The Psychology of Trading

by Brett N Steenbarger

  Mary took a few time-outs in our subsequent meetings. She also explained the time-outs to Larry and was able to step away from her hurt in situations with him. Ironically, it was by walking away that Mary learned that others would not leave her.

  Here it was again: the mood, then the message. Following the gearshift from angry hurt to fear of abandonment when I left the room, Mary was ready to process a different message: Larry is not the problem; Brett is not the problem. The problem is the "tapes" playing in her head. And once the tapes became her enemy—not Larry or her therapist—Mary was ready to engage those people differently.

  It was long, grueling work, but it paid off. Eight months later, Mary and Larry sent me a wedding invitation.

  CREATING POWERFUL EMOTIONAL EXPERIENCES IN TRADING

  Mary's counseling nicely illustrates how therapists act as mirrors to their clients, allowing them to perceive themselves in new ways. If a person is not ready to act as her own Internal Observer, a counselor can assume that role, standing aside from the turmoil of the moment and helping her make sense of what is going on. In no small measure, mirroring this observing capacity so that it can be internalized by others is the heart and soul of therapy. At first, the image mirrored by the counselor may be foreign and uncomfortable. With repetition, however, it becomes increasingly familiar and open for assimilation.

  So what does all of this have to do with trading?

  When you are trading from the couch, you are acting as your own therapist. You are attending to your own emotional and behavioral patterns, even as you process the patterns of the markets. Your goal, as your own therapist, is to supply repeated new endings to old patterns so that you can internalize new modes of thought and action in the markets.

  Much has been written about the power of positive thinking. Many traders attempt to instill positive feelings by imaging favorable scenarios and repeating ennobling messages. There is much to be said for imagery, but perhaps the most powerful rehearsals are not the positive ones. Instead, requiring yourself to image your most destructive patterns—while actively and emotionally reminding yourself of their destructiveness—helps to cultivate the observing capacity to "wake up" and escape the blind repetition of past errors.

  As I mentioned earlier, one technique for accomplishing this is "stress inoculation." Like a vaccine that introduces a small dose of a virus to stimulate the body's defenses and ward off the illness caused by the virus, stress inoculation exposes you to measured doses of a challenging situation, allowing you to mobilize your best coping for when the actual challenges hit.

  In practice, this means avoiding positive thinking when first placing a trade. Almost immediately on placing an order in a superheated market, you want to switch gears, take a time-out (like Mary did), and get yourself in a very focused, relaxed state through deep, rhythmical breathing and a very still body posture. While in this state, you then visualize all of the ways in which your trade can go wrong. It is helpful to think of each trade as a hypothesis: You are a scientist hypothesizing that the market will move in a certain direction, to a particular extent, within a given time span. Framing your trade in this way makes it easier to contemplate all of the ways in which your hypothesis can be disconfirmed.

  One of my recent trading experiences nicely illustrates the idea. Following a market decline, the Standard & Poor's (S&P) futures bounced higher and then remained in a fairly narrow range. There was considerable buying during this narrow range market, as evidenced by the consistently positive futures premium and the high TICK figures for the Dow Jones Industrial Average (the Dow) and the New York Stock Exchange (NYSE) stocks. Another of my indicators, which compares the number of trades during advancing one-minute periods to the number of trades during declining periods, similarly indicated buying pressure. Nonetheless, price was unable to break out of its narrow range. My research generally suggests that if high levels of buying pressure cannot take the market meaningfully higher, a correction is likely to ensue.

  Soon after I shorted the market, however, the S&P dipped and then broke above the high for the recent trading range. Volume picked up, as traders piggybacked on the seeming volatility breakout. Within a matter of seconds, my trade went into the red, and I could feel a jolt of nervous adrenaline. I turned to my trading screen and punched in the order to cover the short sale for a loss. As soon as my stop was hit, I was ready to hit the button and exit the trade.

  I realized that my fear reaction was out of proportion to the situation, however. I never like taking a loss, but I knew that my stop was set closely enough that my account would not be traumatized by getting stopped out. It was at that point that I recalled that a similar market had dealt me a difficult loss the prior week. Following a narrow-range period that appeared to be losing steam, I placed an order to go short. Incredibly, I forgot to check the economic calendar for the day and found that my order was executed one minute before the release of an important number. Sure enough, the number beat expectations, and the market broke out of the range with a vengeance. By the time my stop was triggered, the upside gap and slippage ensured that I took a nasty hit.

  Realizing that no such economic report was likely to undermine my current trade, I took a few deep breaths and, consciously slowing my pace, examined my Excel screen to see how many stocks in the portfolio I follow were actually breaking out of the recent range. This portfolio consists of 40 stocks (the Dow 30 and 10 additional issues in a variety of industries) that mirror the action of the S&P 500. I have generally found that if the S&P breaks out to relative highs or lows, but the majority of these issues do not, then there is a high likelihood of the move being a false breakout. By dynamically linking the Excel sheets for the stocks to my Townsend Real Tick III platform, I am able to calculate breakouts and breakdowns on a running basis without the need to manually check each of the 40 issues.

