Friday, May 1, 2015

A Powerful Technique for Breaking Emotional Patterns in Trading

Traders love patterns. We trade chart patterns, oscillator patterns, historical
patterns, cyclical patterns—you name the pattern, chances are there’s someone trading it.
Much of trading boils down to pattern recognition and the ability to quickly identify and
act upon profitable patterns as they occur. This is particularly challenging for active
futures and options traders, who must read the patterns, make their decisions, and place
their orders within a matter of seconds. Processing market patterns in the midst of our
own emotional patterns—our tendencies toward impulsivity, hesitation, frustration, and
regret—is one of the greatest challenges of active trading.
It is always sobering for traders to realize that they are every bit as patterned as
the markets they’re trading—and sometimes far more so. In this article, I will draw upon
two decades of experience as a clinical psychologist to illustrate a powerful technique for
interrupting and changing repetitive emotional and behavioral patterns that disrupt
trading. The technique is a cognitive-behavioral method known as exposure, and—in the
Ranger tradition described by Brace Barber, Linda Raschke, and me in September’s
issue—it is a powerful tool for challenging oneself for exemplary performance.
Becoming Your Own Therapist
Extensive studies by Axel Cleeremans and Arthur Reber suggest that, with
sufficient experience, people can learn to read patterns in data and anticipate future data
sequences. Interestingly, this pattern recognition is intuitive and implicit rather than
verbalized: we know things long before we know we know them. Such findings
contradict the common belief that successful trading requires an elimination of emotions.
Our feelings, like market data, consist of relatively weak—but vitally important—signals
in the midst of considerable noise. Our sensitivity to market patterns often remains
hidden amidst the pushes and pulls associated with trading fears and ambitions. Traders
can learn to become their own therapists by using techniques such as exposure methods,
not to dull or eradicate emotion, but to gain control of their cognitive worlds and better
extract signal from noise.
The problem, you see, is not simply our patterns of anxiety, guilt, anger, or
discouragement. The problem is that we cannot control these patterns. No one
consciously plans to fail to pull the trigger on a promising trade; nor does anyone want to
impulsively leap into a non-trending but volatile market before evidence of a breakout is
at hand. As I emphasize in The Psychology of Trading (Wiley; January, 2003), such
emotional and behavioral patterns play themselves out against the will of the trader, in
spite of our best-laid trading strategies and sophisticated market research.
For most of us, the scenario is embarrassingly familiar: We make plans to get into
shape, to diet, or to treat others better—and what happens? All too easily, we lapse into
our ruts. At the time we make our resolutions we are sincere. But under the influence of
old patterns, the resolutions lose their force. The plans that we had carefully crafted fall
by the wayside, like so many good dieting intentions.
Our trading (or dieting or exercise) plans are anchored to a particular state of
mind—associated with a particular set of thoughts, feelings, and physical sensations.
When something intervenes to shift us to another state, we lose our anchoring. We no
longer have vivid and immediate access to the motivating experiences that spurred our
initial intentions. The key is not to spend months and years psychoanalyzing why we are
“self-defeating” or otherwise lack “self-esteem”. Rather, we need to become our own
therapists and learn to remain anchored, even in the face of market and emotional forces
that could disrupt our trading plans. That is the purpose of exposure-based techniques.
Overcoming Problem Patterns Through Exposure
Let’s take a classic example of how exposure can break seemingly intractable
emotional patterns. Ellen is suffering from a condition known as panic disorder. Sudden,
episodes of anxiety hit at seemingly random moments, greatly interfering with normal
activities. These episodes are so scary that she is afraid she is losing control and might
even die. As a result, Ellen develops a fear of her panic episodes—something known as
“secondary anxiety”. Sure enough, her fear of the panic attacks leads her to become
increasingly anxious and actually triggers further attacks. By the time Ellen makes it to
therapy, she has been caught in a continuous cycle of worry, anxiety, and panic.
