Mastering the Four Fears

lesm · 19 July 2006

With some of the discussion related to trading and some of the newbies on the forum, it may be worthwhile considering the article below.

This aspect related to the psychological side of trading has been discussed recently on the elitetraders forum, some interesting response there.

http://www.bigtrends.com/document.jsp?documentid=914
A reprint from a 2002 Stock Futures and Options Magazine, by Price Headley.

From the article:
"Merriam-Webster's dictionary defines fear as "an unpleasant, often strong emotion caused by anticipation or awareness of danger, going on to explain that fear...implies anxiety and usually the loss of courage." This definition of fear is useful in helping define the issues that traders face when coping with fear. The reality is that all traders feel fear at some level, but the key is how we prepare to address our concerns related to taking on risk as a trader. In this article I will review four major fears experienced by traders, and I'll take it a step further by noting how the outcomes of these fears create undesirable trading behaviors."

Cheers.

PS: Joe not sure if this is right place or not, please move as you consider appropriate

Magdoran · 20 July 2006

lesm said:
With some of the discussion related to trading and some of the newbies on the forum, it may be worthwhile considering the article below.

This aspect related to the psychological side of trading has been discussed recently on the elitetraders forum, some interesting response there.

http://www.bigtrends.com/document.jsp?documentid=914
A reprint from a 2002 Stock Futures and Options Magazine, by Price Headley.

From the article:
"Merriam-Webster's dictionary defines fear as "an unpleasant, often strong emotion caused by anticipation or awareness of danger, going on to explain that fear...implies anxiety and usually the loss of courage." This definition of fear is useful in helping define the issues that traders face when coping with fear. The reality is that all traders feel fear at some level, but the key is how we prepare to address our concerns related to taking on risk as a trader. In this article I will review four major fears experienced by traders, and I'll take it a step further by noting how the outcomes of these fears create undesirable trading behaviors."

Cheers.

PS: Joe not sure if this is right place or not, please move as you consider appropriate

An excellent piece lesm,

Thank-you for posting it. I especially liked the references to Mark Douglas, and anyone trading can relate to this ongoing psychological battle.

I can really relate to some of the concepts - I still get that brief heart palpitation when I’m about to put a trade on – I’m a lot cooler exiting either at a profit or a loss, it’s pulling that trigger decisively that is just like the moment before walking on the stage.

I believe trading has four foundations: Analysis, System, Strategy, and the most important one (often forgotten or relegated to a minor standing) – Psychology.

When I first read Mark Douglas’ “Trading in the Zone”, it really changed my trading for the better. I achieved trades I would never have believed possible before adopting it.

But I see this process as ongoing, and I think we can all benefit from this article, even if it is just to reinforce the lessons learned in the field, or for newer traders still forming an approach.

Regards

Magdoran

ducati916 · 20 July 2006

Risk = uncertainity
Risk can be further sub-divided;

*geo-political events risk [macro-risk]
*alpha risk [micro-risk]
*beta risk [micro-risk]
*individual risk [the psychological component]

There have evolved specific risk management, and analytical models from a number of areas of enquiry;

*CAPM, VAR, evolved from EMT for beta risk & geo-political risk
*Quant, Fundamental, Technical, for alpha risk
*Game theory & behavioural finance for; individual psychological risk

lesm · 20 July 2006

Magdoran said:
I believe trading has four foundations: Analysis, System, Strategy, and the most important one (often forgotten or relegated to a minor standing) – Psychology.

When I first read Mark Douglas’ “Trading in the Zone”, it really changed my trading for the better. I achieved trades I would never have believed possible before adopting it.

But I see this process as ongoing, and I think we can all benefit from this article, even if it is just to reinforce the lessons learned in the field, or for newer traders still forming an approach.

Magdoran,

Thanks for your comments, glad that you appreciated the article. I haven't read Douglas's book yet, but it is one that is on my list of books to buy.

As you have said it is an ongoing process.

When you have been in the market for a number of years it is an aspect that needs to be worked on, as it can make quite a difference to a persons approach to trading.

Each person needs to understand there own psyche (or strengths and weaknesses) and how they approach and handle risk, especially if this is a contributing factor to the failure or poor performance of their trading system/approach.

Ego is another factor that can influence success or failure in the market, again another psychological factor.

I have included this quote from another forum, which was made in response to a disillusioned trader. Although he hadn't lost any money in the market overall, he was experiencing poor profitability.

".......no system, money management, book, idea, best advice, time frame, instrument or length of time in front of the screen will make you profitable in this business UNTIL you change your own self concept.

