In last week’s article I wrote…

Everyone has had one of those days where it seems that whatever you do costs you money.  The harder you try to get back to breakeven the deeper you seem to dig the hole.  Later in the day the losses just seem to accelerate as you become less and less able to manage your trades in your usual rational way and the day ends with you holding your head in your hands asking “why oh why do I lose control so badly when these days strike?”

Then I promised you the story of LSD, so here it is.  This was written by a very good friend, Dr Ashley Conway, an internationally renowned psychologist who has undertaken research for me.  It is reproduced for you here exactly as he wrote it to me.  It takes a bit of working through, but if you go over it a few times it does all suddenly start to make sense…

Hi Simon – Here is an explanation of sorts – I start with the generalities, and get more specific.

State Dependent Learning Memory and Behaviour (SDLMB)

This has nothing to do with the UK’s comprehensive education system!

The story goes (and I believe that it is true) that the discovery of this interesting phenomenon was all started by the CIA.

When I was a psychology undergraduate student at the end of the seventies, there was this rather odd bit of research, and nobody knew what to do with it.  The research probably went back to the sixties and the cold war.  The belief is that what prompted the research is that the CIA were looking for a way for people to be able to retain information, and not give it up under any duress, even torture.  A brilliant way of achieving this goal was to have them unable to retrieve it even if they wanted to – but you had to find a way for them to be able to get it back at some later stage.  The research involved getting people to learn things under the influence of certain psychoactive drugs – which probably included LSD.

The interesting discovery was this:  With certain drugs, if people learned things while under the influence of the drug they were unable to recall it when the drug had worn off.  However, when the drug was re-administered recall would return.  This phenomenon became known as “state dependent learning”.  Learning in one chemical state could not be recalled outside of that state, and could be, when the same chemistry was re-introduced.

At the time when I first learned about this research it was considered interesting, and rather quirky – nobody really knew what to do with it.

But then, over the years, the pieces started coming together.  Two major components became clearer – the first was that there has been a massive increase in awareness of the number of different natural chemical neurotransmitters in the brain.  I believe that I am right in saying that when I was a student the number of known neurotransmitters was in single figures, and now it is in three figures – this can become infinitely complex, of course when you consider the possible variations of proportion of one to another.

The second component was research evidence clarifying something that we might all know intuitively to some degree – that when people are depressed they find themselves recalling other times when they were depressed, and find it harder to recall happy times, and likewise with anxiety – when people are anxious they remember other anxious times, and find it harder to recall times of calmness and confidence.  It is then not a massive leap to put these pieces together – there are now known to be numerous endogenous (ie produced by our bodies) neurotransmitters, and these chemicals may change in absolute amounts and / or in proportion to each other, according to all kinds of things, including mood.  Psychoactive drugs are psychoactive because they mimic or change neurotransmitter levels.

One particular mood state is very likely to have a particular cocktail of neurotransmitters associated with it, and enable access to memory patterns that “fit”.  An important component that has been added more recently is that it is not just learning and memory that is state-dependent, but behaviour too.  Again this is logical and not that surprising – if we feel depressed we are more likely to act in a depressed way.  If we feel anxious, we are more likely to behave in an anxious way, and avoid things.  Conversely, of course, there is an upside – if we feel confident, confidence is more accessible to us, and we are more likely to act in a confident way.

Now lets get down to specifics for your business – again just another step.

If a trader gets into a mindset that “I am losing”, that is a small step away from “I am a loser”, and either belief is likely to produce a specific endogenous neurochemical state specific to that emotional state.  The risk, of course is that these things have a habit of becoming self fulfilling.  If we feel angry we find ourselves arguing.  If we feel happy we notice people smiling at us.  And if we feel like a loser ….

This is not a good place to be making rational decisions from.  It is not good psychologically, and what this psychophysiological model suggests is that it is not good chemically.  There are probably very sound physiological reasons why somebody who finds himself in that mindset should stop trading for that day (or possibly longer) until that particular psychophysiological state has passed.

Of course there may be a mirror image of this, in irrational optimism.  I guess that sometimes people in your business believe that they are on a roll, and can do no wrong.  Another good time to stop I suspect – because from what I understand from you Simon, is that ultimately what you need is a clear head, and rationality unencumbered by emotional beliefs, and altered neurological states.  We have discussed how it is a numbers game.  It is impossible to win all the time.  There may be chance runs of wins or losses, but you should not allow these chance sequences to alter your game plan.  If you find that your state is changing (and you can learn to recognise this) then the best thing to do is probably take the day off (and for me – go fishing).

