Discussions about psychology among traders tend to focus on the emotional challenges of making sound decisions in the face of risk and uncertainty. Less appreciated are the cognitive challenges of trading. Thanks in large part to the online medium, today's trader is not at all like the tape reader of yesteryear, hunched over a ticker tape spitting out transactions. Today we have multiple screens that display multiple charts, multiple indicators gracing each chart, and an endless barrage of news reports, tweets, and chats. Early traders lacked timely data and therefore operated with very incomplete information. Today's traders are overwhelmed by data, with few ways of distinguishing which of the data constitute relevant information. To use Kahneman's terms, we spend so much time thinking fast--keeping up with the data barrage--that we rarely think slowly, deeply, uniquely, creatively. This leaves us data rich, but information poor. It's not surprising that a knowledgeable observer of the financial media such as Tadas Viskanta of Abnormal Returns counsels in his book that market participants should go on "a media diet." In a world swimming in data, the challenge is focusing on the right information, filtering out the rest. I strongly suspect that Abnormal Returns is popular precisely because Tadas serves as an effective filter for readers. Just as we rely on curators to decide what to include in museums and what to exclude, we rely on the curation of expert websites to help us channel our limited resources of time and attention. In some cases, the filtering expertise of websites draws upon the wisdom of crowds: Trip Advisor for restaurant and hotel suggestions; Rotten Tomatoes for movie reviews; and Beer Advocate for ratings of craft brews. While the crowd may deliver wisdom about such matters as best IPAs and imperial stouts, it's less clear that it possesses a distinctive edge in areas of specialized expertise, such as medical diagnoses or portfolio construction. For those needs, filtering expertise relies upon the wisdom of individual expert curators. (A site like Stock Twits is unique in that it captures both the expertise/folly of crowds via social sentiment analyses and the insights of experts who develop reputations within the community. In a future post, I will explore the curation of tweets--a particular challenge given the sheer volume of content generated daily.) The value of information filters is that they minimize distractions and interruptions from sources with low signal-to-noise ratios. Research suggests that such distractions and interruptions actually make us dumber: we're less able to perform basic tasks with divided attention. Just as having a cluttered physical environment can interfere with concentration and information processing, the ability to avoid distraction can help us process information more intelligently. Might it be the case that traders make poor and impulsive decisions, not because of intrinsic emotional conflicts or lack of discipline, but because their unfiltered cognitive environments leave them less able to identify and act upon valid information? This is a neglected area of inquiry and one I will be tackling in a future post. Further Reading: Finding Your Optimal Environment
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While posting to the blog the other day, I noticed that TraderFeed is closing in on 4000 posts. It struck me that 4000 is a large number. If I wrote a blog post daily for 10 years, I still wouldn't accumulate 4000 posts. Now someone observing that amount of writing might marvel at the level of motivation, passion, and discipline it takes to maintain such a blog. In point of fact, however, motivation, passion, and discipline have little to do with the writing productivity. And therein lies an important, but underappreciated reality for trading psychology. The recent posts on turning success into a habit and the importance of small wins suggest that the right habits are crucial in cultivating a positive sense of self. Many small wins, strung together, become winning habits. When we have winning habits, we don't need to rely on discipline or passion or motivation to do the right things. I take a shower every morning without fail. No one lauds my motivation or my passion for cleanliness. The truth is that taking a shower in the morning has become an automatic act...the day wouldn't feel right if not begun with a shower.
That makes sense from an evolutionary vantage point. Habits enable us to do what we want/need to do in more or less auto-pilot mode, while saving limited attention and willpower resources for novel tasks and demands. Because of that, we can engage in relatively complex tasks--driving in NYC traffic, for example--while carrying on a conversation with a passenger and watching for the next freeway exit. A look at my recent blog posts reveals the times at which they were written (Central, US). Going from most recent to older posts this month the times have been: 1:41 AM; 4:24 AM; 3:53 AM; 4:01 AM; 3:05 AM; 3:25 AM; 2:07 AM; 5:14 AM; 4:38 AM; and 6:40 AM. You get the idea. I start my day with writing, just as I start my day feeding my cats and taking a shower. It's not the result of coaching, counseling, journaling, discipline, motivation, or any of those other staples of trading psychology. It's the result of cultivating positive habits.
