Ride Out Emotions for Greater Success

Mar 25, 2007: 10:13 AM CST

Have you ever been caught in a trade and your emotions are overtaking you, causing you to make a decision based on your feelings? Was it a good decision after the fact?

Typically, if we trade specifically on emotion (greed makes us buy too late, and fear keeps us in too long… or prevents us from entering at all), then our results tend to be average at best and below average at worst. Often, the best trades are the ones that few people are willing to take and “go against the grain” of what appears comfortable.

People tend to play out their emotions in the market, and seek what is certain or comfortable. Unfortunately, seeking certainty takes time, and often causes us to miss low-risk entries into trades. There is no certainty in the market, only greater probabilities.

Recall the most recent market declines (in March 2007 and August 2007). It would have been profitable to buy after the decline when most people were in panic (as they watched their positions lose money and they heard the TV analysts predict a recession). How many people can trade against the TV news comfortably? Consequently, this also would mean paring positions and tempering bullishness when others are decidedly bullish.

The same can be said in trading on an intraday basis. Often, great entries come when a stock/future is declining, and you must take the opposite side in anticipation of a reversal (based on whatever technical decision you make). Needless to say, what is comfortable is not always what is profitable. Furthermore, we realize that almost every trader does what is ‘comfortable’ and those who can handle the negative emotions and uncertainty take money from those who are comfortable.

So how can you deal with fear and being uncomfortable before taking a trade or while in a trade?

Time your emotions, document them, and know that they shall pass.

Do not fight your emotions or deny their existence or seek to eliminate them. They can be powerful indicators if used properly, and they will pass if you allow them to run their course. Fear exists to warn us that danger is likely and that we must be careful. Understand this emotion, along with its purpose and time how long you feel its effects, but do not give in to its demands (do not hold on to a losing trade. Overcome your fear to put on a position).

If you are feeling greed and just cannot wait to jump into a runaway stock, time your greed and see what happens when you ride out your greed and trade based on your system. Is the trade part of your system? If not, wait just a bit and see what happens to the stock. Often, the stock will reverse and trap those that gave into their greed and you will be better for using your system, rather than greed, to enter trades.

Use a stopwatch! Document how you personally react to your emotions. Know that, over time, you can observe how the emotions occur for less time each time they are consciously acknowledged. You will always feel emotion while trading, and that keeps you alive and keeps the game fun and helps you to know you are achieving something worthwhile.

When you time your emotion (in seconds or minutes), you acknowledge it and – if you document it – you might find that the length of time you experience the emotion decreases each subsequent time it is felt. While easier said than done, this is a necessary practice to decrease the effect of emotions on you and increase the reliance on your system, which usually results in greater profits over time.

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Technical Decisions and News Announcements

Mar 24, 2007: 1:00 PM CST

By analyzing fundamental components of the economy and business cycles, you can gain an edge using technical analysis signals. But what happens when fundamental signals (or anticipated releases) thwart an otherwise good technical setup?

When I first started trading, I wanted as many signals to be in line with my analysis as possible, and as such, I analyzed far too much data before entering a position. I am inclined to short-term trading, and found myself overwhelmed by conflicting signals with fundamentals and chart patterns or indicator signals.

One of the greatest examples of my frustration came when I would refuse to take technical signals in front of major economic report releases or specific company earnings statements. I would allow my fear of sudden market volatility to prevent me from properly entering a trade based on a pre-established signal from my system. Many times, the stock would behave properly and would have resulted in large, sudden profits, and in the case where the event went against me, only a small reaction occurred and my stop-loss would have taken me out as predetermined. What I feared most were the rare occasions where a gap would blow far past my stop and result in very large losses.

No matter how clear or ‘perfect’ my technical trade entry was, fundamental news can destroy the best short-term technical trading setup. I have been frustrated many times when I entered short-term positions with clear and precise entries, only to have the trade destroyed by a news report I did not take the time to anticipate.

