Saturday, December 08, 2007

Market Myopia

Does watching the market tick-by-tick improve your trading returns? Clearly, if you're scalping the market (trying to buy bids and sell offers), you have to be glued to the screen. If, however, you're trading over time frames lasting an hour or more, does it add value to be glued to the screen? Does watching each tick lead to better trading decisions or returns, or does it lead to a kind of myopia in which we become reactive and no longer follow our original trading ideas?

My sense is that watching markets tick-by-tick often stems from an illusion of control: that, by monitoring events tightly, we can somehow better control them. Research suggests, however, that getting more feedback about investments leads to risk aversion and reduced returns. This myopia stems from the fact that we tend to perceive meaningful patterns in events even when those aren't present. When we watch markets tick-by-tick, we begin to see patterns that we believe are indicative of shifting supply and demand. This perception leads us to exit positions before they've reached their target or delay entering positions that otherwise offer favorable reward:risk.

I also get the sense that some traders equate working hard with being glued to screens. In reality, the hard work of trading lies in what comes prior to putting the trade on: the research and analysis that pull together observations across markets and time frames to generate valid ideas. To the extent that tracking markets tick-by-tick is an expression of anxiety over one's position, it is not only not productive (in the research/analysis sense), but is actively destructive (keeping oneself in a mindset that is harmful to sound decision-making).

A very useful exercise is to define your trading rules so that you can clearly identify a stop and a target for each of your trades. Then you can see how your discretionary management of the position adds value to simply following those rules. By cutting winners short and delaying entries into good ideas, the trader glued to the screen reduces the risk:reward potential of each trade. Perhaps that is why frustrated traders who are "working hard" find that their trades are hardly working.

RELEVANT POSTS:

* Inside the Trader's Brain

* Four Insightful Studies
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6 comments:

mse said...

Synchronicity - last night I was writing something exactly along these lines before reading your post. I think we as traders need to be very aware of the negative effects of the work ethic on trading activities. For example, I struggle with profitable trades being "too easy" for real work, as if the profits are not quite deserved even though endless analysis led eventually to the trade. It is like the cliche about being guilty of overnight success that took 10 years to achieve.

Jeff Pietsch CFA, Esq said...

This is a truism if I've ever seen one. Holds up in all but the shortest of time frames. Many pitfalls can be avoided by heeding this advice. Your wallet will be fatter, and you will sleep better at night.

Ziad said...

mse's comment is right on the button. I too struggle with profitability that seems too easy. Over the last few months I have developed an ability to locate strong support and resistance levels quite accurately before the market opens, such that the vast majority of times the levels are almost exactly where reversals end up happening, or at the very least a decent reaction is seen. This in itself is an edge such that you can fade at those levels quite profitably just as long as you can recognize the rare strong trending moves and steer clear of them. But interestingly enough, I find myself thinking "this is too easy", and wanting to do analysis before putting the trade on, and watching it very closely once it is on. It's as if I do feel that "guilt" that trading shouldn't be this easy. And also, on a deeper level, I have this notion in my mind that true trading skill equates to being able to know what specific action to take in different scenarios (exactly when to enter, and where to exit), instead of just applying a general trading edge and letting the probabilities do the work for you. This is a theme that I have been contemplating for quite some time now...

Jeff said...

Dr. Brett, do you have any additional suggestion (how to avoid market myopia) for scalpers?

procol said...

Once again, you hit a very important nail on it's pointy head.

I'd like to add another coal to this particular fire.

Participants in the market (hedge, mutual, size traders) have an incentive to bluff and paint the tape as much as they can in a direction OPPOSITE their true intention.

Tick watching can make you a 'victim' of these efforts, unless you are very experienced in detecting these feints.

Less can be more in this case ,as you are more likely to hold to your target when you are not being hustled.

Brett Steenbarger, Ph.D. said...

Hi,

Thanks for the excellent observations. Jeff, by focusing on specific setups and limiting what you look at, you can avoid the myopia that's caused by seeing too much (and reading too much into it).

Brett