THE TRADING DEATH SPIRAL - How to Identify it and Pull Yourself Out

This article is designed to be an add-on to my previous article on trading psychology. There was a lot of interest in the Four Stages of Learning, which can be applied to almost anything in life. I know this because a fellow bodybuilder told me so. This next article highlights what happens during Stage II and even Stage III. It is one of the darkest moments in a trader's career. It's a time where you either "make it or break it" and there is no in between.

What is the trading "death spiral"?

Imagine for a moment: You went short Friday morning (2/27) but the market immediately rallied from the open. Then, you decided to go long, only to see the market head back down. You just took 2 consecutive losses. In your eagerness to "make it back up" or "break even", you start to get frustrated and have feelings of despair.

Later during the day, you see the market is about to breakdown, but you don't go short because you've already been burned twice in the same day. Naturally, you would have made a killing if you took this trade. You then proceed to either literally or figuratively bash your head into the wall. Perhaps you even want to throw your computer out of your window. So you don't wait any further, you then "chase" the stock and short it at ridiculously oversold levels and catch a furious bounce, forcing you to cover. There goes loss #3.

At this moment, you are dazed and confused as to what just happened in such a short period of time. You became poorer in a matter of minutes and you are feeling hopeless and you may even be experiencing shivers, shortness of breath, sweating, and of course you may be cussing and maybe even throwing objects across the room. Your choices are either 1) to calm yourself down and move on or 2) to quit, indefinitely. You are now in a death spiral.

You go through this shift or transition from accepting and embracing losses and correcting the mistakes, into a massive pit of emotions that becomes so convoluted and built up to a point where you lose total confidence and acceptance in anything and everything. This transition can occur within minutes, or even seconds. Emotional responses replace your tactical trading method and plan (if you even have one). The death spiral is simply you digging yourself deeper and deeper into this pit. It's an abyss that you must get out of immediately. If not, you may experience permanent psychological damage that prevents you from trading ever again.

You must learn to control your emotions or you will not be able to trade. All the programs, books, people, and anything else out there will do you no good if you do not master your emotions. Do you understand that? What I am telling you is important. Even if quitting was the only viable choice, most traders that do quit do not do so until the death spiral causes an emotional response that creates a situation so desperate that the trader cannot take it anymore and must quit. You hear of stories about how traders commit suicide, right? Well, most likely, what I said above is the reason why. You want to be aware of your emotions and catch yourself before you visit the depths of hell.

Contrary to some people's thinking, this doesn't apply to only Stage II's and III's. This happens to everyone, even professionals, because we are all human beings. The difference between a pro and a novice is that the pro can quickly identify if he/she is entering the spiral and get out quickly and with only a scratch. A novice has no clue what he/she is getting him/herself into, and as a result, suffers massive losses. You can read my pretty little charts all day long, but they won't save you once you spiral out of control. Your emotions take full control over you as if you were possessed by a demon. You become irrational.

Consider a few a things:

• The first time a spiral happens, you should correct and learn from it. The most important skill you can master here is to control yourself before the spiral controls you. However, every time this spiral occurs and the more you go out of control, the quicker and more devastating the next spiral(s) will be. You will lose control even faster. The pain will shut you down and you will no longer be willing to trade anymore. Correct the problem now.
  

• Instead of quitting, take the time to re-build your confidence and to strengthen your emotional resolve. Quitting is taking the easy road. It is the most convenient thing to do because you don't want to get burned again. You know the story about the little boy touching a hot stove, right? Or how about the one that got bitten by a dog? Quitting doesn't provide any solution, and will only feed your reservoir of painful thoughts.
  

• How many traders start the day winning, only to lose those gains (plus more) at the end of the day? Who's fault is it, the market or the trader? Did the market change or did the trader change? It's always the traders fault and the trader always changes. You NEVER blame the market under any circumstance. The emotions start coming in before the trader even starts to lose. Excitement from winning will cause the trader to lose control. The gains turn into losses. You have started another version of the death spiral.

How do you stop yourself? The key is self-awareness. You have to be aware of what you are doing. How many times have you spiraled out of control and only at the end of the day did you realized what you have done? Would it not be better if you caught yourself in the beginning and knew what you were doing and what the consequences would be if you do not stop? The moment you transition from self-unawareness to self-awareness, you will have broken through a major point in your trading career. It is a pivotal moment.

