Market Manifesto

The psy­chol­o­gy of trend rever­sal is the psy­chol­o­gy of rejec­tion and of sud­den change.

We are most famil­iar with these emo­tions at times of dis­as­ter and per­son­al loss, or rejec­tion. But they also appear with equal strength at times of sud­den and dra­mat­ic per­son­al suc­cess.

These emo­tions are pow­er­ful, with roots that run deep in our per­son­al his­to­ries. The dif­fi­cul­ty that humans have in adopt­ing to sud­den change accounts for the near uni­ver­sal strug­gle that traders expe­ri­ence when try­ing to take advan­tage of a swift trend rever­sal.

So, the emo­tions of sud­den change .… What are they? What are the dif­fer­ences between sud­den change for the bet­ter and sud­den change for the worse?
What are the sources, and what is the cure? What do we need to over­come in order to suc­ceed at times of sud­den change?

First, the emo­tions them­selves.

We see rejec­tion and a sense of loss as the pri­ma­ry emo­tions of sud­den trend change. What we thought would occur, is not occur­ring. Our idea of an order­ly mar­ket pro­gres­sion is sud­den­ly dis­rupt­ed; we are jolt­ed out of our secure expec­ta­tions by this intru­sion of the real world. In a sub­tle sense we are dis­ap­point­ed, we are bereft, we expe­ri­ence loss as our expec­ta­tions of the future are rude­ly rebuffed.

These emo­tions are seen most vivid­ly in sud­den life changes such as death, injury, and loss. They are seen most com­mon­ly when rela­tion­ships change, when the deep feel­ings of inti­ma­cy on which we all rely shift and alter with unex­pect­ed rapid­i­ty.

We see these feel­ings also, in their less painful form, on the flip side, in big, sud­den win­nings or wind­fall events when we have no time to get used to our change in for­tunes.

When things change in a hur­ry, we become unset­tled, no mat­ter if the change is to the upside or the down­side.

Our goal as traders is to respond imme­di­ate­ly to every change, sud­den or not. But our ene­mies here in the land of sud­den change are denial, and depen­dent think­ing, and ten­sion, and fear.

What is denial?

If we can­not or will not believe what we are see­ing, then we expe­ri­ence denial. Denial is man­i­fest­ed by the ten­den­cy to ratio­nal­ize, to explain away, to not rec­og­nize the nose on our face, so to speak. Denial is the five thou­sand-pound hip­popota­mus in the liv­ing room that every one ignores, as con­ver­sa­tion con­tin­ues.

Denial is a weak defense and is best dealt with as one deals with cob­webs, by brush­ing them away.

What is depen­dent think­ing?

Depen­dent think­ing is thought that waits for oth­ers to set the stage, and to turn on the lights. It is the assump­tion that we are not good enough to think for our­selves. It is root­ed in inse­cu­ri­ty and poor self-esteem. Depen­dent think­ing waits for con­fir­ma­tion, for per­mis­sion, and for com­pa­ny. It is best dealt with by refus­ing to look out­side of ones self, by cut­ting off the source of oth­er influ­ences, and by lis­ten­ing to one’s own ideas, and test­ing them for truth.

What is ten­sion?

Ten­sion awaits us when we step toward the unknown, or we fear tak­ing that step. It is the phys­i­cal man­i­fes­ta­tion of anx­i­ety, and it is a bad thing only in mat­ter of degree, as a lit­tle bit of ten­sion sets us up and keeps us alert. We regard ten­sion as a bad sig­nal if, like a traf­fic light that is stuck on red, it nev­er lets us move for­ward.

Ten­sion, anx­i­ety, and fear are close­ly relat­ed warn­ing sig­nals that can eas­i­ly over­play their role in life, and destroy our capac­i­ty to explore new ter­ri­to­ry and to react quick­ly to sud­den change. They can be van­quished and restored to their right­ful place by doing your home­work thor­ough­ly.

Doing your home­work means envi­sion­ing sud­den change before it hap­pens, and learn­ing what to do when these pat­terns occur – in short, accept­ing the pos­si­bil­i­ty of sud­den change at all times.

Trend rever­sals reward the nim­ble, inde­pen­dent, aware trad­er. But they slaugh­ter the unaware, the plan-bound, the inde­ci­sive trad­er.

We can learn a lot from sports, because many sports accom­mo­date sud­den change in strat­e­gy and in the event.

Hock­ey, for exam­ple, is a sport based on sud­den change. And soc­cer, bas­ket­ball and Amer­i­can foot­ball are also excel­lent train­ing grounds for learn­ing about sud­den change, and the emo­tions asso­ci­at­ed with quick rever­sals and sud­den changes of for­tune.

