Trading Habits - Positive, Negative, and How the Market Rewards Bad Behaviour

Discussion in 'Development and Psychology' started by jack, Jun 30, 2013.

  1. jack

    jack Administrator Staff Member

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    Trading Habits - Positive, Negative, and How the Market Rewards Bad Behaviour

    In the world of prop / firm trading, specifically where the company is responsible for the risk their traders take on (and the trader hasn't put up any risk deposit, as you'd find in most prop firms these days,) you'll notice a common theme around hiring practices: Either you are a vetted, highly profitable, experienced trader with a audited track record spanning years...or you're a highly educated new grad with zero market experience. Anything between these two points are usually discarded and avoided like the plague.

    While there are many reasons for this, the main one stands out: Habits. Or bad habits specifically.

    It's much easier to take a green trainee with zero experience and instill the right habits from the start, than it is to undo bad habits someone might have picked up over a few years of unsuccessful trading. So unless a trader can prove their trading habits are working out for them (ie, audited track record showing consistent risk management and returns over 3-10 years,) most will be passed over in the resume pile for greener applicants.

    What causes bad habits? Are these just different schools of thought learned working and trading in other environments or from other firms? Not really, it's the market itself that teaches most bad lessons, and the market has the tendency to reward the worst of choices.

    The very first day you sit down and give this "trading" a shot, your mind starts recording and learning. This is where human psychology steps in, since in trading it's not just about market knowledge but there's a built in reward system for our actions (winners and losers.)

    For each action that results in a profit, you will find that you are more willing to repeat that action, and for each action that results in a straight loss, well, you get the picture. If it ended there, we'd all eventually be great traders with enough practice, but our mind doesn't quite think the same way our trading activity reads: Consider this, if you hold onto a loser just a little longer and it becomes profitable, is that being recorded positively or negatively in our mind's unconscious?

    I've written about this before, but loss aversion strikes hard here. It's easy to be wrong in a trade, but through various methods of position management, people can defer the risk they take on and experience more rewards in the short term. Each time they get a positive outcome, despite the risk they take on, it makes it easier to repeat the steps they took in that trade.

    A great example would be averaging losers to avoid taking a loss. If you hadn't already planned to take an average entry price, and adjusted your risk / position sizes accordingly, then averaging a loser is just a "hope and pray" trade.

    Often failing traders will increase their position at a worse price in order to make recovery happen faster. By averaging down, a trader gets a blended average price on their trade and price action has to move less in their direction before they see profitable results. Since price can move pretty randomly at time, this often has the result of bringing the trade back to break even and allowing the trader to flatten out and avoid the loss they were looking at earlier.

    As I said though, this is just deferring the risk of loss, not eliminating it. From a single entry point with a fixed "I am wrong let's get out" stop and profit (being two possible outcomes,) the trader averaging losers just switched to a 3 or 4 possible outcome scenario, with one outcome being a bit profitable, one or two being near break even but not a loss, and one being a loss far greater than the original trade. Price doesn't have to recover, it could just keep working against the trade, you have no control over it. The probability of that last, loss laden, scenario has been decreased, but the risk hasn't.

    So all the while, a trader who averages losers is building the pathological response (habit) to keep avoiding losses since more times than not it works out to be at least a break even trade. Even when their account balance starts getting hit hard with losses, they find themselves repeating the same mistake because the frequency of losses taken are much less than the winners. Their mind is recording more positive outcomes than negative. So it's hard to break out of the newly formed pattern of averaging down.

    The worst habits are built up over years without a logical reason to stop. These are a death sentence to a trader's career since re-wiring their brains can take just as many years of hard work. The averaging losers example (with two entries) starts to show the trade's true risk rather quickly, and a lot of traders will identify that the method is flawed and work on not doing it anymore early on...

    Sadly though, some traders will just add a third entry, and forth, and fifth...etc.. With each addition, the chance of taking that 'big loss' outcome becomes less, but the risk in such a case gets exponentially greater with each addition. And since the frequency of 'loss' is minimized, the trader is just reinforcing the bad habit stronger and stronger with each trade as their brain only registers the small profit as a positive outcome.

    (If a trader keeps adding positions, of grater size even like martingale, they might be able to avoid any negative recording in their mind from a loss up until the point their account gets completely blown away.)

    Ok, I've covered the averaging losers part many times over now, but it doesn't stop there, other bad habits that could be recorded as positive outcomes include:

    • Not taking major news events into consideration on an open trade (works out until the day the news makes price jump far against you in an instant.)
    • Over-leveraging.
    • Holding onto a single entry with no stop in hopes it comes back.
    • Turning a "scalp" into a "swing" trade since the scalp didn't work. Or as the equity world likes to say: "turning a trade into an investment."
    • Selling option premium too close to the strike to get an extra few bucks. Or selling option premium at all for that matter if you haven't realized the full risk involved or aren't properly hedged.
    • Putting your account in an 'all or nothing' trade.
    • This list can go on for a while... and examples in all markets can be highlighted



    So in conclusion: No matter how hard it might be, learning to love taking losses and moving on to the next trade is paramount for career traders. With each action, even if the result is negative on your P/L, you build a habit. Actions that feel negative unconsciously (realizing a loss when it's time to do so,) in a positive trading context, eventually don't feel bad at all once you repeat them enough (good habits.) And if you allow it, the market will teach you all sorts of bad habits that feel good at the time before you suffer losses you never wanted / expected.
     
  2. b17

    b17 New Member

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    Thanks Jack.
     
  3. Jim68

    Jim68 New Member

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    Good read and a great reminder.
     
  4. jack

    jack Administrator Staff Member

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