evaluate performance. An overemphasis on recent performance leads traders to place too much significance on recent runs of winning and losing trades, not recognizing the important role that luck plays in those runs. Whenever Maxwell had gotten to the point of trying to make meaningful changes in his approach to markets, he would hit a winning series of trades and convince himself that “the market is coming back.” Only after hope was raised and dashed many times did he get to the point of seeking help. By that time, however, like our couple, Maxwell had gotten to the point of questioning whether he could, indeed, go forward.
Maxwell was not broken, just as Gina and Chris weren't broken. Like them, he kept doing what worked and stayed confident in his course even after it ceased to take him where he wanted to go. But also like the couple, Maxwell was doing many things well. In avoiding consensus and the herd behavior of traders, he was able to sustain a high level of intellectual and behavioral independence. His ability to detect ebbs and flows in volume helped keep him out of trades going the wrong way, even if it was now far more difficult to anticipate the market's inflection points. In the old days, Maxwell used to be able to point to a chart level and anticipate how the market would behave once it touched that level. Those days, he realized, were long gone. There just weren't enough idiots left in the market to overreact to those chart levels!
One of my favorite solution-focused exercises in such situations is to institute a review of winning trades. Much of the role of a trading coach consists of comforting the afflicted and afflicting the comfortable. When someone is afflicted like Chris and Gina or Maxwell, some comfort in the search for exceptions to problem patterns can be empowering. When traders are in denial, doing ever more of what hasn't worked, some affliction of comfort becomes useful. A review of best trades reminds discouraged traders that they are not wholly dysfunctional. Talents, skills, and experience remain – they just need to be redeployed.
During Maxwell's trade review, we found an unusual number of winning trades held for a short time. He referred to these as scalp trades. “I see what's happening in the market and I jump on it,” Maxwell explained. It was when he tried to identify longer-term significant price levels and hold positions for hours or days that he was no longer able to make money. From the review, Maxwell and I could clearly see he had retained his reflexes – and his capacity for quickly sizing up markets. It was his thinking about markets and not his instinctive pattern recognition that was off. In scalping mode, he was all instinct – and he made money surprisingly consistently.
Shortly after the review, Maxwell joked with me about an email he had gotten from a guru seeking to charge big bucks for sharing his wave-based trading secrets. He reminded me of my earlier blog post making fun of the “idiot wave” and shook his head at the foolishness of traders who believed such obvious sales hypes. I quickly saw my opening.
“So, Max, if you don't use wave theory, how are you going to figure out where the market will be trading at 3:00 p.m. tomorrow?”
Max laughed and joked that he already had too many crushed crystal balls and was not about to dine on more broken glass.
“But aren't you doing the same thing with your levels that the Elliott guys are doing with their waves?” I challenged. “They're predicting the future and so are you.”
Maxwell looked puzzled; he wasn't sure where I was going with this. “Besides,” I continued, “you don't need to predict markets to be successful. What the review of your trades told us is that you're plenty good at identifying what the market is doing at the time it's doing it. Why predict levels for price movement when you can identify what people are doing in real time?”
You could see the wheels in Maxwell's head turn. Predicting an uncertain future was what idiots do. His job was to identify buying and selling pressure, not anticipate it.
Pattern recognition was his bridge to the future.
Kahneman, in an excellent research summary, identifies two basic modes of thinking. One is fast; the other is slow. In Thinking, Fast and Slow (2011), he explains that fast thinking enables us to respond to challenges in the immediate present. If a car suddenly drifts into our lane, we quickly swerve to avoid an accident. That rapid processing enables us to respond to crisis. If we had to think through every aspect of what was happening on the road, we'd hardly be able to adjust to the flow of traffic – or avoid oncoming vehicles!
The problem with fast thinking is that it is surface thinking. We perceive something, rapidly assess its relevance to us, and quickly respond. In the case of the oncoming car, that's a good thing. In the case where we see an African American man walking toward us on the sidewalk and we quickly cross the street, that same rapid processing allows bias to drive our actions. Indeed, many of the well-known cognitive biases, such as recency bias and the availability heuristic, are the result of fast processing taking control of our decisions and actions.
Slow thinking, on the other hand, is deep thinking. When we think in slow mode, we observe, catalog our observations, analyze what we've observed, and draw conclusions. Such a process is less likely to be swayed by superficial bias, but it consumes a great deal of our cognitive resources. We can drive the car and carry on a conversation while in fast mode. It's unlikely that we could solve a complex mental math problem while remaining fully attentive to road conditions. That's one reason texting and driving so often leads to disaster.
For efficiency's sake, we tend to rely on the efficient fast system except in situations that call for deep reflection. As a result, many of our decisions and actions end up reflecting first impressions, not carefully reasoned conclusions. How many times do we analyze a market, plan a trade, and then do something different in the heat of market action? The problem is not a lack of discipline per se. Rather, our fast thinking brain has hijacked our slow, reasoning mind. Quite literally, Kahneman points out, a different part of the brain controls our fast and slow processing, sometimes taking control at the least opportune occasions.
If we think of two brains – two relatively independent information processing systems – then it isn't a far reach to identify at least two intelligences. We can be smart fast thinkers, smart deep thinkers, sometimes neither, and sometimes both. Think of very talented salespeople or highly experienced air traffic controllers. As a rule, they are not the most intellectual people – not necessarily deep thinkers – but they process information very well, very quickly, and very flexibly. The salesperson reads customers very well and subtly adjusts his or her tone of voice and message to the immediate situation. The air traffic controller doesn't think about each plane, where it's going, who operates it, and so on, but instead quickly processes the many planes coming in and out of a busy airport. This ability to quickly process rapidly changing information enables the controller to make split-second decisions that keep the system functioning efficiently and relatively accident-free.
Key Takeaway
How we think anchors how we trade.
Conversely, we've all known very bright, intellectual people who seem to lack practical sense. They can solve math problems and analyze situations, but then are clueless when it comes to reading the social cues of a dating situation. The engineer could tell you all about the construction and operation of a car engine, but it's the racecar driver who has the smarts to power the vehicle to victory at Indy.
We often refer to trading as if it's a single activity. Trading, however, is like medicine: a broad set of activities and specialties. A psychiatrist is a physician; so is a surgeon, and so is a radiologist. The skills required for each are very different. So it is in financial markets. Market making is very different from global macro portfolio management – and both are quite different from the trading of options volatility.
One of the things that make trading
