Part I
Much of the advice given to traders concerns either what to buy or sell or when to buy or sell. This makes sense, as it is doubtful that brokerage houses and advisory services could make much of a living by telling traders not to trade. My experience with professional traders, however, suggests to me that they frequently wrestle with the question of when to stop trading. This question typically emerges in two contexts:
- The volatility in the market is low – Does it make sense to be in the market? Is there sufficient opportunity?
- I’m not trading well – Does it make sense for me to continue trading? Do I need to take a break?
In the first installment of this three article series, I will tackle the issue of low volatility; the second in the series will cover challenges related to trader psychology, and the third will suggest ways for traders to benefit from their times away from trading.
In a previous article, I presented statistical evidence that suggested a serial correlation between forty day periods of volatility. Going back to the 1960s in the S&P 500, I found that the correlation between the volatility of the current forty days and the volatility of the next forty days has been over .70. This means that you can accurately predict over half of the future variation in volatility simply by knowing past volatility. I have observed similar serial correlations of volatility at other time frames, including intraday.
Here we are measuring volatility as the standard deviation of price changes for a given period. This means that, in a high volatility market, we would see large variability in average price change: some days would have large winners and large losers, others would have smaller changes. In a low volatility market, we’d experience low price change variability. The size of price changes would tend to cluster relatively near the mean for that historical period. Because of this, volatility is one measure that we can use to determine the movement that we are likely to see during our trading time frame; it is a measure of expectable opportunity.
Among the statistics that I make sure traders keep is the average holding time of positions. Holding time also determines the opportunities available to traders, as markets can be expected to vary more in price over a longer time period (multiple days) than over a shorter one (multiple minutes). (The reverse side of that coin is that holding time is a determinant of risk, as drawdowns are likely to be larger on positions held for multiple days vs. minutes). Your typical holding time is an essential part of your trading personality and, ideally, is also a key ingredient in your trade planning. Knowing the expectable volatility of the market for your holding period can be invaluable in telling you when to get out of the water.
An example is a trader I will call Bam. Bam is a scalper of the ES and typically holds positions for a minute or two, trying to get long at good prices when the offers dry up and sell at favorable levels when the bidding wanes. Lately Bam has been feeling like a jackass. He has been getting in at what seem to be good prices only to have the market fail to go his way. Eventually he has to puke these positions for one or two tick losers. Over time this has cost him significant money.
A review of the sequencing of Bam’s trades reveals that he has been experiencing strings of losing trades and strings of winners, a clustering that seems non-random. Direct observation of Bam while trading finds that his frame of mind during trading is generally calm and focused, only becoming frustrated after a losing cluster of trades. Importantly, however, these clusters tend to occur at certain times of day and on certain days. These are times of day (and also during days) when volume is particularly low.
When we look at 1-2 minute charts for slow times of day–particularly on slow days–we find that many of the bars are only two or three ticks wide. Quite simply, there is not enough volatility at Bam’s time frame for him to consistently profit. He cannot be assured of always buying the low tick and selling the high one, so, as a result, he gets chopped up in between. When we look at periods when Bam has been making money, we see that these are during busier times of day and on busier days. A breakdown of his trading results finds that, if the volume of the ES has been averaging at least 1500 contracts per minute, he has tended to do better than if the one-minute volume has been under this level and much better than if the average one-minute volume dips below 1000.
This makes good statistical sense. Since the beginning of June, the correlation between one-minute volume in the ES and the high-low range of the one-minute bar has been .72. High volume brings high volatility and vice versa. By monitoring volume levels, Bam learns when to stop trading. It makes no sense to be seeking 2-3 tick profits when the market is unlikely to move 2-3 ticks during his time frame. Rather than change his entire trading style and start holding positions during slow times, it is better for Bam to simply exit the market when opportunity isn’t present.
Bam is a scalper, but his situation–and the potential solution–really applies to any time frame. I have worked with other traders who hold for hours at a time, but become frustrated when they cannot get their desired 5 point winning trades. Once again, a review of average volatility at their holding period and an analysis of results as a function of volume generally finds that they should either get out of the markets during slow days and slow times of day–or they should readjust their expectations. If volume and volatility determine opportunity during a day, it makes sense to set exit levels and stops in a manner that reflects true reward and risk. You can often identify when this is a problem if you see many of your winning trades returning to scratch before you exit. Your expectations most likely exceed the opportunity that is available at your holding period’s volatility and volume.