The trick is making your conscious and subconscious mind work in harmony to take on the task of believing in yourself 100 percent of the time without fear or hesitation in an environment that is always uncertain and out of your control.

At the end it's all about psychology."

The above is very important if people were to consider moving into higher risk trading strategies, hesitation or the inability to pull the trigger when it counts can be very expensive.

I think that Duc and yourself will appreciate the message in the above quote.

Regards,
Les.

lesm · 20 July 2006

ducati916 said:
Risk = uncertainity
*individual risk [the psychological component]

There have evolved specific risk management, and analytical models from a number of areas of enquiry;

*Game theory & behavioural finance for; individual psychological risk

Hi Duc,

Aware that psychology is an area that you are interested in, would you care to elaborate on the above two points?

Regards,
Les.

Magdoran · 21 July 2006

lesm said:
Magdoran,

Thanks for your comments, glad that you appreciated the article. I haven't read Douglas's book yet, but it is one that is on my list of books to buy.

As you have said it is an ongoing process.

When you have been in the market for a number of years it is an aspect that needs to be worked on, as it can make quite a difference to a persons approach to trading.

Each person needs to understand there own psyche (or strengths and weaknesses) and how they approach and handle risk, especially if this is a contributing factor to the failure or poor performance of their trading system/approach.

Ego is another factor that can influence success or failure in the market, again another psychological factor.

I have included this quote from another forum, which was made in response to a disillusioned trader. Although he hadn't lost any money in the market overall, he was experiencing poor profitability.

".......no system, money management, book, idea, best advice, time frame, instrument or length of time in front of the screen will make you profitable in this business UNTIL you change your own self concept.

The trick is making your conscious and subconscious mind work in harmony to take on the task of believing in yourself 100 percent of the time without fear or hesitation in an environment that is always uncertain and out of your control.

At the end it's all about psychology."

The above is very important if people were to consider moving into higher risk trading strategies, hesitation or the inability to pull the trigger when it counts can be very expensive.

I think that Duc and yourself will appreciate the message in the above quote.

Regards,
Les.

Hello Les,

Oh I agree, that elusive subconscious self can be quite stubborn - nice quote too.

Interestingly Gann talked about an element of psychology saying that everyone has a biased way of looking at the market – some have a bearish bias, others a bullish one which they impose on their perception of the market. He held that to succeed each person must recognise their innate bias, and compensate for it.

McLaren also talks about fear and greed, and like the Gann view on bullish or bearish bias, suggested recognising if you are primarily driven by fear or greed, and also compensate for this.

But Mark Douglas is great for developing what he called the “Probabilistic Mindset” – essentially seeing the market without imposing your view on it, and reacting without fear or greed. I’m probably not doing his work justice, but the concepts really help to disentangle bad trading psychology.

Anyway, I’ll be out of the country for a few days, but look forward to reading more when I get back.

Regards

Magdoran

ducati916 · 21 July 2006

lesm

Kahneman et al showed that human psychology [in aggregate] sought minimisation of loss, over and above the seeking of profit.

Viz. the psychology registered greater pain, on a loss, than pleasure on a win.
This was also the central credo of Game Theory, that the correct *rational* strategy was one of *not losing* rather than trying to win.

When linked to probability studies, the following was calculated;

Example;
An investor who can earn a return of 15% in excess of the Treasury rate, with 10% volatility. Calculated via standard deviations;

Probability of making Money
Scale...................................Probability
1yr.........................................93%
1Quarter.................................77%
1month...................................67%
1day......................................54%
1hour.....................................51.3%
1min......................................50.7%

In the short-time frames, it is a 50/50 proposition, but stretched out to the longer time frames, the probabilities rise very high.

The longer time frame, is generally associated with the *investor* rather than the trader, although that is inaccurate as longer term trend following systems such as TT will exceed that timeframe.

What does become apparent however is this;
If, loss, effects a negative psychological reaction due to the aforementioned greater pain due to a loss, you will by trading short-time frames build up a lot of psychological damage due to the lower probabilities of success.

This aversion to the psychological pain, will affect function of the decision centres within the cortex that are vital for efficient and unbiased processing of information, thus exacerbating the breakdown of optimal *rational* functioning, and the change to *emotional* decisions.

Thus, in a chart, you no longer look at it in a rational manner, you look at it in an emotional mind-set, looking to minimise further losses.
This is the path that erodes, and eventually destroys discipline

jog on
d998

Realist · 21 July 2006

I avoid losses at all costs, it is my first rule to avoid losing.

