The Psychology of Trading

by Brett N Steenbarger

  A parenting example comes to mind. When my son Macrae was in his preschool years, he had periods of frustration where he would tune out adults and even lash out verbally. The imposition of limits seemed to make the problem even worse. He would simply escalate the anger and become increasingly defiant. His day care provider's concern mounted, as she could find no way to communicate with him at those times.

  I found these emotional episodes to be draining and unpleasant. After a long day of counseling, I had few emotional reserves for being considerate and sensitive. Indeed, I found myself tensing up when I entered the door, anticipating the worst. I knew, however, that simply discharging my anger would be counterproductive. Like my clients, like everyone, I felt helpless, and I initially tried to bury my frustration.

  One evening at home, Macrae was playing on the indoor playground in our basement and broke one of his toys. He immediately launched into a tirade and refused to come upstairs for his dinner. I called to him once . . . then twice . . . then three times. I could hear a slight escalation in my voice. The situation was growing increasingly tense for both of us.

  Then I looked down.

  Oddly, my right hand was curled in a tight position. It was as if I was trying to make a fist but had stopped myself midway. Indeed, on reflection, I suspect that is exactly what had happened. I was angry toward Crae and wanted to lash out, but I could not allow myself to do such a thing.

  Awkwardly, I looked down at my rigid, curled hand and took a deep breath, stepping back from the situation. A strange thought entered my head. My hand looked like a spider.

  I tore my eyes away from my hand and looked at Macrae. It was as if I were seeing him in a different light. He didn't seem so angry. He looked sad. I sensed that trying to force the issue would only make his sulking and frustration worse, so I moved next to him. As I approached, I could tell he expected me to reprimand him or threaten consequences if he didn't come upstairs. Maybe he expected to be spanked.

  I leaned down, picked him up, and looked directly into his eyes. I set him down on the couch and explained to him that he was going to be attacked by "evil spiders" that tickle boys unmercifully. I showed him my curled hand and explained that these spiders were very fast and difficult to catch. I also explained that the spiders could only be conquered with kisses; forceful blows only added to their strength, whereas kisses made them turn into "nice spiders."

  Crae's eyes lit up as the spiders crawled toward him. After a few tickles, he managed to catch one and give it a kiss, whereupon it stopped tickling and, instead, offered gentle strokes to his face. Other spiders were much faster and took a while to chase down and kiss. The downside of the exercise was that our food got pretty cold. The good part was that Crae's attention was entirely absorbed by this new game. By venting his frustrated energies toward a game of affection, a tantrum became a kissing, stroking, and bonding episode, and a broken toy was forgotten.

  On my end, by attending to my body, I had learned something about my emotional state. This, in turn, activated my Internal Observer and allowed me to channel my anger differently. Most important, there was valuable information in my curled hand that formed the basis for a creative and constructive response to the situation. Playing "evil spiders" was not a consciously thought-out strategy. My body had provided the inspiration for the game even before I had given it a name. From half-formed fist to spider, my body had created a useful pivot chord.

  I suspect that most people can identify occasions when their bodies knew something before they were consciously aware of the knowledge. Most of the time they chalk such occasions up to intuition and leave it at that. They fail to realize that their bodies are operating under the guidance of a mind and that it is a different mind from the one with which they consciously identify. This nonverbal, action-oriented, emotion-based mind is a treasure house of useful information if one can only attend to its (meta)communications.

  I have repeatedly observed the value of bodily communication in trading situations. A couple of months ago, I placed a routine trade, shorting the market when it appeared that upside momentum had waned. I was trading off one of my favorite patterns, which compares intraday cumulative uptick and downtick readings of the Dow Jones Industrial Average (TIKI) with the readings for price and the NYSE TICK. Because the Dow stocks are heavily traded by institutions, they are quite responsive to program trading. The comparison of the TIKI to both the TICK and the price change of the S&P index gives a rapid reading of the degree to which institutional trading is able to move the market. If there is a great deal of institutional trading in a particular direction and if the general market fails to move commensurately, one can often profit from the market's metacommunication and fade the move.

