Friday, December 26, 2008

Implicit Learning: The Key to Trading Performance

My recent post emphasized the role of planning in successful trading. While trade planning is as important for the trader as game planning is for the quarterback, the reality is that a trader's performance, like that of the quarterback, is a joint function of gut feel and careful forethought. The quarterback may call for a pass play, with the flanker slanting up the middle of the field as a primary receiver, but under pressure from linebackers may opt to dump the ball to a running back or scramble out of the pocket and look for secondary receivers. Similarly, the trader may plan a trade to break below the previous day's low, but noticing very weak holiday volume, might take profits before the target is hit when the NYSE TICK cannot make decisive lows on a down move.

One of the formative experiences of my career as a psychologist was observing high frequency traders in Chicago (those making 50-100 or more trades per day on a discretionary basis) make money consistently, day after day, week after week, and year after year. When I looked at how much they were giving up in commissions each day and yet still could make money, I realized that their skills were greater than any market efficiencies.

Perhaps most interesting to me was that these traders typically could not verbalize to me how they were making their decisions. Yes, they could point to shifts in order flow, volume, etc.,--and, yes, their trading size and ideas about limiting losses and taking profits had a strong element of preplanning--but most of their decisions were like the audibles of the quarterback. It was clear to me that they knew a great deal about markets, but did not seem to know what they knew.

This realization led me to research the field of implicit learning when writing my book on trading performance. It also led to this key post on the objective basis for subjective knowledge. It appears that, particularly in the realm of pattern recognition, we process the world far better in an implicit, subconscious mode than explicitly. As a driver, I respond to the sudden shift of the car in the next lane almost immediately, before I consciously identify what that car is doing. This makes evolutionary sense: if we needed to rationally, consciously evaluate each threat before responding, we would not survive long as hunters, fighter pilots, or race car drivers.

An excellent recent research article passed along by an alert reader (many thanks!) points out that the human brain is hard-wired to make sound decisions in an implicit mode. For example, research subjects watching a computer screen in which most dots move randomly, but some move with a programmed path, can eventually make accurate predictions about the direction of the programmed dots far beyond chance levels. The mathematical calculations needed to make these predictions are beyond the skill level of many participants. Rather, their brains capture the probability distributions in the data and these present themselves to subjects as a "feel" for what will happen next to the dots.

The reason psychology is crucial to developing and experienced traders is that access to this felt, implicit knowledge is easily disrupted by such factors as fatigue, worry, frustration, and performance pressure. Indeed, one of the most common mistakes traders make is that they address performance problems by thinking harder. Like the insomniac who stays awake longer and longer thinking about trying to get to sleep, the trader who analyzes and worries about performance loses that "zone" in which probability distributions present themselves implicitly.

Experienced, successful traders know more than they know they know. Their performance crucially hinges on their ability to sustain a mindset in which they can access their implicit knowledge. Maintaining that "zone" will be the topic of the second post in this series.


Vic Cebollero said...

I submit that there's a combination of things that help make the difference between the successful and unsuccessful trader. However FEAR is the biggest factor as the basis for any trade, and is the fundamental basis of action in both the macrocosm and microcosm.

This is a very broad subject but it affects everything we do.

Success can be measured not only in how much we gain, but also in little we lose. Limit the downside and the upside will take care of itself. Multiplied by many transactions eventually will yield some unlimited upside trades with very limited downside trades, the odds will shift in favor the trader.

Other factors are important as well but ultimately the proper mind set will be created on ones attitude towards fear.

Don said...

The moving dots test sounds alot like part of the multi-layered testing and interview process used in air-traffic-controller recruitment:
watching dots move across the screen, a sudden blank-out, then tasked to place the current dot position after an unexpected time interval;
given a set of rules (eg. sircraft velocity, wind speed, altitude, angle of approach etc), to sort different scenarios and to sequence aircraft landing accurately;
and others.

I learnt later that ATC testing were carried out to measure important skills like time pressure reactions, attention diversion, time monitoring & estimation, pattern recognition, coordination/prioritisation abilities.

While I eventually did not take up the ATC job (confession: I applied in a lark, having always been intrigued after watching the amazing Billy Bob and John Cusack in Pushing Tin), it was a revelation in a later interview for a trading position. The similarities in the skill- and mind-sets required as an ATC or as a trader was personally insightful.

While I may have missed out on pushing tonnes of tin across the skies as an air-traffic jockey, I'm still watching colourful blips and lines on multiple screens.
And the biggest upside is that the worst that can happen is I lose money for my firm and/or for myself. Almost no lives are on the line when I do make trading mistakes.

And well, the money is better.

adan said...

i think i'm beginning to grasp the idea and actuality of the "implicit learning" thesis

enjoying both the articles and responses


Brett Steenbarger, Ph.D. said...

Hi Don,

Great comparison; I think there's much in common between ATC work and scalping electronic markets--


Don said...

Hi Brett,

Indeed, appropriate metaphors and analogies can let us learn better and sometimes even allow understanding to coalesce where it might otherwise be difficult to apprehend.

Imaginative students of the markets have reached for parallels to subjects as varied as complex adaptive systems, tiny quantum-mechanical leaps, and even learnt to play Gallwey's inner game of tennis. More prescient practitioners of the market craft study the predestination paradoxes of St. Augustine, the Way of the Tao Te Ching, or even attempt to wield the diamond-cutter in the Vajra sutra.

All said, a cautionary note needs to be sounded in taking market and trading analogies too far: while maintaining a "lattice-work of mental models" is well and good, we have to be careful we do not end up curve-fitting mental models the way short-sighted traders curve-fit historical data.
And here your evidence-based cognitive psychological lessons go a long way towards establishing appropriate trading and market research methodologies. Dedicated and prudent students of trading can do no better than to use the rich material on this site to launch and facilitate their study of the markets, their trading selves and to build that important edge crucial in trading.

Btw, have enjoyed your work through your books and this site for some time, here's a hearty thanks for all the good stuff.
Have a good new year's eve.

Thanks again.