Algo Trading – The Emotional and Psychological Toll of Trading
I am always amazed at the fakery and outright lies about trading that are out there. Most are told by people wanting to sell you something – either their private trading room, magic indicators or “never lose” system. 90% of what they tell you are lies.
One of the lies I despise the most is “you should algo trade, there is no emotion in that.” Oh really?
Well, here is a story about emotions and algo trading, and how it stopped a 30+ year trader (me!) from trading a certain algo strategy. If it happens to me, it can certainly happen to you!
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As an algo trader, I’ll trade pretty much everything, as long as there is historical data, sufficient volatility (why trade a market if the price does not move enough?) and the market has enough volume in it. I don’t really care about the fundamentals of the markets, and apart from the basics (contract size, months traded, margin requirements, etc), I don’t see a need to learn the particulars.
For instance, I trade Cocoa, but I can’t tell you about its crop cycles, influence of the weather on prices, etc. I feel that info is all factored in the price anyway. My approach makes it easy to just take the market data, test it and if a strategy backtest looks good, trade it.
One market I’ve always liked is lumber futures, especially for diversification purposes. Lumber futures trade on the CME exchange, as do most major US futures. Here is a chart of lumber futures, where each 1 point is worth $110. Certainly a lot of movement, especially in the past few years (over $220,000 in low to high movement, just since 2020)!
A Brief History Of Lumber Futures
So lumber has plenty of historical data, and its volatility is perfect for trading. The only problem is that is a very thinly traded market. This was not always the case, but it certainly is now.
Back even 10 years ago, lots of people traded lumber. In the 70s and 80s, lumber was a popular retail product. In fact, in one of my favorite books, “What I Learned Losing One Million Dollars,” the author had a very nice lumber brokerage and trading business before volume tanked and the market more or less evaporated. You can see all my favorite trading psychology books right here: https://kjtradingsystems.com/my-algo-trading-books.html#jump4)
Today - or at least the last few years - lumber has been relatively quiet:
Back even 10 years ago, lots of people traded lumber. In the 70s and 80s, lumber was a popular retail product. In fact, in one of my favorite books, “What I Learned Losing One Million Dollars,” the author had a very nice lumber brokerage and trading business before volume tanked and the market more or less evaporated. You can see all my favorite trading psychology books right here: https://kjtradingsystems.com/my-algo-trading-books.html#jump4)
Today - or at least the last few years - lumber has been relatively quiet:
The impact of low volume is two-fold. First, the slippage is huge. Buying and quickly selling could easily cost you a few hundred dollars per contract. Compare that to the mini S&P contract, which would cost you about $20 for the same trade. This large slippage causes most algos to fail; just too much "friction" in transaction costs.
The second issue is that the low volume causes this market to dramatically move some days, and can result in a “locked limit” situation. In the old days, locked limit markets were especially prominent in the ags and softs arena (I mentioned in my first book how I got trapped on the wrong side of a locked limit move in Live Cattle during the “Mad Cow” crisis).
What exactly is a locked limit move, you ask? Well, in certain markets, the exchange puts a limit for the amount price can move up or down in any given day. Most markets have a limit, but over the years the limits have gotten so big that they are rarely, if ever, hit. In Wheat, for example, back in the old days the daily limit was 20-30 cents per bushel ($1000-$1500 per contract), and now the limit is 50 cents (subject to change by the Exchange).
In a “locked” limit situation, the price moves as much as it can, and trading ceases or locks. After all, let’s say wheat falls 50 cents in a day. Who wants to buy wheat at the locked limit down price, knowing that tomorrow the price will likely be lower, and they can buy at a cheaper price. No one! That is why the price locks at the low limit and trading ceases. (Sometimes there will be trading at the locked price, but usually nothing significant)
When a locked limit move occurs, traders get trapped – with no real means of escape. For example, if you are long Lumber, and there is a locked limit move down, you cannot sell that contract at all – you can’t exit until the market actually starts trading again. Sometimes, that is the next day; other times it can be days later.
Do Limit Moves In Futures Still Happen?
These days, allowable daily moves (limits) in most markets are very, very big, so we do not see many limit moves. But they do happen fairly frequently in meats (live Cattle, Feeder Cattle, Lean Hogs), and even more so in Lumber futures. This will become important later.
To sum up: nowadays, in 2022, the volume in Lumber just is not there, although the volatility certainly is.
