Friday, November 06, 2009

Eliminating Bias in Trading

A reader asks a good question: "Do you have any good post on eliminating a strong bias? I am so clouded by a bias, I can't trade objectively."

I find this to be a more common problem than is typically acknowledged, particularly among short-term traders who hold positions intraday. They find themselves caught up in strongly held, longer-term opinions about political and economic developments, which makes it difficult to trade against those views.

For example, it is very difficult for an advocate of limited government/individual liberty/free markets (which, parenthetically, are different from the kind of statism represented by the last Republican administration and the current Democratic one) to feel particularly bullish on the future of the U.S. or even global economies. While I have philosophical sympathy for such a perspective, it doesn't change the fact that markets tend to rise during periods of central bank ease. Fighting the Fed is generally not a good way to make a money as a trader or investor.

Too, some traders naturally fall into trend-following or countertrend trading styles. While either of those can be successful, becoming married to trends or fighting strong ones can be a quick way to the trading poorhouse. The opposite of being stuck in bias is being mentally flexible: recognizing when trends are likely to continue and when they are vulnerable to reversal.

Three practices help me sustain mental flexibility. The first is a thorough review of market indicators, intermarket patterns, support/resistance areas, value areas, etc. From the data, I require myself to formulate hypotheses about the action that I anticipate. By forcing myself to ground my views in the data, I try to minimize subjective bias.

The second practice that helps me stay mentally flexible is following a few basic trading rules. I am not allowed to sell a market that shows strong NYSE TICK and positive cumulative Delta (i.e., net volume at offer vs. bid); I'm not allowed to buy a market that shows weak TICK and Delta. In other words, because much of my trading is intraday, I'm not allowed to fight the intraday sentiment trend. At the same time, I'm not allowed to buy the market when TICK is positive or sell it when it's gone negative. I have to execute ideas countertrend, even as I try to ride a trend. In this way, I follow the market; I don't impose my views onto it.

Finally, a third helpful practice is framing all trade ideas as "what-if" scenarios. If the market breaks support on high relative volume and very weak TICK, I would do X. If the market's selling pressure dries up near support, I would do Y. Included in those "what-if" scenarios are plans for stopping out of a trade, plans for adding to a trade, etc. By requiring myself to look at bull and bear possibilities, I prepare myself for either.

No one--myself most included!--can eliminate bias altogether. The key is staying as grounded in markets as possible: listening to them, rather than talking at them.