Because of this fear, I stayed sidelined and passed on far too many trades which would have resulted in possible profit. I regarded any sort of upcoming news as a “Veto” on trade ideas and I would literally avoid trading for the whole day, resulting in many missed opportunities. I have learned that trading is a probability game, and I must take setups offered by my style of trading and not seek external excuses to avoid placing trades.

I advocate each trader and investor consider this point for themselves, whether it is best for you and your strategy to avoid key upcoming announcements, or to hold patiently ahead of them, but do so on decreased position size and with tighter stops. No trader – however much of a technical purist – should be clueless of upcoming news, governmental, or earnings releases that pertain directly to instruments he or she is trading. One can benefit from knowing ahead of time of key announcements – however, one should not avoid trading because of these announcements.

Often times, it is just these very news events which drives price through key technical barriers, which result in technical breakouts from resistance. In fact, the news events and volatility (with volume) may sometimes be necessary for key chart patterns to occur! Shifts in supply and demand can occur rapidly when new information enters the system.

Always be aware of upcoming events, but do not fear them, and recognize them as part of the exciting game of trading!

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Advance Decline Oddity

Mar 23, 2007: 9:13 AM CST

When trying to assess daily market internals, it is helpful to follow the Breadth, or the Advance/Decline Lines (number of stocks positive for the day vs. the number of stocks negative for the day).

I plot these lines to create an inverse graph, rather than simply following the breadth number because it helps show the past and the trend of the breadth better for me.  When the breadth is skewed positive, I only take long trades and vice versa when the breadth is skewed negative.  If the breadth is narrow, I am looking to step aside or trade with small size if I need more practice on a particular strategy.

The breadth line also helps in taking setups from stocks, which can provide much more movement with price patterns and daily bais than the ETFs or even index futures.

Normally, the breadth is skewed in one direction or the other, and may switch once or twice daily.  Yesterday (Thursday), there was an oddity in the breadth which caused me frustration and a couple of whipsawed trades.

Of course looking in hindsight, the action is clear and the market was rangebound, and the best play would have been to fade extremes, but it is often difficult to anticipate a rangebound market and difficult to make money when your bias is for trend trading tactics.

I am showing the Dow Jones Index and using the standard stochastic settings.  For TradeStation, the Advance line is plotted with $ADV and decline line with $DECL.  For the Nasdaq, the symbols are $ADVQ and $DECLQ respectively.  Combine the Breadth with the TRIN for the overall (yet lagging) bias of the day for the market.

The day’s action saw six changes of leadership in the breadth.  Indeed, it was a choppy day.  One can imagine that consolidation was necessary after the large increase following the “Fed Decision” rally.

Today (as of 11:00 EST) we have positive breadth (+500) and a tempered bullish bias.  We will soon see if that will be reversed!

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Regret Aversion

Mar 22, 2007: 7:35 AM CST

While no blog post can adequately address the realities and implications of “regret aversion,” I wanted to alert you to its existence and possible resources for learning more.

Simply stated, we feel regret and remorse more for actions we DID take than for actions we DID NOT take. One way to understand this is that we feel pain that comes from personal experiences, especially of loss (staggering losses in the market, for example) because we lived it, experienced it, and it affected us deeply. The negative feelings from this experience are often easily brought to memory and we tend to take actions to avoid these feelings in the future (when confronted with a decision that may result in similar pain).

On the contrary, it is difficult to internalize the feelings of missed opportunity to such a degree, because the regret from the missed experience is not felt as deeply. Such memories (for example “I saw a trade set-up and did not take it and if I did, I would have made $5,000″) are mostly generated, rather than experienced to the core of our being (such as “The trade set-up I just took cost me $5,000! because I violated my discipline!”). The experience did not touch as deeply and as such is easily forgotten with less pain.

When the time comes to make a new decision, the feelings of the actual loss resulting from the actual decision will appear more readily in our mind and emotions, and distort new information (through fear).

