Trading is easy. I can do it. I’m smart. These are some of the thoughts that ran through my head before proceeding to blow out several accounts, lose a significant portion of money that I had saved, and go through one of the most psychologically trying periods of my life in which I questioned my competency to succeed at almost anything. The following is a composition of lessons I have learned through loss (and more loss), intensive study to understand risk management and trading strategy development, fooling myself into thinking that I had absorbed these lessons, and then ultimately applying them to my life to change my habits and start making money.
Nothing I’m saying here is new, but perhaps my synthesis of ideas, combined with my past failures and growth will resonate with you in a way where others have not. There have been countless others before me who have also felt the pain of substantial early losses and through that pain and self reflection have been able to develop a successful trading style.
Just use a practice account, duh!
Everyone says use a practice account. While I think this is useful for learning a specific trading platform’s execution to avoid forced errors, if you’re like me, trading without real money is like training with Call of Duty before being dropped into a war zone. Without understanding how your emotions can influence your decisions, you will most likely make very bad emotionally driven decisions once you start trading with real money. There’s something about having skin in the game that completely changes your emotional framework — prompting all sorts of irrational decisions that you are not prone to making when nothing is on the line. If I had to give my earlier self advice that he would’ve listened to, I think the better option would’ve been to trade a very small amount of real money and then scale that incrementally. But even then it wasn’t until the pain of successive blown out accounts that I finally started to make real changes with my strategy and psychology. So with all that being said, what I know now to be the most valuable tool for avoiding emotional decisions is to automate as much of the trade as I can and then create a system of negative reinforcement to prevent my emotional mind from intervening. Automation is an obvious recommendation, but it does not entirely negate the emotional override that has deluded many a smart person into overriding their algorithm.
For those that have purely algorithmic strategies, I would say that practice accounts are more useful in that they allow one to practice the trading execution and get lots of feedback prior to live deployment. However, the same emotional caveats still apply. But how can that be if the system is automated? Well, systems can lose money, systems have errors, and despite all the backtesting and stress testing, the non-stationarity of markets and black swan events can create drawdowns that one may never have anticipated. It is at these critical points that emotions come into play and the lessons of psychology still apply.
Where Do I Make Mistakes?
What isn’t measured cannot be improved. You hear it across a lot of different fields, and it certainly applies with trading. However, we live in an age where data proliferates at an unrelenting pace, so the challenge is not in collecting the data, but in identifying what should be collected and how it should be processed. Since trading strategies and styles vary, I have found tracking a few key areas to be beneficial. I will generalize here:
1. Why
Every executed trade needs a reason or hypothesis to test. For the sake of clarity, the “why” I’m referring to doesn’t imply that there needs to be a causal explanation or fundamental reason for taking the trade. One simply needs a reason for taking the trade and that reason could also be a signal generated from a quantitative system that has no known causal explanation. If this rule is violated, it becomes impossible to address the deeper issues of bad performance, as there is no way to assess the process that led to the trade. Once a “why” has been established, you can then delve deeper into the following:
Decision vs Outcome Matrix
It’s not enough to analyze your PnL from an outcome standpoint due to the inherent uncertainty involved with trading. Were you lucky? Was it bad luck? I have found that the best way to analyze my past trades is through a decision-outcome matrix.
While not a panacea, with the more data you collect, the more you strengthen your confidence about which box you’re in. I would say the two most dangerous boxes are bad luck and dumb luck, as these can evoke emotions that create worse future outcomes. With dumb luck, you risk gaining confidence from positive PnL but with no understanding as to why. The greatest risk here is in a strategy that has systemic risk (like naked options) and allows you to incrementally reap consistent gains until one day they are all wiped out and then some (RIP James Cordier). On the other side, repeated bad luck can really rip into your emotional psyche. The beauty and opportunity in trading is the potential to develop an edge under uncertainty, but one must humbly accept that probability is exactly that, probability. A string of bad trades in a positive EV strategy can happen, and the worst scenario here would be to override your strategy due to loss aversion when your PnL could mean revert in the near future. The biggest caveat here of course is, did your strategy actually have a positive EV.
