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.

Every now and then someone calls me and asks me to recommend a “prop” firm and now I can just send them to this article -

Surfing the Tsunami, New York Mag, Feb 2 issue

Evidently this is news to the magazine but from my vantage point, this is no different than the desk I ran or the early firms I traded with – Bright Trading, Schonfeld and ETG. There were others, lots of others, in the 1990’s – but the idea is the same – exactly the same. It is funny to read about head and shoulders patterns in New York (not to be confused with The New Yorker) but it is also a bit instructive – favorite stocks, last minute moves, the thrill of the chase….

The markets are ALWAYS a bet against what other people are going to do and Milman, the trader in the magazine, gets that.

The atmosphere is also the same as I remember it at all but Sharpe Capital where my desk was housed within a true market-making firm. Or at Schonfeld… where the wallpaper (and lunch) was amazing.

Entertaining and instructive… when you want to know who you are trading against.

This is a book everyone should read (even if this Economist link isn’t exactly flattering). My virtual sister-in-law gave it to us for Christmas (trader/market shrink and economist/options trader in the house after all) and I am very glad she did. In these days of blaming the bankers and even capitalism for the economic descent we currently find ourselves in, it would be helpful for more people, at least in my opinion, to understand even just the first chapter.

Chances are if you are reading this, you aren’t a person who needs a refresher course on this but did you know that effectively there was a futures contract in 1500 BC? In “Iraq” no less? Or the real role of credit – over time? Having been raised in a post-depression, no debt household I actually am MORE fond of the use of debt for having read this chapter.

See the thing in my mind is NOT that the banks created structured products but that 1) they were not exchange traded 2) the overall number of market players was very limited (see #1). Then you have the rating agencies …. (talk about a Madoff-like “relationship based decision”) but what about President Bush’s “ownership society” and MOST of all, the people who took out mortgages they KNEW they couldn’t afford!

Part of me wishes I would have realized that I could get that mortgage on the 3.5 million dollar house in Old Greenwich…. but oh well, I wouldn’t have done it anyway because in my own mind, the math wouldn’t have worked – even if it did compute to the mortgage broker.

I digress…. what I meant to say is I personally think the book is worth reading even if the Economist basically trashes it.