Thursday, November 15, 2012

The Trader's mind VIII - The basics of emotions

What exactly are emotions and why do we feel them?
Emotions are a form of self-communication. When our ancestors were primitive creatures facing an uncertain world, the mind would sense imminent danger and opportunity and activate the physical changes need for immediate action.

Obvious examples are when a predator is sensed, the body needs to quickly switch to fight-or-flight mode. Similarly, when food or mating opportunities are sighted, the mind becomes alert and eager.

Practically all your emotions and behavior stem from millions of years of survival adaptation. In the ancient world, reacting to good or bad situations immediately and appropriately meant life instead of death. Modern humans rarely face such challenges and have developed some degree of control over their emotions. Occasionally, the limbic system keeps escalating emotion and may be hard for you to control it.

Emotions are about expectancy and preparedness. Events that you are well aware are likely to happen and are prepared for do not cause strong emotional reaction. For example, if someone close to you dies suddenly, you may feel shock and dispair and cry for days. On the other hand, if they were terminally ill for a couple of years, their death may actually bring you closure and relief instead. Similarly, if you do not win the lottery, you don't really go into an emotional fit because you never expected to win. But when you win, you are delighted.

Events that you are unprepared for can cause your body to go into "just do something" mode. For example, countries where there are fire-prevention drills see systematic evacuation on a fire alarm while those without may see stampedes.

What does this mean to me as a trader?
When you are watching the market, your mind is in a mode similar to the mind looking for mating opportunities. You'll probably hit on every potential trade till one works. Once you are in a trade, you watch anxiously for prey or potential danger. This compels you to exit trades early with no loss than to stand your ground and be stopped out. When you are stopped out, your mind acts like a parent gazelle whose calf has been attacked by wolves.. Your mind goes into "just do something" crisis mode. This is also called classic tilt mode, when a couple of losses force the trader to abandon all risk management and trade management rules and just try to get his money back.

Lets call these three emotions lust, fear and desperation. Of these desperation is the hardest to control. Your mind is in a state where its willing to go to great lengths and take severe risks to get back its precious young. You will do the most damage to your account in this state. Fear prevents you from following through with your trading plan and you will end up with small winners and large losers and you will be a net loser over the long term. Lust traps you into poor trade after poor trade and your account will bleed slowly from a thousand cuts.

So how do I address this in my trading plan?
Once you understand the forces driving you, you can work on managing them. One way to manage this is to try to observe yourself and see how you act. The very act of observation will change the observed (the observer effect).

Desperation: When you are in desperation, you are unlikely to be able to observe yourself and think rationally. Having someone else observe you will often help with a reality check. This could be a mentor or trading buddy. Its important you disclose all your trades to your observer or it wont have the full effect. Your trading buddy can watch out for signs of poor emotional state and support you with feedback. Having a maximum trade count per day and a maximum loss limit will greatly protect your account from an untimely demise.

Fear: More important than entering a trade is what you do after you enter. If the trade was ill-advised and caused by chasing an unexpected large bar, you should probably just exit at the best possible price. If the trade was a legitimate setup, you need to follow your trade management with discipline. Only discipline will help you overcome fear and develop confidence. Making trade management a mechanical affair with fixed stops and targets frees your mind of fear.

Lust: Before you enter a trade and before you have encountered a losing trade for the day, your mind is best prepared to make clear judgements. If you can read the market reasonably well, take every clear setup until you hit your daily loss limit. When starting out, your read of the market will naturally need a lot of improvement and losses are routine. What you do not want to do is to react to unexpected moves. Any trade you took on an expected move is far more likely to be successful than a trade taken on unexpected moves. Tame your desire to be part of the action. Only take well defined setups. Start with one setup and add more with time.

Naturally, these are not the only emotions you face. Greed, which makes you hold well beyond your expected target is another great killer. Hope, which persuades you to loosen your stops prevents you from developing any kind of discipline. All of these need to be understood and addressed.

In summary, realize that your emotions are telling you that an event occurred that you did not expect and were unprepared for. Learn from the event and incorporate it into your trading plan rather than reacting to it immediately by trading. Use understanding, preparation and discipline to tame your emotions.

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