- Have you had your share of lumps in the market?
- Do you now find it hard to follow your trading rules?
- Are you taking profits too quickly?
- Are you struggling with letting your winners run?
- Are you closing out your trades early just to see them ultimately run up and hit your targets?
If you’ve been burned trading here’s why you’re having a hard time making it back
An interesting study which came out in March titled “Cortisol shifts financial risk preferences” may help us shed light on why many traders fall into the numerous bad patterns aforementioned and offers some clues on how we as traders can change these unwanted behaviors.
In a previous study by the same authors that took place during the market crash of 2007-2008 it was in a group of traders in the City of London that as market volatility increased over an 8 day period the traders experienced a 68% increase in their mean daily cortisol levels.
It is generally understood that the hormone cortisol, a glucocorticoid produced by the adrenal glands, is one of the body’s main stress hormones. Under normal conditions (acute situations) such as situations of novelty, uncertainty, and where we lack control an increase in the circulating levels of cortisol is actually desirable.
“Acute cortisol elevation has been found to increase physical, arousal, aid in the recall of important memories, and, by interacting with dopaminergic pathways in the brain, promote learning, motivated behavior, and sensation seeking.”
By contrast, longer-term exposure to raised cortisol levels, as one might experience during periods of sustained uncertainty, can impair many physiological responses.
For example, it can contribute to metabolic dysfunction and immunological impairment; in the brain, it can impair attentional control and behavioral flexibility, and it can promote anxiety, depression, and learned helplessness.
The researchers had come up with a theory from their previous study.
Their theory was that chronically elevated levels of cortisol could actually affect risk taking and their hunch was that it would actually discourage risk taking.
The researchers gathered 36 participants for a double-blind, placebo controlled study using a crossover protocol.
In the experiment they purposely raised the cortisol levels of the test group to approximate the same levels as observed in the initial study done on the City of London traders and then ran the participants through a variety of “financial incentive” related games to measure risk preferences.
So what did they discover?
Under the influence of chronically elevated cortisol the participants preferred safer lotteries, in other words, ones with a lower expected return whereas a sustained elevation leads to greater risk aversion , with study participants preferring lower expected return and lower-variance bets.
The study further goes on to posit that chronically elevated cortisol levels, acting on the prefrontal cortex (PFC), can impair working memory, reduce attentional control, and limit behavioral flexibility.
These effects on the PFC raise the possibility that chronic stress may shift a person’s decision making from goal-directed processes to more habitual ones, and it may reduce their motivation and ability to consider novel actions.
Risk taking requires that we search across a range of opportunities, but stress, by limiting attentional shift and behavioral flexibility, may constrain our choices to those that are familiar and require the least amount of search.
So there you have it, as traders we have to come to the understanding that stress not only elicits a reaction in your mind but a physiological response as well.
Likewise we are all well served to also pay close attention and differentiate between chronic and acute stress in our trading practices.
Acute and chronic exposures to cortisol can have very different, and in many cases opposite, effects.
Once Bitten, Twice Shy
Ultimately in trading terms, chronically high stress levels impacts us by reducing our ability to properly manage risk.
Any trader who has either experienced or has witnessed another trader go through a trading trauma (large drawdown or losing streak) has probably come across this phenomenon themselves.
It is natural after facing a large loss, or series of losses to try to remove the risk and stress by choosing the trading path with the least variability.
The outcome of this comes in the form of taking profits early or choosing setups with a perceived lower volatility to avoid the stress of managing the trade.
In other words the trader develops a fear based mindset.
Am I suggesting you need to try to aim for the fences in each and every trade?
No, but this distinction is often lost on some traders.
There are times when we have to play not to lose vs. play to win. But … there is a time and place for everything.
The mind is amazing at rationalizing trading decisions.
So here is where you need to have the mindfulness and intellectual honesty with yourself to understand whether or not you are reacting out a pattern based upon a perceived stress/threat or whether your quick exit is based on you objectively following trading your plan.
Have you done the inner work to be able to differentiate between the two?
Doing the Inner Work
So what can we do to reset this pattern or behavior?
