Trading
by Rules:
A Psychological Perspective
If I had to give one piece of advice
to most traders who are struggling with their P/L, it
would be to trade tested systems or patterns and trade
them systematically. If you look at highly successful
business organizations, such as McDonald's, Dell, Federal
Express, or Wal-Mart,
If
I had to give one piece of advice to most traders who
are struggling with their P/L, it would be to trade tested
systems or patterns and trade them systematically. If
you look at highly successful business organizations,
such as McDonald’s, Dell, Federal Express, or Wal-Mart,
you’ll find companies that are doing the same thing,
the same way, every day, with a high degree of consistency.
They came up with a winning formula, which is half the
battle, but they execute that formula with high fidelity
and regularity. That is how you want to be trading.
So that brings up two important questions for any trader’s
self-assessment:
- Do I have a winning formula, and have I really tested
it to know it’s winning and to have the needed confidence
in it?
- Am I executing my formula faithfully, and am I truly
tracking each and every trade to know I’m following
the formula and have the confidence in my ability to follow
it?
A very large percentage of traders who have contacted
me for assistance with their trading cannot honestly answer
these questions in the affirmative. They want help for
their psyches when what they need is to treat their trading
like a world-class business.
Trading and Personality
About three years ago, Linda Raschke and I surveyed a
group of approximately 64 active traders. We were interested
in discovering whether there were any personality traits
and coping styles that distinguished more successful traders
from less successful ones. We obtained a number of thought-provoking
findings. For example, we discovered that the winning
traders tended to have lower levels of neuroticism (negative
emotional experience) than their less successful counterparts.
They also employed more problem-based coping methods (coping
by developing strategies for dealing with threatening
situations) relative to emotion-focused coping devices
(coping by venting feelings or seeking support). Profitable
traders, we found, scored higher on a trait called Conscientiousness,
reflecting a general stick-to-it-iveness and motivation
to follow through on plans and commitments. In all, these
findings confirmed what many of us have observed informally
in our careers in the markets: traders who temper their
emotions and stick with trading plans fare better than
their more emotional and impulsive peers.
One unexpected finding from our survey, however, was that
a disproportionate number of the successful traders—about
half—reported utilizing mechanical trading systems.
Of the unsuccessful traders, none were mechanical traders.
When I subsequently interviewed the successful traders,
it turned out that even the ones that were not systems
traders were basing their trades on patterns that they
had carefully researched. Conversely, almost to a person,
the unsuccessful traders lacked such grounding in patterns
and research.
In my recent book The Psychology of Trading (Wiley, 2002),
I describe the orientation of these winning traders as
rule-governed. A major reason they were successful, I
believe, is that they used trading rules both to guide
their trading and to maintain a positive mindframe. In
this article, I would like to explore in detail why rule-governance
is one of the most powerful psychological strategies one
can employ in active trading.
The Psychology of Rules
What is a mechanical trading system? Basically, it is
a set of rule to trade by. These serve several functions.
The first such function is a logical one: they are designed
to maximize profits by exploiting anomalies within relatively
efficient markets. Every set of trading strategies incorporates
what statisticians call Bayesian decision rules. That
is, they establish Conditions A, B,…n that the market
must meet before traders go long or short, stop a position,
etc. The idea is that, without these Conditions being
met, the forecast for any position going in your favor
are determined by chance alone. Once we update this forecast
when the Conditions are met, the odds now tilt in the
trader’s favor. While any single trade may not prove
profitable, over enough time and with enough trades, these
tilted odds should benefit the trader’s equity curve,
so long as the decision rules have been adequately researched.
Here it is vital for any trader to know how the system
was developed. Was it tested over a time period independent
from the one used in its development? Is its real-time
performance consistent with its historical track record?
Is the underlying logic of the system sound, or are there
too many parameters, convoluted logic, or other signs
of curve-fitting?
