Psychological Leverage for Traders

• Posted by Derek on January 14th, 2012 at 8:33 am
• Comments: 0

“Solving the eternal puzzle of markets depends entirely on your ability to fluidly wield the sword of numbers as a language and not as a law.”  Denise Shull

Besides the instant access to all the news and trading ideas I need, what I’ve enjoyed most about the Twitter/StockTwits era has been the new friendships borne out of connecting those of us with common interests. Years of trading had me deeply interested in psychology and decision making, and it took about 2 tweets to realize Denise Shull was someone with whom I shared common interests. Her background as a trader psychologist made her uniquely qualified to share the realities of our thought process, and her approach differed from much of what I’d heard.

Fast forward a couple of years, and she’s now published a book that I believe should be read by anyone looking to understand and improve their decision making ability…trading or otherwise. She believes there is great information in emotion, and attempts to ignore this information takes away one of the great tools in our arsenal.

I’ll highlight just 2 concepts that immediately drew me to Denise, and that got thorough coverage as I read an early edition of her book:

1) As traders, we are motivated by fear and fear, not fear and greed

2) Avoidance of future regret is a major driver of market activity

Let’s review these past 2 days to make it vivid. Brian Shannon is a master at cutting through the BS with great perspective on market structure, while acknowledging the uncertainty that always exists in markets. The title of his post on Thursday was Unmotivated Sellers. Could not have found a more apt description of where we stood…2 words telling us that a) Market energy was clearly up but b) Risk exists the moment these sellers sense that the drift higher can be overcome with new energy.

Then the essence of Shull’s book kicked in. Sellers got a little motivated by the fear of recent gains turning to loss. Then recently sidelined short-sellers got motivated by the fear of missing out on the next drop. Then prices stopped dropping, and the primary driver became “Uh-oh, what if that was the correction?”

We could spend all day interpreting the various news items or CNBC’s take on what’s making markets move. But the truth is that new catalysts were introduced to the market mosaic, and it prompted players of all styles and timeframes to absorb the new information. All of us felt the emotion of the shifting action, but we all absorbed it differently. Some may have seen their plans thrown for a loop, some may have provisioned for the re-introduction of normal volatility.

Denise would tell us not to ignore the emotion but to acknowledge it, accept it as part of what we face every day, maybe even measure it to see if there’s a way we can gain “psychological leverage” over our opponents. Our brain is constantly calculating future potential regret; rather than blocking this out why not accept that most of our competitors are feeling the same and figure out a way to get to constructive action before they do? How about combining our constructive action with their destructive action? This is where the distinction between instinct and impulse becomes so important, and where checklists can enhance our intuitive abilities while accepting our impulsive shortfalls.

Perhaps there’s some alternate universe of flawless humans instructed by the trading version of Cobra Kai. The good news is that math-based factors like probability and reward:risk can be automated; force the theoretical onto the reality of markets and this is where geniuses whiff. I’m strongly in Denise’s camp that markets are a social event more like poker than dice, with prices moving not on complex math but the simple activity of people acting out on their emotions. Her work in this area is thorough, backed up by science, and vital to understanding how traders can use emotional context to place themselves on the right side of the market’s whims…I’m already looking forward to reading the now-published edition.

Preview Market Mind Games here