When to Stop Trading, Part 1 of 3

By Brett N. Steenbarger, Ph.D.*

Posted: Dec 22, 2006

Much of the advice given to traders concerns either what to buy or sell or when to buy or
sell. This makes sense because it is doubtful that brokerage houses and advisory services
could make much of a living by telling traders not to trade. My experience with
professional traders, however, suggests to me that they frequently wrestle with the question
of when to stop trading.

This question typically emerges in two contexts:

Context 1: The volatility in the market is low -- Does it make sense to be in the market? Is
there sufficient opportunity?

Context 2: I'm not trading well -- Does it make sense for me to continue trading? Do I need to
take a break?

In the first installment of this three-article series, I will tackle the issue of low volatility; the
second in the series will cover challenges related to trader psychology, and the third will suggest
ways for traders to benefit from their times away from trading.

In another article, I've presented statistical evidence that suggests a serial correlation between 40-
day periods of volatility. Going back to the 1960s in the S&P 500, I found that the correlation
between the volatility of the current 40 days and the volatility of the next 40 has been over .70.
This means that you can accurately predict over half of the future variations in volatility simply
by knowing past volatility. I have observed similar serial correlations of volatility in other time
frames, including intraday.

In this instance, we are measuring volatility as the standard deviation of price changes for a
given period. This means that, in a high volatility market, we would see a lot of variability in
average price change: Some days would have big winners and big losers; others would exhibit
smaller changes. In a low volatility market, we'd experience low price-change variability.

The size of price changes would tend to cluster relatively near the mean for that historical period.
Because of this, volatility is one measure we can use to determine the movement we are likely to
see in our trading time frame; it is a measure of expectable opportunity.

Among the statistics I make sure traders keep is the average holding time of positions. Holding
time also determines the opportunities available to traders because markets can be expected to
vary more in price over a longer time period (multiple days) than over a shorter one (multiple
minutes). (The reverse side of that coin is that holding time is a determinant of risk because
drawdowns are likely to be larger on positions held for multiple days versus minutes).
Your typical holding time is an essential part of your trading personality and, ideally, is also a
key ingredient in your trade planning. Knowing the expectable volatility of the market for your
holding period can be invaluable in telling you when to get out of the water.

An example is a trader I will call Bam. Bam is a scalper of the ES and typically holds positions
for a minute or two, trying to get long at good prices when the offers dry up and sell at favorable
levels when the bidding wanes.

Lately, Bam has been feeling like a jackass. He has been getting in at what seem to be good
prices only to have the market fail to go his way. Eventually, he has to puke these positions for
one- or two-tick losers. Over time, this has cost him significant money.

A review of the sequencing of Bam's trades reveals that he has been experiencing strings of
losing trades and strings of winners, clusterings that seem non-random. Direct observation of
Bam while trading finds that his frame of mind during trading is generally calm and focused. He
only becomes frustrated after a losing cluster of trades. Importantly, however, these clusters tend
to occur at certain times of day and on certain days. These are times of day (and also during
days) when volume is particularly low.

When we look at 1- to 2-minute charts for slow times of day -- particularly on slow days -- we
find that many of the bars are only two or three ticks wide. Quite simply, there is not enough
volatility in Bam's time frame for him to consistently profit. He cannot always be assured of
buying the low tick and selling the high one, so, as a result, he gets chopped up in between.

When we look at periods when Bam has been making money, we see that these are during busier
times of day and on busier days. A breakdown of his trading results finds that, if the volume of
the ES has been averaging at least 1,500 contracts per minute, he has tended to do better than if
the one-minute volume has been under this level and much better than if the average one-minute
volume dips below 1,000.

This makes good statistical sense. Since the beginning of June, the correlation between one-
minute volume in the ES, and the high-low range of the one-minute bar has been .72. High
volume brings high volatility and vice versa.

By monitoring volume levels, Bam learns when to stop trading. It makes no sense to seek 2- to 3-
tick profits when the market is unlikely to move 2 to 3 ticks in his time frame. Rather than
change his entire trading style and start holding positions during slow times, Bam is better off
simply exiting the market when opportunity isn't present.

Bam is a scalper, but his situation -- and the potential solution -- really applies to any time frame.
I have worked with other traders who hold for hours at a time but become frustrated when they
cannot get their desired 5-point winning trades. Once again, a review of average volatility within
their holding period and an analysis of results as a function of volume generally find that they
should either get out of the markets on slow days and during slow times of day -- or they should
read just their expectations.
If volume and volatility determine opportunity during a day, it makes sense to set exit levels and
stops in a manner that reflects true reward and risk. You can often identify when this is a
problem if you see many of your winning trades returning to scratch before you exit. Your
expectations most likely exceed the opportunity available at your holding period's volatility and
volume.

