Psychological Risk

Psychological Risk is perhaps the biggest hurdle in trading for your own account. There are tons of books written about it. There are tons of essays discussing it and there’s even an academic study around this which is termed “Behavioral Finance“.

I highly recommend taking the time to read the following paper that was written by Ernst Fehr and Jean-Robert Tyran. The article is a discussion around the money illusion which I find to be a fascinating topic with how it relates to trading.

The Money Illusion (PDF)

Studies in behavioral finance have shown that many will inherently make the wrong choices when dealing with their own money especially when there’s risk involved. This plays straight into trading. Traders that trade with emotion will almost always have a difficult time with success. Your logical side of the brain is easily trampled by your emotional side of the brain which causes you to make impulsive illogical mistakes over and over.

Here is a great article discussing the left brain vs. right brain concept. But to be brief, your left side of the brain is said to provide you with logic and reasoning while your right side of the brain is said to provide you with the emotions and intuitions.

A good exercise here would be to ask yourself, what was the worst day of trading you ever had? What happened that day? What was your thought process? Was it derived based on emotions (fear, pain, greed, anguish, euphoria) or was it based on logic?

Typically this is how these types of days evolve. First you start the day thinking logically. You’ve done your research and have a good indication of what you want to do based on your analysis. You take a trade and you get stopped out. You then become upset that it didn’t work. Your emotions make you feel that the market burned you. You blame HFTs or locals making a stop run or whatever the excuse du jour may be. Now, you’re emotional and you decide that you will just jump back in and take another trade to make back your loss. You then place a stop at a level that means nothing to the market and you’re immediately stopped out again. What happens next? You’re even more upset.

What do you do next, you take another impulsive trade with the same idea of making your money back but you get the same result. This happens over and over and the next thing you know you’re down HUGE! This is when the emotions kick in to over drive and you are now operating at an extreme emotional state. You just lost a ton of money and your stress level is over the top. You begin to act extreme around everyone you know. Your spouse sees you in a strange state, your friends can’t figure out what’s wrong with you. You go into hiding and blame the world.

Is this a logical trading process? Absolutely not. Did you follow your game plan? Originally yes, but from that point on you tried to impose your will on the market. The market doesn’t care about our will though and it will crush our ego’s in a nanosecond.

In this psychology subsection, I will spend some time discussing typical psychological trading hurdles and thoughtful ways of overcoming them. There’s no magical cure for this mental battle but overtime, you become used to the “controlled chaos” that is the market. I will expand upon this in this subsection.

What I thought I would do here is list some common psychological hurdles a majority of traders face and I’ll provide thoughtful ways of looking to overcome those hurdles. At the end of the day, the only person we can really rely on in trading is ourselves. No one is going to click that buy or sell button for you. Its important to know this and become self-reliant and confident in your abilities as you encounter the psychological tests throughout your trading career.

Giving Up

As the cliche goes, only a small number of the traders out there are successful. Obviously that is some pretty tough odds. The question is how many traders are there out there? How was this saying confirmed? I would believe that a majority of the failures out there are because traders simply gave up. For whatever reason, they couldn’t find profitability. We know this business is incredibly hard but why the huge fallout? I think the answer is incredibly simple. The reason why so many fail in this business is almost 100% attributed to traders giving up. Obviously for a variety of reasons such as account blow outs, emotional duress, need to make money, etc. But one day, those traders didn’t sit down at their workstations and never came back. Pretty brutal if you ask me.

So what are some of the common issues that lead traders to just give up?

  • Unrealistic expectations? Did they quit their day jobs and think they could just rake in the millions right away?
  • Lack of knowledge and training? What was their backgrounds? Were they a salesmen before and thought trading would make them more money? Poor knowledge of the markets and trading method?
  • Psychological barriers? Do they just lose confidence in themselves?
  • Trading too rich of a market for their account size? Blown out account?
  • Poor business planning? Maybe too high of overhead?

I can go on but I think you’ll get the point. One of the things I’ve commonly seen is traders coming into this business with unrealistic expectations. For example, someone thinking that within a few months to a year, they will be totally profitable and raking in the dough. That is very naive. If someone comes into this business and immediately finds success, its often short lived. You have to be willing to put in the time.

What we these traders doing before they got into trading? Let’s say you worked for several investment banks throughout your career before stepping into the retail world. Trading is and has been your profession. If you now were to go into the medical field and think you would be able to operate on someone, would yiz be successful right away? Absolutely not. We would need to devote years of learning before we would ever fully know what we are doing and feel confident in our abilities. My point here is that traders need to treat this as an academic endeavor at first. Take each day as a learning lesson and do not come down on yourself when you have a bad day or are having a bad stretch. This is your “schooling”. It will take time to become comfortable with what you’re doing and its important to remain patient and learn.

Maybe their lack of knowledge and a reasonable method of trading has a large influence on their failures. We’ve all seen the holy grail indicators out there that promise success while cherry picking examples. I think its very important to learn about the market in which you’re trading. What moves the market? What’s its typical behavior? For example, looking at Crude Oil is a very different market vs. the ES, etc. One is a thin market that is heavily dominated with spread traders while another is used for hedging and outright trading with massive front month volume.

