Trade Mindfully

Achieve Your Optimum Trading Performance with Mindfulness and Cutting-Edge Psychology

Gary Dayton

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118991039
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Comercio

Overcome psychological obstacles to increase trading success

Successful traders need to be well-versed and skilled in a wide range of business and economic areas. But now, in addition to effective trading strategies and sound money management techniques, traders need to possess the know-how to handle the mental and emotional challenges of working in a highly volatile environment. Trade Mindfully is a unique resource that applies cutting-edge psychological techniques to trading skills, allowing readers to improve their mental outlooks and maximize the potential of their trading strategies. This book draws upon recent psychological research in behaviorism to teach new approaches that call for better focus, more confidence, and more positive perspectives and outcomes.

One of the key concepts covered in the book is mindfulness, a state of mind traditionally touted in the East for its ability to reduce stress and increase perspective, useful qualities for traders looking to rise above emotional obstacles and the poor results they cause. The author also discusses the importance of High Value Trading Actions (HVAs), specific actions that are under a trader's control. With this guide, trading professionals will be able to form solid strategies based on a combination of these notions and practices, leading to higher levels of trading performance.

• Applies sound psychological practice and evidence-based research to the trading profession
• Covers the psychological perspectives and mental skills needed to succeed in today's trading world
• Focuses on key concepts that lead to deliberate practice, specific trading activities, and increased awareness and focus
• Designed to help traders deal with the emotional challenges that come with uncertainty and risk

Trade Mindfully touches on the most essential concepts for anyone intrigued by what trading psychology has to offer, and delivers the best strategies for achieving the right mental skills for peak performance.

PART I

UNDERSTANDING
YOUR MIND

CHAPTER 1

Traders' Mental Blind Spots

Colin had been watching the S&P e-mini futures all morning, waiting patiently for a trade. Finally, he saw one setup. He looked carefully at both the price action and the indicators he used to qualify his trades. Everything met his criteria. Price had turned bullish and all indicators were signaling long. “There's no flaw in the setup,” he thought.

The trade started working almost immediately. The market moved up smartly, breaking a nearby resistance level and then moved into “clear air” where no other resistance was located. The S&Ps rallied for twelve points from the trade entry—an excellent intraday run for this market. But, Colin was not on board.

He didn't take the trade. When discussing this later, he said, “The same setup occurred yesterday. I guess I was thinking of that trade, which I took, but it didn't work out. I had a loss. There was even a slight difference in favor of today's trade. One of the indicators did not confirm yesterday. Today's setup was picture-perfect. I kicked myself for not taking the trade. I don't really understand why I didn't take it. I wasn't feeling any big emotions; I certainly wasn't fearful. I just thought that since yesterday's trade failed, this one would, too. I was wrong. Why didn't I take the trade?”

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What failed Colin was not his emotions or misreading the market. What failed Colin was his thinking. Colin's mind entered a natural mental blind spot psychologists call the recency effect. The recency effect is a cognitive bias where our mind weighs the latest information with greater importance than other data when making decisions. In Colin's mind, yesterday's outcome weighed more heavily than today's “picture-perfect” criteria, leading him to shun the trade.

Many traders believe emotions are the most important aspect of trading psycho­logy. This is only partially true. Feelings and emotions are certainly important. Traders cannot make reliable decisions without them. Strong emotions such as greed, anger, and especially fear can significantly influence trading and cause erratic trading behavior. However, emotions are not the only thing that can influence trading. Thoughts and the way we think also play a significant role. Sometimes, thoughts ignite strong emotions and thinking almost always amplifies them. At other times, as we see in Colin's case, emotions play little part in poor trading decisions. Less familiar to many traders is the role that our mind and our thinking plays in trading and the way we make trading decisions.

Our thinking can create mental blind spots that can shackle us, as the example with Colin shows, rendering technical skills useless at that moment. In fact, how we think and how we treat our thoughts are the most important aspects of trading psychology. A main objective of this book is to help you become more aware of your thoughts and how they directly influence your trading actions. Learning and applying skills related to cognitions described in this book may have the most decisive impact on our trading—they can be far more potent than some of the common things we try in dealing with emotions. Of course, this does not mean that emotions are unimportant and should be ignored. We discuss emotions starting in the next chapter. To begin, however, we focus on the natural constraints that arise from our thinking as one of the key aspects of trading psychology that traders need to become aware of and understand in order to trade well.

Thinking is integral to being human. It is so much a part of us that we usually don't think much about thinking. If we pause for a moment and observe our thoughts, however, we begin to become aware of the activity of our mind. This is a fascinating study. We soon realize that we have a near-constant, never-ending stream of thoughts. The mind is tirelessly commenting and telling us things. Unless you practice, you will find it impossible to quiet your mind and stop the flow of thoughts for all but a few seconds. Even with practice, quieting the mind for more than a few minutes before another thought involuntarily arises is elusive for most people. Two important characteristics of our minds thus emerge: thoughts are always with us and we do not have much control over them. This is essential data for traders.

Because we have experienced our mind's chatter every day for as long as we can remember, we are accustomed to it and rely on it heavily. We tend to accept whatever our mind tells us as an accurate reflection of reality. We rarely question or objectively evaluate our thoughts. Because thoughts are a natural part of us, accepting them seems natural, too, but in trading, this can be dangerous.