Let's become self-aware right now. Get an index card and write the following statements on it:

• After consecutive losses, I may be losing control of my emotions
• Many consecutive losses usually result from trading within neutral ranges or doji days, such as 2/26*.
• Are you following your trading method or are you overtrading?
• Trading method losses are acceptable. All other losses are not.
• If unsure about the market, remain neutral. Making no money is better than losing money.

(*Note: I even stated on Twitter early Friday that the day presented no sustainable trading opportunities, therefore I did not place a single trade. Pay attention).

I'm sure you get the idea, and I know that there are more statements that could be added. I will welcome suggestions in the comments section for traders who need them. The card means nothing if you don't use it. Go ahead and tape it to the bottom of your monitor. Don't leave it on your desk as it tends to be swept aside. This visual reminder will help you more than you can imagine.

Now, get another card, and label it as "Symptoms of a Death Spiral". I am not bullshitting you. Now, write the following:

• Self-unawareness may lead to "shortness of breath", "sweating", "squirming in your chair", "nervousness/anxiety attacks", "shaking/restlessness", "feelings of hopelessness", "confusion", and finally, "anger".
• When I reach the "anger" stage of the death spiral, I may "cuss" (more than you would on a normal day), "scream", "throw objects", "break objects", "jump up and down", "bang my head into the wall", "kick myself repeatedly", "direct anger towards other people" (who have nothing to do with trading), "lose full normal emotional function".

Again, you may add a few things on that list as well. If you have ideas, leave it as a comment for others who need it. Now tape this card next to the first card. The purpose of the first card is to help prevent you from digging yourself deeper into the hole. The second card is there to remind you that if you do not follow the first card, you will experience the things written on that second card. I know you don't want to, so follow the first card. Read this everyday before the market opens. In fact, print this entire article out and read it everyday if it helps you.

If you are in a death spiral or have recently experienced one, then you may want to do the following:

• Stop trading immediately. You cannot trade when your emotions have you under control. Go exercise, read a book, play with the dog, do something to clear your head.
• You may want to start paper trading until you become profitable on paper. I tell people all the time, "If you can't make fake money, how in the hell are you going to make real money"? Makes sense, doesn't it? Get your trading methodology in order.
• Start trading again, but only in small lots. If you used 10% per allocation, then start off with something smaller. The less money that you have at stake, the less emotional you'll become. If you had $2,500 at stake, then you wouldn't care much if your normal position sizes are $10,000. The death spiral will come after you the moment you try to make an "unplanned killing" motivated by your own greed.
• As you become more comfortable, gain more confidence, and start turning a profit, then you may increase your position sizes.
  
• Don't forget this article and the two index cards. Read them daily in your trading.
  

I want to mention the importance of remaining neutral to single events, and that includes winning. If you get really fired up and over-the-edge excited when you make money, I mean jumping and down and calling up your friends and telling them how much of a genius you are, then you are 100% susceptible to the death spiral. In fact, you are more likely to go down the spiral faster than a non-excited trader. If you want to start trading for a living, then you have to act in a professional manner. Since most individual traders trade alone, it's easier to "act out" on emotions, but imagine if your mother or your kids or girlfriend/wife, whatever, was in the room with you, how would you act?

I hope this helps you all. Have a great weekend!

MARKET COMMENTARY (2-26-09)

Have you noticed that when a politician speaks, such as Obama, Bernanke, a bunch of senators, or the occasional Geithner, the market trades in a neutral bound range? It's a coincidence. It's important to note who is speaking and when. For example, both the Boston and San Fran Fed Reserve bank presidents will be speaking later today. Have you noticed that Obama has been speaking almost every day? The market trades in a consolidation waiting for clarity, to find a direction at least for the day. It is dangerous to be rapidly trading in these environments. For days now, I have advised against it.

The SPX is still boxed in despite the intraday breakdown. This brings the market to a neutral status where I expect consolidation between 740-780. I warned that the market is flagging and it is very bearish sign. Each day that passes where the market trades in this range, the sooner the market will be able to continue to the downside. Most notably of the three indices, the COMP is the last to test it's low. This divergence will soon be corrected. The probabilities for a downside move (over several days) are higher, simply because they are continuation patterns in most cases. Be careful trading in this range. There will be continued whipsawing.

