The Tycoon Report

Taming the Emotional Tiger in Your Trading

Thursday, July 2, 2009 | Bob De Dea

"In free markets, sentiment refers to the feelings and emotions of market participants.... Every change in price results from a change in the balance between optimism and pessimism.... As oscillation suggests, the psychological state of a market experiences peaks (optimistic extreme) and troughs (pessimistic extremes)....

"This is the rule in all financial markets, where man's impulse to herd creates extreme and unsustainable levels that ultimately lead to a reversal." -- Jamie Saettele, "Sentiment in the Forex Market: Indicators and Strategies to Profit from Crowd Behavior and Market Extremes"

"The emotional qualities are antagonistic to clear reasoning." -- Sherlock Holmes, in "The Sign of the Four"

Herding the Tiger

The market is a wild creature that follows a time-tested pattern. You can view the long-term trends, like Jamie Saettele in the quote above, in terms of optimism and pessimism. Or you can look at the stages of the market (bottoming, rising, topping, descending) and ascribe emotions to them (uncertainty, greed, ambivalence, fear).

In a similar fashion, the individual investor goes through his or her own stages of emotional response to market conditions.



Look familiar?

I don't know about you, but when I first started trading, I went through this cycle on a trade-by-trade basis -- sometimes even during the course of a few minutes.

The cool thing is that we can use this cycle to take advantage of the market's fluctuations. Note the two arrows that highlight the "Point of Maximum Financial Risk" and the "Point of Maximum Financial Opportunity."

(These are identified for the buy-and-hold investor; you and I know that we can make money in any market, with the key being to identify where it is in the cycle. Or, more specifically, where the security is in its cycle.)

That's why sentiment is so important. And why it's usually wrong.

Teaching the Tiger New Tricks

The truth is that emotions fluctuate. But emotions are not the enemy; we can hardly escape them. They just need to be tamed.

For example, when volatility is great, as in the current market, a trader can easily fall prey to the desire to chase the price of a security or an option. In fact, it can be almost reflexive.

But, as Barbara Cohen has written, and as Sherlock Holmes might warn, this could signal the trader's downfall.

So how does one train one's emotions?


An expert in any profession has one thing on his or her side: preparation. The accomplished lawyer is ready for the unforeseen piece of evidence; the professional actor is ready with his lines and his blocking (movement across the set or stage); the effective police officer is trained for any life-threatening circumstance; the sculptor makes many models before placing chisel to stone.

Being prepared for the best and for the worst, and for the middling, is what separates the successful from the merely surviving.

The only way to be prepared for anything in the market (and if you're in the market long enough, you will encounter everything) is to have a plan by which you trade. This should be based on your risk tolerance and your style of trading.

Your Trading Style Must Have Substance

Some people will exit a trade if there's an 8% move to the downside; some will wait till 12%. Some will take profits of 25%; some will risk waiting for a move higher. Some use a real stop-loss order, some a mental stop-loss. (Let me just say, if you don't use stop-losses, you can't consider yourself a pro trader -- a means to limit risk is essential.) And so on and so forth.

A trading strategy of some sort is mandatory. Think about it. Write it down. Try it out on some paper trades. Ask yourself, "What would I do
if ... ?" and try to come up with as many scenarios as you can. This is only way to develop qualities that will make you a skilled and sure trader, free from the emotional merry-go-round.

These qualities include the readiness to change directions midstream if necessary. Your trading strategy has got to include a consideration of the current trading environment. (For instance, the 30% Sector Hunter signals were more "chancy" under recent market conditions than the 70% or 10% signals.)

What the security is doing at the present moment must guide all decisions, not its supposed future course. Evaluate. Then re-evaluate.

The pro is always asking, "How can I minimize losses? Lock in gains?" The relationship between the pro and the market or its constituents is a dynamic one.

One big difference from my time in the early stages of my trading experience to now is that I no longer look at every trade as the measure of my success or failure. I've zoomed out to always remember the big picture instead of getting caught up in the nitty-gritty details. If one trade goes south, another will come along. Likewise, if I make a great profit in one trade, I don't carry that expectation to every other open trade I've got on the line.

Does that mean I'm not excited when I make money? Are you kidding?!

It just means that I don't need to make money on every trade to get excited. I know I'll come out ahead in the long run, since the reward is making enough good decisions to be able to trade another day.





Bob De Dea
Guest Contributor
The Tycoon Report