Wednesday, March 28, 2007

Trading And Information Processing: Why Traders "Sabotage" Themselves

We sometimes hear traders say that they are sabotaging their own pursuit of success. They don't act on what they know, and sometimes they act even though they know better. Usually, traders attribute these problems to personality difficulties. In this post, however, I'm going to suggest that such "sabotage" has a very different source: one that is rarely acknowledged among trading psychologists and coaches.

In my recent post on the epistemology of trading, I suggested that conceptual integration is essential to the acquisition of expertise in any field. This integration is not merely an intellectual awareness. Rather, it becomes a lens through which the expert sees the world. The expert physician, for example, sees patient complaints in terms of clusters. These clusters are organized by his or her understanding of organ systems, pathology, and diagnoses. A patient who presents with a swollen jawline may have (among other things) mumps, a tumor of the parotid gland, salivary stones, or a bacterial infection. Think of the large amounts of information needed to sort through these possibilities to achieve a proper differential diagnosis--and then to prescribe the right treatments. Within minutes, the expert physician can narrow the possibilities, order the proper tests and imaging, and begin treatment.

The expertise of the diagnosing physician is akin to that of the long-term investor: It requires a conscious integration of information acquired over a considerable period. A large fund of knowledge is brought to bear on a particular situation to make a proper decision. Such reasoning-based expertise can be found in many other fields, from jurisprudence (the Supreme Court judge who must integrate the particulars of a case with a long history of case law to render a decision) to engineering.

Other forms of expertise, such as those of the short-term trader, do not allow for the luxury of extended decision making. The fighter pilot, hockey goalie, or SWAT team member must integrate information on the fly, making critical decisions by "instinct" alone. Such instinct, however, is actually highly automatized skill. The expert scalper integrates a huge amount of information from price, volume, time of day, and shifts in the depth of market. This integration, however, is not a deliberative process. It is built into the scalper's perception. Just as a batter must quickly integrate information about the pitcher's delivery, the rotation of the ball, the location of the pitch, and the pitch count in order to decide whether or not to swing, the scalper cannot afford the luxury of deliberation. An entire trade may last but a few seconds.

Perceptually-based expertise is an evolutionary necessity. There are many life situations--from avoiding an oncoming car to responding to a complex social interaction--that require us to react more quickly than we can explicitly process. As I describe in my book, it is the function of training to immerse performers in the real-time patterns of a performance field to hone this perceptually-based expertise. This is one way in which the training of short-term traders is more similar to that of expert athletes than to Supreme Court justices. Investors can learn to weigh evidence and render reasonable decisions like judges. Very short-term traders, however, need their expertise built into their perceptual systems. They are more like race car drivers navigating a speedway than vacationers consulting maps for destinations.

A while back, I questioned several myths of trading psychology and indicated that there is a common process that underlies the acquisition of expertise. What we can see from the above discussion, in addition, is that trading itself requires very different forms of expertise, based partly on the market participant's time frame. The longer the timeframe, the more important the role of explicit deliberation and reasoning. The shorter the timeframe, the greater the need for rapid perceptual processing based upon pattern recognition.

When, however, a trader operates at a time frame that is intraday, but not at the level of scalping ticks, we have a unique cognitive challenge: the need to integrate perceptually-based expertise with an explicit knowledge base. Or, more simply, the need to integrate one's instincts with one's reason. The emergency room surgeon is a good example of an expert who must achieve such an integration: making rapid, on-the-fly judgements with a dying patient, but also bringing to bear a wealth of factual information regarding proper treatment. A trader who manages positions lasting minutes to hours must respond quickly to real-time market developments, but also must constantly process explicit information about where value is located, who is participating in the market, whether buying or selling sentiment is prevailing, etc. Many, many traders stumble because they lack the training to coordinate what they know and what they see. They are trading a time frame that requires, not one, but two forms of expertise.

Many challenges of trading performance--those seeming sabotages--are not a function of personality problems. Rather, they are the result of faulty integration of these two forms of expertise. That is why we may know the right trade to make, but not see it in time to put the trade on. Similarly, we might see a great trade and then talk ourselves out of it. It's as if we have two brains: one trained to respond instantly to our perceptions, the other trained to weigh relevant evidence. In some ways, it's easier to be a pure scalper or a pure long-term investor. The scalper can operate pretty much on auto-pilot, responding to shifts in the order book and from trade to trade. The long-term investor can accumulate research and review markets weekly.

