Saturday, April 05, 2008

Cross-Talk: Why Trading Is So Difficult

Trader's Narrative recently posted an excellent piece on "Why Is Trading So Difficult?" The gist of the post is that, while trading is simple on the surface--it amounts to either buying or selling--it is psychologically difficult, because it requires the ability to meld patience and the tolerance of boredom with the ability to act swiftly and decisively during periods of "adrenaline induced action". I hereby dub this the "fireman's view of trading", as it portrays the trader like the firefighter in the station, sitting around for long periods of time playing cards and washing the trucks, and then suddenly responding to five-alarm events.

There is truth in this portrayal, of course. Trading does require the ability to restrain oneself from acting, just as it requires action in the face of risk and reward. Babak's point that traders need to be both serene and patient as well as decisive--able to analyze as well as act--is well taken. It is possible to be both overly analytical and indecisive or overly impulsive and out of control.

Yet, there are myths embedded in the "trading is simple, but psychologically difficult" formulation.

The idea that trading is easy--that it consists of either buying up markets, selling down ones, or playing for countertrend bounces--is a bit like saying that surgery amounts to either reshaping things, pulling them out, or replacing them. Any skill can be simplified via surface description, and it is precisely such surface description (and the ease of opening an account and trading, as Babak notes) that lures the unwary and unprepared into trading.

Of course, the entire idea that trading is about profiting from directional movement is a gross simplification shared by many traders. Take the example of an energy trader who notices that markets are deviating from historical norms and puts on a complex position of futures and swaps to capture a reversion to those norms. Such a "relative value" trade is anything but simple, as it requires accurate modeling of current markets vis a vis those historical norms. Much stock trading, in fact, is not directional, but rather an attempt to capture abnormal deviations between pairs of stocks or between markets.

It is the very simplification that trading is all about catching directional moves that helps make trading so difficult. The directional trader enters a very crowded space in which market inefficiencies are ruthlessly arbed away. It's when the trader examines more complex relationships--let's say the relationship between fixed income and currency movements and valuations among housing futures--that unexploited patterns are more likely to appear. Perhaps New York real estate will perform better than, say, Chicago properties if reduced interest rates and a falling dollar bring more overseas buying.

This idea that opportunity is to be found among more complex market relationships also changes the trading game psychologically. It is relatively difficult to find a hedge fund portfolio manager who would subscribe to the fireman's view of trading. The reason for this is that the time spent between placing trades is anything but boring. This is the time when you figure out those market relationships, developing/updating your models, assessing deviations from those, and constructing proper hedges following relative value movements. In fact, the actual act of trading is so diminished in importance at many institutions that portfolio managers don't even place trades. Rather, they call in the orders to execution desks, so that they are freed to continue their "real" work: figuring out market themes.

What makes trading difficult is the fact that, for many traders, the time between trades is dead time. Such inactivity--mentally--is what creates the boredom. Locked into a simplistic view of trading, traders perceive nothing to do when markets are providing setups for trades. They don't see their job as figuring out markets--in fact, the entire concept of "figuring out" may be discarded as overanalysis. Instead, they wait for trades like firemen wait for alarms to sound. But where the fireman engages in decisive physical action in the face of adrenaline pumping, the trader has no such outlets. Adrenaline pumping itself becomes a factor that interferes with sound decision-making and trading performance.

So what makes trading difficult is a fundamental misunderstanding of trading. Once a trader views placing trades as a simple matter of anticipating direction and the goal of trading as placing trades, he or she is locked into a perspective in which the goal is action and the challenge is the boredom of inaction. This brings trading perilously close to gambling. It is also not how the best bank traders and portfolio managers operate. Their more elaborated views of markets and trades means that the time between trades is when the real work is done; such time is intrinsically interesting and rewarding.

Consider an analogy: relationships would be difficult if we viewed sexual relations as the overarching goal and purpose. Everything else--the time between escapades in bed, from conversing to sharing experiences--would be boring and difficult to tolerate. To someone who viewed relationships in terms of intimacy, however, those times outside the bedroom would be the heart and soul of encountering the other person--what makes the physical relations *meaningful*.

Trading is not difficult because it blends action and inaction. It is difficult when we view trading through the lenses of firemen, creating both adrenaline spikes and boring interludes.


Three Market Idiots