Remapping the Mind: Cognitive Therapy for Traders
Brett N. Steenbarger, Ph.D.
Active traders of futures and options make frequent rapid decisions, requiring a high degree of mental clarity. Reviewing their losing trades, they often find that they have deviated from their established strategies and plans, talking themselves into decisions that they would never make in paper trading rehearsals. It is acutely frustrating to replay the day’s session and see the ―obvious‖ signals missed and the impulsive decisions made. ―What was I thinking?‖ is the common refrain. At times, it seems as though we are not in our right minds.
According to cognitive therapists, that is exactly what happens. In the heat of trading, we shift our mind states, activating automatic thought patterns that can sabotage the best-laid trading plans. The goal of cognitive therapy is to identify these thinking patterns, intercept them, and replace them with more constructive alternatives. In this article, I will review the basics of this approach and explain how traders can become their own cognitive therapists.
Schemas: The Mind’s Maps
Cognitive therapy begins with the notion that people have a basic need to make sense of their world. Our need to explain life events is so strong that sometimes we will prefer superstitious and mystical explanations to none at all. A classic example comes from people who suffer from a problem known as panic disorder. In the midst of completely non-threatening situations, such individuals can suddenly experience overwhelming fear. Because the reaction seems to literally come out of nowhere, patients with panic disorder invent their own explanations for their attacks. If their panic occurred in a mall or in a car, they will assume that malls and cars are the problem and avoid these settings. Eventually, the list of offending situations multiplies to the point where panicky patients refuse to leave their houses.
The webs of ideas that organize our perceptions are known as schemas. We can think of schemas as mental maps. In a sense, they are the filing cabinets in which our experiences are stored. The Swiss developmental researcher Jean Piaget described intellectual growth as a function of the development of our schemas. When we first encounter new information and experiences, we try to assimilate these to existing schemas. For example, if we are expecting a market to decline, we may interpret a short-term rise to a new high as a potential head in a head-and-shoulders formation. If, however, it is no longer possible to fit the new information with our expectations, we eventually accommodate—or alter—our schemas to explain our experience. Thus if the
market breaks sharply higher rather than turns down following the suspected ―head‖, we might abandon our bearish position and trade the upside in a breakout mode.
Ultimately, all of us are heirs to our experience. As we grow older, we develop increasingly rich and complex schemas, helping us understand more of life’s experiences. The categories in our mental filing cabinets reflect the life events we have encountered. People who have grown up feeling secure and loved will internalize positive schemas about themselves. Someone who has experienced violence and rejection will tend to develop a more negative mental map. Most of us have met individuals with low self-esteem who can barely accept a compliment. Their filing cabinets simply can’t accommodate positive feedback; it doesn’t fit their experience.
The challenge for traders of stocks, futures, and options is that we inevitably bring our schemas to our trading. How we interpret the world will color how we interpret market action. To see how this can disrupt trading, let us consider the example of a trader I will call Tony.
Perfectionism: The Hidden Saboteur
Tony did not grow up in a violent, abusive home. Indeed, his parents loved him and provided emotional and financial security. Both parents, having come from less-than-affluent backgrounds, were determined to provide their family with the material comforts they had never enjoyed. They worked hard and emphasized achievement. Growing up, Tony was always a good student and received praise for his scholastic and athletic accomplishments. His parents were strict with him and required long sessions of nightly homework. This, however, paid off and Tony was able to attend a highly competitive college and business school.
Despite his achievements, Tony was frequently unhappy. He often felt that he did not live up to his parents’ expectations. Secretly, he doubted that he could live up to his father’s example. Even when he achieved in school or on the football field, he feared that he would subsequently fall short. Determined to do his best, he pushed himself mercilessly. He was stricter with himself than his parents had ever been.
Tony developed an interest in trading during his business school education. He experienced early success in a bull market and came to see trading as a means for achieving his lofty financial goals. Soon after trying his hand at full-time trading, however, Tony found his emotional patterns interfering with his trading. Despite developing a trading system that he had carefully backtested and paper-traded, Tony repeatedly violated the system, placing low-percentage trades at times and sometimes avoiding valid signals. On such occasions, he berated himself and felt like a failure. Even when trades went well, he found himself second-guessing his decisions. Maybe he should have traded larger size; maybe he should have traded the more volatile and profitable contract.