Less well appreciated is that such decision rules serve
a second, psychological function. By reducing trading
to a set of rules, traders lessen their ambiguity so that
they can function in a relatively automatic mode. This
permits a clear-headed monitoring of fresh trading opportunities,
so that those improved odds can eventually work to one’s
favor. In reducing ambiguity, rules contribute to a sense
of mastery and reduce much of the stress associated with
high performance activity. Think about how stressful it
would be to drive in a third-world country where traffic
rules are not enforced! This is precisely the emotional
state of many traders who function by the seat of their
pants. The presence of rule governance lends order to
an otherwise chaotic process.
In order for a system to serve as a psychological aid,
however, it must fit well with the personality of the
trader. Research conducted at the London Business School
suggests that yet another personality trait—extraversion—is
positively correlated with risk-tolerance. Some traders
are much more risk-averse than others, simply as a function
of their personality constellation. It is crucial that
the system you trade take this into account. Thus, the
total P/L of the system is only one parameter to evaluate
when looking for the best way to trade. The drawdown statistics
and the percentage of winning/losing trades may be key
to traders’ mental ecology. I have learned in my
own trading, for example, that I am much more successful
trading very short, intraday patterns than swing trading.
With an average holding time of under 30 minutes, I can
make small profits with consistency, maintain my trading
focus, and limit my losses. While it is theoretically
possible for me to make more money by holding on for the
longer swings, in practical reality this does not happen.
The added volatility of the longer time frame interferes
with my emotional state and decision-making, turning my
profitable trading into one that is in clear non-compliance
with minimum wage laws!
Trading is indeed a high-performance activity. Like other
high performance domains, it requires directed effort.
The football team going into a big game draws up a game
plan; the army about to fight a war develops a battle
plan; the master psychotherapist goes into sessions with
a coherent strategy for assisting a patient. These plans
are actually sets of interwoven rules that, as a whole,
orient the performer as to the challenges that lie ahead.
To the extent that the peak performer has a decision tree
mapped out in advance, responses to situations can be
made rapidly and decisively. In many fields—on the
trading floor or in the operating room—the difference
between success and failure can be a matter of seconds
or minutes. This makes cognitive efficiency a prime ingredient
of peak performance. By summarizing years of experience
in a few statements, rules and plans promote such efficiency.
This brings us to another important psychological facet
of rule governance: To promote efficiency in decision-making,
rules must be simple. It is when these rules are assembled
in a coordinated manner that they become plans that flexibly
orient individuals to complex situations. In my own trading
of the equity indexes, for example, I break each day down
into four component mini-days: morning session, midday
session, afternoon session, and overnight (Globex) session.
I then assess market trends and trendiness, gauge the
degree of institutional buying/selling, and look for tests
and breakouts from one time period to the next for intraday
trades. (See my Weblog at www.greatspeculations.com/brett/weblog.htm
for details). By combining simple decision rules with
a segmentation of the trading day, I can approach each
day with a flexible strategy that doesn’t clutter
my head.
Rules and the Brain
Advances in cognitive neuroscience are also helping illuminate
the value of rules in guiding performance-based activity.
We know that a region called the prefrontal cortex is
largely responsible for what is known as the “executive
functions” of the brain. These include planning,
reasoning, problem solving, and many of the activities
that allow us to engage in purposeful activity. When the
prefrontal cortex is damaged, the result is a “dysexecutive
syndrome” in which patients become unable to plan
and execute complex activities. They are easily distracted,
reflecting deficits in memory and concentration. As a
result, even the simplest coordinated goal-oriented activity,
such as grocery shopping, can be challenging.
Recent theories of attention deficit/hyperactivity syndrome
(ADHD) suggest that deficits in the prefrontal cortex
contribute to the distractibility and poor attention spans
of hyperactive children. Indeed, imaging studies find
reduced blood flow to the prefrontal regions of such children.
