The Mindful Discipline of the Medium-Term Trader
The unexamined life is not worth living.
Socrates
Before I opened my first brokerage
account, I had the fortune of coming under the wing of mentors who drilled
into me the critical importance of cutting losses.
I have set initial
price stops with every trade ever since. Without exception, I
have enforced my sell/cover rules whenever a trade hit my stop. Instead of feeling a dent to my ego over being “wrong” on a trade, I feel a sense of satisfaction whenever
I sell for a small loss to elude a big loss. I take professional pride in living up to my plan. And call me perverse, but I feel almost as good about
seeing a stock tank after I sell as I do when bagging a
profit!
Okay, enough smugness. Now that I’ve boasted about my righteous loss-cutting discipline, let me confess my dirty little secret.
Loss containment forms just one part of disciplined trading. While I practiced consistent money management toward losing trades, I failed miserably in my early
trading to act with self-control in the selection and entry of trades. Early on, I
indulged an amateurish tendency to shoot from the hip rather than confining all
my entries to a carefully researched set of stocks. Inevitably, this led me to
enter many losing trades.
While this might sound like a stupid
mistake (which it was), it was not a shortcoming of intellect that led me
astray. Underlying my behavior I discovered a deeper, psychological root, one that I have since noticed in many traders. Once I discovered this root, the path to turning around
my performance became clear.
By sharing this personal experience with you, I hope that you
can learn to recognize counterproductive tendencies embedded in your own unique personality. You may suffer from the same flaw as I did. Or your hidden weaknesses may lie elsewhere. But I believe the solution is the same. One of my teachers calls it mindfulness.
As a beginning trader, I had access to an institutional stock market database as well as a real-time quote service. Armed with these wonderful tools, I would
continuously scan the market for stocks moving on healthy volume during the
trading day. If I saw a high relative-strength stock pop out of a
picture-perfect pattern (“picture perfect,” that is, to my novice eye), I would run a quick-and-dirty
check of the corporate earnings. If that cursory
once-over flashed no red lights, I’d jump in with both feet.
This mindless, gung-ho behavior got me in all sorts of trouble. In my
haste, I would often overlook danger signs in the chart or
problems buried in the corporate fundamentals which might have revealed themselves upon a
more painstaking inspection. I also entered otherwise great stocks too late. Trying to find breakouts the same day I traded them, I wound up
hitting the order-execute button after stocks had extended well past their pivotal points. As a result, I was shaken out
in many subsequent pullbacks.
The markets today show even less tolerance toward late
entries than when I began trading. In the wake of the Internet and brokerage revolutions, armies of online traders are watching in real time for same breakouts as you and I. We also must contend with hostile players: Market makers and other traders who challenge breakouts with contrary trades, shorting after we buy, buying after we short.
Consequently, you must pounce once a stock sends you an entry signal. If you let a stock telescope more than 3% in price while you hem and haw over your decision, you’ll miss out on an early paper profit created by the breakout. Capturing that profit provides a critical margin of safety. Combined with your loss allowance, it forms a cushion to insulate you from normal bouts of adverse volatility after entry. Miss out, and the odds increase that a pullback will hit your stop, throwing you back into cash right before the stock resumes in the direction of your trade.
My stop-loss and position-sizing
regimes steered me clear of catastrophe, but I was dying the death of a thousand
cuts! Small losses mounted. Meanwhile, stop-outs from otherwise winning trades denied me profits needed to offset the drain on my overall capital. I was losing a war of attrition to the market, and the casualties were psychological as well as financial. I felt increasingly frustrated and discouraged. A winning trader must possess his or her nerve as well as a bankroll. I was in danger of losing both.
Trading with discipline
requires more than knowing the proper rules. You also must possess self-knowledge.
What are your bad habits? What are your emotional needs, your compulsions, your vulnerabilities?
Unless you address them honestly, they will influence your trading on a subconscious level and lead you
astray, no matter how well your intellect grasps your chosen trading strategy. The market is a zero-sum game, an impartial, unsympathetic referee of the adversity of thousands of combatants. You can enter the fray heedless of your self, but the market won’t turn a blind eye! The market is like any of life’s forums of adversity. It possesses an uncanny talent for uncovering your vulnerabilities, and it will turn them against you.
In my own case, at some level, I knew darn well that my early
gun-slinging ways were unduly risky. So why did I fool around like that? The
answer was, I craved the “action” too much.