We can create habits for productivity, habits for happiness--habits for most any positive outcome we care to generate, according to recent research. Charles Duhigg, who wrote the excellent book The Power of Habit, suggests that there is a "golden rule" of habit change: retain the cues that trigger a habit and the rewards that sustain the habit and find fresh, constructive routines to link these. I used to write journal articles and books while at home, but I found that when I needed to take breaks, I inevitably drifted mindlessly to the refrigerator. I got my writing done--and I put on the pounds to prove it! That's when I hit on the idea of doing my writing at coffee shops and grocery stores. My breaks consisted of coffee and whatever small snack I purchased--no more grazing at the fridge.
When I first began attending open AA meetings as a community psychologist in Upstate New York, I joked with a colleague that the members had retained their drinking habit: they had simply replaced alcohol with coffee. Little did I appreciate that habit truly is the backbone of 12-step programs. Does AA seek to cure alcoholism with willpower, motivation, or planning? Not at all! Indeed, one of the prime tenets of AA is the member's declaration that they are powerless against alcohol. It's not about willpower.
So how to AA members overcome their destructive habit? They start with 90 meetings in 90 days. "Bring the body and the mind will follow," is a popular slogan. By the time 90 days are over, the coffee urn has replaced the barstool and AA buddies have replaced the drinking ones. One member put it very well:
"What I’ve learned is that taking action is almost always the gateway into feeling better.
Rarely have I been able to think my way into different behavior or
results, instead it’s only when I take action (especially when I don’t
want to) that things begin to shift, and I begin feeling better.The program, like life, doesn’t work when I’m into thinking, only when I’m into action." It isn't that we think ourselves into new action patterns. Rather, new ways of acting create new ways of experiencing ourselves, which cultivate new--and potentially constructive--habits. Doing changes our viewing. Action, harnessed to routine, is a gateway. Further Reading: Turning Goals Into Habit Patterns
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Let's say an explorer discovers gold in the mountains of Alaska. The initial group of miners prospecting the territory has a pretty wide open field of opportunity. They don't need sophisticated equipment to see and extract the gold from river beds. As more prospectors move in, the low-hanging fruit is gone. Now gold must be extracted from rocks and from deeper in the ground. This requires special equipment. The single miner with his pan, combing through the river bed debris, no longer has an "edge" in discovering gold. Still later, as more of the territory is mined, extracting what remains becomes a more complex task. Deep drilling into the ground and exploration of more remote mountain areas is required to make the investment of time and effort worthwhile. Individual miners, picking through areas that have already been explored, have almost no advantage in discovering gold--even though they still recount the stories of big strikes just a few years prior. A well-mined area means that either you have to find new areas to explore or you have to find new means of exploration. In the case of natural gas and oil, fracking has been a new mode of exploration. Drilling in the Arctic would be an example of finding new areas to explore. Either way, ingenuity is required to find value once others have been searching for a while. Financial markets have been well-mined for a while. Excellent traders, portfolio managers, and system developers around the world have been attracted to the gold rush of markets. While looking for nuggets of profitability in new ways and in new places does not guarantee success, looking for them where others have been searching for years with sophisticated tools inevitably invites failure. I recently have been posting on the topics of understanding vs. predicting markets; looking at markets in new ways; and using quant processes to aid discretionary expertise. The common theme is becoming better at the exploration for profits by looking at new things and looking at old things in new ways. Above is a chart of what I call the Momentum Curve. It takes every stock in the SPX and gauges whether it is trading above its 3, 5, 10, 20, 50, 100, and 200-day moving averages. The aggregated data are charted (available through the excellent Index Indicators site), so that you can see how the percentages of stocks shift over time. Observe from the graphic that--going into Friday's session--we had been undergoing a meaningful short-term correction (most stocks moving below their 3, 5, and 10-day averages) in a strong uptrend (most stocks above their 100 and 200-day averages). It turns out that the shape of the Momentum Curve is important in forecasting future stock market returns. The return profile looks very different depending on where the kinks are in the curve, whether the curve is steep or flat, etc. I find it useful as a qualitative tool--it provides a quick visualization of where we stand across multiple time frames--and also as a source of quantitative hypotheses regarding curve shape and forward price movement. Some of the best market tools don't generate conclusions. Rather, they suggest hypotheses worth testing. The first step in finding fresh answers is asking fresh questions. Further Reading: The Psychology of Quantitative Analysis
