Saturday, October 07, 2006

Narrative Complexity and the Trader

Human beings organize a great deal of their experience into narrative structures. When we're asked to provide a detailed biography, we "tell the story" of our lives, connecting events temporally (my childhood, my college years) and thematically (struggles, successes, personal life, career). Cultures were making sense of their worlds through myth and fable long before science was institutionalized; sit around the dinner table long enough at a reunion and you'll hear the narratives that affirm who we are and where we've come from.

An interesting social science experiment years ago asked people to watch a computer screen depicting moving colored shapes and then describe what they saw. To the investigators' surprise, subjects invented narratives to explain their observations, attributing human attributes (aggressiveness, shyness) to the moving forms. Narratives provide coherence to our experience and enable us to make sense of events--even (or perhaps especially) when we are confronted with life's randomness.

A depressed person is one who becomes trapped in his or her own narrative of inadequacy, just as the anxious person's stories are dominated by threat and danger. Our narratives become lenses through which we view the world, essential parts of ourselves. Countries will go to war over differing accounts of the world's origin and nature of the Deity; their leaders expend considerable resources to shape the narrative structures of those they lead. Diplomacy is the art of co-constructing mutually satisfying world views; the therapist is one who helps the unhappy person organize his or her experience in ways that are more enhancing to self and others. Couples tell very different stories about each other before and after successful counseling.

Swiss psychologist Jean Piaget recognized that the "schemas" that organize our perceptions grow in complexity as we develop from childhood into adolescence and adulthood. We test our narrative accounts against reality, revising and enriching as needed. What we value in the greatest novelists is the ability to create complex and revealing narratives that embrace many facets of experience. When narratives lack such complexity, they become cartoons: the very essence of simple-mindedness.

Novice traders are like Piaget's children. When I first started following markets, I focused on price and price configurations, creating such narratives as, "We just made a double top; we're heading lower." With (painful) experience, I learned that volume was an important element in ascertaining demand and supply and expanded the narrative to include how volume was expanding or contracting with price movement. Still later, I reorganized my accounts of price and volume into a narrative of auctions and began to see how markets move toward and away from complexes of price and volume that determine "value".

When I joined a professional trading firm, I learned that not all volume is created equal. I learned to differentiate volume coming from locals and those coming from institutions. I learned to identify and track the largest volume participants in the markets, because they would ultimately control whether trade moved in mean-reverting or trending ways. Still, that wasn't enough. I found that I had to break large volume down into arb/program trading and directional trading to truly understand participation in the marketplace. I had to learn intermarket relationships, in which different markets and sectors impact one another.

Now, when you ask me what is going on in the markets, I won't say anything about double tops. I will give a detailed narrative account of how we're trading relative to value at various time frames, what institutions and locals are doing, which regimes (themes) are dominating the market, and whether trade is dominated by arb and countertrend participants or by directional traders. Years from now, my hope is that my market narratives are richer still, just a bit closer to the complexity embodied by markets.

The idea is not complexity for complexity's sake. Indeed, the function of narrative is to package complicated realities into readily understood accounts. Creating simple narratives that guide market understanding and decision making--and ensuring that those simple narratives are not simplistic ones--is a large part of the trader's developmental process.