Sometimes it isn’t trading problems that frustrate the trader, but frustrations interfering with trading that create challenges for the profit/loss statement. My next article in the series will deal with those and when it makes sense to take an emotional break from trading.
Part II
Being On Tilt
Sometimes in poker, an edge is not present, not because of poor hands, but because the player’s frame of mind is such that he or she cannot exploit the edge that is available. Poker players refer to this as being “on tilt”: reacting to hands (and overplaying them) because of one’s emotional state, not because of the objective odds and “tells” from competing players. Traders go on tilt for a variety of reasons, ranging from sheer boredom and the need to create action to frustration and “revenge trading” after losses. Nearly always, however, the tilt phenomenon results from a physiological and cognitive state of hyperarousal. The out of control trader is, in some way, “worked up” due to anger, anxiety, overexcitement, or confusion. This can lead to a series of debilitating losses that seriously jeopardize the trader’s overall profitability.
In professional trading settings, it is common for traders to operate with warning levels and a “drop dead” level. The warning level is usually triggered by a level of loss during the day that is unusual for the trader and that suggests something is going wrong. The risk manager or trading coach will contact the trader once this level is hit to encourage a break from trading and a reassessment of the trading plan. The drop dead level is a maximum daily loss that traders are allowed to incur before they are required to stop trading for the day. The idea is that, if traders hit this loss level (and each trader has a different level, depending on their size and trading style), they are not seeing the market properly and need to regroup before putting further funds at risk. The warning and drop-dead mechanisms are not so different from the baseball coach’s visits to the mound when a pitcher is allowing too many base runners and runs. The warning is a kind of “time out” to regroup; the drop dead level is a risk management tool to ensure that no single daily loss is large enough to jeopardize the trader’s longer-term profitability.
Independent traders don’t have the luxury of their own risk manager or trading coach. Nonetheless, they can incorporate the idea of warning levels and drop dead levels into their trading plans. On my website and in a recent article, I stress the importance of keeping metrics on your trading: knowing the average frequency, size, and holding periods of your winning and losing trades and understanding your profits/losses as a function of time of day, day of week, and type of position held (long/short). These metrics are invaluable in the proper setting of warning and drop dead levels. Very often, if you examine your typical drawdowns during a trading day, you will be able to identify a threshold amount beyond which you are unlikely to turn your trading around. Indeed, traders often find that, if they hit this level of loss, they continue to lose money if they persist in trading. This makes sense, because that threshold loss level means that the trader is either misreading the market, is out of control, or both. Using that threshold level as a drop dead point helps prevent those blowout days that can jeopardize many days of hard-won profit.
I also encourage traders to look at their metrics to identify the point beyond which they generally cannot pull their trading back into the black. In other words, you’re looking for the average normal amount of drawdown (and variability around that average) during profitable days. The warning level should be pegged just beyond that point: the level tells you that this is not an expectable drawdown. In practice, I find that the warning level usually ends up being about halfway to the drop dead point. As a rule, I advise active traders to set their warning levels at a point that still gives them a reasonable chance of scratching (breaking even on) the day. The drop dead level should also give the trader a decent chance of being green on the week.
The Danger of Digging Holes
Note that nothing in the idea of warning and drop dead levels removes the need for stops on all trades. The stop loss limits risk on a per trade basis; warning levels and drop deads limit daily risk. In order to hit a warning level, the active trader will have needed to be stopped out on multiple trades. This is a good sign that the trader is out of sync with the market and needs the time out to reevaluate. Unfortunately, this is easier for traders to say than do. The same competitive traits that bring trading success also make it difficult to accept defeat. Psychologically, the decision to stop trading may feel like an admission of defeat. As a result, hypercompetitive traders often trade well beyond warning and even drop dead levels, digging themselves a deep hole in the process.
