What Science Can’t Explain About Testosterone, Cortisol, and Compounding Trading Losses

• Posted by DynamicHedge
• on August 30th, 2010

The effects of hormones on trader decision making is well documented. Evidence suggests that the hormones testosterone and cortisol take turns flooding the trader’s brain in accordance with reactions to outcomes and the relative uncertainty of trader decisions.

All men have varying levels of testosterone as a baseline depending on their age and other factors.  When participating in any type of competition, testosterone levels are elevated in anticipation of the event.  The winners of these events experience even more elevated levels of testosterone, and the loser’s testosterone is reduced.  Increased testosterone is associated with better performance and thus the better your past results the more you win in the future.  This positive feedback loop is known as the ‘winners effect’ in sports.  Unfortunately, trading is not an athletic sport even though your brain sees no difference in competitive endeavors with regards to its hormonal regulation.  More testosterone does not necessarily help a trader win more trades in the same way that it will help a runner win more races.  In fact, problems arise when the winning trader experiences too much much testosterone at elevated levels for too long.  This leads to impulsive decisions and extreme risk-taking which can in turn create volatility, uncertainty, and losses.

Cortisol is introduced as a way to cope with stressful or uncertain events.  It alters the way that people perceive and store memories related to stressful or uncertain experiences.  The parts of your brain that store factual details and emotional significance both have cortisol receptors.  Cortisol combats the effects of testosterone by recalling negative events in a different way and thus reducing risk appetite.  Evidence suggests that cortisol is not necessarily a result of direct losses, but a result of increased volatility, or anticipation of losses.  This can be detrimental to trading because times of significant stress or uncertainty often produce the best trading opportunities.

There is a certain hubris and feeling of invincibility associated with long winning streaks.   Each winning trade makes you feel stronger and validates your strategy even further.  After a sting of wins the first loss seems insignificant, a speed bump as opposed to a warning sign.  Traders in this state are under the firm influence of increased testosterone levels.  Conversely, every trader has been in a state of uncertainty while holding on to a losing or volatile position. There is a gut wrenching feeling in the pit of your stomach which intensifies as the loss gets bigger or the swings in PnL increase.  An unshakable urge to retrench from risk.  New opportunities are ignored and winning trades are attributed to luck.  This is the effect of cortisol.

The best traders have learned how to listen to the subtle signals and biofeedback from winning and losing.   They know when to be patient and when to be aggressive.  They know when to have a small position and when to size up.  They are conscious of not only their emotions but of the emotions of the majority of other market participants.  If you bought everything when you were confident and sold everything when you felt uncomfortable you would certainly under perform dramatically.  Listening to the subtlety of your emotions and recalling similar situations and their outcomes can make your trading action crisp and increase performance.  Recognizing when you  are too hot or too cold is critical.

The opposite occurs when traders are conscious of emotions and biofeedback but unable to harness it correctly.  They fade their emotions for the sake fading them.  Or, they choose to ignore them entirely.  They stay far too long in the cortisol bath of pain, playing chicken with your hard-wired risk averse response after they rode the wave of testosterone far past their due date.  The more extreme the events become the more they become numb to the PnL swings and extreme volatility.    The tug-of-war between testosterone and cortisol renders them unable to act in a decisive way.  I’ve seen traders become immune to evidence of imminent doom, despondent and self destructive.

In the artificial construct of financial markets, emotions are multiplied by leverage.  The chemical reactions in your brain that evolved to keep you safe and help you compete in a much different world can hurt you in the stock trading game unless you harness them correctly.   The ability to handle stressful events and big wins are what determines how we will fare over the long term.  Learn how to harness these chemicals.

Source: pnas.org, discovermagazine.com

blog comments powered by Disqus