Wednesday, April 09, 2014

The Power of Cognitive Flexibility in Trading

In response to the recent post on the risks as well as rewards of selective attention, reader Igor Marinkovic raises an excellent point:  If you entertain outcomes at odds with your trade expectations, might you not create a situation in which you overweight non-confirmatory information and prematurely abandon your position?

Igor is absolutely correct.  Indeed, we can think of worry and anxiety as selective *negative* attention.  In becoming too focused on what can go wrong, we can overreact to the first bit of random variance from our expectations and fail to allow trades to go to their targets.

Clearly there is an alternative to blind overconfidence and skittish lack of staying power in ideas.  That alternative, I believe, is flexible commitment.  We can be committed to a course of action at the same time that we're open to modifying it.  Military leaders know this well:  you create a strategy, but few strategies survive the fog of war.  You are always ready to modify the strategy based upon conditions on the ground. 

Cognitive flexibility requires emotional flexibility:  the ability to anticipate being right, but also prepare for being wrong.  We recently moved sharply lower in stocks and my regression models, as well as a breadth query that I ran, suggested the probability of a bounce over a 3-5 day horizon.  Indeed, we got some bounce in today's session.  But I know that models and queries based on historical data rely on a crucial assumption: that the immediate future will mirror the recent past.  

As we look at the tense situation within Ukraine and Russian concerns there, we have to entertain the possibility of a new element entering into markets.  Too, we see fresh tensions between an expanding China and its rivals, including recent concerns over disputed islands.  Can historical models adequately account for unique geopolitical events?  Not without meaningful modification.

Cognitive flexibility means building plans around your research, models, experience, and expectations--all the while creating alternate plans should this time truly be different.  I might expect a bounce in stocks, but I also know that nasty headlines emerging from Ukraine or the East China Sea could severely test nearby support in the ES futures.  I don't just want a trading plan; I also want a Plan B.  The best-constructed quant models are severely challenged when idiosyncratic factors drive price action. 

Hope for the best, plan for the worst: not a bad approach to life and trading.  Flexible commitment is not an oxymoron: it lies at the heart of performance in fast-changing, uncertain domains.

Further Reading:  Why Controlling Emotions is Not the Goal of Trading Psychology