Wednesday, March 11, 2015

Best Practices in Trading: Scenario-Based Planning

A good rule is that we cannot be prepared for a situation if we do not anticipate the possibility of that situation materializing.  Many times we become so focused on our base case--and locked in confirmation bias--that we fail to contemplate alternate scenarios and how we would respond to these.  Many times, emotional overreactions to trading events are the result of lack of preparation:  we are surprised by events that were entirely foreseeable as possibilities.  That element of surprise places us in a stress mode, impairing our perception and reducing our ability to calmly act upon prior planning.  Show me a situation in which a trader violated a trading plan and the odds are good that it's a situation in which lack of planning created surprise, frustration, and emotional disruption.

Today's best practice comes from reader Jitender Yadav from India, who points out the value of building alternate scenarios as part of planning for the trading day:

"One of the interesting characteristics of the markets is that they never fail to surprise us with their actions and catching us off the guard. Often these surprises prove to be costly. Although no one can know for sure market’s next course of action, still we can prepare ourselves to face the surprise. In the evening before the trading day we can imagine about all the possible scenarios that can play out next day regardless of their actual probability to occur. We can, for example, imagine the ideal conditions we would like to see before making a long entry or the worst conditions to make a trade at all. We can imagine about our response to breakout failure or our plan of action during a short squeeze.  It won’t take much time to think of so many other possibilities and we can do it in our free time like during the evening walk, etc. Again the markets have their own minds and even after this scenario building exercise they can have something different in store for us but then if one of our imagined scenarios actually plays out, we are ready with our plan."

Note that such scenario planning requires an open mindedness, as we can only anticipate a range of situations if we are open to many possibilities.  For this reason, scenario planning is a great tool to maintain cognitive flexibility.  It is very common that traders will take actions during the day that, in retrospect, seem unfathomable:  "How could I have possibly done that?"  Generally, such boneheaded actions are the result of becoming so focused on short-term action and one market scenario that we fail to step back, assess the entire situation, and plan for multiple possibilities.  Jitender's observation is that such perspective can be an ongoing part of preparation for trading, enabling us to act decisively in the face of multiple possible outcomes.  It is such planning that allows us to make sound decisions in the heat of battle, as we remove much of the market's ability to fill us with shock and awe.

Further Reading:  Making Use of Visualization