The Psychology of Trading

by Brett N Steenbarger

  Note, of course, that Al's use of the psychological technique would have been to no avail had he not adopted a valid, tested trading method. There is no merit in learning to be calm and collected while placing trades that lack an edge. Trading from the couch does not entitle you to lie down on the job. Emotional techniques allow you to consistently implement good ideas. They do not substitute for the ideas themselves.

  Indeed, consider how damaging it would have been for Al to trade an invalid system. Suppose he implemented his trading ideas but did not incorporate any form of money management. The losses associated with occasional high-volatility reversals would have decimated his portfolio. Even worse, however, Al would have been at his most enhanced state of emotional experiencing at those times when his system is failing him. Sitting in front of the screen, emotionally charged, focused on every tick moving against him, Al would be rehearsing a host of fearful, negative thoughts—unwittingly programming his mind with the most damaging scenarios and messages. In a very real sense, he would be conducting effective therapy in reverse: altering his emotional state and then rehearsing the thoughts, feelings, and behaviors associated with poor performance!

  This is a major psychological contributor to failure in the markets: Traders are most open to change—most receptive to internalizing their experiences—when they are wholly absorbed in the markets. And they tend to become most absorbed when they are losing. If a position is moving in their favor, traders can afford to step away and let the trade do its thing. But if the position is moving against them, it is human nature—the need for perceived control—to follow the market closely and to hang on every tick, looking for signs of reversal, hoping, hoping . . .

  Al was successful because he used the exercise to become most focused and attentive when he was doing the right things in the market. This practice reinforced winning trading patterns. Had he not implemented proper money management, he most likely would have reinforced thoughts and behaviors associated with failure. Traders are accustomed to thinking of money management as a necessary (if somewhat prosaic) tool for preserving their accounts. Equally important, money management is a vital tool for psychological mastery. If you are going to internalize success, you need to experience success. Emotionally, you cannot afford to be at your most aroused and focused when you are experiencing failure.

  For this reason, a disciplined, scratched trade where the market hits your stops is not a failure. It can, in fact, heighten your sense of control and mastery. One of the better pieces of advice I received as a neophyte trader was to move my stops to my entry price once a trade had moved decisively in my favor. The most damaging trades emotionally are the round trips: the ones in which you take an actual loss after losing a paper profit. Those are double failures: the failure to book a gain, and the failure to limit a loss. They are also some of the most emotional, frustrating trades. By moving stops to break even while you are ahead, you immediately gain the confidence during the trade of "I'm not going to lose on this one."

  That is a feeling worthy of reinforcement: a sense of contentment that, over time, becomes a marker for successful trading.

  THE WAKING TRANCE: DAYDREAMS

  People tend to think of hypnotic states as unusual conditions that occur only in response to a professional hypnotist. In reality, however, people pass in and out of trance states frequently during an average day, as their degree of self-awareness waxes and wanes.

  Daydreams are one of the most frequent daily trance states, as your image-based, nonverbal mind takes over for stretches of time and initiates communications with you. It is common to view daydreams as harmless fantasies or as idle wastes of time. However, when you regard daydreams as communications, you become more able to grasp their meaning and significance.

  Daydreams reflect your unmet needs. If you cannot meet your needs at a given moment—and especially if these needs are pressing—you tend to find outlet for them in daydreams. A young man from an Asian family, Xiao, found it difficult to navigate between two cultures and sought my assistance. He had spent many of his growing-up years in the United States, but he still spoke his native tongue at home and followed the traditions of his homeland. Anger was rarely directly expressed in his home, especially toward elders. Xiao's reason for entering counseling was that he was troubled by intrusive thoughts. For long periods of time, he would fantasize various scenarios in which he confronted his professors, became angry toward them, and so on. This agitated him greatly, as he could not understand why he would keep thinking of such unacceptable and unprofessional behavior.

  It turned out that Xiao had been treated shabbily by one of the residents during a medical rotation. The resident made a negative remark about "foreign doctors" and suggested that Xiao would have trouble passing the rotation because he could not relate to American patients. Xiao knew that this was not the case, but he did not know how to respond to the resident. It was unacceptable to express anger directly, so he did so through an indirect means: his daydreams! Once he could understand that the daydreams were serving a valuable discharge function, he could more readily accept them without agitation.

  I often encourage traders to keep a journal of their daydreams as a way of learning about their unmet needs. Like Xiao, many traders find that their daydreams reflect unacknowledged feelings and impulses—ones that can easily distract attention and concentration.

  Some of the most interesting daydreams that occur during trading follow winning trades. Recall Odean's research on the overconfidence of traders. When they go through a period of winning, they tend to trade more frequently and subsequently underperform the market. Behavioral finance research conducted by Mark Fenton-O'Creevy and colleagues in the United Kingdom suggests that many traders experience an illusion of control, in which they believe they are able to predict even random events. Such an illusion may very well underlie most trader overconfidence. Daydreams of glory, untold wealth, fame, and so on, speak volumes about traders' needs to have their perceptions of control validated. Some of these daydreams are simply imagined scenarios of what the market is likely to do—how it is going to break resistance, soar to new heights, or take out prior lows. Very often these fantasies are contemplated in a self-soothing way, to make traders feel better about their positions. They suggest a need for the trade to work out.