If I were using exposure methods with Ellen, I would first teach her a skill, such
as a deep-breathing, progressive muscle relaxation method. This involves learning how
to slow oneself down by reducing the rate of respiration and deepening the breathing
while eliminating physical tension by gradually tensing and relaxing muscle groups from
one end of the body to the other (See Figure One at the end of the article).
Once Ellen has learned this method, the exposure can begin. I would ask her to
take a few rapid and shallow breaths, simulating hyperventilation. This exposes Ellen to
the some of the same physical sensations that she experiences during the early phases of
her panic attacks. It also summons those panicky thoughts and feelings that have become
deeply associated with the physical sensations of anxiety. When Ellen begins to reexperience
a bit of her anxiety, I instruct her to perform the deep breathing and muscle
relaxation. She continues with the relaxation work until the initial anxiety sensations are
After Ellen learns to extinguish the anxiety that comes from a few rapid, shallow
breaths and then from more prolonged hyperventilation, I then have her perform more
intensive exposure exercises. I may have her spin around in the room, recreating the
feeling of dizziness that comes with her panic attacks. Later, I might encourage her to
provoke panicky sensations by entering situations (such as a crowded shopping mall) that
are associated with anxiety. In each case, she would expose herself to the very problem
pattern that she has been trying to avoid, but would always limit the exposure and
immediately follow it with the rehearsal of a coping skill. With daily practice between
sessions, severe problems such as panic disorder can be successfully treated within a
matter of weeks.
What makes this technique work?
Most of our problem patterns are painful; no one likes feeling anxious or
depressed. It is only human nature to want to avoid emotional pain. In avoiding our
problems, however, we never learn the control necessary for their elimination. By
gradually and progressively exposing ourselves to stressful circumstances—all the while
practicing ways of coping and maintaining control—we build a sense of mastery. This is
how people learn to overcome crippling phobias and debilitating traumas. No amount of
talk substitutes for the first hand experience of directly facing fears time and time again
and staying in control. Repeated success changes the self-image, and it alters our selftalk.
Suddenly, we really begin to feel and believe, “I can do this!”
Applying Exposure Methods to Trading
If you are going to serve as your own therapist in the exposure-based mode, the
cardinal rule is: You always must activate a problem pattern in order to overcome it. It
isn’t enough to think about your problems or talk about them. You must actually
experience your problem patterns in real time, gradually and progressively, and make
conscious efforts to counteract those patterns. If your trading problem is triggered by
increasing your size, you will need to gradually and steadily trade larger. If your
impulsive trading pattern occurs during trendless, low volatility markets or in the opening
minutes of trading, that is when you will need to work on yourself.
Fortunately, we can speed emotional change through a process known as
imaginal exposure . Imaginal exposure can be thought of as the psychological
equivalent of paper trading. Instead of starting out with real-time problem situations
(known as in vivo exposure), we can vividly imagine scenarios associated with our
negative patterns—triggering some of the feelings of greed, fear, doubt, and regret—and
mentally rehearse strategies for dealing with those scenarios. Imaginal exposure is not as
powerful as facing problems in vivo (much as paper trading lacks the immediacy of
actual trading), but it is a useful starting point in building the sense of success and
mastery. Just as athletes have found mental rehearsal to aid Olympic performance, the
mental tackling of trading challenges can prepare us for the real thing.
Let’s consider an example:
Lou is an active futures trader, with a little over a year of experience under his
belt. He has made most of beginner’s mistakes and has learned from them, carefully
planning his trades, limiting his losses, and scaling in and out of positions with initial
sizes that are adjusted for market volatility. He largely trades the ES and NQ eminis in a
short-term breakout mode, attempting to catch 1-4 swings per day depending upon trend
and volatility conditions. His entries are based on dual RSI oscillator readings, using
short-term (intraday) and longer-term (swing) parameters. While he has been generally
successful, he notices that he has performed relatively poorly on upside and downside
trend days. He finds that he hesitates too long in entering the market and then is too
quick to exit the trades once they are profitable. As a result, he takes small bites out of
the moves that should be providing him with much of his profit.
