All you want to know but never asked about the stocks and options markets.

domingo, 31 de agosto de 2014

Psychology and Emotions in Trading I

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Investment in financial markets is a psychologically frustrating activity. We can have all the logic on our part and in the end the market can make a move against all odds (and worse, when nobody expect it). We must get used to generate a high tolerance for failure against losses and not build castles in the air when we are in a winning position.

In general, the more frequent our trades, we will face more against our own psychology. For those who do intraday trading (many fast trades that must be closed at the end of the day) or swing trading (transactions in a short period, usually from one day to a couple of weeks), it is absolutely essential to follow the famous three "M" of Alexander Elder: "Money, Mind, Method".

"Money" means that we must care for our working tool: money. Like a blacksmith must watch his anvil and hammer because without these instruments he could not work, the trader should take care of the money through techniques of money management, that will instruct the trader according to their initial capital how much money may risk on each trade.

"Method" refers to the chosen method to analyze the market. Usually the trader chooses technical analysis, however there are many other methods to try to predict the level of market risk (not predict the future, this is simply impossible).

Finally, "Mind" means that we must maintain an adequate psychology to provide us enough selfcontrol to follow strictly the system we have chosen to act as our "Money" and "Method" self. So we must adapt our trading to our emotional behavior.

Why is so important the psycology in trading?

Humans interact with the environment around them basically emotionally. Someone may like us or not just by how they dress. Generally, we love an entire country or hated it as if everyone in the country were one person. We can feel something deeper for an object such as a car or a book than for a real person. At all times we are experiencing some emotion, perhaps we do no notice it or we can not define it exactly, but the fact is that our everyday (our survival) is more or less influenced by our decisions, both automatic and "rational". And as evidenced by the current neurobiological research (eg Damasio, Le Doux or P. Ekman) in the process of deciding, emotions are a must. As already anticipated Pascal: "The heart has reasons that reason does not know." Philosophically, without emotions we would be unable to make decisions effectively, since reason alone would take centuries analyzing risks, pros and cons. Resolve the following question: Suppose someone offers us a game where there is a 99% chance of achieving 1,000 million, but there is a 1% chance of dying. What did we decide? Will we take a rational decision? 

Any decision should be influenced by emotion, because although the probability is on our side, often what we might lose does not compensate us chances. Therefore, the key is not always remove our emotions to act as cold and calculating robots, the key is to learn to distinguish what emotional state we are to know the mistakes usually we make so we can put all our feelings on our part.

For many years various sciences have been concerned with emotions. Medicine, Psychology, Philosophy and social sciences have ha been trying to explain why human behavior is emotional. But is especially during the last two centuries that has changed the way we understand the emotions in social thought and have gone from being a bad thing, to be avoided and repressed by force of reason, to be a good thing. This shift in thinking has given birth to new concepts  such as "emotional intelligence" (as opposed to the known IQ that would measure the "rational" inteliencia).

If emotions exist, is because as Darwin noted, are useful for survival. In the words of A. Sloman, the need to deal with a changing and partially unpredictable world demands methods to distract our attention. Emotions influence our state of attention, but not to distract, but to pay more attention to what our body considers most important for survival. Wukmir said that emotions are a mechanism that tells us whether we experience is positive or negative in order to set standards in our brain to promote our survival. What this psychologist did not take into account is that, like all perceptual mechanism, emotions can us wrong. For example, "Whenever I go on vacation to the north in summer it rains." Even in the north in summer there are more sunny days than rain, though our mind memories select the rainny days according to the emotions, which creates the false impression that we always have such bad luck.

