PRACTICAL PSYCHOLOGY
Much has been written, here and elsewhere, about the psychological issues traders face and the right mind-set with which to approach trading problems. This is a complex subject because traders at different stages in their development will have significantly different challenges and needs. Different personalities will deal with the stresses of trading in significantly different ways, so solutions that might have relevance for one trader might fall well short for another—it is dangerous to make sweeping generalizations. Psychological work is no substitute for actually having an edge, and proper psychology is not an edge in itself. No matter how hard you try, how much you focus, or how much you practice, you are not going to be able to flip a fair coin and make it come up heads more than about half the time, which is essentially what many new traders do.
Many new traders are trading methods and ideas in the market that do not have an edge and, rather than rectifying the real problem, they focus on the performance insights of trading psychology. Much of the time new traders spend on psychology would be better spent understanding the true nature of the market’s movements.
For developing traders though, the situation is different. Once you have a method that has an edge in the market, it is impossible to apply that edge without having the proper mind-set and attitude. Traders find themselves making many strange mistakes that compromise their results, and these are often due to psychological issues. Dealing with the psychological stresses of trading is one of the core skills of competent discretionary trading, and it is something that requires ongoing maintenance throughout a career. No one is ever immune to psychologically driven errors. For more experienced and developing traders, it does make sense to focus on this area, perhaps even seeking the help of a qualified professional in the field.
Most of the suggestions that follow are for the self-directed trader working alone or in a team and, ideally, with a mentor. For institutional traders, portfolio managers, and quantitative system designers, your situation may be different. You will still be inclined to make these same errors, but the constraints of your job or the institutional framework may define your role well enough that your behavior is restricted. You may still find insight in understanding the issues self-directed traders face, because these reflect the psychology of the market and price movements at important inflection points.
Develop an Approach That Fits Your Personality
Who are you? It has been said that if you don’t know the answer to this question, the markets are an expensive place to find out. This is true, and many millions of dollars and years of people’s lives have been wasted because they were trying to trade methods or markets that were a poor fit for their psychological makeup. One of the secrets to managing yourself psychologically is to pick a trading style that plays to your strengths. So, once again, who are you? Some people make decisions intuitively and quickly, while others tend to prefer long debate and a careful weighing of all relevant factors. Some traders are naturally inclined to be more aggressive and active, while others prefer a more sedate pace. Some developing traders have serious constraints on their time and are not able to monitor markets intraday, whereas others can sit at the screen every minute the market is open. Some traders may have backgrounds and experiences that make certain markets more interesting or attractive to them. For instance, a trader who grew up on a farm will probably have natural inclinations toward agricultural markets that might be alien to a trader with a strong background in accounting and corporate finance. Every piece of their trading methodology and trading plan must be shaped by who the trader is.
Choose a Market
The choice of which markets to study and trade is an important one. Many retail traders are drawn to foreign exchange, but this is probably because of the extremely low account balances required to open a forex account. This is also unfortunate because the forex markets tend to be the most random and least predictable of all the major markets in many time frames—it is difficult to derive a quantifiable short term edge in the currency market. One reason might be that a lot of the activity in the forex markets is driven by a complex web of factors and much of the activity in these markets is secondary. Futures are also problematic for many new traders, because even with mini contracts, considerable risk capital is needed to navigate these markets. A stock trader might be able to start trading and, using odd lots (odd lots are less than 100-share lots), might be able to limit her entire risk to $10,000, risking perhaps $50 on a trade. It takes a long time to lose $10,000 in $50 increments, which is exactly how the beginner should be thinking. For most futures traders, $50,000 is probably a realistic initial risk to allocate to their learning period. Many traders are drawn to stocks because they come from investing backgrounds and owning stock is intuitive, but these traders are at a disadvantage because shorting stocks also needs to quickly become intuitive. Choose a Time Frame The primary question here is do you want to day trade, swing trade, or invest for the long haul? Details of whether you want to use 10- or 15-minute bars are considerably less important than this big-picture time frame decision.
