Saturday, January 02, 2010

Decision-Making in Trading: How Simplicity Becomes Simplistic

The recent post on generating trading ideas offers an opportunity for traders to reflect upon their own decision-making processes and where those might be strengthened.

Sometimes the basic decision-making process is sound, but is disrupted by situational cognitive and emotional factors.

Other times, the decision-making process falls short by not taking into account the information most important in generating promising hypotheses.

I see this particularly among traders who seek simplicity and wind up trading simplistic setups that ultimately lack any edge. Consider the following:

* A trader sees a chart pattern on one time frame and decides on that basis to buy or sell;

* A trader sees strength or weakness and jumps in to "follow the trend";

* A trader sees price holding at a certain level and enters a position based on that information;

* A trader hears positive news and buys a stock;

* A trader sees that we have moved below a trend line or moving average line and sells the index.

In each case, a single observation is blown up into a full hypothesis. The observation, in itself, may be valuable, but it lacks the full amount of information that one would need for a promising hypothesis. It would be as if a physician took a single test result (one's temperature, blood count, or pulse rate) and made a diagnosis on that basis.

If a person bought a car because it had a large engine or because it had a nice interior, we would think the person foolish for making such an important decision based upon such superficial and limited information. I find, however, that traders routinely engage in a similar process. They will buy or sell because of particular oscillator readings, chart formations, or numerological relationships.

I have found that a major reason that simplicity in process devolves into simplistic thinking is that traders narrow their field of vision when they are under stress. They focus on what is immediately presented and feel the impulsive need to engage in either flight or fight. This narrowing of vision prevents the trader from taking in the entire range of data at the time and making the most informed decision.

Suppose, for instance, that a quarterback steps back to pass and faces a blitz by the opposing linebackers. The quarterback feels a panicky need to get rid of the ball, focuses on one primary receiver, and throws the ball into coverage, risking an interception. Compare that to the quarterback who scrambles out of the pocket when under pressure, takes a moment to survey the entire field, and selects a secondary receiver who is left uncovered in the middle of the field.

It's that ability to see the whole field under pressure that distinguishes many of the best traders from many of the rest. Anyone can pick out the right targets when they have all the time in the world; the challenge is learning decision-making so well--and making it so second nature--that the right actions will come to you even in the heat of the moment. That is why practice under realistic conditions, eventually with money on the line, is crucial to the developing trader: We learn to perform only by repeatedly facing the pressures of risk, reward, gain, and loss.

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5 comments:

Bob said...

Well Sir, I guess you aren't the prime demographic for buying a Dodge Viper if you think buying due to a huge engine is foolish! :)

For me, having stochs oversold in an up trend is an alert to a possible trade setup but, as you said, it isn't nearly enough information to act on. Looking to see if a trendline or channel can be drawn, seeing how the 20 or 50 day MA's interact (swing trader here), fib grids, etc... are necessary to gain the confidence to place an order.

Is it on the 3rd wave or should an ABC retracement be expected? Is volume acting appropriately? There are a million things to consider and they will never all line up perfectly. Finding the time when ENOUGH of them do line up however is the game we (or at least I) play.

Thanks for the insights
-Bob

Gustavo's Trades said...

Great posting Brett, for the type of trading I do, I have the benefit of time in my favor, I can usually hedge a position and take time between market sessions to evaluate alternatives and outcomes.

This extra time is a blessing but can also become an issue: with so much time, and so many options, how do you know you made the right choice?

Having too many options and time to think about them can clutter your mind and put a lot of anxiety. So I created and use a simple decision-making tree to figure out, in objective terms, the best alternative to follow.

The concept is simple, each branch is a course of action, and they have possible outcomes with probabilities and P/L impacts. Once you outline the options, their outcomes and P/L impacts, the spreadsheet gives you the best alternative.

Now, this is of course not something you can do in the heat of battle. But I suppose a trader can run the decision-making tree with common scenarios to help him/her know and justify to oneself why he/she is taking one action vs. another with a certain condition appears.

Here are a recent examples:
http://gustavotrades.blogspot.com/2009/12/1230-decision-making-process-should-i.html

Cheers!
Gustavo

Radek Dobias, H.B.Sc., M.W.S., B.Ed. said...

Another classic, Brett.

I would suggest that good trading decisions go through three stages:

1) simplicity - initial appearance of a seeming edge. Example: one notices a familiar set-up, say a pullback during a trending day.

2) complexity - additional factors are considered. Example: one factors in volume, order flow, other markets, volatility...etc.

3) simplicity after complexity - decision is reached by considering if the set up has an edge given factors consider in #2.

The final decision is simple, though the process is not.

Curtis said...

Dr. Steenbarger's hypothesis is that trading is a performance activity but there is another counter hypothesis that trading is more or less an automated activity based on statistical models.

If an indicator really offers an edge then context may not be relevant.

Another underlying theme is whether or not the trader has a true advantage or only a slight advantage. The "slight" advantage hypothesis basically states a trader can't add much value beyond making slight adjustments.

Working under the soft edge hypothesis, the trader will want to avoid making too many trading decisions and should only make very key strategical decisions.

The alternative is the trader is trading a very defined edge which will determine his performance.

What about a trader that has a true edge and wants to add discretion? This is fine too and easy to calculate if value was added.

TechVested said...

Hi Dr Brett :
As we go into a brand new year..
One thing has been bugging me...

a) Do I continue to devote more time and effort to trading .
I love trading and can spend hours on end reading trading books and analyzing charts.
However, I am unsure of the quantum of profits (if any) that may result from this "passion"

or

b) Do I shift my efforts to starting a small business as my friends has been encouraging me where I somehow know the chances are better for greater profits.
Entrepreneurship is not really my passion but I believe I will somehow be able to etch out a living.


I know there is no right or wrong answers for this... Just really wish to know your "Psychologist" point of view on what my consideration or course of action should be .

ps: I am holding a reasonably well -paid full time job and do not intend to do anything rash soon.

Best Regards,
Sam