It is very important because with shares losses are magnified.

A 10% loss can only be made up from an 11% gain.

A 33% loss requires a 50% gain to make it back up.

A 75% loss requires a 300% gain to make it up.

Now if you add into thte equation brokerage, fees and taxes you realise just how bad any loss affects your results.

ducati916 · 21 July 2006

Realist

I avoid losses at all costs, it is my first rule to avoid losing.

Which is Buffetts rule #1
Rule #2, refer to rule #1

Which is related to the assumption of alpha and/or beta risk and the management thereof.

Well and good.
Assuming competency, and excess returns, within a given volatility, the probabilities bunch around timeframes.

This has particular relevance to *Value investors* as, in the short-term, the probabilities do not favour outperformance over random.

The requirement then becomes, how to manage the volatility dispersion that will dominate the short-term? If psychological pain is greater than psychological pleasure?

jog on
d998

cuttlefish · 21 July 2006

Magdoran said:
McLaren also talks about fear and greed, and like the Gann view on bullish or bearish bias, suggested recognising if you are primarily driven by fear or greed, and also compensate for this.

This is an interesting thought. I like McLaren's take on it because it focuses on the emotion rather than the market (and so could apply to any type of trade - long, short, volatility trade etc.).

Its interesting that different persona's may bring different emotions to the trading decision and would be interesting to see how the different bias may affect trading/investing styles and strategies.

For example - TA's with a bias towards greed may look for breakout type trades where the risk of collapse is high (and thus the true stop will be wide even if a tight stop is set) but the margin could be large.

A fear biased TA might look for well established low volatility trends and trade them on low margin with tight stops.

A greed biased fundamentalist may focus on looking for profit growth opportunities where the growth is yet to be built into price.

A fear biased fundamentalist may focus more on low risk value opportunities looking for asset protection and income more than growth.

cuttlefish · 21 July 2006

ducati916 said:
If, loss, effects a negative psychological reaction due to the aforementioned greater pain due to a loss, you will by trading short-time frames build up a lot of psychological damage due to the lower probabilities of success.

This aversion to the psychological pain, will affect function of the decision centres within the cortex that are vital for efficient and unbiased processing of information, thus exacerbating the breakdown of optimal *rational* functioning, and the change to *emotional* decisions.

Thus, in a chart, you no longer look at it in a rational manner, you look at it in an emotional mind-set, looking to minimise further losses.
This is the path that erodes, and eventually destroys discipline

interesting comment as well - I can see how this can occur. What you are describing from my interpretation is the psychological process that can cause the disciplined trading/investing mindset to break down into a gambling mindset. I'm pretty sure this is something I've experienced at times, and your comments about investment timeframes and how they can effect this is interesting as well.

ducati916 · 24 July 2006

cuttlefish

The breakdown of discipline tends to effect traders/investors in the following ways;
*Bias in trade selection
*Exiting winning trades too early
*Inability to enter trades.

Bias in trade selection simply results in trade criteria being ignored.
That is to say, your methodology would have you enter 8 trades, you start to "analyse" your methodologies selections to find the "best", taking only 3 of the 8 trades mandated thus exhibiting a bias [unless you really can pick the best]. This in effect breaks the link between trade selection and money management, thus negating the effectiveness of the money management component within the methodology.

Exiting winning trades is the serious consequence of the psychological impact of feeling the pain of a loss, more than the pleasure of a win, as in the majority of methodologies, the "big winners" are required to offset the large number of "small losses". If you start exiting early, due to the "fear of letting a winner turn to a loss, or protecting any kind of win, you negatively impact the methodology, thus effectively crippling the ability to make money on aggregate, and you initiate the slow bleed.

In the worst case, the trader displays such an extreme avoidence of *risk* that they effectively can no longer trade due to the inability to pull the trigger. The trader is finished, unless this can be overcome.

jog on
d998

happytrader · 24 July 2006

Excellent post Ducati,

I thought it would also be useful to outline the 12 Sabotages that distract traders from following their rules from trading coach Adrienne Togharaire

Sabotage 1. Fear of failure - negative anchor - seeing, hearing and feeling or experiencing negative results.

Sabotage 2. Fear of success - negative anchor - unpleasant picture of what success would be like.

Sabotage 3. Needing to be perfect -negative anchor - over analysing

Sabotage 4. Not believing in your method - negative anchor - you question all your signals.

Sabotage 5. Fear of being wrong - negative anchor - you rarely if ever trade real money.

Sabotage 6. Getting back at the markets - negative anchor - you act vengefully.