Competitive Advantage
Do more of what works and less of what doesn’t. This is one of the most underrated common sense statements in trading. Often times we come across a strategy that works and we decide to diversify into other markets or strategies because of the success or monotony from the working strategy. Don’t fall into this trap. Part of cultivating self awareness comes from assessing that we all have limited capital and time, and need to evaluate the opportunity cost of trading across multiple assets, timeframes, strategies etc. More generally, you may have several strategies or spend countless hours trading and improving (hopefully) your system, but is this the best use of your time? If you’re beating buy and hold, dollar cost averaging, or some other benchmark that you’ve set by 1% a year but spend 40+ hrs a week on maintaining that edge, are you succeeding? I like to evaluate edge across three factors: risk-adjusted performance over benchmark, time cost, and emotional stress. Risk-adjusted performance over benchmark is the easiest to evaluate — it’s self evident whether the strategy is performing or not. The other two factors are more nuanced. If you don’t know what your time is worth, I suggest making this your top priority in life, or risk spending decades of your life trying to work, optimize, or focus on things that don’t have the highest marginal return to you. This doesn’t exclusively imply a monetary value, it could be multifaceted. More importantly it’s the question of whether you have a gauge of what matters to you and some value system to assign to it with respect to time allocation. By far the most ignored factor in calculating edge is emotional stress. What’s an extra 5 or 10 percent return if it makes you go insane, destroys your relationships, or causes a host of other psychosocial problems. Like the time cost, this is a very individualized measurement, but worth thinking about and quantifying where possible. Even just tracking moments of emotional distress can pay huge dividends in understanding the psychological cost of your current strategy or whether you can cope with trading in general.
No One’s System But Yours
Since you don’t have the experience, emotional framework, or intellect of someone else, how can you expect to clone their system and perform the same? As with many other important aspects of life, there are no panaceas when it comes to trading. No one is selling a holy grail alpha strategy (by definition this is a contradiction). If you are a discretionary trader, even if you were to adopt someone else’s strategy, it ignores the psychological fit of such a strategy and the costs associated with it. Your guru may show you a positive ROE over a specific timeframe, but could also have had a 40% drawdown within that time period. Could you handle that? Would you be able to stick with the system and not be negatively influenced to change the strategy? These are things that someone selling you a way to make money won’t answer because it is not in their best interest.
For quantitative strategies, the problem set is different but nevertheless exists. Code is certainly easier to reproduce and scale so going to the alpha problem above, if it was really successful the incentive to sell it to the crowd would have the paradoxical effect of reducing the performance of the signal. But let’s say for the sake of argument that someone is selling some useful system that will help you improve your performance somehow (already skeptical at this point). How would you evaluate such a system without the source code? It’s not that you would have to understand the underlying causation for why the trading system has a positive expectation but at the very least would mean you have to know what the risks of the system are and how to change it if it cannot learn on its own. Such a proposition is gambling at best.
Getting to Maybe: The Non-Stationarity of Most Things
So after all this hard work, painful losses, and emotional soul-searching, you finally find a system that has an edge. Congratulations, you’re done! If only that were the case. While finding a strategy that has a positive EV is a monumental feat, with few exceptions, it is rarely something that will go on in perpetuity. While human behavior is largely constant in a cyclical nature, almost everything else is constantly changing. The good news though is that once you find a way to develop a strategy, you can use those tools to continuously iterate and find new strategies with positive EV.
2. Emotional state
As mentioned above, addressing your emotions is an often neglected aspect of trading. Who you are emotionally affects how you trade. I thought for the longest time that I could divorce my emotions from trading and it came at a high cost. You are not a robot. Whatever you do to fight your emotions from expressing ultimately manifests in some other way. With that being said, one of the most rewarding parts of trading for me has been getting to know my emotions and finding a strategy that complements my emotional framework.
Getting Off Tilt
Strings of losses can happen, even with a positive EV system. How you handle those losses, particular successive strings or larger than usual losses (because of slippage, forced errors, etc) is probably one of the most critical aspects of trading. The temptation to revenge trade, tweak the system, or develop a toxic mindset of “making it back” can all lead to even worse outcomes. You must fight these impulses however you can. Get away from the computer and find a distraction (preferably a healthy one), but don’t dig the hole any deeper, because, believe me, that hole can go VERY deep. Stepping away is difficult because it feels so counterintuitive. “I must work harder”, “I must do something soon”, “the market will revert” … I’ve found myself saying all of these things in a desperate attempt to stay glued to the market, and most of the time it was counterproductive and compounded the already larger than average losses. Part of this stems from the emotions we feel from realized losses, especially if we judge ourselves too harshly when we make a mistake as opposed to losing money with good process. The key to getting back on track is to get out of this emotional state. Initially what I would do is go for a walk. While I found this helpful early on, over time the walks consisted of me perpetually obsessing about the market event that had just occurred and the walk no longer helped in taking me away from the market. Eventually I started using the Heart Math Inner Balance which monitors your heart rate variability (HRV) and assists in getting into a meditative state with a visual display. The best part of devices like these is that they store your data from each session so that you can see your initial HRV and the progression that it takes through the session, while also being able to take notes about your initial state. I highly recommend using some type of biofeedback tool to better understand your emotional states and how to shift from one state to another. Another tool that has helped calm me from an emotionally triggered state is listening to binaural beats. There are many free samples of these online that you can listen to, so try out several different frequencies and see which ones get you into a calmer state. Lastly, I have found that switching the physical environment in which you trade can sometimes help in shaking you from the emotional triggers. If you trade in a particular room, change the room. Try standing instead of sitting. These sound trivial but it’s surprising how the emotional cues can get tied into how we physically execute the trade. There are many tools like the ones mentioned here and the important thing is to try to see which ones work the best for you and can be implemented consistently.
