Thursday, June 28, 2007

How To Regain Your Trading Consistency

A reader recently wrote to me the following:

I was a successful consistent trader who always hit singles and doubles ($1000-$3000 a day) for 48 months in a row without having a losing month (1999-2003).Then one day I struck out. I lost $38,000 in one stock and had my first losing month as a trader ever. Since then I have not had two consecutive winning months and in fact have only had a handful of profitable months since then. I am still looking for the road back to consistency. No matter how close I get I always find a way to screw it up even if it is on the last day of the month. Or I give back the month with just some silly unimportant trade that turns into a disaster. It is like I subconsciously look for these situations just so I can mess up.

This is not such an unusual scenario. One large loss can trigger a cascade of attempts to make back the money, further mistakes, and expanding losses. The key is breaking this cycle of losing money, attempting to make the money back with aggressive trades, and continuing to lose.

The first thing I'd have our trader look at is where he is placing stops and targets for his trades. Note that his successful period was 1999-2003. That was a period of much higher price volatility than we've seen since then. What constitutes "singles and doubles" in a high volatility environment is a home run trade in a slow, low-volatility market. It is entirely conceivable that our trader is placing targets too far from his entries, allowing small gains to reverse on him. Similarly, he may be letting trades get too far away from him simply because he is calibrated to a higher level of volatility.

A good way to test these hypotheses would be to study trades over the last several months. If losing trades are larger than winners on average, and if many losers start out as winners, that would suggest that our trader needs to adjust to the post 2003 environment.

To break the cycle mentioned above, the first step is to drastically reduce trading size. I would cut size to 1/4 the average at the most. The goal is to keep a little skin in the game, but take P/L (and the push to make back money) off the table temporarily. The initial objective is not to make money, but to regain a trading rhythm by getting back to singles and doubles.

The next step is to identify those singles and doubles. That means deconstructing the account statement and identifying which trades are making money and which aren't. I would break the data down into time of day, stock/index being traded, long/short, and size. I would also look to see if there are large outlier trades to the downside that are pulling down P/L, and if there are some trades that are making money consistently.

Once our trader has identified what's working, the idea is to keep position size fixed and *only* trade those setups that have been working. This is the foundation to build upon. These setups can be written down and mentally rehearsed ahead of the trading day to build consistency. The idea is to not increase size *and* not trade other patterns until consistency is achieved with smaller size and the most successful setups.

There is only one cure for trauma, and that is repeated experiences of control and safety. We want trading to be routine, not highly emotionally charged.

Finally, I would encourage our trader to take a look at how he is viewing his situation. Note above that he talks of the $38,000 loss and the silly trade that "turns into a disaster" as if these are things happening to him, not things that he is actively doing. A simple strategy would be to have the trader write down the four things he is responsible for prior to each trade:

* The Entry
* The Target(s)
* The Stop
* The Position Size

We can't control whether any individual trade will be a winner, but we can control how much we are willing to bet on each trade. Outsized losses don't happen to a trader; they are actively caused. It is harder to allow those things to occur if you're talking aloud those four trade parameters and have them written in front of you.

So there it is in a nutshell. My advice is to get small, get selective, and take responsibility for what can be controlled.

Do readers have additional advice? Let's see if we can help a reader. Thanks!



Ziad said...

One thing this trader can do is to stop defining consistency as back to back profitable MONTHS. What I think is happening because of this is that he is ending up focusing on the outcome rather than the process. You can tell by how he says "No matter how close I get I always find a way to screw it up even if it is on the last day of the month." i.e. when he is about to post a profitable month, his attention is all on achieving that, instead of just taking good trades and letting things happen naturally. I think it would help if he realized that the end of the month is nothing more than an arbitrary cut-off point in a continuous series of trades. A healthier way to define consistency for him now would be an increase in strings of winning trades and a decrease in the severity and duration of drawdowns. This general definition would allow him to gauge progress without getting bogged down in the outcome of a specific month and thus artificially manipulating his trading to make the month a winner.

This is just one psychological suggestion. In reality I think the problem could also be one of money management. The question is what caused the $38,000 loss in one stock to begin all of this? Either it was failing to keep a stop, or it was extremely excessive position sizing. While a change in market volatility could mean that his old stops are now too large, I dont think it would cause one to take a loss that is 19 times the average daily profit. So I dont think that his failure to adapt to the lower volatility can explain such large losses that he terms as "disasters". The only culprits that can produce such huge outliers IMO are faulty position sizing and not keeping stops. These two things can be easily remedied. Once they are, results should improve substantially. That doesnt mean he will reach consistent profitability, but it will give him confidence and allow him to trade in a state of trading to win instead of trading "not to lose".

So in conclusion, I believe that while this trader's strategy could indeed be inefficient in this market environment, I think the fact that his inconsistency is coming from DISASTER trades means that the problem is likely more of a psychological / money management one rather than a strategy one.

David said...

There are some investing methods, fundamental and technical, that work in one era, and not another. When things are not working, the best thing we can do is refocus on risk control. If it is a psychological issue, eventually confidence and success will return.

Many methods work for making money, but the neglect of risk control causes many to exit their systems, when they could make money in them over the long haul, so long as the risks are controlled.

Brett Steenbarger, Ph.D. said...

Hi Ziad,

That's a great analysis; thanks for the feedback. I strongly suspect that it's the need/desire to make back the lost money that drives the problems with managing position size/stops/risk. Your idea of defining consistency in process terms rather than as consecutive profitable months is excellent. You have a future as a trading coach!


Brett Steenbarger, Ph.D. said...

Hi David,

Great points; thanks for the comments. You're absolutely correct about the waxing and waning of various trading and investing approaches. It's the traders who manage risk during the lean periods for their strategies that survive in the long run--


High Probability Trader said...

I recently had a terrible month.
I made about 20k over the course of a month and then lost almost all of it in a day, made 10k back in 3 weeks, and then lost it in a day.
The causes:
1.Too large of a position
2.Failing to use stops
3.Thinking in disbelief that I couldn't lose a months worth of profit in a day and that the market couldn't keep going against me. Freezing up on the trade, saying screw this, it can't keep going against me, letting emotion do the trading (losing).

Ways to correct this-
Use smaller size and keep your stops, and forget about how much money you had in your account before your big loss, and just focus on the trade setup.
Never add to losers.

Brett Steenbarger, Ph.D. said...

Hello High Probability Trader,

Great observations and conclusions. Thanks for the comment. Focusing on trading as a process rather than on outcomes is extremely helpful to consistency, in my experience.