There are advantages to day trading, especially for the new trader. A swing trader might see a few hundred patterns in a year, but a day trader will see hundreds in a single week. The immersion and focus on pattern assimilation can result in a greatly accelerated learning curve, provided the trader can enter into the right psychological state to take advantage of the opportunity. In addition, the more times you apply a statistical edge, the more consistent and larger your profits will be; no other time frame offers as many “at bats” as day trading does.
However, the costs and challenges of day trading are severe; the impact of transaction costs alone presents an insurmountable barrier for many traders. For instance, imagine a trader with a $250,000 account who does 10 trades a day and who likes to trade stocks in the $150 to $200 range that might have, on average, $0.05 spreads. Furthermore, assume this trader pays $0.001 commission per share and no exchange or electronic communication network (ECN) fees on balance. (These are extremely favorable assumptions.) Last, assume the trader consistently bids or offers for his exits and enters trades with market orders, so he is paying the spread on 50 percent of the shares he trades. If he does 10 trades a day on 1,000 shares, transaction costs will total $502 a day, meaning that he has to make about $126,000 a year just to cover costs. This is a 50 percent annual return, again, just to break even. To put that in perspective, the Renaissance Technologies Medallion Fund, widely considered to be the best of the best, has averaged an annual return just under 40 percent since its inception; traders and funds that can make 25 percent a year are rock stars in this industry. This is a tremendous vig for the new trader, so consider this carefully.
The other issue with day trading is that the psychological demands are extreme. Day traders ride the complete emotional roller coaster from euphoria to despair, usually several times in a single trading day. Unless you have the emotional control of a Buddhist monk, day trading will play on every psychological weakness you have, and you will frequently find yourself under a degree of stress that challenges the open receptiveness needed for optimal learning. I am not saying that no one should day trade, but you need to be aware of the costs and challenges of this type of trading.
On the opposite end of the spectrum are long-term investors who intend to hold positions for years. For many of these players, a month is a short time frame and they consider anything on the weekly chart to be pure noise. At this level, infrequent trading and position adjustment become barriers to the trader who needs to assimilate patterns and to learn to make decisions. It is not that technical patterns do not work in the long term. The balance of mean reversion and range expansion is a little different in some time frames, but technical tools retain their validity even at long time horizons. The problem for the long-term investor is that you will not get to see them work very often and it is difficult to build intuition about the market’s movements if you are making only a few decisions a year.
In the middle of the spectrum are the swing traders. Properly, the term swing trading does not define a specific time frame, but rather a specific style of trading—looking to target and to profit from one specific swing in the market, usually the next one, while tolerating as little pain as possible. A swing trader will attempt to position long as the market turns into an uptrend, and will usually not be interested in sitting through retracements in that trend. Some swing traders may aim for holding periods of two days to two weeks, while others may look to hold for two weeks to three months, and still others may focus on swing trading hourly charts with holding periods ranging from a few hours to two days. For many traders, the swing trading approach in an intermediate time frame of several days to several weeks offers an excellent balance: Trading is frequent enough that learning takes place quickly, and most analysis can be done outside of market hours, minimizing the decisions that must be made under pressure. This has the dual advantage of allowing the trader to enter into an open, receptive state, while also allowing time for deep reflection and analysis of the patterns being considered.
Choose a Style
Though there are a thousand subtleties to a trading style, and every successful trader creates a style that fits some key elements of his or her personality, there are two key questions to consider: are you a trend follower or countertrend trader, and do you want to be a scalper or hold for bigger moves? It is impossible for a new trader to answer these questions without some exposure to markets and to the actual trading process; the answer may change for a trader at different points in a career, but finding the answers to these questions is a key part of knowing who you are as a trader.