An examination of problematic trend days reveals that these begin with a gap at
the open in which price moves sharply up or down relative to the last trade of the
previous day. This gap immediately triggers negative thinking on Lou’s part, much of
which reflects feelings about having missed the apparent high or low in the market.
During this period of regret, he is not actively following price action or planning an entry.
Instead, he finds himself hoping for a pullback so that he might have a better entry point
(and a reprieve from his self-recriminations). Price, of course, does not accommodate to
his desire and moves even further from the open, now registering an “overbought” or
“oversold” signal on the short-term oscillator. Lou uses this as further justification to
hold off on entering a position, allowing him to miss a good segment of the morning
This problem seems unusually rookie-like for an experienced trader, so we
examine Lou’s overall trading performance. Sure enough, we find that his worst losses
have occurred when opening gaps in the market have been reversed. These false
breakouts have left him buying at the early highs and selling at the lows, starting his day
with solid losses and shaking his confidence. This allows us to see that what appears to
be the problem—the failure to enter the market early during trend days—is actually a
coping mechanism designed to minimize the possibility of losses. Unfortunately, it also
minimizes opportunities!
Our exposure therapy for Lou begins with skill teaching, as in the case of Ellen.
We teach Lou a method for behavioral self-control that involves slow, rhythmic deep
breathing and soothing imagery and encourage him to practice this until he becomes
skilled at maintaining his composure. In addition, however, we also want Lou to learn
some vital trading coping skills. He needs a set of rules for distinguishing potential trend
days from those that may reverse and/or rules for quickly identifying reversals once they
occur. For example, his own research and a little mentoring from experienced traders
might teach him that gaps that occur on X-period breakout highs or lows in the NYSE
TICK are more likely to show continuation than gaps that occur without such breakouts.
Alternately, he may find that moves from opening gaps that remain intact by Y o’clock
are more likely to continue through the day than those that partially fill.
Once Lou has identified his trading rules for the problem situation and learned a
method for cultivating self-control, the exposure work is ready to begin. First we can
start with imaginal exposure, encouraging Lou to enter his relaxed mode with slow,
diaphragmatic breathing and eyes closed. In this mode, he vividly imagines an
preopening news report that sends the market gapping lower, well outside its prior
Globex range. He maintains the visualization of the scenario as he practices his slow
breathing and mentally rehearses the appropriate trading strategies. Thus, for instance, he
might image the TICK plunging to a multi-day low on the opening move and the SP
failing to fill its gap on the first TICK bounce toward zero. This would be his trigger for
a short entry, and he would clearly visualize each step he would take in monitoring the
market, placing his order, setting his stops, etc. A similar set of visualizations could also
facilitate the rehearsal of exit strategies.
Once all discomfort is extinguished in the mental rehearsals, the next step in
exposure work would be applying the skills in paper trading. Using historical market
data, we would have Lou advance charts bar by bar in trading simulations of trend days
while rehearsing his self-control and trading strategies. Only when these simulations
proceed successfully (i.e., eliminating anxiety) would Lou undertake real-time, in-vivo
exposure, beginning with small positions and building to larger ones. (The speed with
which Lou progresses from imaginal exposure to paper trading to in vivo work would
depend upon the severity of the problems and the intensity with which he rehearses the
techniques. Research suggests that fewer but longer, more intensive exposure sessions
are more effective in eliminating negative emotional patterns than a greater number of
brief exposures.)
The idea is that, before Lou confronts another potential trending day in the
market again, he will have experienced multiple successes in handling such days in
imagination and then on paper. It is the repeated experience of mastery and success that
provides the power behind exposure-based intervention. Nothing so builds confidence as
repeatedly facing and overcoming one’s fears.

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