We all like to talk about knowing the probabilities … and then just sticking to them. Most of us like to harangue other traders for not doing so while finding it not so easy to do ourselves.

It isn’t so easy for a number of reasons -

1. Whether you are conscious of it or not, your brain recognizes the ambiguity and uncertainty on your charts.

2. Your own level of beliefs and your confidence in those beliefs (the true “in your gut” feelings that need acknowledged) influences your view of the probabilities. This is more or less what the term “subjective probability” means.

Taleb and now Mr. Elie Aiyache, the author of The Blank Swan – the end of probability, like to say that the whole business of probability and markets is “for philistines”. They are really skipping the reality of how probabilities work inside a brain making a decision under uncertainty. It isn’t that the probabilities are worthless or non-existent, it is gaining a better understanding of how to use them for the tool they are.

Everyone knows what they /SHOULD/ do… and everyone has trouble doing it. Why? Lots of reasons -

Market ambiguity compels you to make impulsive judgments … . Not enough sleep… . I can go on and on and on… and talk to you about your emotional architectures and using emotion analytics to better manage your risk as well as better deduce opportunity.

But here is a little “emotion analytics” trick -

Ask yourself – as you are contemplating entering or exiting a position “How will I feel if…. ?” … and then play out the scenarios, #1) the trade continues in my direction, #2) it pulls back and takes away some of my money, #3) it ….

By putting yourself into your potential future emotional contexts, you can make better “risk” judgments in the here and now.

(And oh yes, I know to some of you this sounds absurd…that is OK. Everyone that I have taught to do it, makes more money than when they just tried to use so-called discipline to intellectually overpower their desires to get in or out or… in and out … or ….)

Here are some of the things I’ve been thinking about:

The two areas in trading that separate the men from the boys (so to speak) are:

1.) The ability to divide environmental perceptions in half and process them separately. First I ask myself what I am feeling and in doing so I acknowledge and honor the feelings so that they don’t cry out for expression on the chart. Then and only then I ask the market what it is telling me. (I used to combine these two observations; I used to subconsciously deny how I was feeling because I knew it was wrong to let my feelings dictate a trade and so the feelings were bleeding into my technical observations because I had not acknowledged them and honored them.)

2.) The ability to execute according to #1 as if I am even or in the black when I am in the red. If during my 90 minutes of trading (09:30 -
11:00), I’m in the red, usually the feeling is something like “I’m afraid! I want to be in the market! I want to be in a trade!”

re A.N.N.A.:

I realized it’s not enough to intellectually understand ANNA. I had to write my own version of the ANNA software for my own internal hardware. When I learned to ride a bike, even though I’d observed someone else doing it and they told me how, I still had to write the program in my own head about how to balance and pedal. It couldn’t be just an intellectual understanding.

re trading plan rules:

I think that if you need strict rules, you’re not ready to trade cash. Strict rules mean that you’re not in control of your emotional feedback
in a live market. I’m not tape reading and I have general ideas about where I get in a trade (ideally the pullback at the end of a trend) but
I don’t have strict rules because it seems trading is an art not a science.

-Trader Diagnosis

UPDATE TO POST “Joining the Options Counter Culture“

1. Nice to have a tutor in thinkorswim software … better to have it be the same guy you drink margaritas at home with.

2. A put spread risks less than just buying calls.

3. I am actually bearish for May and bullish for June.. so now I am looking at two simple spreads.

4. Strikes are kind of tough – but not really. SPY 127/128 for the raging bull. In other words, I feel comfortable with 1250  and think even 1300 on the index so… how about splitting the diff?

5. Timing – well I expect to take it off the week or two (or even three) BEFORE June expiration. And this is where some more analysis is needed…

…. now look at that, except for the margaritas, every other decision here is discretionary and ambiguous. I mean I could take the probabilities produced by the model (and its assumption on what the vol will be) …. but then I would have to BELIEVE that vol… and I don’t actually. Trade lesson #1 from 1994 – “Non-volatility begets volatility”.

The key however is that I have an opinion and I am convicted about it… someone explain to me that those two pillars of successful hedge fund managers are NOT feelings. (Now yes those feelings are based on intellectual analysis which is also based on experience -which has a feeling component to it – and yes I could definitely be wrong… particularly with SEC v. GS in the air!)

