Back then, in 1993 – 1994, it wasn’t easy to be a short-term trader. I mean very few people had access to quotes or commission rates that would make it remotely possible. Hardly anyone outside of the neighborhood of LaSalle and VanBuren in Chicago even remotely knew what I was talking about. Almost everyone I was trading with had been on the floor of the exchange. In fact, that was really the only way into any kind of short term trading for a living. It was a small and relatively privileged group.

Enter the internet and brokers and traders who want to make some money off of teaching other people supposedly how to trade and now way too many people say “All I want to be is a day-trader”.

It isn’t for the money. The vast majority lose. So what is it?

I believe I know the answer – and it isn’t the lip-service ideas about gambling or thrill. It might be not having a boss or employees but I think it goes deeper than that… What do you think?

Yet underlying much of what I hear is still the SAME assumption – control your emotions and in turn control your thinking. But ironically NOTHING could be further from the truth. Know your emotions – yes. Control – NO. Plus, why doesn’t it occur to anyone that logically you only have to control your actions… and emotions and actions are actually two different things.

It is actually a case of “focus bias” or the tendency to confirm what you already think that even though many many scholars and practitioners are interested now in investing behavior, their discussions return right to the same underlying and outdated theories.

If you don’t have your emotional neural networks working, you can’t decide what to wear in the morning and chances are, you may not even recognize clothes as clothes! The latest research shows we need the contextual information – which we feel – for our visual cortices to work.

I am thrilled in the interest … but now let’s take it a step further and get down to business figuring out how to understand and leverage the difference between Emotional Intelligence, blink and The Black Swan!

1. You need to know what you are looking for – both to enter the market and to exit.

2. You need to know what the variations on #1 are – and what they are not!

3. You need to know what is imprecise about what you are looking for – it is more than you think.

4. You need to have thought about the imprecision long before you sit in front of the screen and certainly not just as you push the button.

5. You need to know what it will feel like if you turn out to be wrong.

6. You need to know how you will handle, manage, learn from and deal with that feeling.

7. You need to know what it will feel like if you are right – and again, how you will handle, manage, learn from and deal with it.

8. You need to know how to operate on the premise that “perfect is the enemy of the good”.

“Assumption” you say? “It isn’t an assumption Denise! It is truth!” Oh really?

First, if it is such a natural truth – like gravity or the sun rising in the east – then why is it so unnatural to do it? Why do day-traders fail at it at an alarming rate while institutions (with their MBA’s and statisticians) also fail at it has been demonstrated through the now 1000’s of behavioral finance studies and real world examples?

Aside from that basic question is the even more important one of “how does the human brain most successfully process market data“? And luckily The Journal of Finance has finally decided to publish what in my opinion is essentially earth-shattering research by Quartz, Bossaerts and Bruguier of The California Institute of Technology. This seminal and singular piece of research sheds a whole new light on the neurological processes involved in accurately reading markets. (And to boot it in turn explains why so many traders fail and why so many institutional traders can get it wrong!)

In short, …”tests show that Theory of Mind (ToM), rather than mathematical, abilities are better predictors of success in forecasting stock markets“.

Of course this begs the question… “what does that mean”? ToM is basically the ability to read other people. It is the mental capacity where you can imagine/see/”know” what they are thinking and feeling and therefore be better predictors of their coming choices of action. (See wikipedia)

In other words, if we go back and look for example at a very public decision – that of Hank Paulson to let Lehman go bankrupt – it had everything to do with the pressure he was under over the idea of “moral hazard” and very little to do with anything else.

Now that example doesn’t help you much when the market is slow and plodding and range bound but I use it because in retrospect it helps people see how a concerted effort in the Summer of 2008 to understand the human dynamics of the decision makers scenarios would have yielded a better idea about what was likely to happen. What I mean by that is if you specifically tried to play out the possibilities post Bear Stearns and pre-Lehman…. you would have come up with “they let at least one bank fail”. Once you had that idea you could see AIG was going down too!

Conversely all the modeling and probability thinking in the world would NEVER have gotten you there!

