The Psychology of Trading

by Brett N Steenbarger

  The process of attending to cues and making those midcourse corrections should sound familiar to traders. Socially skilled individuals cannot predict the predilections of their companions. But they can be alert for the metacommunications that reveal those predilections—and the shifts in those preferences over time. Nimbleness, not the ability to peer into a crystal ball, is the hallmark of both the skilled communicator and the successful trader.

  There are important implications attached to this line of thought. Markets, like people, engage in communications and metacommunications. A market's communications are its movements over time: up 10 percent in three weeks, down five points in the past hour, and so on. The market's metacommunications describe how it makes these movements: gradually or suddenly, on high or low volume and volatility, with a majority of stocks participating or not participating, and so on. Much of what we call technical analysis is an effort to read the metacommunications of the market.

  Imagine two similar five-minute bar charts: The first depicts a market that has risen from A to B in the span of a day. Its rise was steady and trending. The second chart also shows a market that has risen from A to B during the day session. But this rise was choppy: periods of buying were interspersed with squalls of selling. The market's communications are identical, but the metacommunications are anything but identical.

  The market in the first chart is relatively efficient: The distance it traveled over the entire day closely resembles the sum of the distance traveled during each five-minute time span. The second market is inefficient: It traveled a considerable distance from period to period just to arrive at the same end point. Such inefficiency is an important market metacommunication. It means that the primary trend is encountering significant disruption. A decrease in efficiency—the ratio of distance traveled over a time span to the distance traveled within that span—very often precedes a change of trend. Markets, like rivers and humans, begin their lives straight and swift and end in quiet meandering.

  The same phenomenon can be observed in therapy. Shifts in efficiency precede important changes in thought, feeling, and behavior. Such shifts are among the most important metacommunications. Before a person ever becomes so depressed that they contemplate suicide, subtle signs of inefficiency emerge: They stop enjoying the things that used to bring pleasure; they cannot tolerate stresses with which they had been coping previously; situations they had tackled with energy now become overwhelming. When people with histories of depression and suicide no longer respond to positive stimuli in their accustomed way, they are exhibiting a useful leading indicator of suicidality. The absence of the positive often is predictive of the future emergence of the negative.

  In a similar vein, if you think of the market as a factory—a production system with inputs and outputs—then you can ask meaningful questions about the relationship of inputs to outputs. These are crucial metacommunications for markets, as for people. A market will rise on a given level of advance-decline strength among stocks. Then, suddenly, there will be a shift. A positive advance-decline reading will no longer generate higher prices. The price chart flattens out, even in the face of indicator strength. The market factory is no longer as efficient; it is taking more input to gain the same output. That, for the market as for the depressed client, is a potential leading indicator of trouble.

  Conversely, a market may decline for days, bounce, and then hit a new wave of selling, as measured by the New York Stock Exchange (NYSE) TICK. But the selling may not take the majority of stocks to new lows. The market is losing efficiency to the downside. This subtle but meaningful metacommunication precedes a great number of advances, even on an intraday basis.

  Skilled tape readers appear to be individuals who have spent sufficient time immersed in the markets that they are able to read the subtle shifts of momentum, acceleration, and volatility that precede trending movements. This seems to especially hold true for floor traders, who scalp small moves over a matter of seconds. With trades lasting such a brief time, there is no opportunity for elaborate statistical analysis. Instead, the traders become exquisitely attuned to the subtle metacommunications of the floor: the activity of trading, the ebb and flow of volume in the pits, the quick shifts in the bids and asks, the pattern of activity among the major and minor players. Little wonder that many floor traders initially struggle with their trading when they move upstairs. Denied their database—those metacommunications that guide their internal sense of rhythm and momentum in the markets—they are temporarily left without a trading rudder.

  METACOMMUNICATIONS IN TRADING

  I know all too well the experience of trading without a rudder. When I first began analyzing the markets, I treated all rises and declines similarly. If the market rose 5 percent over 20 days, I would scan my database for all occasions in which the market had made a similar move. I would then see what happened subsequently on each of those occasions, in hopes of identifying a nonrandom pattern.

  While admirably quantitative, my approach was equivalent to participating in a conversation with my eyes closed. My approach allowed me to pick up the communications of the market, but not the metacommunications. It made me a socially unskilled—and not very successful—trader.

  An analogy best captures my predicament. Of the romances I observe among the students I teach, far and away the least successful are those that begin online. Typically, the parties meet in a chat room or through a relationship-oriented web site. They begin a frequent round of communications, often sharing intimate details of their lives. Elated at the prospect of meeting someone who really listens and cares, they arrange a face-to-face meeting.

  That is when it all falls apart.

  The online medium removes most elements of metacommunication from interactions. When you're chatting online, you can't see that the other person has a depressed tone of voice, a disheveled appearance, or a shifty-eyed charm. The person you fantasize about on the Internet ends up being wildly different from the person you meet. Much of what people experience as personal chemistry emanates from mutual responses to metacommunications.

