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

There must be 10,000 lists like this… let me add mine – hopefully with many useful twists.

1. You need to know what you are looking for – both to enter the market and to exit.

2. You need to know what the variations on #1 are – and what they are not!

3. You need to know what is imprecise about what you are looking for – it is more than you think.

4. You need to have thought about the imprecision long before you sit in front of the screen and certainly not just as you push the button.

5. You need to know what it will feel like if you turn out to be wrong.

6. You need to know how you will handle, manage, learn from and deal with that feeling.

7. You need to know what it will feel like if you are right – and again, how you will handle, manage, learn from and deal with it.

8. You need to know how to operate on the premise that “perfect is the enemy of the good”.

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.

Psych cap – emotional intelligence – judgment – feelings – ambiguity perception…. can we get this organized?

Ok

1. Markets are only human

2. The numbers are only a clue

3. The brain knows it

4. The brain believes it is in the jungle fighting for survival

5. The brain knows how to survive and uses all kinds of mechanisms to do so

6. It’s language is FEELINGS. Period.

7. Consciousness is feelings. Perception is feelings.

8. This makes the ultimate market data one of feelings – yours and theirs. Everything else is a proxy.

9. Because it is the jungle, it is a fight for survival.

10. This makes it emotionally intense.

11. Emotions have good info and can also be fueled by memories projecting an expectation.

12. The ultimate goal is to tell the difference.

13. The only way to do that is to get as good at reading your own feelings as you are at the charts.

14. It ought to be easier actually – as you are in total control.

15. It feels harder.

16. It won’t be if you put in just 50% of the effort.

17. You STILL need a game plan.

18. But it is the skill – SKILL – in executing it that will determine the winners.

19. Skill is different than robotics.

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!

“I must say I am finding your stuff pretty revolutionary. Just a big thank you. Just a quick question if I may: what exaclty do you mean by leverage? Your psych cap/emotions? Am I correct in assuming it means when your emotions tell you to do something (by fully experiencing the emotions) that one should then trade a bigger position, size for example, in that case?” Colin asked this question in response to the post below about old brain new brain and since it is such a great question – and comments R kinda hard to click thru to, I thought it best to bring it front, center and top!

First – I use feelings and emotions as synonyms even though technically that isn’t correct (feel a headache, feel angry …) But for practical purposes, they both are information and motivation that we experience primarily in our bodies versus our brains so ‘feelings’ ususally captures both. The idea of leveraging feelings/emotions begins with recognizing them as information.

Look at your feelings/emotions as data. Research them, seek to understand them in the same way you understand a chart. Now yes, that is a big endeavor as they, like price, are ambiguous but the payoff is at least as big as learning to read charts.

Once you are working with feelings and emotions as data, you then are on the path to being able to tell the difference between unconscious pattern recognition (experiential knowledge) and impulse - which generally can be thought of as the desire to trade something because you either want something to happen or are afraid of something else happening.

In the latter category, impulse. Impulses are feelings laced with the urge to act. Where we get revolutionary is the conventional advice which is to overpower that urge with your intellect and analysis. The problem is that the urge is taller, heavier and has been to the gym for years whereas the intellect is sleek, thin, wiry and doesn’t work out. It is funny though – if you look impulse in the eye, if you allow him to threaten you by actually feeling what he is sending out, he withers like a bat in bright sunlight. (OK I am mixing up my metaphors but…) To mix some more, try thinking of it like the martial arts, in other words, with training, you can use the “opponent’s” strength to the service of your goals.

Now what happens when you do this? By definition, you will take fewer impulsive trades and implicitly this improves your bottom line. This is leveraging emotion as a RISK MANAGEMENT tool first and most definitely includes knowing when to walk away because the impulse can bench press 450 pounds.

Now onto leveraging feeling and emotions as a strategic and tactical tool… as you get used to recognizing impulse and feeling the feelings (research), you will start to be able to recognize the difference between the feeling of impulse driven by the fear that your profits will evaporate and the feeling of instinct that your trade is not going towards your target at which point your can wisely make a judgment call to exit earlier than originally planned.

Now at this moment, the revolution really kicks in. But first, if you are following standard trading psychology you have to feel guilty and like you screwed up because you deviated from your plan. This feeling is always exacerbated by the market’s universal trick for rushing to your target moments after you’ve used your judgment or conversely rushing to your stop if you managed to stick to your original plan. These two phenomena always then reinforce that you should have stuck to the plan and you screwed up. This makes it very hard to feel confidence and it exacerbates the worry and impulse. If however you plan to use your judgment and you make the best call you can make at that point, you don’t’ take the same hit to your psych cap. When you don’t take that hit, you are a much better position to read the next trade (i.e. you FEEL MORE CONFIDENT) and know the difference between your intuition and your impulse.

The more you do this, the more you will feel it when you are really in a sweet spot and the market is about to move hard in your direction – and this Colin, when you press it – or in other words, use PSYCH CAP (feelings/emotions) AS STRATEGIC & TACTICAL TOOLS.

The thing is – all of this requires both a change in perspective and more importantly, putting the same effort into understanding your internal signals as you put into the ones the market is providing! It so happens to also leverage the brain’s reading of ambiguous market data and the fact that we are really only trying to predict other market player’s behaviors NOT where the bar on the chart is going!