As a group, most traders have strong personalities, are opinionated, and are contrary to the extreme. As a result, they also tend to be distrustful of consensus and groupthink, and most traders find that fading (going against) moves comes more naturally than following the trend. In addition, there is a tendency to regard markets that have made large, sudden moves as being mispriced, either on sale or ridiculously overpriced. However, traders who would focus exclusively on fading moves need to deal with an important issue: with-trend trades are usually easier and offer better expected value than countertrend setups. The most effective fade traders lie in wait until markets reach ridiculous emotional extremes on the time frame they are trading, and then they pounce. This requires extreme patience, discipline, and maturity. If you go into the market constantly looking for opportunities to fade, you will find them, but you will often be steamrollered as markets simply keep going. The crowd may be dumb, but they are often right and trends can go much further than anyone would expect.
There are advantages to trend following: with-trend trades tend to be less transactionally oriented, and it is possible for a single successful trend trade to make many multiples of the amount risked on that trade. However, trend traders will accumulate many small losses while they work to find the one market that will trend. It certainly is a viable strategy, but it is not the answer for all traders. There are strong statistical tendencies for mean reversion, and traders working a disciplined approach to fade trades may find that they can achieve higher returns and more effective deployment of capital, albeit at the expense of much harder work and many more transactions.
Scalping refers to a style of trading that focuses on a large number of very small trades. We usually think of this on very short time frames, but it is also possible to scalp on a daily or higher time frame; the key is simply that the expected profit or loss is a very small percentage of the average-sized move on that time frame. Scalpers are exposed to very high transaction costs, and are rarely involved for the big swing. Scalpers may take five cents out of an intraday swing that moves two or three points. So, why scalp? The best answer is that some people and some personality types are good at scalping, and it can offer these people consistent profits. If you believe you want to be a scalper, realize that these edges have been significantly eroded in recent years by more efficient market microstructure, and the game could well be completely over for the human trader within the next decade. Many traders choose to scalp because they lack the discipline to wait for actual trade setups—but this is not a good reason to scalp. If you choose to scalp, do so because it is the right answer for your personality, not because you are undisciplined and impatient.
Let me share my personal perspective on these questions: the best answer for most traders is to reach some kind of middle ground. Though traders should focus on a handful of patterns to trade, especially at first, it is probably best if some of those patterns are with-trend and some are countertrend. If you have only one set of tools, you will tend to force every market pattern into the context of that set of tools. If you trade only counter-trend trades, you will always be looking for places to fade. If you trade only with the trend, you will ignore the spots when trends might be overextended and will always be focused only on finding the next spot to enter with the trend. In other words, if the only tool you have is a hammer, every problem you encounter will look like a nail!
Discretionary or Systematic?
The choice between discretionary trading and systematic trading is also important. This book has been written for the discretionary trader, but some traders may discover they are more suited for a systematic approach. They may find that they are not good at handling the stress of making decisions under pressure and that they function better in an analytical context far removed from the heat of battle. These traders are not doomed to failure, and they could be well-equipped to do quantitative system development. Some traders also find success with a hybrid approach, utilizing a trading system and making intuitive interventions in that system’s decisions at critical points. A word of warning is in order here: If you are going to do this, carefully monitor your hybrid results and compare them to the raw system results to be sure that you are actually adding something of value. Many traders who do this intervene based on their emotional reactions to risk, and their actions are rarely constructive. Another point (which would seem to be obvious) is that your system must actually work and must actually show a profit after all costs are considered. If your system does not show a solid track record in properly done backtests and forward tests, it probably will not work in the market.
Also, if you choose to be a discretionary trader, carefully consider why you made that choice. Many discretionary traders avoid the systematic route because of laziness or because they lack the quantitative skills to really understand system development. This is a mistake. Discretionary trading is probably the hardest trading there is; it takes more work, more time, more analysis, more self-reflection, and more self-control to achieve success in this arena than in any other type of trading. In addition, if you are a discretionary trader, you are the most important element of your system. Any outside stress—whether it be illness, financial problems, relationship problems, sickness, or injury—that compromises your emotional balance can seriously jeopardize your trading results. Good discretionary traders who find success over the long haul develop a system to monitor themselves and their emotional state, and usually reduce their risk at times when they are not at their peak performance level.