Those holes do significant financial and psychological damage. A loss of 10% of capital requires an 11% gain to break even; a 25% loss requires a 33% profit to come back; and losing 50% of one’s money requires a doubling of remaining capital just to get back to square one. Equally dangerous are the downward spirals that can be triggered by outsized losses. It is rare to find a trader who does not allow large losses on Day One affect trading on Days Two and Three. Sometimes the effect is to make the trader gun shy, reducing size and missing opportunities. Other times, the urge for revenge kicks in and triggers impulsive and risky trades. Almost always, when I have seen a trader in a slump, the slump has begun with one or more outsized losses that resulted from a failure to honor warning and drop dead levels.
While losses are mounting and traders are approaching warning or drop dead levels, they typically do not know why they are losing money. It is very difficult to sort out whether the problem is one of misreading the market or one of being on tilt. Only time away from trading allows traders the opportunity to reflect upon their expectations, mindset, and trades to figure out what might be going wrong. That time off is also a good time to review the metrics: frequently traders will find that they are trading differently from their norms in the number of trades being placed, the holding times, etc. The key to utilizing time away from trading is mentally rehearsing a mindset that says that time outs are part of the trading strategy–not an admission of defeat. When a coach calls a timeout for his basketball team, no one thinks that he is throwing in the towel. The time out is part of the coach’s strategy, allowing the team the time to adapt to shifting game conditions. Similarly, time taken away from trading during adverse outcomes allows the trader to formulate a winning strategy for later in the day or the next day. Successful trading is not just about making money; it is also about keeping it.
Originally I was going to make this a two-part article series. Readers of my book know, however, that there is a third part to the equation: What to actually do during a break period to get out of tilt and back into the game. Accordingly, I will take up the topic of trader self-help strategies during breaks in a third column.
Part III
Emotional Arousal and the Brain
Cognitive neuroscientist Elkhonon Goldberg, in his excellent book “The Executive Brain”, details the role of the frontal lobes in such executive functions as planning, judging, analyzing, and reasoning. To no small degree, our frontal lobes are the instruments of our rationality. Patients who suffer from damage to their frontal lobes, either through accidents or the effects of dementias, invariably suffer from a loss of self-control, deficiencies in reasoning, and/or difficulties in planning and executing sequences of action. When we are engaged in those executive functions, our frontal lobes stand out in functional magnetic resonance imaging (fMRI) due to enhanced regional cerebral blood flow. Conversely, when we are stressed, blood flow shifts to other, more evolutionarily primitive cerebral regions, such as the amygdala. If it feels as though we are not in our right minds when we are stressed out, that may be because we are no longer activating the brain regions responsible for our executive functions. Little wonder that we say or do things that we regret when we are unusually angry!
That, of course, poses particular challenges for traders. Initiating and monitoring trades, scaling in and out of them, and eventually exiting positions require concentration and keen judgment. Under emotional conditions of boredom, fear, or frustration, we find ourselves activating precisely those “flight or fight” sequences that might facilitate rapid action, but surely not calm reflection. Traders I work with intuitively recognize this when they tell me that they need to take a break from trading and “calm down”. They realize that, under conditions of emotional and physiological arousal, they are unlikely to sustain the concentration and clear-headed judgment needed for superior decision-making.
Conversely, most traders have experienced that sense of being “in the zone” where they feel as though they are at one with the markets, making decisions accurately and effortlessly. This state of “flow”, described in detail by psychological researcher Mihalyi Csikszentmihalyi, results from prolonged activation of the frontal lobes. Because such activation requires sustained cognitive effort, most of us enter the zone only occasionally, cycling in and out of states of greater and lesser arousal and frontal activation.
When traders take a break from trading after a particularly frustrating market sequence, they generally attempt to relax and take their mind away from trading. Some close their eyes and listen to quiet music, others talk with friends, and still others go to the gym and work out. All of these can be useful courses of action in that they interrupt mind states that are not conducive to trading. Decreasing arousal, however, is not the same thing as activating executive functions. Simply relaxing or diverting attention will not bring traders closer to “the zone”. For this, a different kind of activity is needed when taking trading breaks.
