Tuesday, November 08, 2016

Replacing Trading Drama With Realism

One of the most damaging psychological patterns in trading is seeing markets through the lenses of hopes and fears--what you want to happen or what you fear could happen.  Both are quite different from seeing the world in terms of what typically happens and estimates of variability around that.  It's when we view markets through lenses of drama that we create frustration, and sometimes trauma.  

Many traders trade patterns that reflect momentum and/or trend.  They look for stories and catalysts that would justify the kinds of moves they want to see.  A great example of this is provided by Jeff Miller, who notes the frequent calls for recession that never come to fruition.  People look for dramatic outcomes because they want to benefit from the moves that would be created.  Along the same line, I'm surprised by the amount of conversation I hear from traders about the huge downmoves that would be created if we get a Republican presidency in today's election.  Yes, it could happen, but if you look state by state at the electoral count, wouldn't you want to plan equally rigorously for a different outcome?

The tendency to look for big events that could create big (and presumably profitable) moves leads us to underestimate the odds of modest outcomes.  It reflects a long volatility bias, so that when volatility is decreasing, frustration inevitably rises.  I attribute the recent challenge to money management returns in large part to the crushing of volatility across markets in the wake of zero interest rate policy among central banks.  When you look for themes and trends and breakouts in low and declining volatility markets, you'll inevitably be subject to reversals.

The really valuable trading and investment sites, like Jeff's, take a sober look at what is expectable.  That may not provide the click bait of Dow 5000 forecasts, but it enables traders to understand and take what markets give them.  The idea is not to trade viewing markets through the lenses of optimism or pessimism, but with the clear-eyed perspective of realism.

Further Reading:  The Importance of Psychological Risk Management