Saturday, May 23, 2015

Trading, Backwards

A shoutout to Bruss Bowman for pointing out this truly insightful video on backward bicycle riding.  Engineers made a simple change to a bicycle, such that turning the handle bars made the bike move opposite the expected direction.  Sure enough, that made the bike impossible to ride.  The video demonstrates this with humor and insight.  It turns out that it doesn't take much to disrupt the algorithms in our brains!

A somewhat similar experiment was conducted in the 1950's by Ivan Kohler, who had subjects wear prism glasses that distorted their vision.  Since that time, prism adaptation has become a well-studied phenomenon.  There is typically a period of disorientation, in which subjects wearing prism glasses cannot execute simple hand-eye coordination tasks.  Then, gradually, they adapt to the changed world and can function with the glasses.  When the glasses are removed, however, they return to a short period of disrupted functioning.  

Fascinatingly, people who wear the glasses but do not interact with the world during that period do not adapt to the new perceptual world.  It takes repeated experience to learn from errors and recalibrate one's perception.

Think about ever-changing financial markets.  Markets change in their patterns of volatility, sometimes moving a great deal, sometimes quite little.  Market shift in their patterns of correlation, sometimes moving in concert with other markets and other times moving more idiosyncratically.  Markets change their directional behavior, sometimes reversing moves within ranges, sometimes extending ranges within trends.

It is as if the market's handlebars continually change; as if traders constantly put on new glasses with different prisms.

If that is the case, then we would expect disorientation to be a natural part of the adaptation process.  We would also expect losses to be a natural part of adaptation.  Traders *can* adapt to changing markets, but only after a period of interaction with those markets.  

Anticipating those periods of disorientation is helpful to trading psychology:  one need not take them as threats if they are part of adapting to changing conditions.

Anticipating periods of disorientation is also helpful to risk management.  If we know that markets will change, we can keep bet sizes small enough to weather those periods when markets trade with backward handlebars. 

Not long after we seem to master markets, we become students again:  expertise over time is a function, not just of learning, but the capacity to relearn.

Further Reading:  Adapting by Becoming a Better Thinker