The below image of frustration shows what most people have experienced when it comes to trading. Trading is an emotionally demanding profession. Psychology of both the individual, as well as the market itself, constantly affects the decision process.
Below is a hypothetical chart showing various phases of a typical trade. The trader enters a long trade, makes initially money, but then it all starts going the wrong way. The trader ends up relying on hope, on what others told him about the stock, that earnings will be good, he doesn’t apply stop losses, feels agony and pain, short term relief, once again hope, guilt etc.
The chart displays greed and fear at its best!
There are several studies suggesting that majority of day traders lose money. It is important to understand why you are making or losing money. Do you overtrade, do you take appropriate risk, do you make money by being lucky?
Understand your p/l!
EMH and decision making under uncertainty
Traditional financial literature is based on efficient market hypothesis (EMH) that states one cannot consistently achieve returns in excess of average market returns on a risk adjusted basis, given the information available at the time. The theory assumes all available information is reflected in prices, therefore one cannot predict future prices.
There are challenges to the EMH theory due to deviations from the above. Psychological aspects affect humans and we don’t live in a perfect world. Two examples that affect trading are;
- information is asymmetric – different counterparties in a transaction have different knowledge about the gransaction
- investors posses feelings, one common term referred to often is herd behaviour among investors that is all but rational.
Behavioural finance tries explaining the economic man, but includes the various imperfections of the non rational human. A few aspects the theory considers are;
- Cognitive bias – unconscious mechanisms humans can’t control
- Overconfidence – good periods in trading often make the trader less aware of potential risks and negligent behaviour often leads to falling p/l.
- Overreaction – positive or negative reactions are usually exaggerated and lead to less rational behaviour.
- Information bias – focus on relevant information versus irrelevant information, investors are bombarded everyday with tons of totally irrelevant information from media, internet etc.
Irrationality itself is unpredictable but cognitive aspects, deviations from rational behaviour are predictable. Remember the old proverb from Keynes?
“Markets can remain irrational far longer than you or I can remain solvent.”
All decisions are based on expectations. Humans base their expectations on hope, fear, good, bad and other feelings. Information from past experiences also form our expectations. Add also new information to the above mentioned and it is fair to say the process of decision making is fairly complex.
Consider a trend line for example. Past information and experience tells the trader a specific stock should find support on the trend line and bounce, but trend lines still get broken. Why does this happen? Is this an effect of new information or psychology of humans affecting the trend line itself?
Another central concept is the traders’ expectations versus the goal. Every fund manager, trader, financial decision maker believes he/she will beat the market but still most managers underperform (irrespective of fancy charts of Sharpe ratios etc they show you when selling their product). It is actually amazing how non rational the investing/trading space is. There is probably no other industry where the individual performances underperform so much to what the goals and expectations are. I used to run several trading desks and every year all the traders on the desk would try convincing me they would provide higher returns than the previous year, irrespective of market conditions. The belief that one will beat the market (or your past p/l) affects the investment decision process!
Overconfidence affects all decision making.
There are many fallacies when it comes to how people evaluate opportunities. A classical fallacy is the gambler’s fallacy (Monte Carlo fallacy) where people for example believe that because the roulette wheel has been showing X reds lately it must mean a black is up next? The gambler’s fallacy is present not only in gambling but in trading as well. How many times have traders expected a stock to bounce just because it has traded down X days in a row?
The Decision Process
The decision process of a trader is extremely complex. The cognitive process affecting all humans always present. Genuine decision making is also often a habit or routine, ie the past influences future decision making. Very seldomly does a trader objectively and rationally make the decision process from the start without incorporating past experience.
A trader makes decisions in a stressful environment, bombarded constantly with new information while watching asset prices move in real time. These external factors affect the decision process in a complex way.
How many times has a trader been planning to buy a stock, waited for a good entry level but the stock moved quickly, maybe new information hit the market, and suddenly the trader starts chasing the stock 5% higher to then see it revert down after he bought it? These are decisions made under stress since the process is dictated by the environment (the market) and is not a rational, non stressed process. Traders rely many times on their experience, but all experience has a cognitive bias.