Interestingly, these are the same reduced blood flows
that are observed among normal individuals during episodes
of high emotional stress or frustration. Because emotional
experience is processed by lower brain structures, away
from the prefrontal cortex, the relative cerebral blood
flow to the frontal regions serves as a useful measure
of a person’s executive capacity. When people are
highly frustrated, for example, their deactivation of
the frontal cortex leaves them in a state where—temporarily—they
are similar to the ADHD child or even the dysexecutive
patient. How many times did you look back on a losing
trade and wonder if you were in your right mind when you
placed the order? According to brain studies, you might
not have been!
The traditional trading wisdom that says we need to control
our emotions stems from the recognition that highly emotional
states leave us more vulnerable to lapses in concentration
and impulsive behavior. When we are activating the wrong
brain regions, we can expect to make impaired trading
decisions. Rules enable us to stay grounded in proper
trading practice regardless of the mindstate we are occupying
at the time. Indeed, the entire process of formulating,
following, and coordinating rules activates those executive
functions needed for proper trading. In a very real sense,
staying rule-governed is a way of staying focused and
rational. It is for this reason, I believe, that Linda
and I observed that successful traders tend to be rule-governed
and systematic.
Conclusion
It is common to hear traders assert that mental self-control
is the key to stock market and futures profits. This article
is suggesting that the reverse is equally true: Staying
grounded in solid trading rules and systems is one of
the most powerful ways of maintaining a positive trading
psychology. When we are rule-governed, we are in a mental
state that promotes efficient perception, problem solving,
and action. Indeed, training ourselves to stay rule governed
during trading rehearsals is an effective strategy for
cultivating rule governance in real time.
Different rule systems may work better for different traders,
depending on time frames and markets traded. My own rules
make considerable use of such statistics as the NYSE TICK,
the number of stocks advancing vs. declining on an intraday
basis, and the number of stocks making new intraday highs
and lows. Such rules would be poorly suited to the trading
of agricultural commodities, but have proven useful in
trading intraday swings of the equity indexes. Other rules,
such as pure price-based breakout methods, possess wider
application across markets and might allow for the holding
of positions for longer time frames to maximize potential
gains.
Ultimately, the rules/systems you follow—and their
linkage into coherent trading plans—must be well
suited to your personality, including your risk-tolerance.
Researching the performance of your system—discovering
its weaknesses and strengths—and trading them with
small initial positions is of immense help in building
your trading confidence and ensuring that the rules work
for you. If we believe many of the “Wizard”
traders interviewed by Jack Schwager, a key to trading
success is surviving one’s own learning curve. Identifying
the system(s) that work for you, translating them into
consistent trading strategies, and learning to be comfortable
with these is an important part of that process.
Brett N. Steenbarger, Ph.D. is Associate
Professor of Psychiatry and Behavioral Sciences at SUNY
Upstate Medical University. Dr. Steenbarger is an active
trader and author of The Psychology of Trading (Wiley,
2002). He writes feature columns for the MSN Money website
(www.moneycentral.com) and several trading publications,
including Stocks Futures and Options Magazine (www.sfomag.com).
These articles and a daily trading weblog are linked at
Greatspeculations.com.
FUTURES AND COMMODITIES TRADING INVOLVES SIGNIFICANT RISK AND IS NOT SUITABLE FOR EVERY INVESTOR. INFORMATION CONTAINED HEREIN IS STRICTLY THE OPINION OF ITS AUTHOR AND IS INTENDED FOR INFORMATIONAL PURPOSES AND IS NOT TO BE CONSTRUED AS AN OFFER TO SELL OR A SOLICITATION TO BUY OR TRADE IN ANY COMMODITY AND OR SECURITY MENTIONED HEREIN. INFORMATION IS OBTAINED FROM SOURCES BELIEVED RELIABLE, BUT IS IN NO WAY GUARANTEED. OPINIONS, MARKET DATA AND RECOMMENDATIONS ARE SUBJECT TO CHANGE AT ANY TIME. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS.
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