Wed 14 Nov 2007
I attended a webcast last week in which Bob Pardo, author of “Design, Testing, and Optimization of Trading Systems” discussed the idea of Thought Demons that hinder trading performance. This is just another term for negative self-talk. I found it very useful to list thought demons that affect me on each and every trade. I came up with a list of six thought demons that cause me emotional pain, and have ranked them from most painful (1) to least painful (6). If I am prepared for each type of pain beforehand, I will be better able to handle the situation when it arises.
Pain of loss
Â
a) True Drawdown that SEEMS avoidable (1)
Whenever I’m in a drawdown where entry signals were BARELY triggered and then the trades reverse and take me out for a loss, this is the most painful, because it seems that optimizing my entry parameters differently could have saved me this pain. This is the most painful, because a drawdown always feels like a threat to my ability to continue as a full time trader, and losses that I ALMOST avoided make me feel unlucky too. The longer or deeper the drawdown, the worse the pain gets.
 Antidote: I need to remind myself that my system at any given time represents my best attempt to make profit in the market and that drawdowns are unavoidable. Indeed, I’ve recovered from several drawdowns, and even if this particular drawdown really does end my run as a professional trader, I will never regret my decision to try. Anyway, I’m likely to recover from the drawdown, and losses are just what I need in order to be able to build better systems for the future.
b) True Drawdown that seems unavoidable (3)
If I suffer a drawdown that seems unavoidable, that is to say that most parameter sets would have still resulted in a drawdown, I don’t feel quite as bad, but I’m still in a real drawdown, which is a threat to my full time trading career.
Antidote: Same as (1)
c) Giving back profits on subsequent trades (6)Â
Giving back profits on subsequent trades is the least painful, because I know that losses are inevitable and it’s nice to initiate a drawdown from a new equity peak. No antidote is necessary.
Pain of not participating (2)
This is the second most painful of all. I trade a system that uses event-based filters to keep me out of the market. When things are going REALLY well, these filters are counter-productive. Missing a move is painful because I wonder whether I will experience the double whammy of missing a big profit and then participating in the subsequent losses.
Antidote: Most of the time, my event filters work well. They often allow me to have profitable months when a system without filters would have suffered losses. Event filters allow me to take a break from the market and recharge my batteries. A system that is in the market less of the time is inherently less risky. Whenever the unfiltered system does well, the filtered system usually does well too.
Â
Pain of Profit
a) Why didn’t I trade more contracts? (5)
This one always creeps into my mind a little bit at the end of each winning trade, but it’s easy to suppress as I know that if I were taking more contracts, my risk to reward would not be properly balanced.
b) Why didn’t I take profits at the top? (4)
This one is painful too, but it’s not a big deal. My system does not attempt to catch tops, and will always give back some profit before exiting.
Here is the king of Thought Demons for a trading system developer…
The new system underperforms the old system in live trading.
The antidote for this is to realize that the system IS my edge and that system changes represent my best attempt to improve my edge. Each change is either an attempt to increase profits or to limit risk. A change that is intended to increase profit often has the side effect of increasing risk or drawdown in the short term. If the new system passed all of my criteria to be traded live, then I simply have to go with it until such time that I discover a better alternative. If the system change is meant to decrease risk, but it lowers my profit, I need to remind myself that that is exactly the price I pay for controlling risk, and in fact, risk has been controlled. In fact, if I look at my list above, I’ll see that the pain of missed profits is less than the pain of real losses.