You have a responsibility to be prepared mentally each day you choose to day trade.  Many traders shun the emotional realities of trading, and this aspect of trading is among the most important. Recent findings in scientific studies reveal, unequivocally, that a traders emotional state during a trading session may be the single most important factor in determining whether a trader has a successful day or loses money.

In my experience the best way to quiet a group of chatting traders is to ask them about their emotional preparation to trading.  For a variety of reasons, traders are reluctant to discuss how they feel, at the emotional level, during their trading.  Whether the root cause of the this phenomena is vanity, inability or reluctance to share emotional tendencies, or a societal norm for traders to be mentally “tough” is unclear.  What is clear, however, is the incontrovertible evidence that states that your mental and emotional state has a profound effect on your ability to trade.

In a past article I discussed outside factors like television, radio, and music that effect our emotional state, and in this article I will discuss internal emotional considerations each trader must conquer.  There is a feeling that some traders are gifted, that they are natural born traders.  It is my opinion that some traders have an emotional profile that makes them successful, as oppose to a technical style.  As a chaos theory trader, I am convinced the market is, at the macro level, random and difficult to predict.  At the micro level, certain patterns occur over and over.  That being said, most of the successful trading systems share some common characteristics and very little has occurred in the past ten years that we could consider revolutionary breakthroughs in trading technique.  To be sure, no trading style has in any way pulled ahead of the pack of mainstream traders.  Sure, we have new styles of trading, but the ultimate judge of trading successfully is profits and losses, and the new styles have done anything but disproved the long standing tenets of trading with their profits and losses.

So what kind of emotional situations hinder a trader?

Emotional attachments to a trading position are among the toughest to recognize and rectify.  For a variety of reasons, traders invest their emotions into a particular trade in the belief they are right, despite overwhelming evidence to the contrary.  For example, a trader may decide the market is going to go in a certain direction for a certain period of time and positions his trade to capitalize on this perceived winning trade.  Before long, the market begins to move counter to the trader’s theory, but the emotionally invested trader does not take corrective action because he is convinced he is right.  Despite his indicators telling him he wrong, despite the market price action that is telling him he is wrong, the trader has invested himself so deeply in his conviction he is right he rides a trade straight into his stops. (if he has stops)  When I think I know what the market is going to do, especially if it is contrary to what my chart is telling me, I know it is time to stop for the day.

What causes this phenomena?

The need to be right, basically.  The literature on this topic suggests there are more than one factor that contributes to emotional attachment to a given trade.  Losing trades are a part of day trading, and how you handle a trade at the emotional level will determine whether or not you can trade successfully.  You are not going to always be right, and an individuals ability to accept that he/she was wrong and move on to a new trade is essential.  It sounds very easy, but it’s not.  Many traders are unable to adjust if they are in a losing trade, it unnerves and rattles them.  I have watched many traders battle this problem and most are unable to conquer emotional investment in a trading position.  For some, their need to be right simply overwhelms the intellect they possess.  While emotional investment in trading positions is not necessarily the end of a traders career, it takes a considerable amount of work to overcome.

Another serious emotional issue with traders is overconfidence, especially on a day with many winning trades.  This is a tough issue to deal with.  As you make good trades throughout the day, you become convinced that any trade you make will be a winner.  It’s a great way to give back all you have earned, which is not uncommon.  This usually occurs on a trending day when nearly all your trades will be profitable if you stay in the trend.  Of course, the next day may well be a trend in the opposite direction, or a consolidating market, and your overconfidence becomes a distinct liability.  You must be nimble in your trading, and not lock in on ideas to the point where you are not able to properly focus on the market.  Overconfidence is terminal to a trading account.  You must stay a student of the markets, not the master.  There are few masters of the market, just observant and nimble traders.

In summary, we have looked at the effects emotions have upon trading futures.  Many traders tend to become emotionally involved in the positions fail to adjust to the trading situation.  They have an intense need to be right.  Other traders become confident, which is a great attribute to have if you are in a sporting contest with another opponent.  On the other hand, the market is inanimate and overconfidence is poorly deployed in the trading environment.  Your ability to recognize the emotional demands of trading will, more or less, be a major contributor to your success.

Some day traders believe that good traders have some sort of intuition into the functioning of the futures market.  Here is the rub, when you are trading; your ability to control your emotions while you trade will, in large part, determine your success.  Can you simply turn your emotions off and continue to trade on just the facts?

