In life, every intense experience makes an impression on our brain. You can think of these experiences as neuroscientific cattle-branding. The difference is these “brands” are invisible and we tend to have knee-jerk reactions to anything which triggers them.
Unlike issues that screw us with family or romantic relations, trader trauma is more covert. Dr. Brett Steenbarger and Phil Pearlman have written some pearls of wisdom we can all string around our necks from 9:30-4:00 (and beyond). Both these trader psychologists recommend we learn how to experience the uncomfortable sensations of losing trades, then work to accept these sensations (so we honor stop losses) rather than robotically react to these sensations (and let losses run).
In a recent blog post, Phil recommends trading micro-sized positions while learning to be fully aware of sensations arising when a position goes red. Dr. Brett concurs, “We need to refuse to indulge in the defense and purposefully sit in the trade, while allowing the feeling of fear to remain.” This means that when the Woody Allen-esque voice in our heads starts winding down a negative spiral (neurotically rationalizing holding a loser past the planned stop loss), we must learn to ignore Woody and execute our original plan (honoring stop losses).
Phil and Dr. Brett recommend using these micro-positions as training wheels with which to practice until you have learned to meticulously honor your stops. The smaller the position size, the softer and less persuasive Woody Allen’s voice. When Woody’s neurotic negativity is quiet, we can clearly hear our original plan and achieve our goal of properly exiting a trade. Once you achieve your goal at the beginner’s level, you can increase your position size and repeat the exercise again. This process continues until you reach your normal trading size.
When I first started trading, I filled with anxiety when positions went underwater. Sometimes I would panic and sell only to watch my thesis turn into a winner without ever violating my planned stop loss. Other times, when I was on a winning streak, I would fail to honor my stop losses because I was expecting my winning ways to ultimately unfold. I paid my tuition to learn that when we let stop losses lapse, we are playing a super-risky game of chicken: sometimes you dodge the tractor trailer, and other times you get squashed. Both these bad habits caused trauma. The trauma then caused me to repeat the bad habits, and the cycle of losses started gaining steam.
To escape trader samsara, I used the same program Phil recommends. I cut my positions to micro-sizes and forced myself to accept the sensations as an objective witness rather than a blind reactor. I learned to breathe deeply and ignore Woody Allen (“You can’t take a loss. How can you take a loss? Earnings were great! Who the hell is selling? This can’t last. How can it last? Don’t take the loss ‘cause once you exit the stock will come back. This can’t be happening. How is this happening? Why is this happening to me?”). With much practice, I was able to defuse my trauma and eliminate the bombs on my P/L statement.
This lesson is critical because failing to learn how to take losses disqualifies you from your crowning achievement: being a profitable/pro trader. Write down the mantra “You can always re-enter a trade, but a stock may continue to move against you FOREVER.” When you are in a losing trade, the first part of this statement will get you in control and on the sideline to breathe, assess, and protect your profitability. The second part of the statement will cause trauma (which causes future losses) when the lightbulb sputters back on and the “FOREVER” part hits your soul like an existential revelation. These traumatic losses can be avoided when you take the time to practice taking small losses. Obviously, entering hard stop losses upon entry is another way to slay this dragon, but that’s a whole other blog entry …
As Dr. Brett notes in his must-have book The Daily Trading Coach (which soon I will be reviewing for this blog):
“By refusing to act on the old defensive pattern, you guarantee yourself a psychologically helpful outcome. This is very important. As long as your position is sized properly with appropriate risk/reward in the placement of stops and targets, one of two things will happen: you’ll either hit your target and make your money or you’ll get stopped out at your predetermined level.”
Ultimately, this is how a true player not only stays in the game, but masters it.