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The chart above runs from May 6th, 2014 to yesterday morning: it's one of the things I was tracking closely at the start of Thursday's trade. Each point on the chart represents 500 price changes in the ES futures. So, in other words, every time we get 500 ticks higher or lower in the ES front month contract, we draw a new bar. So time is measured in units of market movement, not in movement of the clock. What that does is create many bars during busy, volatile market periods and fewer ones during slow, non-volatile ones. Suppose we get very little price movement during the course of 500 ticks in the index. What that tells us is that price change is occurring within a very narrow band: there is a high degree of consensus in the market at that moment regarding the location of value. If we get a great deal of price movement during the course of 500 ticks, it means that price change is occurring within a much wider band. That suggests a higher degree of uncertainty in the market regarding the location of value. The above chart measures current value uncertainty versus its longer-term moving average. When we have values above 1.0, there is relative uncertainty regarding the location of value. When we have values below 1.0, there is relative certainty. As with traditional measures of volatility, you can see the tendency for there to be greater levels of uncertainty at relative market bottoms and greater levels of uncertainty at relative market peaks. The normalization of the X-axis and the construction of the indicator around its recent moving average--creating a measure that is relative, rather than absolute--makes that relationship easier to identify. One certainly could test this measure in- and out-of-sample and use it as part of a trading system. Indeed, I have conducted such tests and have found the value uncertainty tool to be helpful. My use of it, however, is more qualitative and discretionary: I'm using it simply to identify whether the market environment is becoming more or less uncertain. So, for example, I closed out a long position late Wednesday because, although we had a bounce that day, the market uncertainty was rising, not falling. At the same time, I could see that some sectors of the market--most notably small caps--were not participating meaningfully in the bounce. Indeed, all told we had only about 500 more advancing stocks on the day than declines. Stock sentiment was bullish--the equity put/call ratio was a relatively low .76--but that bullish tide was not lifting all boats. Nor was market action suggesting greater certainty in the location of value. Notice in this example that I am using tested market measures to anchor a reasoning process. My goal is as much understanding as prediction. (Indeed, I did not predict Thursday's sharp overnight decline; I simply identified Wednesday's absence of strength). I want to understand what is happening in the market and why; not just blindly predict future movement on the basis of an algorithm linking variables that happen to fit a given lookback period. A major turning point in my trading occurred when I stopped predicating trades on predictions and instead used predictive inputs to inform a process of understanding. Trading systems and tested indicators are most useful when they reflect an underlying understanding of markets; they cannot substitute for such understanding.
In coming posts I'll be exploring the use of data and quantitative tools to aid the discretionary decision making of traders. Like anything powerful, quant methods can be used to great advantage or misused in destructive ways. The goal is not to supplant individual decision making, but to inform it. Just as aircraft pilots, physicians, and engineers rely upon data-driven methods to aid decision-making, traders can use well-constructed tools to identify valid trading opportunities. Those same tools can lead traders to become fixed in their views, however, and fall prey to confirmation biases. Tools are only useful if employed for the right tasks in the right ways. When discretionary decisions are grounded in proper research, the benefits are psychological as well as financial. It's easier to have real conviction in an idea if you've studied it, run the numbers, and seen how signals behave "out of sample" and in real time. It's like buying a car once you've conducted a compression check of the engine and taken it for a spin. Surely our trade ideas deserve as much due diligence as our automotive purchases! Selecting a car has strong intuitive components of pattern recognition: we sense what we like in a vehicle and know when it feels right. That doesn't stop us, however, from reading reviews of the car, checking its reliability, and running those road tests. The best decisions occur when head and heart are aligned.
Research suggests that the best way to achieve large gains is to make sure you experience small wins. What is a small win? Achieving a tangible step toward an important goal generates a small win. Many times we fail to attain our large goals because we don't pave the path with small successes.
Why are small victories so important? It turns out that progress in work you find to be meaningful gives energy and fuels creativity. This is tremendously relevant to goal-setting. If you fail to set goals, you deny yourself the small wins that come from reaching daily and weekly milestones. If you set goals that are too distant or ambitious, you can unwittingly set yourself up for frustration and a loss of the momentum that small wins can bring.
Small wins can be very small--as small as engaging in a positive behavior to start the day or maintaining a better posture. One reason engaging in exercise first thing in the morning is effective is that the energy of the workout also taps the energy of starting the day on a constructive, successful note.
Imagine yourself surrounded by small wins day in and day out. The mirroring effect of so many wins means that you begin to experience yourself as a winner--which in turn energizes you to further set yourself up for success.
Conversely, consider perfectionists. Because nothing ever reaches their expectations, they never achieve small wins. Indeed, they continually experience small losses--frequent episodes of falling short. What the research tells us is that you cannot internalize the sense of being a winner unless you set yourself up for frequent wins. When each day is pursued as a masterpiece, over time you experience yourself as an artist. The trading week to come may be a profitable one or it may not. If you are focused on small wins and the processes that generate profits over time, however, the coming week can always be a successful one. And that fuels the drive for truly big wins.