Probably the most well known theory in behavioral finance is the Prospect Theory by Tversky and Kahneman. In short the conclusion is;
- People focus on loss or gain and not on total wealth
- Loss aversion rather than risk aversion is the main theme
- Given two positive options people choose certain over probable payoffs, even if the expected value is more favourable for the probable outcome – people take profits too quickly
- Given two negative options people, one certain and other probable, people choose the probable, even if the expected value is for a higher loss – they have the chance to escape the loss – this is the psychology of stop losses. Stop losses are emotionally hard to digest but should be treated as the most normal aspect of trading.
- Risk aversion – preference for a sure outcome over a prospect with an equal or greater outcome
- Loss aversion – Losses loom larger than gains
- Certainty effect – strong preference for positive outcomes
- People overestimate small probabilities and underestimates high probabilities
- Framing of goals influences how people take risk
- Loss or gain depends on reference point. One example; you buy a stock at 50, it goes to 100 (you feel really great), the stock then goes back to 55. You are still up 10% on your investment but how do you feel? Most people feel they have (almost) lost money since they tend to have 100 as the reference point.
The Mindset of a Trader
Below is a classical example of decision making and has big implications with regards to how traders need to adjust their decision making process. Let’s assume:
Pull out marble by chance from a box:
- A: I give you 1000 usd if blue marble – if red marble I give you zero
- B: I give you 700 usd for sure
Majority go for the second option, people take 700 usd which is certain money in the bank even though the expected value of the situation A is larger.
The following example below has exactly the same expected probabilities as the example above but instead of certain outcome we have changed it to being an uncertain event.
- A: You give me 1000 usd if blue marble – if red you give me zero
- B: You give me 700 usd for sure
In this example where there is a possibility of losing people tend to go for option A. This gives them a possibility of escaping the loss, despite the probabilities in favour of the other option.
Risk and p/l Management
Risk – volatility of returns
Risk is a complex area and much has been written on the topic. Simplified I would like to say that risk is the volatility of returns.
See below two portfolios; Portfolio A has boring returns where the trader makes 5% per year. The second portfolio (B) is more dynamic with much higher returns per year, except for one year where the portfolio decreases by 40%. This one big drawdown offsets all other good years in a way so that the total of Portfolio B is actually lower than Portfolio A after 8 years. This shows the importance of limiting your trading from big drawdowns.
The below table is self explanatory and takes us back to the argument of limiting the downside to our portfolio.
You must have the relevant tools in place on order to manage risk and p/l of your portfolio because volatility is risk!
Risk management is a vital part of successful trading! Most people realize this but very few understand what risk is, nor do they have the tools to properly manage the risk in their portfolio. You will read about stop losses and other risk management tools on sites written by so called traders that actually lack proper understanding of risk and p/l management.
There are many ways to calculate the risk in your portfolio, but most of those are formulas not easily understood, one example is VaR (value at risk).
Risk must be understood easily and the tool(s) must be easily managed!
A trader produces only one thing, p/l. Therefore it is vital to manage and optimize the p/l. While most risk management systems focus on the risk via various formulas, I believe, especially for relatively short term trading, one should manage risk in relation how the underlying p/l of the portfolio is developing.
The actual p/l produced should determine what risk you should be taking.
The more money you are generating the more risk you should take. Inversely, the more negative your p/l is developing the faster you need to reduce risk taken.
Over the years I have developed a risk and p/l methodology. It is a simple tool that objectively tellis the trader when to decrease or increase the risk in your portfolio.
The dynamic risk and p/l methodology
The objective p/l management method is built on viewing the aggregate p/l of your portfolio as the benchmark of what you are producing. The trader plots the daily p/l in an excel chart and with time you will build a historic chart of your p/l. If you trade various strategies you plot the p/l per strategy as well as an aggregate p/l.