Fear Of Failure & Realized Loss Aversion
There is a story I read recently about a man named Brian Stevenson¹ who was holding onto the tethering rope of a hot air balloon as it was inflating. When the balloon began to inflate and rose from the ground, others began to let go of the rope but Brian held on. As the balloon began to climb, the bodily risk from falling also increased — perhaps some bruising from a 10 foot fall, maybe some broken bones from a 20 foot fall — but Brian held on and eventually let go at 300 feet where he fell to his death. While extremely tragic, I think this story is one of the best analogies that describes how difficult it can be to admit failure by going from an unrealized loss to a realized loss. Taking a loss that eliminates your market exposure is a known outcome. No matter how painful or how large, you have survived. I cannot stress this enough. Continued market exposure in the hope of reducing the loss is a very dangerous decision no matter the outcome, especially if there is a ruin factor. In thinking about ruin recently, a friend reminded me that there is not only financial ruin (in which you blow up) but that there is also psychological ruin in which one has not lost everything but has suffered a drawdown below the threshold at which they can perform successfully. The latter is arguably more important as it tends to be experienced more often than financial ruin in part because it is not always known in advance where that threshold will be felt.
Realized loss aversion affects us all differently, but knowing how to eliminate or control this bias is key to improving your risk management. However, in the unlucky event that find yourself in a position that has been managed poorly and overridden by emotional distress, just think of the hot air balloon and ask yourself, do I want to keep holding on or should I just let go and take the bruises and broken bones? You cannot keep playing the game if you are dead.
Self Talk: My Relationship With Mr. Market
Like many of the points laid out in this post, understanding and improving your self talk when trading is widely applicable to every aspect of your life. What do you tell yourself when you lose a trade? Do you blame the market? Do you blame yourself? Or do you just keep on moving to the next trade? All of this has to do with your own sense of agency. Do you feel you are making decisions or do you feel that you are merely reacting to the decisions of the market? The distinction is critical. Nevertheless, it’s not just about accepting responsibility for the trade or the system that you designed, for if you are too hard on yourself you end up hindering your ability to move on productively. Dwelling on a past trade only makes sense when reflecting on what went wrong and using that reflection to improve the process in the future. Beyond that, it is a toxic thought. Depending on who you are emotionally, this can be extremely challenging. Part of it goes back to the decision-outcome matrix. Losses that result from a system of good choices should be taken in stride whereas losses that result from poor choices should be looked at through a more critical lens. But again, YOU are in control of these decisions. The market may be smarter than you, but you have the ability to choose how you interact with it at all times. Remember that.
Extrinsic vs Intrinsic Motivation
Another often overlooked point is why are you trading. Everyone wants to make money, but those who succeed and persevere tend to be those that are curious in understanding and improving the process, not the ones who have a singular obsession on the external scorecard. Focusing on the extrinsic with no internal motivation can lead to emotionally trying times when things don’t go your way and can compound the stress of losing money because of the dependency on outcome. Intrinsic motivation can also help in market manias in which others around you are making more profits than you but also taking more risk. If you know internally who you are, how you trade best, and your base motivations, this can insulate you against the temptation to chase a risky market behavior because of the short term gains made by those around you.
3. Risk Management
Uncertainty should be one of the factors that informs the level of risk. I see a lot of traders advocating for a fixed percentage of risk relative to their total equity when it comes to placing a trade. While not a bad way to start trading to protect against strings of bad luck, overtrading, or emotionally increasing risk, I find the set uniformity of risk to be suboptimal, as to me it implies that every trade I take has the same risk profile, which is not the case. Setting risk is a function of confidence. Taken to the logical extreme, a trade that involves inside information or other types of “sure things” should incur maximum risk, whereas a trade that has no confidence should not be taken. Since we are dealing with uncertainty over the long run, determining confidence is a nuanced decision that can only be improved through better data collection of past trades. The longer you trade, the better your confidence measurements should inform how much risk you are taking.
Your risk should also be defined where your hypothesis is invalidated, not where your pain threshold is. If these numbers tend to diverge, then it’s best to rethink how to align your risk with the logical invalidation of your trade idea. This again goes back to the problem of fixed risk. Your trade could be stopped out, but the idea could still be valid. This can cause one to get stopped out multiple times and lose even more money than if they had just placed a stop where the idea was invalidated, even if the initial risk was higher than the fixed risk setup.
