Tuesday, March 27, 2007

Toby Crabel And The Epistemology Of Trading Expertise

I recently posted about opening range breakout (ORB) trades and illustrated an intraday example. An early presentation of ORB trading was Toby Crabel's book Day Trading With Short Term Price Patterns. It has become a classic text and, indeed, now fetches a handsome price, given that it is out of print. (Rumor has it that the author, a successful hedge fund manager who worked at one time with Victor Niederhoffer, has not pursued additional printings of the text, believing that it gave away too many of his valuable trading ideas).

I've read the book several times myself and do find it valuable. One of its great strengths is that it is an attempt to statistically test the efficacy of price patterns. Instead of merely asserting that a chart formation is bullish or bearish, Crabel actively searches for evidence. In this empirical approach, Crabel's work shows the influence of Niederhoffer.

(As an aside, allow me to mention that the works of many fine authors owe a debt to Niederhoffer, including his recent work with Laurel Kenner, which includes years' worth of financial columns and insights via the Spec List. The quantitative tradition is now very well established in the trading world; it's difficult--especially for younger traders--to recall that there was a time when that was not the case and when the idea of testing one's trading ideas was quite novel. Sadly, that empirical influence remains something of a novelty even to this day in the popular trading literature).

Less well appreciated is that Crabel's book is explicitly founded on the base of Ayn Rand's epistemology. Ayn Rand was a novelist and philosopher who developed a philosophy (Objectivism) that emphasized reason, political and economic freedom, and a heroic view of human potential. Her book Introduction to Objectivist Epistemology is an attempt to explain how the human mind is able to grasp reality. (Epistemology is the philosophy of knowledge). Central to Rand's account is the role of concept formation. "The ability to regard entities as units is man's distinctive method of cognition," Rand wrote (p. 7). This ability opens the door to both mathematical and conceptual reasoning.

Rand defines a concept as "a mental integration of two or more units which are isolated according to a specific characteristic(s) and united by a specific definition" (p. 11). The formation of concepts requires abstraction--isolating certain attributes from others--but also integration: combining concretes into a larger category. When we form the concept of a "trend", we are isolating certain aspects of price and volume and integrating these on the basis of a definition. Through ever-widening efforts at abstraction and integration, we expand our conceptual universe and extend our grasp of the world.

Crabel understood this, beginning with very simple notions of range and then investigating increasingly complex patterns over individual and multiple days. His abstraction of a "Principle of Contraction/Expansion" enabled him to widen his investigations to a variety of narrow and wide range price formations. He systematically investigated patterns of 2 bars, 3 bars, etc., using the chart to aid in the formulation of market concepts.

Crabel's book is best known for its treatment of ORB and narrow range (NR4, NR7) patterns, but I would argue that his greatest insight was his understanding of the role of epistemology in trading success. The successful trader may indeed trade patterns that appear to be simple. Behind these seemingly simple ideas, however, is a high degree of conceptual integration. Chess grandmasters do not see an assortment of isolated pieces on the board; they see formations that have strategic value. Similarly, skilled physicians don't perceive an array of disconnected complaints; they see interconnected symptoms that lead them to diagnoses of diseases.

Similarly, the successful trader is not mired in perceptual concretes. A good stock pick, such as the one mentioned in my recent post, integrates a wide range of information, from price action to the behavior of institutions, to actual earnings performance and industry trends. A good trade, such as the breakout example from my recent post, also integrates a large amount of data regarding the prior price range, recent and current volume patterns, and behavior during pullbacks. This integration is achieved perceptually, and it is the role of training to effect such perceptual transformation. The expert performer learns to see his or her domain in terms of patterns, whether they're the patterns of a chess opening, a defensive alignment in football, a military strategy, or a breakout from a trading range.

This is the great weakness of most efforts at "trader education". Such education consists of isolated Website posts, magazine articles, and conference presentations. Even books in the field fail to build a conceptual foundation for traders to help them understand *what* to trade and *why*. And, of course, few educational efforts help traders train their "eye" to see the patterns from their conceptual integrations. That, in trading as in chess and medicine, is a process that takes years of devoted effort.

Ayn Rand understood that philosophy is the most practical of disciplines. Without a solid epistemological foundation, what assurance do we have that we're trading anything other than randomness? Proper training for a trader is, at root, an epistemological undertaking. It transforms the knower by expanding the realm of the known. When you become expert, you forever see the world differently. You also think differently, guided by principles, not just percepts. Crabel understood that as few do. That, in itself, is justification for his book's reputation.