  On this particular occasion, I placed the short trade, as the elevated TIKI was not accompanied by strong upside price or TICK action over a period of two hours. Such a trade is usually good for an intraday countertrend move at the very least. I've researched and traded the pattern long enough to feel comfortable with it.

  After placing the trade, however, I was anything but comfortable. I watched each subsequent tick like a hawk, following the fate of my position. Moreover, after a few minutes I suddenly realized I had a headache. I had been hunched forward in my chair, thrusting my eyes closer to the screen. My eyes were fatigued and my muscles felt tense.

  It was as if I had awakened. I shook my head and said out loud, "What are you doing?" I never follow a trade so obsessively, especially a trade as small as the one I had placed. I realized, however, that my body was not comfortable with the trade, even though I had seemed to be. Despite telling myself I had a high-odds trade, my body was already mobilized for danger.

  Now attending to my body's concern, I looked at the charts in a new light, comparing the one-minute time frame to the larger multiday picture. It then hit me that the trade was not progressing as it should. The market had backed off from its highs but was not approaching the support level that I had targeted. Worse still, it appeared that good resistance wasn't to be seen until much higher. I had made a mistake. I had become so wrapped up in the short-term action that I had missed the larger picture. The market was at a relative high, all right, but it was only a way station to higher levels.

  Quickly I scratched the trade, turning a potential loser into a useful learning experience.

  I swear I had no idea the trade was going sour. But somehow my body knew.

  tions are occurring at a level beneath the interface, in a binary world of machine code.

  If your conscious mind is a reporter of your actions and not simply an initiator, it raises an uncomfortable question. How accurate are the reports of your conscious experience? Can you trust your own mind?

  Here is where the pioneering research of Michael Gazzaniga and of Joseph LeDoux is particularly relevant. As described earlier, these researchers worked with people with epilepsy who had undergone surgery to the corpus collosum, severing the connection between left- and right-brain hemispheres. They found that individuals with split brains could function reasonably well but also demonstrated certain peculiarities. For instance, people shown different images to their left and right eyes could point to what they had seen with their left and right hands, respectively. When asked what they had seen, however, they could only name the item presented to the right eye. The information to the left eye, wired to the nonverbal right-brain hemisphere, was lost to conscious, verbal awareness—even though the individuals clearly knew what they were seeing and could point to it!

  The breakthrough came when Gazzaniga and LeDoux asked the individuals why they had pointed to the picture with their left hand. The specific situation, observed with an individual dubbed P.S., was that the left field of vision (right-brain hemisphere) was presented with a picture of snow, while the right field (left-brain hemisphere) was shown a chicken claw. P.S. could then point with his left hand to a snow shovel and with his right hand to a chicken to demonstrate that he had, indeed, seen each item correctly
.

  When asked what he had seen, P.S. responded that he saw the chicken picture. When asked why, then, he had pointed with his left hand to the snow shovel, P.S. promptly responded that you need a shovel to clean out the chicken shed!

  Gazzaniga's conclusion, captured in his book The Mind's Past, is that the conscious, verbal mind is actually an interpreter. P.S. had no real idea why he had pointed to the shovel, so his verbal, reasoning mind came up with a plausible—but completely irrelevant—rationale. People's minds, Gazzaniga argues, do not present them with raw data regarding the world. Rather, their verbal, conscious depictions of the world are interpretations taken from more basic data that register at nonverbal levels. What a person is conscious of is a construction of events, not events themselves.

  In this light, my trading experience with the uncomfortable short sale makes sense. Consciously, I had woven a rationale for the short position. At a nonverbal level, the trade did not feel right because the patterns I perceived did not fit my prior experience. I had looked at so many charts and internalized their patterns that I could detect deviations from the norm before I had consciously identified them.

