The Dangers of Irrational Exuberance

04/04/2014 6:00 am EST

Focus: TRADING

Rande Howell

Founder and Owner, Trader's State of Mind

To achieve the optimal state of mind for trading, one does not have to eliminate the risk-taking emotional state, but rather effectively manage between risk and probability, writes psychologist, Rande Howell of TradersStateofMind.com.

Tom was in the zone. He had a string of winning trades over a period of weeks that brought in substantial gains. Sure he had a few losses, but his capital was well protected with good risk management. And, in addition to his risk being managed well, he also had a number of big gainers that also brought him a rush of deserved excitement. It felt good, particularly in the competitive environment in which he was operating. Other traders and managers were noticing, with a mix of approval and/or envy.

He seemed to be in attunement with the market, totally in step, and his performance proved it. His confidence built step by step as he saw the risks he was taking on reward him with strong winners. His confidence felt great. It felt so good that, in fact, Tom did not see the slippery slope that he began sliding down.

Over the next week, confidently all fired up to extract more capital out of the markets, Tom fell into a tailspin. He started taking risks that simply were not good risks and he paid the price. Somehow, the very risk management rules that had proven so effective seemed to have fallen by the wayside. His risk manager saved him from plunging off the cliff by putting a brake on his trading, forcing him to take a time-out, so he could regain his composure. Once he cooled down, Tom wondered what on earth had possessed his thinking. His actions had been out of character.

The Delicate Balance Between Calculated Risk-Taking and Irrational Exuberance
How did Tom's confidence turn against him and go so wrong? Traders have to be risk-takers. It is built into the nature of the profession, and traders are rewarded for taking risks that others cannot stomach. Why is it so easy, then, for a trader to be sucked into a state of mind that miscalculates risk when he is trained to manage risk?

The answer starts in the risk/reward system of the brain. From there, the emotions associated with risk/reward take over the mind of the trader and corrupts his or her perception. That is what happened to Tom in the vignette above. It is the lack of understanding of emotional nature and its influence over thinking that gets a trader into trouble, without the trader recognizing any signs of trouble before he is consumed by it.

Risk-taking, so vital in trading, is fueled by the male hormone testosterone. Without adequate concentrations of it, risk-taking is minimized to the point that the rewards do not motivate the action needed to seek reward. Too much testosterone and risk-taking is enhanced to the point that risk management is corrupted in pursuit of the reward. Somewhere between too little and too much testosterone lies a balance that allows a trader to manage risks within acceptable parameters. That balance is what the trader seeks.

NEXT PAGE: Why Euphoria is Dangerous

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Going back to the vignette above, everything (emotional balance) was fine with Tom until the reward was gained from risk-taking. Then the reward centers of his brain were activated and a flood of dopamine was released to course through the brain. If you want to know what a flood of dopamine is like, compare it to cocaine usage. Usually, as a neuro-transmitter, only a certain amount of dopamine (the reward neuro-transmitter) is around in the synapses between neurons, but the chemical agent cocaine changes all that. In the presence of cocaine, dopamine is not reabsorbed, so the brain’s chemistry is flooded by dopamine. This is why cocaine produces such a euphoric state and is so addictive—the reward stays on and apparent risk disappears.

This same principle is at work in the brain of our trader in the vignette—except that the risk-taking and then the reward of winning produced the exaggerated levels of dopamine. Dopamine and testosterone together are major chemical elements of the emotion of euphoria or “feeling good.” The problem with euphoria (irrational exuberance) in trading is that it causes the mind that emerges from the brain to believe with certainty that the good times are going to roll on forever—thereby minimizing perceived risk.

This is the slippery slope. You take risk. You win. And you are rewarded by the thrill of victory, which triggers the dopamine rush—feeling good and gaining confidence in the risk/reward management. The more the trader wins, the more the reward. The reward begets more dopamine so you feel more and more good and the testosterone enhances the trader’s willingness to risk—win by win, resulting in a compromised mind that trades.

The problem is the balance gets warped without the trader ever recognizing that the emotional Kool-aid in the brain is being spiked—gradually corrupting the emotionally stable mind that can manage risk and reward calmly and effectively. The euphoria is ubiquitous to the trader so that he does not recognize it creeping into the balance of the emotions that govern cognition. As a species, humans are so conditioned to seek the “feeling good” sensation created by dopamine that the trader never considers that too much “feeling good” moves him/her emotionally from confidence to over-confidence. The emotional cocktail of dopamine laced with testosterone, so sought after, becomes the sabotage caused by hijacked thinking in the calculation of risk.

Notice that the trader does not see that he is being sucked down an emotional vortex. Most likely he will not even register that he is in an emotional state, much less consumed by one. Euphoria is that diabolical and dangerous as an emotion to manage in the face of risk. Even when the risk manager stops the trader from trading, the trader does not understand why. To him, another victory is just around the corner. This is how drunk on euphoria he is. While in the cloud of euphoria, he does not see that his mind is incapable of managing risk effectively. He still believes he is in the zone, while the risk manager (not influenced by the same brain chemistry) sees a different story—a runaway freight train that needs to be stopped before it spirals out of control and creates a train wreck.

NEXT PAGE: Managing Emotions for Optimal Performance

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Becoming Aware of Emotions and Managing Them for Optimal Performance
It is not the elimination of risk-taking emotional states that is sought in the optimal trader’s state of mind, rather it is the effective management between risk and probability. In the vignette above, the trader began with a proper balance between the level of risk he was taking on and the probability of success that allowed him to execute trades optimally. It was the lack of awareness (mindfulness) and emotional state management that led him down the slippery emotional slope of sabotage.

If he had had the mindfulness skills that allowed him to notice the tell-tale signs of an emotional hijacking and the emotional regulation skills to have interrupted the arousal of euphoria, he could have maintained a disciplined and impartial mind that would have led to better long-term management of risk. However, because he had not developed these skill sets, irrational exuberance clouded his risk-taking perception. In a more stable state of mind, he would never have taken the trades (based on acceptable risk) that he ended up taking. Instead he never saw he had been sucked into euphoria so thoroughly that he was incapable of effective risk management.

Some interesting clinical studies with traders have demonstrated this very fact. In one study, when testosterone levels were measured by saliva samples (as an indicator of euphoria), it was common among the sampled traders that the levels were so high that they were incapable of rational risk-taking. Yet, when given self-assessment emotional measurement tools, the traders reported feeling no emotion at all. Imagine being so thoroughly compromised by an emotional state to the detriment of your performance capacity and not recognizing it! This is the formula for a train wreck in the making. And it happens every day.

Fortunately, emotional intelligence can be developed. Traders can be taught that there is no freedom FROM emotions. The trader is always in an emotion that is generating the quality of mind he is bringing to the management of risk and uncertainty. This is not optional. And ignoring it and staying ignorant of the connection between emotion and states of mind will cost in the performance in trading.

However, what is possible is freedom OF emotion. Learning to recognize the arousal signatures of emotional states (i.e. breathing style, body tension, and heart rate) before the thinking mind is compromised allows the trader the time to disrupt the escalation of the emotion before it takes over the trading mind and takes trading performance over the side of a cliff. It is at this point that emotional state can be managed to bring forth a mind very capable of managing risk/reward in the heat of the moment.

It is here that the trader can develop a performance mind rooted in the emotions of discipline and impartiality. Here is where freedom OF emotion becomes the skill that manages the delicate balance between risk-taking and reward for peak performance.

By Rande Howell of TradersStateofMind.com

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