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.

Back and rested from a weekend trip to academia -

The annual Society for Neuroeconomics meeting, held in Evanston this year, reviews a cornucopia of pre-publication research papers centered on the topic of decision making under risk and ambiguity. With everything from electrodes being implanted into patients who were having brain surgery for intractable epilepsy to the actual formulas of computational neuroscience (which a hedge fund or two lists as their primary strategy) to the one-trial learning of a Monterrey Bay slug, there is an almost incomprehensible amount of information presented over the course of three days.

A couple of extrapolated highlights especially for speculators though -

#1) Inter-temporal discounting refers generally to the phenomenon of taking the money and running – i.e. “why can’t I just wait until my target“? There were numerous studies presented both in session and on poster boards… too many for this short de-brief. Stay tuned -

2) Too many choices reduces the likelihood of a choice at all.  Colin Camerer (pronounced cam-er-er) presented this last and given his stature as a game theorist and neuroeconomist… it was worth the change flight fee!  Too many things on your charts anyone?

3) Courtesy of Nichole Lighthall of USC – under stress, men will react by “more trials” (i.e. over-trading?) whereas women will react by being more careful. Sound familiar?

4) Cal-tech is again coming to aid of the Theory of Mind idea in perceiving and executing in complex games. (In other words, the Social Markets Hypothesis). This IS going to be big – and the original paper does appear on its way belated way to The Journal of Finance per Dr. Peter Bossaerts.

5) And just to make your day – The University of Iowa discussed in some detail why if you engage in “self-control” (i.e. sticking to a trading plan), it is experimentally proven that you will subsequently have less ability to engage in “self-control”. … This could be a disheartening fact for many short term discretionary or even model based traders… but look at it this way, at least it isn’t just you!

So… just a few highlights… and points to look forward to as Trader Psyches and our new parent The Re-Think Group discusses The Psychology of Risk over the next few months!

Oops – one more – our “French PhD Chick” Elise is defending her dissertation on October 9th in Switzerland. Wish her luck and we (sort of) look forward to changing her name to Dr. Payzan Le Nestour. We also hope to bring her to the US as an advisory researcher!

It has been awhile since I had a day with two stop-outs and no more trades. At first I chocked it up to a series of Trader Psyches biz things that went our way in the last 24 – a known hedge fund called for consulting, a big broker offered to market our workshop, a big finance organization offered to post our July 15th talk – it was a good 24.

But now I realize, it wasn’t those things. Oh they may have helped but the One Cocky Feeling was actually much more trading related. This morning I deposited a check from my June trading…and it wasn’t any old check. My SO Bill had commented the other day when he saw it laying near the outgoing to-do pile, “WOW is that your June trading?” … and Bill can be a bit like Mikey from the old cereal commercial (you know, “Wow Mikey likes it!”) … so actually I now realize that what I was feeling as I took a little too much risk on the first trade was that I wanted more of that feeling – the feeling of impressing someone not that impressionable.

So I write for two reasons – one, it is my way of working it out (as I recommend for everyone) and two, as an object lesson in double-checking the exact state of one’s psychological capital before they take a trade. In my case, the bucket was TOO full and almost more importantly I didn’t realize that I was wanting something in particular – something having nothing to do with trading. It is fun to impress a former fed economist who also trades options – one whom you also happen to think is the smartest guy you have ever met.

And that clearly is a truly lousy trade set-up. Truly lousy.

Now about that second stop out…

The arguably most famous and respected trading psychologist on the planet makes a point that we are not and should not be trading for personal development. I respectfully disagree.

Playing the game wherein the object is to take money out of the hands of very many other smart people who are also pouring enormous resources into taking your money may very well be the most difficult endeavor on the planet. How can something that challenging NOT be a journey of personal development? How can playing a game where every nanosecond provides a declaration on your skill and success NOT challenge the ego?

I personally don’t think it is possible to separate the two. And actually I don’t see any reason why one must. After all, isn’t personal development one of the greatest joys in life – to try, to fail, to get better and then learn to succeed… and then learn to succeed MORE?

In any event, this post is really about something else. It is about how we unconsciously create patterns in our trading that reflect our ways of being that we laid down much earlier in life. Yesterday I spoke with someone who trades much better when they are already down money. As we tried to unravel this mystery, we discovered that this person also always did better on college term papers when they left them until the last minute. If they tried to write one in advance, the paper would be mediocre at best. We talked about how that felt then and how it feels now.

And it is in that analysis of those constellations of feelings, that both the trading progress and inseparably, the personal development lies.

We in this day and age still falsely believe that most of what we do as adults we do out of our intellects. In reality, we act out of how we feel. I have said it before and I will say it again, a team of the best neuroeconomists and game theorists in the world (Colin Camerer, Lowenstein & Prelec) says “It is not enough to know what should be done, one must also feel it.”