DKS aka TP

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(Consider this Part 1. Obviously, revolutionary advanced trading psychology is a complex topic that can’t be covered fully in one blog post. Check out the other key words and also this page if the full course in Psych Cap is of interest)

Back in March I read Alpha magazine’s ranking of the 25 top hedge fund managers and was struck by the reported fact that Renaissance Technologies’ disparity between their funds. The flagship fund produced an 80% return, (after fees!) in 2008 but it open only to “partners, employees, ex-employees and friends”. According to Alpha magazine “Outsiders can invest with Simons through his firm’s two other funds, Renaissance Institutional Equities Fund and Renaissance Institutional Futures Fund, both of which were down last year.” (Emphasis mine)

Today’s WSJ reports on C1 “Simons Questioned by Investors” reports that for this year the Institutional Equities fund is down 17% while the flagship (closed fund) is up 12%.

Does anyone have a good explanation?

Everyone thinks the market is a game of numbers. We use complex models, umpteen oscillators or retracement calculations and even a fundamental analysis of supply and demand – all based in numbers and about numbers.

But in reality, the numbers of the market are but an illusion.

Markets are only the vacillating prices that other human beings, using the same mathematically based tools, are willing to pay. For example, what can be expensive one day can be very cheap the next if a trend has ensued.

It is only a matter of perspective. And perspective is a matter of the judgments you make.

Judgments on the other hand will be influenced by both impulsive feelings and by intuitive feelings – or pattern recognition. The trick is to have all the data on the table so you can tell the difference.

In order to do this, us market participants need to do a couple of things – give up the notion of a iron-clad trading plan based purely on historical probabilities and replace it with a trading plan based on historical probabilities (yes you read that right) AND a systematic way to leverage your judgment under uncertainty. This way you can make a decision about factors that may now be in play for the future probabilities. I mean who thought the VIX could stay over 30 for 6 months? … I am just askin.

Now in order to do this successfully, you have got to learn to optimize your judgments – which means spending more time focused on deciphering and understanding them than you spend on deciphering and understanding the charts.

This is revolutionary trading psychology – and it works.

In trading we talk about odds, risk and being consistent. We see ourselves go on winning and losing streaks where we feel like “I finally have it now” and “Oh man I am doomed – I will never be consistent!“? Many traders see-saw back and forth between the two states and then find themselves at the end of the month, quarter or year making substantially less than they could have if they hadn’t spent the downside time on the teeter totter.

In pursuit of becoming more consistently profitable, typically traders will either tweak their system (Oh if I just look at the market this way) or read a book. Trader faves when it comes to books can run the gamut from sports psychology to the current Deep Survival. Nobly, everyone is trying to understand the market and their reaction to it. In fact, many traders work harder at trading than they have ever worked at anything.

Nevertheless, there are a couple of secrets lurking out there that aren’t well publicized…

#1) The first impulse trade you take is meaningless. In other words, you can totally #&$*)@ -up, ONCE and it means almost nothing to your end of the month.

#2) It is what you do next that makes all the difference.

#3) The most profitable action you can next take is to resolve the immediate emotional/feeling dilemma. If you made a really stupid mistake, you are in BIKB – or but I know better…. and you are likely to punish yourself with more losing trades. You are mad at yourself without putting that feeling into words, you will act it out but taking it out in your account.

#4) The least profitable thing you can do at this point is to intellectualize or intentionally try to control your emotions or feelings.

How can this be? Doesn’t every book on the shelf say “control the emotion” and take ALL your signals. Yes I think almost every book does. (I don’t read them anymore but this is what people tell me).

See here is the real secret, no one can say for sure how we make a risk decision (despite books like How We Decide) but the contours appear to look something like this. If it isn’t LITERALLY mathematically precise – if you can’t solve for X, then our brains use context, senses, and feelings to evaluate what action should be taken. No one can tell you exactly how the brain uses context, senses, and feelings to assess, but the experimental evidence is mounting to the point that top neuro-researchers are willing to say “It is not enough to know what should be done, one must also feel it.” (Camerer, et. al. Journal Economic Literature)

If you turn that around it means that every single thing you do has a feeling associated with it.

Where does this leave us in relationship to consistently good trading decisions? The simple (but not easy) answer is all you need to do is understand the feelings - preferably both macro level (what you expect of yourself and echoes from your past) and micro or in the moment reactions to the result of a trade or price movement.

Every time you truly understand what you feel in the moment – you will make a better trading decision. The feelings may be ugly, they most likely are at least a bit uncomfortable but if you research and analyze them, well… as the Men’s Wearhouse hawker on local NYC TV says, “I guarantee it, you are going to like how you look“.

PS You will also automaticaly know when you feel clear and calm enough to venture back into the jungle of uncertainty that is trading.

Today I am being interviewed in conjunction with a project @ Columbia’s Graduate School of Business and a journalism fellowship project. Nouriel Roubini and Emmanuel Derman have been/are also on the docket for the subject of “What Went Wrong & What Can Be Done.”

The major points I want to make – and they apply to all traders – are

#1) Start with the core question – the Social Markets Hypothesis question of “what will the other guy do?” – in the timeframe you care about.

#2) Realize that numbers of any sort are just a tool to help in understanding the answer to question 1. No algorithm or program anywhere can account for the vicisstudes of human behavior and in order to most effectively deploy the algorithm/system, one needs to know its limititations. Without acknowledging its limitations, you have no resources when the tool is inadequate.

#3) Learn to research and evaluate internal feeling based data. Both value it and beware of the risks it brings – a double edge sword. Instinct delivered through the conduit of feelings can tell you things your deliberate analysis cannot (due to human brain’s ability to recognize a cat versus a dog) but unexamined feelings can lead you astray via their natural tendency to inject risk management (fear) or take the simplest route (the same thing will happen next as happened last).

Sophisticated modelers have powerful tools at their disposal but they still have to answer the same question that discretionary less capitalized market participants do. Anyone will be well served to make decisions in concert with their brain’s view on the ambigous data of human markets!