Wednesday, March 26, 2008

Control Your Brain by Controlling Your Risk

I received an eloquent email from an excellent trader who marveled that he trades very well when he trades moderate (but still significant) size, but then trades quite poorly when he trades his maximum size. His level of risk-taking, he finds, affects his emotional experience in trading. Yesterday, when he traded moderate risk through the day, he traded consistently and made significant profits. Last week, when he maximized his risk, he violated a number of his trading rules and lost significant money.

Same trader, same trading methods--only risk levels altered his emotions, his decision-making, and his performance.

Research suggests that different areas of the brain process risk and reward. Moreover, brain activation in the face of reward tends to be more rapid than in the face of risk. Other research shows that individual differences in our patterns of brain activity are closely correlated to our risk tolerance and risk aversion. This research finds that "reward centers" in the brain become more or less active depending upon how much money can be won or lost. Significantly, these reward centers are "some of the same areas of the brain that are activated when people take cocaine, eat chocolate or look at a beautiful face."

It appears that the thrill of risk and prospect of reward "hijack" the reward centers of the brain, particularly the dopamine system. This research emphasizes that gambling affects the portions of the brain associated with "planning and forming strategies". Is it any wonder that traders report "losing discipline" as a common psychological concern?

There is a very important lesson to be learned from the trader who wrote to me: By controlling our exposure to risk and reward, we control the degree to which our brains get hijacked. Trading 100% of our risk turns planned trading into gambling; cutting risk back moderates the reactivity of our dopamine systems.

There is also another sobering conclusion: failing to moderate our risk--day after day, week after week--can make permanent changes in the brain. According to one researcher, "In people that develop problems with gambling it seems that parts of that area don't work as well as they used to." By altering the dopamine system, a normal person can turn into a gambling addict. This is an example of neuroplasticity: the ability of the brain to change structure and function as the result of experience.

By creating the right kinds of experience, we literally can shape our brains for success. By generating the wrong kinds of experience, we can turn ourselves into impaired decision-makers. The difference between right and wrong, for traders, often boils down to the amount of risk we take with the capital we have.

I try to avoid overstatement, but in my opinion, this is one of the most important topics I've ever posted to the blog. Those who read the research linked above and the posts linked below--and who heed the message of risk levels and brain function--quite literally can save their trading careers and meaningfully advance their odds of success. You can't succeed if you don't have control, and you don't have control if the reward circuitry of your brain is hijacked by the risks and rewards you're pursuing.

RELATED POSTS:

The Brain and Handling Volatile Markets

Trading and the Brain

Trading Performance and the Brain
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8 comments:

Seemingly Useless said...

This may very well explain why every time I decide to size up my positions, I coincidently always achieve inferior results. Sometimes controlling risk is easier said than done. Perhaps strategies should be tweaked to take into account position size rather than a uniform scaling approach. Maybe we can take some dopamine inhibitors during times of extraordinary position sizes although the long term biological effects might be scary.

Lewis said...

there's a really interesting dialogue about neuroplasticity between Richard Davidson (a neuroscientist at the University of Wisconsin) and Daniel Goleman (the author of emotional intelligence). It's worth a listen to and there are free samples available at www.morethansound.net

Marc said...

What a great post, Brett!

You have a knack for insight that is unmatched amongst all the blogs I read.

Thank you,
Marc

P said...

Brett

Thank you for your insights. Do you have any suggestions on how to increase one's "comfort" position size over time?

P

Globetrader said...

Hi Brett,
I just posted a set of trading rules on my blog (http://globetrader.blogspot.com) and reading them in light of your two articles is sure very interesting.
It seems I found myself rules to avoid overtrading or addiction:
- Take 3 to 8 trades / day and try to maximize the profits of each individual trade.
- Have a daily goal per contract traded, which when hit only after a certain amount of trades or hours at the screen, means I stop trading for the day
- No more trading after 3 stops in a row
- High internal margin per contract to avoid overleverage of my account

Of course I'm trading for my own, so I'm not forced to trade at all or can stop any time I like to do something else.

Brett Steenbarger, Ph.D. said...

Thanks for the comments on the post; they're much appreciated. I'll be linking Globetrader's work Fri AM; very good stuff.

Building comfort with size is best done, I find, gradually so that the trade never feels qualitatively different. Mental rehearsals can be helpful to anticipate the new size and the changed P/L swings.

Brett

heywally said...

Nice post; I like to control my risk with smaller position sizing and by being very selective - trading only at key resistant/support areas. One of the biggest dangers in day or short term trading is overly large positions that 'require' too-tight stop losses, that invariably get hit.

Trader Kevin said...

Great post, Brett, thanks.

This helps explain why the pain of a winning trade can be almost as great as the pain of a losing trade.