Trading Can Be Counter Intuitive

Trading Can Be Counter Intuitive
Dr. Woody Johnson
Instructor

How often have you been in a trade and you thought, “Why should I put a stop in or let the price action hit a stop and take me out?” Actually, if you’ve had this thought it would have been “natural” and “intuitive” because humans in almost all cases have a “loss-aversion bias” meaning that we would rather leave money on the table than give back what we perceive is already ours. In other words, trading can be counter-intuitive. Here’s an example of this concept. Let’s say that Sylvia took a trade on the YM E-mini 5 minute chart, which had been trending downward in a highly volatile manner. Sylvia knew better than to tinker with her stop, but she really wanted to avoid getting stopped out. Just then, before she knew it, despite her promise not to, she had moved the stop a couple of points higher. A few moments from that it happened again and again until Sylvia had done it several times leaving her with a looming loss by the time she closed her position. This was a considerably larger loss than she would have experienced had she followed her plan and simply allowed the stop to do its job. Now she felt angry, stupid and sick to her stomach as the realization that she had again done the very thing that she swore she wouldn’t. Shirley was caught in the middle of something that was intuitive; that is, attempting to avert a loss by keeping the price action from canceling what she hoped would be a winning trade. Of course, consistent successful trading is based on behavior that is often “counter-intuitive,” which in this case is incurring a small loss to avert a bigger one.

This and a number of other examples demonstrate that trading is a counter-intuitive process. In the above we looked at how the fear of failure can and often does drive decision making as described in Prospect Theory also known as “loss-aversion” theory as proposed by Kahneman and Tversky, two psychologists in the early 1980’s. They state that people value gains and losses differently and will base decisions on perceived gains rather than losses. Sylvia’s compulsion to move her stop and keep the hope alive for a profitable gain outweighed her desire to keep her losses small. In other words if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose possible gains even though it meant actually losing more in real terms. Some other “intuitive” trader mistakes are holding losers too long and exiting winning trades prematurely. Here we have another instance of the importance of holding and following through on counter-intuitive thinking, emotions and behaviors. Additionally, Terrance Odean in a paper written in The Journal of Finance, October 1998, discussed in his research that traders and investors have strong inclinations to “follow the crowd” and either jump impulsively on poorly planned trades or put money into popular stocks that do not merit investment. Similarly, it is counter-intuitive to “wait to buy” in a demand zone as the price action is screaming straight down when the natural tendency is to jump in on the short or to fearfully stay out due to an inability to pull the trigger.

So, what do you do when your body, mind and emotions in their natural tendencies tell you to disregard plans, violate rules and break commitments to yourself? One way is to embrace an approach that is emerging as an important field of thought regarding the financial markets. An example of this is behavioral finance (accepting and tracking markets as more than cash flows, earnings, and interest rates, when more-to-the-point these variables are actually psychological barometers that are indicative of the current mood of traders and investors). According to James Berman, a behavioral finance expert, this notion of “counter-intuitiveness” is extremely important when preparing, analyzing, processing and executing your investment strategy or trade. Considering a behavioral finance approach means dropping the traditional assumption that the markets are driven by rational decisions and realizing that cognitive psychology (how people think…and often the irrational quality of thought processes) drives much of the inefficiency of the markets. This realization that the markets are unpredictable will help you, if you are counter-intuitive, to avoid the frequent bubbles that surface from time to time like the dotcom bubble that left many investors out in the cold when it burst. Or in the words of Warren Buffet, counter-intuitive trading and investing in part means, “Be greedy when others are fearful and fearful when others are greedy.”

Another approach to employ that uses the information from the psychological barometers of the markets is to extricate yourself from “herd mentality” as a novice trader and investor. You must be able to track the order flow and identify when the losers will quit which means the market will retrace or reverse. The order flow is created from a natural imbalance between buyers and sellers; this imbalance becomes the price action. Your order must be ahead of the next wave of orders in the direction of the price action. You must understand what prevents you from seeing where the loser is…because as a novice you “are” the loser at this point. In many ways your thinking is the same as every other novice out there. This is paramount to your trading because these changes in the markets, and the beginning of substantial moves, are where trading and investment profits are realized. In order to remove yourself from the crowd you must monitor your thinking. Learning how you think gives you clues to how they (the herd) think. Identifying those times when you feel the urge to do something that is out of line with your stated plan or a violation of your rules is to be documented. Remember, you can’t change what you can’t face and you can’t face what you don’t know. You must track your thinking, emotions and behavior. This is key to getting the results that you want.

Clarity of thinking and emotional patience precede counter-intuitive behavior. Furthermore, your A-Game depends on it. Master your mental game by first becoming aware of what you are thinking and then you are in a better position to change in the direction of growth in your trading outcomes.

Happy Trading,
Dr. Woody Johnson
wjohnson@tradingacademy.com