It took a major meltdown to jar them from their biases but the intellectual powers that be, from the Hudson and Charles rivers to the shores of Lake Michigan, finally are giving serious credence to the reality that most people, even professionals, don’t and even can’t act rationally in the face of making risk decisions. The list of the ways we don’t act rationally is limitless and defies categorization (believe me I have tried) but there are a few things I can definitively say about taking the next step in a real understanding of “the brain on risk”.

The first – instead of just saying “emotions are required for a decision” – explore what that means. Maybe we will find that the emotional states or emotional data will be easier to categorize than the behavioral! Think “emotions as information”.

Second, start to take the social context – and what is known as Theory of Mind – into account when understanding your own and someone else’s seemingly irrational decision.

It is hard for me at this point to decide for myself which comes first – the feeling or the social setting. And in fact they are most likely reciprocal but I can say for sure that the forefront of understand behavioral economics lies not in thinking harder but in fact in thinking about thinking and rethinking the role of feelings and social expectations in perception, judgment and decision making.

60 seconds in and Ohio State is plowing down the field. As I write this sentence, they dropped the ball in the end zone. … Try it again – 3 and 10 and in!! Now the question relevant to trading and risk psychology is … 15 minutes ago did they KNOW that was how it was going to go? Did they know exactly what the Oregon Ducks were going to do? Well of course not you say….

Okay then… can someone explain to me how the game, and particularly the QB’s job, is any different than being a trader or a portfolio manager? I mean sure they have a plan and they have studiously developed and trained-for expectations but don’t they still have to think “on their feet”? Don’t they have to assess the situation and make nanosecond judgments?

Why does everyone buy the widespread idea that traders have to come up with “plays” and then in turn execute them in a robotic fashion in the game of the markets? What happens to the need for judgment when faced with changing volatility? What happens to the need to use your brain in the toughest game on the planet?

Yep it is easier to NOT to have to use judgment… but is it realistic? I mean should stops and targets always be the same? Does that idea make ANY logical sense in as fluid environment as the markets present?

And in fact – worse, what is the downside to believing in the myth of the robot following the plan? There is one you know… and I submit to you that it accounts for some large % of the fact the vast majority of traders can’t consistently and reliably take money out of the markets.

And if it isn’t quite a robot – the isn’t it judgment? And if you have to use judgment at all … then what do you have to do to improve it? What do you have to do to capitalize on the fact that it is an asset?

This is a thought experiment… it is meant to help those who try it learn something… or at least stretch our minds to the point that we see the situation more as it really is.

A year ago tonight I was merrily watching my Cleveland Browns actually win while on a Jet Blue flight to the CME’s Inaugural Global Financial Leadership conference when my first cell beep on landing was Bill Long calling to say LEH was BK and ML was BAC. 365 days after that watershed event we have endured the panic of complete financial destruction, more than adequately blamed Wall street, inadequately blamed (imo) borrowers, the rating agencies and mortgage brokers but most of all, inadequately attempted to understand the human decision processes behind these events.

Rarely does anyone stop to think about “how do we think” – “what goes into the process”? For one, we think we know. For two, and probably more importantly, BLAME is easier and actually much more fun.

Well to that I say 1) We barely know and are just now, through neuroeconomics, beginning to put the jigsaw puzzle together and 2) blame, vitriol and the almost certain associated regulation isn’t going to stop the next “Black swan” as long as the underlying causation isn’t fully understood – which is exactly where we are.

It is far too easy to assign responsibility to “animal spirits” and “greed” …. but it is not clear at all that neuroscience would support those two well-accepted demons. For one, animal spirits generally can be taken to mean emotion and unbeknowst to those who care about markets – whether on Main or Wall – is the fact that without emotion, nary a single decision can be made. In fact, the latest news is that without emotion our ability to see and identify objects might not even work. Think about that – without emotion you might not even know if you were making or losing money!

