From the latest issue of The Economist:

JUST before the hovering finger clicks the mouse to trade, there is one thing that online investors of the future might want to check: their “Rationalizer”. The device, a prototype of which was unveiled this week, is an emotion-sensing system designed to help investors keep a cool head when buying and selling. [...]

The Rationalizer, which is still under development, consists of a bracelet that measures something called a galvanic skin response. This is a change in the electrical resistance of the skin which can be caused by various stimuli, like anger or elation. It cannot determine if the emotional arousal is negative or positive, only that it is happening.

ABN’s interest reportedly stemmed from a study by Andrew Lo and Dimitri Repin, “Psychophysiology of real-Time Financial Risk Processing” (Journal of Cognitive Neuroscience, 14(3), pp, 323 – 339,  2002), showing that day-traders who exhibit more intense emotional reactions also have significantly worse trading results.

One may question the efficiency of using this new device, trading performance wise. My guess is that this kind of practice is based on a somewhat misguided view on emotions. This view emphasizes the negative effect of emotions on behavior, the idea being that emotions vitiate rational decision-making. Here “emotions” stands for “passions.” Automatic emotional responses mediated by structures such as the anterior insula or the amygdala – see Joseph LeDoux’s beautiful book “Emotion, Memory, and the Brain” (1994) for the functions of the amygdala in fear conditioning – would trump higher-level responses mediated by the prefrontal cortex. Very Platonic stance, sometimes referred to as “dual process theory.”

This is not to say that emotions never prompt us into the wrong direction, they surely do, often “short-circuiting” logical reasoning and long term planning that are essential to efficient trading (Cf Andrew Lo and collaagues, “Fear and greed in financial markets : A clinical study of day-traders” American Economic Review, 95(2), pp. 352-359, 2005). The dual process theory is thus heuristic in that it highlights such phenomenon. However, it may lead to a hyperemphasis on emotions as sources of mistakes. Such hyperemphasis is wrong-headed. Because in many domains, nonconscious emotional biases drive behavior before conscious knowledge does; without such emotional inputs, overt knowledge is in effect insufficient to ensure rational behavior.

Antoine Bechara, Antonio Damasio and colleagues highlighted this role of emotions in implementing rational decisions (”Deciding advantageously before knowing the advantageous strategy“, Science, 275, pp.293 – 1295, 1997). Further, John Allman, an eminent neurobiologist from Caltech, has been pinning down the role of the Von Economo Neurons (VENs) of the anterior cingulate cortex in providing humans with a system for quick and intuitive behavior in the face of uncertain ever-changing conditions. This work stresses that in complex situations involving fast intuitive assessments, such as day-trading, fast intuitions are melded with slower, deliberative judgments (e.g. “Intuition and autism: a possible role for Von Economo neurons“, Trends in Cognitive Sciences, Volume 9, Issue 8, pp. 367-373, 2005), whereby emotions are best viewed as informational inputs serving deliberative processes. Consistent with this view, recent studies on decision making under uncertainty has revealed the amygdala and the anterior insula to provide uncertainty signals. See, e.g., the paper by Wofram Schultz and colleagues “Explicit neural signals reflecting reward uncertainty” in Philosophical transactions of the Royal Society of London. Series B, Biological sciences, 363(1511), pp. 3801-11 (2008); or the one by Tania Singer and colleagues “A common role of insula in feelings, empathy and uncertainty” in Trends in Cognitive Neurosocience, 13: pp. 334-340 (2009). A famous paper by J Coates and J Herbert, “Endogenous steroids and financial risk taking on a London trading floor” (PNAS, 105(16) pp. 6167–6172, 2008), helps pinning down the nature of these uncertainty signals: these may be relayed to the neural structures involved in decision making through neuropharmacological signals. For instance cortisol, which has receptors in the insula and the amygdala, would signal market risk in the brain.

All this suggests that emotions are key information providers when deciding under uncertainty. They make us tuned to our environment. Actually, in some contexts of fast and intuitive decision-making in the face of unstable (high vol) conditions, one expects that the stronger the emotional uncertainty signals of the day-trader, the higher the performance. To be more specific, I would not be surprised that for a trader “in the zone” at a particular point in time, the light pattern of  “EmoBow” (the object displaying a moving light pattern to illustrate the user’s mood) reach a deep red. Shall one conclude that the trader is too aroused emotionally at that moment, and hence should take a deep breath? Or merely that he has achieved a state of focus that intense, that all the relevant stimuli in his environment are integrated as emotional inputs? In the second scenario, stopping the decision process is like stopping a high-speed driver in the middle of the race.

