The Trader’s Brain: Gaining An Edge While Your Emotions Run Amok Pt. 1

Traders are the best salespeople in the world. Although used car salesmen are saddled with reputations as being pushy and dishonest, they don’t hold a candle when compared to the average trader.

Why is this? A trader, once in a position, can deceive himself or herself into believing half-truths faster than a house cat pouncing on a freshly escaped hamster. When faced with a loss, Joe Trader will look at a chart and tell whomever is within spitting distance, “The market is acting as if a reversal is about to happen.” Net result: He does not exit the position.

When faced with a profit, Joanne Trader hesitates to pull the trigger, telling her goldfish, “The market is acting great. It would be premature to sell at these levels.” Net result: She does not exit the trade.

The mistake these traders are making is a common, yet fatal affliction found in most beginning traders. The net result is a trader who “eats like a sparrow, and defecates like an elephant.” This is a situation, of course, that no account can withstand. Worse, this cycle of emotional slavery will never end until it’s met head on. By stepping back and examining this process in more detail, the trader can learn to use their own emotional reactions as indicators. Properly tuned, these emotional indicators, instead of leading to mistakes, can create great triggers to enter and exit a market.

The problem is simple. Many traders feel they can rely on their judgment while in a trade. On paper, this makes a lot of sense. After all, before a trade is placed, a trader is at his most objective. However, once the trade is on, the degree of objectivity diminishes immediately and in direct proportion to the number of shares or contracts being traded relative to the account size. Think of it this way: If one trader is long 10 Emini S&Ps in a $10,000 account, and another trader is long 1 Emini S&P in the same sized account, who is going to be sweating bullets over each tick? A trader relying on their judgment while their brain churns with extreme trading emotions is like someone trying to row a boat upstream with a piece of Swiss cheese—it simply does not work.

This perpetuates a vicious cycle, with the end result being a trader who, like a bad used car salesman, is consistently selling himself a faulty collection of beliefs that sets himself up for slaughter. Instead of following a game plan about when to exit a position, the trader in this situation will close a position for one of two reasons. First, the pain of holding becomes so great he cannot “take it” any longer. Once he reaches this “uncle” point, he starts frantically banging his keyboard to sell (or cover) “at the market” in order to relieve the pain. Second, a broker exits the position for the trader. Not because he is a nice guy, but because the account has run out of margin. This trade is also placed “at the market.” In these situations, there is no plan, no thought, and no objectivity. There is just a batch of forced sell orders, or, in the case of someone who is short, a batch of forced covering.

This act of capitulation – traders exiting a position because they have to, not because they want to – is emotions-based trading at its finest. Whether it is a sustained multi-month move to the downside due to continuous capitulation selling, or a quick 10-minute rally due to shorts being forced to cover, these acts are responsible for the major moves in all markets, on all time frames. In the end, markets don’t move because they want to. They move because they haveto.

This imbalance of market orders causes rip-like movements that result in even worse fills. Disgusted with themselves and red in the face, the victims of these trades stalk off to contemplate the insanity of the universe. Meanwhile, another group of traders took the opposite side of this “capitulation trade” and made great profits. How does a trader get on the winning side of these trades? The key is for the trader to use his or her own emotions as triggers to take advantage of these “get me the hell out of this position” panic runs. To fully understand how to do this, we must first step back and understand why traders continually and instinctively sabotage themselves in the first place.

The problem is that the tactics an individual uses to achieve his or her goals in everyday life do not work in trading, and, in fact, are one of the main reasons for failure. While “good judgment” is critical to an individual who wants to climb the corporate ladder or start a business, we have already seen why it doesn’t work in the middle of a trade. In addition, stubbornness and determination are prerequisites for success in many aspects of life, yet in trading these qualities will get you killed. To say that the trader who is unaware of this phenomenon is set up for failure is like saying that Donald Trump “dabbles in Real Estate.”

In addition, traders who “play the markets” with a mental framework oriented towards how external society rewards and punishes “good” and “bad” behavior are set up to lose from day one. For example, “cutting losses short” is difficult when there is the possibility of the market coming back to the breakeven point. At breakeven, the trader is not a “loser.” Thus, according to the benchmarks of society, if the trader can exit a position with a gain, they are “successful”. This leads to the removal of stops “once in a while” in the hopes of getting out at breakeven . . . in order to be a winner in the eyes of society (sigh).

This can work ten times in a row, but it is the one time it doesn’t work that knocks a trader flat on his back. On this particular day, this trader will be one of many who cause a “rip like movement” in the markets. This habit of removing stops, even if it is only once in a while, is reinforced by the societal belief of what defines a winner versus a loser. This is a habit that will destroy an account faster than The Donald can mutter the words, “You’re fired.”

Tomorrow we will look at a few of the leading “account killers” and how we can take advantage of others – and our own – emotions for more profitable trading

John Carter

John Carter President/CEO

John Carter’s father was a Morgan Stanley stock broker. One day during high school, John came home from the mall where he was working at a store making cookies. He had saved up $1,000 over the course of a few months and his dad told him that he and some of his friends were going to buy “some call options on Intel” the next day. With his father’s direction, he bought 10 call options at $0.75, and sold them a few days later for $1.50, doubling his money. He was hooked and has been trading ever since—going on 25+ years now.

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