Bail Out Early

One of the advantages of bailing early from a bad trade is that you then have cash reserves when the market presents a new opportunity. If you stick with a bad trade, then you can't take advantage of a good trade when it presents itself because your cash is all tied up!

Losers Determine Your Success!

Art Simpson: "...understand how simple it can be to not care because of your rules and just do it -- DO IT! ...it only matters what you do with your losers that determines your success.

Phantom of the Pits: "...Keep emotion out of it. If you do the right thing in trading, never be a weeper."

It's OK To Take It Personally!

I was just reading in Phantom's Gift the following:

POP: (speaking of his early days in trading) ...I took it personally when I would throw money away. I started out with such a small amount of money, and I couldn't stand to lose money at first.

There are two principles named here:

1. First, that it is normal and even expected to take it personally when we lose money on a trade. It hurts!
   
2. Second, that it is possible to build a life-long trading career from a small monetary base.

Losing Money Correctly

from Dr. Brett--
So much of trading success comes from learning how to lose the right way. If many of the traders I work with followed a few basic guidelines about losing well, it would aid their performance immeasurably:

1) Never lose so much on a single trade that you can't come back and be green for the morning or afternoon;

2) Never lose so much in the morning that you can't battle back and be green for the day;

3) Never lose so much in a day that you can't rally and finish the week green;

4) Never lose so much in a week that you can't have a profitable month;

5) Never lose so much in a month that you can't make money for the year.

Psychologically, it's healthy to experience defeat and then overcome it. It strengthens you to battle back and win. If you lose the wrong way--by taking so much risk that you can't come back for the day, week, month, or year--you rob yourself of the victory that could be yours by going from red to green.

Sound risk management is the cornerstone of a healthy trading psychology.

Regaining Trading Consistency

from Dr. Brett--
A reader recently wrote to me the following:

I was a successful consistent trader who always hit singles and doubles ($1000-$3000 a day) for 48 months in a row without having a losing month (1999-2003).Then one day I struck out. I lost $38,000 in one stock and had my first losing month as a trader ever. Since then I have not had two consecutive winning months and in fact have only had a handful of profitable months since then. I am still looking for the road back to consistency. No matter how close I get I always find a way to screw it up even if it is on the last day of the month. Or I give back the month with just some silly unimportant trade that turns into a disaster. It is like I subconsciously look for these situations just so I can mess up.

This is not such an unusual scenario. One large loss can trigger a cascade of attempts to make back the money, further mistakes, and expanding losses. The key is breaking this cycle of losing money, attempting to make the money back with aggressive trades, and continuing to lose.

The first thing I'd have our trader look at is where he is placing stops and targets for his trades. Note that his successful period was 1999-2003. That was a period of much higher price volatility than we've seen since then. What constitutes "singles and doubles" in a high volatility environment is a home run trade in a slow, low-volatility market. It is entirely conceivable that our trader is placing targets too far from his entries, allowing small gains to reverse on him. Similarly, he may be letting trades get too far away from him simply because he is calibrated to a higher level of volatility.

A good way to test these hypotheses would be to study trades over the last several months. If losing trades are larger than winners on average, and if many losers start out as winners, that would suggest that our trader needs to adjust to the post 2003 environment.

To break the cycle mentioned above, the first step is to drastically reduce trading size. I would cut size to 1/4 the average at the most. The goal is to keep a little skin in the game, but take P/L (and the push to make back money) off the table temporarily. The initial objective is not to make money, but to regain a trading rhythm by getting back to singles and doubles.

The next step is to identify those singles and doubles. That means deconstructing the account statement and identifying which trades are making money and which aren't. I would break the data down into time of day, stock/index being traded, long/short, and size. I would also look to see if there are large outlier trades to the downside that are pulling down P/L, and if there are some trades that are making money consistently.

Once our trader has identified what's working, the idea is to keep position size fixed and *only* trade those setups that have been working. This is the foundation to build upon. These setups can be written down and mentally rehearsed ahead of the trading day to build consistency. The idea is to not increase size *and* not trade other patterns until consistency is achieved with smaller size and the most successful setups.

There is only one cure for trauma, and that is repeated experiences of control and safety. We want trading to be routine, not highly emotionally charged.