Inverting that means there is a feeling associated with EVERY action.

Digging deeper one finds that the feelings associated with trading often mirror, reflect or echo feelings we had earlier in life in challenging or stressful situations. The markets tap into our core self-image and ways of being. (“emotional architecture.”) How could they not with their tick by tick assessments?

This doesn’t have to be detrimental to our P&L. If we know it and we learn to be aware of it, we can accomplish two things – make more? money and “personal development.”

Sooner or later, it is bound to happen. The markets conspire to converge in a way that fits your optimal trading strategy. You see it, you know it and then at the same moment, the phone rings, or the boss yells or the ….. Something happens that interrupts your ability to execute as you planned and you miss the trade. In those moments, it seems that you are cursed. It seems that all of the time, energy, effort and money spent learning to read the markets is for naught. The whole endeavor is doomed.

And what do you want to do?

Dollars to donuts, the urge is to take another trade. The feeling of needing to do something… anything… is totally consuming. Chances are you have already done something before you even realized how consumed by the energy you are/were.

It so happens that a version of this is happening to me the author right at this very moment. For months, the CME Group and Trader Psyches have been working on an event in New York wherein I am the featured speaker talking about how the brain perceives uncertainty and unknowable probabilities. I have been working on reading all the latest research to put a really stellar, worthwhile talk together… and just now I get an invite from a woman who told me she would promote it, who is holding a competing event! Besides flabbergasted, I am infuriated.

And the ONE thing I know NOT to do is trade or even look at the markets!!!

See the markets are very deceiving because we can always act. We can reduce our annoyance, frustration or anger by substituting the feeling that we are doing something. And yes we are, we are taking a risk that will either make money or not. Most likely, if the trade is perceived and conceived within the feeling of wanting to reduce the frustration (DO SOMETHING god damn it!), the odds of the perception being accurate are just about zero.

What does this get us? For a moment we feel better. We took control of our situation and made something happen. Then the price starts to move. It may even tick in our direction for a minute. If we are lucky.

The next feeling is “Oh S***”, the D*** trade isn’t working!” At which point, we either stop ourselves out and feel doubly worse than we did at the beginning of the blog post (only to watch it turn back) OR we insist we have power and take the stop out altogether. “It will come back we tell ourselves.”

The hardest part about this whole scenario is it is SO natural to want to take action when we are frustrated. It is particularly natural to want to take action in the arena that frustrated us. In the markets, that never works. But knowing that intellectually won’t help you. Otherwise, Trader Psyches would never exist because everyone knows this intellectually.

Doing it is hard because it is about allowing yourself the feeling but also the capacity to think about the feeling in order to find the best course of action.

Anger always has an instructive message buried deep within. We have unfortunately been brain-washed to believe otherwise because we have confused feeling with acting. Maybe it is telling you, you need a trading bubble where people can’t get to you. Maybe it is telling you to find another way to focus.

In the meantime, punch a bag, pillow, chair, even your desk. Pound on the wall. Write a comment on this blog. Just DO NOT take a trade – at least until you know what the real lesson is.

Finding that lesson hidden within the fury is the action you need to take!

Conventional wisdom (and even academic research) says/said that we have basically three parts of our brain – the old lowest brain that helps us breathe and makes our heart beat, the “mid-brain” where emotions occur and the frontal cortex or higher brain where our more highly developed, analytical and linear thinking occurs. A second way of categorizing the brain is right to left with the right being generally speaking more artisitic and the left being more scientific.

At least the former, the old “triune” brain idea is now, well how can I put this delicately, WRONG. It began with Damasio in 1994 and Descartes’ Error and continues at an exponential pace today with researchers like Tor Wager and Lisa Feldman Barrett but the tsunami of evidence that we can’t make a single decision without a functioning foundation of feelings is just that – a tsunami. For example, Damasio, now at USC, has provided experimental evidence wherein the lack of healthy emotional circuits prevents an otherwise normally functioning human to be unable to choose between two outfits of clothing. Colin Camerer of Cal-tech, noted game theory expert, said in his 2005 summary article with Lowenstein and Prelec of Carnegie-Mellon and MIT respectively, in the Journal of Economic Literature “It is not enough to know what should be done, one must also feel it.” Barrett just did a summary article on all of the MRI pictures of emotion acting in the brain and concluded that neural networks facilitating emotion infiltrate areas within the frontal cortex. There is even evidence that we can’t identify an object, i.e. our sense of sight won’t work without an emotion firing first.

