Students whom I see in therapy often remark to me that a first date went wonderfully because they spent hours discussing intimacies of their personal lives. Invariably, these dating situations do not work out. Why? Sharing details of one's life is inappropriate to the context of a first date. Normally, one would only reveal such information to a trusted confidant. If people speak of their lives indiscriminately, it is a sure sign of neediness: the impulse to get close quickly due to loneliness. It won't be long before both people find themselves over their heads, backing away from the vulnerable positions in which they have placed themselves.
Traders can be similarly heedless of context. Successful traders approach a new market position the way a rational person approaches a first date. They will wait for the market to prove itself before committing a large stake. By risking a limited amount of capital at the outset, they do not become emotionally entangled prematurely. If the anticipated move is for real, there will be plenty of time to get on board. If it is not for real, the losses will not be devastating. I refer to my small initial positions in the market as "pioneer positions." They are designed to scout the terrain and—more often than I like—are apt to get the arrows in the back. Plunging into a market, like becoming infatuated in a relationship, speaks more to the needs of actors than their objective circumstances.
Many technical market signals, such as chart patterns and oscillator readings, are interpreted mechanically. They are seen as possessing a fixed meaning regardless of the context in which they occur. I might pay attention to a double top or a head-and-shoulders formation if it occurred in the context of a market that had risen greatly, was now losing volatility, and was facing a rising-interest-rate environment. The same exact formation occurring after a lengthy, steep, volatile decline with interest rates falling might possess very different implications.
Its shortcomings notwithstanding, chart reading has been in use since the nineteenth century and is likely to retain its popularity well into the twenty-first. Once again, chart reading is fulfilling that human need to extract meaning from events, an element that distinguishes humans from most species. The human ability to perceive meaning in patterns of nature underlies every scientific achievement. Unfortunately, it also leaves people open to superstition and delusion.
Take the example of panic disorder, a debilitating anxiety condition. Many people who suffer from panic disorder also experience agoraphobia (a fear of public places). Panic disorder is a frightening condition in which a person can be stricken—without seeming cause—by sudden, intense feelings of dread and anxiety. Indeed, many people who first experience panic episodes truly believe that they are going to die.
What makes the panic all the more intolerable is that it often occurs out of the blue, not during periods of acute stress and threat. A person can be sitting peacefully in his or her car, stopped at a light, and suddenly experience overwhelming anxiety. That rubs violently against the human need to understand the world. A person has no ready filing cabinet in his or her mind for causeless dread.
As a result, panic sufferers arrive at ingenious—and wholly superstitious—explanations for their disorder. Without an obvious candidate for a causal explanation of the attack, the sufferer's interpreter kicks into overdrive, attempting to make sense of the senseless. If the attack first occurred in a car, the patient concludes that the car was the problem. If it happened in a shopping mall or in a crowd, the person will avoid malls and crowds. One client of mine had her first panic attack while driving on a thruway exit ramp. Thereafter, she avoided all roads with ramps, including unrelated ramps, such as those leading to parking garages. As the attacks multiply, the list of offending circumstances also expands, until the person is effectively agoraphobic—unable to leave his or her dwelling.
Market traders, especially in the throes of economic turmoil, are similarly apt to read meanings into even random events. Chart patterns, readily available to anyone with a computer, a newspaper, or an advisory service, are prime candidates for such rampant meaning making. Just as people are most likely to consult fortune-tellers when their lives are highly uncertain, traders are most likely to turn to charts and oscillators when their positions look most dicey. The need to know—to feel in control—is so strong that they will often prefer dubious answers to no answers at all.
From this perspective, chart patterns are as much a psychological tool as a true analytic device. They are a ready source of explanations for traders' confused interpreters. This, however, gives the patterns a certain value. If you know that anxious traders are apt to latch onto chart patterns to justify their positions, you can look to profit from those anomalous occasions when the chart patterns fail.
Most chart patterns involve consolidations—periods in which the market stays within a relatively narrow range relative to a previous trend. This is true of flags, pennants, double tops/bottoms, head-and-shoulders formations, cup-and-handle patterns, and the like. Any consolidation, by definition, entails a decrease of price volatility: Prices are moving less net distance per unit of time during the period of consolidation. When the market reverts to more normal, higher volatility, the result very often will be a trending move out of the consolidation range.
This is where the failed chart pattern comes in. Suppose a stock has fallen and now looks to be in a cup-and-handle formation, generally thought to presage a market bottom. Emotional investors, stung by the prior decline, are apt to latch onto this pattern as a rationale for initiating new long positions or for hanging on to existing longs. They are banking on the hope that the pattern will propel them to new highs, well above the top of the chart formation.