You can read the original research yourself @ Encoding Financial Signals in the Brain … or on the Social Science Research Network. (The latter compels me to point out that Antoine (Tony), whom I have been bugging for over two years about this, is an Electrical Engineer and he was kind enough to email me this week and let me know the paper had finally been accepted!)

Now the question is how much will the behavioral finance tendencies of status-quo and confirmation bias kick in … and prevent a large majority of people who care about reading markets from really grasping how to capitalize on an assumption turned upside down?

1.    Realize that numbers reveal only ¾ of the picture.
2.    To see 99%, wrap all numbers in a cocoon of qualitative data.
3.    Elevate qualitative analyses to the level of quantitative analyses.
4.    Leverage how all human brains interpret uncertainty.
5.    Differentiate implicit learning from impulse.
5.    Never forget which game you are playing – poker or rugby.

Given that I was actually in the Wall Street subway station and could barely hear, I said “Sure I can stop by after my lunch appointment with the Director of Research @  fund of funds X (hec just because I also share an apartment and two dogs with the man I was meeting didn’t seem THAT relevant)  I figured (assumed) they must want me to talk about the same thing I just got done talking about – how key levels play themselves out in market reversals.

Guess again – and note to self NEVER EVER – even if it is Charlie Gibson (or his proxy) calling skip the pre-interview! The point of the segment was to say that Friday morning’s drop in consumer confidence caused the Monday morning market swoon. But hec, to me, the discretionary high-frequency trader, Friday morning could have been 2001 by Monday afternoon.

But of course, I am the odd man out here – and not viewing the markets the way the “average investor” does. It also brings up some thoughts about the markets really do work – or the infinite loop between fundamentals, facts and fear.

Many traders and investors work off “fundamentals” – i.e. company prospects or economic data. Many traders work off “facts” i.e. the actual price something is trading at and the relationship of that price to prices gone before (some may not think these are enough but they are indeed facts – the S&P is trading right this moment at 984.50 and that IS a fact) and we all can get caught up in the two kinds of fear that drive the market – fear of losing and fear of missing out.

An uncanny phenomenon however is how the facts and the fundamentals converge. Last Friday we had been trading for 8 days at the November highs in the ES S&P mini futures contract when a worse than expected US Consumer confidence number was released – causing the market to take an intraday swoon. Now that swoon was in the making regardless in that we had failed to close above the key swing high for days and days.

So I simply saw it as a failure of a key level – but David Muir saw it as a disappointing confidence reading. Was one of us more right than the other? (Okay I am biased but)… In reality, NO. The two are different lenses used for different types of “photographs” but both explain the subsequent price action.

Fear may be the trump card – if we are rallying hard off of a low – like one made in March – there is a rush to get in and not miss out. If we are falling hard, like we did last Fall, there is a similar albeit more violent rush to get out. And here we are right back in the loop as those rushes change the facts (price) and price influences the fundamentals – at least consumer confidence and a whole slew of other economic or company earnings data.

The lesson here – enter this infinite loop through any door – fear, facts or fundamentals. Just know which one it is so you have the breadcrumb path to get back out!

Why? Well in studying various forms of technical analysis since 1994 I knew a bit about candles, EW, Drummond geometry, fibonacci’s … you name it. All seemed to have some value. When actually I finally listened to someone who understood auction market theory I realized that every thing I more or less knew about TA was encapsulated in a market profile chart.

Case in point was yesterday. I wasn’t really planning on trading but I keep my basic ES market profile chart up. I could see (and tweeted to Twitter (@traderpsyches)) that we were developing a trend day down in the AM. Each of the first four half hour periods had lower lows and lower highs … and then I saw it. I shove lower and a bounce…. right to the highest volume node (Tom calls them key reference areas or kra’s.? (He is @kratrader on twitter and stocktwits) of the day.

Now when more volume has accumulated at a price (over time), that means there are lots of traders in trades where that is their break even point. It tends to mean they will add to their trade there – or defend it – or if they were long from there, in this case, they will be back to break even and get out. Since I was going short, it basically meant we shouldn’t go too far through that price because of those traders who care about that price. If we do, well then they have been overwhelmed by another group. In short, (no pun), it meant this was a good place to be short.

