Investors and traders around the world are always wondering “How do I remove the emotions from trading?”

We’ve all experienced the downside of emotions –panicking and closing out a trade at the worst possible moment; being too greedy and taking on an excessive amount of risk; or just watching our overall emotional state fluctuate with the markets.

The natural reaction is to blame our emotions, believing that they made us or caused us to trade worse than we should. And if our emotions are going to hurt our trading and make us look bad, then we want to suppress them and distance ourselves from them.

One of the most common complaints from traders, either new or experienced, is that their emotions go through a roller coaster when they are involved in the markets. There can be a variety of very powerful emotions that mess with their heads, like greed, exuberance, fear and the fear of missing out. Moreover, these emotions can affect someone even if they have a solid trading plan, excellent discipline and years of experience. Every full-time trader, no matter how successful, can tell you about days where they come home and feel like they’ve had the stuffing knocked out of them.

Sometimes, it seems like the ideal is to be a robot—completely dispassionate, mechanical and making decisions without any emotion at all.

However, we run into a small problem with this goal—it’s impossible. We are still human beings after all, and emotions are one of the key defining traits of being human. We can’t NOT experience emotions.

Besides, it misses the point. We don’t want to become unfeeling robots. What we really want is to make better decisions, which will ultimately lead to improved profits. As I love to emphasize repeatedly, trading well is all about making better decisions.

Of course, there is an emotional component of trying to make better decisions. it doesn’t mean becoming robots—rather, it means reducing the impact, especially the negative impact of emotions, on our overall trading. But making better decisions is broader than that – it also entails combating and minimizing the biases and heuristics that afflict us all. These are more subtle than emotions but nonetheless also get in the way of making good decisions.

The challenge of making better decisions is a holistic one. It involves both technical skills, e.g. strategy, how we are getting in to and out of positions, etc, just as much as it is psychological.

In this piece we will look more at the emotional side of trading, with two ideas in mind: the first is what concrete steps we can take to make better decisions and thereby lessen the role of emotions; the second, what can we do to dial down our emotions, independent of our trading. This will draw on various psychological tools, coming from the world of sports psychology and therapy.

As we have discussed, trading is decision-making in action. This is actually an incredibly empowering idea. As humans, we possess extremely powerful brains, capable of processing as much as most supercomputers. When we engage the rational, logical parts of our brain, they can be incredibly powerful and capable of making objective, complex decisions.

However, the part of our brain that handles higher level, abstract thinking, the neocortex, is not the only part to our brain. We also have to consider that our brain is made up of two other evolutionary artifacts—the reptilian bran, which controls most automatic functions and instincts; and the limbic or emotional brain, which is responsible for our feelings, memories and emotions. While we would love it if only the detached and logical neocortex was making our trading decisions, we have to contend with the other parts of our brain—the emotional and instinctive parts, which may not even be fully aware of. But they can influence any decision we make, including our trading calls.

In real life, our decision making is subject to all kinds of biases, heuristics and other influences. As the behavioral finance literature has demonstrated, we make all kinds of financial decisions that demonstrate distinct biases. The most notable of these is prospect theory, which Daniel Kahneman describes as the idea that “reference points exist, and that losses loom larger than corresponding gains”. In different words, we will do more to avoid losses than to reap the same financial gains—making $100 in the markets makes us feel good, but losing that same amount makes us feel terrible. The reason is that we are overly influenced by the negative emotions that can come with losing money—such as regret, shame and embarrassment. Whether we are aware of it or not, we will make decisions that are influenced by our emotions.

Yes, our trading decisions will be influenced by our emotions—that’s an inevitable part of being human. However, we don’t have to be controlled or dominated by them. The solution is simple: we have to structure our decision-making in a way that plays to our rational, logical strengths.

There are three ways that we can approach our trading in a way that allows us to make better decisions and to dial down the emotional impact:

1. Better Preparation
2. Checklists
3. Becoming Process Oriented

Preparation

Trading may seem like a good fun and a big adrenaline rush, but like many professions, you absolutely have to be prepared. If you are just shooting from the hip, then you are asking for trouble. It’s like going to an exam without having studied—you will an enormous amount of stress. Yes, the exam may be difficult, but you can remove a lot of that stress by being properly prepared.

With the markets, figure out how much effort and preparation you think you need to put in to be successful – and stick diligently to it. You need to have done your preparation work before the markets open and before you even think about putting on a trade. Furthermore, you should be following a bunch of potential setups and actions, and the more you prepare for different scenarios in advance, then the more calmly you will be able to execute them when the markets are open and gyrating.

