BarroMetrics Views: The Thin Line III
The answer today. Let me first give credit to those in Ultimate who have diligently kept their journals (equity and psych, without which it would have been difficult, if not impossible, to track the reasons for the divergence).
Secondly, this is a long blog; so tomorrow, I’ll be answering the questions submitted in this forum and by email.
Today, we are looking to identify the reasons why there was a divergence in expectancy returns….divergence in situations where method and instruments were similar.
Note, we are not talking about the results, but expectancy. Clearly results will differ for a variety of reasons. However, we should see positive expectancy converge – if the method and money tactics are robust, and the traders are executing consistently.
The givens are: we have a group of trader who……
- Have a discretionary rule method that is based on the same theories; as a result, the core setups are identical.
- Have a set of money management rules.
- Have a process by which they record their trades which provides the means to make the corrections for constant improvement.
- Execute consistently.
- For the most part, trade the same instruments at any given moment.
To trace the answer, I found I needed to return to our brain’s hard wiring. One aspect of the hiring is we humans, move towards pleasure and away from pain (i.e. ‘towards life’ and ‘away from death’). And, it’s more the physical pain we move away from: anything we perceive as ‘pain’ is likely to cause discomfort and anxiety.
When trading we are constantly assailed by:
- Possibility of loss
- Possibility of being wrong
- Possibility of Missing Out
- Possibility of Failing to Maximise the results of a trade.
And, they all cause cause discomfort and anxiety. Dr. Andrew Menaker calls these Pressure Points.
When we encounter Pressure Points we usually behave in one of two ways: we become aware and accept the discomfort: despite the anxiety, our response is based on reason (left brain) and intuition (right brain). Or, our response is shanghaied by ‘fear, freeze or flight’ (3 Fs) – what I call ‘impulse trading’.
(BTW, an aside……It’ s important to draw a distinction between behaviour resulting from an intuitive response and impulse behaviour. Both are emotionally based. Damasio and others have shown that emotions are essential to good decision-making. Decisions based solely on reason are not possible; and, if even they were possible, the decisions arrived at would be far less than optimal. It’s not emotional trading we need to manage; we need to manage impulse trading).
In short, in the context I described above (i.e. the ‘givens’), it is our response to Pressure Points that determines our results.
The studies show that one way to reduce the incidence of impulse trading is to have a plan that suits our personality. There are two types of plans:
- “A”: one with few decision-making parameters where the resulting action is specific e.g. If X happens, I go long with stops at ‘price a’ and a target at ‘price b’. Let’s call this a mechanical method.
- “B”: one with numerous decision-making inputs where the resulting action is probabilistic and constant verification is required.
There is a gulf of difference between the two. What I found was, those with negative expectancy returns were ‘type A’ personalities using a discretionary rule-based system i.e. their plan and personality failed to mesh. As a result, they constantly made poor decisions, usually involving where to enter and where to exit.
To test the idea that they could alter their expectancy by altering the form of the plan – from ‘B’ to ‘A’, I engage in the first of two tests. In fact, I found that by changing the type of plan, the trader was able to change the expectancy from negative to positive. I am currently engaged in the second series of tests.
What does this mean for you?
If your trading is not bringing the results you want. First ensure you have a robust method (positive expectancy), you have a money set of rules (at the minimum have a set governing position sizing), and you are keeping an equity and psych journal.
Then seek to execute this simple strategy: do all you can to reduce the impact of Pressure Points that lead to impulse trading. Some ways of doing this……..
1) Assess your personality. Are you better suited to a mechanical system or to a discretionary rule based? If you need assistance for the personality assessment, there are a couple of sites you can go to:
- Market Psych LLC
- IPIP-Neo. For this test. best you read Jason Williams’ “The Mental Edge in Trading“
2) make sure your plan and personality mesh. If not, change the format of the plan.
3) Finally do what you can to make your analysis and execution, habitual.
For example, use a checklist for your analysis. Before executing, take a moment to visualise:
- the trade being stopped out and
- exiting the trade at your profit target.
The aim here is to make the loss and profit a reality in the mind – in this way you seek to exit as a matter of course – when the stop price is hit or the exit conditions occur.