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Emotion Management System

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Tue, Jan 8 2008, 13:24 GMT
by Dima Chernovolov

What is Emotion Management System?

Emotion management system is the subsystem of the forex trading plan which controls how closely you follow your trading system and your money management system. The control is executed through the weakening of the destructive emotions (those that force you to deviate from your systems) and strengthening of the beneficial emotions (those that force you stick to your systems). That is, emotions which make you deviate from your trading system or your money management system are weakened and those emotions that encourage the strict adherence to these two systems are instead strengthened.

The premise of the emotional management system is that each type of emotion uses a portion of a limited reservoir of mental energy that should be carefully protected against wasteful uses. An emotion is, in essence, a form of mental leverage that turns ideas into actions. Because this storage of mental powers tends to be limited it should be used carefully - without becoming too attached to or "invested in" - your trades (in the same manner that the leverage is best used sparingly), so that no single trade can hurt you emotionally - because the outcome of any single trade is almost always random. It is best to use this energy for the implementation of your trading system and money management system (which are simply computerized expressions of your analytical abilities or another professional forex trader) than for the implementation of your subconscious fears (which are often inappropriate defensive mechanisms derived from your past experiences). Below is the description of destructive and beneficial emotions along with the techniques which can be used to manage them.

Quote: "Management of one's emotional state is critical. The truly exceptional traders can stand up to anything. Instead of getting emotional when things don't go their way, they remain calm and act in accordance with their approach." Charles Faulkner, in Jack D. Schwager's book "New Market Wizards".

Destructive Emotions

One of the strongest destructive emotions is fear of losing money. This fear comes from the internal programming that the money is limited and very important commodity. Most people, during the whole of their lives, learn to associate money with various types of tangible (e.g. property, luxury objects) and intangible rewards (e.g. security, prestige, feelings of self worth). Through this process of association money starts to symbolize deeply ingrained notions of prosperity and freedom. So strong is the association, that any "attack" on the capital base (e.g. by a sharp currency price movement against an open position, or a series of losing trades) is likely to trigger the defensive mechanism in the form of fear to protect the embodiment of so many notions of well-being. This fear can lead to the premature exit of a profitable position - that is before the exit signal is generated by your trading system. It can also force you to not take a signal after a series of losing trading signals or to open position smaller in size than that suggested by your money management system.

The twin brother of fear is greed which arises from the same programming towards the money. The greed can manifest itself in tempting you to hold a position longer than dictated by your trading system - that is beyond the time the exit signal is generated. The greed can make you open a position when there is no entry signal from your system (in which case it would only be the fear of losing a trading opportunity). It can also lure you into greatly increasing your position size after a long series of winning trades - in direct violation of the parameter set by your money management system (percent risked). The pride is similar to the greed in that it forces the trader to commit the same digressions from their trading systems.

To overcome fear and greed all that required is to remember that you are not fishing for all trading opportunities. It would be extremely dangerous to try to take advantage of any profit opportunity that arises - because no system or trader can consistently capture all trading opportunities. You are aiming not for the quick profit but for consistency in system performance and with it for the confidence that you will achieve your profit objective if you strictly follow your system. Your backtesting will also show you that as long as you follow each signal from you trading system and every instruction from your money management system you will achieve your profit objective sooner or later (provided that your system has a positive expectation). It also pays to keep in mind that your systems are only the extension of your pattern recognition abilities. So if you ignore any of your system instructions you are in effect saying that you do not trust yourself - which is a sure sign that you should not be trading currencies.

I have found that forex trading simulator (Please note: The size of this page is 0,6 Mbs and it requires that you have Flash installed and Javascript enabled in your browser)- through its ability to model entirely random trading outcomes - can be of great help to traders and investors who find it difficult to accept that winning systems can go through long losing streaks. If you model a few trading scenarios you will quickly see that systems with positive mathematical expectation tend to turn out profitable in the long run (after 100 trades) - even if they can go through a few losing streaks in the short run. The calculator is also good for reminding traders who sometimes overtrade that any long winning streak is always followed by the losing one - therefore, it pays to keep your positions size within the limits set by your money management system. All in all, forex trading simulator can be very useful for preparing yourself psychologically for the trading of mechanical trading systems in general (not discretionary systems - because you cannot backtest them to calculate their accuracy and payoff ratios).

Quote: "A person's trading psychology can make or break a trading plan. One advantage of a trading system is the elimination of human emotion. The computer makes all of the decisions and the trader is along for the ride. When a trader overrides a system trade, he loses that advantage. How many traders will follow a system trade after it has issued five losers. To reap the benefits of system trading, all system traders should take the sixth trade." from the "The Ultimate Trading Guide" by John R. Hill, George Pruitt, and Lundy Hill. For more information on how to cacluate the probability of any number of cosecutive losing trades please visit here.