Sabotage 7. Believing you are invincible - negative anchor - you trade with no rules.

Sabotage 8. Trading for the wrong reasons - negative anchor - you don't follow your excellent plan.

Sabotage 9. Trading scared money - negative anchor - all risk is too much.

Sabotage 10. Resent authority - you trade against your rules.

Sabotage 11. The system is not right for you - negative anchor - you trade inconsistently.

Sabotage 12. You don't have what it takes - negative anchor - you are a gambler - no calculated risk.

The no. 1 mental hangup for traders is - they let their emotional state take over their neurology when their actions should be automatic.

The above is a brief outline only. To get full transcript you might like to visit these websites.

Adrienne www.tradingontarget.com
excerpts from www.lbrgroup.com

Cheers
Happytrader

ducati916 · 27 July 2006

This aversion to the psychological pain, will affect function of the decision centres within the cortex that are vital for efficient and unbiased processing of information, thus exacerbating the breakdown of optimal *rational* functioning, and the change to *emotional* decisions.

When stated within NLP terminology, we can say;

The map is not the Territory
Now of course the *map* could just as easily refer to the *psychology* or the *methodology* while the territory in this context is simply the *market*

The greater the deviance of the map from the territory, the faster the ultimate breakdown of the map entirely, thus, whether you define the map as methodology, and or, psychology, the endpoint is the same.

This actually appeared on this forum;

Finally, let me give you a couple of quotes.
The first comes from John Murphy, author of 'The Visual Investor', resident technical analyst on stockcharts.com, and considered one of the worlds foremost technical analysts................

"Chartists are cheaters. Why? Because charting is a shortcut form of fundamental analysis. It enables a chartist to analyse a stock or industry without doing all the work of the fundamental analyst. How does it do that? Simply by telling the analyst whether a stocks fundamentals are bullish or bearish by the direction its price is moving.
If the market perceives the fundamentals are bullish, the stock will be rewaded with higher prices."

So in essence, it would seem from the above that the *Map* could be defined as *Charting*. The answer from a Chartist was;

Charting is a short-cut form of fundamental analysis. YES! With 1800 odd stocks on the ASX for example, shortcuts come in very handy.
It enables a chartist to analyse a stock or industry without doing all the work of a fundamental analyst. YES!
Simply by telling the analyst whether a stocks fundamentals are bullish or bearish by the direction its price is moving. YES!

How is a bullish, or bearish stance, an analysis?
No different from anyone else making a fundamental bullish or bearish stance.
If I read tea leaves and the prognosis said buy, then my tea leaf reading is bullish.

Would this analysis include a stoploss?
YES
If so, why?
Because I’m ready to admit (a) I’m wrong, (b) there is now new negative information recently coming to hand which may not be openly publicly available yet and (c) the market is maybe valuing stocks cheaper – market correction. Placing a stop loss can also mean I will exit for the short term and re-enter later at perhaps a cheaper price – readjusting an entry level.

If yes, why bother with claiming analysis.
The analysis is claimed by weighing up the total present emotional and system engineered buying and selling and arriving at a consensus of the whole.
If one feels the bulls have an edge, then join them. I am analysing the market mood. Duc analyses spread sheets, still an analyse, just a different type.

Just enter a position with a stop.
You mean random entry, therefore buy anything and whack a stop in straight under price? No, I don’t go along with the random entry theory.

Is this not simply money management?
No. buying and selling is not money management.
It is carefully weighing up the best prospects at the time and going along for the ride. My belief that a 3 year or long term trading strategy is nonsense – rubbish!
One can have faith in the best company in the world but 1 month down the track that can all change when for example stronger competitors arrive or some unforseen subtle change occurs where this company is no longer rated a favourite. Why trade in second rate companies, better putting your money with the flyers at the time. They may only fly for a few months but if one keeps this up one will be far ahead of the pack.

Seeking to ascertain the validity of the above thesis a question was posed to the Charting & Technical Analysis schools in regards to an analysis, based on Chart analysis to provide an analysis of the fundamentals, based on a bullish or bearish prognosis; the analysis came back as follows; [POT]

Potash Corp…..
Stumbled for several years, then climbed up steeply, ($30 to $110 in 2 ½ years) then dropped steeply, now hesitating.
Looks like recovering recently. Would I buy it? No.
Why? Because it is failing to make headway, drop offs fast, recovering too slow.
I have not looked at fundamentals.
Summary: It may pick its boots up slowly, there are better prospects around with less uncertainty and quicker pace.