Activating the Executive Brain
Several years ago, realizing that I could neither afford nor regularly access an fMRI unit, I obtained a biofeedback unit that several innovative psychologists were using to treat attention deficit disorder. Unlike most biofeedback devices, which measure the body’s level of arousal, this unit measured forehead skin temperature. The idea was that, under conditions of frontal activation, the enhanced regional cerebral blood flow would be reflected in higher skin forehead temperatures. When the brain’s executive functions were not under recruitment, the blood flow would withdraw from the frontal cortex and result in lower temperatures. Several hours of trials, in which I engaged in a variety of intellectual, social, and emotional activities, convinced me that the device’s rationale was sound. It also convinced me that I could enter the zone at will if I were willing to sustain the cognitive effort needed to maintain my forehead temperature above a threshold level.
What I have found using the device is that relaxation alone does not result in higher forehead temperatures, because relaxation does not actively engage such cognitive functions as attention, concentration, and reasoning. Indeed, we generally soften our cognitive focus in order to relax. The state that most reliably produced the high biofeedback readings and feeling of the zone was one of relaxed but intent concentration. I tried many different exercises at home to consistently produce this state, and the one that worked best (and has since worked well for others) was as follows:
You sit in front of the television, tuned to CNBC, with the volume off. Your sitting position is very still, and you’re breathing deeply, slowly, and rhythmically. While doing that, you intently watch the ticker on the CNBC screen and the numbers that accompany each stock symbol. Your task is to keep a running sum of the last digit of these numbers. This is easily done when the numbers are small, but as the cumulative sum increases and natural fatigue and boredom set in, it takes ever-greater mental effort to keep the sum running. While initiating and sustaining that effort, your skin forehead temperature steadily rises and then plateaus. After 15-30 minutes of this, you find yourself in a different “zone”, much more clear-headed and calm than when you started. Another variation that has worked for me involves counting backward by sevens from a very large starting number.
This technique works for several reasons:
- The physical stillness and rhythmical breathing facilitate a state that is incompatible with emotional arousal;
- The cognitive focus on emotionally neutral stimuli (such as number sequences) interrupts the flow of frustrating events;
- The sustained concentration allows access to new cognitive and emotional states.
My experience is that thinking is clearer and more intuitive after this exercise than it is normally–and much better than when we are emotionally charged. It is possible that this is merely a placebo effect: we expect to become calmer and more focused, so that is how we experience ourselves. Thus far, however, my trading results–and those of traders I’ve worked with–also support my experience. The key is sustaining concentration beyond the normal threshold of boredom. If you keep counting the numbers even after antsiness has set in, eventually you get to a quiet, focused point where the counting becomes near effortless and your perception is very clear. And, if you perform the exercise routinely, you can access that zone with increasing ease.
My Latest Experiments
Most recently, I’ve been using sensory isolation tanks to push the limits of sustaining concentration in an emotionally neutral environment. For this exercise, you float in water that is filled with epsom salts and heated to exact body temperature. During the float, you are enclosed in a soundproof and lightproof tank. You hear and see nothing, and you feel very little, because your body’s surroundings match the condition of your body. The task is to sustain concentration in the absence of all external stimuli. This requires a complete stilling of our normal internal dialogue–a task very reminiscent of Zen meditation.
What happens after an hour or more of isolation is that the mind and body adapt to the changed environment. Once again, this requires a willingness to stay in the tank, focused, beyond the normal boredom threshold. My experience is that you know you have adapted to the environment once you no longer feel a need to move or leave the tank. Although I am not hooked up to the biofeedback machine during my time in the tank, I strongly suspect that my skin forehead temperatures are quite high, as I sustain active, directed awareness during my time of isolation. By the time you leave the tank, the world looks and sounds different, as you are now no longer adjusted to the world’s colors and volumes. The clarity of perception and thought that are characteristic of the biofeedback work are even stronger following immersion in the tank.
Although work with meditation, isolation tanks, and biofeedback is often couched in esoteric terms, there is nothing mystical about them at all. By controlling our environment and cognitive activities, we can access states of mind that are associated with executive functioning and deactivate brain regions that are associated with impulsivity. Elkhonon Goldberg foresees the day when all of us will participate in gymnasiums of the brain, just as we join health clubs to attend to our bodies’ health. Traders might be the first in line to benefit from his vision.
Brett N. Steenbarger, Ph.D.
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