Sometimes, it isn't trading problems that frustrate the trader but, rather, frustrations interfering
with trading that create challenges for the profit / loss statement. My next article in this series
will deal with those and when it makes sense to take an emotional break from trading.

When to Stop Trading, Part 2 of 3

By Brett N. Steenbarger, Ph.D.*
Posted: Dec 29, 2006

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 on, edges in the marketplace -- and the willingness not to 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 available edge. 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 attendant 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 hyper-arousal.

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 this: If traders hit this loss level (and each trader
has a different level, depending on trade 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 have stressed 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 misreading the
market, is out of control, or both. Using this 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 number of drawdowns (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, hyper-competitive 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 percent of capital
requires an 11 percent gain to break even; a 25 percent loss requires a 33 percent profit to come
back, and losing 50 percent 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 to affect trading on Days Two and
Three. Sometimes, the effect is to make the trader gun shy, so that he or she reduces trade size
and misses 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 on 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, and
so forth. The key to using time away from trading effectively is mental rehearsing of 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 he is throwing in the towel.
The timeout is part of the coach's strategy, allowing the team time to adapt to shifting game
conditions. Similarly, time taken away from trading when a trader is experiencing adverse
outcomes allows him or her 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 article.

When to Stop Trading, Part 3 of 3

By Brett N. Steenbarger, Ph.D.*
Posted: Jan 5, 2007

In the first article in this series, I suggested that profitability results as much from knowing when
not to trade as when to initiate positions. That article explored the relationship between volume
and volatility, concluding that successful trading might require traders to stand aside when
markets offer insufficient movement and opportunity.

The second article in the series examined reasons to stop trading that are internal to the trader,
emphasizing the need for warning and drop-dead levels to limit daily losses and preserve overall
profitability. Even when opportunity is present, sometimes traders are not in a mindset that
allows them to exploit their edge. This is often due to emotional arousal -- fear, frustration or
excitement -- that interferes with concentration and judgment.

In this final installment, I will summarize a few of the practical steps traders can take to
profitably re-enter the game after they have stopped trading for emotional reasons.

Emotional Arousal and the Brain

Cognitive neuroscientist Elkhonon Goldberg, in his excellent book, The Executive Brain, details
the role of the frontal lobes in such executive functions as planning, judging, analyzing and
reasoning. To no small degree, our frontal lobes are the instruments of our rationality.

Patients who suffer from damage to their frontal lobes, either through accidents or the effects of
dementia, invariably suffer from a loss of self-control, deficiencies in reasoning and / or
difficulties in planning and executing sequences of action. When we are engaged in the
previously-listed executive functions, our frontal lobes stand out in functional magnetic
resonance imaging (fMRI), due to enhanced regional cerebral blood flow.

Conversely, when we are stressed, blood flow shifts to other, more evolutionarily primitive
cerebral regions, such as the amygdula. If it feels as though we are not in our right minds when
we are stressed out, that may be because we are no longer activating the brain regions
responsible for our executive functions. Little wonder that we say or do things that we regret
when we are unusually angry!

That, of course, poses particular challenges for traders. Initiating and monitoring trades, scaling
in and out of them and eventually exiting positions require concentration and keen judgment.
Under emotional conditions of boredom, fear or frustration, we find ourselves activating
precisely those "flight or fight" sequences that might facilitate rapid action but surely not calm
reflection.

Traders I work with intuitively recognize this when they tell me that they need to take a break
from trading and "calm down". They realize that, under conditions of emotional and
physiological arousal, they are unlikely to sustain the concentration and clear-headed judgment
needed for superior decision-making.

Conversely, most traders have experienced that sense of being "in the zone" when they feel as
though they are at one with the markets, making decisions accurately and effortlessly. This state
of "flow", described in detail by psychological researcher Mihalyi Csikszentmihalyi, results from
prolonged activation of the frontal lobes. Because such activation requires sustained cognitive
effort, most of us enter the zone only occasionally, cycling in and out of states of greater and
lesser arousal and frontal activation.

When traders take a break from trading after a particularly frustrating market sequence, they
generally attempt to relax and take their mind off trading. Some close their eyes and listen to
quiet music; others talk with friends, and still others go to the gym and work out.

All of these can be useful courses of action in that they interrupt mind states that are not
conducive to trading. Decreasing the degree of arousal, however, is not the same thing as
activating executive functions. Simply relaxing or diverting attention will not bring traders closer
to "the zone". For this, a different kind of activity is needed during trading breaks.