In the course of writing my next book, I've been reading The Power of Habit by Charles Duhigg. It's an excellent read, citing a wealth of real-life examples and cognitive neuroscience research to explain how making life changes often boils down to making habit changes. This flowchart provided by Duhigg explains the structure of habits and illustrates what must be done to change them. Habits begin with cues that lead people to anticipate rewards. Once cues are activated, the routines that bring the rewards become relatively automatic. It is the automatic nature of habits, grounded in the brain's basal ganglia, that makes them difficult to change. Only by restructuring the routines that connect cues and rewards can we channel automatic efforts in constructive ways. Interestingly, this can be done by finding small, consistent ways to disrupt an existing habit, rather than by trying to overhaul bad habits in general. For the most part, the problem is not that traders lack positive trading behaviors, but rather that they have not been able to turn those behaviors into routines. To the extent that we rely on willpower to do the right things, we are vulnerable to inevitable lapses in willpower. The beauty of habits is that they take on a life of their own, freeing the conscious mind to tackle fresh challenges. That life of their own, however, is precisely what traders lament when they find themselves reacting to cues in unintended--but habitual--ways. Once upon a time, psychologists tended to operate with the conceit that talk therapies were somehow deeper and more profound than other change modalities. Brain research suggests that precisely the opposite might be the case: talking to people about their habits is a singularly ineffective way to change those habits. If the action patterns are coded non-consciously in the basal ganglia, engaging the reasoning, conscious mind to initiate change is less likely to be successful than initiating fresh action patterns that reprogram the relevant brain region.
When traders become competent, they replace trading mistakes with best trading practices. When they become expert, they turn those best practices into positive habit patterns. Finding the right cues and rewards is half the battle in changing our trading routines.
I like this New York Times article on companies that pay employees well above prevailing normal wages in order to secure top talent and highest loyalty. It's an example of thinking outside the box. In this case, the box is that you have to minimize expenses in order to maximize profits. The out-of-box idea is that maximizing compensation and benefits secures the best workforce, provides the best service, and ultimately generates the best retention of customers. In the case of companies that provide premium compensation, values are an important driver of the business model change. One executive put it this way: "If we're talking about building a business that's successful, but our employees can't go home and pay their bills, to me that success is a farce."
Values enter the picture when the motivation driving the business is to do the right things, not just to do things right. Values drive the innovation; they are the motive force that nudge people out of the box. At several trading firms where I've worked, I've been part of the hiring process. Over the years, I've had a front row seat to who succeeds and who does not. The one conclusion that experience has taught me is that generic approaches to business cannot produce extraordinary results. If a trader describes a generic thought process in a recruitment interview; if a company's traders are generating consensus ideas from reading the same research and looking at the same information; if a company's management does not innovate in the running of the business, then why should we expect uncommon results from them? To innovate, however, you have to be willing to fall flat on your face. It was Edison, after all, who said, "I have not failed. I've just found 10,000 ways that won't work." It sure feels like failure when you're at the 5,000 mark, though, and it's likely to look like failure to others. The status quo seems far more secure; as Keynes observed, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." If your profit margins are suffering and you're paying employees premium wages, you come perilously close to looking like a well-intended idiot. It takes a deep level of commitment to values and vision to see any campaign through. Back when Big Data was not a big thing, I recall meeting a trader who hired dozens of college kids to surf online and check prices for hotels, car rentals, airfares at different times and across different locations. The kids spent hours and hours each week checking those prices and never once did they actually reserve anything. Instead, the trader assembled the data into pricing curves that expressed whether business was getting firmer or softer over time, region by region, industry by industry. The aggregated data provided a meaningful real-time window on consumer discretionary spending, which in turn had forecasting promise for the economy. You know when you are in the presence of talent, because the originality of their efforts smacks you in the face and you have the unmistakeable impression of, "Why didn't I think of that??!!" Looking at new information in new ways and assembling those data into fresh insights: that's what creates a trading edge. Those trading edges come from signature personality, social, and cognitive strengths. The trader with the college shoppers was a data junky and loved piecing data together into coherent pictures, whether or not they led to a trade. The values that drove his business were born of his strengths as an information processor: he loved learning and investigation. In a very real sense, the business was an expression of who he was as a person. When you're doing what you believe in--when you're expressing the very core of your strengths and what you love doing--you don't need discipline to work long hours or stick to your plans. You don't need to be pushed to do the right things when you're pulled by what you believe to be right. If a strong trading business is the expression of the trader's signature strengths and the innovations that embody those, there can be no question of greater importance to trading success than: "What makes me--and my trading--special?" Further Reading: Signature Strengths and Trading Success
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According to this article, a shocking proportion of people don't like being alone. It's literally a shocking proportion, because they choose to undergo electric shocks rather than the stillness of solitude. As one news report put it, people apparently prefer negative stimulation to boredom.