Furthermore, to the topic of greed specifically – a number of experiments show that it isn’t about making more money – it is about the fear of regret over not making money that you could have made. THAT is a whole different ballgame. It means for example that Morgan Stanley or Citigroup, while they may have recognized the ensuing wobbliness of MBS’, it was hard to stop… or as Chuck Prince, then CEO of C infamously said, (roughly) – if the music is playing, we have to keep dancing.

In order to have even a remote chance of averting the next killer black swan, we simply have to come to understand the true role – both good and potentially bad – of feelings/emotions in perception, judgment, decisions and actions. Right now we are still on the complete wrong track thinking that regulation, pay-cuts and better models will solve the problem.

Markets are a game of predicting of other human behavior in the midst of changing circumstances- social markets vs. efficient markets. Our brains understand them as such and use context to interpret the data. In the use of context, we rely on implicit learning to which we may or may not have conscious access. The trick is to start getting conscious access – that is the ONLY path to fully objective decisions. And actually it is the only path around fudge factors and confirmation biases in model building too.

In other words, deliberate understand and conscious access to how our brains understand risk – the psychology of risk – is the true uber-risk management tool. Conscious access, by definition,  means internal and external emotion analytics.

In short, it is time to Re-Think Thinking.

More to come….

Per the Washington Post “But in each instance, inexperienced officials, at times ignorant of other agency probes into Madoff, took his explanations at face value and did little to verify them.“

Why would anyone – no matter how inexperienced – take a potential criminal at face value? I mean no one intentionally tries to fail at their job do they? Is there any upside to that?

The answer goes back to Re-Thinking Thinking – or understanding how we ACTUALLY perceive and judge because it isn’t how we think – or have been taught – that we do. We believe that as children we rely too much on our emotions and as we mature, we become more rational and more objective. Well that may be true on the surface – but essentially only on the surface.

Most of our analysis is done below the surface of our consciousness – and most of it has to do with how we are feeling (or being made to feel) and we don’t even know it. In the SEC’s case, they were victimized by Madoff’s charms in the same way everyone else was. His extraordinary ability to make people feel good – to trust him – worked its magic on the young, inexperienced (maybe intimidated) investigators the same way it worked on his friends at The Palm Beach Country club and his feeder funds and his charities and his…

See the whole sordid affair is a spectacular object lesson in the reality of how we actually make decisions.

It isn’t time to just be out-raged at the SEC (although that is fair). It is time to use that out-rage to actually learn that the real job in risk psychology is to stop fooling ourselves and start being realistic about how we really think – and to Re-Think Thinking.

Being interviewed on CNBC & “ABC World News Tonight” on the same day makes it so clear to me how differently the market is viewed depending on what kind of desk you sit behind. I had no sooner walked out of the NYSE when an ABC producer rang (thanks btw to whomever changed the rules so that you can keep the same cell phone number even if you switch carriers – which come to think of it, is a factor in the economy recovery… hmm… a post for Greenfaucet –  but I digress.)

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!

Today

Set the alarm for 6:40 am, but ended up going to bed pretty late.

6:40 am alarm rings, still super tired, so decide to sleep in till 7:30 and then see if I want to trade

7:28 wake up without alarm, feeling good.

7:45 ish, notice the market has really sold off. Want to jump in short, but realize I need to wait for the perfect setup.

7:50 ish Don’t get filled on a short on a retracement, and cancel all orders. At this time, I am relaxed, calm… and cooking breakfast.

8:00 or so, I see the setup I am waiting for, and take the trade.

8:01 ish, I realize that my intial stop placement was a little tight, and loosen it up to my typical stop placement.

8:10 market is doing what I thought it would, and I just leave the trade alone and let it work.

9:15 or so, I take a nice profit on half the position, and lock in some more profit on the rest.

9:30 or so, I am stopped out, and realize I have done well for the day. Very relaxed, very calm, and able to predict with an uncanny accuracy what the market was going to do. Turned out that was the only live trade I did that day.

