Wednesday, July 19, 2006

Two Kinds of Traders

Since the publication of The Psychology of Trading, I've been honored to work with many groups of traders. Some have been home-based and independent; others have worked for proprietary trading firms, hedge funds, or investment banks. FWIW, I would say that, based on this experience, about half of what is written about trader psychology and successful trading is not grounded in reality. A simple example of this is the bromide that successful traders either control or eliminate their emotions in trading. I consistently find this to not be the case. Successful traders are extremely competitive individuals who, as a whole, hate losing. They don't take losing lightly, but they channel that emotion constructively, to enable them to overcome loss.

In general, I find there are two kinds of traders. The first kind trades visually, from patterns that are evident on visual inspection. Those include chart patterns, oscillator patterns, Elliott waves, and the like. Their trading decisions are discretionary, in that they elect to buy, hold, and sell based upon their perception of patterns and their judgment as to their meaning.

The second kind of trader distrusts visual inspection. Such traders are more likely to buy into the behavioral finance notion that unaided human perception and judgment are subject to a variety of biases. Accordingly, these traders use some form of historical/statistical analysis and/or system development to test ideas and trade only those that test out in a promising way.

Now here's the interesting part: The first group of traders almost universally asks me to help them tame their emotions. They have problems with impulsive trading, failing to honor risk limits, failing to take valid signals due to anxiety, etc. The second group of traders, having researched successful strategies, almost universally asks me to help them take maximum advantage of their edge. They want help taking *more* risk and trading larger positions.

The trading psychology literature focuses strongly on the first group of traders, because much of the universe of retail traders falls into this category. At many investment banks and hedge funds, however, visual trading is practically non-existent. If you don't have a model with a demonstrable edge, you don't trade. Such traders tend to have solid analytical strengths, but are not necessarily risk-takers.

So there you have it: some traders are risk-takers without a demonstrable edge; other traders are researchers who find an edge but have trouble assuming the risk of trading it. The true rarity is the trader who has both head and gut: the ability to find an edge and the fortitude to trade it aggressively.