The Limitations of our Brain
How to get the right trading mindset for success ? The first thing you have to understand is that this is an internal search. As a trader you have to learn what is holding you back in being a successful investor. Only when we have such an awareness we are able to change.A big problem in today’s world is the vast amount of information we must process. More precisely the vast amount of information of which 90% is useless and just a waste of our precious time. The French economist George Anderla measured changes in the rate of information flow. He began by defining the known technology in 1 AD as a unit and showed that it had doubled in 1500, doubled again in 1750 and again in 1900. According to Anderla the amount of human knowledge in 1973 was 128 times greater than in the year 1 AD. The problem is that the conscious mind has a limited capacity to process new information.
How do we cope with that vast quantity of information ? We generalize and ignore most of the information to which we are exposed. We generalize the information we do pay attention to. For example lets say we are interested in the futures market. In our next step we have to be more specific – “I am interested in trading crude oil” Now let’s go one step further. What moves the crude oil market? One more. I am going to analyze 15 minute bars on the third trading day of the week. I am going to examine price dynamics and the number of contracts traded when the EIA report is released after 10:30 a.m. (Eastern Time).
In psychology it’s called judgmental heuristics. The reason it’s called judgmental heuristics is because they affect our decision-making. They allow us to filter and sort out information in a short period of time. This filtering can also be dangerous. We might filter out those bits of information that are important in developing our trading strategy. The primary way people use judgmental heuristics is that they don’t change their mind easily. The correct way to do it is to accept when we are wrong and start over again focusing our efforts on another bit of information. Thus avoiding a flood of information that only brings us back to where we started.
Before we think of developing a trading system we should visualize and simplify the information. Have a look at a daily chart. The information is summarized into four pieces of information, open, the high, the low and the close. After looking at a daily chart bar you accept it at what it is. Just a chart with daily bars on it. Nothing more and nothing less. The next step is to find a certain day and look at shorter time frames. The observation and processing of information is done by adding layer after layer. The next step would be asking yourself what other important things you should have a look at. How much volume was traded. How much volume during the specific time of the day. What kind of data or news was coming out at that time of the day. What was the volatility. When would various traders be likely to liquidate and at what price. What are the likely resistance and support levels.
When you analyze the information and develop your trading strategy its crucial to not judge something by what it looks like. Probability is what you should look at when drawing conclusions. What is the probability of a certain outcome ? Do you consider the percentage of time that your predicted outcome follows your signal ? When looking at the results avoid the gambler’s fallacy bias. This is how most people enter their trades. When you had three losing trades in a row people tend to bet more on the next trade being sure the next one will be a winner. They ignore the randomness element. They look for certainty and trade their systems as if they had it. Thus, they don’t even consider position sizing as part of their system. As a professional trader you must make proper position sizing part of your trading regime and stick to it. Cut your losses short and let your profits run. Easier said than done but that’s how it should be.