Obviously the psychological aspect (which is why I’m discussing this in length) is the major cause of people just walking away.

Maybe it was having a small account and thinking that as long as they can cover their brokers’ intra-day margin, they were good to go. We know how that typically will end.

Another potential issue could be just too high of business overhead. Did they use a few platforms that were just depleting their capital? There are of course the bare minimums one would need to conduct business but there can also be excessive use of the tools available.

My point in this explanation is when going into trading, you have to remain patient and have realistic expectations. Without those two, you will have a hard time in advancing in this business.

Fear of Loss

One of the first common hurdles I see traders battle with is the concern of loss. Yes, its certainly something to be aware of but if we dig deeper, we need to ask why are we scared of a loss? Is it simply because you don’t like “being wrong”? Or is it a fear you’ve developed from having a few bad days that led to blowing out your trading account? As I’m sure you’ve probably discovered, trading will bring out all of your emotional character traits. If you have a hot temper, you will definitely get pissed off while trading. If you are easily saddened, you’ll probably finish a few days in tears. That’s what this business does to you. It can chew you up and spit you out so fast.

So we now know that emotions really have no business in trading. In order to combat this we need to think logically. So in the case of a concern of loss, we need to step back and logically analyze the potential outcome. When we do that, it should quickly come to light that there really are only two or three outcomes. The worst of them being that you’re wrong and the best being you’re right. With the third being, you talked yourself out of the trade and closed out before the trade materialized.

Further logical thinking will bring us to the conclusion that we should know what our predefined risk is and we should be comfortable with that. If we end up getting stopped out, that means something has contextually changed and we did our job of guarding our capital and we would then analyze what went wrong and adjust our perspective from there. So with that being explained, that is the worst thing that will happen. Not as bad as what your mind makes you feel right?

If you aren’t comfortable with the risk required for a trade, you need to take a step back and ask yourself why. Is the market you’re trading too rich for your trading account size? Are you trading too many contracts? Etc.

Always put risk in front of everything else. That means making sure you can handle the potential stop outs. For example, I’d say the average risk in the ES is around 3 points. That works out to be around $150 per contract. If you’re trading say 3 contracts and you do not want to risk more than 3% of your account per trade, you would need an account size of at least $15,000 or so. Risking 2% of your account with these parameters would require an account size of at least $22,500 and so on. My point here is if you’re sweating on a 3 lot in the ES make sure your risk is in line with these basic numbers. If you have a $10,000 account, maybe trading 3 cars isn’t the best idea. Reduce your position size.

When the risk is comfortable for you, that fear diminishes. You won’t be sad or pissed off when you’re wrong and you are now thinking logically. You will then begin to focus on the process of trading and not on the outcome of that particular trade. Remember, trading is not about money! That may come as a bit of a surprise but that’s the honest truth. Yes, we are “handling” money in our trading but that’s just the product we’re working with. I will continue to say this as we go through this section.

Emotional Trading

As I’ve said before, emotions have no business in trading. This is an incredibly hard concept to overcome and a majority of traders battle with this forever. It doesn’t have to be that way though. We can overcome this through some simple planning before and after each session while maintaining a logical perspective on what we’re doing.

Some thoughtful ways to overcome this would be the following:

  • Have a game plan before each trading session.
  • Make sure your risk is clearly defined before taking the trade.
  • If you make an impulsive trade, get out and collect yourself. No need to continue in the trade.
  • If you make continued impulsive mistakes, keep a list of them in front of you so that you’re always aware of them.
  • Don’t trade your PnL. There’s no need to stare at your PnL all day. You need to focus on the process not the outcome. Trading is not about money.
  • If you’re having a bad day, have a cut off point. Shut everything down and come back later after the market is closed to analyze what happened and learn from it. You can then come back the next session fresh and educated.
  • Balance. Having some sort of interest in your life beyond trading is so important. You need to have a balanced lifestyle and by doing that, your mind does not place too much emphasis on your day-to-day trading. What I mean by that is, if you’re sitting at your workstation all day and putting all of your emphasis on trading, you will tend to have a hard time accepting when you’re wrong. Alternatively, if you just follow through the daily process of trading but also have other things in your life, your emphasis becomes more balanced.

Overconfidence

Overconfidence can become a major detriment to trading success. Just imagine having the biggest month ever and you made a bunch of money. You feel on top of the world and you have this thing (trading) figured out. You can’t lose now. You go out and buy a bunch of stuff and are a big hitter now. Wrong…

Why is that wrong? Because you’re in a state of euphoria which is solely based on the outcome of what you’re doing. Ever look at what happens to professional athletes when their careers dry up? Those that are the flashy types throwing money around tend to end up broke while those that were fairly low key and just focused on what the process of their sport was tend to end up doing great. Another way of looking at this is if you were a professional baseball player, what would you rather be a home run slugger or Mr. Consistent with a high batting average? The home run guys are pure emotion typically while the singles, doubles and RBI guys are usually very calm, collective and focusing on the process.

Sorry for those that aren’t familiar with baseball. But my point here is the human nature of it all which brings us back to trading. You have to be humble with what you’re doing and not be concerned with the outcome. Trading isn’t about money (yep, I said it again).

I can go on discussing the various hurdles in trading but I think this addresses some of the more common ones that arise.