Handling Volatile Markets: Lessons From Neuroeconomics

In my recent post, I proposed biofeedback as a best practice in trading. This is because biofeedback can aid the development of emotional regulation, crucial to the maintenance of attention, concentration, problem solving, and access to implicit learning.

A more basic issue, however, is why we need such regulation in the first place. Isn't decision making simply a process of weighing pros and cons and arriving at best alternatives?

A great deal of research suggests that there is far more to decision making than the rational actor model would suggest. The field of neuroeconomics is illuminating the complex brain mechanisms that underlie choice and action under conditions of risk, reward, and uncertainty. A recent article in The New Yorker provides a readable account of much of this research. A more technical, but highly informative, review can be found in this article.

The gist of neuroeconomics research is that multiple brain systems are responsible for our processing of information and making of decisions. Utilizing animal, as well as human, subjects, researchers have found neural bases for risk preferences. One interesting finding is that the salience of rewards affects propensity for risk-taking. This certainly would seem to be adaptive in the animal world, but could easily lead to imprudent investor behavior in volatile markets that appear on the surface to offer heightened movement (and hence reward).

Conversely, volatile markets may make potential losses more salient for traders, leading to negative expectations in the face of ambiguity. In either scenario, however, the heightened movement of markets leads to an exaggeration of potential gains and losses, biasing perception and decision-making.

To make the issue concrete, consider the high-low trading ranges for the S&P 500 Index over the past four trading sessions compared to the four prior sessions. The most recent average range in SPY during the day session has been 3.15 points, or the equivalent of about 31 ES points. The average range for the four previous days was 1.05 points, or about 10 ES points. For all intents and purposes, then, it is as if--suddenly and without warning--traders and investors have found themselves with three times their normal positions. That, of course, means three times the risk and reward.

How can traders cope with this new market environment? In his book The Only Three Questions That Count, Ken Fisher suggests that traders and investors entertain a straightforward question: "What is my brain doing to blindside me now?" Notice that the mere asking of the question helps the trader stand apart from biases and look at decision-making more objectively. Your investment and trading decisions, Fisher emphasizes, must be made on the basis of your knowing something others don't: you neither want volatility to excite you to the point of trading without an edge; nor do you want risk aversion to blind you to advantages that might actually be present.

I recall a trader who, frustrated with the market's low volatility, became quite excited when an economic report came in out of line and led to sharp market swings. He traded twice as frequently as usual with his normal size and quickly lost his maximum for the day. When I asked why he had traded so aggressively, he replied that it was because there was so much "opportunity". Clearly, his excitement led him to define opportunity as movement, not as an objective edge in the marketplace. I've known many other traders who, confronted with a pick up in market movement, stare at the screen, frozen in the headlights, because the market is "too risky". That trader also sees heightened movement as enhanced opportunity: opportunity for loss!

A very simple strategy I've used with beginning traders is to cut position size when volatility ramps up. That keeps expectable P/L per trade constant, which in turn helps traders keep their perception level. The idea is to trade with the largest size that will not trigger the flight-or-fight responses that evolution has hard-wired for us. With experience and rehearsal (mental rehearsal as well as simulated trading), that size can gradually expand. By keeping in mind that our brains are apt to blindside us during times of heightened risk and reward, we can step back (literally and in size) and ground ourselves in what we know that others might be missing.

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