It is ironic because on one hand the book blink has been a huge hit and its message is to use “gut-feel” much more often. Simultaneously, the vast majority of us still believe that feelings are detrimental to good decision making. The answer lies in each individual learning a whole lot more abut their own feelings. There are impulsive feelings and there are intuitive, unconscious pattern recognition feelings – one is helpful and the other is deceptive.

It is indeed possible to learn the difference … and it is even more indeed, profitable. After all, isn’t the ping pong between confidence and fear what drives markets anyway? Markowitz said in one of his first treatise’s on Modern Portfolio Theory that it all hinged on confidence but that confidence was something that he didn’t understand much of anything about. Today’s neuroeconomists are starting to fill in that open question.

What is this blog about anyway?

In short, it is supposed to be immersion in thinking about trading and behavior from a totally radical perspective – one where your emotions and feelings matter more than anything else. They will influence your perception of risk and in turn influence your decision making and the trades you take.

We get a little zealous about it because we see how powerful this realization is to so many traders. It also applies to all traders – from the newbie to the quant in Greenwich. How can that be? Well the underlying idea of you can’t make any decision without emotion is a human reality. The idea that we like to rely on numbers and probabilities MORE than we like to rely on squishy mushy feelings is well proven.

Why? Well for one – and it is a big one – it is easier. We know what to do with numbers while the qualitative aspects of feelings are something we have assiduously and theoretically wisely avoided for as long as we can remember.

That fact doesn’t change the real fact that without those feelings you can’t decide what to wear. It doesn’t change the fact that there is emotional motivation in every trade. It doesn’t change the fact that there is impulsive emotional energy in every deviation from the plan.

What it does do is mean that if you really want to make it in this business – regardless if you recently started or if you were laid off from JPM or even if you are at one of my friendly funds in NYC, the key to more effectively assessing risk is to get in line with your psychological capital. Or better put, get your psychological capital in line – front and center – and always the thing to be managed alongside of the probabilistic or mathematical risk.

ALWAYS.

When you feel confident, presuming you do sometimes feel confident, where do you feel it? Can you feel it in your brain or is it in your thorax (i.e. middle part of your body)? Better yet, why do I ask?

Well if you think about it, part of our mission here at Trader Psyches is to teach traders of all stripes how to use the message in Gladwell’s blink to assist in the d/m (that is decision making) process. The zillion copies it has sold prove the interest in it but the practical parts about what I read – sort of the “just do it” related to using your instantaneous impressions seem frankly impossible.

And I honestly still feel that most traders are for good reason, stuck in their heads. So, I ask this simple question – when you feel confident where does it hurt?

It is all too easy to forget that trading (not to mention life) is a physical experience. (See Descartes’ Error “I feel, therefore I Am” by Damasio) The path of least resistance is believing that risk decisions are mainly, if not exclusively, cognitive (thinking) events.

My just-ended golf weekend in Amelia Island reminded me how true this is. On certain chip shots I thought about things like ball placement and whether I wanted a full-swing or not. On others I “thought about” what felt right. I looked at the distance to the hole and just focused on the physical experience. Ditto for putting. Which do you suppose led to better shots?

If you said “thinking shots”, you are wrong with one exception.

I tried a whole new way to hit a sand shot and it required that I consciously execute each step. I couldn’t do it by feel because I had none. And true to the intent of this letter, the response of the much better golfers I was playing with was “great, now you have the FEEL of it.”

Trading is like this. At first you have to intellectualize a risk situation. But the best results come when you arrive at the place where on top of that cognitive activity you can effectively layer an awareness and integration of the physical experience – the data that exists in your body not your head.

This is what is meant by the term “art and science”. Trading by definition cannot be a science as it is only the sum total of all human risk decisions but its numerical nature allows it to pass as a reasonable facsimile. The idea of financial engineering btw is kind of an over-statement. There is no engineering of markets. Anyway, as for the art part, the thing that is missing from almost all trading advice is how to research and interpret data that isn’t presented in statistical form. Or put another way, how to leverage the qualitative along with the quantitative.

The vast majority of experts will still tell you not to try.

The irony of that is your brain is going to interpret market data via pattern matching regardless if you want to use that input or not. Most importantly, the holistic system communicates the result of the pattern match through the physical feeling-sensory-dimension of our existence. The reason the conventional wisdom is so wrong is that it never learned to distinguish between the feeling of an impulse and the feeling of an intuition or what comes to feel like instinct. That however isn’t a good enough reason to stick with the old earth is flat/intellect is all approach.

The way we see it, the brain will always win in the end so why not get started as soon as possible on working in concert with a brain and a body that work together to assess and address uncertain situations – price movement or sand traps. The job might be as hard as learning to shoot a 90 but did you really think other traders or money managers were going to let you take their money without a fight?

Bring all your faculties to the game!