What Poker Teaches You About Being a Consistently Successful Trader
Editor’s Note: This is Part 2
of a two-part series.
Click here to read Part
One.
In the
first article of this series, I took a look
at market conditions that determine the opportunity available in trading. Much
like poker, where long-term success hinges on the player’s willingness to “muck”
hands that offer poor odds of winning, trading boils down to the ability to
perceive and act upon edges in the marketplace–and the willingness to not play
the game when the edge is not present. In this article, we will explore the
need to stop trading when opportunity might be there, but the trader is not able
to take advantage of it.
Being On Tilt
Sometimes in poker, an edge is not present, not
because of poor hands, but because the player’s frame of mind is such that he or
she cannot exploit the edge that is available. Poker players refer to this as
being “on tilt”: reacting to hands (and overplaying them) because of one’s
emotional state, not because of the objective odds and “tells” from competing
players. Traders go on tilt for a variety of reasons, ranging from sheer
boredom and the need to create action to frustration and “revenge trading” after
losses. Nearly always, however, the tilt phenomenon results from a
physiological and cognitive state of hyperarousal. The out of control trader
is, in some way, “worked up” due to anger, anxiety, overexcitement, or
confusion. This can lead to a series of debilitating losses that seriously
jeopardize the trader’s overall profitability.
In professional trading settings, it is common
for traders to operate with warning levels and a “drop dead” level. The warning
level is usually triggered by a level of loss during the day that is unusual for
the trader and that suggests something is going wrong. The risk manager or
trading coach will contact the trader once this level is hit to encourage a
break from trading and a reassessment of the trading plan. The drop dead level
is a maximum daily loss that traders are allowed to incur before they are
required to stop trading for the day. The idea is that, if traders hit this
loss level (and each trader has a different level, depending on their size and
trading style), they are not seeing the market properly and need to regroup
before putting further funds at risk. The warning and drop-dead mechanisms are
not so different from the baseball coach’s visits to the mound when a pitcher is
allowing too many base runners and runs. The warning is a kind of “time out” to
regroup; the drop dead level is a risk management tool to ensure that no single
daily loss is large enough to jeopardize the trader’s longer-term profitability.
Independent traders don’t have the luxury of
their own risk manager or trading coach. Nonetheless, they can incorporate the
idea of warning levels and drop dead levels into their trading plans. On
my website and in
a recent article, I stress the importance of keeping metrics on your
trading: knowing the average frequency, size, and holding periods of your
winning and losing trades and understanding your profits/losses as a function of
time of day, day of week, and type of position held (long/short). These metrics
are invaluable in the proper setting of warning and drop dead levels. Very
often, if you examine your typical drawdowns during a trading day, you will be
able to identify a threshold amount beyond which you are unlikely to turn your
trading around. Indeed, traders often find that, if they hit this level of
loss, they continue to lose money if they persist in trading. This makes
sense, because that threshold loss level means that the trader is either
misreading the market, is out of control, or both. Using that threshold level
as a drop dead point helps prevent those blowout days that can jeopardize many
days of hard-won profit.
I also encourage traders to look at their metrics
to identify the point beyond which they generally cannot pull their trading back
into the black. In other words, you’re looking for the average normal amount of
drawdown (and variability around that average) during profitable days.
The warning level should be pegged just beyond that point: the level tells you
that this is not an expectable drawdown. In practice, I find that the warning
level usually ends up being about halfway to the drop dead point. As a rule, I
advise active traders to set their warning levels at a point that still gives
them a reasonable chance of scratching (breaking even on) the day. The drop
dead level should also give the trader a decent chance of being green on the
week.
The Danger of Digging Holes
Note that nothing in the idea of warning and
drop-dead levels removes the need for stops on all trades. The stop loss limits
risk on a per trade basis; warning levels and drop deads limit daily risk. In
order to hit a warning level, the active trader will have needed to be stopped
out on multiple trades. This is a good sign that the trader is out of sync with
the market and needs the time out to reevaluate. Unfortunately, this is easier
for traders to say than do. The same competitive traits that bring trading
success also make it difficult to accept defeat. Psychologically, the decision
to stop trading may feel like an admission of defeat. As a result,
hypercompetitive traders often trade well beyond warning and even drop dead
levels, digging themselves a deep hole in the process.
Those holes do significant financial and
psychological damage. A loss of 10% of capital requires an 11% gain to break
even; a 25% loss requires a 33% profit to come back; and losing 50% of one’s
money requires a doubling of remaining capital just to get back to square one.
Equally dangerous are the downward spirals that can be triggered by outsized
losses. It is rare to find a trader who does not allow large losses on Day One
affect trading on Days Two and Three. Sometimes the effect is to make the
trader gun shy, reducing size and missing opportunities. Other times, the urge
for revenge kicks in and triggers impulsive and risky trades. Almost always,
when I have seen a trader in a slump, the slump has begun with one or more
outsized losses that resulted from a failure to honor warning and drop dead
levels.
While losses are mounting and traders are
approaching warning or drop dead levels, they typically do not know why
they are losing money. It is very difficult to sort out whether the problem is
one of misreading the market or one of being on tilt. Only time away from
trading allows traders the opportunity to reflect upon their expectations,
mindset, and trades to figure out what might be going wrong. That time off is
also a good time to review the metrics: frequently traders will find that they
are trading differently from their norms in the number of trades being placed,
the holding times, etc. The key to utilizing time away from trading is mentally
rehearsing a mindset that says that time outs are part of the trading
strategy–not an admission of defeat. When a coach calls a timeout for his
basketball team, no one thinks that he is throwing in the towel. The time out
is part of the coach’s strategy, allowing the team the time to adapt to shifting
game conditions. Similarly, time taken away from trading during adverse
outcomes allows the trader to formulate a winning strategy for later in the day
or the next day. Successful trading is not just about
making money; it is also about keeping it.
Originally I was going to make this a two-part
article series. Readers of
my book know, however, that there is a third part to the equation: What to
actually do during a break period to get out of tilt and back into the
game. Accordingly, I will take up the topic of trader self-help strategies
during breaks in a third column.
Free Associations
In the past week, I’ve posted useful resources
for traders on my blog.
Thumbs up to
Ken Levey for telling it like it is. Not all trades are equal–and you need
to track the leanings of the large players to adequately handicap the odds of a
market breakout or trend continuation.
Nice listing of ETFs and their place in trading
by
Deron Wagner. I love ETFs, especially as a way of exploiting intermarket
and global themes. The first wave of change occurred when ETFs allowed
individual investors to create their own mutual funds by buying and selling the
broad indices. The second wave will eventually permit individuals to create
their own hedge funds, by implementing sophisticated strategies with interest
rate, currency, commodity, and equity instruments.
Brett N. Steenbarger
Brett N. Steenbarger, Ph.D. is Associate
Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical
University in Syracuse, NY and author of
The Psychology of Trading (Wiley, 2003).
As Director of Trader Development for
Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders
and coordinated a training program for traders. An active trader of the stock
indexes, Brett utilizes statistically-based pattern recognition for intraday
trading. Brett does not offer commercial services to traders, but maintains an
archive of articles and a trading blog at
www.brettsteenbarger.com.