Kelly Criterion
I have found that one of the best tools for optimizing trade size and risk is the Kelly Criterion. For those not familiar, the Kelly Criterion is an equation that allows you to plug in the probability of success and computes the percent of your bankroll that you should risk. I should note that this formula is used in many variations with gambling and that the best way to implement it in trading is to use some fraction of the formula to test it out and then scale up (or down) accordingly. It is worth reading about in detail if you struggle with determining trade size and efficient risk especially if you encounter a string of material losses. It’s important to note that the Kelly Criterion is a very powerful tool, but without a successful trading strategy, the best it can do is slow the rate at which you lose money.
While extremely helpful, there are a few caveats with the Kelly Criterion worth mentioning:
1. It doesn’t take into account a minimum trade size, meaning that if your bankroll drops significantly, the Kelly Criterion could reduce the recommended trade size to less than the minimum order and you would not be able to trade.
2. It doesn’t factor in changes to volatility. The past confidence data that you are feeding into the Kelly Criterion may have been during a different volatility regime than the current one, and the trade size will not reflect this change.
3. Games are known risks whereas trading is based on approximations and unbounded uncertainty. Since one is always dealing with estimates of confidence when using the Kelly Criterion, this is the reason why it is best to always start with a fraction of the Kelly Criterion’s recommended position size and play with different fractions before scaling higher.
Kelly criterion is also useful with expenses. If expenses are a fixed cost of your life, how does that affect your trading when you are on a losing streak? “I must make X in order to sustain my lifestyle” is a dangerous emotional framework. If you have the opportunity to use the Kelly criterion as a function of both your capital allocation and expense allocation, it will allow you to live with a degree of freedom that most people do not have.
Margin of Safety
There are no contradictions in reality.² Models can be wrong, reality cannot. Don’t fit reality to your model, especially when encountering extreme events. Extreme events happen and we tend to undervalue the premium on liquidity and other risk considerations at these critical points. It doesn’t matter that most of the time this consideration could be irrelevant because you don’t know ex ante when it will be relevant. This is mandatory for any position that could have a ruin factor and a worthy exercise in all other cases as well.
Know Thyself
No habit exists in isolation and it’s been said many times that if you want to know who you really are, learn to trade. There is something about being tried emotionally by winning and losing money with such objective and rapid feedback that can allow you to grow as an individual if you are intentional with the process. Many of the lessons laid out in this post, if implemented, will also spill over into other parts of your life. This principle is a double edged sword, as many of the bad habits and cognitive biases that we possess while trading also exist in other areas of our life as well. Trading is both a self discovery of these traits and ultimately, with lots of work, a transformation into the person one wants to be.
To end, I wanted to briefly delve into habits as I have found that building good habits is the key to improving one’s trading and life. I have struggled with improvement at many times in my trading journey and have learned the following through that struggle:
How to Enforce Habits
In trying to improve my trading decisions and avoid commonly identified mistakes, I read countless books, online material, and talked to many risk professionals about how to approach things differently. While all of this information was extremely valuable, I continued to make the same mistakes. Even worse, I had deluded myself into thinking that because I had read or learned how to correct the mistake that I was somehow better off, but the beauty of trading is that your PnL doesn’t lie. It truly is the best source of feedback. If you are really implementing positive changes, your PnL should reflect this (caveat: on a specific time horizon that you set, it may not reflect this right away so setting a boundary time condition is important based on time metrics that matter in how you assess your performance) and mine was not. Despite implementing positive reinforcement tricks and even some light forms of negative reinforcement, I eventually regressed back to my faulty decision making when the old emotional triggers came back. Thinking about how I would act from an emotionally neutral perspective was very different from how I acted when my emotions ran hot. I was my own worst enemy. Sometimes I would implement multiple hurdles to delay me from making an impulsive decision, but all this would do was make me good at going through the hurdles quicker each time and yield the same result. The path to improving this was arduous and painful. I tried numerous different behavioral modification techniques over a six month period of time before finally settling on a habit tracker app (Repeat Habit Tracker), a consistent weekly error analysis, accountability triggers with those close to me, and a decision making process designed to slow down my execution. Trying many tools here is highly encouraged because some may only work some of the time or only in certain situations, so it’s best to have a few in your back pocket should some fail or become less effective.
Barring a back office risk department, a buddy system can really help as it gives you the critique of someone else when executing a trade. This is extremely valuable in identifying your biases, what your state of mind is (are you on tilt), etc. Finding someone who can play devil’s advocate, especially if they have differing internal biases is something I have found to be really helpful, as it forces you to think more critically about your idea and how best to defend it. Like some of the other methods mentioned above, this accountability system can also be applied to other areas of your life.
Remember: you don’t have to be the best, the smartest, or right all the time, you just need to make money on a risk adjusted basis. And you just might learn something about yourself along the way.
Feedback, both critical and otherwise, is appreciated.
[1]: Story excerpt from Christopher Ryan’s book Civilized To Death
[2]: Quote from David Deutsch’s book The Fabric of Reality
