Ambiguity is one of those words that to me is both ambiguous and onomatopoetic – in other words, it is easy to be not quite sure what it means and the words itself sounds like being not quite sure what it means. … (Or, at least it does to me given the relatively lousy education I got in high school).

But beyond linguistics and back to the regularly scheduled program of Psychological Capital, why does ambiguity matter – particularly to sophisticated traders?

Ambiguity matters because it is the hallmark of markets. At any point and from any perspective, markets of all types are always ambiguous. They are never ever certain – no matter how many algorithms or sophisticated studies of historical probabilities a trader wraps around them. These techniques lure us into thinking that our results can be certain – i.e. we have a 67% chance of generating X points if we get long or short according to this relationship of these four factors – when in fact we cannot be certain.

How much time will it take? How much “negative drift” will it incur? Just these facts alone mean the possibilities are essentially endless and therefore the question is at its core ambiguous.

But why does THAT matter you say if you have tested your 67% chance and believe in it? Well first because how immutable are your beliefs? Confidence levels (feelings mind you) are variable i.e. creating more ambiguity even if this portion is actually in your psyche versus in your data.

This dilemma if you will is the exact reason that the vast majority of traders lose money. In order to be successful, it is necessary to understand, appreciate and even love the ambiguity. It is also necessary to know what to do with it. And for the latter it helps to know how your brain handles it – which is not as a serially updating computer solving a calculus or even a basic statistics question.

Faced with ambiguity, your brain naturally resorts to filing through unconsciously stored patterns and communicates with you through your feelings as much as your thoughts. Which adds even another challenge to this already daunting mental exercise of taking money from other traders (that is what the game is btw – alas, but for another post).

So… what have you been taught to do with your feelings? Discount or ignore them, right? Now you are in the position of purposely overlooking the very data you need to fully interpret what is going on in front of you – at which point, in this sea of ever-changing ambiguity, you are lost. This is why sometimes seems if you just took the opposite of every trade you would make money. How many traders have said “if I could only use myself as a counter-signal”?

The question is – instead of me lecturing – how do you handle these facts of trading?

I always know if my randomly generated “Psych Cap Tricks & Tips” hits the nail on the head by the number of unsubscribes I get. If I tell it like it is – i.e. you need to plan to use judgment in your trading plan… I get 5 people who unsubscribe.

It used to hurt.

It basically infuriates me when I hear the other talking heads talking about what stocks to buy during the exact moments that the index futures are making new multi-year lows. Why do people do this? Is it to try to make people feel better? To look smart? To feel smart? Just for TV because that is what the proverbial investors want to hear?

Bear markets mean lower lows and lower highs … and we are in a bear market until we get higher lows. and higher highs … which is decidedly NOT today.

At least Charles Payne on Fox Biz talked about SDS – one of the short ETF funds.

On one hand the world gives credence to “you can’t market time” (well what do they know) and on the other they all do the same thing us short-term, high frequency traders do which is go nuts over “missing out.” Yet missing out on the bottom is a great thing – regardless of your timeframe. The market has this funny tendency to trade at a price, reverse from it and then go back and take a look – kind of like a criminal goes back to the scene. Everyone gets a second chance to get in at a safer spot – after the market has shown its hand – and this is true in ANY timeframe.

But back to rocket surgery Mario and all of the other experts who want to tell people what to buy – this is a bear market. How can you sleep at night knowing that people will listen to you and buy what you say – maybe even today?

Today’s WSJ front page – Deutsche Bank Fallen Trader Left behind $1.8 Billion Hole. Now we have be inured to news of billion dollar losses? in the midst of Made-off, trillion dollar stimuli and Wall Street’s meltdown but.. really now. Boaz Weinstein is leaving and going to create his own hedge fund.

Mr. BW is a chess and poker whiz according to the article. So how is it that someone who is so good a figuring out probabilities got into such a mess? I am sure he is saying it was because of the unprecedented move in credit default swaps and other esoteric instruments and that excuse will be bought by untold number of investors.

The problem is, just like Brian Hunter (also formerly of DB if my memory serves me right) brought down Amaranth in 2006 with his second set of “unusual markets”.

See probabilities are not enough if you don’t also listen to your instincts and learn to tolerate the miserable feelings of being nervous or predicting that something could go wrong. That kind of Emotion Analytics would have saved Boaz …. or Brian or…..

Those who survive and thrive in these markets are those who will learn to do both. In fact, the “alpha” edge will most certainly go to those who learn the chess of the markets – which is a game about people and not about statistics.

Markets are nothing more than the reflection of human beliefs and feelings. It doesn’t matter how anyone decides upon a price at which they might buy or sell, once they “are in” it is a belief about the future (10 seconds or 10 years) that is at least the underlying REASON (ironic) they have a position.

Most of us think about the markets as an abstract series of numbers when really those numbers are just like avatars for the people behind them. Let’s suppose you trade using a complex mathematical algorithm which arbitrages gold and silver futures. It sounds as if you are trading off of the probabilities inherent in your analysis doesn’t it?

Well in reality you are trading off of your BELIEF (which you feel as the feeling of confidence – more or less so) that the model will accurately predict the movements of price in the future…. and that is always the way it is – global macro fundamentals or sub-one minute high frequency… it is always about what you BELIEVE/FEEL about what some other human will pay in the future…

Understanding this leads then to the absolute prerequisite that you understand your own beliefs, feelings and biases in order to produce the maximum in excess returns your trading is intended to create.

1. Markets are human

2. Humans make decisions and take action out of emotional foundations

3. Understanding one’s own emotional foundation enables one to make the best decisions about human markets.

Does this sound nuts?

The idea of human risk offers a different angle on the idea of psychological capital. It is easy to think about markets and pricing as abstract entities when in reality they are the sum total of human decisions. Hence, human decisions are at the core of all bubbles, crashes, rallies, sell-offs and market volatility – regardless of what time-frame you are looking at.

But does the world really have a good understanding of how humans react and make decisions?

Not exactly.

It gets complicated but the biggest news is that emotions are actually germane to decisions. In fact, without them, traders can neither decide nor act. Lots of scientific evidence supports that idea yet books, trading coaches, CNBC reporters and most people still talk in term of being unemotional. Not to use an over-used analogy but essentially that perspective on human risk is akin to still believing the world is flat.

Reducing human risk requires a whole new understanding and strategy for dealing with the reality of emotions and their role in decision-making. Step one is to change your opinion about emotions from one of they are a liability to one of they are both information and motivation – in that order!

Decision-research basically proves that we need our emotions to make a good risk-reward decision.

If this is the case, what do you suppose happens when you proactively attempt to eliminate all emotion from your thinking? Do you think you can succeed? Do you really want to succeed – given what we now know about how the human brain processes feeling-denominated sources of input?

Does the idea of “marking-to-market” your feelings make sense?