Friday, December 26, 2008

Implicit Learning: The Key to Trading Performance

My recent post emphasized the role of planning in successful trading. While trade planning is as important for the trader as game planning is for the quarterback, the reality is that a trader's performance, like that of the quarterback, is a joint function of gut feel and careful forethought. The quarterback may call for a pass play, with the flanker slanting up the middle of the field as a primary receiver, but under pressure from linebackers may opt to dump the ball to a running back or scramble out of the pocket and look for secondary receivers. Similarly, the trader may plan a trade to break below the previous day's low, but noticing very weak holiday volume, might take profits before the target is hit when the NYSE TICK cannot make decisive lows on a down move.

One of the formative experiences of my career as a psychologist was observing high frequency traders in Chicago (those making 50-100 or more trades per day on a discretionary basis) make money consistently, day after day, week after week, and year after year. When I looked at how much they were giving up in commissions each day and yet still could make money, I realized that their skills were greater than any market efficiencies.

Perhaps most interesting to me was that these traders typically could not verbalize to me how they were making their decisions. Yes, they could point to shifts in order flow, volume, etc.,--and, yes, their trading size and ideas about limiting losses and taking profits had a strong element of preplanning--but most of their decisions were like the audibles of the quarterback. It was clear to me that they knew a great deal about markets, but did not seem to know what they knew.

This realization led me to research the field of implicit learning when writing my book on trading performance. It also led to this key post on the objective basis for subjective knowledge. It appears that, particularly in the realm of pattern recognition, we process the world far better in an implicit, subconscious mode than explicitly. As a driver, I respond to the sudden shift of the car in the next lane almost immediately, before I consciously identify what that car is doing. This makes evolutionary sense: if we needed to rationally, consciously evaluate each threat before responding, we would not survive long as hunters, fighter pilots, or race car drivers.

An excellent recent research article passed along by an alert reader (many thanks!) points out that the human brain is hard-wired to make sound decisions in an implicit mode. For example, research subjects watching a computer screen in which most dots move randomly, but some move with a programmed path, can eventually make accurate predictions about the direction of the programmed dots far beyond chance levels. The mathematical calculations needed to make these predictions are beyond the skill level of many participants. Rather, their brains capture the probability distributions in the data and these present themselves to subjects as a "feel" for what will happen next to the dots.

The reason psychology is crucial to developing and experienced traders is that access to this felt, implicit knowledge is easily disrupted by such factors as fatigue, worry, frustration, and performance pressure. Indeed, one of the most common mistakes traders make is that they address performance problems by thinking harder. Like the insomniac who stays awake longer and longer thinking about trying to get to sleep, the trader who analyzes and worries about performance loses that "zone" in which probability distributions present themselves implicitly.

Experienced, successful traders know more than they know they know. Their performance crucially hinges on their ability to sustain a mindset in which they can access their implicit knowledge. Maintaining that "zone" will be the topic of the second post in this series.