From The Heart (Part 1)

How to reduce emotion and maintain confidence in a trade.

In a week where most news was concentrated in one day, the market maintained some similar themes, before and after Wednesday. Stocks continued their relentless march into the SPX all time high with an unusual beat in CPI and the Fed minutes revealing nothing new. The dovish tone to ECB ironically preserved a potential DAX catch up trade. This was despite signs of a ‘buy the rumor sell the fact’ response from Bunds that helps maintain our view of a major reversal—with implications for EURUSD. And the endless rumours about a hoped for Brexit resolution, dented by continuous disappointments, drowned the UK GDP beat. Even though volatility appears to falling (evidenced by a further collapse in currency implied volatility this week) sentiment and consequently emotion still appear to be rising as traders seek resolution and direction.  That in itself is a likely cause of an impending return to volatility.

 

Last week’s article highlighted the impact of such emotion on trading. This and next week we look at how to turn this hindrance into a help, not so much with textbook responses but what actually works. In other words, from experience and not always pleasant.

 

Last year was challenging. From published records, it is clear most funds or traders underperformed. This is particularly because volatility fell in some asset classes such as foreign exchange. But other markets such as indices were unusually erratic. This is normally a type of market we excel in as it is much easier to identify, compare and trade very similar previous erratic markets. In other words, evidenced based analysis. But for the next two weeks we focus on the, arguably more important, evidence-based trading and why this year has started and should continue very differently and not just because we expect forex markets to wake up.

 

Identifying what successful traders do best, that is maximise their strengths (their ability to translate analysis dispassionately into successful trades) and minimise their weakness (reducing interfering emotion) is still an underdeveloped area. Partly because the evidence tends to sporadic and anecdotal. Partly because what is good advice for one trader is not always good for another

 

And partly because the resulting generalised clichés are easy to believe and accept but much hard to implement and maintain. Emotion inevitably gets in the way of successful trading. It is a cliché that you should not trade with emotion. And yet as humans risking money that it is almost impossible.

 

Serious people pay serious amounts to experts to help them control their emotions and not be controlled by markets. But more than that they seek to use those emotions to help bolster their convictions, confidence and modus operandi.

 

The legendary Paul Tudor Jones pays motivational coach Tony Robbins a $1 million annual fee, along with an undisclosed portion of profits.

 

"The amazing thing about Tony is how he can deconstruct what drives certain behaviors and help you develop a plan for action with carefully considered risk and reward propositions." 

 

Paul knows Tony very well. Besides the million reasons, they exchange emails every day, frequently talk on the phone and, if necessary Tony visits. Who knows you that well to act as a mentor?

 

No one knows you better than you do or indeed knows Paul better than Paul. Yet he chooses to use Tony because he has the money and inclination to externalise his emotions and have an expert assess them. But YOU can externalise and assess yourself. We have done just that ourselves.

 

Over 30 years of trading I have learnt that emotional control is important in both the particular which we outline this week and the general (next week).

 

In the particular it is essential to ensure, by adequate preparation and anticipation, that stress doesn’t turn into distress during challenging market moments.  And that we are constantly aware of not just markets but ourselves so that emotion does not affect specific trading decisions. Rather, such stress and associated emotions are used positively to drive our overall approach (transference) both as trader and analyst. Indeed, rather than allow emotion force us into a downward spiral it can help provide us with the resilience and confidence to develop as traders, through good times and difficult times.

 

How do we prepare for moments where emotion could derail us? Most trading emotions are driven by money, profit and loss. There are several ways of minimising the impact adverse or even positive market reactions have on our psyche so much the better. These can be usefully framed by the Matrix we use for all our trades.

 

Probability x Return/Risk = Matrix (Position Size)

 

1. Probability
Evidenced based analysis. Thorough analysis (and that process itself) should, other things being equal, lead to better outcomes. This and the knowledge of this helps build confidence. Even if your view proves wrong, knowing that your methods of analysis produce results helps prevent second guessing and move onto the next market, if necessary. It is one reason at Matrix we assign probability score to the likely success of the trade – based on the experience of similar trades and our confidence in the particular set up.

 

2. Risk/Return
Evidence based risk management. Sound trade plans based on sound analysis has a similar effect on reducing emotion and building confidence.

 

Stops and limits are extremely important devices to controlling emotion as, based on previous analysis and present, they effectively remove the possibility of emotion affecting the decision and outcome. Relatively poor or rushed trade execution and trade management can all be responsible for much emotional distress later. Remember trading can affects our psychology as much as psychology affects our trading.

 

This is particularly true for stop losses as they reduce the potential impact of fear, indecision and invoking hope rather than cold blooded analysis.

 

And if you get stopped, so be it. Losses are an inevitable part of the process. And learning to take losses is essential to maintaining emotional balance. You are not only as good as your last trade. Knowing that your next trade or the next five to seven out of ten will be successful allows the experienced trader to move on objectively analysing and identifying the next opportunity.  In this respect, it is a useful device to write the trade off as you take it and this helps maintain focus.

 

3. Appropriate Trade Size
One of the reasons why traders become emotional is because of an unanticipated or undue impact on their P&L. This is often because the size of the position is too large not just or their capital base but also perhaps what they are used to or even because their level of confidence/conviction about the trade is proportionate to the size of the position.

 

It is important then to optimise the size of the trade. It has almost become (perhaps wrongly) a market standard to risk 1% [of your capital].

 

Or another way of putting it—as Dickson Watt explained as far back as 1880...

 

It is one reason why we do not flex the size of our trades above a certain size even if the Matrix score suggests we should have a much larger position.

 

4. Focusing on the Market.
When a position is too large, traders will focus more on the impact of the trade rather than neutrally filter information about its likely success. It is essential to trade a market rather than the specific P&L of a trade. I never watch the P&L of a trade (indeed many platforms allow you to conceal this). After all the analysis that led to the trade should have factored in the impact of the P&L swings and therefore allow for market movement. Expected or otherwise.

 

5. Expecting the Unexpected.
There are times when new information will come to light (whether an unexpected fundamental event, a related intermarket move, a technical break in your or related instrument, or a sudden price only related shift in sentiment).

 

Anticipating the unexpected as much as reasonably possible will also empower the trader to adjust trade plans when they feel necessary again subject to predetermined analysis rather than emotion. Structured trade plans and adaptive trading strategies allow traders to interpret the event or market move in the context of what they are expecting for that and other markets and therefore what is consistent or inconsistent with their view.

 

All these traders’ tricks, if you like, are designed to help maintain emotional balance throughout a trade. Next week we will discuss how to maintain balance and confidence over a longer period if not an entire trading career.

 

Here’s to making the very best. If you would like to hear me live in person, please register for the XTB Masterclass on April 25th by clicking the banner below.

 

Good Luck

 

 

Ed Matts
Founder
Matrix Trade

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