If you look at highly successful business organisations, such as McDonald’s, Dell, Federal Express, or Wal-Mart, you’ll find companies that are doing the same thing, the same way, every day, with a high degree of consistency. They came up with a winning formula or plan, which is half the battle, but they execute that formula or plan with high fidelity and regularity. That is how you want to be trading.
So that brings up two important questions for any trader’s self-assessment:
- Do I have a winning formula, and have I really tested it to know it’s winning and to have the needed confidence in it?
- Am I executing my formula faithfully, and am I truly tracking each and every trade to know I’m following the formula and have the confidence in my ability to follow it?
A very large percentage of traders cannot honestly answer these questions in the affirmative. They want help for their psyches when what they need firstly is to treat their trading like a world-class business.
Trading and Personality
About seven years ago, a study was conducted of approximately 64 active traders. Its aim was to discover whether there were any personality traits and coping styles that distinguished more successful traders from less successful ones. A number of thought-provoking findings where discovered.
It was found that the winning traders tended to have lower levels of Neuroticism (negative emotional experience) than their less successful counterparts.
They also employed more problem-based coping methods (coping by developing strategies for dealing with threatening situations) relative to emotion-focused coping devices (coping by venting feelings or seeking support).
Profitable traders, we found, scored higher on a trait called Conscientiousness, reflecting a general stick-to-it-iveness and motivation to follow through on plans and commitments.
In all, traders who temper their emotions and stick with trading plans fare better than their more emotional and impulsive peers.
One unexpected finding from our survey, however, was that a disproportionate number of the successful traders—about half—reported utilising a systems based trading approach. Of the unsuccessful traders, none were mechanical traders. When subsequently interviewed the successful traders, it turned out that even the ones that were not systems traders were basing their trades on patterns that they had carefully researched. Conversely, almost to a person, the unsuccessful traders lacked such grounding in patterns and research.
A major reason they were successful is that they used trading rules both to guide their trading and to maintain a positive mind frame. We would like to explore in detail why rule-governance is one of the most powerful psychological strategies one can employ in active trading.
The Psychology of Rules and Systematic Processes
What is a systems based trading approach?
Basically, it is a set of rules and processes to trade by. These serve several functions.
The first such function is a logical one: they are designed to maximise profits by exploiting anomalies within relatively efficient markets. While any single trade may not prove profitable, over enough time and with enough trades, these tilted odds should benefit the trader’s equity curve, so long as the decision rules have been adequately researched. Here it is vital for any trader to know how the system was developed. Was it tested over a time period independent from the one used in its development? Is its real-time performance consistent with its historical track record? Is the underlying logic of the system sound, or are there too many parameters, convoluted logic, or other signs of curve-fitting?
Less well appreciated is that such decision rules serve a second, psychological function. By reducing trading to a set of rules, traders lessen their ambiguity so that they can function in a relatively automatic mode. This permits a clear-headed monitoring of fresh trading opportunities, so that those improved odds can eventually work to one’s favour. In reducing ambiguity, rules contribute to a sense of mastery and reduce much of the stress associated with high performance activity. Think about how stressful it would be to drive in a third-world country where traffic rules are not enforced! This is precisely the emotional state of many traders who function by the seat of their pants. The presence of rule governance lends order to an otherwise chaotic process.
In order for a system to serve as a psychological aid, however, it must fit well with the personality of the trader. Research conducted at the London Business School suggests that yet another personality trait—extraversion—is positively correlated with risk-tolerance. Some traders are much more risk-averse than others, simply as a function of their personality constellation. It is crucial that the system you trade take this into account.
Trading is indeed a high-performance activity. Like other high performance domains, it requires directed effort. The football team going into a big game draws up a game plan; the army about to fight a war develops a battle plan; the master psychotherapist goes into sessions with a coherent strategy for assisting a patient. These plans are actually sets of interwoven rules that, as a whole, orient the performer as to the challenges that lie ahead. To the extent that the peak performer has a decision tree mapped out in advance, responses to situations can be made rapidly and decisively. In many fields—on the trading floor or in the operating room—the difference between success and failure can be a matter of seconds or minutes. This makes cognitive efficiency a prime ingredient of peak performance. By summarising years of experience in a few statements, rules and plans promote such efficiency.
The traditional trading wisdom that says we need to control our emotions stems from the recognition that highly emotional states leave us more vulnerable to lapses in concentration and impulsive behaviour. When we are activating the wrong brain regions, we can expect to make impaired trading decisions. Rules and systematic processes enable us to stay grounded in proper trading practice regardless of the mind state we are occupying at the time. Indeed, the entire process of formulating, following, and coordinating rules activates those executive functions needed for proper trading. In a very real sense, staying rule-governed is a way of staying focused and rational. It is for this reason that successful traders tend to be rule-governed and systematic.
Conclusion
Staying grounded in solid trading rules and systems is one of the most powerful ways of maintaining a positive trading psychology. When we are rule and systems -governed, we are in a mental state that promotes efficient perception, problem solving, and action. Indeed, training ourselves to stay rule governed during trading rehearsals is an effective strategy for cultivating rule governance in real time.