Trading by Rules: A Psychological Perspective

Brett N. Steenbarger, Ph.D.

www.brettsteenbarger.com

The following was written in October, 2003 for Rickey Cheungs trading system website
(www.rc3200.com).

If I had to give one piece of advice to most traders who are struggling with their
P/L, it would be to trade tested systems or patterns and trade them systematically. If you
look at highly successful business organizations, such as McDonalds, Dell, Federal
Express, or Wal-Mart, youll find companies that are doing the same thing, the same way,
every day, with a high degree of consistency. They came up with a winning formula,
which is half the battle, but they execute that formula with high fidelity and regularity.
That is how you want to be trading.
So that brings up two important questions for any traders self-assessment:

Do I have a winning formula, and have I really tested it to know its winning and
to have the needed confidence in it?

Am I executing my formula faithfully, and am I truly tracking each and every trade
to know Im following the formula and have the confidence in my ability to follow
it?

A very large percentage of traders who have contacted me for assistance with their trading
cannot honestly answer these questions in the affirmative. They want help for their
psyches when what they need is to treat their trading like a world-class business.

Trading and Personality

About three years ago, Linda Raschke and I surveyed a group of approximately 64
active traders. We were interested in discovering whether there were any personality traits
and coping styles that distinguished more successful traders from less successful ones. We
obtained a number of thought-provoking findings. For example, we discovered that the
winning traders tended to have lower levels of neuroticism (negative emotional
experience) than their less successful counterparts. They also employed more problembased coping methods (coping by developing strategies for dealing with threatening
situations) relative to emotion-focused coping devices (coping by venting feelings or
seeking support). Profitable traders, we found, scored higher on a trait called
Conscientiousness, reflecting a general stick-to-it-iveness and motivation to follow
through on plans and commitments. In all, these findings confirmed what many of us have
observed informally in our careers in the markets: traders who temper their emotions and
stick with trading plans fare better than their more emotional and impulsive peers.
One unexpected finding from our survey, however, was that a disproportionate
number of the successful tradersabout halfreported utilizing mechanical trading
systems. Of the unsuccessful traders, none were mechanical traders. When I subsequently
interviewed the successful traders, it turned out that even the ones that were not systems
traders were basing their trades on patterns that they had carefully researched.
Conversely, almost to a person, the unsuccessful traders lacked such grounding in patterns
and research.
In my recent book The Psychology of Trading (Wiley, 2002), I describe the
orientation of these winning traders as rule-governed. A major reason they were
successful, I believe, is that they used trading rules both to guide their trading and to

maintain a positive mindframe. In this article, I would like to explore in detail why rulegovernance is one of the most powerful psychological strategies one can employ in active
trading.
The Psychology of Rules
What is a mechanical trading system? Basically, it is a set of rule to trade by.
These serve several functions. The first such function is a logical one: they are designed
to maximize profits by exploiting anomalies within relatively efficient markets. Every set
of trading strategies incorporates what statisticians call Bayesian decision rules. That is,
they establish Conditions A, B,n that the market must meet before traders go long or
short, stop a position, etc. The idea is that, without these Conditions being met, the
forecast for any position going in your favor are determined by chance alone. Once we
update this forecast when the Conditions are met, the odds now tilt in the traders favor.
While any single trade may not prove profitable, over enough time and with enough
trades, these tilted odds should benefit the traders equity curve, so long as the decision
rules have been adequately researched. Here it is vital for any trader to know how the
system was developed. Was it tested over a time period independent from the one used in
its development? Is its real-time performance consistent with its historical track record?
Is the underlying logic of the system sound, or are there too many parameters, convoluted
logic, or other signs of curve-fitting?
Less well appreciated is that such decision rules serve a second, psychological
function. By reducing trading to a set of rules, traders lessen their ambiguity so that they
can function in a relatively automatic mode. This permits a clear-headed monitoring of
fresh trading opportunities, so that those improved odds can eventually work to ones
favor. In reducing ambiguity, rules contribute to a sense of mastery and reduce much of

the stress associated with high performance activity. Think about how stressful it would
be to drive in a third-world country where traffic rules are not enforced! This is precisely
the emotional state of many traders who function by the seat of their pants. The presence
of rule governance lends order to an otherwise chaotic process.
In order for a system to serve as a psychological aid, however, it must fit well with
the personality of the trader. Research conducted at the London Business School suggests
that yet another personality traitextraversionis positively correlated with risktolerance. Some traders are much more risk-averse than others, simply as a function of
their personality constellation. It is crucial that the system you trade take this into
account. Thus, the total P/L of the system is only one parameter to evaluate when looking
for the best way to trade. The drawdown statistics and the percentage of winning/losing
trades may be key to traders mental ecology. I have learned in my own trading, for
example, that I am much more successful trading very short, intraday patterns than swing
trading. With an average holding time of under 30 minutes, I can make small profits with
consistency, maintain my trading focus, and limit my losses. While it is theoretically
possible for me to make more money by holding on for the longer swings, in practical
reality this does not happen. The added volatility of the longer time frame interferes with
my emotional state and decision-making, turning my profitable trading into one that is in
clear non-compliance with minimum wage laws!
Trading is indeed a high-performance activity. Like other high performance
domains, it requires directed effort. The football team going into a big game draws up a
game plan; the army about to fight a war develops a battle plan; the master
psychotherapist goes into sessions with a coherent strategy for assisting a patient. These
plans are actually sets of interwoven rules that, as a whole, orient the performer as to the