  Some may argue that this line of inquiry destroys the understanding of human reason. If I cannot trust my mind, how can I ever know the world? Such a skeptical conclusion, I believe, is unwarranted. It is not that human beings lack reason, but that there is far more to human reason than conscious, verbal experience. When you duck from a thrown pitch prior to consciously identifying what happened, you are behaving most reasonably, albeit nonconsciously. You are at your most rational when you coordinate your minds, gathering information, making sense of it, and testing your understanding with future experience. This, of course, is the task of any trader.

  There is much to be said for mechanical trading systems and their potential for reducing the human, emotional element in trading. Like Deep Blue, the chess-playing computer, mechanical systems may ferret out opportunities in the market far more efficiently with brute force than can a good trader. And yet chess masters do not rely simply on brute force. They have so immersed themselves in the patterns of the game that they can see moves far in advance. This allows them to quickly respond to situations that don't neatly follow the scripts of games they've studied. The great chess players, after long years of immersing themselves in the game, have reached the point where they are processing moves on the board nonconsciously, aligning their "intuition" with their "reason."

  A similar phenomenon may well be at work in market mastery. While it is comforting to rely on the advice of market gurus, there is no substitute for the deep knowledge that comes from immersing oneself in market patterns. One of my best steps as a trader was to print out every day's market action, along with every reading of every indicator I follow, for a period of years. Reviewing these charts each night cemented into my mind the normal ways the market moves, allowing my body to sense deviations from the norm, those all-important metacommunications of the market.

  This, I believe, helps to explain why the development of focus and concentration through daily rituals of market study is a common theme among those who have mentored successful traders. Only daily immersion in the markets can provide the base of information needed for the subconscious mind to discern normal from abnormal events. The psychologist Dean Keith Simonton has summarized research suggesting that greatness in any field of endeavor requires 50,000 chunks of information. Such a storehouse of knowledge can only be acquired through years of intensive study. The average trader, tossed to and fro by various mind states, is poorly equipped to sustain such effort. If immersion is crucial to reading the metacommunications of markets—just as it is critical to learning a foreign language—it is little wonder that emotionally reactive traders fail to master the markets. Their self-focused attention competes with the very processing of subtle information that provides the basis for trading expertise.

  KNOWING MORE THAN YOU KNOW: IMPLICIT LEARNING

  Step back for a moment and ask how children are able to acquire complex skills, such as speaking their native language and engaging in proper social interaction. When children are very young, they have not yet internalized the rules of grammar and syntax. As a result, they often speak in fragmented sentences, with improper usage. When I was a very young child, I could recognize Chevrolet cars on the road and would call out, "Da-da-da." Although I didn't know the word "Chevrolet," I clearly had an idea of Chevrolet and the fact that it consisted of three syllables. Similarly, before our young son Macrae had the word for "celery," he would ask us for a "lettuce stick."

  The rules of social behavior are acquired in much the same way. Young children typically lack an internalized sense of etiquette and manners and will interrupt conversations, take toys from other children, and otherwise fail to contain their impulses. Later, they learn to wait their turn, to ask permission for things they want, and to demonstrate sensitivity to others. Even before they can verbalize these rules, however, they seem to possess rudimentary knowledge of social rights and wrongs. A young child who could never verbally conceptualize rules of proper behavior still will hide a wrongdoing as soon as a parent enters the room. The child knows that he or she is doing something wrong but cannot verbally express the basis for this knowing.

  Michael Polanyi has referred to this as tacit knowledge. Much of what you know, you cannot verbalize. An excellent example is your recognition of people's faces. You would know the face of a good friend if you saw it, yet it is unlikely that you could provide a verbal description that would allow a stranger to recognize the friend in a crowd. The web of interrelationships that comprise a face is simply too complex and nuanced—too fuzzy—to neatly fit the categorical terms of language: dark hair, light hair; short, tall; and so on.

  As a young child, I knew Chevrolet, but my knowing was not amenable to verbalization. This is common among children in general: Their receptive language competencies precede their skills at spoken language. Long before a child can say, "I want a banana," she can nod "yes" to "Do you want a banana?" or reach out when she sees a banana. The concept of banana is there in some form; but it is tacit, rather than explicit.