There are many benefits to time spent alone, including time for deep and creative thought and activity. While loneliness can be a painful emotional state, there are ample historical examples of artistic, spiritual, and intellectual genius emanating from periods of solitude. Could this be why creativity is so often linked to introversion? Solitary work fosters deep concentration, which is essential to generating unique insight. Extroverts can dazzle us with charisma and leadership, but it is difficult to differentiate oneself from the herd if one is of the herd. That is why successful invention is so often a joint function of research in solitude and implementation through collaboration. Show me someone highly successful in a field and I'll show you someone who seeks alone time to engage in work in that field. That is because being alone is not necessarily being lonely; being alone is being all-one, in one's own company. In solitude, we have nothing but our thoughts, feelings, memories, ideas, plans, values, and interests. Whether that is appealing or aversive speaks volumes about an individual: active minds are rarely bored ones. Further Reading: Life Lessons From Great Inventors
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Yes, I was there for the infamous HST presentation at Duke University. The backstory was that, after insulting his audience (he claims he hallucinated them as animated okra plants) , wrestling with his stage mike (he claims he hallucinated it as a snake), and tossing his bourbon onto the stage curtain, Mr. Thompson proceeded to meet with a smaller group of students on the university lawn and engage them in a completely sober and enlightening discussion. Not all who rave are divinely inspired, but there was at least a touch of inspiration amidst the ravings that day.
Having an "edge" as a trader: rarely has anything been so frequently discussed and so infrequently demonstrated. We can demonstrate a trader's edge through a long-term, real-time track record of trading; we can demonstrate a strategy's edge through properly constructed backtests. My preference is to trade a strategy that has displayed a historical edge and then let the track record display whether I have an edge in implementing it. Like Hunter once said, it's fine to pray, but row away from the rocks.
Sometimes you don't really know where your edge lies until you go over it. We like to think that trading what fits our personality will provide us with our edge, but that can be a socially acceptable way of justifying a failure to move outside our comfort zone. Indeed, the whole reason psychologists get involved with traders is because trading one's natural predilections tends to mean trading one's perceptual and cognitive biases, acting out one's bad habits in markets, etc.
Getting on stage and imagining your audience consists of animated okra plants is considered crazy. Sitting in front of a screen daily, trading away with no demonstrated edge, and justifying it all by "trading my personality" and "following my plan"...well, that's considered a career.
Admittedly, going over your edge and seeing what lies on the other side is crazy. It's a lack of discipline. It's not trading your plan or being in your zone or beating one's breast with manly pronouncements of conviction. And what if what lies over the edge is *not trading*? Well, perish the thought: that would show a lack of passion for trading, and we all know how necessary that is for market success (and high commissions).
I once decided to play it brutally straight and, in a first meeting with a client, calmly explained that the strategy he was trading was based on randomness and a simple backtest would prove that. That, I suggested--more than any psychological problem--was responsible for his trading woes. Needless to say, the backtest was not requested and neither was my coaching. Throwing bourbon on people's stage curtains is a great strategy for getting yourself ejected from the auditorium.
So what brought all this on?
Let's go out on the lawn and get back to basics.
The time series of any market consists of a linear component and one or more cyclical components. When the linear component is near zero, we have a range-bound market. When the linear component is very strong, we have a trending market. When we have more than one significant cyclical component, we have a noisy, choppy market.
When we see a stable time series, what we're really seeing is consistency of linear and cyclical components. When the world changes in material ways, those components change and we shift from one regime to another. What makes trading so difficult is that the strategies that work well when linear components dominate are not those that work well when cyclical components dominate--and once a strategy works well, a shift of regime can undermine its efficacy. Trends change their slope; cycles change their frequency and amplitude: it's tough to trade your personality when the market is changing its own. Trading fixed "setups" in changing markets is perhaps a setup in ways that are unintended. In the current stock market, there is a strong positive linear component (uptrend) and a strong low-frequency cycle superimposed on it. That regime has persisted for some time. In such a regime, my "edge"--short-term trades of 1-3 days based on backtested predictors--has not been a particularly good edge when traded real time. Why? In essence, I'm trading a short-term cycle, when a short-term cycle is not dominant. I'm trading my personality and my predilection, not what the market is giving me. To borrow a phrase from a savvy trading friend, short-term strategies "get run over" when lower frequency cycles and strong trend components are highly dominant.