Emotions help the brain to choose what to remember because our mind is not ready to remember 100% of the things so our memory must choose what to remember and what not to remember, according to what it thinks is necessary for our survival. Emotions are very important in this type of process. Moved into the world of trading, often the memories of the previous trade can play tricks, if they make us face the market with excess or lack of confidence. Their is overconfident when we recall a winning trade which produced very high profits. With lack of confidence when we remember the losers trades. Analysts that appear in media can play with this because it is rare that someone is pointing exactly everything they say. However, when an analyst says, "as I said last week, that stock has gone ..." if the listener heard the commentator last week, he or she will remember this and will give more value to that stock than the other 25 shares that ​​were also recommended but eventually fell - of course the analyst will not say that he failed with the other stocks. It also happens with analysts, or with ourselves, when we defend with passion one side of the market. Imagine that we have a view that the market will go up hard and we defend this idea with passion, recommending to everyone we know to buy. However the market keeps falling, but we do not want to acknowledge this reality and cling to the idea "better now, which is cheaper ...". When the market went from 12,000 to 7,000, we continue to defend the rebound. Then the price starts to climb to 10,800 points. We will say, you see that you had to buy? And our friends (or thousands of listeners) will remember our statement and not the price we said and treated us like a guru. When in reality we will have ruined us, because what matters in the market is usually not where, but when and how.

Emotions are a psychological phenomena, because they change the standard hierarchy of responses from people. These responses have an important social aspect. Thus, from a behavioral point of view and as Levenson rightly points out, emotions establish our position on the environment around us, making us more similar to people, animals, objects ... and less to others.

A curious fact is that whenever you make a decision, our first reaction is chilling for having rejected other options. However, our minds quickly exaggerates the qualities of the decision we made and despise the other options. Something that helps us to convince ourselves is to see that other people make the same decision. Extrapolated to the stock market I think that you do not need an example ... we all feel identified with this. It is what is called in psychology the "buyer's remorse".

Our mind becomes especially dangerous when we make decisions in uncertain environments. A clear example of this is what is known as the "gambler's fallacy": when the roulette runs 5 times in a row in red, we think the probability of getting black on the next spin is greater to come back to red.. This is a mistake, since in a run (in separate events, as is the case) the probability that the result is red or black is the same !! ie 50%. Another thing happens when we want to calculate in advance the probability of having the red 6 times in a row, because once the black has come as a result, the past is reset (since the events are independent). Hence the inefficiency of the martingale (and we can move to trading: hence the disadvantage of averaging a losing position). 

Another example that we can not trust our minds in such situations can be found in Kahneman and Tversky (pioneers of "behavioral finance"). These two psychologists, inone of his experiments gave the following choices: 

You prefer: 
  • A. Win 2,400 USD with 100% certainty.
  • B. Win € 10,000 USD with a 25% chance or 0 USD with 75% probability. 
In this game most people choose the first option (option A), but in fact, the mathematical expectation of risk (option B) is greater than the expectation of no risk.
  • A. Mathematical Expectation =  2,400 USD x 100% = 2,400 USD.
  • B. Mathematical Expectation = 10,000 USD x 25% + 0 USD x 75% =  2,500 USD.
But it is even more interesting when we speak of a loss: 

You prefer:
  • A. Lose 2400 USD with 100% certainty 
  • B. Lose 10,000 USD with a 25% chance or 0 USD with 75% probability.
In this game people usually choose ... risk! (Option B), when according to the mathematical expectation, ie, from a rational point of view, the loss would be greater:
  • A. Mathematical Expectation  = -2400 USD x 100% = -2400  USD
  • B. Mathematical Expectation = -10,000 USD x 25% + 0 USD x 75% = -2,500 USD
Another interesting finding of Kahneman and Tversky shows that we are unsound and that our brain fills gaps assigning preconceived ideas about things and people. Their experiment consisted of a question such as: 

Mary is a person committed to environmentalism. She attend conferences, use recycled paper, has 3 cats and has attended rallies to save the seals in the Arctic. 
  1. Mary is a bank teller. 
  2. Mary is a bank teller and is affiliated to an NGO. 
Normally people chose option 2 when it is much less than likely option 1 With the information we have, that is, almost nothing encompasses option 1 option 2. With the information we have, that is, almost nothing, the option 1 encompasses option 2. 

In this case also involves a problem of too much data, very common in the stock market.

But this should not frighten us. We were not born to be mathematicians, we born to survive in a world full of uncertainty and if nature has chosen to give greater value to the emotional to the rational part, must be because it is more effective for survival. We just have to learn to live with it, to stop emotions when necessary and be driven by them on our behalf.

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