Monday, February 25, 2008

Should You Really Trade What You See?

"Trade what you see" is a common mantra among short-term traders who formulate their trade ideas from charts. But do we process information from charts in accurate and non-biased ways?

An interesting set of studies reported in the 2003 Journal of Behavioral Finance suggest that perceptual biases in what we see can skew our trading and investment decisions.

Specifically, when investors see a chart that has a salient high point, they are more likely to want to buy that stock. When the chart depicts a salient low point, they are more apt to sell. In the words of the authors, "expectations about future prices assimilated to extreme past prices."

The authors found that, when a chart contained a highly noticeable high point, traders listed more favorable features of the stock; when the chart depicted a salient low, more negative aspects of the stock were emphasized. Their analyses suggest that charts affect investors by providing them with enhanced access to either positive or negative information about the stock. In other words, our processing of the chart creates a selective bias in retrieval, leading us to view shares in artificially positive or negative ways.

It isn't too far from the authors' finding to a broader psychological hypothesis that *any* highly salient feature of a trading situation may skew information retrieval, perception, and action. For instance, the salient information may be a recent large gain or loss; a dramatic market move; or a piece of news. Trading what we see might be dangerous for the same reason that it is dangerous to trade what we hear or what we feel.

When one facet of a situation becomes highly salient to us, we overweight it in our perception and information processing. Our ability to view the entire situation in perspective is compromised. What is most obvious in a chart--or in our minds--may not be an accurate reflection of underlying supply and demand in a marketplace.

RELATED POSTS:

Perceptual Distortions in the Market

Inside the Trader's Brain

Attribution and Bias in Trading
.

5 comments:

Bill aka NO DooDahs! said...

Sounds like a firm argument for automating a screening process?

LiggerPig said...

As someone who follows the mantra, all I can say is one trader's perception can be very different from another's.

I can't claim to have a good understanding of the psychology but I'm sure the studies' finding are true. The evidence is in the market every day, to a greater or lesser degree.

When I'm in a trade I'm biased, no doubt about that. What I try to do is think in terms of 'what do the longs/shorts want/need here?' and the result of what happens next.

To give a quick example of "trading what I see";

This afternoon (Monday) I perceived a big battle between bulls and bears. The bulls won with a good rally, leaving the bears running scared into the close.
To me that says ES will move higher at or before Tuesday's cash market open.
It's very common for others to now perceive ES is short-term overbought and require a pullback whereas 1372 was my pullback area to enter my long position.

The real danger of trading what you see, I think, is staying in a losing trade to prove you are right. Been there, done that....

Anatrader said...

Brett

Even a good accurate read of the charts does not guarantee a good trade; take the case of last Friday when in the last half hour of trading, the rumour of the bailout of the bond insurers upset the apple-cart, so to speak. Most indices reversed trends, going north.

WE still have to deal with any break out of the tight range of the market to the upside, then for it to settle down, and then we'll see a good risk/reward opportunity on the long side for a trade.

So, apart from technical analysis, fundamentals like surprise events or acts of God will affect our trade entries and exits.

We can only hope to get into a trade with the greatest probability of success on our side.

The Lonely Trader said...

Agree with liggerpig on his points. And although LP may not agree with me here, you have misappropriated and bastardized the term, effectively creating a straw man argument to make a very good point that most traders who "trade what they see" would agree with anyway. There is benefit in your message, and a bit of irony.

This is something that many psychologists are prone to, in my experience...

MPconvert said...

I think that this is true. As I trade more and learn more about he markets, the more I realize that a low is not a low and a high is not a high.....it's really just a price. Price is only a mechanism for conveying movement or direction. Past movement or price change is not always relevant to future moves. Our goal as traders is to follow the big money to position ourselves with those larger traders