Thursday, August 14, 2008

More Thoughts on Mindful and Mindless Trading

I was pleased to see that my recent post offering thoughts on trading stress and emotions generated a bit of controversy. I appreciate comments to the posts, including those that push back and stimulate a little more consideration of the issues involved.

The point that generated some discussion was my example of the currency trader who blindly entered a position in euro/U.S. dollar without any awareness that a key piece of economic data was coming out in Europe. It was a known market mover, and the trader was blown out of his position with a significant loss. My comment was that "this represents trading at its worst."

Here's why:

It's a question of awareness. Had the trader *known* about the report, known the expected volatility around the news, and placed his trade accordingly--sizing it to reflect the increased volatility and placing stops around the expected noise around the news--this could have been a fine trade. If you think, for instance, that the fundmentals support a weaker euro relative to the dollar because of bearish economic fundamentals in Europe and if you see technical reasons to be long U.S. dollar, then placing a core trade ahead of the news in anticipation that the news may be a catalyst for your trade could be *excellent* trading.

The key is that the trade is planned, with full awareness of what's happening in Europe and the U.S. and with conscious reasons for being in the market. The stop-loss point would reflect that point at which you decide that: a) the news is not a catalyst; b) the news is so dollar-bearish that the fundamentals have changed; or c) the move is sufficiently adverse that the technical picture has changed.

But, no, that's not what the trader in my example did.

He had no more reason for being in the trade in the first place than a simple, superficial chart pattern. The pattern involved short-term market strength, but was neither confirmed by any longer-term, contextual technical analysis or by any fundamental view. Was there overall bullish demand for the dollar or overall bearish supply overhanging the euro? The trader had no clue, never looked at other currency crosses. It was simply a shape on a chart, and it was never tested for any kind of edge. That was the first shortcoming.

The second shortcoming of the trade was that the stop was placed in ignorance of the news report and the increased volume/volatility of that market around the news. The same was true of position-sizing: the trader had large size on the position, in ignorance of the report. This greatly increased the odds that: a) the trade would get stopped out on normal, expectable noise around the trade; and b) the trader would lose a meaningful sum because of the trade sizing.

In short, it wasn't the fact that the trader was in the market before a news event that constituted bad trading. It was the fact that the trade was placed mindlessly, without thought and awareness, without any demonstrable edge, and without any realistic planning. "Here's a good shape on the chart, let's go for it," was the sum and substance of the trade idea. That's why it was "trading at its worst."

Too often, such mindless trading is justified by having a "feel" for the markets. Intuition is important in trading and can reflect a sophisticated pattern recognition that comes from years of experience. But even an intuitive currency trader (and I know several good ones) understands his/her markets and doesn't place large-size trades with relatively close stops ahead of market-moving news. Very often, intuition will prompt an idea; analysis will confirm it; and planning will guide the execution. There's no conflict between being discretionary/intuitive and being planned/thoughtful once you distinguish the genesis of an idea from its validation and execution.

Thanks for the opportunity to clarify an important issue. For another interesting debate on an important topic, check out the Daily Speculations site's recent back-and-forth about stop-losses and whether or not they add value. My short take on the question: they do add value, especially when they are conceptually based (i.e., based on considerations that the reasons underlying the trade have changed, not just based on a particular price/loss getting triggered) and when they are placed in the context of expected market volatility and proper position sizing.
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4 comments:

Ryan said...

Brett,

That was a thoughtful reply. It seems to me that the biggest question is whether or not the trader has an edge in the first place. If he does, then it might not be necessary to alter his trading or to avoid trading his strategies near economic releases. Of course, he might not know whether or not he has an edge until he takes such news into account. We can easily imagine a scenario where the increased volatility around economic releases is enough to erode his edge. How traders should handle this kind of information will differ according to their style. Rules-based traders might include economic news in their models. Or, as you so aptly pointed out, the trader might alter his stop losses in deference to the greater volatility. If his style involves discretionary trading, he might even decide to wait until after the news hits the market before opening his position. In conclusion, I didn't like your initial statement because it didn't seem to acknowledge the fact that economic news can be irrelevant if it doesn't significantly dilute your edge. But of course, that doesn't mean that such information should be ignored outright. And it would be especially perilous to ignore it if a trader hasn't demonstrated that he has an edge in the first place. I am in full agreement with you there. That is, indeed, the worst kind of trading.

dgov

The Financial Philosopher said...

This topic is one that is quite central to my financial philosophies as well as those of life in general. It demonstrates the struggle of mind vs. brain.

If we act mindlessly, our brain is doing our "thinking" for us. If we are "mindful," then we are using our reasoning capabilities to "think about thinking" -- we are using our mind.

The brain is essentially lazy and wants to take shortcuts -- the path of least resistance -- to reach the object of its desire -- much like a rat and its cheese.

The mind does not succumb to the desire of reaching an end in the quickest most efficient manner. The mind seeks understanding, value and meaning in the process itself -- the means -- with little thought of the end.

"The shortcut is the longest distance between two points." ~ Unknown Author

"Between the conception
And the creation
Between the emotion
And the response
Falls the Shadow" ~
T.S. Elliot, The Hollow Men

Thanks, Dr. Brett, for provoking thought with this post...

Kent (The Financial Philosopher)

MarcoA said...

You post says, "... the trader was blown out of his position with a significant loss". Why was the loss on this trade more significant that on any other? Was it because of his entry or his risk management?

Brett Steenbarger, Ph.D. said...

Thanks, Ryan and Kent, for the thoughtful comments on the post. Marcoa, the trader incurred a large loss because he set a mental stop and the market blew through it while he had a full-size position.

Brett