The Psychology of Trading

by Brett N Steenbarger

  In subsequent sessions, that behavior led us to a fruitful exploration of the demands of relationships and investments and the ways he met or avoided these. His state shift, assuming the same facial and vocal expression in both market and relationship situations, alerted me to the issue he was facing. My own shift, confessing my feelings of inadequacy in a lurching, volatile market, modeled for him a different style of interaction: one that faced problems, rather than pushed them away.

  Successful traders and counselors use themselves as emotional barometers. Like poker players attentive to the tells of their opponents, they scan for the subtle cues that inform them when conditions are ripe for change. Whether you're trading from the couch or the couch is your trade, you become proficient when you learn to read the markers and use them to time your interventions.

  MARKERS AND THE MARKETS

  I find it helpful in my own trading to think of the market as one of my patients. Each day, sitting in front of the screen, I am in session. The market is telling me its story, written in upticks, downticks, trends, and consolidations. As in my counseling sessions, I attempt to catch the themes in the market's communications. I watch for the markers: the evidence of shifts in pace and tone, the overreaction and underreaction to news events, the depth of conviction of buyers and sellers on the market-maker screen, the relative activity of institutions on the buy and the sell sides. If I can stay focused, identify the themes, and time my interventions according to the markers, the odds are pretty good that I'll be successful. Conversely, if I'm caught up in my own reactions or especially if I am trying to impose the themes I want to hear, the chances are great that I will miss what is being said and pay the price.

  Following the markets or holding a counseling session is much like attending a great symphony. The composer begins with the exposition of a theme and then develops this theme through rich variations and elaborations. In the ballet Petrushka, for example, Igor Stravinsky introduces distinctive themes for each character, including a melody for the title character, a puppet that wants to come to life. In the interplay of the themes, the interactions of the characters can be visualized: the soaring hopes of Petrushka, his love for the ballerina, his conflict with the Moor, and his eventual demise. Appreciating fine music, much like reading fine novels, requires an ability to abstract themes from the score and to follow their development.

  In counseling sessions, as in great works of music, the dominant themes are generally expressed in the opening minutes and subsequently elaborated. Skilled therapists are attentive to the communications and the metacommunications at the opening of a session. These generally establish the themes for the remainder of the visit, encapsulating the most important issues in the person's life at that time. Psychoanalysts sometimes refer to a triangle of conflict, in which themes are recapitulated in past relationships and present relationships and in the relationship with the counselor. Underlying the triangle notion is the awareness that themes are the glue that cements an emotional life.

  Last week, a student began her meeting with me by spending an inordinate amount of time talking about trivia: the weather in Syracuse, her vacation plans, and so forth. Knowing that she had her board exams coming up in less than a week and chafing just a bit to get down to business, I jumped in and asked if she was having trouble with procrastination in her studies. She gave a surprised look, as if I were clairvoyant. There was no extrasensory perception (ESP) involved at all, however. I simply relied on the symphonic principle that there is a structure to communications, in which seemingly different topics express variations of underlying themes. Her avoidance of therapy work in the opening minutes of our session mirrored her larger avoidance of schoolwork.

  There is a similar structure to market communications as well, allowing traders to place their stocks on a couch and read the themes. In the market, as in counseling sessions, the opening minutes of a trading day often establish durable themes. Sometimes the themes involve the outperformance of one sector over others, as in occasions when traders can see money being pulled out of old economy stocks and placed into technology, biotech, and other new economy shares. In the opening minutes of the session, I scan sector indexes for the performance of consumer ($CMR), cyclical ($CYC), financial ($NF), and technology ($MSH) issues, as well as for the performance of broader old economy stocks ($XMI). Even within a large group such as technology, it can be worth identifying themes that distinguish among, say, networking companies ($NWX), semiconductor manufacturers ($SOX), and computer manufacturers ($XCI). Occasionally all the groups will be up or down solidly, signifying a possible trend day for the sector or for the overall market. Much of the time, however, some groups will be outperforming others, sometimes significantly. These themes often persist through the session and can set up worthwhile trades.

  Other themes that set up early in the market day may be somewhat subtler. I like to think of the markets in the stock index futures as segmented three ways: (1) the day session, from the market open (9:30 A.M. ET) to close (4 P.M. ET); (2) the overnight session, from market close to 8:30 A.M. Eastern Time (ET), at which point the next day's trading picks up, often in response to fresh economic news (the overnight session tells how the market is responding to overseas markets and overnight news); (3) the preopening market, from 8:30 A.M. to the open, reveals the market's response to economic data coming out that day. (Sometimes the data are released at 10 A.M., creating a larger window for viewing the response to economic news.) Does the overnight market significantly penetrate the previous day's highs or lows? Is the overnight range significantly extended following the release of economic data? Very often, the failure to take out prior highs/lows in the face of strong/weak economic data and overseas markets is a meaningful marker for a pending reversal.