Activating the Executive Brain

Several years ago, realizing that I could neither afford nor regularly access an fMRI unit, I
obtained a biofeedback unit that several innovative psychologists were using to treat attention
deficit disorder. Unlike most biofeedback devices, which measure the body's level of arousal,
this unit measured forehead skin temperature.

The idea was that, under conditions of frontal activation, the enhanced regional cerebral blood
flow would be reflected in higher skin forehead temperatures. When the brain's executive
functions were not being used, the blood flow would withdraw from the frontal cortex and result
in lower temperatures.

Several hours of trials, during which I engaged in a variety of intellectual, social and emotional
activities, convinced me that the rationale behind the development of the device was sound. It
also convinced me that I could enter the zone at will if I were willing to sustain the cognitive
effort needed to maintain my forehead temperature above a threshold level.

What I have found using the device is that relaxation alone does not result in higher forehead
temperatures because relaxation does not actively engage such cognitive functions as attention,
concentration and reasoning. Indeed, we generally soften our cognitive focus in order to relax.

The state that most reliably produced the high biofeedback readings and feeling of the zone was
one of relaxed but intent concentration. I tried many different exercises at home to produce this
state consistently, and the one that worked best (and has since worked well for others) was as
follows:

You sit in front of the television, tuned to CNBC, with the volume off. Your sitting position is very
still, and you're breathing deeply, slowly and rhythmically. While doing this, you intently watch
the ticker on the CNBC screen and the numbers that accompany each stock symbol.

Your task is to keep a running sum of the last digit of these numbers. This is easily done when
the numbers are small, but, as the cumulative sum increases and natural fatigue and boredom
set in, it takes ever-greater mental effort to keep the sum running.
While initiating and sustaining this effort, your skin forehead temperature steadily rises and then
plateaus. After 15 to 30 minutes of this, you find yourself in a different "zone", much more clear-
headed and calm than when you started.

Another variation that has worked for me involves counting backward by sevens from a very
large starting number.

This technique works for several reasons:

Reason 1: The physical stillness and rhythmical breathing facilitate a state incompatible with
emotional arousal.

Reason 2: The cognitive focus on emotionally neutral stimuli (such as number sequences)
interrupts the flow of frustrating events.

Reason 3: The sustained concentration allows access to new cognitive and emotional states.

My experience is that thinking is clearer and more intuitive after this exercise than it is normally
-- and much better than when we are emotionally charged. It is possible that this is merely a
placebo effect: We expect to become calmer and more focused, so that is how we experience
ourselves. Thus far, however, my trading results -- and those of traders I've worked with -- also
support my experience. The key is sustaining concentration beyond the normal threshold of
boredom.

If you keep counting the numbers even after antsiness has set in, eventually, you get to a quiet,
focused point where the counting becomes nearly effortless, and your perception is very clear.
And, if you perform the exercise routinely, you can access that zone with increasing ease.

My Latest Experiments

Most recently, I've been using sensory isolation tanks to push the limits of sustaining
concentration in an emotionally neutral environment. For this exercise, you float in water filled
with Epsom salts and heated to exact body temperature. While floating, you are enclosed in a
soundproof and lightproof tank. You hear and see nothing, and you feel very little because your
body's surroundings match the condition of your body.

The task is to sustain concentration in the absence of all external stimuli. This requires a
complete stilling of normal internal dialogue -- a task very reminiscent of Zen meditation.

What happens after an hour or more of isolation is that the mind and body adapt to the changed
environment. Once again, this requires a willingness to stay in the tank, focused, beyond the
normal boredom threshold. My experience is that you know you have adapted to the
environment once you no longer feel a need to move or leave the tank.
Although I am not hooked up to the biofeedback machine during my time in the tank, I strongly
suspect that my skin forehead temperatures are quite high because I sustain active, directed
awareness during my time of isolation.

By the time I leave the tank, the world looks and sounds different because I am now no longer
adjusted to the world's colors and volumes. The clarity of perception and thought characteristic
of the biofeedback work are even stronger following immersion in the tank.

Although work with meditation, isolation tanks and biofeedback is often couched in esoteric
terms, there is nothing mystical about it at all. By controlling our environment and cognitive
activities, we can access states of mind associated with executive functioning and deactivate
brain regions associated with impulsivity.

Elkhonon Goldberg foresees the day when all of us will participate in gymnasiums of the brain
just as we join health clubs to attend to our bodies' health. Traders might be the first in line to
benefit from his vision.