My Algo Trading Strategy For CME Lumber Futures
In any event, Lumber is something I always test with my trademarked Strategy Factory strategy development process. And in late 2021, after many years of trying I finally developed a viable strategy for this market.
Here is the equity curve of the system I developed. "Blah" for the beginning years, but the last few years were pretty nice:
Although, when you look at the detailed equity curve, the picture is not so rosy. Drawdowns with lumber – even trading just one contract – can be gut wrenching.
Who wants to trade an algo with an $80K intra-trade drawdown? (apparently me!)
Who wants to trade an algo with an $80K intra-trade drawdown? (apparently me!)
Even with the high drawdown, I decided to trade this starting in January 2022. In my mind, I dismissed the big drawdown – probably I was blinded by the big profits. After all these years you would have thought I’d have learned that was a bad idea! Even after all these years, sometimes markets have to teach me lessons I should have long along remembered...
I sometimes wish my trading life had a musical background soundtrack to it, like in the movies. In movies, when something bad is about to happen, the music gets dark and creepy and then you know something bad or terrifying is coming. When I decided to trade this algo strategy, the ominous music definitely had started. But unfortunately, I had the sound turned way down!
I entered long as shown, and things were going well for a while.
Even with the high drawdown, I decided to trade this starting in January 2022. In my mind, I dismissed the big drawdown – probably I was blinded by the big profits. After all these years you would have thought I’d have learned that was a bad idea! Even after all these years, sometimes markets have to teach me lessons I should have long along remembered...
I sometimes wish my trading life had a musical background soundtrack to it, like in the movies. In movies, when something bad is about to happen, the music gets dark and creepy and then you know something bad or terrifying is coming. When I decided to trade this algo strategy, the ominous music definitely had started. But unfortunately, I had the sound turned way down!
I entered long as shown, and things were going well for a while.
At this point, I was feeling pretty happy with my foray into Lumber. Of course, it always seems to happen that as soon as you start feeling good, things start to go bad…
During the rest of January, the Lumber futures market tanked, including 3 consecutive locked limit down days. Even if my strategy had signaled to exit, I could not have gotten out! In little over one week, my $18K open profit was now a $17,820 loss!
Through most of this down period, I was losing about $4,950 per day (limit moves most days were 45 points). That was the most I could lose in any one day – 45 points of adverse movement. As a percentage of my account, it was not the end of the world, but emotionally it was a different story. Losing $5K per day – day after day – takes a toll on you, pretty much regardless of account size. You start to think of all the things you could have bought with $5K, then $10K, then $15K. It was emotionally draining, to be honest.
Add to that the fact you do not know WHEN the bleeding will end, and on those locked limit days, there was NOTHING I could do about it. Add it all up and the whole situation becomes VERY stressful.
Still think algo trading is emotionless?
Here is my equity curve for the month of January for just that strategy:
Yikes! A $40K drawdown in just one month. Even though I knew such a big drawdown was possible – one twice that size had certainly recently happened – thinking something could happen is a whole lot different it actually happening!
At the end of January, I was down about $20K on the trade, with no end in sight. Even though I was following the algo, I felt AWFUL about it. I even reached out to Carley Garner, one of my brokers, to see if she had any insight into when the bleeding would stop (I highly recommend one of her books for traders new to futures). I was in a flooded raging river, headed for Niagara Falls, searching for anything to hang on to.
As February started, it was suddenly like someone said “OK, let’s have Lumber rocket up!” (That may be exactly what happened, since one or 2 players in a low volume market like Lumber could wield a lot of power).
At the end of January, I was down about $20K on the trade, with no end in sight. Even though I was following the algo, I felt AWFUL about it. I even reached out to Carley Garner, one of my brokers, to see if she had any insight into when the bleeding would stop (I highly recommend one of her books for traders new to futures). I was in a flooded raging river, headed for Niagara Falls, searching for anything to hang on to.
As February started, it was suddenly like someone said “OK, let’s have Lumber rocket up!” (That may be exactly what happened, since one or 2 players in a low volume market like Lumber could wield a lot of power).
The next days were GLORIOUS. $5K profits almost every day, including 5 locked limit up days. Stress, but a good stress!
My initial big open profit had turned into a big open loss, and was now a big open profit. But after all this I was emotionally spent. I was spending way too much time and mental energy on this algo. It had to go.
In 30 trading days, 14 days had a sizable profit, and 13 days had a sizable loss. That, to me, is insanity!