  Trading without an appreciation of metacommunication has about as much chance of success as online dating. As important as what the market is doing is how it is doing it. Markets are like people: They signal changes in their emotional states with shifts in metacommunication. I refer to these subtle changes as "gearshifts."

  If you have ever driven a manual transmission automobile, you are familiar with gear shifting. At a high gear, the car will reach a rapid speed for a given level of engine revolutions per minute (RPM), perhaps 140 miles per hour, before the tachometer hits the redline. At a lower gear, the car will reach the redline well before this maximum speed: Lots of revs produce less speed, but greater acceleration. If you want to pull out into traffic quickly, a low gear will provide maximum torque, propelling you into the flow. If you want to cruise at high speeds along the highway, a high gear will work best.

  A capable driver is one who knows when to upshift and when to downshift, depending on road conditions. Driving is an active process, involving continuous adjustment to turns in the road, traffic patterns, road surface conditions, and so forth.

  People shift gears, as well, in the course of their conversations. The gearshifts take the form of changes in the volume, the rate, and the inflection of speech. Other gearshifts are manifested as body language, as when a person alters their posture in response to a topic. Often, by watching the metacommunications of two people having a conversation, you can determine whether they are in sync. Rapport between people is evident when each person tracks the metacommunications of the other. The result is an elegant ballet, in which eye movements, vocal tones, and bodily postures are coordinated in a manner that could never be duplicated by conscious effort.

  Conversely, you can tell when a conversation is going poorly when the parties are shifting gears at different times and in different ways. The result is akin to a speedway in which some drivers are accelerating, while oth
ers are slowing down. A pileup is the likely outcome.

  If there is one thing known about therapy, it is that the outcome is highly dependent on the rapport that develops between counselor and client. Therapists are unlikely to have any influence and credibility if their clients do not trust them. Consequently, the first task of a therapist—or anyone in a field where results hinge on the quality of the relationship, whether it is dating, sales, or medicine—is to develop a strong bond. In therapy, like dating or sales, results will occur much more quickly when rapport is present from the start.

  As in Mary's case, I invariably begin my work with a new client by engaging in small talk and scanning for the subsequent metacommunications. I especially like to introduce an element of humor or chitchat in the opening minutes of sessions. The responses are instructive, indicating whether people will be able to stand sufficiently apart from their concerns to engage in humor. If the client responds to my "How are you?" by subsequently asking how I am doing, or if they can chat about sports, the weather, or the latest school rumor, it is a sure sign that they are not overloaded by their presenting problems.

  I utilize such interpersonal indicators the way a trader employs market indicators. When people do not give the "normal" response to a situation, it is a sign that something abnormal is afoot. Similarly, when markets fail to respond normally to an interest-rate cut or to a piece of good earnings news, it is a metacommunication worthy of attention. It means that the market is not shifting gears when expected. There may be trouble on the expressway dead ahead.

  Dashed expectations are one of the most important metacommunications a market can give you. When the market is not doing what it is supposed to be doing, the chances are good that a profitable opportunity is at hand. This is why my early efforts to investigate current periods by investigating all similar past periods missed the boat. The context of that move—whether it occurred after favorable economic news or interest-rate hikes, whether it was achieved on low volatility and breadth, whether it occurred all at once early in the period or was evenly spread throughout—makes all the difference in the world with respect to future expectations. What traders see on the screen is the market's conversation with them. Like psychologists, traders want to be attentive to the tone and the pace of the communications, not just to their literal meaning.

  Here is a simple example of such attentiveness. A market moves sharply lower for two or three days in a row, carrying the majority of stocks to multiday lows. The following day, it opens lower still, perhaps aided by the comments of pundits who latch onto the evident weakness. This morning drop, however, is subtly different from that of the past several days. The NYSE Composite TICK—the number of stocks making downticks versus upticks at each moment—stays well above its prior lows. One or more sector indexes may even resist the morning decline, suggesting pockets of strength in the market.

  Many traders fail to read the metacommunications. They are wired as human beings to look for patterns—signs of meaning—in the things they perceive. Once something happens two or three times in a row, traders are likely to see it as part of a meaningful pattern. When they experience a market decline for several days, their normal human expectation is to expect continuation.

  On such occasions, I generally look to see how traders are responding to the market as a useful piece of body language. One of my favorite ways of doing that is to take an exchange-traded fund (ETF), such as the SPY or QQQ, and watch its action trade by trade. Specifically, I look for the proportion of trades that are being made in small lots—100 or 200 shares—versus very large lots. Very often, it is the smaller, less-sophisticated trader who fails to read the market's language. If the proportion of small trades spikes up during the morning decline, even as pockets of strength are evident, it's generally worth fading the little guys. They are missing the market's metacommunications.