We are all different type of humans and we trade all different strategies, so the p/l chart will look different for most traders. The pro with plotting the p/l is the fact it shows you clearly and objectively what is happening. Some traders will have smooth charts while others have more volatile charts.
The basic concept is that the p/l chart shows how your trading is performing. In order to manage the p/l chart we apply various moving averages.
In the charts below we mainly work with the 21 and 8 day moving averages. A positively sloping moving average is telling you that your trading and strategy works well. A negatively sloping moving average is telling the trader the current strategy is not working well. The 21 day average is seen as a somewhat medium term average while 8 and shorter averages are more aggressive averages to watch.
The method is built around two concepts;
- Reduce risk when you are losing. If you lose too much then cut all risk and take a break.
- Increase risk when you are winning. Force yourself to take on more risk and produce great p/l by deploying more risk.
The method practically
Below we show a few charts of hypothetical portfolios and different types of traders and what they need to improve and focus on.
The Smooth Trader
The chart below shows us the smooth trader. Note how the p/l (blue) is positively sloping without any big oscillations. The chart is a bit exaggerated in terms of returns but the important aspect is to show how this trader trades smoothly. The green line is the 21 day and the red line the 8 day moving average.
The typical trader showing the below type of p/l is aware of his risk and usually trades constant risk with disciplined stop losses. The problem is that this type of trader doesn’t use the full potential in his/her ability. When the p/l slopes this smoothly one needs to apply a more aggressive approach and take more risk since whatever you are doing is working well. You simply need to do it in more size!
The smooth trader needs to increase risk in order to lift the p/l to new plateaus. Downside p/l risk is managed by the trader naturally.
The Bad Trader
The chart below shows the bad trader. This is the trader usually making the first money by pure luck, but lacks the understanding why he even made the first profits. The successful part of trading usually turns when the trader enters a trade where the stock or entire strategy starts going against him/her. Many times these type of traders have very big egos and must be right. They see stop losses as personal failures and refuse adjusting to the thought of them being wrong. Any trader that lets the ego control the mind will end up in tricky situations as losses are a big part of trading.
Losses must be treated without emotions.
The bad trader often sees the p/l chart and understands something is wrong, but this trader lacks the tools and discipline to manage p/l that starts going negative. Frustration, prestige, ego usually take over and negative p/l starts accumulating and many times reinforces even more negative behaviour such as doubling down etc.
Let the p/l control risk
We talk about letting the p/l control the risk in the portfolio. How is this done practically?
The blue chart is the aggregate p/l of the portfolio below and the other lines represent the moving averages. The methodology using the p/l to determine the risk in the portfolio will automatically raise the first warning signal when the p/l starts falling below the 8 day moving average (red line).
We can clearly see that as the p/l starts dropping below the 8 day moving average, the slope of the blue line starts shifting to being negative. Whatever the trader has been doing up to now has been fine, but something has changed as the p/l starts going below the 8 day average. There is absolutely no panic to stop trading. The system is simply flashing the first red light to start monitoring the risk a bit extra.
The methodology will automatically tell the trader to cut down on risk as p/l moves below the 8 day moving average. A general rule would be to reduce risk by 20-30% of the overall risk. It is vital to continue trading, but just with a bit less size. The bad trader lacks the relevant tools to use and many times starts doing the opposite of what we are describing. Traders many times start adding to risk and hoping what they did up until now will work again.
When the p/l starts dropping below the green line, the 21 day average, the bigger red alert flag starts flashing. There is still no panic and the trader MUST continue to trade, but needs to have the discipline to reduce risk further. By now the objective observer clearly sees that the p/l simply isn’t working and that whatever the trader is doing simply doesn’t produce positive p/l.
When looking at the p/l chart from start, the trader has still produced nice returns, but as we cross below the 21 day moving average, it is vital to have all tools and discipline in place to not give back more p/l than necessary. There is of course not one single trader nor strategy that always makes money, so it is important to take proactive action.
