other hand, when they begin divulging intimate details in the first mi
nutes, you know something is amiss. A gushing firehose is a sure indication of internal pressure.

  So when you are a therapist, you look for just the right blend of healthy openness and healthy caution. Mary had that blend. Reserved, straightforward, candid. Not a "sick" person.

  I usually test that initial impression, often with humor. My rationale is simple: A person who is completely overwhelmed by a problem cannot stand outside himself or herself enough to laugh. Humor requires an ability to see things from an unusual perspective, or, more correct, an ability to shift perspectives. That kind of shift is central to the change process. If a person can't make a small shift to see humor in a situation, he or she will find the larger shifts required by therapy to be difficult indeed.

  I have found that this same principle operates in trading the markets. If I am comfortable with my position, I can stand back and respond to the humor of others, to my e-mails, or to a particular news item. Conversely, if I cannot respond with characteristic easygoing humor, that is a powerful sign that I am absorbed with concern about my position. Very often, there is reason for this concern, and I can use the emotional information as a gut check. Most often, my discomfort stems from having violated one of my trading rules. Although I have talked myself into the "exception," my humorless mind seems to know quite well that I am on dangerous ground!

  So I introduced a bit of humor to this first meeting with Mary. When she said, "I work so hard at relationships, but get nothing in return," I smiled and pointed out, "Hmmm . . . that's what I hear from your classmates about the program you're in." Mary was in a very challenging health sciences program, one that is well known for frustrating even the best students. Immediately she cracked a smile and acknowledged, "That's exactly how I feel."