Finally, I would encourage our trader to take a look at how he is viewing his situation. Note above that he talks of the $38,000 loss and the silly trade that "turns into a disaster" as if these are things happening to him, not things that he is actively doing. A simple strategy would be to have the trader write down the four things he is responsible for prior to each trade:

* The Entry
* The Target(s)
* The Stop
* The Position Size

We can't control whether any individual trade will be a winner, but we can control how much we are willing to bet on each trade. Outsized losses don't happen to a trader; they are actively caused. It is harder to allow those things to occur if you're talking aloud those four trade parameters and have them written in front of you.

So there it is in a nutshell. My advice is to get small, get selective, and take responsibility for what can be controlled.

Do readers have additional advice? Let's see if we can help a reader. Thanks!

Brett

How to Lose Right; The Psychology of Losing

from Dr. Brett--
A large body of research conducted by James Pennebaker of the University of Texas, Austin finds that the expression of emotion has long-term mental and physical health benefits. His book Opening Up is an excellent, readable summary of his investigations, with numerous practical applications.

One particularly interesting finding is that the venting of emotion alone does not help people deal with traumas and other difficult experience. Rather, it is placing experience into words--either through speech or writing--that helps us achieve a perspective that enables us to move on from difficult circumstances.

Study after study finds that, when people cannot give proper voice to their troubles, they experience significant health problems and increased medical utilization down the line. Perhaps this is why psychotherapy, online social tools, and religion confession are so popular in our culture: they are ways for us to process our daily experience--not just to unburden ourselves, but to find new views of our situations.

The relevance to trading is clear: It may not be losing that damages traders, but unacknowledged losing.

I recall one trader I met with who went through a nasty downturn in his P/L. He felt guilty about his losses and felt that he could not tell his wife, who was going through her own problems at the time. The more he hid the problems from her (and from friends), the more he felt stressed and upset--and the more his emotional state interfered with his trading. Only once we had a couples session and laid everything out was he able to clear the air emotionally and get back to trading basics. The losses were manageable in their size, but hiding them took too much of a toll.

Similarly, a trader who ignores a stop and turns a short-term trade into a longer-term hold is attempting to squelch the experience of loss. Instead, internal tension builds and helps the trader make further bad decisions, such as doubling down on the losing position.

Contrast that with the situation I described in my most recent entry on the Trader Performance page, where I look at the epistemological unit of a trader's thought. When a trade idea is based upon an anticipated market movement, not a single entry/exit, it frees the trader to anticipate a loss in advance and flexibly reverse a position. Psychologically, this means that a loss is processed before it even occurs. It is used as information that can help the trader capitalize upon the anticipated market move.

Increasingly, my trade ideas take the form of "what-if" decision trees that include the possibilities of initial, small positions moving my way and moving against me. The decision trees address adding to positions and scaling out of them, and they enable me to be wrong with the initial small position and still benefit from the larger idea.

By requiring yourself to map out these decision trees, you can process trading experience proactively and constructively. A losing trade is placed into a larger context in which it has potential value.

A trading journal at the end of the day then serves the purpose of reviewing performance, highlighting what you did right and wrong, and setting goals for the next day. Such a journal, too, has its psychological benefits. Pennebaker has found that the same benefits achieved by talking about one's feelings can be achieved by writing for 30 minutes in a journal.

I am increasingly convinced that how traders process experiences of loss--including extended periods of drawdown--separates those who come back strong and those who become bogged down and even traumatized.

* * *

PS - I'm now forwarding links to worthwhile readings across the Web via Twitter. If you do not have the Twitter comments automatically sent to your reader, you can check out the daily reading links and indicator summaries on my Twitter page. The most recent five Twitters appear on the TraderFeed home page under the column "Twitter Trader".

RELEVANT POSTS:

Some Painful Truths About Trading

Regaining Your Trading Consistency

Inside the Trader's Brain

Winning As a Trader Is 90% Learning Not to Lose

from Dr. Brett-
One of the fascinating conclusions of the research I posted yesterday is that traders learn by trading; that it is the number of trades placed--not the amount of time spent trading--that best predicts success in markets. That same research, however, finds that there is a very high attrition rate among traders; the most common learning that occurs in markets, quite literally, is that traders find out that they can't make money at what they're doing.