If you are trading a mechanical trading system you can solve all the problems created by your emotions by simply automating the trading process. However, if you are using a discretionary trading system this can potentially greatly complicate the trading because you will be using yourself to generate the trading signals. Because the trading signals will be generated by your logical mind and your emotions will be produced by your emotional mind, a conflict is likely to arise when these two minds will insist on opposing courses of action. Needless to say, there is a high probability that your emotions will override your trading signals in highly stressful situations. This is especially true of the starting traders with limited experience. The mental constructs that they have built (e.g. using the books on currency trading) are still very young in comparison to the "ancient" and powerful defensive mechanisms related to money that they have been building during their whole lives. It will take a slightest price shock to activate these "dreaming monsters". This is the reason why the only way a trader can learn discipline in the early stages of his or her career is by following the professionally created forex trading system. Otherwise, there will simply be not enough realistic confidence in the trading system (that beginning traders create on their own) with which they can fight their destructive emotions.

Quote:"Like most traders, I myself am most often my own biggest enemy. This is not only true in my endeavors in and around the markets, but in life in general. Other traders do not pose anywhere near the threat to me that I myself do. I do not think that I am alone in this. I think most traders, like myself, are their own worst enemies." Ralph Vince in his book "The Mathematics of Money Management: Risk Analysis Techniques for Traders".

Beneficial Emotions

Confidence in your trading and money management systems is the primary emotion that is required for the successful trading (defined as %100 adherence to your systems, more on this below). Confidence is very important because it forces you to follow your systems. Have a confidence and the execution will follow (execution precision is directly proportional to how much confidence you have in your trading system). This makes it very important to cultivate this feeling to the extreme prior to starting the actual trading. If you do not have sufficient confidence in your systems this will invariably lead to deviations from them - with drastic consequences for your financial and emotional well-being. Each signal not taken or instruction ignored (for any reason) with subtract from your confidence in your method (similarly to the way the losses cut into your equity). In the end the trading discipline (or the quality of the execution) can be defined as the [(confidence in the method)/(signals not taken)]. The more signals you miss (intentionally or inadvertently) the more this will impact your confidence in the system and the faster your execution will deteriorate, which in turn will lead to further spiralling loss of confidence and worsening of execution. Therefore, it cannot be emphasized enough that the genuine success in currency trading can only come through taking each and every signal that your system generates (which is the assumption of all trading simulators on this site) - be it a mechanical signal or your own hunch or intuition (if you are using the discretionary trading system). By closely following your trading system you are in effect strengthening your own discipline which will, in turn, help you to stick to the system during the hard times (long losing streaks).

Quote: "The only criterion that ultimately matters is that the investor/trader is sufficiently confident about the signals that they will not continuously be doubted. " Tony Plummer in his book "Forecasting Financial Markets: The Psychology of Successful Investing".

To maintain your confidence in a system you should have a long record of its application in the real forex trading which you can compare with the recent results. As long as the system continues to perform similarly to the way it did in the past (without sharp divergencies) you can be perfectly confident in it. It pays to remember that there are absolutely no certainties in the forex trading and the only way you can expect to reach your target return is through It also helps to have realistic expectations of the future system performance. Such measures of the system performance (usually derived by the backtesting) as the average duration of trades, the average value of the loss/profit, the maximum drawdown, the longest winning/losing streak and the rest should be carefully studied by the traders or investors before starting to trade the system with the real money. Knowing these statistics will help to bridge the gap between the expected and the real system performance and, consequently, to reduce the stress and to preserve confidence in the system during the inevitable drawdowns. Some of the authors also recommend downgrading your expectations on purpose - which should be done only if there is not enough information about the real-time system trading performance (the system is evaluated primarily on the basis of backtested data):

Quote:" You can use the "rule of two," as follows, to modulate your emotional expectations: 1. Expect half as many winning trades in a row as you project from your testing. 2. Expect twice as many losing trades in a row as your testing may show. 3. Prepare for half the expected profits." Tushar S. Chande in his book "Beyond Technical Analysis: How to Develop and Implement a Winning Trading System".

Another important requirement for successful currency trading is that you remain committed to the method that you have chosen. Unless you stick to a single method you will most probably fritter away your energies and the capital among a variety methods - abandoning each at the slightest sign of being less than perfect. In fact, there is no such thing as a perfect trading system. All trading systems - without expectations - will go through their losing streaks and equity drawdowns. You cannot escape this. It is best to come to terms with this truth before you begin currency trading - so that there are no unrealistic expectations left to undermine your commitment when you trade with the real money. To strengthen your commitment to a trading approach you should reduce your emotional involvement in any single trade. In other words, you should treat wins and losses with the same emotional detachment (as an example, by stripping the money of its internal connotations). Forex trading is the game of probabilities so as long as you stick to a proven method you will reach your profit objective with time - regardless of "individual personalities" of your current trades (which almost always cannot be predicted beforehand).

