Can You Neutralize Emotions as a Trader?
This article originally appeared in the Ask Jack column on Bidnessetc.com. Each article answered a question submitted by readers.
Do you think it’s possible to use self-suggestion to have neutral emotion while we have a position? Is there anything to do to change our subconscious behavior or should we just bypass it, along the lines of Bruce Kovner who said “I know where I’m getting out before I get in”?
Your question assumes that emotions are detrimental for trading, and I would certainly agree. Many, if not most, of the errors traders make can be tied to emotional influences. A partial list of emotionally induced trading errors might include the following:
- Getting into a position in a spur-of-the-moment emotional response to market action rather than as a consequence of a planned trade.
- Being influenced by greed to put on positions that are too large—a size such that fear drives the decision process.
- Panicking out of positions, even though the planned exit point has not been reached.
- Taking marginal, or even no-edge, trades due to impatience.
- Getting out of winning trades without good reason because of a fear of giving back gains.
- Holding on to a losing position for “just a little bit longer” in the hopes it will come back.
In fact, Bill Eckhardt, the former partner of Richard Dennis and the co-trainer of the Turtles, whom I interviewed in the New Market Wizards, goes so far as saying that our emotions are so poorly attuned to trading that people will make trading decisions that are worse than random. He is, in effect, going one-step beyond the efficient market proponents who say that a monkey throwing darts at the stock quote page would do as well as the professional money managers. Eckhardt is saying that the monkey will do better because at least it will achieve random results. The managers will be so hampered by human nature, which has evolved to seek comfort—a characteristic that is detrimental to trading—that they will make trading decisions that have negative value relative to dart throws or coin tosses, which merely have zero value.
So, I think you are on the right track in seeking to eliminate the influence of human emotions in trading. Can you neutralize your emotions, through “self-suggestion” or other means so they don’t impact your trading? The answer to this question is outside my area of expertise. I don’t have any training in psychology, and I don’t know if there are methodologies in this discipline that might be helpful in eliminating, or at least reducing, the influence of emotions in trading. But even if there are, your question suggests a more practical solution: Adopt trading rules that short-circuit the influence of emotions. As you indicated in your question, Bruce Kovner’s rule of knowing where you will get out before you get in is a perfect example of a method to circumvent the influence of emotions on trading. Many of the emotional pitfalls in trading are directly related to exiting positions. If you decide on an exit price before you place the trade—and have the disciple to stick with that decision—you effectively avoid all the emotionally influenced mistakes that lead traders to hold onto losers too long and exit winners prematurely.
By the way, you can enforce the discipline to stick with the predetermined exit plan by placing the liquidation order at the same time you place the entry order. This exit order can be either a good-till-cancelled (GTC) stop to control the loss side or a GTC one-cancels-other (OCO) order that combines both a target and a stop. You may wonder, Can’t the trader still be subject to emotions by cancelling these exit orders? Theoretically, yes, but the difference is then it requires an action to undo the preplanned exit. If the trader does nothing, which is far more likely, the exit plan will be enforced, and emotions will be banished from the liquidation decision.
Placing an exit order upon position entry is an example of using a “nudge” to elicit the desired behavior, as popularized by Richard H. Thaler and Cass R. Sunstein in their book, Nudge: Improving Decisions About Health, Wealth, and Happiness. As an example of using a nudge to achieve a desired outcome, making participation in a retirement savings plan the default option (instead of requiring employees to take action to opt in) will result in much higher employee participation in the savings plan because an action is required not to participate. As another example, making organ donor participation the default option—that is, an action is required to opt out of being a donor—leads to tremendously higher organ donations. In the same way, placing the exit order (e.g., stop-loss order) at the time of entry will result in much better adherence to risk management rules because an action is required to cancel the exit order. This approach takes advantage of the natural human inclination to stick with whatever the default option is and not make a decision to change it.
You are probably thinking, OK, I get it about neutralizing emotions on trade exits, but what about the impact of emotions on trade entry? A similar approach would apply here. Establish a trading plan for trade entry and don’t allow any trades that are not dictated by the rules. If you are using a systematic methodology, defining specific entries is straightforward. But even if your approach requires discretionary analysis and evaluation for defining a trade, you can still spell out all the rules you follow in deciding whether a market offers a trade opportunity. You would then analyze each market based on those rules and only take a trade when the requisite conditions—as you have defined them—have been met. Impulsive trades—read trades born of emotional influence—would be prohibited. Of course, you would still need the discipline to not take any impulsive trades—that is, trades not based on your predefined trading rules.
So rather than trying to control your emotions through psychological exercises and training—the hard way—eliminate the influence of emotions on your trading by adopting the following three rules pertaining to entry, exit, and prohibited trades.
- Trade Entry Plan—Define the analysis procedures and the rules that determine whether a trade opportunity exists in a given market and, if it does, what the entry price would be. Note that the sizing of the position—another potential emotional pitfall—would be precisely defined by the trade entry plan as well.
- Trade Exit Plan—Decide on the exit plan before trade entry and enhance the likelihood of compliance to this plan by placing an exit order at the time of entry.
- Prohibited Trades—Everything else. Maintain the discipline to never take any trade that fails to meet either conditions 1 or 2.
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