Wednesday, March 28, 2007

Trading And Information Processing: Why Traders "Sabotage" Themselves

We sometimes hear traders say that they are sabotaging their own pursuit of success. They don't act on what they know, and sometimes they act even though they know better. Usually, traders attribute these problems to personality difficulties. In this post, however, I'm going to suggest that such "sabotage" has a very different source: one that is rarely acknowledged among trading psychologists and coaches.

In my recent post on the epistemology of trading, I suggested that conceptual integration is essential to the acquisition of expertise in any field. This integration is not merely an intellectual awareness. Rather, it becomes a lens through which the expert sees the world. The expert physician, for example, sees patient complaints in terms of clusters. These clusters are organized by his or her understanding of organ systems, pathology, and diagnoses. A patient who presents with a swollen jawline may have (among other things) mumps, a tumor of the parotid gland, salivary stones, or a bacterial infection. Think of the large amounts of information needed to sort through these possibilities to achieve a proper differential diagnosis--and then to prescribe the right treatments. Within minutes, the expert physician can narrow the possibilities, order the proper tests and imaging, and begin treatment.

The expertise of the diagnosing physician is akin to that of the long-term investor: It requires a conscious integration of information acquired over a considerable period. A large fund of knowledge is brought to bear on a particular situation to make a proper decision. Such reasoning-based expertise can be found in many other fields, from jurisprudence (the Supreme Court judge who must integrate the particulars of a case with a long history of case law to render a decision) to engineering.

Other forms of expertise, such as those of the short-term trader, do not allow for the luxury of extended decision making. The fighter pilot, hockey goalie, or SWAT team member must integrate information on the fly, making critical decisions by "instinct" alone. Such instinct, however, is actually highly automatized skill. The expert scalper integrates a huge amount of information from price, volume, time of day, and shifts in the depth of market. This integration, however, is not a deliberative process. It is built into the scalper's perception. Just as a batter must quickly integrate information about the pitcher's delivery, the rotation of the ball, the location of the pitch, and the pitch count in order to decide whether or not to swing, the scalper cannot afford the luxury of deliberation. An entire trade may last but a few seconds.

Perceptually-based expertise is an evolutionary necessity. There are many life situations--from avoiding an oncoming car to responding to a complex social interaction--that require us to react more quickly than we can explicitly process. As I describe in my book, it is the function of training to immerse performers in the real-time patterns of a performance field to hone this perceptually-based expertise. This is one way in which the training of short-term traders is more similar to that of expert athletes than to Supreme Court justices. Investors can learn to weigh evidence and render reasonable decisions like judges. Very short-term traders, however, need their expertise built into their perceptual systems. They are more like race car drivers navigating a speedway than vacationers consulting maps for destinations.

A while back, I questioned several myths of trading psychology and indicated that there is a common process that underlies the acquisition of expertise. What we can see from the above discussion, in addition, is that trading itself requires very different forms of expertise, based partly on the market participant's time frame. The longer the timeframe, the more important the role of explicit deliberation and reasoning. The shorter the timeframe, the greater the need for rapid perceptual processing based upon pattern recognition.

When, however, a trader operates at a time frame that is intraday, but not at the level of scalping ticks, we have a unique cognitive challenge: the need to integrate perceptually-based expertise with an explicit knowledge base. Or, more simply, the need to integrate one's instincts with one's reason. The emergency room surgeon is a good example of an expert who must achieve such an integration: making rapid, on-the-fly judgements with a dying patient, but also bringing to bear a wealth of factual information regarding proper treatment. A trader who manages positions lasting minutes to hours must respond quickly to real-time market developments, but also must constantly process explicit information about where value is located, who is participating in the market, whether buying or selling sentiment is prevailing, etc. Many, many traders stumble because they lack the training to coordinate what they know and what they see. They are trading a time frame that requires, not one, but two forms of expertise.

Many challenges of trading performance--those seeming sabotages--are not a function of personality problems. Rather, they are the result of faulty integration of these two forms of expertise. That is why we may know the right trade to make, but not see it in time to put the trade on. Similarly, we might see a great trade and then talk ourselves out of it. It's as if we have two brains: one trained to respond instantly to our perceptions, the other trained to weigh relevant evidence. In some ways, it's easier to be a pure scalper or a pure long-term investor. The scalper can operate pretty much on auto-pilot, responding to shifts in the order book and from trade to trade. The long-term investor can accumulate research and review markets weekly.

But what happens when we follow the markets short-term, tick-by-tick (like a scalper) but make decisions based upon planned setups (like an investor)? We run the risk of having one set of mental inputs and outputs interfere with the other. How to deal with this challenge? That will be the topic of my next post. For now, however, let me suggest a basic principle: Trades must be managed on the same basis on which they were put on. That means that, if planned, reasoned criteria put us into the trade, we need a set of planned, reasoned criteria to manage the trade, and we need to limit our tracking of the market to those criteria. Conversely, if our gut put us into the trade, we need to manage the trade by what we perceive, not by all the possibilities of what we *think* might happen.

Trading problems begin when we enter trades by one information-processing system, but manage them by another.