challenges that lie ahead. To the extent that the peak performer has a decision tree
mapped out in advance, responses to situations can be made rapidly and decisively. In
many fieldson the trading floor or in the operating roomthe difference between
success and failure can be a matter of seconds or minutes. This makes cognitive efficiency
a prime ingredient of peak performance. By summarizing years of experience in a few
statements, rules and plans promote such efficiency.
This brings us to another important psychological facet of rule governance: To
promote efficiency in decision-making, rules must be simple. It is when these rules are
assembled in a coordinated manner that they become plans that flexibly orient individuals
to complex situations. In my own trading of the equity indexes, for example, I break each
day down into four component mini-days: morning session, midday session, afternoon
session, and overnight (Globex) session. I then assess market trends and trendiness, gauge
the degree of institutional buying/selling, and look for tests and breakouts from one time
period to the next for intraday trades. (See my Weblog at
www.greatspeculations.com/brett/weblog.htm for details). By combining simple decision
rules with a segmentation of the trading day, I can approach each day with a flexible
strategy that doesnt clutter my head.
Rules and the Brain
Advances in cognitive neuroscience are also helping illuminate the value of rules in
guiding performance-based activity. We know that a region called the prefrontal cortex is
largely responsible for what is known as the executive functions of the brain. These
include planning, reasoning, problem solving, and many of the activities that allow us to
engage in purposeful activity. When the prefrontal cortex is damaged, the result is a
dysexecutive syndrome in which patients become unable to plan and execute complex

activities. They are easily distracted, reflecting deficits in memory and concentration. As a
result, even the simplest coordinated goal-oriented activity, such as grocery shopping, can
be challenging.
Recent theories of attention deficit/hyperactivity syndrome (ADHD) suggest that
deficits in the prefrontal cortex contribute to the distractibility and poor attention spans of
hyperactive children. Indeed, imaging studies find reduced blood flow to the prefrontal
regions of such children. Interestingly, these are the same reduced blood flows that are
observed among normal individuals during episodes of high emotional stress or
frustration. Because emotional experience is processed by lower brain structures, away
from the prefrontal cortex, the relative cerebral blood flow to the frontal regions serves as
a useful measure of a persons executive capacity. When people are highly frustrated, for
example, their deactivation of the frontal cortex leaves them in a state wheretemporarily
they are similar to the ADHD child or even the dysexecutive patient. How many times
did you look back on a losing trade and wonder if you were in your right mind when you
placed the order? According to brain studies, you might not have been!
The traditional trading wisdom that says we need to control our emotions stems
from the recognition that highly emotional states leave us more vulnerable to lapses in
concentration and impulsive behavior. When we are activating the wrong brain regions,
we can expect to make impaired trading decisions. Rules enable us to stay grounded in
proper trading practice regardless of the mindstate we are occupying at the time. Indeed,
the entire process of formulating, following, and coordinating rules activates those
executive functions needed for proper trading. In a very real sense, staying rule-governed
is a way of staying focused and rational. It is for this reason, I believe, that Linda and I
observed that successful traders tend to be rule-governed and systematic.

Conclusion
It is common to hear traders assert that mental self-control is the key to stock
market and futures profits. This article is suggesting that the reverse is equally true:
Staying grounded in solid trading rules and systems is one of the most powerful ways of
maintaining a positive trading psychology. When we are rule-governed, we are in a
mental state that promotes efficient perception, problem solving, and action. Indeed,
training ourselves to stay rule governed during trading rehearsals is an effective strategy
for cultivating rule governance in real time.
Different rule systems may work better for different traders, depending on time
frames and markets traded. My own rules make considerable use of such statistics as the
NYSE TICK, the number of stocks advancing vs. declining on an intraday basis, and the
number of stocks making new intraday highs and lows. Such rules would be poorly suited
to the trading of agricultural commodities, but have proven useful in trading intraday
swings of the equity indexes. Other rules, such as pure price-based breakout methods,
possess wider application across markets and might allow for the holding of positions for
longer time frames to maximize potential gains.
Ultimately, the rules/systems you followand their linkage into coherent trading
plansmust be well suited to your personality, including your risk-tolerance. Researching
the performance of your systemdiscovering its weaknesses and strengthsand trading
them with small initial positions is of immense help in building your trading confidence and
ensuring that the rules work for you. If we believe many of the Wizard traders
interviewed by Jack Schwager, a key to trading success is surviving ones own learning
curve. Identifying the system(s) that work for you, translating them into consistent trading
strategies, and learning to be comfortable with these is an important part of that process.

Brett N. Steenbarger, Ph.D. is Associate Professor of Psychiatry and Behavioral

Sciences at SUNY Upstate Medical University and a daily trader of the stock index
markets. He is the author of The Psychology of Trading (Wiley, 2003) and the
forthcoming The Art and Science of the Brief Psychotherapies (American Psychiatric
Press, Inc., 2004). His articles on trading psychology and daily trading strategies are
archived at www.brettsteenbarger.com.