We have GDP Q4 in the morning (8:30AM) in addition to the Chicago PMI (9:45AM) and Consumer Sentiment (9:55AM). I am 100% cash, so again, I could care less. Trade the reaction, folks.

Don't forget to try the Free Trend Analysis. It's FREE, so give it a shot!

MARKET COMMENTARY (2-25-09)

I did not do much today and only rebalanced my existing minuscule long/short positions. The market is once again boxed in after failing to hold the inverse h&s pattern. This time, they do not involve the major moving averages. You can take a look at the 10-day SPX chart to see that the SPX is at overhead resistance around 780, support at 755, and a lot of whipsaw in between. I will personally be waiting for an exit from this box to load up on positions.

On the daily chart, if the market flags down here, then the chances of going many more points lower is well above 90%. It's almost a near certainty. This is why the market needs to spike higher to avoid flagging down at the lows for a meltdown set-up. We formed a doji yesterday which is more of a 50/50 day (not good odds). There's no rush. Really.

Still reading "When Giants Fall: An Economic Roadmap for the End of the American Era" by Michael Panzner (Wiley, 2009).

WalStreetPro (WARNING: Extremely Offensive)

Don't forget to try the Free Trend Analysis. It's FREE, so give it a shot!

MARKET COMMENTARY (2-24-09)

Remember that pipe bottom we had that formed the November lows? It's "possible" that we made one. I cannot say with as much certainty for this one because you can compare the volume levels between the two. If you don't know what a pipe bottom is, notice the red and white long candles in November and how they "canceled each other out". They are effective short-term reversal signals.

I am expecting to swing long this market and enter longs on any decent pullbacks. If you look at the 10-day chart, we formed a cup, and the question is "do we form the handle on it or breakdown like a dumped gf"? This is why I like to wait for a successful test of the handle, if there is one. On the breakdown, I will add shorts.

Either way, there is quite a bit of significance to the move that occurred yesterday. First, it canceled out Monday's losses. This at least gives the market some hope for a bounce. Second, the bounce occurred on the lower trend line of the DJIA's down sloping channel, the COMP bounced off of 1400, and the SPX on the 740-750 major support level. This gives added significance to the move. The downside to this? Someone can open their mouth and plunge the markets immediately.

I have no comment on Obama's speech yesterday except for the fact that there were A LOT of promises made. I don't know man...

I'll be taking it easy today due to my swollen mouth (double root canal yesterday + the 'feel good' drugs I have to take).

Don't forget to try the Free Trend Analysis. It's FREE, so give it a shot!

MARKET COMMENTARY (2-23-09)

Yesterday was boring. I did make some adjustments to the existing small short positions I had and I broke even for the day despite my original thinking and despite the fact that I had a 10% BAC long position from Friday. The technicals said that we we're going to gap up and maintain momentum higher. That obviously did not happen and it shows the importance of keeping an open mind to all possibilities. I am net short with a large cash position.

I am aware that we have been down for 6 straight sessions, but know that the MSCI World index has been down 11 straight sessions, so heck, who knows, anything is possible. There are some things to note though on the individual indices.

First, the SPX closed 2 pts above the Nov low, which was 741.02. Volume indicates that we have not yet seen capitulation for all the dip buyers at the top. This sell-off is so slow and the buying is so weak that I'm questioning both sides of the market. Typically, the best thing to do is to have a large cash position available.

Second, the COMP is divergent with the SPX/DJIA and has yet to test it's own lows (Nov low: 1295.48). The volume is definitely not capitulatory and there is a lack of selling pressure. I see more downside room for the COMP, and by default, the SPX has more downside.

Third, the R2K, after the SPX, is likely to test it's own low (Nov low: 371.30) next. I also see more downside room for the small-caps.

Fourth, the DJIA is broken and it's the first that's going to the abyss. Take a look at the comparison of the 4 large bears. This makes me wonder - we may actually be starting a new primary leg down on the DJIA. It is possible and I won't rule out it. The DJIA did break and close below the 2002 low (7197.49).

Where is the selling (the fearful and panicky type)? Long investors, when are you going to puke it all out? I remember the days when we would get huge gap downs, effectively marking capitulation, and a rush of buying would come in to mark a bottom. You also had cases where there would be huge massive intraday reversals that completely wiped out all losses on huge volume days. Those are the reversals you want to be buying, not the dips on a slow meltdown.

Don't forget to try the Free Trend Analysis. It's FREE, so give it a shot!