Saturday, January 02, 2010

Decision-Making in Trading: How Simplicity Becomes Simplistic

The recent post on generating trading ideas offers an opportunity for traders to reflect upon their own decision-making processes and where those might be strengthened.

Sometimes the basic decision-making process is sound, but is disrupted by situational cognitive and emotional factors.

Other times, the decision-making process falls short by not taking into account the information most important in generating promising hypotheses.

I see this particularly among traders who seek simplicity and wind up trading simplistic setups that ultimately lack any edge. Consider the following:

* A trader sees a chart pattern on one time frame and decides on that basis to buy or sell;

* A trader sees strength or weakness and jumps in to "follow the trend";

* A trader sees price holding at a certain level and enters a position based on that information;

* A trader hears positive news and buys a stock;

* A trader sees that we have moved below a trend line or moving average line and sells the index.

In each case, a single observation is blown up into a full hypothesis. The observation, in itself, may be valuable, but it lacks the full amount of information that one would need for a promising hypothesis. It would be as if a physician took a single test result (one's temperature, blood count, or pulse rate) and made a diagnosis on that basis.

If a person bought a car because it had a large engine or because it had a nice interior, we would think the person foolish for making such an important decision based upon such superficial and limited information. I find, however, that traders routinely engage in a similar process. They will buy or sell because of particular oscillator readings, chart formations, or numerological relationships.

I have found that a major reason that simplicity in process devolves into simplistic thinking is that traders narrow their field of vision when they are under stress. They focus on what is immediately presented and feel the impulsive need to engage in either flight or fight. This narrowing of vision prevents the trader from taking in the entire range of data at the time and making the most informed decision.

Suppose, for instance, that a quarterback steps back to pass and faces a blitz by the opposing linebackers. The quarterback feels a panicky need to get rid of the ball, focuses on one primary receiver, and throws the ball into coverage, risking an interception. Compare that to the quarterback who scrambles out of the pocket when under pressure, takes a moment to survey the entire field, and selects a secondary receiver who is left uncovered in the middle of the field.

It's that ability to see the whole field under pressure that distinguishes many of the best traders from many of the rest. Anyone can pick out the right targets when they have all the time in the world; the challenge is learning decision-making so well--and making it so second nature--that the right actions will come to you even in the heat of the moment. That is why practice under realistic conditions, eventually with money on the line, is crucial to the developing trader: We learn to perform only by repeatedly facing the pressures of risk, reward, gain, and loss.