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The Psychology of Trading
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Psych yourself out of the market's rut
Market psychologist Brett Steenbarger checks in with six tips for trading in this range-bound market. His first prescription? Humble yourself.
By Jon D. Markman
Eight months gone, and the broad market is basically flat for the year. All those trading days, all of the experts talk about the best strategies and sectors, all those weekly reports of Dow points up and Dow points down, have brought most stocks to an absolute standstill.
If youre a trader -- or even an investor -- the futility of it all is enough to make you want to pull up the bedcovers and sleep a bit longer in the morning. But perhaps there is something to be gained in a period of net slop for the big indexes. Maybe we should take advantage of the multi-month lull in the action to reflect on our mental approach and refine our technical methods.
Few are better at peering inside the heads of traders than Dr. Brett Steenbarger, the former New York clinical psychologist and university professor who gave up his hospital whites two years ago, first for a career as a short-term futures trader and then, soon after, as in-house shrink for a major Chicago futures-trading firm. He published an illuminating book in 2002 called "The Psychology of Trading," but says he has since learned a lot more as hes worked side by side with some of the most successful pros in the world.
His prognosis for an improvement in your approach to this eerily range-bound market?- Learn to use your emotions, not avoid them.
- Trade the time frame thats right for your personality.
- Adapt your style and expectations to the conditions of the market.
- Distinguish between a good trade and a profitable trade.
- Avoid perfectionism.
- Develop a personal success template."
- Focus on the process to be consistent.
Investing by gut feel
The good doctors most surprising finding is that many pros flourish without using any of the tools most commonly discussed in books and the media: They dont use technical analysis, quantitative analysis, accounting, discounted cash flow analysis, earnings projections, insider transactions or macroeconomic conjecture. Instead, they trade intuitively off a feel for the market honed during long hours of market observation and participation.
Forget about unemotional investing. Trading superstars are very aggressive, very emotional guys capable of using their unusual perceptive capabilities to process information quickly and make split-second decisions, Steenbarger says. They have an intelligence of a sort, though you would not necessarily say they are book-smart.
Since no schools teach this stuff, top trading companies start with men and women who meet the personality profile of a riverboat gambler -- definitely not MBA types -- and then train them to hone their instincts to take advantage of the repetitive flat-footed reactions of their competitors. You cant be analytical -- no big-picture stuff, he says. Youve just got to know when to go for the kill, when to add aggressively to your position when its winning, rather than taking profits. In other words, just as in the days of Wyatt Earp, theyre the quick and the dead.
Tips for the Average Joe
For those of us who dont have the tools or desire to be a gunslinger in the bond or crude-oil pits, here are a few ideas to work on over the remainder of the year:- Adapt to the market. Steenbarger says he sees many traders who want to trade this range-bound market as aggressively as if it were a trending, momentum market; they keep trying to buy potential breakouts or short-sell potential breakdowns. But they just get chopped up. The problem is that the big ego required to be successful gets in their way. In times like these, he says, traders need to subordinate themselves: Be a bit more humble, and just take what the market offers. Expect breakouts and breakdowns to fail, and play excursions out of the range only for a reversion back to the range.
- Sometimes the right play is no play. The successful poker player knows he isnt at the table to play cards, but to win money. He knows when to hold em and when to fold em. In the market, periods of extremely low volatility, such as the weeks before three-day holidays or virtually the entire summer, hold scant opportunities for traders. Dont force it. It may be best just to hold cash and wait for better, higher-volume opportunities.
- Set process goals, not P&L goals. Setting ambitious goals to make a certain amount of money in a non-trending market may put you on a path to disaster. It takes your attention away from trading well -- doing your homework and following your rules. Its like a baseball player who sets a goal to hit 30 home runs rather than to execute their swing properly. If they fall off pace, theyll start to press and swing wildly instead of focusing on a smooth, solid stroke. The most successful traders are ones who develop a set of rules that work in most markets, and then painstakingly follow those rules day in and day out without regard to the precise amount of money theyre making. Set a goal of consistency, not of dollars.
- Avoid the urge to be perfect. Many traders look back over a week or month and see trades they feel they should have done, or positions they should have pursued more aggressively. Steenbarger finds this attitude can be damaging. You are psychologically translating a modest success into a frustrating failure, he says. Traders dont develop confidence by finding fault. Fault-finding often leads to the dangerous step of revenge trades, in which you try to make up for a perceived past failure by pushing the next trade twice as hard, regardless of merit. Good traders accept missed trades and underleveraged trades as a natural part of the lifelong learning process.