  Unfortunately, such daydreams can become a straitjacket. Once you are locked into a fantasized scenario, it is difficult to be sufficiently flexible in your perception and thought that you can catch meaningful markers in the markets. This is especially damaging where the imagined scenario is for a long-term market move. The trader then utilizes the scenario as a rationale for holding onto losing positions and violating stops. With each disconfirming piece of market action, anxiety rises, as does the need to defend the fantasy.

  I knew several traders who could not accept that the market was in a bull mode through the majority of the 1990s, preferring instead to focus on minute pieces of economic events that suggested an impending crash. To a person, they missed the market bottoms in the 1980s and 1990s and sought vindication for their errors. They spent a significant amount of time daydreaming about the coming economic collapse and the ways in which they would uniquely benefit from the event. Their trading was no longer dictated by reality; it was based entirely on their emotional needs to be proven right.

  Later, in the early years of the new millennium, the shoes were on different feet and many traders with whom I corresponded could not believe that the Nasdaq stocks would not quickly return to their days of glory. People who had given up their jobs to pursue full-time trading were caught in a state of cognitive dissonance: They could not reconcile themselves to the fact that they had committed themselves to a market that had peaked. Their way of relieving the dissonance was to ignore the evidence and instead to indulge in fantasies of the markets coming back.

  Once you begin to trade in a self-aware manner, the emergence of daydreams can become one of your trading markers, indicating that y
ou are now more focused on unmet needs than on the markets. I recently found myself daydreaming about outsized profits on a short position in the S&P stocks. The trade was solidly profitable, and, indeed, I had forecast the move to a number of my trading colleagues prior to the market open. I realized, however, that I had stopped watching the screen and stopped following my data with intensity. I was no longer in the zone; I was immersed in my own fantasy of success. That recognition led me to take money off the table before it could be lost and to reestablish my equilibrium. My fantasies became an important marker, enabling me to shift gears.

  CONCLUSION

  Your mind and your body are always communicating, even when you are silent. The flow of your thoughts, gestures, postures, activities, vocal tones, dreams, and daydreams all provide a stream of information, revealing your processing of events. The trader is thus doubly attuned, casting one eye and ear to the procession of market data and the other eye and ear to the flow of personal experience. Both sets of data encapsulate patterns that serve as markers for change events. These markers are the potential information in the noise: the signals that the trader can use to prompt his or her trading decisions.

  A simple example illustrates the interplay of objective and subjective data in trading. A little while ago, the market experienced a bounce from a stiff decline in the S&P futures. During the bounce, I noticed myself feeling a high degree of certainty that the market was vulnerable to further decline. I could not put my finger on the precise source of the feeling, though I knew it had something to do with the lack of vigor of the rise compared to the prior decline. What was clear to me was that this intuition was not simply a case of hoping the market would decline. I had no position in the market and no particular desire either to trade that day or to trade from the long or short end.

  I used the occasion to more carefully inspect the market action during the bounce. Right away I noticed that the lowest TICK value achieved by the market over the prior 10 hours was approximately –230. This struck me as unusual. I hypothesized that this might serve as a short-term overbought signal, thereby accounting for my sense that the market was vulnerable.

  At that point, I inspected historical data and found that the most recent several short-term tops in the market also possessed this pattern: a minimum 10-hour TICK value greater than –300. I promptly e-mailed the observation to a few trading colleagues, a couple of whom validated my hypothesis with hard data. Armed with this information, our little group had a successful trading day with a double-digit decline in the S&P futures.

  I believe this example challenges the usual dichotomies between "discretionary" trading and "system" trading, as well as the polarization of intuitive and quantitative methods. A debate has recently raged on the Spec List regarding the merits and demerits of technical analysis and "counting." Such debates, I fear, miss the essence of discovery in science.

  As you can see from my trading example, subjective experience often provides the inspiration for hypotheses. My hypothesis of a weakening market began with a feeling, which was supplemented with a descriptive account of price change and TICK values. Once this qualitative hypothesis was framed, however, the counting work with historical data helped determine whether this hypothesis was valid—whether the observed pattern led to outcomes that were attributable to chance or that were truly nonrandom.

  Technical analysis is a handy descriptive language for framing market hypotheses, just as the language of psychology can help convey subjective experience. If you are looking for markers in the markets, a picture is worth a thousand words and captures subtleties that ordinary language cannot. Like an X-ray, the charts and the indicator patterns of technical analysis can provide snapshots of market structure and a gross sense of whether that structure is normal or abnormal.