Of the schemas we bring to trading, perfectionistic ones are among the most corrosive. Depressive (―I’m worthless‖) and anxious (―Something bad is going to happen to me‖) schemas are obviously negative and bring painful emotional consequences. Perfectionistic schemas, however, masquerade as virtues. Tony prided himself on his
high standards and achievement motivation. He saw these as answers, not as part of the problem. What he didn’t realize is that the message of the perfectionistic schemas—―I’m not good enough‖—was the real source of his motivation. As long as those schemas were operative, he would never truly accept himself. Indeed, many of Tony’s worst
losses occurred after he increased his trading size following several consecutive wins. The profits were not enough, so he had to put more on the line. When an inevitable loss occurred, it wiped out much of the previous gains.
In my book The Psychology of Trading (Wiley, 2000), I tell the story of a Kansas
bar that I once frequented. A blue neon sign on the window promised ―Free Beer Tomorrow‖. When patrons came the next day, however, the bartender informed them
that the free beer was tomorrow. Needless to say, no one received free beer at that bar.
The motto of the perfectionist might well be ―Self Esteem Tomorrow‖. ―If only I am better,‖ the schema suggests, ―then I’ll be OK.‖ When better arrives however—a new
high in the equity curve, a gain in the market—the underlying feeling of not being good
enough persists. Tony believed he could never measure up to his father, and that colored all of his self-evaluations. Though he believed himself to be motivated by achievement, he was, in fact, motivated by a nagging sense of inferiority. Like the bar patrons, he kept coming back, only to find the promise of self-esteem one day removed.
Identifying Negative Schemas
Piaget would say that Tony is assimilating his trading outcomes to his perfectionistic schema. Instead of concluding that he really is successful and competent, he rationalizes away his victories and dwells on his shortcomings. After one particular successful trade, he seemed joyless. ―Yeah,‖ he reported to me, ―that’s great. But will I be able to keep it up?‖
The first step in altering negative schemas is identifying them in the first place. Cognitive therapy views the negative thinking that emerges from depressive, anxious, and perfectionistic schemas as habit patterns. Catching ourselves in the act of misinterpreting events and then interrupting those habitual thinking errors is half of the change process.
How can we recognize a problematic schema when it first arises? The pioneer of cognitive therapy, Dr. Aaron Beck, found that one hallmark of negative schemas is automatic thinking. Once these schemas are activated by life events, there is a cascade of automatic, negative thoughts that generate anxious, depressed, and angry feelings. These thoughts have a scripted quality, almost as if a tape plays inside our heads. Very often the same thoughts will emerge for very different situations, suggesting that this is not true independent reasoning, but a byproduct of schemas derived from previous life experience.
Tony, for example, produced a number of automatic thoughts that began with the words, ―I should have.‖ He frequently second-guessed his trades, even when these were
profitable. One of his favorite—and most destructive—exercises was reviewing the
trading day and identifying all the trades he ―should have‖ made. These trades were not signaled by his systems and, indeed, would have required omniscience of a real-time trader. Nonetheless, Tony prided himself on doing this after-hours homework, convinced that reviewing the markets would make him a better trader.
Very often people are not aware of their automatic, negative thoughts. By keeping a cognitive journal, traders such as Tony can become better observers of their habitual thinking. Figure One (at the end of this article) depicts one such journal page, and sample entries that might have been made by Tony. The psychologist Albert Ellis organized his journals in an ABC format, where the first column represented the Activating Event (the current situation); the second column described the Beliefs about this event (the person’s self-talk, or internal thought process); and the third column
captured the Consequences of these beliefs (anxious feelings, missed trading signals, etc.). By filling out a journal entry every time a targeted problem occurs (a bad trade, feelings of frustration regarding trading), traders train themselves to become better self-observers.
One of the best ways for traders to begin a cognitive journal is to integrate it with a trading journal. Many traders keep a journal of their trades, noting the setups they are trading, the entries, trade sizes, parameters for stops, exits, and profits/losses. Review of such a journal often yields helpful insights into one’s trading strengths and weaknesses.
