Saturday, March 12, 2016

Trading With Your Brain--And Your Gut

It's been said that many traders who claim to trade based on intuition are actually more into wishin'.  The gut can be used as a great excuse for not using the brain.  The reality is that the gut and brain can act in harmony, and it is the trading plan that accomplishes this synthesis.

A good example can be found in the current stock market.  If you've been following my trading notes, you know that I've been highlighting the vigor of the recent market.  Following February's lows, which saw considerably fewer stocks making new lows relative to the January bottom, the launch has been strong.  Indeed, as of Friday's close, we had over 90% of SPX stocks close above their 3, 5, 10, and 20-day moving averages and almost as many above their 50-day averages.  Only a handful of days in the past ten years have displayed such broad strength.  

So during this vigorous rise, my plan has been to be a buyer of weakness.  That's the brain, the head, the analysis:  I've looked at past market cycles and the behavior of momentum early in the bull phase of those cycles and know that strength has tended to beget further strength.  The plan provides my strategy.

But when will this weakness materialize?  I have no f*cking clue.  But I'll know it when I see it--that's the role of the gut.

In yesterday's trade, we had already traded considerably higher in overnight hours, so I wanted to be a buyer of intraday weakness.  When early selling could not take us to meaningfully negative readings on the uptick/downtick measures I follow and could not keep us beneath the session's opening price, I became a buyer.  I acted on my strategy with tactics--the gut provided those tactics, identifying that we were getting sellers and sellers could not move the market.

Differentiating strategy from tactics helps a trader figure out his or her mistakes.  If you've been a bear during the recent market period and losing as a result, your problem has been one of strategy.  Whatever has led you to your directional stance has been wrong.  It's a problem of the brain, a flaw of analysis.

On the other hand, if you've had market direction correct but implemented your trades unsuccessfully, that's a problem of tactics.  Your gut is failing you.  That happened to me this past week when I bought weakness following the breakdown of trade on Thursday (the reversal of the ECB impact) and bought too early.  The market continued meaningfully lower and I stopped out with a loss.  In my review, I saw clearly that I had identified when there was weakness, but did not wait for that weakness to dry up.  I was too eager to buy and never waited for that gut sense that sellers could no longer push the market lower.

That failure of the gut often occurs when we become so focused on the plan that we stop listening to our experience.  It's equally problematic when we trade our feel and fail to plan.  We might pick up a short-term pattern, only to be run over by what is occurring in the larger picture.  I've found it helpful to do all my planning before the market open and then stay open to experience during the trading session.  Failure comes from lack of preparation before the open (not feeding the brain) and staying too plan focused during the trading day (overriding the gut).

One of the great challenges of discretionary trading is that we have two information processing systems operating at all times: one intellectual, one intuitive.  Trading with half a brain is the surest way to trade half-assed.

Further Reading:  Paying the Tuition for Your Intuition