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Understanding, Prediction, and What Makes Discretionary Traders Successful

This post was written from Glacier National Park in Montana.  Sometimes it takes a complete change of scenery to create a fresh mindset and renewed focus on what is essential--in life, as well as in trading.  It's when we introduce novelty into our lives that we are most likely to achieve new insights.

Recently I wrote a post that has found unusually strong interest from readers, focusing on what is most important in markets.  The post was distinctive because it emphasized market understanding, not the prediction of markets.  This is a very important distinction for discretionary traders.

Let's say I'm a parent and I notice my son being unusually quiet, talking softly and keeping to herself.  I've seen those facial expressions, tones, and behaviors before and know that they have typically occurred whenever he has felt hurt or rejected.  As a psychologist, I also know that those same behavior patterns occur in other people for other reasons, such as when they are deeply reflective about a challenge at work or when they are deeply frustrated about a situation.  For those other people, the period of quiet might be followed by a burst of work effort--or a burst of anger.  The quiet comes from a different place for my son, however, and has in the past led to periods of sad mood and poor work performance.

With that understanding, I simply give him a hug and let him know that he is special to me.  That reaching out is enough to bring him out of his shell and get him talking about what went wrong with his best friend.  With the emotional release, he begins to feel better, short-circuiting the depressed feelings and helping him reengage with other life activities.

Being a therapist is all about tracking the thoughts, feelings, and actions of a unique human being;  understanding what is driving those; and then using that awareness to help create a set of conditions that can lead to growth rather than setback.  In a different context, that is also what a great parent does.  What therapists and parents don't do is conduct backtests of all similar occurrences across all people and then generate a prediction of future behavior to figure out how to respond.  Understanding is built from the ground up, taking particulars and making sense of them, creating possible explanations.  Prediction is a top-down process, starting with universal patterns and applying them to particular contexts.

A meteorologist seeks prediction, making use of complex models that track temperature, humidity, wind, air pressure, etc.  A historian seeks understanding, looking at the motives and cultural influences that lead to political, economic, and military decisions and outcomes.  Each is an approach to knowledge:  we might accurately predict the outcome of a ball game and also understand the decisions and strategies that led to the outcome.  

Successful discretionary traders I've known and worked with have been distinguished by their level of market understanding.  Successful quantitative traders I've encountered have excelled at analysis and prediction.  Sometimes the successful discretionary trader makes use of predictive models as inputs to decisions; the successful quantitative trader will ground models in sound market understanding.  At the end of the day, however, quants trade their predictions and discretionary participants trade their understanding.  One trades universal patterns; another trades insights specific to what is observed here and now in a particular market.

What I realized in the Montana mountains is that the psychological challenges faced by traders often leads them to seek quick (and artificial) security in market predictions.  Instead to staying grounded in what is happening here and now, as in the example of my response to my son, a frustrated or uncertain trader might look for answers in top-down predictions.  If a psychologist were to do this, he or she would become emotionally tone-deaf, no longer tracking the meaning of the unique individual in the conversation.  When discretionary traders leap to a mode of prediction, they often lose their feel for markets by imposing ideas that clash with the actual messages of "the tape".

I propose that successful discretionary traders are successful for the same reason that people are successful in relationships:  they are able to stand apart from their own emotional responses and habit patterns so that they can appreciate and understand the thoughts, feelings, and actions of others.  When we track who is in the market, what they are doing, and the price levels at which they are acting, we assemble the raw materials for understanding market activity.  It is difficult to truly understand what someone is saying if we're busy fitting them into a model and trying to predict what they'll do.  The same is true for the trading of markets:  we fail when we become so eager to anticipate outcomes that we stop listening to the actual messages of markets.  Quantitative information can assist the understanding of a discretionary trader; it can never substitute for it.

Further Reading:  Trading Emotionally, With Intelligence
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