How to Overcome the 3 Most Common Trading Vices

Dave: Welcome to Real World Trading, Dr. Brett.

Dr. Brett: Thank you, Dave. It’s a real pleasure to be part of RealWorldTrading.com. One of the joys of my work is the opportunity to be a part of people’s personal and professional success. I’m looking forward to contributing to the success of your subscribers.

Dave: I find your work fascinating, particularly your ability to break complex theories into easily understandable and instantly applicable rules. One of my favorites is your three vices of trading. Please tell us each vice.

Dr. Brett: I first wrote about the three vices in an article on my website, www.brettsteenbarger.com as part of a seminar I offered Woodie’s CCI Club, a large group of traders who educate each other about pattern-based technical trading. The response to the article was favorable because the vices seem to capture many of the mistakes we’ve all made as traders.

The first vice is perfectionism, the tendency to set unreasonable goals and standards for oneself. I can’t tell you how often I’ve heard a trader express frustration with a winning trade because “I should have taken more out of the move.” What the trader is really saying is, “I should have been able to catch the absolute highs and lows.” Because their standard is unrealistic, it sets them up for frustration, turning winning trades into psychological failures. If traders find themselves using the term “should” frequently when talking about their trading, there’s a good chance that perfectionism is lurking in the background. Perfectionism is not about being achievement oriented or competitive; perfectionism is a repetitive emotional pattern of self-talk that says, “What you’ve done isn’t good enough.”

The second vice is ego. Ego enters into our trading when we write a blank check for our self-esteem, allowing our feelings about ourselves to ride the ups and downs of our P/L statements. Hanging onto losing trades to avoid feeling like a loser: that’s one manifestation of ego. Impulsively putting on a trade after a losing trade to make back your money—revenge trading--that’s ego at work as well. One of the most common but subtle examples of ego is the tendency to fight the market by picking tops and bottoms. This leads traders to fade strong markets and buy falling ones. This can work fine in range-bound markets, but inevitably leads to disastrous drawdowns in trending markets. If the need to be right—to beat the market—is stronger than the need to make money, the seeds of trading self-destruction are sown.

The third vice is overconfidence. Traders often assert that their trading is hurt by a lack of confidence. My experience, however, is that it is more common for traders to be hurt by their overconfidence. A simple litmus test that distinguishes valid confidence from overconfidence is to keep a log of each trade placed during a day or week (or, better yet, videotape your trading) and ask the question: “What was my edge for this trade?” If you cannot identify a specific edge for the trade, the odds are good that your trade is born of overconfidence. Very often, overconfidence takes the form of overtrading: actively trading narrow, thin markets, trading position size that is inappropriate for one’s account size. Overconfidence is also evident when traders focus on entries but fail to identify exits, particularly to stop losses. It is easier to think about entries—the opportunities to make money—than face the possibility of loss or limits on profits. Great traders have an understanding of—and respect for—risk management. When that respect is missing, overconfidence is generally the culprit.

Dave: I often see those in myself when trading. Can you suggest ways to conquer each one of these vices?

Dr. Brett: Notice that the three vices are closely intertwined. Perfectionism, ego, and overconfidence all share one element: the tendency to derive one’s feelings about oneself from the outcomes of trading. That is one reason I worry about traders who make trading their entire lives. If all of your self-esteem eggs are in the trading basket, it is going to be difficult to separate yourself from your trading results during those inevitable dry spells. The simplest and most powerful way to overcome this problem is to have a rich life apart from trading: other productive pursuits, collegial relationships, romantic relationships, recreational activities, etc. It is difficult for me to put too much ego into my trading, for example, simply because I am surrounded each day by things that are so much more important than any day’s, week’s, or month’s trading results: my wife and children, my counseling activities, my extended family and friends. A rich and broad life brings much needed perspective to trading.

The other way I help people overcome these vices is by focusing on the process of trading, rather than the outcome. If necessary, we’ll cut back to trading one-lots in order to take the pressure and allure of outcomes out of the equation. Then we can just focus on trading well. For instance, I encourage traders to verbalize each trade as a scientific hypothesis: we are making an educated guess as to the direction of the next market movement. That forces traders to also identify how they will know their hypothesis is being validated, and how they will know if it is proven wrong. Requiring traders to talk their thinking aloud grounds them in the trading process and allows them to just let the outcomes take care of themselves. I am forever talking to new traders about the importance of distinguishing between losing trades and bad trades. Some very good hypotheses sometimes fail to find support. A bad trade is one that was placed impulsively, not scientifically. My mentor and friend, Victor Niederhoffer, impressed upon me the need to think scientifically about markets. His excellent books are a living tribute to the Galtonian tradition in trading. If you don’t know who Francis Galton is, take the time to read a biography and think about his approach to knowledge. You will learn much about the process of acquiring market knowledge.

Dave: We all have negative habitual behavior patterns that sabotage our success as traders. What are the common negative behavior patterns you have observed in traders?

Dr. Brett: Let me focus on one very common pattern: the tendency to focus on negative behaviors rather than positive ones. Traders generally come to me wanting to discuss their shortcomings: their negative traits, their bad trades, their conflicts. Only rarely do they want to take a look at their successes. And yet, if you think about it, your strengths are all you have to build upon. No amount of reducing negative qualities will, in itself, generate positive ones. Eliminating bad trades will not give you good ones. It is vitally important to look at what you’re doing right in the markets and see how you can build upon those successes. What works for you in the market? What is it that you’re looking at, what is it that you’re doing, when your trading goes well? That will do more than address your problems: it will offer solutions.

