Brett Steenbarger, Ph.D., is an author of many popular books on the psychology of trading. He also coaches portfolio managers and traders in financial institutions on how to improve their efficiency. In the article below he gives advice on how to cope with emotions most dangerous for successful trading and deal with them in a constructive way.
Some time ago I worked with a trader and looked through his profit and loss statistics. Keeping good statistics of your trading is a universal best practice. Regularities of profitable and unprofitable transactions, as well as overall performance throughout the entire trading period, say a lot about your trading and its psychological component.
This trader was distinguished by one feature – the pattern of "small victories and small losses". He had a daily loss limit, and he never approached this value.
When we studied his trade, it became clear that he had goals on the profitability of each transaction, as well as stop-loss levels on it. This was appropriate given the daily loss limits. Having established stop-losses, the trader gave himself the opportunity to make a mistake, and also to continue to the trade if they worked.
So what is the problem?
After analyzing the trading of this trader, we quickly noticed that he rarely allowed his losing trades to reach the level of stop-loss, and rarely reached his profit targets. He quickly fixed the loss when the market was going against him, and just as rapidly fixed the profit when the quotes were moving in the right direction.
In short, his trade was an exercise in fear. When he was afraid of losses, he quickly got out of the deal. When he was afraid of losing profits, he quickly fixed it. Over time, this turned into what is called “playing with trifles,” that is, it became a meaningless and unpromising occupation, creating the appearance of work. Psychologically, this meant that he was constantly driven by fear.
We consolidate and strengthen in our minds the emotions we are constantly acting on. If we act based on fear, we increase fear. If our actions are based on disappointment (frustration), we strengthen it. Is it any wonder that, fearfully closing one trade after another, this trader never felt confident in what he was doing?
An important psychological rule is that we can overcome our fears only when confronted with them face to face. If I am afraid to go out, I cannot develop confidence by staying indoors. I need to live through what I fear, and make sure from my own experience that nothing terrible will happen, despite the risks of an adverse outcome. In this sense, we do not gain confidence only from success. We gain confidence by failing and seeing that, despite this, we can bounce back.
This is where the use of visual images is extremely useful. We can imagine in the smallest details how the profitable position is turning in the opposite direction, and mentally rehearse how we would like to cope with this situation. If you “scroll through” similar scenarios in your mind again and again, they become habitual and cease to be so threatening. This builds confidence because we tell ourselves that we can fail and come back to normal after that.
Please note that with the help of such visualization methods we maintain a state of self-consciousness, repeatedly taking the mind through a “terrible” episode. Having sufficient practice, we can gain a good ability to use self-awareness in real time. The way we worked with visual images, comes back to us during real trading.
The trader with whom I was engaged learned how to rethink their fears. As soon as he realized that the "game of pods" ensures that he will never achieve his goals, this person became afraid of being frightened. In other words, he changed his point of view. The problem is not the loss of money, but the fact that the fear of this has become an obstacle to making money! In a state of self-consciousness, he now looked at his situation differently, and this allowed him to trade quite differently.
Overcoming disappointment (frustration)
Often it is disappointment that can put a trader off balance and disrupt trading plans, including risk management. When trading does not work, or when we miss good opportunities, there is plenty of room for anger and frustration. This condition, otherwise called frustration, occurs when we have a large set of strong desires or needs, but they are not achieved. Getting into a big traffic jam when we are late for an important interview is a great example of this condition.
There are 2 types of methods that can help us overcome frustration:
1. Behavioral – it includes relaxation / visualization exercises, work with biofeedback and meditation. Using these methods, we learn to recognize signs of frustration as they arise (evil thoughts, physiological arousal, etc.).
Then we distance ourselves from a disappointing situation and perform exercises that help to calm down and require concentration. For example, in meditation we can slow down and deepen our breathing, keeping it fairly regular, while concentrating on a calming image.
Entering cognitive and physical states that are incompatible with frustration, we can lock the anger and prevent it from dominating our actions and decisions. One of the powerful behavioral variants is the use of managed images when we do not trade, and we vividly present the market scenarios that are usually capable of upsetting us.
While you imagine the scenes of disappointment in the smallest detail, you simultaneously maintain peace of mind: slow, deep breathing, maintaining stillness, etc. Repeating this exercise allows you to reinforce a calm response when a disappointing situation arises in real life. The main thing is the repetition, which helps to ensure that calm becomes an automatic response to situations that do not give the desired result.
2. Cognitive – methods in this category view our thoughts and states of mind as triggers of our emotional responses. As stated above, frustration is usually preceded by strong expectations and needs. If we hope too much that the transaction will work and, moreover, if we really need it to work, we set ourselves up for disappointment when the very desired scenario is not implemented.
Similar expectations and needs arise when we put too much ego (part of the human person that is recognized as "I" and is in contact with the outside world through perception) in trading, so much that our feelings for ourselves grow and fall along with the profits and damages.
One of the techniques that suits me personally is the moderate size of the initial position and the perception of the first transaction as a kind of hypothesis. If my hypothesis is not confirmed, I can fix a small loss and use this information to potentially carry out the opposite transaction.
Considering my trading idea as a hypothesis, and not as a final conclusion, I’m mentally ready to make a mistake, and I’m really in a position where I can accept the loss as money spent on market information.
Risk management is a powerful tool for maintaining manageable frustration. I never want to lose so much in one day that I cannot return to trading within a week. I never want to get such a big weekly loss that I can’t even beat off after a month of successful trading. When we can consider losses as challenges, they are able to charge us with energy, and not drive us into a state of frustration.
Trading with a very small amount, along with expectations of unrealistic profit, which should make our lives beautiful, only set us up for dissatisfaction and disappointment. I know novice traders who view every day and week as a verdict about whether they will succeed in what they are doing or not. It is just too much stress that prevents the consistency in trading.
We are much more likely to be consistent in our trade if we can maintain a consistent structure of our mind. This means that we must adequately take losses and learn from them, seeing small failures as opportunities for learning, and not as existential (life) threats.
Practicing behavioral and cognitive methods can help us create positive habits that weaken frustration and allow us to control our own trade, so that it brings not only a stable positive result, but also emotional satisfaction, not emptiness, frustration or constant fear.