Ok… so I have my idea … and I have my time-frame …. i.e. after maybe a “pro-longed” (relative to recent history – after all, ALL market moves only occur in context) swoon/retracement over $GS, we will resume the march known as “markets climb a wall of worry”.

Now think about it – those two “decisions” in and of themselves require taking a stab within the relentless roller-coaster of market uncertainty. Take the first – market direction – this SEC takes on GS theme could pound away at the banks for months … and if it does, we have just seen the high of this 13.5 month bull market that started in March ‘09. I am going to consciously take the bet that “the trend is your friend (until it is not)” …but of course I could be wrong.

2nd…. time-frame…. well…. over the course of my trading lifetime, I have seen too many summers plagued by sell-offs…. so for now, I just want to get started with implementing a relatively short-term spread for an expiration between May and June. But… which one? Man… I just don’t know.

B back to you after I spend some time with this “new-fangled” thinkorswim analytics I now have.

Despite the fact that the guy who got me into the trading business in 1994 had been almost an original CBOE floor member, despite the fact that one of my best trades ever was a covered write on LU in July of 1999 (think sell Lucent @75), despite the fact that the man in my life now is fully conversant in delta, gamma, theta, vega and even thinkorswim software…. I have personally resisted (sometimes actively, sometimes passively), the whole idea of options.

When I think back to when I was first introduced to speculative trading (versus the buy and hold AT&T for a lifetime that my father did) I remember thinking “it’s weird, they are so cheap!” -sort of like I was looking at a pair of Armani shoes priced at $99 and thinking “something isn’t right here“. But that really isn’t why I didn’t do it. I mean after all – all of my best friends were current or ex-CBOE floor traders (ZAP, WAR, SUG, DEO, ) …I ate lunch in the building, worked out in the building, drank coffee amidst the flowers just west on Jackson… but went back to my momentum trading shop a few blocks away to actually trade.

And I guess if anything that is it… I was inculcated with the idea of short-term directional momentum from one of the legendary traders of the time – Steve Schonfeld -  and options just seem so damn hedged. Somewhere in my mind, I wasn’t really taking a risk (like that was a bad thing! What real chicks don’t hedge?) …anyway…

Well… I have changed my mind. For a multitude of reasons -

1. I owe Jared Levy – “The Statistician” on CNBC’s FAST MONEY – a chapter for his book.

2. I lost a lot of my capital a few years ago betting on one CEO and one industry that I knew very well (industry and CEO) but I still intend to be living in Aspen in 10 years so I have some ground to make up! Yes I made all the “behavioral economics and finance” mistakes there are to make – confirmation bias, anchoring, framing… you name it. (You don’t think I know all this trading psych stuff because I read it in a book do you?) Without the gory details… let’s just say those cheap Armani shoes make a bit more sense now!

3. Most of all, I am committed to finally finishing my own book – and that takes lots of time … time that doesn’t allow for sitting watching the charts all day to catch intra-day momentum moves on the index futures (something I am, even if I say so myself, rather good at) but does allow for tactical planning at any hour of the day and even better, doesn’t require stops because real option trading – spreads, straddles, iron flying things … have “stops” built in by definition.

… so building my own options book… well that I think I can and now even WANT to do. I have been struggling with my time constraints vis a vis trading, speaking, writing… and options now seem like the overwhelmingly obvious answer. In fact, I think it will be good – I will learn something, I will extend what I know about the brain and risk to a trickier environment and eventually, I will most likely even make money.

See options trading sounds easier from a psychological perspective – after all you have these well-worn models to guide you right? But in reality, I don’t think it is. You actually have more inputs, more possible outcomes and therefore more decisions to make. By virtue of the fact that I am not going to scalp options I will also have more time decay (and TIME) to tolerate… which while it is supposed to be good – a day like yesterday (SEC announces fraud charges against GS) proves that anything can happen – and while theta (that general reality that all options get cheaper with every passing day) may work in your favor, on a day when the market moves seriously directionally (my previously most beloved of all days), theta doesn’t stand a chance.

Stay tuned… options perception, judgment, decision making and anxiety … through the eyes of psychological capital. First trade up … a bullish put spread for either May or June expiration – probably May …”sell in May and go away” after all …

Virtually everyone believes that the key to investing and trading success lies in a better read (and execution on) probabilities. “Expert” after expert, from retail educators like “Be_a_GR8Trdr” to financial engineering labs in Boston, rely on this assumption.