Dave: Is there a simple way to identify solutions?

Dr. Brett: First, keep a log of all trades. Make sure you identify the trade direction, size, holding period for the position, and profit/loss. Then at the end of each day correlate those trades with two things: what was happening in the markets and what was happening in your head. Focus on your very best trades and ask yourself: What was the market doing at those times? How was I processing information at those times? You’ll see some interesting patterns. For instance, in my own trading, I found that my best trades uniformly occurred in the mornings and were the result of homework that I had done the night before and observations I made during the overnight, Globex trading session. I had an idea in my head that I was going to be a full-time trader, but the reality is that I traded best when I traded for a couple hours a day, staying task-focused for short amounts of time, and putting large size on just one or two tested ideas. Had I not performed an inventory of my winners, I’d still be trying to fix my busted afternoon trades!

Dave: A unique concept of yours involves helping traders to become their own therapists. I understand that you do not sell any private consulting services for traders, preferring to teach traders to help themselves. Is there a step-by-step system that we as traders can use to become our own therapists?

Dr. Brett: If I were Ed Seykota, I’d probably respond by saying that the first step in the system is to recognize that there is no step-by-step system. Traders in search of change frequently look outside themselves, and the desire for a foolproof system continues this error. We become our own therapists when we realize that we, like the markets, are patterned, and when we become keen observers of our patterns. To the degree that we stand apart from our patterns as observers, we cannot be consumed by those patterns. That simple insight forms the cornerstone of change systems as seemingly different as Zen, Freudian analysis, and the Gurdjieff work. If there is a recipe for change, it is this: 1) place yourself in situations that, in the past, have elicited problem patterns of thinking, feeling, and/or acting; 2) stay mindful in these situations, fully experiencing desires/impulses to respond in the customary (problematic) ways, but consciously making efforts to respond in new ways; and 3) actively rehearse new, constructive ways of responding discovered in this manner until they become automatic. The important thing is to undertake change in the very situations that elicit your problem patterns. Talking about change apart from the contexts in which your patterns occur is not a productive use of time. You can’t change your trading by talking with a trading coach. You can only change your trading during your trading.

Dave: That is fascinating. What is your opinion on the standard self-help books that cram the shelves at every bookstore? Is the knowledge contained within these books beneficial to traders?

Dr. Brett: Some books are quite helpful, in that they provide ideas for seeing yourself in new ways. My own career in psychology was inspired by a book called The Fountainhead by Ayn Rand. Ms. Rand was a master at portraying the human heroic spirit. When I read her book during my sophomore year at Duke, I immediately realized that my mission in life would be to help people find their own heroism. Ideas move the world, and the right books are phenomenal repositories of ideas.

That having been said, I’m not sure that books really provide self-help. They provide ideas for self-help. Self-help is something you do, not something you read. A desperate trader relying on a book is a bit like a starving man seeking sustenance in a menu.

Dave: Trading is truly one of the last refuges of the individual. You are totally responsible for your actions or lack thereof. You talk about seeking the path of least comfort. What do you mean by this?

Dr. Brett: One of the things I teach beginning therapists is that the purpose of working with people is to comfort the afflicted and afflict the comfortable. Most of us are too comfortable with our patterns. We repeat our ways of thinking and feeling mechanically, going through much of life mindlessly, without self-awareness. In facing obstacles we take the path of least comfort; we push ourselves to become more than we are. That is how we build muscles in a gym; that is also how we become great traders. The really good traders are always working on their trading, and when they’re not working on their trading, they’re working on themselves. Nietzsche’s observation, “Under peaceful conditions, the warlike man turns upon himself,” perfectly captures what it means to seek discomfort.

Dave: You stress the importance of having trading rules. Does this mean that the discretionary trader is at a disadvantage to the mechanical or systematic trader?

Dr. Brett: Not at all. I am not at all a mechanical trader, but I do consider my trading to be rule-governed. For instance, I will fade moves to an extreme in a range that do not expand the number of stocks making fresh short-term new highs or lows. If the number of stocks registering fresh two-hour highs or lows expands during a move to a range extreme, I will play that move for continuation. I also have rules for trading different times of day, especially in markets such as currencies, where volatility can vary greatly within a single trading session. Such rules can be tested for their accuracy, but need not be mechanically implemented. I suspect chess players and special forces troops—others making rapid decisions under conditions of risk/reward—similarly blend rule governance and behavioral flexibility.

Dave: Thank you for joining us today. Is there anything you would like to leave our readers with?

Dr. Brett: At root, trading is a function of pattern recognition, and pattern recognition is a function of immersion in the markets. The majority of traders fail, not because of occult psychological reasons, but because they lack such immersion. Part-time traders are as likely to succeed as part-time surgeons or ballet dancers. Frustration with trading is more often a result of trading problems than a cause of them. Nothing in psychology substitutes for the arduous process of absorbing the ever-changing patterns of markets. Psychology helps you make the most of your experience; it does not provide that experience.