But what happens when we follow the markets short-term, tick-by-tick (like a scalper) but make decisions based upon planned setups (like an investor)? We run the risk of having one set of mental inputs and outputs interfere with the other. How to deal with this challenge? That will be the topic of my next post. For now, however, let me suggest a basic principle: Trades must be managed on the same basis on which they were put on. That means that, if planned, reasoned criteria put us into the trade, we need a set of planned, reasoned criteria to manage the trade, and we need to limit our tracking of the market to those criteria. Conversely, if our gut put us into the trade, we need to manage the trade by what we perceive, not by all the possibilities of what we *think* might happen.

Trading problems begin when we enter trades by one information-processing system, but manage them by another.


22 comments:

Paulo de León said...

Excelent Post. I´m currently diversifying mi intraday trading, trading longer term (instead of minutes, maybe days).
For me is refresing to switch from a rapid fire trading into something more planned. It´s like placing the emotional part of trading in different places.
I´m really looking forward for your next post on the topic.

Brett Steenbarger, Ph.D. said...

Hi Paulo,

You raise a great issue, which is finding the right fit between your cognitive style and your trading style. I think that's where many traders run aground. They don't know their cognitive style and thus try to trade in ways that don't fit them.

Brett

AnaTrader said...

Brett

Quoting you:
But what happens when we follow the markets short-term, tick-by-tick (like a scalper) but make decisions based upon planned setups (like an investor)? Unquote

I trade more intraday for ES, and should immerse myself like a fighter pilot?

I have read your latest book once, and I think what you propose to cover has to do with cognitive and behavioral techniques?

D TradeIdeas said...

A great enlightening article. It helps put my firm's technology into a larger context and for that I am grateful for these ideas!

Brett Steenbarger, Ph.D. said...

Hi AnaTrader,

Cognitive and behavioral methods are techniques for changing patterns of thought and emotion. They are relevant to information processing, but mainly when emotional patterns are interfering with reading patterns in markets.

Intraday trading is interesting in that sometimes it entails highly planned trades over longer intraday periods and sometimes it entails quick pattern recognition over short periods. Not all intraday traders are like fighter pilots for that reason--

Brett

Brett Steenbarger, Ph.D. said...

Thanks, David. It *is* interesting to think of trading tools as cognitive aids--

Brett

Dinosaur Trader said...

Brett,

Wonderful post. Thank you for sharing this kind of insight.

I've been having difficulties for some time now. Lots of "classic" mistakes, the most obvious has been holding losers and cutting winners short.

I've been an "instinct" trader for some time. But lately, I've lost confidence in this "instinct" and have tried to study things more. It's a work in progress. Have you seen traders change successfully from one style to another? or could I just be barking up the wrong tree?

Thanks, DT

MIsstrade said...

I love this post. Your book and your daily stuff is truly the best. Opaque yet direct for each individual. I try to enter each trade with direct goals of risk and time. This helps in all types of trades. Some for me are intraday, some are swing trades for a day to weeks. Some are very long term. The key for me is still establishing risk upfront and some idea of time frame. That puts me at ease.

MikeH said...

Another great post, of course.

I think the football analogy from "Mind over Markets" fits the intraday trader profile. Before the trading session, you do your pure analytical work - study the market's action over different time frames, what direction it has headed and what future action it may take, and your performance. Much like a player studying film of the opponent, their own playbook, and sharpening their strengths and weaknesses in practice.

At game time during a play, it's the instinctive/intuitive mind that directs your actions when it recognizes your setup.

Perhaps the most difficult item I am learning to come to terms with is that a good portion of my trades fly in the face of my analytical study. A lot of times I don't even look at my notes once I begin, and at times they seem like a wasted effort. I just have to trust that this work is the basis of my intuitive flow state when trading my best.

Brett Steenbarger, Ph.D. said...

Hi Dinosaur,

I do think it's difficult to change time frames, precisely because it's also changing how we process information. FWIW, my experience is that short-term traders have been more successful moving to other markets and retaining their short-term style than moving to longer time frames in the same markets.

Brett

Brett Steenbarger, Ph.D. said...