Part of the danger comes from natural limitations in our cognitive capabilities. There are certain mental boundaries that often constrain the way we think, distort the way we process information, and impact the way we make decisions that cause predictable errors in trading. These are our mental blind spots commonly referred to as cognitive biases and heuristics. The most important mental blind spots for traders include:

• The representativeness heuristic
• The recency effect
• Loss aversion
• Confirmation bias
• Base rate neglect
• The affect heuristic
• Hindsight bias
• The endowment effect
• Optimism bias

We discuss most of these mental blind spots in this chapter. Some—notably loss aversion and optimism bias—are covered in later chapters. Understanding these mental blind spots and becoming aware of them in one's own trading are crucial for the trader as they can directly affect trading performance and results.

■ Heuristics and Cognitive Biases

The term heuristic is just another word for mental shortcut. When faced with a complex or difficult decision, people often simplify their task by applying an abbreviated rule set to help problem-solve and make the decision. This streamlines the thinking chore into a more straightforward and manageable job. Heuristics shorten the decision-making time and reduce the mental load. Their use allows people to function efficiently and quickly without having to mentally process and make sense out of a large amount of data. These mental shortcuts are handy in many situations and produce reasonably accurate results much of the time. For an example, let's say we are planning a trip and need to budget gasoline expense for driving. To do this, we need to know how many miles can be driven on a tank of gas. One way to do this is to keep detailed records on gallons and mileage for each fill of the gas tank for the next six months and then calculate the average. It would produce an accurate figure of miles per tank of gas across many different driving conditions, which we can then use to calculate fuel costs. Alternatively, we can use a simple shortcut of setting the odometer to zero when the tank is next filled and apply the mileage gotten from that one tank of gas for our fuel cost projection. Will the shortcut be as accurate as gathering six month's worth of data? Probably not, but the simple approach produces a good enough result for our trip planning purposes. That's using a heuristic.

Heuristics are used all the time. When deciding to go into an unfamiliar restaurant, for example, we might use the restaurant's overall appearance in making our judgment. Rather than taking a survey of patrons' dining experiences as they exit, if the restaurant looks clean and inviting, and there are cars in the parking lot, we are apt to dine there. Note that an easier mental task is substituted for a harder one. This is a hallmark characteristic of heuristics. It's easier to assess the appearance of the restaurant than interview its patrons. Likewise, it is easier to calculate mileage from one tank of gas than to record and process mileage data over a six-month period for estimating driving expenses. Heuristics have value; they help us manage our world efficiently. Because they are effective and do have such value, we normally apply them as our default mode of thinking.

There are times, however, when heuristics and other abridged mental processes lead to significant errors and inconsistencies in our judgments. In their pioneering work on how we think and how we produce thinking errors, two psychologists—Nobel laureate Daniel Kahneman and Amos Tversky—found that when people make decisions under conditions of risk and uncertainty, they have a strong tendency to abandon careful rational analysis and, instead, apply heuristics and other cognitive short cuts. This often produces predictable errors and poor outcomes. Their research was in striking contrast to the conventional wisdom at the time it was published. This and subsequent work spawned a new discipline emphasizing psychology's influence on economic decision making now known as behavioral finance.

Kahneman and Tversky's research was followed by a long line of studies that demonstrate how natural limitations in our information processing—that is, how we observe, think, and problem-solve—automatically emerge in situations that involve the assessment of complex and often incomplete data and also entail risk and uncertainty in outcomes. The research is clear, robust, and their findings are significant for the trading world: in uncertain, risky conditions the application of heuristics and other cognitive biases in making decisions often results in significant errors and costly mistakes. Trading always involves risk. Trade outcomes are never certain, and traders confront complex and incomplete data in every trading judgment. When traders favor mentally efficient thinking shortcuts known to produce errors, they end up making poor trading decisions and these lead directly to poor trading results.

We saw this with Colin and his weighing of a recent trade outcome, which caused him to miss a sound trade. What makes it difficult for traders is that what works well in everyday life can lead to costly errors in our trading lives. Consider Jackie who has just moved into the city and now walks to work. Over the past two weeks she has enjoyed her walk in the warm, early morning sun. But yesterday, a cloud-burst drenched her and she arrived at the office sopping wet. Today, she carries an umbrella. This is an adaptive use of a recent experience. Contrast this with Colin's missed trade. Like Jackie, Colin also had an unpleasant experience in the form of a trading loss. The next day with the same type of trade setting up, Colin weighed yesterday's failed trade outcome—which has no bearing on today's trade and was irrelevant to his decision—as more significant than today's textbook trade setup because what happened yesterday was fresh in his mind. Jackie stays dry; Colin misses a good trade. Afterward, Colin could not understand why he didn't take a sound trade. This is the poignancy of using heuristics and cognitive biases in trading. Because we do use them so frequently in day-to-day decisions, it's natural that we readily bring heuristics and other cognitive biases into our trading. Because we also trust what our mind is telling us unquestioningly, we can be mentally blind to the serious trading mistakes we are making as we make them. It is crucial for all traders—from novice to the more experienced—to understand and become aware of these blind spots. We start with what is likely the most common trading heuristic called representativeness.

■ Representativeness

The representativeness heuristic means that we use a mental shortcut that looks for similarity between the current situation or event and its overall class as a way to judge probability. If an event is similar to our model or prototype, then we assume that the event has the same probabilities as the model. Representativeness occurs when something appears (or represents itself) to be likely, when, in fact, it may not be likely. An example from outside of trading will help clarify representativeness.

When buying a used car a buyer may look for dents, lift the hood, and kick the tires. If the engine looks clean, the car is shiny, and the tires look new, he may think, “This car has been maintained well.” That's using the representativeness heuristic; however, mere appearance can be misleading. It is only by reviewing maintenance records and having the car checked out by a mechanic will the buyer be able to accurately assess the probability that this is, indeed, a well-maintained vehicle worth buying. Simply relying on appearance does not mean it is a sound car, even though it looks good. In our mind, the car represents itself...