Explaining trading logic and overcoming cognitive biases – Guest Trader

Today Anand turns to the psychology of trading and it’s an issue we like to highlight ourselves. In my mind the psychology side of trading is probably one of the most important aspects. If we can’t get to grips with our own minds how can we get to grips with trading? Anyway, enough of my thoughts, this is Anand’s slot so I’ll leave him to it.

His previous posts can be found here

Marcel Proust

Marcel Proust

“People wish to learn to swim and at the same time to keep one foot on the ground” – Marcel Proust

Learning to trade, much like learning anything, is like peeling back the skin of an onion. When we start we have preconceived notions of how to trade. We learn something new and think we know everything, as we are not capable of knowing what we do not know (unknown unknowns). The learning curve continues (if we can survive). At each stage of learning we peel another layer of the onion. We will usually vigorously defend our take on things sometimes dogmatically.

In my case I started like many traders in the equity markets then branched out into other areas. Incidentally I now believe trading single stocks is one of the hardest markets in which to consistently succeed, despite it being most popular due to easy access. This is because 1) Number of variables which affect a stock 2) Number of traders tracking shares 3) The fact professional managers, rather than owner managers, are actually incentivised to destroy company value and not create it 4) Company management regularly deceive investors through aggressive ‘earnings management’ practises 5) The equity markets are rife with insider trading .. not just in the cowboy small cap markets, but all the way up into the mega caps stocks.

The first layer of the onion usually takes the form of what I like to call ‘common sense trading’. This basically takes the form of the following type of logic;

The ECB has lowered interest rates therefore the Euro is now less attractive than the dollar … so I’ll sell EURUSD.

I should also point out that most of the sell side still use this type of rationale as it serves their purpose. Anyway the trading statement I made above may sound appealing but it has several logical flaws which I will explain;

  1. It assumes EURUSD was fairly priced before the ECB made the rate announcement
  2. It assumes EURUSD will price this rate move quickly or at least in the near term
  3. It assumes EURUSD will price in the correct amount of movement following the rate announcement

It inevitably leads those who use this type of ‘piecemeal fundamental analysis’ to question ‘whether something was priced in or not’ which is impossible to ever reach a conclusion on.

The truth I believe is that markets are hardly ever fairly priced, but in the long term will move around a fair value (which itself is moving according to changing conditions). Therefore to trade on fundamentals is valid, but only in the very long term, by that I mean on the basis of at least many months if not years (with the exception of agricultural commodities which I believe have a relatively short feedback loop between fundamentals and price action due to short term supply/demand dynamics in the physical market which are bound to their related financial markets. This is largely why I like to trade them).

To fundamentally analyse a market on a piecemeal basis doesn’t work, as you never know what the starting point was i.e. what was the fair value, before one variable’s impact (news, data or whatever) is taken into account. You have to take all variables which feed into the price into account. {A recent example of where you can see this in force is when a company like Tesla for example in the US is valued at an earth shattering valuation, the management pumps the stock with a release on a new store in Holland/China/Outer space or plans to build a battery factory and the stock lurches even higher, as this must be good news, right? Ah … yes the eternal question “but was it already priced in?”} J The industry will never talk about this, as it’s just not good for business, as every salesman knows, nothing sells like a good story (the human mind is wired to follow narratives, more on our primitive human mind below).

Therefore I believe as a short term trader (by this I mean not a long term investor with a time frame in at least months if not years) what are you actually left with? Well, I would suggest, you only have market behaviour to go on. You are essentially looking at past behaviour (even if you are looking at orders in the market, left only a second ago, they are still orders left in the past) and attempting to predict what will happen in the future.

An example would be when using basic support/resistance levels. All a support level does is say that a buyer(s) was for instance buying something at a certain level, so perhaps they will come in and start buying at that level again. Hardly, logic on which you’d like to put granny’s nest egg on … which is why to trade and survive you have to practise careful trade management. This means controlling your risk through stop losses and more importantly sizing positions conservatively and intelligently. If you risk 2.5% of your overall book to each trade, it will take 40 bad trades to wipe you out completely, in reality most wouldn’t get that far, the emotional pain suffered once a large percentage of your book is wiped out would probably result in an individual giving up {or if you are a mercenary trading for a firm, you may continue marching into the office each day in a state of utter despair, probably planning an exit strategy of some kind}.

