Stock Trading

Stock Trading Basics – Mental Management

The Thinker by Rodin

Here is a question for you: if you think with your mind, how can you control it? It’s kind of like grabbing a ruler to measure a board of wood and the ruler grabs you back.  And how can you measure the wood when the ruler that is grabbing you back is also sawing away at the end of the wood too, throwing all of your numbers off and messing up your plans? Yet, despite this challenge we still need to do what we can to control our minds if we are to have any trading success. An implicit part of success, after all, is erasing failure i.e. tearing down of bad neuroses and emotional reactions that get in the way.

In my last article I talked about the various mental shortcuts that our mind uses to make sense of the world, and the emotional problems that result from these errors. Today, I’ll go over some practices that can help overcome these obstacles.

The Internal Observer

One trick that I’ve found helpful is called “The Internal Observer”, where you try to stand outside of yourself temporarily to get an objective view of the situation, i.e. you imagine yourself as different person who watches what you do and offers commentary. By dissociating yourself from your immediate situation, the emotional swings that affect your judgement and drive you mad become less dire. It gives you a chance to breathe, and once you have that opportunity, you can break out of the cycle. For example, before I ever put on a trade I imagine myself from the future sitting right beside me. The future me often laughs his head off, chuckles to himself, or shakes his head marveling at how foolish and stupid I am. “Are you really doing that again?”  “Are you really sure that’s what the trend is?”  “Why are you trading such a large position, you idiot!” While this hasn’t saved me in every circumstance, it has always pushed me to doublecheck my work before putting on a trade.

Regulating Your Emotional Temperature

A second concept that’s worth thinking about is emotional temperature – where being hot means that you’re excited and being cold means being lethargic. If you’re too hot, you become narrow-minded. You’re so focused on the one thing that sets you off that you can’t think about the broader situation and lose sight of the risk involved. You leap at the chance to take action and fly all over the place as your focus shifts, like an air balloon whose end as been loosed and is zooming around the living room.  All the air is leaving immediately, the balloon is moving, but the area of focus is scattershot and so is the direction the balloon takes.  Conversely, if you are too cold emotionally you simply shut down. It doesn’t matter what is going on in the world at large, or with your trade, because you are too busy retreating into yourself to pay attention. This happens to a lot of traders in the market. They get extremely excited about getting into a trade, become extremely excited when it goes in the wrong direction, and then cool off and shut down and wait for the stock price to recover (if ever).  Either extreme, hot or cold, hurts your ability to trade – it’s when you are lukewarm that you are in your sweet spot. You’re comfortable enough to be curious and active, but not so comfortable that you aren’t wary of danger.

So how do you keep your temperature in the middle?  One way to keep from becoming too hot is to take money out of trading account after every profitable trade.  If you can only trade with the bare minimum in your account, the amount that came out of your pocket, you will be much more careful about losing any of it. It also helps keep your winnings tucked away out of sight so you can focus on the trade in front of you without reliving the glory of past success and becoming overconfident.

Another practice is to follow proper risk management and keep your position size down. You can’t become too excited over a winning trade, or too despondent over a losing one, if the dollars involved are reasonable.  It takes discipline, but if you can keep the game to an unexciting grind and not some gambling, winner-take-all adventure, then you are going to keep churning out profitable trades and making money. If you follow the 2/6/10 rule as I mentioned in my article on risk management, you will also not lose so much money that you shut down and lose sight of the game entirely.

Stress Inoculation

Before we dive into this concept, it’s helpful to describe what the term “inoculation” means in the first place. It is a term from the medical field used to describe the practice of helping patients become immune to diseases through the exposure to low-level agents that cause the disease in the first place, i.e. weak and dying germs.  The device used to deliver these germs are called vaccines, so when you go to the doctor to get vaccinated for X disease, you are being inoculated from said illness.

With that said, how does one inoculate for stress? It’s a emotional and physiological reaction after all, not a disease.  You don’t “catch” stress, you “become” stressed. Surprisingly enough, you inoculate for stress the same way as with diseases – through low-level exposure, in this case by using your imagination. Find yourself a comfortable chair or couch, close your eyes, and imagine putting on a trade from beginning to end.  Then imagine that trade going to hell.  If your going long, imagine the floor collapsing and the price is half what it used to be.  If you’re shorting, imagine the price gaping up and skyrocketing to the moon.  Feel yourself beginning to panic – your hands get sweaty, your thoughts race, and maybe you even start getting a headache. You think about all of your dreams going up in smoke and the shame you’ll feel about admitting your losses to others.

