Wednesday, December 30, 2009

Mental Flexibility vs. Sticking to Trading Plans: Which is Correct?

Reader George raises excellent questions concerning my recent post on mental flexibility and trade planning. Citing Henry Carstens' ideas in the article "The Axiom of the Small Edge", George asks how one resolves the seeming discrepancy behind the notion of sticking to trade plans that have an edge and staying mentally flexible and adjusting plans as needed. Isn't being mentally flexible, he asks, just a nice way of describing getting scared out of a trade?

(By the way, do check out the huge collection of worthwhile articles on Henry's site. There's a lot of good and thoughtful reading there.)

I would argue that Henry is correct and that my post on mental flexibility is also correct. That is a key difference between mechanical systems trading and discretionary trading.

When one has a properly backtested system for trading, meddling with the parameters is usually going to degrade performance. The system is designed to exploit a relatively small edge over a large number of trades. Failing to take signals, taking extra signals, and sizing trades differently than in test conditions all invite a reduction in that small edge, as they introduce untested elements into the system.

A discretionary trader, on the other hand, is relying upon pattern recognition skills, research, and a feel for markets to make buying and selling decisions in real time. The performance of a discretionary trader is no different than that of a trading system: both can be analyzed for profitability, risk, and other performance parameters. If a discretionary trader maintains positive risk-adjusted returns across a range of market conditions over time, that trader has a demonstrated edge.

Getting scared out of a trade implies that a trader is reacting to emotional factors and not to objective characteristics of the real-time market. To be sure, that can be a major hindrance to performance. When one gets scared out of a trade idea, that emotional reactivity is substituting for informed discretion, eroding the discretionary trader's edge just as changing parameters can degrade the performance of a system.

There are times, however, where a discretionary trader will start with a plan or framework for a trade and then adjust the plan, not based on emotional upheaval, but upon the unfolding action of the markets themselves. This is part of a skilled discretionary trader's edge.

We see similar dynamics in other discretionary performance fields. A poker player may begin with a plan based upon the draw of cards, but will adjust betting and strategy with each new card drawn. A football quarterback will come to the line of scrimmage after calling a play in the huddle, but may call an audible to adjust the play based on the real-time read of the defense. A boxer will have a fight strategy, but will adjust that strategy round by round based upon the strengths and vulnerabilities of the opponent.

George touches on a very important point: it is all too easy for a trader to rationalize an emotional, reactive trade as an informed discretionary decision. The key difference is in the reasoning behind the decision. Let's take an example:

This morning I bought the S&P 500 Index early in the day when I saw that there wasn't enough selling interest to take out the overnight low. My plan was to hold the trade for as long as needed to test the bull highs, making this a swing trade idea. The Chicago PMI numbers came out and stocks popped nicely higher...and then sat there. I waited and saw a lack of follow-through buying interest, so I took my profit and told myself I'd get back into the trade at a better price. That did happen later in the day on a market pullback.

Had my swing trade idea come from a backtested system, Henry (and George) would be correct in chiding me for meddling with the system. In this case, however, the discretionary decision to take a quick profit and re-enter the longer-term trade at a better price added value to the original plan. Could I have been wrong and missed my move? Quite possibly. Over the years, however, I've found that my ability to read short-term shifts in sentiment, momentum, and strength generally serve me well. That's quite different from getting scared out of an idea, and it's quite different from meddling with a proven formula.

At least in my case, I can state without reservation that my greatest losses have come when I have lacked mental flexibility, not when I've modified existing trading plans based upon a reading of supply and demand. To be fair, however, I also have to say that my greatest growth as a trader has come from sticking with trade ideas after opportunistically trading around them (as in today's trading). It's easier to see losses in an account statement than lost opportunities: being mentally flexible is no advantage if it ultimately takes you out of sound longer-timeframe ideas.



kleenup2 said...

Dr. Brett I know you have written thousands of these daily articles but I will say that this has got to be both the best and most useful for new traders to learn. The human mind is the greatest computer in the world and does a much better job of adjusting and evolving with real time market movements than any quant fund ever could.

George said...

I agree with everything you said, but the key point you made is that you are a discretionary trader who has repeatedly proven his skills over time and under fire.

Me. I'm a numbers guy. I like math. I like spreadsheets. I like to keep track of things. I like to analyze stuff. Because of that, I tend to lean more towards a mechanical, rules-based approach to, well, just about everything.

And I'm much more comfortable when I'm in a black-and-white zone than I am when I'm in a gray zone, especially when under pressure. That is why I'm attracted to using win:loss ratios and risk:reward ratios to create a positive edge, and then using the risk:reward ratio and technical analysis of the chart to determine the exit parameters for the trade.

Truthfully, I don't feel I have the skills to be a discretionary trader -- at least not to the point where I change the exit parameters of a trade while I'm under fire. That said, I do believe that a trader can use discretionary skills to determine when to enter a trade and then switch to a mechanical, rules-based system to determine when to exit the trade. As long as the edge holds up, you're golden. That's where the spreadsheets come in. ;-)

Thanks for taking the time to respond to my comment. And thanks for sharing your trading insights with all of us.

