Psychological stress is a response to threat. Most of the time, that response is adaptive, as it mobilizes our resources for flight or fight: to escape or confront a situation. Cognitive psychologists emphasize, however, that the stress response is not only a reaction to events, but to our interpretation of those events. What counts as a threat is partly a function of our perception: how we think about the world around us.
That is very true among traders. Two market participants may experience the exact same market move, but respond very differently based upon their interpretation of events. Although it is common for traders to attribute their stress to the market action that particular day, it would be more accurate to point the finger at how they had processed the market move. How traders interpret market events frequently makes the difference between a constructive response to adversity and an impulsive and destructive one.
Several months ago, Linda Raschke and I undertook a survey of over 60 active traders and investors. The survey examined their approaches to trading, their personality traits, and their coping styles. Not surprisingly, there was a close connection between the self-reported stress of the traders and their self-reported trading results. Poor trading contributed to greater emotional upheaval, which in turn further impaired trading. Interestingly, one of the personality traits most correlated with self-reported difficulties in the markets was “neuroticism”, the tendency toward negative emotional experience. Overall, traders who experienced a high degree of anxiety, frustration, and depression tended to report worse trading results than those who were more even-keeled.
This finding led me to inquire as to the emotional patterns that distinguish successful traders from less successful ones. Here are a few tentative conclusions that form the basis for hypotheses for future studies:
1) Successful traders tend to be successful at activities other than trading. Most of us are acquainted with the concept of diversification. We don’t bet all of our trading capital on one position; nor do we place all of our investments in a single stock. Successful traders tend to be more diversified in their life positions than unsuccessful traders. They report satisfactory involvements in their social and personal lives apart from trading. This, I believe, inoculates them from undue distress during inevitable dry spells of trading. Unsuccessful traders, conversely, appeared to have very poor or absent relationship lives and very few personal involvements outside of the markets. In short, most of their self-esteem eggs were in the trading basket. (More than one such trader confided to me that he could not consider himself a success in life until he had made a significant amount of money in the markets). Such traders are apt to interpret those inevitable drawdowns as threats to their self-esteem, magnifying their stress responses.
2) Successful traders tend to moderate their risk exposure. I found this to be eye-opening. Traders who were reporting high stress and poor trading results tended to have small account sizes, but frequently took leveraged positions and held these for long periods of time. Indeed, the account sizes of the unsuccessful traders were less than half of that of the successful ones, but their reported positions were very similar. This meant that the unsuccessful traders were taking on much more risk (variability in returns as a percentage of trading capital) than the successful ones. Similarly, most unsuccessful traders and successful ones reported having a structured method for entering trades. The successful ones, however, were much more likely to have developed structured methods for exiting trades, suggesting a greater attention to risk management. In short, unsuccessful traders experienced a greater stress/threat response because their trading capital really was threatened!
3) Successful traders tend to utilize some form of quantitative analysis to guide their decision making. This was perhaps the most enlightening finding of all. Of the handful of traders who reported consistent profitability, all indicated that they utilized some form of data analysis to guide their trading methods. Of the traders who reported consistent unprofitability, none utilized data analysis. Instead, they relied entirely upon discretionary trading and their intuitive feel for chart and indicator patterns. Discussions with the traders suggested to me that the long, arduous process of analyzing market data had given the successful traders a “feel” for market action and helped them internalize a sense of confidence in their systems and methods. Traders who had not immersed themselves in the flow of market action did not cultivate this sense of control and were more likely to oscillate between the extremes of fear (“Can’t pull the trigger”) and impulsivity (“I can’t believe I made that mistake again!”). Interestingly, the traders who had examined their methods historically knew exactly how often their methods would yield losses. This helped them construe such events as normal, expectable occurrences, dampening their stress responses.
4) Successful traders tended to utilize problem-focused coping styles rather than emotion-focused ones. When problems in trading hit, successful traders tended to have already reviewed their options and had strategies ready to limit their losses, reverse their positions, etc. Losses were accepted as part of the business. Unsuccessful traders, however, often did not rehearse adverse outcomes, possibly because they found these to be too threatening to their egos. As a result, they were more likely to become frozen by markets moving against them, racking up fearful drawdowns and losses. Many of the unsuccessful traders actually reported reasonable batting averages: they had about as many winners as losers. The size of their average losers exceeded those of their gainers, however, because of their inability to deal with loss expediently. The least successful traders of all were those who tended to ignore or deny market problems, preventing them from making any constructive coping responses at all. This was a common scenario among investors in 2000 and 2001, who rode the NASDAQ down to devastating losses.
The moral of the story, I believe, is that emotional mastery of the markets begins with mastery of good trading techniques. A few psychological methods or exercises directed toward positive thinking will not make a person a fine surgeon or basketball player. Nor will they transform the average trader into a money-making machine. A scientific approach to trading is the best psychological technique a trader can adopt. If I could offer advice to traders in just a few lines, it would be this:
Risk the same, small proportion of capital on each trade and ground each trade in a historical analysis that places the odds on your side.
If that sounds too boring, the chances are good that you’re trading for ego and excitement: reasons other than making money. This will leave you exposed to the distortions of stress responses just when you most need your wits about you. Markets are merciless; if you do not master the market’s emotional dynamics with prudent, tested methods, the pros will be only too happy to take the other side of your trades.
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