I wrote a piece on “How to Be More Consistent in Your Trading”, which covers in more detail how to boost the quality of your preparation and to make it more consistent.

The Checklist Manifesto

In his wonderful book, The Checklist Manifesto, the famous doctor Atul Gawande talked about a simple solution that dramatically improved surgical outcomes: the introduction of a pre-operation checklist. Doctors are obviously highly intelligent and well-trained people, and they perform tasks of mind-boggling difficulty and complexity. Naturally, they are also very capable of preparing for an operation. However, things can and do go away when doctors are stressed, or when there is a miscommunication between the various people in the operating theater.

A checklist is a straightforward document that makes you do one thing—check off each point to make sure that every exact thing has been done properly. The advantages are numerous: you can’t forget to do something; you do the necessary pre-operation steps in the right order; the discipline of the checklist frees you up mentally to focus on the specifics of the operation itself. In the stressed, hectic environment of an operating room, the checklist forces you to stop; to take action in a disciplined, methodical way; and gives you a solid, reliable plan in any circumstances.

A Checklist for our Trades

This should be a guide for our own trading. When we want to make the best decisions possible, free of stress and other negative emotions, then we should create a tool to facilitate that. For traders, a checklist is an ideal. We create a rational decision making tool to guide us, no matter how we are feeling. We put into the list all of the important components of any investment decision, which guarantees that we review them in the heat of the moment.

In the book the The Checklist Manifesto, Gawande even mentions a famous investor who had done just that – Mohnish Pabrai, a value-oriented investor. He and his team came up with a checklist with a hundred items on it, which they could use to sift through their investment universe. Given that they are very long-term and may not make any new investments in a given year, their checklist is designed to give them a full 360 degree view of the risks involved. (Read more about Pabrai and his checklist).

Mike Bellafiore’s Playbook, espouses a similar approach, advocating that “the key to your optimal trading is to stick mostly with what you trade best”. That is, traders should do a self-inventory and focus on their strongest setups and discard everything else. In the book, he comes up with a five point checklist for what he teaches to traders at SMB—a disciplined way to think about and execute your own best setups.

The process of creating a checklist is pretty straightforward, just as Bellafiore demonstrates. You take your thought process for how you get into one of your best or ideal trades and codify it. What do you look first, then second, etc? In your best risk/reward setups, what absolutely has to be there? What are the essential criteria and what other factors are desirable but not essential? And lastly, where you would get out—both as a stop loss and take profit?

Obviously, if you don’t yet have a methodology, then you need to get one! All of the talk about a checklist is completely irrelevant if you don’t have a solid methodology or approach. If you are still flailing around and looking for one, then I would point you in the direction of a previous blog post, on “How Do You Start Trading Without A Methodology”.

Process Orientation

Having a checklist makes it easier to make disciplined decisions in the heat of battle. But there is another benefit that matters in the long run: we shift the entire frame of what we are doing. Before we had checklists, we were trying to put on trades that would make money. We were looking at the markets and grasping for whatever would work. Like doctors, we were smart and prepared, but we could overlook things or make mistakes in the heat of battle. The checklist gives us a more disciplined way to make decisions. Now, we just have to follow it.

Going forward, we need to think about markets differently. Our goal becomes to stay disciplined all the time. We stick to the checklist on every trade. Wash. Rinse. Repeat.

When we are reviewing our own activity and results, we judge ourselves first on how well we stick to our own rules and to our checklist. If we stuck to our checklist religiously for a certain period of time, then we should congratulate ourselves—even if the P&L is disappointing. Remmeber Pabrai, who can go a year without a putting on a single new position, because nothing met his investment criteria? He stuck to his checklist—great! That’s true discipline. Rules are rules.

Peter Brandt describes this mindset very well in his Diary of a Professional Commodity Trader: “many novice pedestrian traders focus on the next position. Consistently successful traders focused on the process and care little about the outcome of the next trade. The distinction is enormous:” Indeed. We need to care more about sticking to our rules and process and judging ourselves only on that. We become rues-based investors with enormous discipline.

By focusing on our rules and our discipline, we are shifting the focus away from P&L and money. Given that people usually have an emotionally charged relationship, we are distancing our trading from any of the emotions that come when we focus on money. Moreover, as a lot of cognitive biases and heuristics revolve around money – such as prospect theory—we are also removing ourselves from this potentially dangerous territory. By comparison, rules on a sheet of paper have very little emotions attached to them. Good—that’s just how we want it.

