TRADING PSYCHOLOGY 101: RECOGNIZING AND CONTROLLING EDS
This article also featured on TheStreet.com
The battle with yourself is never-ending. The more you become involved in activities that tend to press your emotional weak spots, the more you will experience inner-turmoil as you are delving into an area of the psyche that is uncomfortable being in the spotlight. Activities that involve speculation of any type, whether in the stock market, poker, sports handicapping or horse racing will involve diving into those emotional dark spots (EDS for the purposes of this article) on a fairly consistent basis. In fact, what is at the core of many traders or investors frustration during their first 5 years in the financial markets is the fact that they are not able to resolve the inner-conflict that develops when you probe those emotional areas that enjoy remaining shrouded in darkness.
I'll give you an example of this conflict to illustrate the point. Let's say that you have Joe Investor. Joe enjoys trading and investing in the stock market on a regular basis. He has been at it for a number of years with mixed success. He is cognizant of risk, which has enabled him to avoid any stupendous blowups to date. He finds himself consistently getting into positions too late and out of positions too early. He trades based on a combination of technicals and fundamentals.
Day 1: A trading opportunity arises in the stock of XYZ corp. trading at $15 per share. Joe Investor decides that there is an opportunity for 20% upside and takes a position at $15 per share during the first hour of trading. At the market close, XYZ corp. is trading at $14.90. Although it would have been nice to close the first day with a profit, Joe Investor remains comfortable with the trade. He goes to sleep that night thinking of how good it is going to feel when XYZ is trading at $18 per share.
Day 2: XYZ begins drifting downward right from the open. This is beginning to make Joe uncomfortable, but nothing that is causing him a great deal of concern. Past mid-day, XYZ is trading at $14.35. The pressure is beginning to build on Joe Investor. His mind begins accessing his EDS (remember? emotional dark spots) creating great turmoil from within. Despite this inner-conflict, Joe takes another look at the chart and sees a great deal of support around $14.25. He sees that the CEO of the company was recently out with some very positive words. He takes solace in these two facts. He goes to bed that night thinking of how nice it will be to be able to get out at between $15.50 to 16.
Day 3: XYZ continues falling and pierces right through support at $14.25. Joe begins panicking, which forces him to delve deeper into EDS. At this point, he is completely vulnerable. He is subject to decisions that will no longer involve logic. The inner-turmoil he is facing that have come as a result of constantly opening the door to EDS have made him into a bowl of Jell-O. XYZ closes the day at $13.90. Joe goes to bed that night thinking of how wonderful it will be to escape with a .25 cent loss. He will sell at $14.75 when the opportunity arises.
Day 4: XYZ begins the day with strength, as it moves above $14.20. Joe becomes somewhat hopeful. Perhaps $14.75 or maybe even $15 would be a possibility. By mid-day the trend reverses. With an hour left in the trading day XYZ is trading at $13.60. The constant opening and closing of the door to Joe's EDS has made him into a mouth-breathing shell of his former trading persona. He wants to shut the door on his EDS permanently. The pain of accessing it so many times over a 4 day time-span has left him exhausted. He exits the position at $13.45. Game over.
The key day in this entire scenario is day 2. During day 2 Joe accesses his EDS. Once his EDS has been accessed, he is no longer capable of making correct decisions. It tilts the balance, so to speak, between reasonable trading judgment built on the back of experience and emotional trading judgment dictated by his EDS. This creates an inner-conflict or battle between the experienced self and the emotional self. As soon as this battle begins, you begin functioning at a significantly lower level of emotional reasoning and well-being. This will lead to incorrect decisions being made at the most inopportune times. You are no longer functioning anywhere near full emotional capacity.
How does one know when the door to their EDS is being opened? It comes in different forms for different traders. I have heard of traders having physical reactions to it (most famously, George Soros with his backaches when in a bad position). I have heard of traders hearing a voice in their head telling them to get out. I have heard of traders who become irritable and moody when the door to EDS is opened. Every trader or investors reaction is different. More importantly, it takes every trader and investor a good amount of time before they are able to correctly judge when they are in a state brought on by EDS.
Ways to combat your EDS are as follows:
1. Plan your trades or investments. Do not deviate from the plan. The moment you do, the door to EDS is opened.
2. Plan your trades around your familiarity with your emotional capacity for risk. If you are risk averse and attempt to risk 15% on a trade, you will constantly be accessing your EDS, whether you like it or not. Don't plan your trades without knowing your tolerance for risk. The whole goal here is to keep the door to your EDS closed.
3. Remain in emotional balance throughout the trading day. Should something aggravate you outside of the trading arena, it will bring you within a footstep of EDS's door. Keep external conflicts as far away as possible.
Emotional control in the field of speculation is the primary reason the failure rate is so high. The financial markets have a tendency to go after human weakness with pinpoint precision. Think of the markets as water and traders as a dam attempting to contain the water. The more cracks you have as a trader, the sooner the markets will find the cracks and make your efforts fruitless. Even those of you with few cracks will allow the water to seep through at times. Recognizing EDS and attempting to combat it will go a long ways toward the goal of making sure that small cracks don't become enormous gushers.
