“Everybody’s got a plan until they get punched in the face.”Mike Tyson
In the past 10 years, we have helped hundreds of retail traders learn to trade futures. Most begin by using a simulation account – paper trading – and most of them quickly learn to trade profitably … as long as they aren’t trading real money. But many of the same people who can accurately assess opportunities and fearlessly trade them using paper money turn into timid, indecisive losers the minute they have to do exactly the same thing with real cash on the line.
The emotional impact of having their savings at risk is like getting punched in the face by Mike Tyson. All their careful, well-reasoned, rational trading plans disappear in a fog of fear, uncertainty, and doubt.
Why Traders Go Nuts
Why traders go nuts when real money is on the line, and why it happens so frequently, is one of the main themes of an interesting and valuable new book by Dr. Janice Dorn (A contributor to TraderPlanet) and Dave Harder entitled Mind, Money & Markets: A Guide for every Investor, Trader and Businessperson.
Mr. Harder is a well-respected Canadian banker who has spent the past three decades as an active and successful investment advisor. Dr. Dorn is an Arizona M.D. trained in psychiatry with a Ph.D. in neuroanatomy with an active interest in the psychology of trading.
The book is filled with easily-understood advice for long-term investors, but the work on trading psychology is also deeply pertinent to the kind of short-term trading that is our meat and potatoes. The central question is this: How can traders, or investors, learn to make correct decisions when they are punched in the face by unexpected market events? How can they avoid irrational impulsive behaviours and the negative emotions that overcome them when they things go wrong?
In other words why do traders, who are generally pretty smart people, do obviously stupid things, such as holding on to losers and cutting their winners short?
The Short Answer
Nothing evokes a stronger emotional reaction than losing money, and as Dr. Dorn shows, when the market goes against you, the part of your brain that responds is the limbic system, the part some researchers call “the lizard brain.” It was once responsible for allowing us to make swift, unthinking reactions when danger threatened our ancestors on the African Savannah. Now it murders your investments.
When you are trading, swift unthinking reactions are disastrous. They bypass the part of your brain that makes the calculated, rational responses that could help you protect your capital … and your sanity. Here’s an example every trader will recognize. You enter a long trade with a protective stop below your entry. To your surprise the market drops toward your stop. You quickly pull the stop, and as the market drops below that price, you see your losses mount. What do you do?
If you are smart, you exit, and curse your stupidity in pulling your stop.
But you are uncertain. Maybe the market will bounce back up. After all, if it was a good trade at your original entry, it is a much better trade now that the market is lower. And you want to avoid a big loss. So you hang on, and even add to your position, because this will allow you to break even or make a little profit when the market recovers.
This is known as “doubling down” – adding to a losing position. Everybody knows how dumb it is, because you end up risking a large amount of money to prevent a small loss. And everybody who trades (including very successful traders) has done it. And the worst of it is as soon as you swallow your pride and eat your loss, the market reverses in your favor. If you had only held out a little longer, it would have worked! “Next time, I won’t quit so soon,” you tell yourself.
But I’m Too Smart To Do That!
If only. When the time comes, stubbornness, pride, reluctance to admit failure, the negative reaction that losing evokes, false hope, self-deception, and a host of other emotions will cloud your judgement, as at various times they have clouded mine.
There are some evil consequences of this behaviour. One is that sometimes it works. The market recovers and you manage to avoid a big loss. So, of course, you try it again the next time you get into a jam. But you only have to lose big once to be out of the game, and eventually you will lose. Mind, Money & Marketsis filled with tragic examples of big-time successful traders losing billions on this rookie mistake.
The second consequence is that you start to grab profits whenever you can, even when the trade promises bigger rewards if you just do nothing. The fear of seeing a little profit slip from your grasp is about twice as strong as the greed that drives you to trade in the first place; the emotional pain of losing is much stronger than the thrill of winning. Before you recognize what is happening, you have started cutting your winners short, and letting your losers run. See how easy it is?
What To Do About It
This is a complicated issue. At one point we were teaching a 12-week course designed merely to help new traders survive their first three months as traders. Mind, Money & Markets suggests several methods of using technical indicators to help long-term investors deal with these complex emotional issues.
Short-term traders have an advantage in that they will encounter these stress-inducing events much more frequently, and, thus, will be better prepared when the next one arrives.
Here are a number of practical steps our members use to protect themselves:
- Size trades properly. Mental errors occur more often when you have too much at risk. Our members use a spreadsheet to help calculate the maximum size of each trade and the maximum allowable loss for each day, week and month. The smart ones stick to it.
- Honor protective stops. Everybody gets stopped out. When it happens to you, decide if you want to get back into the trade, then look for a better place to enter. Much smarter than riding it all the way down.
- Keep a trade journal. Write down every trade, every day: the outcome; the reason; the entry; the exit; and the emergency response, if it goes south. Online trading is deceptively easy; one click of the mouse is enough to bust your account. Keeping a journal imposes discipline.
- Use technical analysis to plan entries, exits and stops. You won’t be right on every trade, so you want to be able to find out quickly – and with smaller losses – if you are making a mistake. Using technical indicators and chart patterns helps you place your trades at the inflection points where a bad trade announces itself more quickly.
- Master the mechanics. It is amazing how often new traders (and some fat-fingered pros) make mechanical errors in entering trades. They buy when they meant to sell, enter market orders when they meant limit orders, trade 20 contracts when they meant to trade two. You’d think at least some of the time the mistakes would work to your advantage. Nope. Every mistake will cost you money, and sometimes a lot of money.
We hope these simple ideas will help you too. There is lots more to learn, and, unfortunately, there are no minor leagues where you can practise. So, before you take the plunge, find a way to learn that doesn’t leave you poorer. Mind, Money & Markets is a good place to start.
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