The overwhelming response I receive when this question is posed is “of course I can!”  Most day traders do not want to see themselves as weak or deficient, yet when they trade these deficiencies are nearly always present.  Your emotions betray you when you trade, and the secret to trading is to have firm control over how you think at the emotional level.  It is easier said than done, too.  While confidence in trading is important, over confidence is an account-buster.  The markets will humble you before you get a handle on what went wrong.  Taking a respectful approach to the markets and the risks involved in trading will service you far better.  I tell myself several times a day “the market is right, you are wrong.”

When I trade, my goal is to trade what I see on the chart.  I don’t trade the news, I don’t trade on rumors.  I don’t trade the economy.  No, I have a specific methodology for trading the chart on the screen and it does not include outside influences.  I am not interested in what market pundits have to say about trading on a given day.  For many traders, that is a tough pill to swallow.

Here are some of the measures I use to control my exposure to emotional roadblocks.

1.  I don’t watch television when I trade.  Most of the networks have an agenda in their announcing style that is not objective.  Some networks are eternal optimists in the face of contrary facts, and other networks are overly pessimistic in the outlook.  I depend on my own analytical skills in reading charts and arriving at my conclusions.

2.  I generally play classical music when I trade, as I find this music emotion neutral.  Some rock n roll affects me at the emotional level, which is to say the music is psychologically stimulating and I have found I am too aggressive in my trading.  As you can see, I have thought some about this issue.

3.  I never look at a chat room in my trading, and usually don’t frequent chat rooms at all.  Why?  Most chat room posters are doomsday types.  The sky is not falling, and I am not chicken little, and I do not want my trading influenced by spurious information.

4.  I sometimes listen to a radio station when I trade, but it is usually a talk sports station and nothing more than banter.  This does not seem to effect my trading unless they talk about the Chicago Cubs, then I am usually irritated and turn the radio off. (yes, I am a long suffering Cubs fan)

So outside influences can, in fact, be an issue; but there are even tougher influences to conquer, and that is the psychological point of view within yourself.

Your own outlook on the world can influence your judgment, regardless of the outside influences to which you expose yourself.  Emotional considerations like greed can cause you to trade recklessly and outside the parameters of your trading system.  Greed?  Yes, there have been several books written in the last 2 years that compare the hormone levels after a very successful trade to pre-trade hormone levels, and found your body’s physiological response was to release large amounts of endorphin, resulting in temporary euphoria. (See “It’s Not What You Think, It’s How You Think,” Larry Pesavento, author)  Temporary euphoria is not a good state to trade, and may result in terrible losses.

In summary, there is good evidence to suggest that your state of emotions is the determining factor in day trading success.  Anecdotal and scientific research has brought this consideration to the forefront in recent years.  It is important to realize the detrimental effect your emotions can have upon your trading and take action to minimize outside influences, especially those involving greed, euphoria and overconfidence.  And finally, trading psychology is one of the least understood facets of trading and will likely stay that way, because of traders aversion to talking about their feelings in the trading environment.

I know for me it’s simple; anytime I think I know what the market is going to do, I need to remind myself…I don’t know what the market is going to do, and I need to simply trade the chart in front of me without bias.  It’s easier said than done.

You owe it to yourself to investigate the eye opening features of this program. It’s money in your pocket.

Note:  I thought that analyst statement a bit bombastic, after all, surely there has been a better time to buy than now, like, say, right in the middle of a roaring bull market.  But an analyst gets paid to pump stock and issue buys….not spread gloom and doom.

Anyway, I have been thinking about this run up in equities of late and wondering just exactly is the root cause of all this stock buying euphoria?   I would also note that the volume on the run up has not always been overly impressive, and further, trading in the financial stocks has been much heavier than the norm.   Then again, when a company is being wholly subsidized by the government, who wouldn’t invest in that stock?  But I digress….

You see, I keep thinking about these darn unemployment numbers.  There are a lot of people out of work, and people out of work don’t spend much money.  We are a consumer driven economy and common sense tells me we need robust consumer spending to really emerge from the recession.   The unemployment number are horrifying…the market got all excited last week because the economy only jettisoned half a million jobs, which is better than past months.

Half a million jobs is good news?   It’s horrible news.

I look at the housing inventory and foreclosure rates and I am not very excited either, especially with a new round of resets on the Alt-A mortgages.  That might not be a pretty thing, and the projected defaults on the resets is alarmingly high, depending on which economist you care to follow.

On and on it goes, with the government in full spin cycle trying to convince me that things are honky-dory.  They don’t seem all that good to me.  I worry that this latest rally my be short lived and a nasty correction may ensue.  Look at 1933, they thought they had the depression whipped, so the government tightened monetary and economic policy and the depression started all over again.