As a general rule the trader should reduce risk to 50% of normal risk usually traded as thep/l drops below the 21 day moving average.
The aim is to continue trading and continue being in the game but with much less risk so even if the strategy doesn’t work the trader doesn’t lose too much p/l.
Looking at the chart below we see the p/l has moved from 1 510 000 to slightly above 1 400 000 as the p/l falls below the 21 day average. The aim is to continue trading but with reduced overall risk.
Despite the reduction in risk the below trader’s p/l chart continues falling. A general rule is to start reducing risk further as the moving averages start crossing just below the 1 400 000 level. The strategy is obviously not working well at the moment but the aggregate p/l since the start of the chart is satisfactory and given the fact the strategy currently doesn’t work the risk management focus needs to shift to defense and focus on limiting further downside.
One negative effect, apart from the obvious, is the fact negative p/l periods often affect the trader negatively as self esteem gets affected. It is important to not let the p/l develop into the chart below. The methodology will automatically reduce risk by 50% as the two moving averages cross (the trader needs to follow the methodology of course!). Should the p/l continue lower, risk needs to be cut further. Despite reduced risk the trader will continue to trade but with strong focus on limiting further downside.
In a scenario where the p/l falls below the 1 400 000 level risk needs to be reduced further and predetermined rules need to be implemented. It is advisable to set up rules where the trader in this period is allowed to lose only small amounts per day. One good rule is to switch off trading for the day if you lose approx 10% of a normal daily p/l swing. This will still keep the trader active trading but will make sure the p/l is not allowed to go much lower. This is the last phase of aggressive risk management.
Should the p/l still continue lower it is advisable to use the minimum p/l drawdown per day for a week and if the p/l still continues lower the trader simply must switch off and take a break.
Plan of action
The chart below shows the plan of action and how the risk is predetermined and adjusted in accordance to the p/l.
First risk reduction occurs when the p/l falls below the 8 day moving average (red line). The second risk reduction occurs when the p/l slips below the 21 day moving average (green line). Further reduction of risk occurs when the moving averages cross. At this stage the trader should be trading a fraction of the normal risk, approx 25%. Should the p/l continue to be negative the trader needs to apply the last part of the risk reduction by applying a small max drawdown per day. If this max drawdown is hit during the day, the trader simply stops working that day. In case this max daily limit is hit for a period of one week, the trader must take time off.
The methodology predetermines all these rules that must be followed. The point is that the trader must not stop trading, but needs to reduce risk according to the rules, all in order to preserve capital and not give back too much of the capital gained so far.
Bad Trader 2
The next bad trader 2 is the typical individual that lacks all forms of understanding of the p/l and use of risk management is absent. The danger with these types of individuals is the fact they make money in certain periods (mainly by pure luck) but when p/l starts going against them, they start relying on luck, hope and fallacies like doubling down etc.
In the example in the chart below we see how the trader initially makes money and the p/l chart shows good progress. A very common problem among these type of traders is that many times their p/l suffers rather violently with sharp negative days.
The chart shows how the first crossing of the 8 day moving average occurs fast and we can clearly see that the trader lacks methodology to reduce risk and slow down the negative p/l. In this example the p/l drops abruptly below the 21 day average as well.
Typical behaviour is that traders at this stage have not applied stop losses nor reduced risk. They start hoping for the positions to revert back and once they revert the trader will be happy to get out flat.
We all know this seldomly happens. Traders start doing the opposite, instead of cutting risk they many times start accumulating more of the positions producing negative p/l.
After the first blow to the p/l traders often see the p/l chart accumulating. Very often these type of traders lack methodology and are very eager to make it back. This results in premature adding to risk and given the recent strong pullback in p/l creates a very delicate situation where the trader feels he/she must make lost p/l. Since the trader often is obsessed with making back money too much risk will be at play and if/when the p/l turns down again, big damage is done to both the p/l and the trader’s psychology. Instead of having a methodology in handling risk in relation to p/l, the below type of trader continues more and more into negative territory.