Regret aversion can take the form of action paralysis, where a trader cannot execute a trade because of the potential fear he or she remembers from prior experience. However, the experience can attack from the back as well. Once in a trade that has gone against your entry, you might hold the trade because you do not want the pain of yet another large loss. Another factor of mental accounting is that investors treat paper losses differently than real losses. It’s almost as though the loss does not materialize until we hit the sell (or buy to cover) button, yet the loss is still real.

Our previous experiences can PREVENT us from selling when we should and thus a small loss turns into yet another large loss and builds an additional layer on our regrets and negative experiences. One can imagine the bitter cycle that is created when our mind lures us to avoid our discipline or system and try to ‘reframe’ our situation to make us feel better.

For me, this was particularly true in that my initial experiences with loss kept me sidelined because I did not want to repeat the pain I felt. The lure of profits wasn’t enough to overcome the pain of losses – I’m sure this occurs with many new traders. I felt happier when I avoided losing money (through a potential trade idea I didn’t take) rather than the pain of “missed opportunity” which resulted from seeing the market move exactly as expected when I didn’t take a trade set-up I should have taken. Overshadowing the whole process was my previous experience which shaped me to value protecting my capital over growing my account.

You must be aware of your own responses and memories and apply behavioral techniques (later posts and resources) to reprogram this “regret aversion” response. What helped me was restructuring the natural association so that I hated the pain of missed opportunities over the pain of lost money – remember that you cannot control the outcome, but the process. I plan to elaborate more on this later.

In the meantime, for a plethora of academic resources on regret aversion, visit the resource at www.behaviouralfinance.net.

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Victory to the Bulls

Mar 21, 2007: 10:19 PM CST

How did everyone enjoy today’s market action? I am noticing a shockingly similar pattern to trading days where Federal Reserve policy is announced: There is sharp contraction in volatility and immediately following the action, there are usually three sudden pulses (bursts) of trending price movement.

Such days are indeed for the bold and daring, but stops can be maintained very close to the entry and price targets (rewards) – if you are willing to hold through up to three impulses – are astronomical compared to the risk you take. I must admit that I didn’t hold through the full duration of the rapid move following the announcement but I’m not kicking myself either.

I noticed the Advance/Decline line tilting decidedly positive going into noon while the market stayed relatively flat. This was an internal hint that the market bias was biased to the upside, but entering before Fed Decisions is dangerous. Today was one of those “grit your teeth and hope you’re right” days if you chose to play.

With all the fun of the day’s action behind us, today leaves the major indices above critical resistance levels and the entire technical picture is brighter where dark clouds once loomed mightily over the horizon (in the form of converging declining moving averages). We are in a new technical picture and now odds could be favoring a potential upside bias now. This is especially true on the weekly charts.

From a “Swing” perspective only, price on the daily chart made a lower low, lower high, found support at the lower low, and then rallied to take out the recent swing high. This sets up a good picture bullishly.

On the daily charts, we found support above the rising 50 period moving average and made a higher swing low. This also is good for the bullish camp.

What looked horrible last week is now looking brighter for the market.

A major negative, however, is that this quick rally occurred on lower relative volume that the most recent (shock) decline. We’ll need to see if the moving averages can hold as potential support before sounding the “all clear” and jumping back aggressively into long positions.  If the market fails below them, then all bullish bets are off the table.

One other cautionary note: Those who own stock who refused to sell during the shock decline in early March may see a second chance to unload their position (some for breakeven now) and might sell into this recent rally. We would need to clear those pockets of supply here before going markedly higher.

I hope you enjoyed the ride down and then back up!

Addendum:

As per Vega’s comment, I wanted to post the Fibonacci grid of the most recent market move and, Vega is right – it is important to temper the bullishness with the following chart which shows that the DIA hit (to the penny) the 68.2% retracement and could indeed head lower based on this fact. What looks exciting this morning could actually be the top of a simple retracement. Do keep an eye on this if you are overly bullish on this most recent move.

Always consider both sides of the equasion before trading!

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