Evidently I just can’t get enough of what the Ivory Towerites have to say about the “brain on risk“. This weekend, despite Open House New York and two of the three living creatures I must tend to out of town, I found myself listening to Joseph LeDoux of NYU, David Brooks of the NY Times and  5th year post-docs from as far away as Peking talk about their latest findings (or thoughts in the case of Brooks) regarding how our brains use, perceive, process and react to emotional data ... and I LOVED it!

See the real reason Trader Psyches exists (full disclosure here) is of course, like every student of any form of psychology or psychiatry, I wanted to understand my own thinking, decisions and actions – particularly in relationship to my ability to easily take gobs of money out of the market but almost just as easily – okay even more easily – give it back. (I have cured the second btw – and yes with my own methods).

Believe it or not, social and emotional (affective) neuroscience holds the key. Questions like how does the brain interpret symbols that represent other people’s intentions versus how does the brain interpret direct physical evidence of other people’s intentions (a raised fist or pointed gun for example), go directly to the heart of the matter of trading in a pit versus trading on a screen as well as in the case of the aforementioned, directly to chart reading.

Evidence is mounting that despite the widespread belief that markets are about numbers and probabilities in fact our brains are not fooled and know they are about predicting other traders and investors intentions and future motivations. In other words, maybe the reason so many people have such a hard time consistently thinking in terms of probability is that the brain knows that just because you have a hammer, a hammer isn’t necessarily the right tool for the job!

A couple of specific points – and names of researchers to ponder – (in many cases this data comes from what are called poster sessions where doctoral and post-doc explain their latest research so it isn’t published yet.)

1. Pranjal Mehta, Columbia University  “Neural Mechanisms of the testosterone-aggression relationship: the Role of the OrbitoFrontal Cortex” A couple of the salient points for trading here 1) any effects of testosterone were relevant within gender norms or in other words, women with relatively high testosterone compared to other women showed the same effects as men with relatively high testosterone. Take home for female traders – you know that news item a few years ago about traders in Europe and testosterone and lengths of fingers… don’t worry about it!

Ancillary points include the location of the actions (frontal cortex) and the complex interaction of testosterone and cortisol. Why do they matter? – more evidence that our higher brains aren’t just extraordinary computers and maybe the whole widely held assumption that our brains CAN work like ultimate computers needs revised!

2) Kateri McRae, Stanford, “Bottom-up vs. Top-down emotion generation: Implications for emotion regulation”. (Now as any regular follower of ours knows I think the whole emphasis on regulating emotions is mis-placed because the FACT OF THE MATTER IS, you only have to regulate actions! Nevertheless, the concept of modulating one’s own emotions still permeates lots of the science so my other attitude is let’s see what we can learn.)

The most salient point here – and I quote  – “Reappraisal paradoxically INCREASED amygdala activity during bottom-up generated emotion“. Okay I know that the meaning of that isn’t intuitively obvious to a trader (otherwise why would you even be reading this?) so let me explain. I think it is safe to say that the most widely held BELIEF regarding changing negative emotions centers around the ideas of re-framing or in layman’s terms, changing your perception about the meaning of something. All kinds of official and pop psychology strategies including NLP or “neuro-linguistic programming” rely on the idea that if you change how you think, it will change how you feel.

What this study is saying is that process worked for certain processes like interpreting “words, statements or autobiographical memories” but it not only did not work for more basic interpretations like “phobic objects” (red on your P&L) but in fact, when tried with more survival (my word) type emotional reactions, it actually made it worse.

All I can say is Hallelujah! If I have answered a question about NLP or re-framing in a trading psych webinar once, I have answered it 1000 times. “Do you use, believe, recommend etc. NLP?” I am always adamant, militant and maybe even rude because I am so sure it doesn’t work when it comes to losing money (based on talking to 1000’s of traders and the a priori knowledge of the centrality of emotion to perception) and I know it tends to make it worse because when tried you have not only a negative trade but an additional experience of failure to deal with!

So… how to apply? If you have tried reappraisal or what most call reframing or even reprogramming and it didn’t work for  you, don’t waste one second wondering or worrying about why. The Darwinian nature of trading and the conscious and unconscious meaning of a red P&L is almost certainly a “bottom-up” emotion and behavioral & brain picture evidence says that strategy worsens the situation.  (As an aside – you’ll find more around the blog but in short try words instead – put the feelings into words. Write it out or talk it out – without judgment. No one at the conference will verify this technique but give it a try – and let me know.)

… I skipped the end of the meeting today (just to write this post but yesterday ended with David Brooks calling for  those who will create a revolution by bridging what science knows about how we think and the long held misunderstanding that we are single, isolated beings rationally maximizing our utility. I can only hope that Mr. Brooks will consider Trader Psyches and our new parent The ReThink Group an element of that revolution.