Compared to a Fundamental Analysis;

INDUSTRY

Potash Corporation of Saskatchewan is an integrated fertilizer and related industrial and feed products company. During the year ended December 31, 2005, the Company's potash operations represented an estimated 17% of global production, 22% of global potash capacity and 75% of global potash excess capacity. In 2005, its phosphate operations represented an estimated 6% of world phosphoric acid production. During 2005, Potash’s nitrogen operations represented an estimated 2% of world ammonia production. The Company's potash is produced from six mines in Saskatchewan and one mine in New Brunswick. Of these mines, it owns and operates five in Saskatchewan and the one in New Brunswick.

CAPITALIZATION

Market Cap (intraday): 8.88B
Enterprise Value (13-Jul-06) 10.80B
Trailing P/E 17.35

The Capitalization structure fulfills investment grade criteria. There are no areas that suggest imprudent practice.

INCOME STATEMENT

Profit Margin 15.70%
Operating Margin 23.81%

There has been a marked improvement within profitability by comparison with the aggregate. It is this rather marked improvement that delineates the potential for a successful investment, or a speculative operation that may not play out quite as planned.

BALANCE SHEET

Total Cash 172.70M
Total Cash Per Share 1.666
Total Debt 1.86B
Total Debt/Equity 0.829
Current Ratio 0.955
Book Value Per Share 21.677999

I would be concerned with regards to the Current ratio. This weakness in the Working Capital limits the flexibility of the company to respond to either adverse or positive opportunities. The weakness of the Current Assets in relation to total debt is also very weak. The issue is currently priced to reflect only positive outcomes.

MANAGEMENT
The management is excellent controlling costs and margins very well. In some regards this may balance or offset to some degree the weakness within the Balance Sheet. Cost controls improved adding to the bottom line, but there is probably little improvement available for increasing earnings any further in this manner. [Earnings via cost reductions were in any case marginal]

CASH-FLOW
There are no discretionary or hidden cash-flows available in the future to bolster or maintain earnings, the ship is running very lean currently, any surprises would be to the downside.

ANALYSIS
So what’s the story?
The story is Ethanol. With the shift of US energy policy towards the reduction of oil within GDP, there has been a huge move towards Ethanol based securities. This move started actually some twelve to eighteen months ago. POT as a producer of potash, which is the primary fertilizer utilized to replenish soils where corn is grown, benefited tremendously from this speculative surge.

The question really becomes twofold; in the first instance will corn based Ethanol become the predominant Ethanol fuel, or will sugar based Ethanol win the majority share of the market? The second component of the question becomes, if, corn Ethanol wins market predominant market share, how is this currently reflected in the market price for POT?

The first question is difficult to answer and can be considered pure conjecture at this point in time.
However, assuming for the moment that corn Ethanol does dominate, we can value the shares currently based on this intangible component, thus coming to a rational investment decision.

Currently the Market, in its wisdom is valuing the productive assets as requiring a 13.85% return to maintain the earning power.
This exceeds the best returns achieved by a factor of almost two. Therefore, should corn Ethanol not dominate the market in the future, we can safely conclude that the earnings will not support the current market price.

The earnings currently required by the market on the Intangible component are some 2.56%. Should corn Ethanol fail to command dominant market share, we can safely conclude that the Market’s requirement will rise, thus necessitating a fall in the share price.

On that basis, we can conclude that should Corn Ethanol not actually pan out, there will be a rather drastic revaluation.

What if Corn Ethanol does dominate the market?
Again, the return being valued into the Tangible assets have not ever....come remotely close to that return. Thus, the market must continue to value the Intangibles at this remarkable level. This is most unlikely.

INTRINSIC VALUE
I have calculated two scenarios, each based on a different assumption.

Scenario #1
Based on Corn Ethanol being superseded by Sugar Ethanol;
Value range $35.02 to $48.54

Scenario #2
Based on Corn Ethanol being market dominant;
Value range $71.20 to $96.24

CONCLUSION

Based upon the speculative nature of the business prospects currently I would recommend only a small speculative position if, you believe that Corn Ethanol will win market share, buying as close to the low seventies [or lower] as possible.

I would personally only purchase if I could purchase on the basis of established earning power independent of speculative pricing.

Mastering the Four Fears

lesm

Magdoran

ducati916

lesm

lesm

Magdoran

ducati916

Realist

Billie Jean is not my lover

ducati916

cuttlefish

cuttlefish

ducati916

happytrader

ducati916

Similar threads

Mastering the Four Fears

Billie Jean is not my lover

Similar threads

Privacy & Transparency

Privacy & Transparency