  As a market therapist, I keep my eyes open for early market strength or weakness—as revealed by futures premiums and the Dow, the New York Stock Exchange (NYSE), and the Nasdaq TICK—that fail to penetrate the price highs or lows from the previous night's Globex session. This suggests that fresh buying or selling is lacking, setting up a hypothesis that I may test the night session's opposite extreme. Conversely, a sharp breakout from the Globex range suggests that new buyers or sellers have entered the market, encouraging the hypothesis that a trending move may be afoot.

  Volume and volatility patterns can form another valuable set of markers. There is a normal pattern of volume and volatility during a trading day, with the highest levels registering early in the morning, waning into the midafternoon, and then picking up in the later afternoon. Sometimes, however, volume levels become distorted, violating the usual smile curve of intraday volume. For example, afternoon volume may pick up on a breakout, nearing or exceeding opening levels. Such moves often serve as markers for fresh market buying/selling and, as such, tend to have legs.

  The question for the trader is when a difference among sectors, price levels, or volumes represents normal, expectable variation and when it encapsulates a distinctive theme. Those who immerse themselves in the market and continuously follow the various groups in real time gain the ability to tape read meaningful deviations among the averages. I find it helpful, again following the Galtonian example of Victor Niederhoffer, to rely on counting exercises to determine if a theme is operative. For example, simple studies over a given lookback period can establish the average relationship between price changes in two averages and the normal variation from this mean. When I see the price changes of averages moving away from their historical relationship by two or more standard deviations, I know it's a rare event, and one worth paying attention to.

  As a short-term trader, I perform some of my counting in a simplified manner, simply scoring each minute in the market as up, down, or flat for each sector average I follow. When the averages are in sync, their cumulated up/down scores are quite similar. When they diverge greatly, however (and, again, I can ascertain this statistically by identifying the average divergence and the variation around this), I can hypothes
ize that money is moving out of one area and into another. This is generally a theme worth paying attention to, helping you make choices if you are contemplating buying, say, Dow versus Nasdaq futures or large cap (SPY) versus midcap (MDY) exchange-traded funds.

  MARKERS WITH THE NYSE TICK

  Other themes that pertain less to individual sectors also tend to show up in the market's opening minutes. A gap opening on an extreme TICK reading very early in a session will very often signify trending strength or weakness that persists through the day. Early dips that terminate at a zero TICK level—failing to get into negative territory—often suggest that selling will be modest through the day. Conversely, gains early in the day that cannot push into positive TICK territory generally occur in choppy-to-downward markets where rises will not be sustained.

  At the start of each trading day, I make sure that I am aware of the recent TICK range for the most recent session. The TICK range is the difference between the highest NYSE TICK reading for the day and the lowest reading. I then utilize my nearest neighbor modeling to identify all previous days in my database with a similar TICK range. I specifically examine the average TICK range for the next day and the expected variation around this. My working hypothesis is that the coming day's TICK range will be within the range described by this average and variation.

  This has important implications, creating a new set of markers. If a hypothesized market bottom early in the day occurs at a TICK level of –250 and the projected TICK range is 1050, I entertain the notion that the market will, at some point in the trading day, hit a TICK around 800. Right away that tells me two things: (1) that there is likely to be net buying for the day (positive TICK levels exceeding negative ones, which correlates with the day's advance-decline numbers); and (2) that a tradable bounce may be at hand, as the market moves from a TICK of –250 to +800.

  Some of the most interesting junctures in the market occur when early themes are interrupted by new markers. This indicates that the themes are shifting, pointing the way to potential trend change. Those are the occasions when traders, like therapists, need to be their most nimble.

  Suppose a market has been chopping around in the early going in a fairly narrow range, with the cumulative TICK neither exceeding +200 nor declining below –200. That is a market that a short-term trader might stay out of, given the low volatility and directionless trade. Suppose, however, the market breaks down to a new daily low on –750 TICK and rebounds only slightly on a rise back to a positive TICK level. What do you do?

  Unless the market has been declining for a while, making this a last gasp decline, the winning move, on average, will be to place a short. The sharp downside move in the TICK and the violation of the trading range signify a change of theme. Up to the point of that decline, moves into positive TICK were taking the market to the upper end of its trading range. Now the moves to positive TICK are barely moving the market higher. This loss of efficiency is an important marker that generally heralds subsequent weakness.

  An important marker—and one of the least well understood—is trading volume. Extremes of volume (which are correlated with volatility extremes) often occur toward the end of market moves, as the majority of traders attempt to hop aboard a train that has already left the station. If I am holding a profitable position and the market moves sharply in my favor on high volume, creating an unusually wide bar on the chart, I almost always will formulate a plan for taking profits. If the trend is that obvious, with traders clamoring to get on board, it is generally in its latter stages.