So we have a catch: traders need to learn by trading, but they also need to preserve their capital as they traverse their learning curves.

As I stressed in the Trader Performance book, much of learning in trading is pattern recognition. If that is the case, than it may be the frequency and intensity of exposure to patterns--and not the trading itself--that facilitates learning. This very much fits with my experience that traders can accelerate the development of competence by engaging in simulated trading (with live data) and by reviewing their trading via video. "Any techniques that you use in trading--whether for money management, self-control, or pattern recognition--require frequent repetition before they will become an ongoing part of your repertoire" (Psychology of Trading, p. 154).

Traders drop out of markets, perhaps not because they lack talent, but because they fail to achieve the necessary repetitions to internalize skills prior to depleting their capital.

They also fail because, even with repeated trading, they do not have a system for reviewing their performance, setting goals for improvement, intensively working on goals, and holding themselves accountable for those. Instead of a week's worth of experience, they repeat a single day's learning five times over.

The research cited yesterday, as well as this interesting study, suggest that an important component of learning to trade is learning to avoid behavioral biases in taking profits and losses. The traders who lose their disposition to sell winners early and hold onto losers are those that tend to be most successful. Ironically, turning loss-taking into routine behavior may be one of the most important learned skills in the evolution of a trader's success. The key is staying small enough, long enough to learn from the experience of losing.

After a Devastating Trading Loss

from Dr. Brett-
The year was 1982. I had been short most the year and was doing quite nicely in this, my fourth year as a trader of U.S. stocks. For the first time I allowed myself to think about trading as more than an avocation: as a potential source of ongoing income that could help free me to do the writing that I loved best.

Then we hit mid-August. A ferocious rally drove prices sharply higher and left me in the red. I decided to hold and wait for a pullback, but the pullback was mild. We moved sharply higher again in the fall and I was forced to take losses that consumed not only most my profits, but all my dreams of supplemental income.

I'd have to say it was the most depressing period of my life overall. I was questioning the work I was doing in community mental health--a great learning experience, but not a viable career path--and I was not happy in my personal relationships. The trading losses were the icing on a not so delectable cake. The bottom came in a bar in Homer, NY after too much to drink and a smoke that I discovered too late to be adulterated. It was not a happy time.

I'm convinced that the most successful people are not those who avoid those ruts in life, but the ones who use those to turn themselves around. I discontinued trading and embarked on research regarding market timing that, I vowed, would enable me to never make the same mistake. Out of that research came the work on new highs and lows and sector lead/lag relationships that I draw upon to this day.

I also turned it around socially. After consuming a full bottle of scotch at a New Year's party at the end of 1983, I found myself too inebriated to ask the pertinent questions of the woman I had met. Had I asked the questions, I would have found out that she was not yet divorced, had three children, and was nine years my senior--not at all what I was looking for. Today, after 24 years, she remains my wife and the best decision I ever made.

With the marriage in 1984, I inherited shared responsibility for three children. The steps I didn't take for myself I had to take for the new family. Gone were the drinking and partying. I parlayed my community mental health experience into a student counseling position at Cornell University, taking a 33% pay cut in the process. One year later, impressed by the Cornell experience, Upstate Medical University in Syracuse hired me and I joined a medical school faculty.

At Upstate, I realized that my counseling skills were not ideally suited for the medical school environment. I undertook a lengthy review of the research and practice literatures and taught myself the fundamentals of an emerging approach to helping called "brief therapy". Shortly thereafter, I began teaching brief therapy in the psychology and psychiatry programs. In 1990, I published my first review paper in the field, then another in 1992. I had found my niche: one that would lead to over 50 published papers and book chapters, two books in psychology and psychiatry, and two books combining my trading and psychology loves--and, of course, this daily blog.

I look back on that trading loss in 1982 and now see it as the beginning of a turnaround, not as the ending of a dream. But it took an unflinching and unforgiving look in the mirror to make that turnaround. It also took relationships with people I loved enough to want to make more of myself.

I've received several emails and blog comments from traders who have been through devastating trading losses. This post is for you. What doesn't kill you *can* make you stronger, if only you can sustain that hard look in the mirror.

RELEVANT POSTS:

Resilience and the Courage of Your Convictions

Blueprint for an Uncompromised Life