ReThinking Trading Psychology 101 (version 2)

Originally posted on Business Insider, April 17.

Conventional wisdom in trading psychology used to depend on two primary tenets – discipline and ‘control your emotions’. But that was before neuroscience started putting traders, poker players and other risk-gamers into brain scanners. Now that we know that all decisions depend on the presence of an emotion, most perception occurs outside of our awareness and that how our bodies feel influences what we think, Trading Psychology 101 requires a re-write.

Did you know that research indicates we can only make a few – maybe as little as two – “disciplined” decisions in a row? Researchers call this decision fatigue or ego-depletion. For traders, it means that instead of sitting at the screen fighting for every tick that that same quantity of discipline imbued into a structured plan for getting away from the quotes will most likely produce an increase in P&L.

Research also shows that complex decisions, or those with many conflicting data points, create the most satisfying results when they are made non-deliberately. This means that letting a trader’s unconscious – or all of his or her accumulated knowledge – percolate into the realization the trading brain has delivered the decision equivalent of superb coffee.

In other words, going to the gym not only in the middle of the day but even in the middle of a trade will optimize your trading psyche to make the most profitable judgment call on a trade’s exit point. Pumping iron or spinning those bike wheels turns what we used to view only as physical energy into market-reading clarity. In fact, it is likely that your better read on the market’s next dance will seemingly magically come to you when your earbuds have your favorite song beating – not when you are staring at every tick trying to force the screen to give up the future’s secrets.

Which brings us to the inexorable connection between the body, feelings, emotions and risk decisions: the maxim “control your emotions” emanates from a misunderstanding. Any of us can feel anything – and not act on those feelings. Despite some pillars of psychological thinking from the 1700 and 1800’s saying that emotions essentially equal action, it isn’t true. Think of all the times you want to act-out frustration – tell your mother-in-law your real thoughts, punch the driver next to you – but you don’t. We feel without action all of the time.

Logically we only have to control our actions – and we can. The realm of feelings – which includes emotion and the sense of intuition, needs to be completely recast as data and therefore analyzed.

Adopting the strategy of “feelings as information” leads to two primary benefits – knowing the difference between and impulsive feeling and an intuitive (market experience) one. Second, untangling repetitive emotions, a sub-category of feelings, from the automatic and unconscious re-creation of “why does this always happen?” Fears and frustrations from the past, when not viewed as data, skew what we see and feel in a fractal manner – just like the small pattern in broccoli or cauliflower that repeats itself into the whole head.

In other words, we all bring our personalities and characteristic reactions to our expectations of what will happen next. A large part of those perceptions are based in the past – the market is out to get me, I will all snatch defeat from the jaws of victory, the price action (authority figures) can’t be trusted and … whatever your psyche’s fractal fingerprint is.

Antonio Damasio and his team got it started with the research reported in Descartes’ Error but now the brain-science proof is in, every decision includes emotion. This means every trading decision that turns out to be regrettable can be analyzed not from what went wrong with the analysis but from what feeling or emotion was really driving it. Everyone can look for FOMO or fear of missing out or what is really fear of future regret. Decision theory indicates this feeling to be maybe the most powerful one we have.

To take another example of unconscious emotions and how the concept of fractal applies not only to price but to perception, say a trader has a tendency to fight the trend, most of the time this can be traced to a wholly unrelated mental context of needing to prove how smart they are, needing to buck authority or being stuck in feeling like a victim who missed the real move. Analyzing feeling and emotional data, versus ignoring it, gives a trader the opportunity not only to be making judgment calls on the here and now but opens up their whole perceptual and judgment toolbox to see and act on the fundamental question, what are most of the other market participants about to do.

Given that most traders try to predict market movements based on numbers alone, the trader who wraps the human question around the numbers while simultaneously adopting what decision science now knows about the role of physical, sensory and emotional feelings in risk perception and judgment automatically derives a calculable advantage.

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This Post Has 3 Comments

  1. Steve

    Did you know that research indicates we can only make a few – maybe as little as two – “disciplined” decisions in a row?

    At what point does the clock reset when referring to the phrase “in a row”?

    If I make 2 disciplined decisons in 5 minutes & then another one 30 minutes later, or 60 minutes later, or 4 hours later is that “3 in a row”.

    What if I make a decision every 10 minutes all day long, or a decision every hour, or every 2 hours? How long would you need to rest in between decisions to avoid “decision fatigue”?

  2. DKS

    That’s a very good question – and not one that the research has addressed. My intuition about it though is at least after some kind of other mental activity and some kind of actual rest.

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