Hold on to this feeling for as long as possible so that you immediately recognize it in the future when it happens to you. Then, imagine getting yourself under control and executing the steps you need to take to recognize the problem and exit the trade. Be as detailed as possible.  Repeat this exercise dozens of times so that the emotions and actions involved become second nature. By going through this exercise, you will sense not only when a trade is going wrong and will affect you, you will know exactly what to do when it happens.

The reverse of this exercise is also extremely beneficial – imagining all the steps that go into a trade, the feelings that you have when it goes well, and then successfully exiting the trade and keeping your profit. This is a common practice among Olympic athletes gearing up for the next contest. They think about the course in front of them, such as a slalom run when skiing down a mountain, going through every twist and turn and how to perfectly manage them, so that when they need to do them in real life they feel as though they’ve done it a hundred times before and feel less fear. If it works for them, it can certainly work for the rest of us. If you can imagine the ideal trade, you can imagine being the ideal trader, and eventually you’ll become one too.

Repetition

That being said, the idea of using repetition to control your mind, while a part of stress inoculation, is a distinct concept in its own right because it hits upon the single hardest part of any self-improvement activity: cementing change.  Everyone wants to change, but few actually do so because few people live out the change every day.  They practice a new habit or a new way of doing things once or twice, or maybe even for a month or two, but then its gone and all that’s left is remorse.  If change is driven largely by how much something impacts us emotionally, then we need to practice vivid stress inoculation dozens if not hundreds of times until that understanding becomes second nature.  If we learn better ways to trade, we need to execute that practice constantly so that it becomes a part of us. Success doesn’t require being able to manage our mind once, but repeatedly and for many years.

That is perhaps the one advantage that short-term traders have over long-term investors, or those who look at the market daily over those who do so weekly or monthly.  By trading hundreds of times, thousands of times, they have institutionalized best practices in their own trading and, moreover, have developed an understanding for the market that unconsciously understand where price is going to happen next even if the technicals don’t give a sign.  There have been a few times in my trading where I just knew that a stock price could not drop any further, and it is a wonderful feeling to have when you have capital to execute it.  Short term traders have that feeling all the time.  Conversely, longer term investors avoid the daily whiplashes and worst emotional temptations that wreck short-term traders, but at the same time trade so infrequently that they don’t have the large body of experience that helps others understand where the market is going and when to get out.  It’s unpopular to say this, but for every billionaire investor like Warren Buffet there are millions more who lost money because they weren’t able to navigate the highs and lows as skillfully.  They didn’t know when to get in, and didn’t know when to get out (or stay out), simply because they didn’t trade much and weren’t involved every, single day.

Focus on One Thing

Lastly, you can control your mind, your fears, your worst impulses by finding one thing and sticking to it. You don’t need to be good at everything to make money in the stock market. You just need to be better at one thing than most people.  Do you know how to follow a trend? Do you know when the best time is to buy an undervalued stock and ride it up? Do you know how to find an over-valued stock losing steam and short it? If you master even one of these things you will make money.  That toehold of success will give you confidence, help you explore and learn new strategies, and enable you to ride out the bad times until the good come again.

One famous example of this is Gerald M. Loeb, a Wall Street trader who cut his teeth in the early 20th century.  He was never very good at shorting stocks but did know how to find an undervalued stock, as well as stocks in a downtrend that would reverse themselves for a while. He was so good at this one strategy, that he made money using it and going long during the Great Depression. I repeat, during the greatest market collapse of the century, he made money buying stocks for price appreciation. The stock market is not rocket science. A simple strategy can see you through, but you need the mental fortitude to keep a clear head and act as the situation dictates.

In conclusion, controlling your mind is an extremely tricky thing. It requires constant effort to maintain awareness of what it’s doing and avoid sabotaging yourself.  By striving to step outside of your own shoes, regulate your emotional temperature, imagine and endure stress, focus on one thing and above all – practice, practice, practice – you too can achieve a level of success as a trader that few obtain.  And it is by being the best at a few things that one can enter that blissful state of financial independence.

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