  Cognitive scientist Axel Cleeremans and colleagues in Brussels believe that all knowledge is graded in consciousness, beginning as tacit, implicit knowing and moving through various levels of awareness until it is fully explicit and verbal. Macrae's "lettuce stick" is a nice example of an intermediate level of verbal knowing. He clearly knew that there was a resemblance between celery and lettuce (green vegetable), and he knew the shape of celery (stick-like); but he did not yet possess the word celery. Cleeremans's provocative contention is that most learning begins as implicit knowing—people acquire knowledge and skills but are not able to verbalize what they have acquired. This implicit learning, he believes, captures how people acquire language, learn faces, and internalize rules of social interaction.

  Later in this book, I will explore implicit learning and its profound implications for acquiring expertise in trading. For now, one implication stands out above others: Traders can know things about the markets without necessarily being able to verbalize them. If reading a market's communications and metacommunications is like reading social interactions, it is not surprising that beginning traders would be as unskilled in their readings as children might be in social situations. Moreover, it would not be surprising if their first dawning awareness of patterns in the market manifested itself tacitly and implicitly, rather than explicitly and verbally. Traders are going to feel what they know, point to it, and utilize imprecise language to express their knowledge long before they can accurately describe and convey it to others. Much of the accumulated wisdom of technical analysis is like Macrae's "lettuce sticks": a halting effort to capture, in words and pictures, pieces of internalized knowledge.

  Are such efforts necessarily accurate? Perhaps not. The successful trader utilizing a Fibonacci method or a chart-reading technique may be very much like Gazzaniga and LeDoux's patient P.
S. Recall that P.S. was the split-brain patient who was shown snow and a chicken claw to his left and right eyes, respectively. When asked to point to a picture that described an aspect of what he had seen, he could point with his left hand to a snow shovel and with his right hand to a chicken. But he could only verbalize what he had seen with his right eye, the chicken. When asked why he had responded with his left hand to the shovel, he invented a rationale: He asserted that one needed a shovel to clean out the chicken coop!

  It may well be that theories of trading are similar rationales: The verbal, explicit mind attempts to make sense of what the trader is experiencing tacitly. The Gann, Elliott, oscillator, chart, and candlestick patterns on which many traders rely are constructed explanations for their felt understandings, helping them make sense of their experience. As with P.S., however, the explanations may have little to do with underlying reality. They fill more of a psychological need—traders' need for coherence—than an epistemological one.

  This phenomenon is not unique to trading. Studies of psychotherapy processes and outcomes consistently find that what therapists do in sessions and what they say they do are widely discrepant. In short, therapists rely on their favorite theories to describe their behavior in sessions—cognitive, psychoanalytic, humanistic approaches—but rarely adhere to these schools of thought in any systematic fashion. Indeed, studies suggest that skilled, experienced therapists across these different schools behave surprisingly similarly. Moreover, these similar elements appear to be more crucial to the success of therapy than the specific, unique techniques advocated by each of the schools of thought.

  In trading terms, the various theories of charting, indicator analysis, cycle behavior, and waves may have more to do with how traders describe their actions than with their actual behaviors and understandings. I have noticed this during my own participation in Linda Raschke's trading chatroom, an educational service that allows traders to watch Linda trade the markets in real time. Many times, Linda has pointed out a buy or a sell signal at the same time that I have noticed it. However, whereas Linda might explain the pattern as a function of a chart configuration and a volatility-based oscillator reading, I might describe the pattern in terms of a waning level of buying or selling on the intraday advance/decline and new high/low data. We saw the same thing—and traded very similarly on those occasions—but captured our understandings quite differently. One can only wonder if both of us didn't first detect the waning velocity tacitly, only later scanning for the evidence to support our felt understandings. This would fit with Libet's research, in which our bodies respond to situations before our conscious minds.