Now don’t misunderstand me. To trade successfully, a trader must love the action. Great traders love to trade. Wealth is
the byproduct of successful trading, but pursuit of wealth is not the primary motivation
of great traders, at least not in their formative years. Unless the markets
fascinate you, unless you wake up each day with a passion for the game, you will
not become a successful trader. I believe great traders share this quality with
great athletes. I’m sure Alex Rodriguez, Michael Jordan and Tiger Woods enjoy
the immense material fortunes that their careers have brought them. But long
before they won fame and fortune, they fell overwhelmingly in love with their
chosen sports. That passion drove them to mastery and excellence.
But any emotional need, indulged without balance, is a prescription for disaster, whatever your field of endeavor. In the world of trading, the pros learn to harness their passion for the game with a disciplined, businesslike approach aimed at maximizing returns and minimizing risk. To find that balance, you need more than a defined trading plan. You must align your emotions with your goals. Only then will you possess the resolve to carry out your trading plan.
We all consciously desire profits, but deeper impulses lurk at a subconscious level. If those impulses remain in the subconscious, they will influence our trading decisions to our disadvantage. By becoming mindful of those impulses, we can take corrective action.
Hyperactive hunger for the action was my own psychological Achilles heel. I’ve overcome this weakness through sustained effort. I remain vigilant against it every day of my trading life, but over time, the temptation to overtrade has diminished considerably. What is your Achilles heel? Nefarious influences come in many different forms.
It doesn’t take a psychologist to find out, but you must put forth an honest effort at mindfulness throughout your trading career.
Try to be aware of your random thoughts
and emotions during the trading day. Don’t over-focus on them or empower them. Just take notice. And have a sense of humor about them. That is the first step to keeping those influences clear of your decisions.
The next step involves regular post-game analysis of your trades. You should already be doing this. The study of losing trades is the best way to improve your skills and technique. However, don’t focus exclusively on technique. Ask whether something within you blinded you into making those technical mistakes. I assure you: You will make many startling discoveries as you find misjudgments rooted in yourself rather than in the market!
If this sounds too touchy-feely for
the macho trader in you, you’re missing the point. Self-appraisal is key to success in
any field. Consider the examples of Stuart Walton and Steve Cohen, two
phenomenal money managers profiled in Stock
Market Wizards, the third in Jack Schwager’s famous “Wizards” series of
books.
Walton
trades in complete solitude, with not even a secretary to help him manage a $150
million fund. Is this lone-wolf machismo? Quite the contrary. In his interview
with Schwager, Walton said: “I found that having another opinion in the
office was very destabilizing. My problem is that I am very impressionable. If I
have someone working for me every day, he may as well be running the money
because I’m no longer making my own decisions.”
In contrast, Cohen requires a team
approach. He told Schwager: “I’m not a lone wolf. Many traders like to
fight their own battles. I prefer to get a lot of support. The main reason I am
as successful as I am is that I’ve built an incredible team.”
Each Wizard has evolved to reinforce his psychological strengths and minimize his psychological weaknesses.
One
of the most insightful interviews that I ever read was with trend-follower Ed Seykota in
Schwager’s first Market Wizards.
Seykota is one of those people who are so perceptive that it’s scary!
I’ll never forget his quote: “Win or lose, everybody gets what they want out of
the market.”
When I began trading, I consciously
desired profits, of course. But on a deeper level, the trading action itself
gave me my immediate pleasure. So on a subconscious level, I got what I wanted from the market, even though I was losing money! It was only after I recognized
this fact that I developed the emotional control needed to carry out a rational trading plan. I still love to
trade. I still enjoy the action. But I have subordinated those pleasures to the goal of making money.
At that point, I ceased shooting from
the hip and became an ambush artist. I adopted
and stuck by two rules:
1. Trade no stock that is not already
on my watchlist. If I discovered a stock breaking out during the trading day, I
might analyze it to develop an idea of current market conditions and strength,
but I would not trade it. I also would ask why I had missed the stock in my
afterhours research. Sure, I’ll miss out on some great winners, but I’ll avoid even more losers. This discipline has upgraded the overall quality of the stocks that I do trade while curbing my risk to capital.
2. No idea qualifies for my watchlist without passing a thorough review conducted outside normal trading hours.
It’s not just a matter of giving myself the time to conduct thorough research. I
want my mind as free as possible from the pressures and distractions of the trading
session. My watchlist work includes fundamental analysis, analysis of daily and weekly charts, careful
week-by-week inspection of the accumulation-distribution picture, a check for
upcoming splits (which can produce excess supply), comparison to group brethren
and comparison with all my other ideas. This last hoop forces me to allow only the very best names into
the watchlist. Many times a stock will meet my minimum
criteria, but I will still reject it if it appears distinctly inferior to the
other names on my watchlist. I want only the very best merchandise on my watchlist
at any point in time.
