Wednesday, July 19, 2006

Two Kinds of Traders

Since the publication of The Psychology of Trading, I've been honored to work with many groups of traders. Some have been home-based and independent; others have worked for proprietary trading firms, hedge funds, or investment banks. FWIW, I would say that, based on this experience, about half of what is written about trader psychology and successful trading is not grounded in reality. A simple example of this is the bromide that successful traders either control or eliminate their emotions in trading. I consistently find this to not be the case. Successful traders are extremely competitive individuals who, as a whole, hate losing. They don't take losing lightly, but they channel that emotion constructively, to enable them to overcome loss.

In general, I find there are two kinds of traders. The first kind trades visually, from patterns that are evident on visual inspection. Those include chart patterns, oscillator patterns, Elliott waves, and the like. Their trading decisions are discretionary, in that they elect to buy, hold, and sell based upon their perception of patterns and their judgment as to their meaning.

The second kind of trader distrusts visual inspection. Such traders are more likely to buy into the behavioral finance notion that unaided human perception and judgment are subject to a variety of biases. Accordingly, these traders use some form of historical/statistical analysis and/or system development to test ideas and trade only those that test out in a promising way.

Now here's the interesting part: The first group of traders almost universally asks me to help them tame their emotions. They have problems with impulsive trading, failing to honor risk limits, failing to take valid signals due to anxiety, etc. The second group of traders, having researched successful strategies, almost universally asks me to help them take maximum advantage of their edge. They want help taking *more* risk and trading larger positions.

The trading psychology literature focuses strongly on the first group of traders, because much of the universe of retail traders falls into this category. At many investment banks and hedge funds, however, visual trading is practically non-existent. If you don't have a model with a demonstrable edge, you don't trade. Such traders tend to have solid analytical strengths, but are not necessarily risk-takers.

So there you have it: some traders are risk-takers without a demonstrable edge; other traders are researchers who find an edge but have trouble assuming the risk of trading it. The true rarity is the trader who has both head and gut: the ability to find an edge and the fortitude to trade it aggressively.


Dave from StockTickr said...

Great points, Brett. Are we to assume that your first book targeted the first group of users where your second book will be geared toward the second?


Nusair Bawla said...

Regarding the follwing conclusion:

"The true rarity is the trader who has both head and gut: the ability to find an edge and the fortitude to trade it aggressively."

Most traders do not want to trade aggressivlely even if they have an edge because they know what kind of emotional damage can occur if things don't work out. Discipline over conviction. I'd love to take on bigger risks, but I can't imagine being around very long if I did. Trading, to me, is not about making the big bets , but rather a slow journey that yields small but meaningful results. It's rare to find traders that have both the edge and the fortitude to trade aggressively because there are not many that survive those kinds of high wire acts. Just my opinion.

Jace said...

I have been trading successfully for about 8 years and I'm not sure that I have a 'demonstrable edge'.

I also do not rely on visual inspection, like the TA things you mentioned.

I also do not consider myself a risk taker. In fact I think my trading style involves very little risk. A position that goes negative is wrong, and thats usually the case. Taking risk would require getting into a large enough position that you cannot get out of if your wrong immediatly. So I'm interested to hear your idea as to what type of trader I am. I dont sound like either. All my decisions are instinctual based on time in sales and overall market conditions. I might guess a tape reader.

Brett Steenbarger, Ph.D. said...

Hi Dave,

That's a perceptive observation. My first book indeed dealt with changing problem patterns and my second one focuses on the development of trading competence and expertise. Both are important facets of trading psychology, IMO. I'll be posting more on the topic in the very near future. Thanks for your interest and support!


Brett Steenbarger, Ph.D. said...

Excellent point, Nusair. Trading in an overagressive style and subjecting oneself to large P/L swings is indeed a prescription for emotional disaster. I have worked with many traders traumatized by precisely that scenario.

That having been said, I do find that it is common for traders (with an edge) to be risk averse to the point where they are not taking advantage of prudent opportunity. This is not discipline. Rather, it's a refusal to leave a comfort zone. The cost is that, when that trading edge is no longer present, the (attenuated) gains are not sufficient to carry the trader through the leaner times.

Separating aggressive risk taking from outright recklessness, however, is all-important. And, if a trader is simply not psychologically wired to assume large risk, it is folly to try to reshape his or her personality.

Good points, and thanks for the comment--


Brett Steenbarger, Ph.D. said...

Well, Jace; I'd have to disagree on one point: Anyone who is successful trading close to the market for eight years--across very different market conditions during that time--does have a demonstrable edge! It's just not necessarily a quantified one.

I have worked with order flow traders who function more as market makers than as position traders who will hold positions that go against them at times. You're right; such traders are not visual traders in the TA sense, but they are definitely grounded in visual pattern recognition and discretionary trading based on that recognition. Many times, it's the pattern recognition of order flow in a DOM; tracking of volume at price; etc.

There are many successful individuals--from fighter pilots to baseball hitters--who have the ability to recognize rapidly shifting patterns in real time and make quick adjustments. That takes considerable talent that I'm not sure can be taught to anyone. Having worked with individuals possessing such talent, however, I know that it is a genuine source of edge.

Thanks for your note and congratulations on your success--