No, we are still walking on a very slippery slope and I am not very comfortable with the level the market is sitting on, and the the underlying cause of the run up….which is pure speculation.  Speculation doesn’t make for a bull market rally.

Then again, maybe I’m all wet and things will be just fine.   I just am having a difficult time swallowing the “everything is great” pill right now.

Of course, there is always a compulsion I fight and that is to get “back in the money” immediately.  The temptation to increase the number of contracts being traded and straighten things out is irresistible.  This is a very normal attitude, after all, who wants to be a loser in the market?

Don’t do it.  It’s as simple as that…

A very common mistake traders make is to try to get back in the money in one fell swoop.  Often times a trader will take a trader of lower probability to accomplish this just to quit looking at the red numbers on his DOM.

Don’t do it.  It’s as simple as that…

Don’t try to overtrade, or make back your loss all at once, no matter how irresistible the urge is to do so.  It is a recipe for disaster.   A good trader stays with his game plan and trades his account using his pre-defined money management technique.  A few good smaller trades will right a poor opening trade.  And the opening trade may not have even been a poor trade, sometimes the market just will does not cooperate…for a variety of reasons.

My point is, stick to your trading plan and trading strategy, and don’t let a losing trade force you into unnecessary trades, overtrading or trading an excessive number of contracts.

But the volume of mail bears out something that I think is important.  Early in my trading career I always thought about becoming an expert in chart reading.  I believed that if I could master charts, or unlock the hidden code of the market, I would become a great trader.   Back then, computers were a luxury, and not very helpful, and we used support, resistance, and pivots, along with volume numbers to time our trades.  We weren’t nearly as sophisticated in our trading as the average trader is now, but we learned to be profitable.

My trading mentor used to get quite a chuckle with my preoccupation with charts.  He would tell me that trading is 30% technical knowledge and 70% psychology, and great traders were able to sift through the information and take only quality trades because of the way they view trading.   I never gave his comments much weight on this subject until years later when I realized that the most important component in trading is my view of the market.

But how do you filter out all of those components of thinking that doom your trading success? Greed, anxiety, anticipation, overtrading, and a host of other psychological factors are the stuff of failure, not chart reading.  Really, it’s how you think that will determine your success.  For example, there is an area of trading devoted to mathematical analysis and prediction of the market generally referred to as “quant” trading.  I have a buddy who is a quant.  He has periods were he is quite profitable, and periods where his computer and mathematics betray him and loses great sums.  He is devoted to his math, his charts.  An examination of most quant traders will reveal they have a difficult time matching the index return over any five year period.

Hmmm….

I don’t ever get really hot with my trading, or go on prolonged winning streaks.  I am very consistent with my trading style and churn out impressive results consistently.  I don’t ever get into prolonged losing streaks either.  Pretty boring, I guess.

Why?

It’s how I think.  I have a view of the market and have worked hard to maintain than view, integrate it into my trading and not let outside influences or bad thinking effect my trading. (I should note that I do have the occasional slip up, or lapses in consistent thinking, I am not a computer)

The point is a simple one: Trading is a reflection on how you think, and THE MOST IMPORTANT COMPONENT OF YOUR TRADING IS YOUR THINKING.  I would also point out that it is the most difficult skill to master, and I have in no way “mastered” my own trading psychology.  Learning to trade is like being on a never ending path of learning, and only until I realized and understood the detrimental effects of my thinking on my trading did I get very consistent in my trading results.

This is a difficult post to write because emotions are impossible to quantify, and I like to quantify things…it’s my nature.  It took me years to realize what my mentor was trying to tell me when he said, trading is 30% skill and 70% “how you think.”  I’ve gotten better over the years in my trading thinking.  I still have a way to go…

There is no secret code to trading profitably, and it’s true that most traders “bust” their accounts within three months.  But some don’t, and I suspect they are the ones who innately think properly about the market, and they get better as time goes by.  For some of us, it takes years.  I understand that trading psychology is like stepping into a mud pile, not very fun…but I am convinced that the key to profits is between my ears, reading the chart is simply a variable in the trading process, along with processing the information I see on the chart in a consistent and disciplined manner.

A few posts back I listed some great trading psychology books.   Books can effect your thinking but you will have to shape your trading to your own personality.  Go to the library and see if one of those volumes isn’t there, trading psychology is too important to ignore.