  But technical analysis, like X-rays, is generally the beginning of diagnosis, not the endpoint. Radiology can identify a tumor, but only the counting of a blood test or a cytological analysis of a biopsy will determine definitively if the tumor is malignant. Similarly, the charts of technical analysis may reveal an unusual market pattern. Formal testing, however, is needed to determine whether this pattern contains information about the future.

  Markers—those of the markets and those of traders—provide hypotheses. The successful trader is both open to these hypotheses and sufficiently skeptical to demand support for them. The best trading is art elevated to science.

  Chapter Nine

  Trance-Forming the Mindscape

  Sustained attention makes for sustained intention.

  Subjective experience, as we have seen, can both disrupt trading and serve as a fruitful source of market hypotheses. Extracting information from noise in our personal experience is not unlike the same process in following the markets.

  In this chapter, we will explore subjective experience in greater depth, building on our core notion of multiple minds. If markets are relatively efficient, as the finance research literature suggests, the ability to process market events in fresh ways may be an important facet of pursuing a tradable edge. Such novel ways of processing can entail the use of ever more sophisticated mathematical tools; this is the way of data mining. Still another novel means for processing is to improve the information processing of the trader. In learning to process market information differently, we can make ourselves better generators of promising trading hypotheses.

  THE RADIO DIAL OF CONSCIOUSNESS

  Imagine that your mind is a receiver, like the radio in your automobile. This receiver has a dial, with a band of frequencies. At various frequencies, there are signals corresponding to radio stations. Some of these signals are strong, some weak. Some are formatted as news/talk stations; others feature rock music, country tunes, or religious broadcasts. Each frequency has different content and its own distinctive sound and feel. During an average day, you will spend most of your time at one or two points on the dial, tuned in to your accustomed stations. Indeed, you may spend so much time at those frequencies that you forget the remainder of the dial and miss out on what might be there. Instead, you listen endlessly to the same music, the same announcers, and the same commercials.

  Most people utilize a relatively small bandwidth along the dial of consciousness. The shifts in effective therapy that I have mentioned represent those occasions when one moves from the comfort—and limitations—of one spot on the dial to a fresh frequency. The goal of counseling is to enable people to control the knobs that move them from one frequency to another. When you are stuck in a given frequency, it is all too easy to forget that the knob is even there.

  The modern existential philosopher Colin Wilson vividly describes this dilemma in his book New Pathways in Psychology. Wilson pointed out that nature has endowed human beings with a most adaptive capacity: the ability to learn new behaviors so well that they can perform them automatically, without conscious effort. For example, when you first learned to drive a car, you needed to expend considerable mental energy on the task: recalling where each pedal was and what it did, watching for oncoming traffic, staying in the center of the lane. With practice, these actions became automated, allowing you to attend to other matters, such as conversations, while you drive.

  This ability to automatize complex behaviors is evolutionarily adaptive. If each of your actions required effortful concentration, you would become quickly exhausted. Once behaviors become routine, you are freed to devote resources toward the acquisition of new action patterns, continually expanding your repertoire.

  Yet, Wilson pointed out, your ability to act automatically comes at a dire cost. You live much of your life on autopilot, not fully conscious of what you are doing or why. It is that state of sleep described by George Ivanovitch Gurdjieff. You interact with friends and family automatically, drive to work automatically, perform chores automatically. In fact, during a great deal of the day, you are like a robot. You are stuck in a small bandwidth of consciousness, blind to what lies on either side of the dial.

  Abra
ham Maslow was a pioneering psychologist who studied peak experiences: those moments in which people feel most alive and healthy. He found that unusually creative and productive individuals, whom he dubbed "self-actualizers," spent an unusual proportion of their time in the peak mode. Wilson observed that routine states of consciousness cannot sustain such peaks, which result from the shifts that occur when one moves effortfully from one spot on the dial to another.

  This is the second-wind phenomenon that I discovered when using meditation-based techniques. Recall that if I sat completely still in a totally quiet room and focused all of my attention on a stimulus, I found that I rather quickly became bored and antsy. I invariably felt the impulse to allow my thoughts to wander, to shift my body, and to terminate the exercise. If, however, I did not yield to this impulse, a dramatic trance-formation occurred. I suddenly entered a new spot on the radio dial of consciousness. I no longer felt bored or antsy. Indeed, it took effort for me to rouse myself from this new, strangely pleasurable state.

  Moreover, once I was in the new state, I found myself thinking and feeling in very different ways. Problems that had seemed insurmountable suddenly seemed minor. Patterns in the market that had eluded me stood out in bas-relief. It was as if I had changed lenses, as in Fredric Schiffer's experiment.

  Gurdjieff once wrote that effort is the money one pays for self-development. Wilson's analysis and my personal experience support this conclusion. Focused acts of effort shift one along the mind's radio dial. Self-actualizing people have become so accustomed to absorbing themselves in their work—achieving what psychologist Mihalyi Csikszentmihalyi called the state of flow—that they routinely operate at high bandwidth, enjoying the peak experiences that come with an expanded mindscape.