“I return from holiday rested and relaxed, to quote Ben Lichtenstein, “I have tasted the sweetest Mediterranean tomatoes brought to me by dusky maidens and washed down with oaky red wine in the shade of orange trees, I have felt real warmth from the sun on my skin again.” Pulling up a chart once more, and looking at the comments to my previous post, I am full of good will. I have set aside my weapons of war and my heart has turned to love.

I do not quite, however, see trading as some kind of sixties group hug, where there’s plenty of weed for everyone. The money has to come from somewhere after all. So where’s the love? There are so many beautiful trades, so little time. How to choose? I should explain that I am truly a romantic. I long for commitment, for a lasting relationship. I enter each trade with the same hopes, the same fervour, the same simple faith that our love might last forever, that we will trend and trend and never look back. Once the first flush of my passion is over and my first target filled, my second half is there for as long as my lovely companion continues to show interest. And I am quick to forget the sins of the past: if I have been hurt by Cupid’s arrows before, I myself have wounded too, and will happily embrace again yesterday’s lover.

On my return, I found that the languid Euro (I always see her as French don’t you?), has invited me to join her for the afternoon. Charmed, I accept her invitation, but find her at first quarrelsome then sleepy. I take what pleasure I can, but as she dozes, I notice the door push open and her pretty blond cousin from Switzerland winking at me and beckoning to join her. Perhaps all that mountain air gives her more energy, but I am pleasantly surprised by her enthusiasm while Euro sleeps, and even more so when she introduces me to a young American friend she has made, a certain Mini Dow from Chicago, who is eager for me to help her with her extraordinarily tight shorts. Naturally, we have met before. From the window I see that the fickle Miss Soy Bean has made other friends while I was away, and seems to have had a fine old time after kicking me out of her bed just before I left for my holiday. But I forgive her already. I love them all, and I know that despite our occasional tiffs, we will always make up.

Before I let my imagination go too far, or grossly offend anyone, I should perhaps say two things: first, I would like to assure you that I am neither a psychopathic killer nor a serial philanderer. This is all part of a game to engage the psyche with the human side of trading, to connect the flickering numbers and bouncing price bars with some of the real human feeling that this strange activity has such a capacity to generate. And yes, perhaps trading does touch on the darker side of our psyches. By acknowledging this I believe there is a chance we will become better traders.

Secondly, there are of course many metaphors for trading, and I certainly don’t see combat as the only one. I have found helpful comparisons with sailing (attention to currents, the tide, the strength of the wind etc), viticulture (trading is like harvesting a crop, a stroll through a vineyard in search of the ripest and juiciest grapes, much is wasted, but the wine at the end is worth it), skiing, paragliding, the list goes on. I am sure there are many ways of visualising the process, and each trader must find what rings his or her bell. Ultimately, trading is the Lottery of Babylon in Borges’s story – it is like life itself, filled with perverse rewards and punishments, a labyrinth of both startling simplicity and complexity. Recently, though, with Denise’s help, I have come to see a particular reality in metaphors that recognise the traders on the other side of my trade, and my attention to detail, my ability to use judgement to enter or exit a trade at the right moment is linked to that sense of my enemy’s strength or weakness, or of my lover’s enthusiasm or languor.

Now, you’ll have to excuse me, but I must go and get some flowers for Euro before she wakes up.”

Trader K

I love the smell of blood in the morning. To wake at dawn and find your order filled, a steady stream of red staining your screen, and as the day progresses to the inevitable climax, when at five in the afternoon your first targets are filled, and you witness the dying dreams of the bull felled by your skill, kneeling, panting, looking dolefully into his killer’s eyes.

OK, let’s not get too poetic here, but what better way to start the week than with a three hundred point fall in the Dow, with a position that took no heat even as I slept? Short overnight from the break of Friday’s low, I have had a good day. I got a nice entry, got out of half, and got to move my stop to break even, so I’m not going to get gored in the groin, even if the bull does lumber to its feet again.

Yet still it is not enough. The pleasure of a clean, well-executed kill, of dispatching an animal that behaved perfectly, is always tempered by regret. I am not just speaking about the tragedy of exits: the sadness of scaling out when it goes still further, the sorrow of the trailing stop that gives back so much. All this is the necessary regret that every winning trade must bring; no, it is worse than that. For once again, I am in mourning for the Euro, for the one that got away.