Should the pattern fail, however, there is a built-in set of emotional traders and investors ready to be disappointed. Their capitulation will add to the thrust of the move out of the consolidation area, creating a nice opportunity for the contrarian. Moreover, it is known from the availability heuristic research of Daniel Kahnemann and Amos Tversky that people will be relatively slow to revise their mental maps once they have latched onto a particular chart pattern. The promising "pinball" trade, therefore, is identifying the earliest stages of a failure of a chart pattern as an entry point for a contrary move. For example, suppose the market moves nicely higher, but the stock does not break out of its handle to resume its uptrend. At the first downside penetration of the handle base, you would want to be short, taking advantage of the stunned, paralyzed traders who will only bail out of their positions when they experience the pain of much lower prices. By playing the game opposite to the way in which it was designed, you can find unique niches of opportunity.
If you can identify contexts that do not support the validity of popular chart and indicator patterns, you may have the start of a successful contrarian trade. Thruway ramps have nothing to do with mental health, and charts do not move markets. In a world of panicky people, however, ramps and charts may be all there is to explain the inexplicable. The more visible the stock, the more popular the pattern, and the more the pattern is being bandied about by trading gurus, the more likely it is that you can make money by playing the game in an unorthodox way, fading the trading maps of the majority.
I have spent considerable research time analyzing one-minute data on the markets, including price, price change, put/call volumes, TICK statistics, E-Mini volumes, intraday advances/declines, intraday new highs/new lows, and the interplay of sector indexes in order to reverse engineer the trading strategies of the average trader. My goal has been to determine "how the designers want the game to be played" so that I can craft my own anomalous strategies. In short, I'm pursuing with the markets my college strategy with pinball machines.
After all this reverse engineering, what I can report with a reasonable degree of certainty is that the average trader is looking at price and price alone in two different (but overlapping) contexts:
1.The average trader seems to be sensitive to price breakouts to new highs and new lows and will piggyback on these breakouts.
At the present time, these dynamics make trading false breakouts a promising strategy. Following an insightful column on the MSN Money site, Victor Niederhoffer and Laurel Kenner took some heat for questioning the shibboleth, "The trend is your friend." My research, however, suggests that they are correct. The markers that average traders employ to gauge trends are over-utilized and vulnerable to sharp reversals once these traders realize their errors. The winning strategy, at least for now, appears to be to identify the signs of failing breakouts and to use these as markers for contrarian trades.
INTERNAL MAPS AND INKBLOTS
One of the most revered instruments in psychological testing is the Rorschach Inkblot test. It is a series of 10 cards that depict complex inkblots. Some of the cards are colorful; others are black and white. The only instructions for the test are that the viewer should indicate what he or she sees in the cards. Perhaps part of the card looks like something; other times the entire card might call an object, a person, or an animal to mind. It is a bit like looking at the clouds and seeing what you can find in the shapes. There are no right and no wrong answers; the purpose is simply to allow people to use their imaginations.
The inkblots are known as a projective test because people tend to project themselves into their perceptions. What people see, especially in ambiguous situations, is a reflection of the content and the structure of their thoughts. The Rorschach inkblots are intentionally ambiguous, in an effort to force people to project more of themselves into their responses. The test is effective, because few people know what the psychologist is looking for. It is difficult to hide one's true feelings and personality on an inkblot test.
A sophisticated examiner can derive quite a bit of information from inkblot responses. First, the psychologist might look at the content of the responses: what the person sees. Are the perceptions mostly of people, or are people missing from the responses? That could say quite a bit about the social inclinations of the test taker. What are the emotional themes embedded in the responses? Are there many images of violence and conflict, or do the responses reflect greater harmony? And how many responses are there? Very anxious people will often provide a flood of responses, focusing on minute details within the cards. Depressed people, unable to respond to the external world, may see very little in the blots.
It is painful to observe the inkblot responses of an individual who has undergone emotional, sexual, or physical abuse as a child. The content themes of the responses almost always involve damage: broken objects, injured bodies, and so on. The responses also reflect tremendous anger, with such images as explosive volcanoes, bloody knives, and severed limbs. In such cases, what the person sees is a reflection of his or her traumatic life experience.
Second, the psychologist learns a great deal about people from the ways in which they see the cards. What is seen becomes less important than the way in which the perception is assembled. People with serious mental illness, who may lose contact with reality through hallucinations or delusions, will generally produce responses to the Rorschach test that are highly idiosyncratic and not well grounded in the blot itself. The term that psychologists use for this is form level. A poor form level indicates that the response is not justified by the contours of the blot itself An example would be a long, thin, red area of a blot that the person says resembles a setting sun because it is red. In such an instance, the person is so responsive to the red color that he or she ignores the difference in shape between the blot area and the sun.