The inevitable losses on your journey are why you have to love the game and not the money, (perceived) glamour or status that comes with trading. I personally believe to become a good trader you have to actually not be that interested in the money (which is what may at first seem attractive and draw you to this game) as the money generated is often ephemeral, after a certain level of money utterly pointless, with the glamour and status having no real worth anyway. This may seem strange, but then I believe to be a good trader you have to be abnormal in more ways than just not caring about the money.

The reason I say this is because as many traders have discussed (most notably Richard Dennis who is one of my idols) the human mind is wired up in the wrong way in order to trade effectively. These cognitive biases mean our natural impulses are actually telling us to usually do precisely the wrong thing at any one time. Our primitive brains are wired primarily for survival and replication … which means that as long as you feel ‘ok’ your mind would like to retain that state and not jeopardise it in any way. Traders such as Richard Dennis moved to systematic trading from discretionary trading as he believed this was a potential solution to trade without these cognitive biases forcing you to override your own ‘rules’.

It also fits with what Soros has often has said, which is that ‘trading is a painful activity’. What I think he meant is that to make optimal decisions you often have to suffer negative emotions through putting on trades you have a negative emotional reaction to (but a higher intelligence has told you to put on) and the emotional distress from short term losses. It’s what people mean when they talk about traders needing discipline. It’s probably also the reason that when you see a 35 year old professional trader, they usually look washed out and about 10 years older than they really are (it could also be the late nights and drug use but this is another matter). What I’d like to get across to new traders is that this isn’t going to be all fun and games. If you choose this it’s going to be a hard life, with a lot of pain (as discussed), sacrifice (lost time and energy which perhaps could be better spent elsewhere) and hard knocks along the way.

Key cognitive biases to be aware of;

  1. Loss Aversion… A preference for avoiding losses over acquiring gains
  2. Sunk Cost Effect… Treating money already spent as more valuable than money that may be spent in the future
  3.  Disposition Effect… A tendency to lock in gains and ride losses
  4.  Outcome Bias… A tendency to judge a decision by its outcome rather than the quality of the decision at the time it was made
  5.  Recency Bias… A tendency to weigh recent data or experience more than earlier data or experience
  6.  Anchoring… A tendency to rely too heavily or anchor on readily available information
  7.  Bandwagon effect… A tendency to believe things because other people believe them
  8.  Belief in Law of Small numbers… The tendency to draw unjustified conclusions from too little information

I believe that you can read all the trading books in the world (and I have bookshelves filled with them) but ultimately to learn how to trade you need to actually throw yourself in at the deep end and start trading. Learning through experience is the only way, as I believe the technical aspects of trading are fairly rudimentary. Yes complex systems exist, I have tried many, but in my experience they often don’t work any better and often are worse than the simplest techniques (which is why if you look at the charts I have produced they are child like in simplicity). What is really difficult is overcoming those cognitive biases and having the mental strength to do the right thing at the right time. It is not so much an intellectual test, as a test of one’s emotional and psychological strength. However, learning through doing will probably result in losses, perhaps you will be wiped out several times (if you look at the great traders of the past, this seemed frequently to be the case, interestingly they came back and tried again (and again), which is how I think they managed to gain enough reference experience to develop as great traders).

This brings me back to my initial quote from Proust, if you wish to learn how to swim you have to make a decision, if it’s what you want to do (please examine why you wish to do this), you have to just dive in, you can’t keep one foot on the ground. You may drown, there are without doubt sharks circling who may remove a leg, but ultimately it’s the only way to develop.

I wish you luck.

Author: Ryan Littlestone

Ryan Littlestone has been working in financial markets for more than 20 years. Wide-eyed, he stepped out of Bank station in London to join LME founding member Rudolf Wolff where he worked his way to the main order desk and brokered customer orders to the LME floor and across virtually every global market. An opportunity to help set up and run a new LIFFE floor operation saw him catch the trading bug and it wasn’t long before the pull of the pits was too great to refuse. He became a ‘local’ and has been trading his own account for more than 10 years.

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