  Volume markers can be difficult to discern, however, for short-term traders. As mentioned earlier, there is a natural tendency for volume to be highest toward the beginning and the end of each trading day and lowest in the midday hours. A given volume at 12:30 P.M. ET may be quite high for that time period but relatively low compared to the opening or closing volume. For this reason, I compute a statistic that I call relative volume. Simply stated, relative volume compares the volume at a particular period (from one minute to one hour) with the average volume for that period over the past X days. (In my own trading, I have a chart of average five-minute volumes for the exchange-traded futures [ETFs] and futures contracts I follow, with a 100-day lookback period.) This allows a trader to know, objectively, when volume at a particular period is high compared to its norm. When a trader sees a move out of a trading range at 10:30 A.M. ET on a five-minute volume that is three standard deviations above the normal 10:30 A.M. ET value, he or she will often see a continuation of that new trend. This is because the heightened relative volume designates an expansion of buying or selling interest. Conversely, when a trend has been in place and there is a sudden surge of relative volume, it often serves as a marker for prospective periods of consolidation or reversal.

  (Note: As mentioned earlier, I prefer to measure volume in trades rather than in shares traded. This statistic is available from most real-time data feeds. Although the number of trades placed per unit time generally correlates well with the number of shares traded, there are times when the latter yields considerable distortion due to individual large-block trades, especially if you are following volume on a very short term basis. The number of trades is more sensitive to the buying and the selling activity of small traders, enhancing its contrarian potential.)

  Many markers of change in the market closely resemble those in therapy sessions. Sometimes I open a window on my screen and observe the time-and-sales data flying by for a given stock. The screen captures every trade that is placed and the shifts in the bidding and the asking prices. At market turning points, you can often see a quickening of the screen's pace; you can also observe the uptick in pace when a dull consolidation range is broken and a new trend emerges. Floor traders are well acquainted with this marker, observing the noise levels in the pits for an indication of buying and selling interest. It is almost as if the market were acting like a therapist, shifting the pace and the tone of communications to emphasize certain points and to induce shifts in awareness.

  Long periods of immersion in the markets are invaluable in helping traders become sensitive to these rhythm shifts. The trader's sensitivity, however, is like that of the therapist, in that the best move to make may be contrary to the rhythms. When a client's voice goes flat, that is often the best time to introduce emotion; when the pace of conversation slows, that cues a shift to a livelier topic. Similarly, a quickening of the trading pace late in a downside move may induce feelings of panic for traders long the market, as drawdowns mount. The proper couch-trading response, however, is the one that does not come naturally, viewing the panicky trader behavior as a marker for future reversal—and a possible long entry.

  Themes and shifts in themes are seen in social conversation; in works of literature, art, and music; in psychotherapy; and in markets. Just as alterations of mind states precede psychological change, so do shifts in themes commonly accompany market changes. When the market is on your couch, you're listening to it talk and following its ever-changing, ever-fascinating permutations.

  THE POWER OF DREAMS

  Yet another parallel between traders and therapists is that both listen to their own emotional themes. For that purpose, few sources are more powerful than dreams.

  Dream work holds a venerable place in the history of psychology. Ancients believed that dreams were portents from the gods. Freud theorized that dreams are a royal road to the unconscious mind, informing the dreamer of repressed conflicts. Carl Jung expanded on the Freudian notion, emphasizing that dreams are communications from the collective wisdom of unconscious minds, pointing the direction to solutions, not just problems.

  What is definitely known is that dreaming is essential to mental health. Deprived of sleep, individuals first become tired and cranky, then disoriented. People with sleep apnea, a condition in which snoring interrupts their sleep, often experience reduced dreamtime, resulting in fatigue, poor concentration, and symptoms that mimic depression. It is interesting that medications for the
treatment of depression often increase the frequency and vividness of dreams, perhaps helping to restore a vital function.

  Freud emphasized that the manifest content of dreams—the story they tell—is generally less important than their latent content—what they symbolize. Although interpreting dreams is a perilous task, fraught with the risk of lapses into sheer mysticism, it is often the case that themes emerge across series of dreams. Indeed, these themes seem to capture important emotional realities.

  Recall Mary's dream, in which I made a clear advance toward her. The dream was triggered when I displayed a personal interest in her artwork, which she subconsciously experienced as a personal, sexual interest. Her dream expressed her fear of replaying her childhood abuse, even as she consciously tried to dismiss the dream and its significance.

  Many years ago, early in my graduate training, I found myself alienated from many of those around me. Worst of all, I did not feel adequately challenged in my work or sufficiently fulfilled in my relationships. I wasn't depressed; and to all outward appearances, I was doing fine. But something was missing from my life. Here is a dream from that period that I brought to my therapist:

  I am about to go off a large slide. The slide is hundreds of feet high. To get from the ladder portion to the slide portion, you must walk through a small room. I am a bit fearful, but I go down and, to my surprise, the ride is slow and not at all scary. I decide to go down again, but this time I am intercepted in the small room by Liz [my therapist]. She chides me for my first trip down the slide, pointing out that it was a gentle ride because I didn't even turn the slide on. She points out an on-off throttle switch in the room and a machine that allows me to choose a "coefficient of daily experience." My normal daily experience is a "1" coefficient. If I want more powerful daily experience, I choose a number greater than "1"; smaller than "1" will give a "grayer" experience. I settle for 1.15 and decide to go down the activated slide.