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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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