When to Stop Trading - Part II

By Brett N. Steenbarger, Ph.D.

In the first article of this series, I took a look at market conditions that determine the opportunity available in trading.  Much like poker, where long-term success hinges on the player's willingness to "muck" hands that offer poor odds of winning, trading boils down to the ability to perceive and act upon edges in the marketplace--and the willingness to not play the game when the edge is not present.  In this article, we will explore the need to stop trading when opportunity might be there, but the trader is not able to take advantage of it. 

Being On Tilt
Sometimes in poker, an edge is not present, not because of poor hands, but because the player's frame of mind is such that he or she cannot exploit the edge that is available.  Poker players refer to this as being "on tilt": reacting to hands (and overplaying them) because of one's emotional state, not because of the objective odds and "tells" from competing players.  Traders go on tilt for a variety of reasons, ranging from sheer boredom and the need to create action to frustration and "revenge trading" after losses.  Nearly always, however, the tilt phenomenon results from a physiological and cognitive state of hyperarousal.  The out of control trader is, in some way, "worked up" due to anger, anxiety, overexcitement, or confusion.  This can lead to a series of debilitating losses that seriously jeopardize the trader's overall profitability.

In professional trading settings, it is common for traders to operate with warning levels and a "drop dead" level.  The warning level is usually triggered by a level of loss during the day that is unusual for the trader and that suggests something is going wrong.  The risk manager or trading coach will contact the trader once this level is hit to encourage a break from trading and a reassessment of the trading plan.  The drop dead level is a maximum daily loss that traders are allowed to incur before they are required to stop trading for the day.  The idea is that, if traders hit this loss level (and each trader has a different level, depending on their size and trading style), they are not seeing the market properly and need to regroup before putting further funds at risk.  The warning and drop-dead mechanisms are not so different from the baseball coach's visits to the mound when a pitcher is allowing too many base runners and runs.  The warning is a kind of "time out" to regroup; the drop dead level is a risk management tool to ensure that no single daily loss is large enough to jeopardize the trader's longer-term profitability.

Independent traders don't have the luxury of their own risk manager or trading coach.  Nonetheless, they can incorporate the idea of warning levels and drop dead levels into their trading plans.  On my website and in a recent article, I stress the importance of keeping metrics on your trading: knowing the average frequency, size, and holding periods of your winning and losing trades and understanding your profits/losses as a function of time of day, day of week, and type of position held (long/short).  These metrics are invaluable in the proper setting of warning and drop dead levels.  Very often, if you examine your typical drawdowns during a trading day, you will be able to identify a threshold amount beyond which you are unlikely to turn your trading around.  Indeed, traders often find that, if they hit this level of loss, they continue to lose money if they persist in trading.  This makes sense, because that threshold loss level means that the trader is either misreading the market, is out of control, or both.  Using that threshold level as a drop dead point helps prevent those blowout days that can jeopardize many days of hard-won profit.

I also encourage traders to look at their metrics to identify the point beyond which they generally cannot pull their trading back into the black.  In other words, you're looking for the average normal amount of drawdown (and variability around that average) during profitable days.  The warning level should be pegged just beyond that point:  the level tells you that this is not an expectable drawdown.  In practice, I find that the warning level usually ends up being about halfway to the drop dead point.  As a rule, I advise active traders to set their warning levels at a point that still gives them a reasonable chance of scratching (breaking even on) the day.  The drop dead level should also give the trader a decent chance of being green on the week.      

The Danger of Digging Holes
Note that nothing in the idea of warning and drop dead levels removes the need for stops on all trades.  The stop loss limits risk on a per trade basis; warning levels and drop deads limit daily risk.  In order to hit a warning level, the active trader will have needed to be stopped out on multiple trades.  This is a good sign that the trader is out of sync with the market and needs the time out to reevaluate.  Unfortunately, this is easier for traders to say than do.  The same competitive traits that bring trading success also make it difficult to accept defeat.  Psychologically, the decision to stop trading may feel like an admission of defeat.  As a result, hypercompetitive traders often trade well beyond warning and even drop dead levels, digging themselves a deep hole in the process.

Those holes do significant financial and psychological damage.  A loss of 10% of capital requires an 11% gain to break even; a 25% loss requires a 33% profit to come back; and losing 50% of one's money requires a doubling of remaining capital just to get back to square one.  Equally dangerous are the downward spirals that can be triggered by outsized losses.  It is rare to find a trader who does not allow large losses on Day One affect trading on Days Two and Three.  Sometimes the effect is to make the trader gun shy, reducing size and missing opportunities.  Other times, the urge for revenge kicks in and triggers impulsive and risky trades.  Almost always, when I have seen a trader in a slump, the slump has begun with one or more outsized losses that resulted from a failure to honor warning and drop dead levels.

While losses are mounting and traders are approaching warning or drop dead levels, they typically do not know why they are losing money.  It is very difficult to sort out whether the problem is one of misreading the market or one of being on tilt.  Only time away from trading allows traders the opportunity to reflect upon their expectations, mindset, and trades to figure out what might be going wrong.  That time off is also a good time to review the metrics: frequently traders will find that they are trading differently from their norms in the number of trades being placed, the holding times, etc.  The key to utilizing time away from trading is mentally rehearsing a mindset that says that time outs are part of the trading strategy--not an admission of defeat.  When a coach calls a timeout for his basketball team, no one thinks that he is throwing in the towel.  The time out is part of the coach's strategy, allowing the team the time to adapt to shifting game conditions.  Similarly, time taken away from trading during adverse outcomes allows the trader to formulate a winning strategy for later in the day or the next day.  Successful trading is not just about making money; it is also about keeping it.

Originally I was going to make this a two-part article series.  Readers of my book know, however, that there is a third part to the equation: What to actually do during a break period to get out of tilt and back into the game.  Accordingly, I will take up the topic of trader self-help strategies during breaks in a third column. 

Brett N. Steenbarger, Ph.D. is a clinical psychologist and active trader, writer, and researcher for the past 20 years, Brett is the author of The Psychology of Trading (Wiley; 2003) and numerous articles on trading psychology for print and online financial publications.  Click here for full bio >>