“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?

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.

Here’s an ironic twist – research shows it is easier for the human mind to comprehend and leverage probabilities and logic IF the question is posed in terms of people versus cards, numbers or objects. Yet research also shows that we continue to build arsenals of data in the form of numbers and that in fact we also feel much more comforted when we believe we understand the numerical probabilities of a future event.

Does anyone else see the irony here? The latter is called “the ambiguity aversion” and the former the Wason Selection test and it seems to me that the ultimate question of consistent trading or investing success is the ability to bridge the gap – i.e. know the numbers but know them in the right context – the context of predicting other people’s future perceptions and behavior.

Try it sometime – in a situation where you don’t know what to do or specifically in a trading/investing decision. Ask yourself – how will the others react?

Yes I know – it seems too nebulous a question. I am fairly certain however that if you can put the anxiety about not knowing who the others are or what their motivations might be into words (therefore dissipating the discomfort of “nebulous”) and then think about this question, your answer will help you be more accurate in whatever you are attempting to predict.

(Oh yeah – one more thing… if you think you are NOT attempting to predict when you are trading, think again.)

A few weeks ago I trekked to Cambridge for Harvard’s annual Investment Decisions and Behavioral Finance conference. Excited to hear a speaker list that included renowned economist Richard Zeckhauser, MIT’s Andrew Lo and Michael Mauboussin who recently authored THINK TWICE, The Power of Counter-Intuition, I admittedly however didn’t know quite what to expect.

Reflecting now – two plus weeks post – I realize I haven’t drastically changed my long-standing opinion regarding the difference in content and value between the field of behavioral finance and neuroeconomics. BF (for short) describes and documents the inordinately probable likelihood of not seeing all the data, of seeing only yesterday’s data and of making so called “irrational decisions”. In fact, at Harvard in November, BF even demonstrates that a room full of 75 portfolio managers fall prey to the exact same perceptional “deficits” as the general population. Neuroeconomics on the other hand is attempting to reveal exactly what is happening in our brain (or at least where it is happening) as we make these well-known errors in judgment.

Anyone who has followed our thinking for any period of time knows that we explain these behavioral tendencies under the general rubric of acting out unconscious emotions and I didn’t hear a single word that dissuaded me from that position. What I did however hear and realize is  that BF as a body of work gives us a list of cognitive/intellectual strategies we all can use simultaneously alongside the pursuit of greater emotional awareness and skill to help us make better decisions.

I think however the problem is in categorizing the list of so called “biases”. To BF’s way of thinking, our sometimes funny, sometimes sad tendencies to not see information that is either right in front of us or glaringly obviously missing (and we should therefore realize we have to look for it) are called biases. For example, we have a confirmation bias – the tendency to see all data in a way to proves what we already belief. (If you can think political leanings here.)  We also have a tendency to research a problem in terms of data we already have and fail to look for data we don’t. Generally, this is considered the availability bias.

As the weeks go on, this blog (and our upcoming December online workshop) will outline the biases and how to work with them from an intellectual point of view.

Before we get started on that however I submit for your consideration the research that shows we update our beliefs, preferences and decisions in ways that keep us feeling good (Kuhnen and Knutson, 2008) and suggest that the real underlying cause, regardless of where it happens in the brain, is the emotional impact of finding, seeing, using new and possibly contradictory data.

One more thing for today – speaking of “where” in the brain … many a respected academic still talk about the triune model of the brain proposed by Maclean in 1990. Theoretically, we have a higher reasoning brain, a mid emotional brain and a lower “keep the heart” beating brain.

With NO disrespect meant, this idea is outdated. Beginning in the late 1990’s we started getting pictures of real live healthy brains and it is clear now that emotional neural networks infuse, integrate and work reciprocally with those ostensibly higher brain centers. In essence they are higher yes  – but only because they are at the top! The most recent research however shows they are non-functional without infiltrations from the emotional networks (Damaraju et. al., 2008) so I again submit the idea that understanding the reciprocity and sequencing between brain centers offers us our best possibility of defeating our otherwise seemingly entrenched “biases”.