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Trade Like a Scientist
02/17/2014 6:00 am EST
A theme I emphasize with new traders is that it is important to trade like a scientist, says Brett Steenbarger, PhD, of BrettSteenbarger.com.
The scientific mindset is one that can be rehearsed and cultivated–and eventually internalized. What do scientists do? First, they observe regularities in nature. They look for patterns: repeated sequences of events and commonalities among structures. Those regularities differentiate what is meaningful from what is random.
After observing regularities, scientists attempt to explain these. Explanation is the role of theory. The theory is the scientist's way of making sense of the world. Theory is not truth; it is a first approximation at truth.
Scientists gain confidence in their explanations by testing them. If a theory is meaningful and accurate, we should be able to use it to generate future observations. These predictions are hypotheses for the scientist. By testing hypotheses, we keep an open mind with respect to our observations and explanations.
Finally, once empirical tests provide fresh observations, scientists revise their explanations of nature and use these to generate further hypotheses, observations, and revisions. Knowledge, for a true scientist, is always provisional: that is what separates science from dogma.
The scientific mindset is one of humility: a recognition that our best theories are only approximations and that many of our tests of hypotheses are apt to fail. When we trade, we have an implicit or explicit theory about the current market, and our trade tests a hypothesis that we frame around our explanation. That is why a scientific trader never wagers too much on any single trade. Nature will always be more complex than our science, and our understanding will always be partial. Such a perspective is a powerful antidote to overtrading and overconfidence.
Below, we'll walk through a trade from a scientific perspective.
We examined the process of science and its relevance for trading. In this post, we'll look more specifically at how we frame our trading ideas as scientists.
If I am trading like a scientist, I am carefully observing the market and watching for patterns. I already have observed many markets in many conditions and have some theoretical understanding of what makes markets move across different time frames—from interest rates and liquidity at longer periods to the aggressiveness of large traders at short ones.
Perhaps I notice that, as selling hits the market, volume is declining and fewer individual stocks are making fresh price lows. I also notice that one sector of stocks, the semiconductors, are actually moving higher and gaining money flow. Bonds, which had been falling with stocks, are now catching a bid. I hypothesize that the market is running out of sellers, that we are in the process of bottoming, and that we will likely see short covering as a result. That should propel the market higher.
Having formed this hypothesis, I make note of a recent short-term high price in the semiconductors and the low price. I say to myself, in essence, "I think we will hit this price (prior high) before we touch that price (recent low)." In other words, I am willing to risk a possible move back to the low in order to participate in the hypothesized move to the high.
This is only a hypothesis, however; it is not truth. For that reason, as a scientist, I must remain open to data that tell me my hypothesis is not supported. A fresh influx of sellers hitting bids; a fresh drop in bonds—many factors could alert me to a potential problem with my hypothesis. I also must keep my bet on this hypothesis modest: to risk much of my capital on the idea is to treat the tentative formulation as absolute truth.
It is in this context that every good trade tests a hypothesis. When we observe a pattern, frame an idea, test the idea with a trade, and actually profit, our idea—our theory—is supported. That may lead us to another trade that extends this idea. Conversely, if we do not profit from our theory, we may need to go back to observation mode and revise our explanations.
NEXT PAGE: 3 Common Trading Mistakes|pagebreak|
Thus it is that a scientific trader will gain confidence and become a bit more aggressive when his or her ideas are confirmed; a bit more cautious when ideas do not pan out. When you trade like a scientist, every good trade provides you with information, because every good trade is a solid test of your market understanding. For this reason, the scientific trader values losing trades. They, no less than the winners, are data to be assimilated and can push you to further market insight.
Next, I'll look at three common mistakes traders make from the scientific vantage point.
In the first part in this article, we examined a scientific mindset and how it affects trading practice. Let's now turn the tables and view three common trading mistakes through the scientific lens:
1) Mistake #1: Trading Without Understanding - Sometimes traders put their capital at risk without taking the time to observe market patterns and integrate these into a concrete explanation of what is happening in the marketplace. A number of traders I work with observed the recent rise in interest rates very early in the move and formulated ideas of shorting rate-sensitive sectors. They tested their understandings with initial positions and scaled into the idea as markets confirmed their views. How different this is from simply putting a position on because a market is making a new high or low!
2) Mistake #2: Oversizing Positions – Many psychological problems in trading can be traced back to excessive position sizing. Traders trade too large for their account size in order to make windfalls, not in order to test their ideas. Scientists conduct many tests before any hypothesis is truly supported, and they test many hypotheses before they accept theories as versions of truth. If you were a lab scientist, would you risk your entire grant funding on a single experiment? Of course not; a single study could fail for a variety of reasons, including experimenter error. Similarly, any single trade or idea can fail for a variety of reasons. A true scientist knows that his or her understanding will always fall short of reality. That is why scientists will conduct doable experiments to refine their ideas before they dedicate significant resources to large investigations.
3) Mistake #3: Not Knowing When You're Wrong – A scientist does not actually test his or her hypotheses. Rather, each experiment is framed as a test of the "null hypothesis": the proposition that variables of interest do *not* affect the outcomes under study. Scientists thus never accept their hypotheses; they at best only reject null hypotheses. Embedded in this perspective is the idea that it is crucial to know when it is necessary to accept that mull hypothesis and conclude that a view is not supported. Can you imagine a qualified scientist becoming emotional because an experiment produces no significant differences and then conducting numerous revenge studies?! Traders, however, sometimes do just that. They don't have rational stop losses identified and so can't terminate their "experiment" at a prudent time. That leads them to take on excessive losses and react out of frustration rather than understanding.
A simple checklist would aid many traders who would become their own performance coaches:
1) What is my understanding of this trend/trade idea and what is the evidence behind it?
2) How much of my capital am I initially willing to devote to my understanding of this trading theory?
3) What outcome(s) would lead me to devote more capital to my idea and what is the maximum portion of my portfolio I'm willing to put at risk on this idea?
4) What outcome(s) would lead me to abandon my idea and how much am I willing to lose on this idea?
Many bad trades could be avoided simply by requiring oneself to answer these questions aloud prior to any trade.
By Brett Steenbarger, PhD, of BrettSteenbarger.com