By adding ABC columns to the traditional trading journal, traders can now monitor the relationship between their trading results and their state of mind. Tony, for example, was shocked to discover that his worst trading losses typically came after he ―motivated‖
himself (i.e., criticized himself for not making enough money) and increased his trading size and frequency. Such observations were crucial in helping him recognize that the perfectionism he took as a virtue was actually holding him back.
This latter point is very important. People tend to identify with their negative thoughts, failing to recognize that their thinking is an integral part of their problem patterns. A real-time trading journal that incorporates a description of the thoughts, feelings, and behaviors at the time trades are placed, managed, and exited allows traders to review their self-talk and identify its consequences. Equally important, the filling out
of a journal during problem periods requires an interruption of the automatic thoughts.
By adopting the role of self-observer and identifying the consequences of negative thoughts, the trader begins the process of divorcing the self from schemas. It is a real step of progress when people can say, ―This isn’t really me thinking; it’s that silly tape going through my head.‖ Interrupting a pattern is the first step in divesting it of its strength.
Changing Negative Schemas
The beginning work in cognitive therapy, maintaining the journal, allows traders to identify their negative thoughts as they occur and observe their destructive impact. Once traders become proficient at interrupting their automatic thinking, however, the next step is to turn their thinking around.
There are a number of techniques for altering disruptive thought patterns, as summarized in Figure Two at the end of this article. This can be accomplished in cognitive therapy is adding a fourth column to the journal. Ellis incorporates a Column D, in which the individual Disputes the negative thoughts and beliefs that are generating anxiety, depression, and frustration. This disputation is an active process in which people challenge and undermine their negative thoughts. In a sense, the trader plays devil’s advocate to his or her negative thoughts, questioning their validity and reminding themselves of their consequences.
In my own practice, one of my favorite techniques for disputation is to have people role-play conversations they would have with others in similar situations. For instance, I asked Tony to carry out a mock conversation he might have with a trader-friend who had missed a breakout move. Interestingly, people who become immersed in their own negative thoughts can be very positive, encouraging, and supportive of others who face the same dilemmas. In talking with an imagined friend, Tony was invariably constructive, telling the friend that this was a learning experience, that he should feel good about honoring his stops, and that he should be proud that his overall track record was positive.
Once Tony could enact his positive conversations with others, I had him perform a guided imagery exercise in which he pretended that he was the best friend he was
talking with. We then rehearsed conversations with friend-Tony, helping him talk to himself the way he knew how to address others. By making such self-talk a regular part of homework exercises, Tony was able to cultivate a new, more positive cognitive pattern.
As is so often the case, however, it was not any great therapeutic strategy, but life itself that provided Tony with the best method for changing his perfectionistic schemas. During a visit to his parents’ home, he went to the bathroom and happened to look inside the cabinet above the sink. There he noticed a bottle of Prozac that had been prescribed for his father. In a flash, Tony recognized what should have been obvious all along: his father was an unhappy, depressed man. Burdened by the same self-doubts that tortured Tony, the father had reached a point where he needed the medication to get through the day.
Suddenly Tony’s father was no longer on a pedestal. He was a vulnerable human being, just like Tony. Instead of driving himself to match his father’s inflated image, Tony indicated for the first time that he didn’t want to end up like his dad. As bad as it was to undergo trading losses, Tony found it worse to contemplate the possibility of living the remainder of his life as a depressed human being.
Armed with this realization, we conducted homework exercises where Tony was to stop himself whenever he encountered an automatic thought that had sabotaged his past trading. After taking a few deep breaths and focusing himself, he confronted the automatic thought by asking, ―Is this my thought, or my father’s thought?‖ and ―Will this thinking help my life, or will it make me a depressed person?‖ Instead of identifying with his negative schemas, Tony turned them into adversaries. In a very real sense, Tony
retained his motivation to outdo his father, but he had redefined the challenge. Instead of outdoing his father’s perfectionism, he became committed to leading a happier life than his dad. As he found success in this goal, his trading benefited as well.