I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Wednesday Wealth, I write about money management, retirement, estate, and long-term care planning.
The emotions of trading: hope, fear, regret, greed, euphoria, despair, misery.
Yesterday was a tough day. I had leaned too heavily into semiconductors and I suffered. I knew that I was overconcentrated but I told myself, “it only makes sense to lean into what’s working! I don’t need to follow my diversification rules. Surely they are too pessimistic.”
I felt some misery, but not that much, because I’m gradually learning that losses are inevitable, and that I can control how large they get before I stanch the bleeding.
My stop-losses triggered for a number of positions, so I am less concentrated into semiconductors today. My tracking spreadsheet, which controls my trading activities, has been updated to put diversification stats right up front, and highlight when they are unbalanced.
In The Best Loser Wins, Tom Hougaard writes:
I deal with fear when I am in a trade by having an exit strategy. I have a stop-loss, which defines the size of my loss. I have accepted this loss before I started the trading day. It is part of my trading plan.
Because I trade options, I don’t use stop limit orders to automatically execute if my stop-loss level is crossed. Options prices swing wildly especially in the first hour or so after the market opens. Instead, I check at one point in the morning — usually 8:30 am mountain time — which positions need closing. This does mean that the position may have moved further against me, so I might be out more than the stop-loss defines. Or I might be out less, because I don’t actually close the position until later in the day. Nevertheless, this keeps me from sticking with a losing position too long.
Risk management – the key to trading
Of course you need a decent edge and plan for entering your trades, and exiting them with profits (when you have them). But you need risk management as much or more to succeed in trading. Risk management can include sizing your positions so that one trade doesn’t blow up your portfolio, diversifying across sectors so that when rotations happen you aren’t left offsides, specifying trading criteria up front (e.g., choosing a “delta” of .20 or less for a short put, to maximize the chance it expires worthless), and, of course, determining when to exit a losing trade.
Hougaard says that the most frequently observed problem behavior that he has seen in traders is “the inability to take a loss.”
Why is it so hard for traders to say, “this trade is a dud, I’m out!” Hougaard says it’s about hope:
Hope features high on the list of reasons. As the saying goes, hope dies last. Our minds seem ill equipped to engage in risk management. Our minds have one primary objective: to protect us against perceived or real pain.
During the process of running an open position that is producing a loss, our subconscious mind is telling our conscious mind to keep the position open. It will mask this message as well as it can, in order to protect the ego, which is more fragile than the state of your trading account….
As long as a losing position is open, there is hope that the position will turn positive. The moment you close the position, and you crystallise the loss, the pain of the loss becomes real.
I’ve succumbed to this a couple times this year, and lost a lot more money than I needed to in the process. These two episodes were made worse by the euphoria and greed that got me into the positions. I saw certain assets, let’s call them milver and moil, that were running up parabolically. I thought, “this is a great way to make way more than the 10 and 20% I’m used to!” So I got in near the top and held on down, reading any news or analysis I could that suggested they might come back.
So the emotions of trading interact with each other to produce serious dysfunction.
Lessons in trading
It’s difficult when you start your trading career that you have to learn so many lessons, and be tested on them multiple times, before you really get them, and commit to living by them.
I’m getting better at taking my losses as they come, especially because Mark Douglas’ book Trading in the Zone made me see trading as a game of probability rather than a game of prediction and professorship. My goal now is to trade in accordance with a relatively simple set of trading rules that define when to get into a position, and with what characteristics. Then, I have rules for getting out of it if it doesn’t go my way, and rules for exiting if it does — if there is profit potential from a move in the direction I hoped for, I want to maximize the probability that I capture a good portion of it.
I have made quite a bit on semiconductor-related trades the past couple months and I surely may make some more in the future. But yesterday was, as they say, a lesson more than a blessing. I had too much capital exposed to one euphoric sector of the market, and I joined in the euphoria. I had multiple large positions in the sector rather than, as planned, one medium-sized one. The losses on closing out those trades blow away the gains I’m seeing on my other positions.
Today, I intend to act with discipline and resolve. I want to cultivate equanimity, a feeling of confidence, and a sense of peacefulness even with the noise of market news and brokerage updates around me.
If I picture a trader and her emotions, I imagine she might ride a rollercoaster of feelings, running from joy and exultation to despondency and anguish. I’m learning, however, that a successful trader instead has learned to calm her emotions so instead she feels interest, curiosity, acceptance, resignation, and other mild feelings.
I am surprised at how different the actual experience of trading is compared to what I imagined.
Here’s to a calm day, no matter how crazy the markets get!