Curtis said...

Humans make use of dynamically changing information whilst most systems/studies take advantage of static probabilities.

Exactly, your hole cards have a base probability but when the flop comes down then those probabilities can change dramatically.

The future is not the past!

I think the synthesis is a very key element. It is not the axiom of small edge that defines winner but the ability to press when the odds are in favor within a defined LIMIT.

A key point to flexibility is ALWAYS flexibility combined with restraint. Restraint is needed even with perfect prediction because execution and transaction costs are not zero. A perfect trader who exercised NO RESTRAINT would lose all money.

One way to combine always flexibility with restraint is to create rules or give restraints but then rules are made to be broken.

This really relates to your other post Brett about "the time frame of a trade".

I think, what this goes back too is being opportunistic to take profits but also to hold on for longer gains.

It is not ALWAYS better to listen to the system unless the system takes advantage of ALL information available to a discretionary trader.

You're right about getting scared of a trade though. What getting scared out of a trade means is the market is saying you are wrong for the NOW for the risk you want to take.

This is what gets us into trouble. The optimal pathway is always changing and different.

If I buy INTC on a pullback and it doesn't bounce then I know the traders will target previous swing lows. If I trade like a system then I know my stop must be below those lows but what if I don't want to hold until those lows?

Then the correct play is to exit and re-enter at the lows.

The pathway is always changing!

Imagine, I predict the market will drop and take out a previous LOW. It does drop to my first target.

Now, I have a decision: I know that because Target 1 is hit then price will rebound to my entry. I can either hold to Target 2 or take my profits and re-enter at Target 1 again.

But at Entry 1 then I may decide that the risk is too great to re-short. Thus, I may look to buy at Target 2.

The key is to restrain to execution abilities. The better the execution the less restraint required.

OKL said...

i'll add another example w/a recent court case that i had.

one of the defendants' ground of appeal against the judgment was that the judge was biased, as the verdict was delivered in less than 2 hours. the defendant argued that it was impossible for the judge to deliver a fair verdict after a mere 2 hours of deliberation.

at the appeals hearing, the high court judge said that it is reasonable for the previous judge to come into the case with a pre-conceived notion of which law/s the current case falls under, then proceeds to amend his view of the case as the trial proceeds and as fresh evidence comes into view.

the high court judge further asked the question "does that constitute bias? you could argue so, but i do not see any grounds/evidence for such case. can a doctor be considered to have malpracticed if he/she approaches his patient's case with a pre-conceived idea of what his/her ailments are before meeting with his/her patient in person?"

i dont want to go too far into the case lol, because there are many other factors.

the point is had the judge "stuck to his trading plan", a fair verdict, according to the judicial process, could not have been delivered.

similar to trading, we approach the markets with an idea of what has happened and what is likely to happen; if fresh evidence comes in that points out otherwise, the trading plan changes accordingly to fit the market action.

different from legal processes is that trading has no hard&fast rule of which evidence constitutes what; its all from personal experiences, what is relevant to the trade and under what context is the evidence being viewed under.

Curtis said...

This whole topic goes back to strategy vs tactics. For example, it can rephrased to say that Steenbarger strategy was to be long in anticipation of a retest of the previous high. But, the tactics dictated that he sold and then waited to re-buy. I'm not much of a chess player but in chess terms: he gave up a pawn to protect something more valuable, say a bishop "capital".

I imagine in one way, having a trading system, and it giving me an indication -- the market is likely to decline or rise AND then my acting on it. Or sense I am very good at direction then perhaps the opposite: I give it direction and then it executes.

I postulate also the BIG EDGE. The big edge says I will use market orders because I know the direction. I will not watch the intraday market because my edge is big. This is how I've always felt when doing well but then perhaps a synthesis is required to get to top level. Fighting for every point but also keeping the big edge idea in mind.

Sami said...

Hi Dr. Steenbarger,
Firstly, I greatly appreciate your work and the great educational info you make available to all of us free of charge. I think you touch upon a good point in this article, but I respectfully disagree with your conclusion. Here is why:

1. There are a million ways to make money in the market, and I can never tell anyone that they have to do it this or that way. But, from my experience, and I think from the experience of a lot of traders, including Mark Douglas, the intuitive stage comes at the end, not at the beginning. I think the most important thing to realize about Dr. Steenbarger's article is that he probably wasn't able to trade from an intuitive state, or based on his feel for the markets, when he first started trading. He probably got there only after years of trading, AND after developing a proven track record that what he does works. I do think that it would be disastrous for a beginner to start out trading from an intuitive state. Typically, that means trading randomly, and not being responsible & disciplined enough to follow your trading plan.
2. I think a thorough and detailed trading plan will address almost anything that can happen in the market. If almost everything can be addressed in a trading plan, I don't see why intuitive trading should mean not following a rigid set of rules regardless of what the market does.
3. It is said that you first have to learn the rules before you can break them. In trading, you can only break the rules (i.e., take action based on your feel for the markets) once you have a proven track record that you are better off doing so than strictly following your plan. Again, this only comes after much experience in the markets.

Those were my 2 cents.