In other words, my dogma has been run over by my karma. If I take what the market is giving me, I'd trade a helluva lot less often and align the trades with the most significant components of the present regime. So, I've gone over my edge to see what's on the other side. I'm trading the direction and time frame suggested by the components that account for the lion's share of market movement. That means I'm not daytrading, I'm not swing trading, and I'm not watching screens nearly as much. I'm just making more money. Further Reading: Preparing to Win
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So every morning I plant myself at the kitchen island at 4:00 AM and every morning I am joined by my feline company. Those are my most productive hours, connecting with four-legged friends, enjoying the quiet, and alternating between work and morning exercise. No phone calls, no emails, no messaging, no television, no errands to attend to: just free time to reflect and work at what I love. Half of productivity is proper structuring of your environment: interpersonally and at the office.
I wrote the majority of my first book at a Wegman's grocery store in DeWitt, NY. It was a perfect environment, with plenty of coffee, food, and available tables. There were always plenty of people around, but none of them were distractions. Being in public can be a great way to find solitude.
Some traders work well in teams and thrive on debate and discussion. Others work well apart from people and view discussion as distraction. Some traders fill their immediate environment with multiple screens and a variety of visual displays. Others have a very simple trade station and greatly tailor their information flow. In structuring our social and work environments, we can either draw upon our strengths or frustrate those.
One of the problems with our environments is that, too often, they are not flexible. The setting that is best for deep thinking and analysis is not necessarily the one that is best for processing real time market information. Traders intuitively recognize this when they speak of the need to "get away from the screens" periodically. The right environments, like my mornings, are ones in which you feel free, unencumbered, and truly at home. The wrong environments understimulate or overstimulate, leaving us frustrated. When I first meet with traders, I learn a great deal by observing their environments. The world we structure outside has an uncanny way of mirroring our internal realities--and helping shape those. Further Reading: Assessing the Right Trading Environment
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Traders are generally sensitive to emotional factors that take them out of their zone and lead them to trade either too impulsively or too cautiously. Less well recognized are biases in our thinking processes that lead us to erroneous conclusions and poor trades. This is because not all cognitive biases are accompanied by emotional upheaval. Indeed, many exist precisely to maintain an emotional status quo--even at the cost of distorting perception.
There are many cognitive biases that can impact trading decisions; more than we can typically be aware of at any given point in time. One of the most common that I observe is in-group bias. We allow our personal affiliations to overvalue and overweight the observations and decisions of our peers. This leads to a kind of bandwagon effect, where we no longer make truly independent market observations and trading decisions. For trading firms this is particularly pernicious, as--combined with overconfidence bias--it can lead to concentrated bets and correlated returns just as thought is most biased. Another common bias is the anchoring effect. This occurs when we seize upon a particular piece of information--often the most recent, salient observation--and draw conclusions from that limited data point. This frequently happens when traders don't have strong views on markets, but feel a need to place trades. The desire for a trade rationale leads them to overvalue recent observations. Of course, these biases can operate in concert. For example, a group of traders can anchor off a piece of salient data and set off a bandwagon effect that impacts other traders, leading to biased group-think. Some traders seek to minimize cognitive bias by taking a quantitative approach to their trading. Alas, this can have the effect of substituting even more subtle distortions for the better known ones. Strategies that look too good to be true often are, as the search for patterns can find seemingly good results in random ways. This most notably occurs when backtests of strategies are overfit: we keep searching for "significant" results until we find them. Such strategies typically boast phenomenal Sharpe ratios--lots of gain for little pain--but, as Marcos Lopez de Prado has recently observed, such ratios are deceptive if they are not deflated for selection bias. Traders typically think of discipline in emotional terms: taming one's fear, greed, and frustration in order to stick to trading plans. These plans, however, are only valuable insofar as they reflect a different, cognitive discipline. Rules that guide our trading are only as good as the rules that guide our identification of trading opportunities. More on that topic to come. Further Reading: Changing Self-Talk by Talking to Yourself
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Here are a few interesting ideas gathered this weekend: * Here's a post that caught my eye on the Dunning-Kruger effect--a cognitive bias in which people who don't know tend to also not know that they don't know. This excellent article puts the DK effect into context and makes the observation that experts are more likely to accurately assess their level of knowledge and success--and even modestly understate their gifts--relative to those who are poor performers. I have consistently found that to be the case in the trading world: less sophisticated participants seek levels of percentage of return that are never consistently achieved by the expert performers, whereas elite money managers tend to be humble about their current and future performance. * Thanks to a savvy trader at SMB for pointing out this article on collecting cortisol levels via smartphone. This very much fits with the Quantified Self movement, which uses real time technology to collect ongoing data regarding our lives and functioning. Check out this fascinating post on rhythmanalysis, as well as this post on mapping and tracking your happiness. It's only a matter of time before such projects assemble into big data efforts that tell us much more about psychology than ordinary (biased, limited) self-report.