In these games, a steal or inter­cep­tion, a quick burst down field, down court, or down ice, a score … well, we see sud­den rever­sals every day in team sports.
A good play­er can react to the inter­cept­ed pass instant­ly, and shift from defense to offense in a nanosec­ond. But it takes as much men­tal quick­ness as phys­i­cal agili­ty to do so. It is hard to shift gears so fast. But these sports prove that it can be planned for, and trained for, and suc­cess­ful­ly so.

How do foot­ball teams get to the point where every play­er is so alert to the pos­si­bil­i­ty that an inter­cep­tion or fum­ble can occur at any time that their reac­tion time is cut to a frac­tion sec­ond and the assign­ment of every team mem­ber can shift in an instant?

It is large­ly a mat­ter of rehearsal. In sports we have the expe­ri­ence itself but we also have the abil­i­ty to rehearse. And that is exact­ly what we do, or should do, in the mar­ket as well. We plan for the unex­pect­ed as well as the expect­ed. We know the per­cent­ages, and we under­stand what is most like­ly, but we also plan for the unex­pect­ed, and what to do when it occurs. We keep in mind that the unex­pect­ed can hap­pen at any time.

It is as if we are con­stant­ly and con­tin­u­ous­ly going through a process that says, “OK, now we have two pos­si­bil­i­ties here. Either the mar­ket will do A or it will do B. If it does A, then I will take X action. If it does B, then I will take Y action.”

The trick is to main­tain an open state of mind, where either course of action holds an equal pos­si­bil­i­ty, even if the prob­a­bil­i­ty leans one way or the oth­er. We must always ready to play either pos­si­bil­i­ty.

This is hard­er put into prac­tice than one would think. Traders are con­stant­ly catch­ing them­selves devel­op­ing an opin­ion that grows in strength so that the alter­na­tive sce­nario shrinks into insignif­i­cance, and then is for­got­ten or dis­count­ed or ratio­nal­ized into sub­mis­sion. A men­tal bias is dan­ger­ous, how­ev­er. Good traders rec­og­nize that when this occurs it is the very time they need become the most awake and alert.

Con­stant­ly ask your­self, “What else could hap­pen here?” Con­stant­ly remind your­self, “The mar­ket can do anything!” Con­stant­ly review the pro­gres­sion of the types of trad­ing, so that you can envi­sion to your­self the next pos­si­ble actions. Con­stant­ly visu­al­ize what you will do under the dif­fer­ent alter­nate sce­nar­ios.

Trad­ing is in some ways no dif­fer­ent than oth­er parts of your life. If you are aware and bal­anced, you will con­sid­er all of the pos­si­bil­i­ties that the future holds, and not be lim­it­ed to just one pre­dic­tion. When you are con­stant­ly ask­ing your­self, “What about this?” and “What will hap­pen if that occurs,” then you are well on the way to cop­ing with the sud­den change that has not yet occurred. Nev­er for­get that we are sur­round­ed at all times with latent sud­den change.

You will find that an easy-going, free-float­ing, aware, alert, open method of approach­ing the trad­ing day, is the best. If you are tense, and anx­ious, then you have not done your home­work cor­rect­ly, and some­thing is wrong.

What about oth­er exam­ples of cop­ing with sud­den change?

How about real life dis­as­ter sit­u­a­tions? Or hos­pi­tal emer­gency rooms, where a whole cul­ture has been devel­oped to deal with the sud­den, the unex­pect­ed, and the urgent. What about the mil­i­tary? How do they train offi­cers to make deci­sions when con­di­tions sud­den­ly change?

Much can be learned from the prin­ci­ples of dis­as­ter pre­pared­ness, and from emer­gency med­i­cine triage, and team plan­ning, and so forth. They learn to con­trol the flow of infor­ma­tion, to make the most crit­i­cal deci­sions first, to rehearse the pos­si­bil­i­ties, to set up branch­ing deci­sion-mak­ing trees in advance, so that under con­di­tions of duress time is not lost try­ing to fig­ure out who should be asked what.

Inter­est­ing­ly enough, when the mil­i­tary looked for mod­els of how bat­tle­field offi­cers could learn to make deci­sions under uncer­tain con­di­tions, one of the places they looked was in the Chica­go futures trad­ing pits. They rec­og­nized the par­al­lels. In the pits we find lots of infor­ma­tion about devel­op­ing sit­u­a­tions, but that infor­ma­tion is con­fus­ing and con­tra­dic­to­ry and incom­plete.

Deci­sions need to be made and there is not a lot of infor­ma­tion, or not enough infor­ma­tion. Yet act­ing on incom­plete data is the nature of bat­tle, and the nature of trad­ing. In the mar­kets, there is always more infor­ma­tion to be had, but gen­er­al­ly speak­ing it is not time­ly and there­fore use­less, as it entails delay and the oppor­tu­ni­ty will not wait.

