Tuesday, April 07, 2009

Trading Scared is Trading Scarred

A trader dropped me an email today to explain that he was "trading scared": missing out on opportunities because he was overly risk averse. As luck (or Freudian psychology) would have it, he spelled "scared" as "scarred". That little slip revealed considerable psychological insight.

Most traders who trade scared are also trading scarred. Normal losing trades and periods of drawdown are processed normally, as expectable--if somewhat disappointing--events. When losses are substantial, however, they can be processed as traumatic events. Instead of being processed through normal, explicit, verbal channels, they activate the flight/fight emergency mechanisms of mind and body, leaving their emotional imprint. Later, events similar to the traumatic losses--even normal ones--can trigger the emotional and physical reactions of emergency, including paralyzing anxiety.

Interestingly, our trader had an excellent March after losses in December - February. During those losses, he explains, "I basically got pretty close to running out of money in my bank account." He feels that he should increase his size after the good month, but instead he's trading even more scared than he did before the winning month. As he recognizes, the making of money in March has restimulated his experience of losing money in December through February following a profitable fall season. Because the earlier losses nearly bankrupted him, they weren't experienced as normal losses. They scarred him in a traumatic way, and now he's trading scared.

When traders need profits to make the next paycheck that will put bread on the table, that is too much performance pressure. I've commented in the past that the smartest thing I ever did when learning trading was to begin with a trading stake that I could afford to lose in its entirety without affecting my family's lifestyle. Having the cushion of a second income and/or a secure savings account as backup means that normal slumps don't have to turn into career-threatening events. I've worked with traders who felt that, if they didn't make money in the current month, they would not be able to cover their mortgage payments. Normal losing trades became extreme threats, and the traders traded scared as a result.

It's when the desire to profit becomes an acute need for profits that performance anxiety is likely to overcome efforts at prudent risk-taking. Any business, when it gets off the ground, has to be adequately capitalized, so that it can weather initial adversity. The lack of adequate capitalization leads many traders to take large risks (to make enough money to support themselves), but also to trade with large fear (due to the absence of any cushion in the event of loss). Our trader should not be thinking of ramping up size after only a month in the black. Rather, he should work on achieving consistency with the kind of trading that worked in March.

That will build his cash cushion, his confidence, and ultimately his ability to take risk in a secure manner. The links below outline methods that are quite useful in addressing psych issues related to trauma.

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7 comments:

leonarbull said...

I too experienced trading anxiety after a period of record returns. Somehow I found myself afraid to succeed, afraid to give back my record profits. Your mind, which once focused on all the right thoughts (entry, exits, position control, etc.), is now focusing primarily on protecting the profit you earned. In so doing, you let stops slip by, you let it run a few cents further against you. After you had failed a couple of trades, you started to engage in revenge trading. Your emotions overcame your logic and made you enter dumb trades. Because you succeeded in the prior period, you started feeling cocky and performed more actions showing disrespect to the market. Like a death spiral, you suddenly gave back all the profit you earned and then some.

Dtowntrader said...

Ironically I have found that the need to make profit actually sharpens my focus and ability to "settle" for reasonable daily profits. This might be analogous to a basketball player who says the team plays best when they have their "backs against the wall," or when they're forced to play well or be eliminated. My worst performance has arguably taken place when I know that there is a cushion of cash that I can lose without any consequence, as I tend to subconsciously take greater risks/make less disciplined trades when this is the case.

One technique I have used to reduce this effect is to actually extract some money from my trading account after a decent run-up, so as to start from ground zero. It's very tempting to just leave it there and compound what I have, but that's a departure from my fundamental strategy of making linear gains, and what often times happens is that any additional cushion might be floundered once again.

I am currently trying to overcome this weakness by training myself to ignore past performance and current account value, and focus on my strategies. This greatly eliminates any anxieties associated with "trading scared" or overconfidence for that matter. It is absolutely amazing what one can achieve in the markets, but this can only be realized by not allowing one's emotional baggage associated with previous performance to impact present and future performance (assuming you have an edge of course!).

markus said...

Lack of capitalization is the reason for a lot of start-ups to fail.
And if one is trading for a living she/he should not expect to make 60% or more consistently year over year. But there are a lot of wannabe-traders who think they can do 100% or more and make a living with 50.000$ trading capital and 50.000$ of living expenses. That's ridiculous.

Cheers,
Markus

OKL said...

I like this phrase from Bon Jovi's 'Just Older', it has stuck in my mind ever since I first heard it.

"You can't win until you're not afraid to lose."

No, its not good to be 'Living on a Prayer' when it comes to trading, or anything else for that matter.

Swing Trader said...

I faced similar problem before too.

In February, I had a good winning streak for the first 3 weeks, winning 19 trades in a row. However, in the final week, I gave it all up and more.

I think the problem is I risked too much too soon - not being content with risking just $100 per trade, I went ahead and started risking $300 to $500 per trade. Surprisingly to me, my performance became poor when I did that. I actually thought I could just "scale up".

I'm not sure if it's just random (all winning streaks must come to an end), or something else, but everything just fell apart in that final week. I just want to block and forget that episode.

I probably fell apart. Instead of taking losses when they are small, I started to hold on to losses as they got bigger, hard to execute the stop loss when one risks $500 per trade.

Also, looking back, part of the reason why I could have the 19 wins is that for a few trades, when I was wrong, I simply held on, and eventually, the stock price turned and when I had a small profit, I quickly sold out and book the profits. It's okay when risking $100 which turned into $200 loss because it's still acceptable. But ironically, whilst I have many small wins, all it took was just 3 big losses to completely wipe out all that profits, after I scaled up.

As Dr Brett says, better to wait until one has say 3 months of consecutive profits, before even thinking of raising the $ risk per trade.

I should have just kept the risk small at $100 per trade, until I put on 3 solid months of results. Scaled up too quick, and got burnt.

Live and learn!

Damien said...

I had a very similar experience. I've found that it's good to designate position size units for high risk, medium risk, and lowest risk scenarios. For example, I trade trending markets best. So, I use my largest position size in a pure trending market. On the opposite end, when I try and trade crazy moves after Fed announcements (etc.), I use my smallest position size. In range bound markets I tend to use my base case position size.

Once in a while I get caught using my large position size outside a pure trending market, and most of the time it bites me in the ass. One of my new goals is to NEVER use my large position outside a trending market -- no questions asked. Working on goals is something encouraged in The Daily Trading Coach, and it has been paying dividends in tweaking my performance.

Also, when I moved from setting stop losses to using "mental" stop losses (after a long time of proving disciple), I still found myself letting stops lapse after winning streaks. It's like I couldn't accept the loss because I was waiting for it to turn and manifest my thesis. BAD IDEA. I now set hard stops and figure if the market makers can see them and hit them, oh well (and I doubt it cause I am not institutional size). It sure beats watching a few days of hard earned profits evaporate in one stubborn moment!

Brett Steenbarger, Ph.D. said...

Thanks for the perspectives; they're very helpful--

Brett