* My last post has me thinking about the information that should ideally appear on a market chart. What I realized is that there is almost no overlap between any chart review I perform and any quantitative analysis I undertake. That doesn't seem right. What if a chart visually captured backtested patterns from market research? I'm working on it...
* Along that same line, I wonder if you took 100 traders and gave them access to market charts and X pieces of data that they found most relevant to making trading decisions. They would follow the same market for the same time period. Would the number of trades taken be a measure of the Dunning-Kruger effect? By the way, here's the original paper on the effect. The abstract neatly states their thesis. * Thanks to Abnormal Returns for the link to the article on diversification and the observation that diversification smooths emotions as well as investment returns. This strikes me as a broader life principle: those who are diversified in their sources of well-being are more likely to sustain consistent well-being than those with their psychological eggs in a single basket. One of my observations is that traders who sustain long-term success enjoy studying markets and understanding what is driving them as much as they enjoy trading. That gives them positive outlets when there are no trades to be had. When trading is everything, it's not surprising that everything is approached as a trade.
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Above is a chart of the last week's action in the ES futures. It looks like a normal chart, but there's a difference. Almost all charts are denominated in time. We can have price on the Y-axis, we can show an oscillator or indicator on the Y-axis, but the X-axis invariably reflects time.
Time is a chronological event, whether we measure time in birthdays or in the behavior of cesium atoms.
Where is it written in stone that markets move in chronological time? Lopez de Prado explains that our reliance on chronological time is "rather arbitrary", as it reflects the role of the sun in agricultural societies. He describes the "new paradigm" in market analysis as one in which we move from chronological time to event time. Indeed, there have been efforts to liberate market charts from the strictures of chronology. Point-and-figure charts draw a new bar when a threshold market move is made, making market movement the X-axis. Richard Arms adjusted the width of chronological bars for their volume, thereby changing the scale of the X-axis. Lopez de Prado's high-frequency trading directly denominates time in volume, as each X number of contracts or shares represents a time unit. As he points out, this brings a number of statistical advantages, including eliminating intra-session seasonal effects (e.g., changes in volume and volatility as a function of time of day). Once we liberate the X-axis from chronological time, we open ourselves to the graphical display of many relationships. Just as the X-axis can bucket movement or volume, it could reflect units of sentiment change, volatility, correlation change, relative strength change, etc. My experience is that such event time charting displays relationships that are not immediately apparent when looking at standard charts based on chronology.
So back to the above chart of the last week in ES. A fresh bar is drawn every time the price of ES moves 500 times. During busy periods, we see more bars; during slow periods, we see fewer. If you had a trading system that went long or short with an X-bar signal, the system would give you more trades in busy markets--and busy market times--and fewer trades during slow markets. In other words, the chart would not only normalize market action statistically, but it would normalize the trader's behavior, creating fewer trades when markets offer less movement. That makes the event-time chart a psychological tool, as well as an analytical one. I will be posting more on event-time analysis in the near future.
So you draw a poor hand at poker. What do you do? You "muck" that hand: you fold and wait to bet a better hand. Good poker players know that there are times to bet and times not to bet. They bet when odds are in their favor and when they perceive weakness among the other players. Suppose a poker player was into the thrill of betting and played every hand. Over time, the odds would catch up to him and he would lose his stake. You can't win at poker until you master the art and science of not playing.
It's a lesson worth heeding for traders.
If you only traded on days when you had objective, tested odds in your favor, how many trading days would you play? How many would you muck? Perhaps one reason so few traders succeed is precisely because they have a "passion for trading". If they had a passion for markets and the calculation of odds, they would be far more likely to win by knowing when to not play. Further Reading: Poker and Trading
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Animals adapt to their environments in part through their displays. Some blend in with their surroundings so as to avoid predators. Some have bright, showy displays to attract mates. Some have threatening displays to ward off predators. Some have deceptive displays to attract prey. Displays attract or repel. Displays maintain offensive or defensive positions in the ecosystem. People maintain their own displays, through how they dress, how they speak, and how they present themselves in person and online. A great deal of unhappiness is created when people need one thing, but achieve the opposite because their displays achieve the wrong purpose. Consider lonely people who long for companionship, but who maintain defensive displays to avoid hurt; vulnerable people who wish for safety, but send signals of neediness; traders who desire collaboration, but keep themselves--and their work--hidden. All experience a mismatch between what they need and what they display. What are your displays? What do they say about you?