  As I indicated earlier, I have also found the intraday volume of the Standard & Poor's (S&P) and Nasdaq E-Mini contracts to be useful in reading the metacommunications of the market. A scrutiny of one-minute volume readings placed in the context of market action suggests that a large proportion of the small, E-Mini traders operate in a breakout mode, piling into the market on new highs and lows. When there is such a rush to enter or exit on a weak breakout—one in which a significant number of sectors and stocks do not participate—these often turn out to be false breakouts and profitable opportunities for fading the crowd. Your position will benefit once the herd has to unwind its positions.

  When the market reverses its down open and moves into positive territory, or when it reverses a seeming breakout, the action violates the psychological expectations of traders. They're expecting a fifth-gear cruise downward, and the market suddenly downshifts and heads north. Temporarily they are out of sync with the market, just as I am out of sync with a client who cannot respond to my humor.

  Good traders—like good psychologists—know what to do in such circumstances. They have a short throw on their manual transmissions and can shift gears at a moment's notice. Some of the best trades occur when the market violates logical or psychological expectations. A trader's own emotional reactions to such about-face moves can provide some of the best cues for engaging his or her gearshifts.

  The majority of very short term traders lack the time to engage in lengthy mathematical analyses of the market and hence rely on more readily available tools, such as chart patterns. These patterns frame the traders' expectations and, as a result, become a useful tool to trade against when those expectations are not met.

  While the average trader may be focused on the communication—the chart pattern or oscillator signal—the metacommunications may be pointing in a very different direction. A good example is a region of flat price action following a nice market advance. The flat action interrupts the rise on the charts and thus naturally appears as a forming top. Indeed, the technically minded trader may even monitor volume in the flat region and conclude that a decline is at hand because a waning number of shares are changing hands.

  Missing from the trader's analysis is a reading of the market's body language, an appreciation for how the market is correcting during this flat period. An instructive exercise is following a basket of stocks and observing new highs and new lows on a short-term basis. In my own trading, the aforementioned basket of 40 stocks (30 Dow issues and 10 tech, financial, transportation, and other issues to mimic the S&P 500) offers a nice reading of metacommunication. Specifically, I monitor the number of new highs and new lows being made on a rolling 30-minute, 2-hour, and 10-hour basis. (Ten hours corresponds to roughly 1.5 days of trading). Longer-term, position traders may utilize a lengthier time frame for counting new highs and new lows, such as a 20-day period. The important thing in trading a consolidating market is that you be able to observe the shifts among new highs and new lows within the period of consolidation.

  It is interesting that what appears to be a topping region may end up looking quite different when placed under the metacommunication microscope. With each drop inside the flat zone, fewer stocks make new lows. The negative TICK numbers during selling periods dry up at higher levels. Volatility begins to move a bit upward. Then, bam! The market breaks out of the flat area to the upside. The shorts are forced to cover on the volatility breakout, further fueling the upward move.

  Later, the faked-out traders will look at the chart and see an upward trend dwarfing the flat region. They will shake their heads and wonder how they missed such an "obvious" move. They may even search for new chart patterns and advisory services to remedy their errors. All of this is akin to shuffling the deck chairs on the Titanic. Reexamining communications will not avail when the issue is one of metacommunication.

  THE COMMUNICATIONS OF TRADERS' BODIES

  Traders have their own body language, which can be very helpful to monitor. Traders are constantly communicating, even when they are not talking. Their facial expressions, body postures, and gestures all communicate their emotional state to
the outside world. Unfortunately, most traders do not attend to their bodies and, hence, are unaware of these most valuable sources of information.

  The psychiatrist Wilhelm Reich first introduced the idea that people's emotional defenses are actually bodily phenomena. People tense their muscles and hold their bodies in awkward positions in order to prevent themselves from experiencing uncomfortable emotions or impulses. If, for instance, I am particularly threatened by my own anger toward my children (because it contradicts my image of myself as a loving father), I may become particularly tense during a moment of conflict. I will tighten the muscles in my forehead and try with all my might to banish the evil thoughts that no good dad should have. Later, inexplicably, I will complain to my wife that I have a headache and feel exhausted, completely unaware of the internal, emotional battle I have been waging.

  Various approaches to therapy have been developed to utilize shifts in people's physical state as triggers for reprocessing their problem patterns. In bioenergetic work, for example, a person may find herself feeling sad for no apparent reason. After relaxing her muscles and unfolding her arms and legs, she may suddenly gain access to new pieces of information. Only then will she recall that today is the anniversary of an important loss.

  The metacommunications of one's body are vitally important because the body often knows things that the mind does not. Or, more properly, you process the world nonverbally before making sense of it through language. If you can read your own body language, you can obtain a deep insight into the goings on of Mind #2.