The Trader’s Mind
At one point or another, everyone who has interactions with the market asks oneself, “Why is trading so hard?” There are legitimate reasons why trading should be difficult: markets are highly random; whatever edge we can find is eroded by competition from smart, well-capitalized traders; some traders work within various constraints; and markets are subject to very large shocks that can have devastating effects on unprepared traders. Even so, it seems like something else is going on, almost like we are our own worst enemies at times.
What is it about markets that encourages people to do exactly the wrong thing at the wrong time, and why do many of the behaviors that serve us so well in other situations actually work against us in the market? Part of the answer lies in the nature of the market itself. What we call “the market” is actually the end result of the interactions of thousands of traders across the gamut of size, holding period, and intent.
Each trader is constantly trying to gain an advantage over the others; market behavior is the sum of all of this activity, reflecting both the rational analysis and the psychological reactions of all participants. This creates an environment that has basically evolved to encourage individual traders to make mistakes.
That is an important point—the market is essentially designed to cause traders to do the wrong thing at the wrong time. The market turns our cognitive tools and psychological quirks against us, making us our own enemy in the marketplace. It is not so much that the market is against us; it is that the market sets us against ourselves. These issues are particularly relevant to the individual, self-directed trader who has few limits placed on his or her behavior and is faced with the nebulous job description of “making money.” Traders in institutional settings have many advantages over the individual, not the least of which is that the institutional framework places many restrictions on their actions.
These constraints, along with guidance from management and implicit mentoring from senior traders, provide a strong framework for shaping behavior and make new traders in these settings less vulnerable to some of the common psychological stresses and errors. Furthermore, many institutional traders have specific, clearly defined roles such as executing and managing complex sets of hedges, or managing inventory and flow resulting from customer orders.
These traders are not faced with the broad task of beating the market and can become quite skilled at their jobs without fully conquering all of the psychological challenges of trading. One word of warning: Though we now turn our focus to psychological elements of trading, positive thinking, meditation, visualization, and correct psychology can take you only so far.
You absolutely must have an edge in the market to make money. For most styles of trading, it is impossible to apply that edge well without the proper psychological skills, but those psychological tools are not, by themselves, an actual trading edge. This chapter begins with a look at how the market turns some of our reasoning ability against us and how we become our own worst enemies in the market.
Next, we look at intuition and flow, which are essential components of top-level trading for many traders. In particular, the flow experience is an important part of both performance and skill development. The chapter ends with some concrete suggestions for developing an environment that allows the developing trader to work to overcome some of the more common psychological errors.
PSYCHOLOGICAL CHALLENGES OF THE MARKETPLACE
The psychological demands of trading are almost unique in the human experience. First, there are serious consequences for making errors; trading decisions are high-risk decisions. Even if losses are limited so that no one trade can hurt us badly, it is a rare trader who can face 10 losses in a row without significant pain and suffering—even traders with secure institutional jobs may be in trouble after a string of losses.
Furthermore, losses do not always result from bad decisions, and, even more ominously, bad decisions sometimes lead to good outcomes. This is a reflection of the randomness in the market environment, but it is very difficult to hone skills and to develop intuition when results cannot always be clearly tied to actions. Furthermore, every trading decision you will ever make is always made with insufficient information.
We never know everything there is to know about any trade, and, no matter how good our research is, there are many things that are simply unknowable. Even if you somehow could accumulate every relevant piece of information, known and unknown, there is always the possibility that a large order could be dumped into the market with unpredictable results—anything can happen in the market. In addition, many
trading decisions must be made quickly and under pressure. There are certainly types of trading for which this is less true, but the actual decision to do something always comes down to one point in time. Someone has to pull the trigger, and risk management decisions sometimes have to be made on the fly in response to developing market action.
This is the trading environment—high-risk decisions, made under pressure with insufficient information. Seen in this light, the reasons for some of the psychological challenges become clearer.