How did I miss thee? Let me count the ways - I should have been short on Friday morning, from early in the European session. My setup was coming together in multiple time frames, I was relaxed and confident, and had a little extra time on my hands. I thought I would watch the market review offered by a well-known and likeable commentator who was cheerfully bullish on the Euro. A shadow passed over me. I don’t listen to others when I trade, I know that I have often found myself in conflict with this other trader’s analysis and come out on top, and yet it is curious how little it takes to sow the seeds of doubt in your subconscious when you let your guard down. Once the intellect and the rational arguments of others had started to interfere with my judgment, my resolve weakened without me realising it.

I should have left my orders in place and gone about my business. Instead I scratched my chin, looked at a couple of e-mails, and decided to make a nice cup of tea and to shave. Perhaps my pattern was not as clear as I thought. Why not leave it for a little bit to mature like a nice Camembert (it was a Euro trade after all)? Nothing would happen in the next 20 minutes, and I could be back at my desk before whatever dull news announcement there might be at half past.

Of course, what with one thing and another, it was more like 40 minutes before I was back, the Euro had rolled over along with the other currencies, and my entry was gone. The pain is doubled by the fact that this is the second big Euro trade I’ve messed up in the last few weeks.

So how did it really happen? Was I unconsciously repeating the previous experience in order to relive the pain of the unrequited trader? Was I afraid of the trade, and looking for other reasons to be elsewhere? Did I let the fellow who wanted to be long get under my skin? Well, I haven’t had a chance to talk to Denise at length about it yet, but I suspect all of these, and probably something else too. Whatever it was, it bugs me far more than today’s success. And to make things worse, I cut myself shaving while I should have been trading. So there really was blood that morning too.

Trader K

I have to start by declaring my genius. This is no place for false modesty. I am the bee’s knees. The caterpillar’s spats. I was long 30 year Bonds last Wednesday before the Fed spoke, from 124/13, and exited the second half of my trade at 131/16.5, lower than I intended, because my charts locked up after the Fed belched the latest piece of news on to the world’s financial stage provoking a reaction like a teenager overdosing on speed and Viagra. And I got pretty much the whole monstrous day’s range.

Of course, you, my dear readers, want to know my secret. Well, it all started with a weekly chart, that looked promising above 127/11, and somehow didn’t seem to want to make new lows to me. But we were far from that level last Wednesday morning. The 60 minute chart was bobbing about doing nothing, but that prickly feeling in my upper arms told me, along with something close to my normal setup, that a break upwards was worth holding for the longer term. A cheeky little bar popped up and teased me into action, along with the tickling up the back of my neck and the slight increase in heart rate as I leant towards my screens, sat straighter, visualising the blood of those on the other side of my trade dripping from my trading knife, and I was in, expecting to hold for a week or so. I was prepared to stalk the kill for a while, but it was quite a surprise to be gutting the great beast in front of the fire a couple of hours later.

More than a surprise: my euphoria was overwhelming: I immediately celebrated by looking at what my other markets were doing. The pain a glance at Euro futures inflicted on me was at least as great as the pleasure of the Bond trade: I should have been long from 1.2653; as I write, that trade is just over at 1.3514, over $10k per contract. I was in the trade at the start, and with the help of a migraine and a sleepless night, I over-managed it and stopped myself out for a nice little loss right at the beginning and quite senselessly ? fear, and a feeling of vulnerability and inadequacy brought on by my headache, made me quite incapable of staring at the possibility of a modest loss: I took a certain, smaller loss and a huge lost opportunity instead. About the same time I should have been long ES and missed it for the same reason.

So how was I to celebrate? The Euro upset me so much I took a quick impulse long at the high of the day that cost me a few points. At last I had the sense to turn everything off, and share the tale of my extraordinary deeds with my wife. Used to bringing back rabbits and the odd antelope to the family cave, I had dragged a full size woolly mammoth home to feed the family. I encouraged her to spend as much as she could on clothes the next day while I stayed off the charts, drank beer and generally basked in my astonishing prowess. And yet, the Euro still gnawed away at me?

Denise has written persuasively about the fear of missing out being the worst fear of all. Having missed out in a big way last week due to physical feebleness and incompetence, at the same time as getting rewarded massively for a mixture of intuition, timing and an awful lot of luck, I am struck by the longevity of the pain of the former set against the ephemeral nature of the pleasure afforded by the latter. Coming up for a week later every glance at a daily Euro chart is torture: I need at least five minutes with a punch bag to overcome the urge to revenge trade again whenever I look at it. The glow from the Bonds is fading, but I am still mourning my lost Euro trade.