- Develop self-knowledge by creating a success template. Steenbarger says his trader-patients always want to talk about their losers rather than their winners. He recommends they develop a solutions focus by dwelling on their winners while still acknowledging their losers. To start this process yourself, write down the one thing you did best each day in the market and which you want to repeat tomorrow. Likewise, write down the biggest mistake you made each day, and wish to avoid tomorrow. If you keep up this simple two-entry diary, and review it regularly, you will be on the path to achieving self-knowledge and developing the ability to observe and change your behavior. Change starts slowly, but then it gets momentum and starts turning faster and faster, the psychologist says.
- Collaborate with a colleague or mentor. Its useful to work with someone who can help you build self-awareness. Not in a didactic, teaching environment like a classroom, but in a self-reflective environment. It could be two traders in the same office, or someone on the phone or over instant-messenger with whom you can exchange ideas with goodwill and honesty. Talk about what worked and didnt work each day or week, and probe each others comments without bravado or self-flagellation, as if you're in a group-therapy session.
My approach
Personally, I have found my participation in Strategy Lab helpful in my development as a trader in this difficult year. Forced to make trades under the watchful eye of the public, the Lab has forced me to develop the qualities of consistency and self-observation. Ive found that I do best when I dont try to worry too much about the direction of the overall market, but rather limit my tradable universe to stocks near their 52-week highs rated 9 or 10 by the MSN StockScouter system, and then focus my purchases on ones that have traded sideways for a week or two within an overall uptrend. I also have learned to hold onto stocks as long as possible and avoid unruly biotechs completely.
Click here for the screen that I use (you will have to download the MSN Money Investment Toolbox in order to view the chart). Heres a list of the 15 names that come up now. This strategy works for me and my personality, but it wont be right for everyone. If you can explain, in two sentences or less, a simple, consistent strategy that works for you, e-mail me at jon.markman@gmail.com; Ill collate and publish some of the best submissions in a column later this fall.
| Top-rated stocks near year highs | | Company | StockScouter rating | % chg YTD | 9/3 close | Industry | | Qualcomm (QCOM, news, msgs) | 10 | 42.7 | $38.49 | Communications equip | | Autodesk (ADSK, news, msgs) | 10 | 79.9 | $44.21 | Software | | Ispat (IST, news, msgs) | 9 | 206.0 | $27.14 | Steel | | SouthTrust (SOTR, news, msgs) | 9 | 27.4 | $41.70 | Regional banks | | Occidental Petroleum (OXY, news, msgs) | 9 | 26.3 | $53.34 | Independent oil & gas | | IMC Global (IGL, news, msgs) | 10 | 64.5 | $16.33 | Agricultural chemicals | | Norfolk Southern (NSC, news, msgs) | 9 | 23.8 | $29.27 | Railroads | | Maverick Tube (MVK, news, msgs) | 10 | 61.0 | $31.00 | Oil & gas equipment | | Grant Prideco (GRP, news, msgs) | 10 | 49.2 | $19.43 | Oil & gas equipment | | Black & Decker (BDK, news, msgs) | 10 | 45.7 | $71.88 | Small tools | | Intuitive Surgical (ISRG, news, msgs) | 10 | 57.7 | $26.95 | Medical appliances | | Denbury Resources (DNR, news, msgs) | 10 | 66.1 | $23.11 | Independent oil & gas | | Southwestern Energy (SWN, news, msgs) | 10 | 53.0 | $36.56 | Independent oil & gas | | Paxar (PXR, news, msgs) | 10 | 61.3 | $21.61 | Business services | | Wilshire Bancorp (WIBC, news, msgs) | 9 | 69.5 | $32.45 | Savings & loans |
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Fine Print
Ed Seykota, a trader who gained fame as one of the featured professionals in the Jack Schwager books Market Wizards, has developed a concept of regional trader mutual-assistance cooperatives called trading tribes. Visit his Web site to learn more. Another good site to help you explore the inner world of trading is Innerworth.com. My own support group consists mainly of a small group of veteran traders and friends like Terry Bedford, Richard Rhodes and Mr. P, with whom I exchange instant messages all day. Until Steenbarger mentioned it, I hadnt realized that these chats were a form of ongoing therapy, as well as opportunities to trade ideas. Steenbarger maintains a daily trading Weblog at http://www.brettsteenbarger.com/weblog.htm.
In my column last week, I left the impression that dividends from real estate investment trusts got the same favorable tax treatment as dividends from common stocks. That wasnt what I meant to say, and of course its not true -- sorry for the confusion. I still think, however, that REITs are likely to benefit from a second Bush administration.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jon.markman@gmail.com; put COMMENT in the subject line. At the time of publication, Markman held a position in Paxar.
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