Monday, July 16, 2007

Do Traders Prefer Winning Trades or Making Money?

It seems like a strange question to ask: Would traders rather make winning trades, or would they rather make money in the market?

As the Dr. Mezmer blog nicely outlines, people tend to prefer the positive: they preselect samples so that they can make positive predictions about the future and they gravitate toward positive short-term outcomes when given the chance.

Consider the situation in which people face two situations:

1) A majority of their bets win money, but occasional large losing bets cause them to lose money overall;

2) A majority of their bets lose money, but occasional large gains cause them to make money overall.

As the good Dr. Mezmer notes, nearly half of participants in such an experiment choose the first option--even when they know the negative expected returns. When they don't know the odds in advance, a larger proportion of subjects select the first condition. That is, they prefer winning in the short run to making money over the long haul. (See this study for a fascinating discussion of the preference for short-term wins over longer-term success in a card game).

Is it any surprise that traders have difficulty letting profits run and containing losses? The desire for frequent wins causes traders to take profits quickly; the aversion to losing leads to holding losers in hopes of converting them to winners.

The culprit, perhaps, is our preference for good moods. Frequent wins make us feel good momentarily, even though they might not be in our best interest in the long run. (A trend following style of trading--and the difficulties sticking with such a style--is a good case in point). An interesting post from Dr. Richard Peterson supports the Wall St. adage "sell in May and go away" and suggests that seasonal shifts in moods might be responsible for the pattern. Indeed, he cites research that finds greater evidence of seasonal patterns in higher latitude markets (such as Scandinavia)--and that finds opposite patterns in southern hemisphere markets (where seasons are reversed).

Does it make sense that returns could actually be superior when people are risk-averse and in bad moods (as the "sell in May" pattern would suggest)? Peterson quantified negative and positive words in the transcripts for the Nightly Business Report and found a significant correlation between the number of negative words in the show and stock market returns over the following week. Returns were best when the news was most negative.

It is only natural to gravitate toward the positive and shun the negative. Traders do not simply trade to make money; they inevitably trade to maximize their positive moods. This is why sentiment measures--from the options premiums (VIX) to put-call ratios to the predilection to transact at the market bid vs. offer (NYSE TICK)--can be powerful tools for understanding market behavior.


What Drives Investor Sentiment?

A Different Way to Measure Market Sentiment