Hope that this is useful. – Best wishes, Ashley

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Copyright © Simon Townshend Ltd 2010, all rights reserved

Are you serious?  Well sort of!  This little gem does take some working through I will warn you, but it does provide an explanation for a very real phenomenon, even if you have to read it six times before it starts to make sense!

But before we get into the heavy stuff (in Part 2) I have a little exercise for you to do:  Go back over your last 12 months accounts and in each month identify the worst losing day.  I bet each one is a real killer?  If you were to remove just that one day each month from your results would that have a big impact on your overall performance?

I’m betting it would make a huge difference, because I once did this very exercise and it changed my trading for good.  What I found was that within each month lurked 1 or 2 real wipe out days – ones that knocked you back in spades, blowing away many days or even weeks of profit.

Everyone has had one of those days where it seems that whatever you do costs you money.  The harder you try to get back to breakeven the deeper you seem to dig the hole.  Later in the day the losses just seem to accelerate as you become less and less able to manage your trades in your usual rational way and the day ends with you holding your head in your hands asking “why oh why do I lose control so badly when these days strike?”

Sound familiar?  When I did this exercise some year ago I was staggered at the impact on my bottom line of removing that worst losing day each month from my results.  As a result of that exercise I vowed to change and to find a way to eliminate those rare but deadly days.

But how can you do that?  Actually the answer is too simple for most traders to give it due consideration – when you get into a hole just stop digging!

When I did this exercise I realised something very important.  The best days offer relatively few opportunities.  Yet the nasty choppy trappy days somehow lure you in time after time only for a further haircut.  Why is it that a day of complete random rubbish seems to offer so many more opportunities?

I don’t know the answer to this, but I do know what I did about it.  I set myself a limit on the number of losing trades per day I am allowed to take – 3.  Three losers in a day and I quit for the day, shut up shop and I’m gone.  No longer will I allow a day of zero opportunity to suck me in 20 times and to produce that occasional nightmare day.

So that is my personal rule.  It is absolutely 100% guaranteed to eliminate the nightmare day each month, quite possibly along with a few other nasty ones.  Yes it is true that it will eliminate the very occasional day that started off as a loser but that suddenly turned around.  We can all remember such days and the relief we felt at the end of the day.  But the reality is that for every one of those turnaround days there were a dozen of the other sort that we have somehow managed to erase from our memories!

My logic is simple – if I take 3 losses there is a very high probability that it is a rubbish day that is underway and it will continue to bleed me of money if I allow it to.  If you take a loss on a decent day, which is quite reasonable to expect, you still have 2 other lives left.  That is plenty of breathing space if it really is a decent day.

There are a couple of more detailed points:

• A scratched trade is not a loser so doesn’t count towards the limit of 3.  Nor does a trade have to be exactly zero to count as a scratch – if you make or lose just a couple of ticks that is just as much a scratch as exactly zero.
• Any 3 losers = time to stop.  It doesn’t have to be the first 3 trades.  It could be 3 losers in amongst 5 winners.  But however and whenever they occur, loser number 3 is the last trade of the day.  If I am on form I should not be seeing 3 losers so it is time to stop, whether I am up or down on the day.

So that is basically my daily safety net that takes away all of those financially disastrous and confidence shattering days.

I urge you to do this little exercise yourself and then to design your own safety net along these lines.  But please do the exercise!  If you don’t prove to yourself just how much better off you would have been with such a safety net, you will never put one in place.

I wrote about this topic only a few weeks ago, so why am I reiterating it?  Well for two reasons actually.  First of all I have now spoken with three traders who each read that recent article and who each said what great advice it was.  But none of them had actually acted upon it!!!  Why?  Because none of them had actually proved to themselves the massive financial impact it would have had on them.  One even told me he just knew that the numbers would be so dramatic if we went back over his old records that he just could not face the truth.  So trust me on this – it is a painful exercise, but if you don’t do it, you are very unlikely to take that action needed to rectify it.  Please dig out those records and get started!

The second reason is set the stage for part 2.  Next week I am going to send you an article written by a very good friend, Dr Ashley Conway, an internationally renowned psychologist who has undertaken research for me in the past.  His work suggests that these disaster days that can kill you so badly may not be totally the market’s fault or the traders fault.  He argues that drugs may play an important part in this.

Yes, this is where we get onto the LSD, so keep your eyes open for next week’s article!

Disclaimer, risk warning and copyright notice apply to all articles published on this site.

Copyright © Simon Townshend Ltd 2010, all rights reserved