Saturday, November 15, 2008

Conflict and Creativity in Trading Performance

As part of elaborating a cognitive perspective on trader performance, I recently took a look at the role of creativity in trading. From this vantage point, idea generation can be described as a two-part process of observation and analysis followed by comparison and synthesis. The creative insight occurs when observation and analysis lead to contradictory conclusions, requiring a fresh perspective that bridges these contradictions.

Let's take an example that has occurred many times over in my work with portfolio managers and traders. Suppose I am working with an active trader while he is trading; he is intently watching the market and trying to make sense of what he is seeing. The market moves within a relatively narrow range near the highs for the day session. Once, twice, three times the trader starts to click on a price to enter a buy order, only to pull back. It looks as though support is holding and an upside breakout is imminent, but every time the S&P 500 futures tick up, they run into a wave of selling from market makers. The NASDAQ futures move to a marginal new high for the day...once again the trader is ready to buy...the bank stocks still look weak...the trader is glued to the screen.

Suddenly, the trader exclaims, "This thing is ready to collapse!" Not enough volume could eat through the modest offers resting above the market and suddenly there is a pulling of bids. "That's what happened yesterday!" the trader explains, recalling a similar intraday decline. He quickly sells the futures before a flood of sell orders hit the market, waits for the futures to take out an obvious near-term support level on increased volume, and covers his position into the selling.

What we see in such an example is a careful process of observation and analysis initially leading to contradictory conclusions. During the tension of this contradiction, the trader is caught between competing impulses. Then a fresh set of observations leads to a new perspective: the way in which orders were entered and pulled near a resistance level brought to mind the previous day's market. That similarity reorganized the trader's thinking and led to the creative insight that the market was about to collapse. No longer trapped in contradiction, suddenly possessed of clarity, the trader is able to act decisively.

An important implication of this cognitive account is that many problems of trading performance are the result of a breakdown in the creative process. Effective creativity seeks contradiction; it thrives on dialectical tensions and resolutions. This tension, however, is not comfortable--and it does not come naturally. As we know from behavioral finance research, some of the most common trader and investor shortcomings are confirmation biases and disposition effects that lead us to avoid short-term discomfort. We look for evidence that supports our positions; we sell winners for quick gratification and hold off on selling losers to avoid pain.

Many of the most successful portfolio managers I've worked with are quite insightful about their process of idea generation. They know what to read, who to talk with, and how to process information to get to the point of "Aha!" Most market participants, however, are only dimly aware of how they generate good ideas for trading and thus cannot standardize how they think across situations. Imagine a factory that changed how it produced goods based on the ups and downs of daily sales: quality control would go right out the window. Traders, however, will shift their processes from hour to hour, day to day in ways that they don't recognize.

Much coaching of traders helps them think about performance. Some of the most effective coaching, however, helps traders think about their thinking and understand the processes that they utilize to make sense of markets.