  To my amazement, only 7 of the 40 issues had broken out of the range to a relative new high. The "breakout" move in the S&P was almost totally accounted for by several stocks making a bounce upward. As soon as I saw this, I said out loud, "There is no way this move can be sustained." I knew from long hours of research that many more issues need to participate if a move is to have legs.

  Just as I said that, my price stop was hit. For once, I made a conscious and reasoned decision to override and reconfigure my stop. Instead of basing the stop on a price level, I would stop the trade once 15 or more of the portfolio stocks made a breakout. I waited, and shortly the momentum abated. When the S&P reentered its prior range, I realized that the breakout was false and sat back with a sense of relief. The trade went on to a nice profit when the bottom of the range was violated. The market was thus able to provide me with what I had given Mary: a new ending to an old scenario.

  A fun variation on this exercise is to talk aloud or to visualize past mistakes you've made when your hypotheses have been disconfirmed. For instance, if the market moved against me in the opening minutes of a past trade and I magnified my woes by doubling up on my position (trying to achieve a better average entry price), I would visualize doing this again, while laughing at myself or smiling and shaking my head. It is very difficult to become identified with a pattern if you are making it the object of humor. Laughing at oneself is a potent strategy for gaining self-perspective. When contemplating unfavorable market outcomes, think of all the things you could do to really mess up and then ridicule them before they can ever be enacted.

  Notice how these couch tactics are not so different from the therapy with Mary. In both cases, change occurs when you experience an old, destructive pattern in real time, develop observing awareness of what is happening, shift into a different mode, and try something different. In the therapy with Mary, I helped to shake up her old patterns—afflicting her comfort—by not immediately disavowing my interest in her and by leaving the room when she became enraged. In the trading situation, the shakeup occurred when I checked my Excel sheets and realized the extent to which the breakout was narrow
ly based. The research, to no small degree, acted as my therapist in the trading situation by challenging my construction of events and helping me see things in another way.

  The situation with the false S&P breakout demonstrated how a past trading debacle led me to become overly sensitive to its recurrence the following week. Hours of inoculation practice had taught me to question myself any time an emotional reaction in the market seemed to be excessive. The jolt of adrenaline thus became a cue to take a few deep breaths and question the basis for my reaction. Instead of becoming lost in the fear, I used it to become more deeply immersed in the data. Had the spreadsheet figures confirmed my fears, I most certainly would have exited the trade in haste and ensured that the honoring of my stop would leave my trading capital as dry as possible for the next opportunity. Instead, the figures disconfirmed my fears, allowing me to write a new ending to the script.

  A couple of years ago, my 10-year-old daughter, Devon, and I were looking at market charts and preparing a joint e-mail to the Speculators List inspired by Laurel Kenner and Victor Niederhoffer. Laurel and Vic were kind enough to memorialize Devon's e-mail in a subsequent publication of Spec List insights. The market, Devon asserted, was like a school of fish. There are two types of fish that diverge from the pack: (1) the weak and infirm and (2) the leaders. The entire school will shift position in response to the leaders, leaving the weakest behind. To anticipate a prospective move, she suggested, it is necessary to identify the leaders.

  I have since placed Devon's insight to good use in many trading situations. Very often, a stock sector, such as semiconductors or financial stocks, will make its breakout ahead of the general market. These sectors sometimes will also telegraph their occasional lead status by refusing to drop during a morning decline and then becoming the first groups to enter positive territory on a rebound. It is easy to become absorbed in market moves, losing sight of what the entire market is up to. For that reason, I keep handy on my screen, in minimized form, the charts of the most common lead fish. Keeping an eye on their action strengthens one's ability to become an Observer to the market and catch nascent moves.

  I have found this principle to be helpful even at the finest level of resolution, following the market maker screens for various stocks and exchange-traded funds. The lead fish will be those that demonstrate the greatest stickiness in their bid/ask action in the face of institutional buying or selling. Such stickiness in the midst of premium extremes in the S&P and the Nasdaq futures and Dow TICK levels often points the way to lead fish that will diverge even further from the pack over time. It is when I am most immersed in my preconceived notions of the market that the jolt of seeing the lead fish change direction is most helpful. If you are open to the data, the market will afflict your comfort and create jolts worthy of the best therapists.

  CONCLUSION

  Because trading is so fast paced and emotional, it is a perfect medium for activating your repetitive emotional patterns. Once those patterns are triggered, only a significant jolt can prevent you from reenacting past solutions that have outlived their usefulness. In therapy, counselors provide this jolt by consciously countering the patterned tendencies of clients. Traders can administer their own shifts by using emotional exercises, such as desensitization, inoculation, and laughing at their old patterns, and by consulting research-based strategies that challenge their perspective on the markets.