Hi Misstrade,

Great point; thanks for the comment. Setting those goals of risk and time very much can help a trader stay grounded. I'll be touching on that shortly in an upcoming post.

Brett

Brett Steenbarger, Ph.D. said...

Hi Mike,

Great point. The research and preparation can alert us to past tendencies, but it's what's happening now that will ultimately shape short-term trading decisions. The football analogy is right on: the preparation is important, but games are won by split second decisions by quarterbacks, running backs, defenses, etc. Thanks for the comment--

Brett

John Friedrich said...

Brett,

I believe knowledge that has genuine value comes from the ability separate levels that have previously been confused. It is easy to spot such confusions as they are usually wrapped in emotional language. "Sabatage" is such an example. You have eloquently separated two levels that have been confused for shorter term traders, like myself. I can certainly identify with the internal conflicts you describe. When things are not going well with my trading I often find myself wanting to retreat to a scalping time frame or abandon the short term time frame altogether and limit my trading to investment decisions. Perhaps now, with your insight, I can follow this internal dialogue without feeling confused, and, perhaps with a little patience I will be able to interpret the meaning of these dialogues with greater skill and profitabilty - now that is real value.

Thank you.

Brett Steenbarger, Ph.D. said...

Hi John,

Great observation; thanks. Many times we shift time frames when trades don't go well, altering not only the trade, but our ways of processing it.

Brett

Nicholas said...

This post probably represents the largest problem I have with my trading. I enjoy trading options on a swing/momentum basis, my holding periods last from a couple days to 1-2 months. But because options are so volatile, my stops can be suddenly reached within minutes/hours intraday during price spikes. This often puts me in situations where I must react with so called "instinct", even though the longer term plan I had mustered from technical/fundamental data may be intact. Poor decisions are easy to make in such situations.

Brandon Wilhite said...

Brett,

Great posts lately. I'm sure I've mentioned in the past my interest in epistemology, so I find all of this really interesting. I could probably give at least three or four more examples off the top of my head of how that area can be helpful to traders....but I also find it interesting from the philosophical end too. I think that trading provides a very interesting sort of "laboratory" for the philosopher.

At any rate, I look forward to reading your next post. I think you're right on with keeping the management of the trade consistent with the 'cognitive style' from which you placed the trade. I also think that a related idea might be this: Indicators should be used for the rapid processing, analysis, and integration of knowledge the trader already possesses. This is in contrast to many traders' seeming belief (based on their actions) that indicators give them knew knowledge. In other words, if you don't understand your indicator in a detailed way, maybe it's not as useful to you as you think...

I guess this is why I've always felt uncomfortable with most indicators in the past, because I've never understood how they really added to my knowledge. But as my trading becomes more complex and I develop my own framework to trade from...I find myself developing better and faster ways to process the data through the knowledge that I possess.

BW

John Cook said...

Brett,

Your research into trader performace is unmatched. I just stopped trading again to adjust my plan because I wasn't getting the results I expaected. After reading your last two posts you explained exactley the issues I was having. I wish I could repay all the value I have gotten from your site, but I don't think my trading accout would recover the huge hit. Thanks again for the great work.

Cheers,

John

John Cook said...

The other question I have for you is how do you determine what your cognitive syle would be?

John

Brett Steenbarger, Ph.D. said...

Thanks, Nicholas, for articulating a problem that affects many traders. The thing to evaluate is whether your short-term managing of those positions actually contributes *overall* to P/L. Many times what we do to manage volatility and drawdown during a planned trade actually reduces overall performance, because it is so reactive. It helps to trade size small enough that you can comfortably ride out the noise, and it helps to use mental rehearsals and simulation trading to develop the habit of riding out noise.

Brett

Brett Steenbarger, Ph.D. said...

Hi Brandon,

Great point. The best indicators are ones that conceptually integrate large amounts of data for you, much like lab tests might do for a physician.

Brett

Brett Steenbarger, Ph.D. said...

Hi John,

Thanks for the notes. I do think the exercise I mentioned in the most recent post can aid traders in identifying the time frame (and hence the cognitive style) they are most comfortable with and adept at. By investigating how you make decisions in other parts of your life (explicit reasoning, intuition and gut), you can also gain a sense for what might work for you in trading--

Brett

Héctor said...

You have opened my eyes! Switching from one trading system to another without the proper exit strategy is one of my mistakes! Thanks a lot!