Tuesday, October 31, 2006

Intuition, Risk Taking and Trading

One of my ongoing battles in the game of trading has been fighting my propensity for risk taking. I've used a variety of measures to combat this bad habit, one of which is actually allowing myself to take a risk every once in a while, as long as I use proper steps to manage that risk. For example, setting a tight stop and entering with a small position size. However, I've always wondered if this is a bad idea. Afterall, those with chemical dependencies are supposed to go cold turkey. Is allowing myself to "feed my habit" every once in a while going to lead me down a road I don't want to go on?

I posed this question to the esteemed trading psychologist, Brett Steenbarger. He sheds some great insights that have already helped me restructure my plan to fight risk taking. Here is his response:

You're asking a great question. There are traders (often who have
attention-deficit related problems) who seem to be attracted more to the action
of trading than to the making of money. They approach trading like gambling and
have difficulty tolerating periods in which they're not trading. I have
uniformly found that this *need* to trade and take risks is never truly filled.
Eventually the trader habituates to one level of risk taking and has to go still
higher to get that thrill. The result, invariably, is a blow up.

This is very different from the scenario in which a systematic, rule-based trader
decides to follow an intuitive hunch and place trades outside the rules. Those
intuitive hunches may represent a pattern recognition that results from long
hours of seeing and internalizing markets. I think those kinds of trades are
fine, as long as they're properly sized and as long as you keep score on them to
determine whether or not your intuition really is based on something driving
supply and demand.

In general, I think it's important to have outlets for one's needs that are outside of trading. If you have social needs, it's important to have separate outlets for those so that they don't interfere with trading. Similarly, if there are needs for risk and excitement, it makes sense to get those fulfilled outside of trading so that you can better focus on your discipline when you're in the markets. Unfulfilled needs often drive our behavior, and I'm not sure "cold turkey" is a practical solution. That's very
different from making the occasional intuitive trade when an idea just feels

Brett N. Steenbarger,

Now that I think about it, I wouldn't characterize my "risks" as "falling off the wagon" type risks. They are usually based on intuition gleaned through experience with the markets, which would seem to be perfectly healthy as long as proper risk measures are taken. Thus, no need to change my trading plan. What a relief. Thanks for the advice doc!


walter said...

what do you make of UARM and today's candle?!

The Market Speculator said...

I don't have much of an opinion on UARM. It doesn't look attractive as a long or short. Maybe if it breaks out over $48 on the longside or below on $42 as a short.