Saturday, March 21, 2009

Learning How to Trade: Managing the Psychological Risks

A couple of years ago, I posted an article (now available as a PDF) on managing the psychological risks of trading. I encourage you to review that article; it offers an important perspective for those learning how to trade.

The financial risks of trading are fairly well known: If we size positions too large or incur too many runs of losing trades, our capital will become depleted. Lose half your money and suddenly you have to double your remaining capital just to return to breakeven. If you trade every day and average 55% winning trades, you'll incur runs of four consecutive losing trades roughly every month. Size those trades too large and you'll be looking for a new vocation or avocation.

(Another article in PDF worth reviewing is Henry Carstens' Introduction to Testing Trading Ideas. Even if you're a discretionary trader, knowing your typical win ratio, average loss size, average drawdown, etc. helps you gauge your financial risks).

When you are learning to trade, those financial risks turn into psychological ones quite quickly. We might have a 55% win ratio, but we don't know how that 55% will be distributed over time. Consider Henry's P/L forecaster illustrated above. We have a small trader with a $33,000 account who has an average win equal to their average loss ($1000 per week after commissions) and a 55% winning percentage. The above chart shows one possible path for their two-year (100 week) P/L.

Overall, the trader is quite successful. The two-year return on capital is 33%, enough to support a career in the portfolio management world. But note that the first 15 weeks are spent in the red. Moreover, there is a drawdown late in the period in which nearly one-third of profits are lost. These adverse events--entirely expectable and having nothing to do with altered or poor trading--create many of the psychological risks of trading.

Most new traders, facing 15 weeks in the red, will change what they do, abandoning profitable trading methods. Many more, facing a profit drawdown, will shut down or change their methods, again drifting from their strengths. The resilient trader learns to expect these setbacks as a normal part of doing business. No matter how good you are--and I work with some very good traders--you will have extended periods in the red. The psychological risk for those learning to trade is not that you'll lose your money--proper position sizing and risk management can prevent that-- but that you'll lose your nerve. Just because you have an edge doesn't mean it won't feel at times like you're on the ledge.


info said...

Hi Dr Brett. Don't you think having set daily dollar stop levels and forced timed outs will help you reduce extended dradowns?
Don't you think these functions are helpful and if so, why do not most traders implement?


Brett Steenbarger, Ph.D. said...

Hi Ronin,

You're one step ahead of me; daily stops and time outs are very important. That is going to be the topic of my next post on this theme. Thanks for raising the point--


Matthew C. said...

This is an excellent topic.

Depending on the kinds of trades you make, there are some additional techniques that can help you psychologically.

One thing I do is start with small positions and I take profits quickly. In the morning I typically make trades and take all the profits off the table, building up a trading "cushion" that I can use as margin for setting up more positional "daily swing" trades that usually work best for me in the afternoon.

What this trading style does for me is to make it much easier for me psychologically. While I end up giving away a significant amount of my profits on "home run" trades, I am smoothing out my P&L over time, minimizing drawdowns, turning many days that would have been small losses into small gains instead, and increasing my win percentage.

For me, the most important thing in my trading is to keep the trading mentally and emotionally manageable, so preventing large negative craters in my P&L is my paramount concern. I just can't handle that, so I've found ways to trade that eliminate that as much as pssible.

Brett Steenbarger, Ph.D. said...

Hi Matthew,

That's a very interesting and worthwhile strategy. Many traders find that they're looser and much better at taking risk when they're up money. Starting smaller and building the cushion, whether it's at the start of a month, week, or day, can be helpful to such traders--