Trading naked - a psychological perspective
Robert, I would like to make a small contribution to your excellent thread, and I hope that what follows will be up to your standards!
As you know, when it comes to business my main interest is psychology, because that is where I believe the real difficulties lie when it comes to trading. I find that people - especially beginners - find this hard to believe, but interestingly once they have been pitting their wits at the markets for a little while, most of them eventually come to the realisation that it is true. Some don't however, and what they do when they lose money is they invariably try out another trading system in the misplaced belief that it was their system that failed them, not their own approach. This is the road to wipe out.
In the light of this I would like to address a particularly interesting human trait, and one which has been responsible for enormous growth in one of the business areas related to trading, that of forecasting markets. It is also the reason for the existence of so many market indicators, such as Stochastics, RSIs, Bollinger Bands and others. Here we go…
The human brain is constructed of many parts, one of which is the neocortex. This is the reasoning part of the brain, and it happens to be a relatively new part in terms of our human evolution. Unfortunately, rather like a new piece of software, it is not always very good at what it is supposed to do. One of the things it tries to do, unfailingly, is find order - even when there is none.
Some years ago an experiment was carried out with rats, in which they were placed at the base of a T-shaped tunnel. Food was placed at one of the ends of the cross bar and the rats were released. If the rats turned the correct way, they got the food; if not, they went hungry. What the researchers did was to place the food either on the right or the left at random, but 60% of the time on the left. Eventually the rats learned this. Once they had done so, they without fail would run up to the junction and turn left, thus getting fed 60% of the time.
The interesting part is this: when the experiment was repeated with university students (although perhaps not with rat food this time!), the students spent a great deal of time analysing the pattern of the food drops in an effort to work out the system and optimize the success rate. Unfortunately, the food drops were, as before, completely random with, as before, a bias to the left of 60%. The students were convinced that they had found a pattern. They followed the imagined pattern and only got the food 52% of the time.
Outcome? Humans were outdone by rats! Read on…
Let us now think about this in the context of the markets. How accurate are market forecasters? How accurate are economists at predicting the state of the economy? How accurate are the press when it comes to share tips?
The best trading systems are those which allow for the possibility that the market can do anything! Once we accept that the market can truly do anything, we then cease to have an expectation – and this is absolutely fundamental. Trade management is where we should concentrate, and that includes risk management and money management. Identify trading setups which give an edge, cut the losses, run the profits. Identifying trade setups which give us an edge is not the same as forecasting the direction of the market; there is a subtle difference. This does not belong here however, but falls within the domain of crowd behavioural theory and that particular area of trading psychology.
The final point to mention is that the types of indicators and price studies I mentioned in the second paragraph of this article are a direct result of this human trait of wanting to find order out of chaos and thus be able to predict the future. Sadly however, they do not predict the future, but instead they give us an illusion that this is what they are doing for us, and that illusion serves as a comfort blanket. By their very construction, price studies can only provide a descriptive statistic. It is when we choose to use these as inferential statistics that we are bound to fail, like when we try to find a pattern for the food drop in the T-shaped maze. Price alone will tell us where the buyers and the sellers have won the day, and remains in my opinion one of the most effective ways of judging the likely direction of a market. Support and resistance are where we should concentrate, leave the indicators to those who are continuing their search for the perfect system. If any single indicator was really useful, it would be the only one!
Trade what you see, not what you think! Happy trading.
William Robinson