Do you display confidence or lack of confidence? Energy or lack of energy? Interest or lack of interest? Sincerity or lack of sincerity? What others see is what you get. Further Reading: Corrective Emotional Experience
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An important line of research and thinking in cognitive neuroscience suggests that, not only does the body hear the mind, but our consciousness is also influenced by our physical states. Embodied cognition means that much of our thought is grounded in physical experience and metaphors that link body and mind. Consider the psych experiment on priming where people were asked to rate a stranger. In one condition the raters held a warm cup of coffee; in the other, they held a cold cup. The first group rated the stranger as significantly more trustworthy than the second group. Literally, the first group had warmed up to the other person.
Damasio's somatic marker hypothesis suggests that cognition is embodied as experienced states. When traders say they have developed a "feel" for markets, they may be literally correct. What we typically call intuition may be felt knowledge: our body's preconscious apprehension of a situation. We have all had situations in which something just didn't feel right, though we couldn't put our finger on the source of our concern. Similarly, we may have a gut hunch about the right answer on a test, even though we cannot pull up the specific material we had studied. The somatic marker idea suggests that what we feel is inextricably linked with what we know, shaping our preferences and choices. In recent posts, I have suggested that a key to peak performance is our ability to control our internal environments, as well as our external ones. Tuned minds and bodies are most likely to be sensitive to the felt signals that deliver our embodied knowledge. A noisy environment--whether the noise is internal self-talk or external chatter--is likely to drown out the subtle cues that give us our market feel. Because somatic markers are so crucial to fast pattern recognition, trading performance is likely to be a function of our capacity to access those signals. It is common for traders and portfolio managers to ground their ideas in explicit research and reasoning. Once the idea is generated, however, what determines when and how we act on it and how we manage its forward path? We like to think that all of those decisions are codified and made mechanical via trading plans. My experience, however, is that the implementation of such plans is greatly influenced by market feel at the time of trade execution and position management. This is not to suggest that trading decisions are "irrational"--rather, decision making may be a much more complex interplay of body and mind than we typically acknowledge. If this is the case, the next leaps in trading psychology may come, not from helping traders tame their emotions, but from enabling them to become better generators and receivers of their embodied wisdom. Further Reading: Biofeedback and Self-Control
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An interesting news article once again points out the benefits of moderate exercise for both physical and emotional health. One of the particularly valuable points is that exercise can be as effective in health outcomes as a prescribed medication. This is not to disparage the use of medications, but rather emphasizes the value of physical activity. A particularly fascinating study finds that exercise changes the microbes in our digestive system, aiding digestion, regulating weight, and guarding against health problems. The implication is that it is important to both decrease sit time and increase fit time. Surprisingly, this simple formula brings cognitive benefit as well as emotional gains, aiding learning and concentration. What these studies don't reveal are the potential virtuous circles created by positive lifestyle changes. For example, more exercise and better eating may aid sleep quality and mood, which in turn could improve our willpower reserves and aid real-time pattern recognition and disciplined trading. Those gains in trading could further boost self-confidence, provide energy for deeper market preparation, and thereby yield further trading gains. Could it be the case that, just as lifestyle changes can be as effective as a drug, that they could be as effective as coaching or counseling? Might we accelerate learning curves in trading by maximizing our physical, emotional, and cognitive resources? My recent post suggested that our work environments are often poorly suited to maintaining an optimal state of focus. It may well be the case that our inattention to the needs of mind and body place us in inefficient states for sustaining peak performance. Can we really expect to fire on all cylinders when we fail to maintain our cognitive and emotional engines? It takes a world-class pit crew to win an auto race; perhaps no less to win the race for trading performance. Further Reading: The Value of Preparation
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Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab). I teach brief therapy as Teaching Professor at SUNY Upstate in Syracuse, with a particular emphasis of solution-focused "therapies for the mentally well". Co-editor of The Art and Science of Brief Psychotherapies (American Psychiatric Press, 2018). I don't offer coaching for individual traders, but welcome questions and comments at steenbab at aol dot com.
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