Aligning your emotions with your
trading rules is not limited to overcoming bad habits. I also draw on my aversion to risk and my pride in my craft to reinforce good
habits.
To quote Seykota: “One of the
best ways to increase profits is to do goal setting and visualizations in order
to align the conscious and subconscious with making profits.”
In my case, I now feel “right” only about only those stocks that made it through my watchlist vetting. When I happen to see an attractive-looking breakout that I
have not yet researched, I imagine the danger of the unknown lurking behind that
stock. I practice the same emotional alignment when I sell a stock for a small
loss. I mentally reward myself for playing good defense. Don’t limit your
positive emotional reinforcement to profitable trades! Mentally congratulate
yourself whenever you enforce sound trading rules.
Here are 10 rules that I believe will
improve your self-discipline:
1. Always cut losses small. Never
cheat on a stop. This not only protects you financially. It also protects you psychologically.
Nothing can shatter a trader’s nerve like severe losses.
2. Be aware that in almost all its
aspects, human emotions run contrary to
successful trading. Fear, greed, hunger for action, anger with the market and
mood swings are all inimical to profitable trading and risk management. During a
recent informal discussion among TradingMarkets contributors on psychology, Len
Yates expressed the view that the only human emotion conducive to successful
trading is the desire to win.
3. Know thyself. While you cannot
become an unemotional human being, you can practice mindfulness, which is to say, awareness of your emotional states, of your thoughts, of
everything entering your mind. Then you will be better equipped to prevent your
mental state from influencing your trading. Keep a trading diary of your market
observations and reasons for entering trades. When you conduct your postmortem
analysis of losing trades and you spot errors in judgment, ask yourself, what was
behind the lapse? Did you get greedy? Did a desire for action lead you to making a
hasty, ill-considered decision? Did you allow something in your personal life to
distract you? Did arrogance, born of a string of successful trades, blind you to sell signals? Did discouragement, born of a string of losing trades, paralyze your ability to act on buy signals? Mindfulness is not a one-time accomplishment. It is a lifelong practice.
4. You can and should watch the market
for ideas during the trading day, but defer the heavy research on those ideas
until after the close. Prepare all aspects of your trading
plan — watchlist composition and stock selection, position size, entry and
exit points — outside normal trading hours. Leave as little to improvisation as
humanly possible. When a watchlist stock or account holding sends an entry or
exit signal, there is no “decision” to make. You instantly and
robotically execute your plan.
5. Never project your emotions onto
the market. If a stock stops you out, then resets and breaks out again,
re-enter. Don’t allow the previous trade to color your view of the same stock.
The only thing that matters is whether the new setup appears valid.
6. Never, ever double up in an effort
to come back from a losing trade. Amateurs fall prey to “gambler’s fallacy,” the misguided notion that the next trade is more likely to
succeed because the prior trade failed. Doubling up on your losers is a sure-fire way to the poor house. This kind of behavior,
incidentally, is how a 28-year-old investment officer named Nick Leeson racked
up losses of $1.3 billion in the derivatives market and brought about the
collapse of Britain’s Barings Bank in 1995.
7. Pare back your trading around
major lifetime events. (I learned this one from Dave Landry.) Episodes of euphoria or great hardship — divorce, the birth or adoption of a child, the death of a loved one
— all can shift your emotional balance in ways that can distort your perception and acuity.
8. Hold your theoretical risk per
trade — the total amount of money you are willing to risk on a single trade
before executing your stop — to a fixed percentage, probably no more than 2%
of your total account size. This is a matter of psychological risk management as
well as financial risk management. You will not make balanced decisions under
market pressure if you take on more risk than you can stomach. For example, let’s say your account is worth
$500,000 and you set your stop 8% below your entry price. You decide to limit
your risk to 2% of your account. Your maximum loss in any stock would be $10,000
(.02 X $500,000) and your maximum position size would be $125,000 ($10,000/.08).
Set that fixed percentage at a level where you feel comfortable with the risk
level while still being able to gain materially from a favorable trade.
9. In the morning, your first
assignment is to establish mental clarity and balance before diving into your
pre-market research in preparation for the bell. Some traders just go into a
clear, distraction-free state as soon as they sit down to business. If you’re in
that category, great. If you face a lot of distractions or demands in the
morning, start your day earlier to find some time to yourself. You’ll probably find this practice enhances
your mental performance through the rest of the day. A quiet breakfast. A
morning walk. Jogging. Meditation. Whatever puts you in the best possible space
for the remainder of the day.
10. Mental clarity and balance are as
much a result of brain chemistry and metabolism as they are of logical thinking.
Incorporate regular exercise and proper nutrition into your life.
What the mind does, that it experiences as truth.
The Yoga Vasistha
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