Quote: "The only traders who fail are traders who quit." Ryan Jones in his book "The Trading Game: Playing by the Numbers to Make Millions".

Quote: "If you are seriously committed to winning, you can make a zillion dollars/multiply your money 100-fold - over time." John Percival in his book "The Way of the Dollar".

Emotion Management Methods

You can manage your emotions by reprogramming your subconscious mind to channel your mental energy into beneficial use - that is towards forcing you to stick to your trading approach. The first and most important step is to learn to experience emotions only in relation to your trading approach - that is your emotions should be system-related not price-related. In their words, you should shift your emotions from price to trading system - to how well you are following it. No matter what the price is doing now (e.g. breaking to new highs/lows) if your trading system is silent so you should be. Once you get the trading signal from your system you can allow your excitement to move you into placing the trade immediately. It is important to use your mental energy wisely so the only time you can allow yourself to become excited is when you receive an entry or an exit signal from your system. At the same time, grieving about missed signals is much more helpful than grieving about missed opportunities not detected by your system. This is because no single profit opportunity can compare with the possibility of long-term geometric capital growth made possible by consistent application of your trading approach.

This method of shifting you attention and emotions from one aspect of the trading to another with the aim of benefiting rather than suffering from your emotions gave birth to the system or the collection of shifts. The following list includes the above shifts along with a few more helpful ones that you can use in your trading:

  1. Shift from currency price action to taking all signals: Shift happiness of profits to taking the signals and the sorrow of losses to missing the signals.
  2. Shift from missed opportunity not detected by your system/any signle trade to the long-term geometric capital growth made possible by sticking to your trading method.
  3. Shift from profits to losses.
  4. Shift from a single loss to a series of losses (drawdown).
  5. Shift from creativity in real-time trading (reduces emotional attachment to any single trade) to the creativity in system development phase.
  6. Shift from the dollar value of your profit/losses (and the value of goods you can buy with this money) to their percentage value of your account balance.

It should be noted that destructive emotions mentioned above - because of their strong motive power - can be very successfully ustilized using some of these shifts. Rather than fearing to lose the money in a single trade you can condition yourself to fear missing a trading signal and with it hindering the process of geometric capital growth. It is best to desire geometric capital growth than a single chance profit not captured by your system. Rather than opening a trade when no signal is given by your system - because you are proud of a momentary creative impulse - it is better to feel the pride in your knowledge and experience embodied in your trading system - by following only it.

You can make the affirmations/mantras from the above shifts or similar ideas and repeat them daily to yourself to drive them into your subconscious. For example, "I shift my attention from the currency price action on to how well I follow my trading system". As you internalize these principles they will become your silent guiding "angels" that will keep you from the harm in your currency trading.

Quote: "The affirmation is made regularly to yourself, out loud if possible. Hence, for example, the simple statement 'Every day I trade according to my system trading rules' will be a powerful reinforcement to your goal of doing so." Tony Plummer in his book "Forecasting Financial Markets: The Psychology of Successful Investing".

Also, if you treat your equity as your "trading life" all the sound principles of the trading will come naturally to you. Because your self-preservation instinct is a very powerful emotion, if you are able to condition it to accept - however figuratively - that your equity is your trading life you can be sure it won't allow you to take excessive risks (i.e. larger than defined by your money management system) and will force you to take the signals only from your trading system - because only with it you can hope to safely (read - consistently) reach your goals.

One more principle that can be helpful in removing the emotions from the trading is as follows:


Mastering Emotion Control

To master your emotions you should remember that any currency trading system is, in essence, an organized method to profit from other traders' emotions - therefore, unless you learn to control your emotions you will not be able to profit from any system. The path to the complete mastery of ones emotions is very long one - requiring a lot of introspection and hard work. Because of this, beginning traders are encouraged to automate their trading systems (applies only to the mechanical trading system) - which can sometimes save years of life time. It should be noted that the advantages of the automation of the mechanical trading systems in most cases far outweigh the relative benefits of superior pattern recognition capabilities of the human mind - precisely because the human mind (or rather its logical part which identifies the patterns) is not functioning in the vacuum but alongside other subconscious mental frameworks which often obstruct the decision making process through destructive emotions.

If you still decide to manually execute your forex trading system you can learn to manage your emotions (i.e. remove obstructing mental blocks) through the books which have been written specifically on this subject. One of the best ones are the two books by Mark Douglas - "Trading in the zone" and "The Disciplined Trader" and Tony Plummer's book - "Forecasting Financial Markets: The Psychology of Successful Investing".

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