Yesterday

Woke up tired at 6:30. Checked the market. Went long, grabbed some pts. But still very tired.

7:00 am to 1:00 pm – Did a gazillion trades in anemic volume, at one point seriously denting my account, only to manage to catch a good move and stay in long enough to get closer to breakeven, but still in the hole. I was complaining about the volume, complaining about how setups didn’t seem to work. I was writing things down. I was thinking, “I should just stop and trade another day”…. and thinking that early on in the day.

But I didn’t stop.

I was tired. Being tired, made me take on more risk. Once in the hole, I started making riskier decisions. Then you overtrade. Once you start overtrading, it is a downward slide…. and I believe a large part of it was simply “I WAS TIRED”.

I want days like today… not yesterday. Yawnnnn, going to get some rest now.

When we first learn anything, we need to do it consciously, deliberately and intentionally. Think back to learning to write in cursive in 2nd grade – each letter was formed with much focus right? (Did you know they are leaving that OUT of grade school curriculums these days?). Then by the time we got to high school, we didn’t give a squiggly A or Z a thought but they started teaching us to think – to justify and create in classes like English and Sociology. College extends the process of teaching us to think and grad school – at least outside of the professions – is all about original analysis and thought.

At each step of the way, the information we learned earlier goes underground. Again, we don’t consciously, deliberately or intentionally THINK about each item of information that five years earlier we did not know.

Now tell me, if succeeding at trading is one of the most difficult endeavors on the planet, why would the process of becoming more learned and sophisticated be any different? More importantly, why should it?

Trading education, especially outside the “prop” world (OPM or other people’s money) is not like progressing through levels of formal education. There is no standard curriculum, if you switch from one school to another you might not even recognize the lingo and even in OPM situations much of what the junior traders are asked to do is sit at the screen and lose money.

What are they doing – what is that form of learning called? Experience right? And why is experience important? As dictionary.com defines it “the ability to judge, make a decision, or form an opinion objectively, authoritatively, and wisely, esp. in matters affecting action; good sense; discretion”.

But ironically most trading education tells you NOT to use judgment. “Trade what you see, not what you think” for example – well now tell me, how on earth are you really supposed to do that?

There is this bizarre overlooked contradiction in much of what passes for trading wisdom – or at least smart trading psychology. On one hand, developing a trading strategy/tactics and a plan are OF COURSE the foundation to work on but on the other, the most successful firms ask their traders to spend years learning judgment while the independent/retail world is taught not to think!

The answer to this lies in re-thinking thinking altogether. How do I look at the markets? What do I believe about how they work (on my timeframe), what style of trading suits me? And then once those questions are answered, how do I put together a strategy, tactics that embody that strategy and systematically inject my judgment – or my brain’s extraordinary ability to recognize patterns – into play in order to take money out of the market (or really from other people who are trying to do the exact same thing)?

In short, without an exceptional money-making mentor (and they are very hard to come by), traders have to create the learning progression of high school, college and grad school themselves. I submit that if they look at the thinking/judgment process and institute a program for themselves that they will do much much better than if they just try to rote follow what some other “trader” teaches them.

Is it work? Yep? Is it a LOT of work? Yep. But c’mon does it hold water at all to think that competing with other motivated traders across the planet, some who will do ANYTHING to succeed, is (or was) going to be easy?

…and one more thing, this is also the process of belief and confidence building – which is exactly what you need when things go wrong – which in the markets is a whole bunch of the time! In other words, most will tell you to go back to your plan. I will tell you to go back to your judgment – judgment you have honed through a systematic process.

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!

A few years ago I discovered Tom Alexander of Alexander Trading and finally “got” what those wacky charts with the horizontal letters were saying. The next thing I did was strip my Tradestation charts of all of their fibs, oscillators and graphics that had accumulated over the years.

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!)