I put a tight stop in at 941 (trade entered at 939). My Ninja trader platform helped a whole lot here because we did in fact trade at 941 but I was not taken out because my Ninja strategy is set to trigger the stop only if there are less than 50 trades on the offer (in the short scenario).

It took a fair amount of having to talk through the chop and slop but then around 1 p.m. (over an hour into the trade) …. whoosh…. and a basic 10 points I had.

I looked at the drop. Trailed my stop (which Ninja would do automatically I just didn’t have it set up in this strategy)? and then saw we really were at the next KRA or high volume node from two days earlier – again a place where other traders will be more willing to be involved because many of them already are involved at that price. So I covered… knowing it might go lower.

In the end, I think I covered about as well as could be expected. In other words, the whole thing was almost the perfect trade. (In contrast to Monday when I tweeted about rotating back into the range just prior to the violent move upward – and then wrote about it on Greenfaucet.com)

The long and the short of it is – market development as can easily be seen through a market profile chart and as taught by Tom Alexander hugely simplifies the process of understanding the market – for me. I suggest everyone take a look -

Alexander Trading

Ninja Trader

(btw they don’t know I am writing this and I won’t get anything for it…it just works and that trade went so well and was so public on twitter that it seemed right to explain).

btw2 – if you have trading strategies and tactics that you really understand and feel good about – PLEASE IGNORE all of this!! Please!)

But why should it be?

Technically the market has to take out the last high which at a minimum is ES 942.75 and clearly on its last two tries it couldn’t get through the 875 area. As Boaz Weinstein who I wrote about last week was prone to say “this isn’t rocket surgery.” Bear markets are bear markets as long as you get lower highs… which is exactly what we have… the only question is WHEN not where will the next low be?

to be continued ….

Having just received (Thanks Sandy!) my copy of NEUROECONOMICS, Decision Making and the Brain, edited by Paul Glimcher (NYU), Colin Camerer (Cal-Tech) Ernst Fehr (University of Zurich (wonder if our French PhD Chick knows him?)) and Russell Poldrack, UCLA, I personally am all giddy over the avalanche of research demonstrating what I have been karping about for years now – feelings & emotions are part and parcel of all decisions – so we might as well figure out how to use those ephemeral psychological dimensions to our advantage.

To quote (and back to the topic) “Over the first decade of its existence, neuroeconomics has engendered raucous debates…” Raucous debates – over neurons? Really? … well you see, scientific advances typically are met with great resistance. (See Structure of Scientific Revolutions by Thomas Kuhn). In my mind, it was Damasio and Descartes Error that got this field going. He is the now USC neuroscientist (Iowa before) who studies the unfortunate individuals who have had the experience of brain damage that destroys their ability to feel emotion but leaves their cognitive capacities intact.

Neuroeconomics itself however is simply the study of what brain anatomy and functions are happening while we are making decisions that involve financial or social rewards – i.e. money in the former. The idea is that no matter what else anyone wants to theorize, that in the end, seeing what the brain does and how it does it will settle once and for all how our minds really work.

For our purposes it is about how we perceive and react to “risk”. Of course the neuroeconomists (and John Keynes before them) don’t think as traders we are dealing with risk. Risk to them is precise and knowable – i.e. likelihood of drawing an ace in a four-player one deck game of blackjack. Markets however are unknown, imprecise and ambigous – always.

The whole idea of psychological capital is therefore to maximize that side of the “probability” so that the judgments we make regarding the unknown, imprecise and ambigous prices can be the best judgments.

A couple of things to keep in mind

1. The brain assumes the next trade will be the same as the last – which is why you want to press it after winners and get skiddish after losers.
2. The brain knows the difference between card games and markets – even if we try to make markets look like card games. (We are better served to remain conscious that we are trying to trick our innate brain’s ability)
3. An upcoming study will demonstrate that it is the ability to read the other – not the ability to think in probabilities that is the real skill in trading.

…. okay the text is 8.5 x 11 and 500 pages long so they have lots more to say besides that…. but all in all, you might not need to know anymore – despite my personal fascination with the subject.