It makes a dif­fer­ence if the infor­ma­tion is ger­mane or not. Fun­da­men­tal infor­ma­tion about sup­ply and demand is not use­less but it is prob­lem­at­ic because you will nev­er know if you have enough, or the right, infor­ma­tion, and hence it is dif­fi­cult to use for trad­ing.

In tech­ni­cal analy­sis the infor­ma­tion is restrict­ed to price action, but price action orga­nized and inter­pret­ed accord­ing to def­i­nite rules and actions. As long as we have time­ly price data, we can man­u­fac­ture a time­ly set of inter­pre­ta­tions and analy­ses. In P&L we restrict these to the essen­tial, and we set pat­terns and screens for our deci­sion-mak­ing so that we are not devoured by uncer­tain­ties. Thus we are able to make deci­sions quick­ly, and eas­i­ly, and with a min­i­mum of stress.

So, like a bat­tle­field com­man­der, we learn to take action in a time­ly man­ner on the infor­ma­tion that we have avail­able to us, and then to adjust as con­di­tions change. It is this abil­i­ty to adjust that makes a great sol­dier, and a great trad­er. Wait­ing for more infor­ma­tion is rarely the road to suc­cess.

We have seen the reac­tions to huge nat­ur­al dis­as­ters, such as the ter­ri­ble tsuna­mi that hit the shores and lagoons of Indone­sia and Sri Lan­ka and Thai­land in Decem­ber of 2004. With­out warn­ing an earth­quake just off­shore thrust the sea-bed upwards and sent a 30 foot high wall of water crash­ing ashore, wash­ing away all in its path. Impos­si­ble to pre­dict, instant­ly chang­ing the land­scape, wip­ing out whole vil­lages in an instant. Thou­sands died – and the sur­vivors expe­ri­enced the shock of sud­den rever­sal.

We can imag­ine the event, but can we under­stand how to pre­pare for such a cat­a­stro­phe?

Per­haps not real­ly.

But it is like a sud­den death, or per­haps any kind of death, where think­ing about the event in advance can­not dupli­cate the expe­ri­ence of the loss. But plan­ning and visu­al­iza­tion can go a long way towards giv­ing us the men­tal and emo­tion­al strength to under­stand grief, and to accept it, and to deal with it in a far bet­ter man­ner than if we have not devel­oped this relat­ed self-under­stand­ing.

We have so much under­stand­ing of unex­pect­ed dis­as­ter, and so lit­tle expe­ri­ence with unex­pect­ed hap­pi­ness, and sud­den pos­i­tive events.

What are some such pos­i­tive events? Win­ning the lot­tery per­haps? An unex­pect­ed prize or award that comes attached with great pres­tige and a large amount of mon­ey?

One of us has had the unique expe­ri­ence of talk­ing with over four hun­dred such indi­vid­u­als, peo­ple who moments before had won a com­plete­ly unex­pect­ed six-fig­ure prize for their pro­fes­sion­al work, an award that car­ried with it great inter­na­tion­al renown and pub­lic­i­ty. This was a life-alter­ing event for all of them. With few excep­tions it took them weeks and months of adjust­ment, as their self-image worked to catch up with the real­i­ty of this sud­den cash award. It took them time to get used to this unex­pect­ed feel­ing of suc­cess.

This kind of unex­pect­ed life-alter­ing finan­cial gain is meat and pota­toes in the trad­ing world. Many traders have expe­ri­enced it, and many more wit­nessed the suc­cess of those that won big.

This is trend rever­sal to the upside, where a sud­den inflow of some large amount of mon­ey turns your head and cre­ates a dis­con­ti­nu­ity in your self-image. The actu­al fig­ure is rel­a­tive, for the amount that changes one indi­vid­ual will not be a change for anoth­er. But imag­ine for the sake of argu­ment that you expe­ri­ence an instant inflow of a mil­lion dol­lars.

If one is unpre­pared for such suc­cess, chances are high that it will have a desta­bi­liz­ing effect on the recip­i­ent. Cer­tain­ly there are legions of traders who have expe­ri­enced large, sud­den gains only to lose them in a short time, usu­al­ly due to self-sab­o­tage brought about by anx­i­ety accom­pa­ny­ing the sud­den change itself.

The con­ven­tion­al view is that it takes time to get used to your “new self” and it takes time to work through the under­stand­ing of how things occur in this new space. But we believe that an aware­ness of the emo­tion­al dynam­ics of sud­den change can do a lot to blunt these effects, and short­en the peri­od of adjust­ment. (It would nonethe­less still prob­a­bly be wise to take a few weeks off so that you don’t give your huge win back to the mar­ket.)

Thus we hold one can avoid the emo­tion­al traps of the mar­ket in sud­den rever­sals.
It is not mag­ic, but a mat­ter of hav­ing the right tools, and the right train­ing, for the prob­lem at hand.