"When It Comes To Trading, Romance Is For Losers"

Authored by Kevin Muir via The Macro Tourist blog,

A few readers have asked me to tell more stories about trading. They encouraged me to share more of my experiences throughout the years.

After giving it some thought, I decided that instead of taking the easy road and recounting a tale of when I was fortunate enough to nail some trade, I would approach from the opposite direction. In keeping with my theme that all I bring to the party is 25 years of mistakes, I have decided to recount a losing trade. And not only that, instead of just picking one losing episode, I will confess a weakness I still struggle with today.

But before I do that, I would like to talk about a book. I have always been a big Michael Lewis fan. Ever since reading Liar’s Poker as a young kid trying to make it onto a trading desk, it has held a special place in my development. Throughout the years, as Michael has published more books, I have devoured them with a ferocity reserved for just a handful of authors.

Yet when Lewis published his most recent book, The Undoing Project, I did not rush out to buy it. The story of two psychologists and their relationship throughout the years? It sounded hokey and not at all interesting. Deciding Michael had finally jumped the shark, I ignored the new release.

Lucky for me, my old man is retired and has more time on his hands. More importantly, he did not suffer the same prejudices. He bought it. After reading it, he plopped it in my hands and encouraged me to give it a whirl.

Was I ever wrong about my initial impressions. Michael Lewis’ The Undoing Project could be one of his finest books. As traders and investors, we should all be forced to read it.

The psychological concepts the two main characters discovered are essential to understanding the constant battle we are all fighting when we trade. The themes throughout the book are complex and become more nuanced, but at its heart, the book is about the understanding that human beings do not act rationally with anywhere near the frequency that most of us believe.

Specifically, humans have trouble with statistics. There are tendencies embedded within us that are difficult to overcome. In fact, the story’s two heroes developed experiments designed to exploit these biases. It was no surprise that the average person failed to overcome this human flaw. But more importantly, even professors who were trained in statistics were unable to correct for this bias.

In their breakthrough paper, the two psychologists concluded;

“People’s intuitive expectations are governed by a consistent misperception of the world.”

This observation has profound ramifications for almost all social sciences. Economists especially, base their entire framework on people behaving rationally. Yet these two psychologists had just proven that this was not always the case.

There was one part of the book that really hit home. It was when a statistics professor explained that he understood what was happening with the experiment, yet he felt the pull to go the other way. His logical brain was telling him one thing, but another part was telling him something different.

And for me, this is the perfect analogy to one of my biggest trading weaknesses.

Do you know those days when something dramatic happens in the market and stocks rocket up 1% or more at the open? Maybe it is a big employment report, or maybe some Central Bank eases.

Either way, the market opens at 9:30 and you are staring at a big gap open. Everyone is all bulled up, and excitement fills the air.

Let me assure you, I know the statistics. By far and away, on those days, the most likely outcome is for the market to chop around for the first half hour, fake a couple of sell offs, then start grinding higher. At lunch, the grind might slow down, but then at 1pm, the buying resumes. At 2:30pm there is often a decline, and it looks like it might roll over. Yet that dip is met with more buying, and the market proceeds to rip into the close, finishing at the highs of the days as the shorts cover. Although this doesn’t always happen, this is the correct bet. In fact, it’s better than the correct bet, it’s a great setup.

But I find it extremely difficult to trade this scenario. In my mind, I have glorified the handful of times (most likely one hand) that the gap open proved to be an “all baked in situation.” I distinctly remember a couple of days on the program trading desk where my floor partner and I stood in there, shorting futures to locals and ETFs to institutional clients, taking the other side of the buying panic. Before we could figure out how short we were, the buying dried up, and then next thing we knew, the market rolled over, and we were deep into sell programs, buying back our position while hammering stocks lower in the cash market with our sell baskets.

Even as I write this, there is a smile on my face. I loved being right while everyone else was wrong. It was almost romantic.

Yet I can’t tell you how much money I have wasted over the years trying to replicate these romantic dreams in my head. It is enormous, and it has cost me so much mental and actual physical capital. Springsteen wrote about the old deadbeat sitting at the bar thinking ‘bout it, and I now understand a little better what he meant.

When it comes to trading, romance is for losers.

I struggle with these different tugging forces. My logical brain knows I shouldn’t be shorting that open, but the other side desperately wants to relive those glory days.

And this is what trading is all about. We are constantly battling what we want to do, and what we should do. Even those who understand the game exceptionally well, are constantly battling their own inner demons.

Everyone’s demons take a different form, but make no mistake, we all have them.

Michael Lewis’ book told the story of the psychologists who proved they exist. We are not rational actors. Our brains are not wired to make consistent correct statistical calculations. The sooner we understand that reality, the better our trading will be.

I have by no means conquered my affliction. A little part of me worries that by writing this piece, I have almost assured the next big gap open will fail and roll over. Maybe I should just try shorting the gap higher one more time…