The issue with habits is that you can’t get rid of habits – only replace habits with other habits.
It’s like if I ask you to not imagine a pink elephant what are you going to think about? Or asking a smoker not to think about smoking!
According to Maxwell Maltz’s theory of habits formation, the creation of habits is based on 3 factors –
- intensity of stimulation
- source of authority,
- and repetition.
Take our trader who has experienced chronic stress due to market volatility which has led to some large losses which he/she is struggling to recover from.
What develops is a trader who trusts in their ability to fail more than in their ability to win.
It is this fear based decision-making process which must be re-programmed and as the study we referenced earlier in the article suggests, the first part of this equation is to manage the physical cortisol issues associated with the learnt chronic stress response followed by rewiring the learnt habit.
We have written about the 2 following methods previously but there is a great amount of literature to support how mindfulness in the form of meditation and HRV training can reduce the cortisol response.
According to numerous studies, mindfulness and meditation training has proven to lead to a reduction in stress which, in turn, leads to a fall in cortisol levels. According to this an experiment conducted on medical students the fall in cortisol levels was statistically significant due to meditation. The same results were proven in this experiment where the students were made to do Buddhist type meditation. Harvard expert physician, Herbert Benson has also mentioned that meditation leads to a relaxation response and thus a reduction in cortisol levels. Remarkably the levels are known to fall by about 20% when the meditation protocol is successful.
Heart Rate Variability, alternatively, has been shown to be a good predictor of stress in various studies. According to a cross-section of studies –
- experiment done on female students on a 48 hour fast,
- experiment on naval cadets subjects in a memory and focus experiment,
- experiment on beginner scuba divers to measure stress levels in this experiment,
- and finally, the same result has been found in research done by Ghent University in children.
The conclusions were that there is a negative correlation between HRV and cortisol levels. Hence any HRV training which improves the HRV score can lead to lower levels of stress thus directly impacting and reducing cortisol levels.
Reprogramming the Habit – Can you keep it green?
Once a trader has reclaimed their cortisol response then we can focus on changing the fear based decision-making process which remains.
In HRV Training apps like Inner Balance, the goal is to train your HRV by keeping in a steady state of coherence defined as maintaining the status light in the green zone.
Once you can consistently keep the status light green slowly re-expose yourself to the market conditions which trigger that fear based response.
At first rehearse using just visualization. That is, run through the identified scenario as clearly and vividly as possible. Play this through your mind numerous times and strive to maintain in that coherent state.
Once you can consistently achieve that progress towards exposing yourself to live market data, then to trading a small position, then to trading full size.
If you can maintain that state of coherence in all scenarios you’ll notice that you have not only short circuited that fear based response but that you will have a whole level of emotional control and mastery which you can call upon in any situation.
For other techniques, check out this great post from Dr. Steenbarger’s blog – http://traderfeed.blogspot.ca/2007/04/handling-performance-pressures-of.html
Given the wrong set of conditions it is very easy for a trader to revert to a primal fear based decision-making process. This mindset may have served us eons ago when the right response was to either fight or flee however the response is certainly not appropriate for traders who want to perform at the highest of levels.
The key is in recognizing when that shift has happened and appropriately managing not just the emotional and mental aspects of straightening the trading ship but the real physical biological responses as well.
Please let us know how we’re doing and if you’re struggling with a fear based mindset in your trading or if you have found ways to work through it we’d love to hear about it in the comments section below.
Cited Sources and Related Articles –
Kandasamy, Narayanan, et al. “Cortisol shifts financial risk preferences.”Proceedings of the National Academy of Sciences of the United States of America (PNAS) (2013).
Effects of mindfulness meditation on serum cortisol of medical students.
Effect of Buddhist meditation on serum cortisol and total protein levels, blood pressure, pulse rate, lung volume and reaction time.
10 Fun Ways To Reduce Your Cortisol Levels
Beat Your Stress Hormone
Mindfulness from meditation associated with lower stress hormone
Mindfulness Meditation Could Lower Levels Of Cortisol, The Stress Hormone
Effects of a 48-h fast on heart rate variability and cortisol levels in healthy female subjects.