Month: April 2009

In previous posts, I’ve begun introducing the cognitive theory of noise (CTN), a comprehensive model of market participant experience which will include a prescriptive component that will help traders decrease irrational behaviors and improve profitability.

This is a big project and there will be many more posts that are theoretical in nature. But in this post I would like to skip ahead a bit and offer a prescriptive technique that traders can implement on their own which will promote taking losses quickly.

I have had the opportunity to talk with a number of very successful traders over the years and have found that even while their trading styles and asset classes of choice differ, they all tend to share a few common attributes which separate them from less successful traders and which I believe contribute to a significant portion of their profitability.

In addition, I have traded equities profitably for a number of years myself and have applied certain rational behaviors to my own routine that have served me well.

Getevenitis

One in particular stands out as crucial and so I will begin there. Every winning trader that I know habitually takes losses quickly before they become outsized.

While taking small losses may seem like a simple matter of discipline, there are a number of reasons why this is not the case. I have written about it already here and here but to summarize briefly, holding a losing position tends to spur a set of psychological processes which interrupt the rational choice of realizing the loss.

Once the trader is holding a loser, anxiety increases which spurs the avoidance of loss realization.

Next, the trader will tend to begin rationalizing the position and the loss avoidant behavior with automatic internal statement such as, “this has to come back” or “if I can just get even.”

There are five basic components at play here. These are:

Situational – The trader is in a losing trade

Behavioral – The trader is avoiding loss realization by holding the loser and not selling rationally while the loss is small.

Affective – The trader is experiencing anxiety which increases as the loss increases.

Cognitive – The trader has begun rationalizing the loss with automatic internal statements.

Neuropsychological – The anxiety is accompanied by chemical changes in the central nervous system.

Taken together, these five components form a CTN profile for the disposition effect within the domain of losses or what Shefrin and Statman have also called getevenitis. (I will be writing much more about CTN profiles in upcoming posts)

If you have the tendency to fall into this pattern, you are not alone. It is the normal reaction and a empirically based evidence suggests that the majority of humans in such a situation will tend to respond similarly.

The Clinical Psychological Correlate to Getevenitis

The getevenitis profile I have outlined above is similar in some ways to certain anxiety disorders which result in behavior avoidance. These include simple phobias as well as agoraphobia.

Take for example those who suffer from an intense and irrational fear of bridges, gephyrophobia. They might have a 5 component profile which looks like this:

Situational – The bridge phobic is faced with the thought or prospect of crossing a bridge.

Behavioral – The bridge phobic avoids bridges similar to the way the trader avoids taking the loss.

Affective – The bridge phobic is experiencing anxiety which increases as the bridge approaches.

Cognitive – The bridge phobic rationalizes the fear with automatic internal statements such as, “that bridge might fall while I am on it and I will be killed” and/or “I remember seeing the bridge in Minnesota fall and this one is probably also faulty.”

Neuropsychological – The anxiety is accompanied by chemical changes in the central nervous system.

The treatment might also be similar. Clinical psychologists successfully utilize a treatment for phobics who avoid situations called graded exposure. In exposure, the phobic is guided through a series of exercises in which the exposure to the irrationally feared stimulus is gradually increased until the client is able to approach instead of avoid the it.

Self-Directed Exposure Program for Getevenitis

I will now describe a program that traders can use which might be effective in extinguishing the irrational behavior of holding losses too long.

The rationale here is that if you expose yourself to the action of taking losses quickly, then over the course of the program you will gain the capacity to cut losses fast while you are trading. You will train yourself to make it automatic.

Step One: Imaginal Exposure: Find a quiet and comfortable place and close your eyes. Then, imagine that you are at the screens during the trading day and that you have entered a trade that begins to go against you. Make sure that you take your time during this exercise and visualize every small detail that you can, the ticker, the price of entry, the number of shares, the movement of the stock against you and the feeling you get as this occurs. Then, imagine closing the trade for a small loss quickly.

Repeat this process twice total.

Step Two: Tiny Trade Tiny Loss – Now that you have imagined yourself taking a loss quickly, you will move on to making a set of very small trades and setting very tight stops. Ideally, you will be using a system that charges you by the share rather than by the trade and if you are not you might want to contact your executing broker to see if this is feasible.

Next, pick a stock that you trade and know well and buy a very small increment 1/10 to 1/20 of your normal scale size and buy it. Do not concern yourself with the set up or whether this is a good trade or not. Set an extremely tight mental stop of 10 cents below your entry and a prfit goal of 25 cents.

Then, close the trade down a dime or up .25.

Repeat this several times until taking the loss is almost automatic and extremely easy to do.

Then, repeat it again!

You might be surprised that even though you are not setting the trade, your p/l is not bad. This is because taking small losses quickly is in and of itself rational and limits downside while allowing upside.

Step Three: Repeat Step Two but increase your trade size by 2x. Make sure that before you move on, you are extremely comfortable with taking the small loss and have done so several times.

Step Four: Repeat Step Three but increase your trade size by 2x. Make sure that before you move on, you are extremely comfortable with taking the small loss and have done so several times.

Step Five: Repeat Step One.

Conclusion

You have now gone a long way to training yourself to take losses quickly.

This may take several days to perform the program. Return to your normal trading regiment. You will be well on your way to automatizing the behavior of taking losses quickly and of incorporating it into your routine of trading behaviors which come naturally and with less difficulty than before you started the program.