The initial phase of most bull markets is usually based in speculation, though.  So you might argue that we are entering a new bull market, except this run up is actually quite extraordinary when compared with initial phases of past bull markets.  To be sure, we are nearly twice as high, in percentage, as any other initial bull market phase.

And then there is the extraordinarily low volume.  Have you noticed that a good deal of the trading, nearly half, has been concentrated in the financial stocks?  Yep, the very nebulous of the onset of the recession is now the focal point for high stakes speculation.  And why not?  If the government is committed to these five or six banks to the point that they are “too big to fail” how could buying and selling them be a losing proposition?   It hasn’t, either.  Most of the ultra large banking stocks have posted some decent profit numbers.  Then again, if you give me 80 billion dollars I would like to think I could make a decent profit.  It always brings to mind something my father, who was not prone to besmirch anyone, once told me, “your banker is not your friend.”   Smart guy, pops.

The conspiracy theorists are having a field day with this rally, as they are utterly, without a doubt, convinced the government is heavily involved in propping the market up to restore public confidence.  Sure would take a lot of money, though, to prop up all the exchanges simultaneously.   I have my doubts about the conspiracy theorists, though, because excessive speculation is also a trademark for a bear market rally.

A bear market rally?  I don’t see how this market can continue to rise on the sketchy tidbits of good news and the massive amounts of bad news being released of late.  Oddly enough, the blue chips are performing at about half the rate of return as the small caps,, and that disparity in stock appreciation is a real concern for this trader.  Unless we see some radical turn in employment and corporate earnings, along with some real volume from investors and not speculators, I suspect this rally is unsustainable.  Then again, the stock price is the “decider” (to coin a phrase from our last president) and the stock prices have had a great run.   Picking market tops and troughs is among the most unscientific and least understood aspects of investing.

But it does appear we have gotten ahead of ourselves in this rally whether it is a bull market or bear market rally.  AIG, Fannie and Freddie have all tripled their value in this current month, and none of the three is in anywhere near financially sound.  Then again, there is the notion they are “too big to let fall”…oh yea, I already mentioned that, didn’t I?

So this market worries me some, and makes me feel like the ground beneath my feet is very slippery.  Then again, not everyone falls down on slippery ground, but some do fall, and this rally has defied gravity so far.   Gravity is a finite variable, and not good to play around with, if you know what I mean.

It’s why I write everyday, or nearly everyday, about emini topics.

But I have been thinking an awful lot about trading psychology lately.   Let’s face it, the failure rate of traders is astounding.  Some figures estimate the rate of busts at 90% within the first three months.  Is it true?  I guess so, I don’t have any evidence to the contrary.  And yet, I think most traders, when they start out, have a pretty good idea what they want to accomplish.  Sure, they may take the odd flyer, or get into a few too many trades, but by and large they have paper traded enough to have a good idea what an ideal setup should look like.

Yet, traders fail in droves.

And one thing is for certain, most traders DO NOT WANT TO TALK TRADING PSYCHOLOGY.

The subject is a near taboo topic for most.  Most traders are content to rationalize their poor trading on some faulty indicator, a little bad luck, or the market took an unexpected move.   These things happen.  But more often, the trader took a bad trade based upon emotion or some unknown intuition.  A guess, really.  I see it all the time.

I suppose the average trader’s psyche is a fragile thing, and the books that have been written about trading psychology are not often a part of a trading discussion group.

Trading for a Living: Psychology, Trading Tactics, Money Management by Dr. Alexander Elder had a profound effect on my thinking.  There are other books on this topic but you seldom see them discussed.  No, we like Fibonacci retracements, pivots, support…you know the topics, but not enough is discussed about what is going on in a trader’s mind while he trades.

Why is that?

My personal feeling is that it is a sensitive subject because the average trader would have to discuss his failings and/or shortcomings.  And yet, I have seen some of the very best traders make absolutely terrible trades.  The common denominator in all these shortcomings is emotional/ego involvement in trading.   And that emotional/ego involvement seems to stifle too much talk about trading psychology.  Who wants to talk about failure?  Of course, we are more than happy to talk about success, but it is the analysis of failure that makes us better traders.

I keep a trading log, and am my own harshest critic.  It’s easy to write derogatory analysis about yourself when you know you are the only one who is going to be reading your diary.  But lately, I have been thinking I ought share some of my boneheadedness with the regular followers of this blog.   I try hard to reinforce, in my mind, an aversion to the mistakes I have made in the past.  And it’s not always a pleasant process, analyzing your failure.  But I believe that understanding your mistakes makes you a better trader.

On the other hand, I’m not sure analyzing mistakes is a very popular topic.  What say you?