  The need for such strategies to break patterns of arousal that manifest themselves in trading appears to be especially critical for less experienced traders. In a fascinating study, Andrew Lo and Dmitry Repin of the Massachusetts Institute of Technology connected both experienced and inexperienced traders to biofeedback machines to examine their reactions to the markets. By coordinating the biofeedback with the minute-by-minute market action, the researchers were able to observe the specific market events that triggered emotional reactions from the traders. It is interesting—and perhaps not surprising—that the inexperienced traders displayed the greatest emotional responses to such market events as volatility expansions. This raises the distinct possibility that experienced traders gain their experience and success, in part, by acquiring strategies for reducing their physiological arousal in the face of challenging market events. Their prior experience, coupled with many hours of research and planning, may function as a stress inoculation, desensitizing them to the events that toss novices to and fro.

  Lo and Repin's work further suggests that one need not have diagnosable emotional and behavioral disorders to find that his or her patterns sabotage good trading. Normal and natural ways of processing information are sufficient to interfere with good trading. A good example of this is the endowment effect described by researchers Tversky and Kahnemann. I may be willing to only spend $5.00 to obtain a household item. Once it is mine, however, I may not be willing to part with it for even $10.00. As soon as something becomes mine, I naturally endow it with special value and significance.

  This applies to trading opinions and predictions as well. I maintain a weblog on my personal site (www.greatspeculations.com/brett/weblog.htm) in which I share my hypotheses about the markets and my thinking about trading psychology. It has become a useful part of my discipline in writing out my thoughts, obtaining useful feedback, and integrating the feedback into my subsequent trading plans. Recently I posted the results of a nearest-neighbor modeling exercise that suggested a bullish tendency over the coming 40 days. Shortly thereafter, the market made a nice upside move in the overnight session, and I entered a long position at the first morning dip, without even consulting my other market data. My grounding in my bullish conviction had become so great that I was no longer scanning for disconfirming data.

  Had I looked carefully, I would have seen that the opening breakout was not a breakout for a majority of indexes and, indeed, was part of a larger topping pattern. It took a quick hit of three S&P points, violating my stop, to get me to question my assumptions. By the time I performed the homework I should have finished prior to the market open, my position had not only stopped out but meaningfully continued in a downward direction. Not only had I lost a few points, but I had also missed a shorting opportunity that should have been crystal clear.

  It is a rare individual who can form a conviction strong enough to act on and yet remain sufficiently flexible to reverse this conviction in the face of objective evidence. Simple human nature, not any emotional disorder, cuts against this grain, allowing one to interpret the world through his or her beliefs and convictions. Successful traders are trading against their own human nature, making unnatural ways of processing information natural.

  It is in this vein that I believe that markets accelerate evolution, selecting for the ability to sustain purpose. The successful trader cultivates his or her ability to stay plan-focused and disciplined even in the face of violent market action. Much as bodybuilders go to the gym to develop their physiques, traders can utilize the markets as workouts for expanding their capacities for intentional action. This makes trading one of the best of all therapy couches.

  Chapter Six

  The Evil Spiders

  In markets as in nature, tornadoes begin in stillness; earthquakes end in aftershocks.

  Communication is the therapist's stock in trade. Much of understanding another person consists of being able to read their communications, both verbal and nonverbal. My personal interest in the markets was piqued when I recognized that stocks and futures produced streams of communications not unlike those of clients. As with people, I found that what markets said often conflicted with how they said it, creating complex and rich communications.

  In this chapter, we will explore the reading of people and markets and the ways that therapists and traders can become sensitive to the nuances of communication. We will take a particular look at the research of cognitive neuroscience, which suggests that we process far more information than we are aware of. As we will see, the simple but profound fact that we know much more than we know we know holds
an important key to our development as traders.

  COMMUNICATION AND METACOMMUNICATION

  An enduring theme in psychology is the difference between communication and metacommunication. Communication refers to what people say—their intended meanings. Metacommunication refers to the body language that accompanies communication—how people say something. Metacommunication influences what is heard.

  Many disagreements arise from discrepancies between a person's communications and his or her metacommunications. A woman, for example, may confront her husband: "Why don't you spend time with me?" If you read the words alone, they appear to be an innocent inquiry. When the words are accompanied by an annoyed tone of voice, arms folded tightly, and an elevated volume, however, a very different message is heard: one of scolding.

  The husband, of course, attends to the metacommunications (actions speaking louder than words) and either beats a hasty retreat or responds defensively. Either way, the woman will feel that he has not heard her concern, that he doesn't care about her.

  A classic incident once occurred in a couple's counseling session that I held with a successful businessman and his frustrated wife. At one point, she cried out in anguish, "You never say you love me." Eyes rolling upward, he said, "Okay, I love you." The wife, of course, was not satisfied. The metacommunication—the rolled eyes—spoke louder than the content of the communication.

  When people are said to have good social skills, it generally means that they are adept at reading the metacommunications of others. These typically take the form of body language, vocal tone, shadings of speech, and the like. A boring person talks continuously, clueless to the shifting body postures and sideways glances of his audience. To a more socially skilled person, those are cues that the listener has tired of the conversation, just as an attentive gaze and a mirroring of tone and posture signify that the listener is tracking a speaker. The socially skilled person makes frequent midcourse corrections in the face of such cues, pursuing topics that elicit favorable nonverbal response and minimizing those that turn off the listener.