The fact is, every day there is a new opportunity to experience fear, disappointment and elation. How to deal with it all? From one day to the next I’m still not really sure, but I know that sooner or later, if I acknowledge my own weakness and frailties, keep sharpening my spears, and ensure that when I enter battle I am prepared mentally and physically for anything, most of all my own limitations, that prickly feeling will come again, the blood of my adversaries will flow once more, and another great beast will meet its end at my hands.

….but inside he was terrified. “I can’t believe this is happening.” he said – Today’s NY Times reporting on a Katie Couric interview with Captain C.B. Sullenberger.

Not surprisingly, the hero pilot of flight 1549 unconsciously used a technique that works – his feelings were put into words – even if only in his head. This kind of acknowledgement of anxiety actually helps the brain to focus because it isn’t wasting energy on trying to suppress a feeling that is a very real reflection of the situation.

This works in much less dire circumstances where the only risk is a loss of capital. Giving voice – verbally or internally – to one’s acutal feelings – without edit or judgment – allows one to much more easily see (and execute on) what needs to be done. I have said it before and will say it again, FDR was wrong. It is not that the only thing we have to fear is fear itself, the only thing we have to fear is no fear at all.

With apologies for being out of touch, I would like to make a couple of notes on psych cap. First, and I have said this before in different way, it really does appear that our brains have special “curcuits” for detecting imprecision or uncertainty. In other words, that feeling that someone or something is there – even if you can’t see or hear anyone? (which would have come in handy while searching for food in the woods) most likely has its own chip.

And this chip works.

Ever wonder why you review your plan and within minutes do exactly the opposite? It is because your brain detects that the plan doesn’t perfectly fit the circumstances and it goes into “ambiguity” mode. In ambiguity mode it relies on gut-feel more than anything. …. yet who among us has really been taught to systematically use gut-feel?

In that mode most of us are lost. We can’t tell the difference between a tickle that the market is going to turn on us and residual fear left over the last time the market burned us.

Now this game ain’t easy – and to make it harder is this conflict between planning for markets in estimated probabilities while fighting our brains which are using the uncertainty circuit. There is only one solution to this – get better at differentiating amongst our feelings. Don’t blame the messenger but the data lies there.

Right after “what the heck is psych cap” should come “what the hell is neuroeconomics”? Neuro on one hand and econ on the other? … Could they be more different – microscopic brain cells versus broad based financial interworkings?

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.

Okay it’s the name of this blog and a term we banter about but what do we mean? In short, we mean the power of an entire human psyche – intellect, thought, senses, feelings, emotions and energy. Each factor weighs in on the judgment, decisions and performance a trader (or investor) delivers and hence, elevating the whole (psychological capital) and leveraging the dimensions (thought, feeling etc) maximizes the performance a trader can deliver.

Underlying our zealotry for this topic is the reality that so much of our judgment and decisions is based on our senses, feelings and emotions despite society’s general reluctance to believe this. Neuroeconomics knows it. In fact the most highly respected neuroeconomists in the world say “it is not enough to know what one should do, one must feel it.” (Camerer, Lowenstein and Prelec, 2005).

Learning to read internal data – the ping pong between thought and feelings – helps one make better risk decisions. Understanding one’s emotions helps one make better investment decisions (Seo & Barrett,2007)…. so psych cap, simply put, is about using our brains (and psyches) in the way they are designed and to our fullest advantage.

Is there any good reason NOT to do this?

We didn’t believe it at first. We were amazed that traders transferred their deepest emotional architectures and echoes onto the prices… but alas, they do. In fact, it isn’t really all that surprising now that we know. I mean after all, the markets encompass and symbolize competition, winning, money, success and smarts. If you are going to have the echo of your deepest issues show up anywhere, why would it be somewhere with less stakes?

Which brings me to the question of Madoff…. last year at The Philoctetes Center (look it up? .org) he said that when he started his career everyone hated him for bringing electronics to the markets – and causing the human brokers to loose their jobs. So now at the end of his career everyone truly hates him again. And in between, he used charm and popularity to create this scenario.

This is how Freud’s Theory of The Repetition Compulsion works (see my paper published in Annals of Modern Psychoanalysis). My opinion? – this ain’t no accident and greed is a sorely insufficient explanation!

At this point I can only conjecture but my conjecture is that it was about the fear of missing out and the fear of being ostracized… the exact things he unconsciously created. This guy, for some reason, recreated being hated. This would leave the question of who hated him early on in his life open… but I for one would bet A WHOLE BUNCH on the idea that someone did.

It is horrid and shameful and everything else. There are a million things to say and that will be said…. but one of the lessons for traders and investors is – understand the emotional drivers behind market, investing and trading decisions. … whether it is you or your manager who is doing the trading …

to be continued. and… tell me I am crazy!