My initial big open profit had turned into a big open loss, and was now a big open profit. But after all this I was emotionally spent. I was spending way too much time and mental energy on this algo. It had to go.
In 30 trading days, 14 days had a sizable profit, and 13 days had a sizable loss. That, to me, is insanity!
Here is what my equity curve looked like. Nearly a five figure gain, yet overall I felt AWFUL.
Why did I feel so bad, even after an overall nicely profitable trade? Here are some reasons:
1. I initially ignored a big historical drawdown, emotionally discounting the severity of it. So right from the start I had unrealistic expectations for this algo (no big drawdown could happen to me)
2. I let emotions get in the way of this trade, turning off my algo and exiting early. Who knows where this trade will end up, and how many thousands of profit I will have left on the table? Or maybe, this winning trade will end up a big loser – anything could happen. But I wanted off this roller coaster. This has almost never happened to me from algo trading.
3. I let this trade/this market / this algo get to me mentally. I spent way too much time thinking about this one algo, when I had 37 other algos I could have been focusing on. Lumber was on my mind, day and night.
So, while this story had a good financial ending for me, I still consider it a “bad” trade!
1. I initially ignored a big historical drawdown, emotionally discounting the severity of it. So right from the start I had unrealistic expectations for this algo (no big drawdown could happen to me)
2. I let emotions get in the way of this trade, turning off my algo and exiting early. Who knows where this trade will end up, and how many thousands of profit I will have left on the table? Or maybe, this winning trade will end up a big loser – anything could happen. But I wanted off this roller coaster. This has almost never happened to me from algo trading.
3. I let this trade/this market / this algo get to me mentally. I spent way too much time thinking about this one algo, when I had 37 other algos I could have been focusing on. Lumber was on my mind, day and night.
So, while this story had a good financial ending for me, I still consider it a “bad” trade!
My Algo Trading - Emotions and Psychology - Lessons Learned
Here are some lessons I learned through this fiasco.
1. Emotions can definitely impact your algo trading
I’ve said it numerous times before, and I’ll repeat it here: Algo trading can be VERY emotional and psychological. People who say there are no emotions in algo trading likely are not trading, or if they are, are likely only sim or paper trading.
2. Don’t dismiss historical drawdowns
I’ve written about this before – drawdowns on an equity chart tend to be dismissed and overlooked. Don’t let that happen to you. Imagine riding the equity curve like you would ride a roller coaster – could you handle the extreme ups and downs? Would you get sick on this ride, or worse yet, get thrown off the ride entirely?
3. Stay away from thin markets
Always remember: thin markets are dangerous. Dramatic moves can happen quickly, and you may not be able to do anything about it. While there may be profit potential in these markets, don’t forget the downside – the volatile swings that can occur. Just look at me. I have been trading futures for over 30 years, and the Lumber market of January and February 2022 freaked ME out. And I’ve traded through some crazy times!!
I hope my little story helps you in your algo trading. Never underestimate the emotional side of trading – even algo trading – and you’ll be much better off. Trust me on that!
1. Emotions can definitely impact your algo trading
I’ve said it numerous times before, and I’ll repeat it here: Algo trading can be VERY emotional and psychological. People who say there are no emotions in algo trading likely are not trading, or if they are, are likely only sim or paper trading.
2. Don’t dismiss historical drawdowns
I’ve written about this before – drawdowns on an equity chart tend to be dismissed and overlooked. Don’t let that happen to you. Imagine riding the equity curve like you would ride a roller coaster – could you handle the extreme ups and downs? Would you get sick on this ride, or worse yet, get thrown off the ride entirely?
3. Stay away from thin markets
Always remember: thin markets are dangerous. Dramatic moves can happen quickly, and you may not be able to do anything about it. While there may be profit potential in these markets, don’t forget the downside – the volatile swings that can occur. Just look at me. I have been trading futures for over 30 years, and the Lumber market of January and February 2022 freaked ME out. And I’ve traded through some crazy times!!
I hope my little story helps you in your algo trading. Never underestimate the emotional side of trading – even algo trading – and you’ll be much better off. Trust me on that!
About Author: Kevin Davey is an award winning private futures, forex and commodities trader. He has been trading for over 30 years. Three consecutive years, Kevin achieved over 100% annual returns in a real time, real money, year long trading contest, finishing in first or second place each of those years.
Kevin is the author of the highly acclaimed algorithmic trading book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: http://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.
Kevin is the author of the highly acclaimed algorithmic trading book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: http://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.