Color on the Rorschach test is indicative of emotion. A set of responses that makes extensive use of color suggests an active emotional life. The absence of color in a set of responses might indicate that the person is choking off his or her emotional experience. When an experienced clinician administers the Rorschach test, indicators such as color can be integrated with other test elements, such as form level, to obtain a rich view of the individual. For example, the person who saw the thin, red blot area as a setting sun might be highly responsive to color (emotionally reactive). This occurs, however, at the expense of form level (perceptual accuracy). Such a person is apt to misperceive situations in real life when he or she is in an emotional state—a condition not unknown to traders!
Indeed, I strongly suspect that many traders could learn a great deal about their internal maps and map making by taking the inkblot test. Consider the following patterns I've observed among individuals taking the Rorschach test:
•The person perceives one part of a blot accurately but then tries to make the whole blot fit that perception, introducing considerable inaccuracy. For example, part of a blot might look like an ear. The person will then say that the whole blot is a head, pointing to the one area as the ear. Although the ear detail shows good form level, the entire blot may look nothing like a head. This is seen among traders who focus on one or two pieces of data and concoct an entire market forecast on that basis.
•Some people respond to the blots very deliberately, carefully examining each detail before giving their response. Often they will reexamine the blot after giving the response, changing their answer each time. It may take quite a few minutes before they can arrive at a single response that they will stick with. Such people, often highly anxious, would have similar difficulty making trading decisions.
•Other people are highly impulsive in their response style. As soon as they are shown the card, they blurt out what they see, often focusing on the color of the blot area, and often with mediocre form level. Such impulsivity could be expected to lead to mediocre, emotion-filled trading decisions as well.
•People may give accurate responses with positive content themes when the blot area is seen as an object. When the blot is seen as a person, however, the accuracy decreases, and many more troublesome themes emerge. Similar situations can be observed among traders who are very successful in the markets and very poor in dealing with people. There are also Rorschach subjects—and traders—who display the reverse pattern.
• Action-oriented individuals will tend to see objects, animals, and people in motion; their responses describe a great deal of movement. More cerebral individuals will provide responses with less movement and more complex interplay of detail. There are similar differences among trading styles as well, with some traders relying on tape reading and floor experience, and others building and testing elaborate systems.
Of course, there is nothing magical about the Rorschach blots. The test could use clouds in the sky or pictures from magazines just as well. In fact, there is a test called the Thematic Apperception Test (TAT) that also acts as a projective instrument. It consists of a series of pictures of people in ambiguous situations. The test subject is asked to tell a story about the situation depicted on the card. One card shows a boy looking down, seriously, at a violin. My story, when I first took the TAT, involved a boy dreaming of becoming a world-famous concert violinist. Other people have produced different stories, such as a boy who is depressed because his violin is broken or who is upset because he cannot play the violin. Themes of achievement, loss, and failure are a few of the life stories that people tend to project into such pictures.
It is difficult to imagine any stimulus more ambiguous than the markets. Each market chart is a Rorschach test, encouraging viewers to project their hopes and fears and to read trends, patterns, and meanings into the up-and-down movements. The markets are especially interesting for a psychologist because they are a group administration of a projective test: You can see the ways in which different people are perceiving patterns in the same stimulus. As with the Rorschach or TAT, what people see and how they see it is as much a reflection of the viewer as of the market itself. Approaching the financial media from such a vantage point yields interesting insights. What commentators and traders focus on is a function of their mental map
s, allowing rare insight into market consensus.
Of course, it helps to know which pundits to focus on when gauging the mental maps of the trading public. I generally look for market commentators that spend as much time hyping themselves as offering market information. In fact, whenever I see a newsletter or a column filled with the words "I" or "we," I know that the writer has a large ego investment in the forecasts being made.
On average, such forecasts are most likely to be biased by the writer's needs and emotional makeup. Indeed, Laurel Kenner and Victor Niederhoffer performed a study of firms that exhibited "hubris" in their corporate communications and found these to underperform the market. (The dramatic bankruptcy of Enron in 2002 is an especially vivid example.) In the terms of the Rorschach test, such writers and companies will be prone to misperceiving their markets, viewing reality in color-filled ways that lack good form level. Such hubris is a great contrary indicator, and a consensus among multiple such writers or firms (think back to the heady dot-com boom) is often meaningful.
Along this line, one of my favorite projective indicators for the market is the cadre of writers who feel the need to remind readers about the wonderful calls they have recently made. This is particularly significant if the writers have also been prone to bouts of silence following not-so-successful recommendations. It is when the writers are most full of themselves, most feeling the need to elevate themselves, that their judgment is apt to be clouded. They become like the manic patient—grandiose in their thinking, impulsively providing responses to the Rorschach cards that miss essential details.
The Psychology of Trading Page 32