What can the trader have done differently?
With risk being an effect of p/l, the trader in the example should have automatically reduced risk as soon as the 8 day moving average was reached. Given the pace and magnitude, prudent risk management would have cut down risk to around 50% of the size traded up until that level.
As p/l continued rapidly lower the next step would have been to reduce risk even more aggressively when the 21 day average was violated. At this stage the methodology would have had the trader deploy a fraction of normal risk and would have been focused on max daily losses as the last part of risk management before the trader would be forced to liquidate positions and take time off.
The period post a liquidation is important. The trader needs to come back in the trading game but must initiate this period with trading small positions and running small risk exposure. You can compare this to a person having fallen off the horses back, you need to get back up, but you start slowly.
We have written about the single most important aspect of trading:
Know when NOT to trade.
The second most important aspect is the concept of stop loss. Most sites will write that the stop loss should be your risk management tool number one etc but that is just the first step in risk management. The methodology described above is focused in some aspects on stop losses, but even more importantly the connection between p/l and risk usage. Just having a stop loss is not a sufficient risk management tool. Even by only applying the above is NOT going to make you a great trader. Surely, the down periods will be properly managed but only focusing on how to minimize downside won’t make you a very profitable trader.
How do you improve your profits by optimizing your p/l management?
You do so by creating what I call it The Zone Trader. The Zone trader is always on the alert, has done the obvious such as; prepared, decided on the strategies etc but also connects all the trading with the most dynamic p/l management.
Number one is managing the downside but if you wish to take your trading to new levels, you need to know what you do with risk when you are trading well. It is during these periods where you can take your p/l to new plateaus.
Majority of traders utilize equal amount of risk, irrespective of being right or wrong. I have explained why this is bad in periods of negative p/l, but in order to maximise your trading you need to know when to increase risk and how to manage those periods of good trading.
Contrary to our methodology most traders tend to reward themselves when they have had a good run by going for spontaneous vacations or other luxuries. This is totally wrong. The basic concept of our methodology is to utilize more risk when your trading is in the zone. It doesn’t really matter what you are doing as long as the p/l chart is pointing upwards and you are above the moving averages, the thing you are doing is working well!
This is where most traders fail to use their maximum potential. They usually get scared of deploying more risk and don’t maximize those good periods. A higher p/l is just a function of how much risk they deploy.
The chart below explains in detail how a trader that is in the zone should behave. As long as the trader is above the 8 day average additional risk needs to be considered. This must be done automatically (ie no subjective thoughts that interrupt the process of risk taking) since the objective method is telling you to do so. Of course one needs to be aware and manage possible downside, but risk must be added irrespective of the trader’s view or feelings or other subjective aspects.
By adding more risk, ceteris paribus, the p/l will get a boost given that what the trader is doing still works well.
Instead of keeping risk same, the increase of risk will be a direct function of a positive p/l and will take the p/l to a new level.
In periods of very good p/l I would consider adding a 5 day moving average even. This is rather aggressive but will keep you very aware of p/l and risk.
One typical problem many traders have is that when they reach a new high in the p/l, then experience a drawdown and then recover that and reach old highs. Traders many times get scared of pushing above old highs in the p/l.
We can see in the chart below that the trader must add to risk where it says bang. Whatever the trader is doing is working fine, and given the p/l being comfortably above the averages, an increase in risk is a must. This is what trading in the zone looks like.
Taking out new highs in p/l and adding risk aggressively will reinforce the good and positive feedback loops. The pro trader will keep on adding risk, managing the p/l according to the predetermined rules and will grow as a trader.
One thing very important is to not get sloppy and start experiencing hubris. If the method is followed properly, the risk will be cut down accordingly when the p/l starts going lower, which is inevitable.
The Zone trader has the methodology and tools in place to manage his/her trading!