As you grow into this focus on executing your plan, you will find that trading becomes more of a challenge to do outdo yourself—you want to try harder to stick to your rules and stay disciplined. The emotional attachment to money fades and immediate material gratification becomes less important.

And as the emotions fade away, then your trading actually gets better—because you are trading from a more rational, disciplined and calm state. This in turn only encourages you more to stick to your rules. It becomes a virtuous  cycle of more discipline, less emotions and better results.

 

Visualization

What we have covered already is the technical side of trading—the nuts and bolts of decision making. Once we change the way that we make decisions, then we should find that emotions have less of a hold on us while we’re trading. But as we are human beings and unable to remove emotions completely from our trading, we will want to have other ways to further dial down emotions in our trading.

The exercise below Is adapted from some of the exercises in my Visualization series. Borrowing from both peak performance and therapy literature, it should help induce a more relaxed feel when dealing with markets.

Dialing down the emotions associated with trading

Below is a exercise on how to dial down the emotions in your trading. Notice I said: dial down, not turn completely off. We want to preserve some of them. While we addressed the negative impact of emotions earlier, there are a few things to keep in mind as to why we want to turn them down, not off.

The first thing to understand is that emotions are necessarily bad. It is important to note that there are emotions which can be helpful in our trading. One way is when we derive information from the emotions—our spidey sense is tingling, we feel fearful and start to consider exiting a position.

There are also emotions that generate very helpful motivations for us. We would also not want to lose these. For instance, our competitive streak could provide us with a very powerful motivation. Our fear of poverty could do the same. Or our curiosity could propel us to do the work necessary. Our desire to save face could make us cut losses at the right time.

Altogether, emotions are somewhat of a mixed bag. Some are quite debilitating and difficult to manage. Others can be helpful. But we wouldn’t want to turn off the helpful ones. Actually, we can’t turn off emotions, because we are human beings.

Our goal is to turn them down, to leave ourselves feeling calmer; more detached; and more even-keeled, free from the emotional up-and-down that can often characterize a trader’s life, even if he’s successful.  The ideal state is one where we still have and experience emotions but we are doing so on a level where our rational, decision-making brain can easily cope with them.

This exercise is designed to tell your brain to turn down the emotional intensity of all emotions involved in your trading, so as to make you more dispassionate, calm and rational.

We follow this set of instructions:

1. Get nice and relaxed, preferably in a sofa or a good chair. Do not do this in bed—you don’t want to fall asleep!
2. Breathe in and out deeply and get into a slow, deep, comfortable rhythm. Become nice and relaxed.
3. Imagine yourself very much involved in the markets—watching prices, looking at charts, researching trades, paying attention to your P&L. Recreate the whole experience. Feel how hard you’re working, how focused and concentrated you are, how “in the flow” you are. Summon up all of those feelings and experiences.
4. Get ready to feel all of the feelings that come along with trading. Feel the exuberance of a trade that is very profitable; feel the tension as you’re researching a position before you put it on; feel the despair after a bad day where you feel like you had the wind knocked out of your sails. Get into each kind of emotion that can come up and sample the whole spectrum of emotions.
5. Imagine that there’s a chart over your head, and the graph correlates with each mood. When you are feeling energized and happy, then the graph goes up; when you’re feeling frustrated, then the graph goes down. The chart can fluctuate in between those two extremes. Cycle through some of your different moods and then imagine the chart moving up and down, depending on the intensity of the feeling.
6. Now, step out of your body. Imagine yourself a few meters away, watching the trading version of you with a chart over his head. Watch yourself trading from a safe distance—notice that trader working away, going through the usual steps of trading, and staying calm and focused and disciplined. Notice the focus and concentration.
7. Imagine the chart above that trader’s ahead that tracks emotions. Instead of the chart that was there before, with big ups and downs, flatten out the chart. Imagine a chart that’s more like a flat line, with very smalls ups and downs. This is designed to signal to your brain to have fewer emotional ups and downs.
8. Rewatch yourself trading, this time watching this trading you with a very flat emotions chart, never moving away from what’s almost a flat line. Watch the trading you with even deeper focus and concentration; with more of a detached and dispassionate air about him; and with little emotionality.
9. After a few minutes of watching yourself trade dispassionately, come back to the present, and begin breathing normally.

No relevant positions

 

By Bruce Bower | E-mail: Bruce [at] howoftrading.com

Blog: www.howoftrading.com | Twitter: @HowOfTrading