Why Successful Traders are Masters of the ‘Best Guess’.

During a conversation with a coaching client, the client remarked to me that 'He could not see any logic or rationality in anything in the market'. 

I explained that the logic we apply to the market is rarely fully formed or complete. By the time a complete and fully formed logical explanation is available, the market has moved to discount it. In the absence of that we have to try and make a 'best guess'. 

The problem with best guesses of course is that they are based on extremely limited information and lead to dubious logic. 

This was illustrated last month in some comments I saw from news reports after the May Non-Farm Payroll release. 

The figure released showed an increase of just 75,000 against an expected a gain of 180,000. Immediately the S&P Futures dropped 7 points. 

Financial news reporters always have to have a story, and thus the first news report stated: 'Disappointing payroll data had seen US stocks drop on economic concerns.' 

However within an hour the drop had been fully reversed and the future were surging. A new headline then read: 'Disappointing payroll data sees US stocks rally as likelihood of rate cuts increase.'

Often the story fits what we observe rather than the other way around. This may be a news story, but the mental processes a trader goes through are nonetheless the same.

Thus, what is a trader to do if they rely on logic in these situations? A trader has to make choices.

This is challenging for many new to the game. That is not how they have been educated. Their education systems tells them, 'get all information, gather the facts, make an informed choice'. 

But in markets, how can you make an informed choice when all the information is not present and certainty is impossible?

You may get situations which have a high degree of certainty, but, the problem then is the risk reward pay-off is very low. On the contrary the high risk-reward scenarios come with a very low degree of certainty. This simple concept is demonstrated by a typical risk/reward versus degree of certainty graph as shown below.

The Human Mind and Best Guessing.

Ultimately the job of the trader, or the speculator, is to take 'best guesses'.

Making a best guess is challenging as the human mind dislikes incomplete pictures made from a few basic focal points and thus seeks to complete the picture based on previous experiences of similar situations or images. 

Our minds seek extra information to complete an incomplete picture. Unfortunately, in markets, time is not on your side. What the mind therefore does, is fill in the gaps to allow us to make the best sense of what we can with the information we have.

The danger is this can undermine our vision and our perception can become distorted. The narrative may be correct, or it may represent a logic based on a false premise used to justify a ‘feeling’ based decision, or a decision not necessarily based off clear logic (Which abstractions often are).

I confided in my client that when I was a trader, this happened to me on many occasions, and sometimes could seriously undermine my trading. I shared an example with him from my own trading.

Bizarrely the example I shared with him was one that turned out to be a very successful trade.

The rationale for the trade was based on a technical set-up, however once the trade was in motion, I started to develop a fundamental narrative which fitted with what was happening in the market. In a similar way to the payroll example above. 

The logic-based narrative, which I constructed, based on a macro-economic fundamental case, turned out to be completely wrong. Fortunately, it did not matter, as the technical aspect of the trade had been executed perfectly and proved extremely successful. But it did distort my subsequent behaviour. Rather than looking objectively at the market, which was now ripe for a reversal, I had convinced myself it was moving higher. I did not lose any money on this, but I did miss a great opportunity. Trading failure, is not always losing money, it can be failing to make money when your system, method or process identifies value producing opportunities. 

The discussion with my client continued and my client raised the famous trading mantra; - ‘Trade What You See, Not What You Think You See’.

The challenge in markets is that 'what we see' rarely is a true and complete image. Instead it is a pieced together image based on templates from experience. This is how the brain works.

Optical illusions provide good examples of this:

In the image below, the squares marked A and B are identical in colour and shade. However, your brain is not seeing this because it expects something different given the checkerboard pattern and the shadow cast by the green cylinder. 

No matter how hard you stare at them, whilst they remain in this format, your brain will not allow you to see the truth.

You may wish to go to this link explains this.
Alternatively check out this excellent YouTube video demonstrating this. 

Another excellent example, which I think provides a better metaphor for markets, is this image: 

Markets rarely allow us to see a clear and logically constructed picture. There are just too many variables, different views and varying possibilities. We are therefore left making ‘best guesses’, whether we like it or not.

The Job of a Trader is to Master Guessing.

Thus, the job of any trader is to become the 'Master of the Best Guess’. 

It is for that reason they need to have checks on their behaviours, on their optimism and pessimism, on their arrogance and their levels of confidence.

That is why they need processes and structure to their trading, their analysis, their trade management, and their self. 

That is why trading is more art than it is science. The art of trading was wonderfully defined by another client who said: 

‘The Art of Trading is learning to sit around and do nothing, when everything in your mind screams at you to do something, balanced with having the guts to do something when everything in your mind screams at you to do nothing.’

We cannot help ourselves as humans in applying logic and rationalisations to fill gaps in data or to try to explain data or events, that is how we roll. 

This is why the concept and idea of developing an 'Alpha Mindset', a mindset geared towards the production of Alpha, is so vital for traders and investors. 

The starting point for that is understanding your 'self', then learning to manage your 'self', and then learning to master your 'self'. 

This means understanding the basic drivers of your decision-making, behaviours and action. Developing an understanding of who you are, both from a 'first-' and ‘third-' person perspective, and being conscious of how your evolving and emerging situations impact what you do and how you are. 

As you become more self-aware, so you should be able to start capturing the upside of your capabilities more effectively, and limiting the downside which results from some of the negative aspects of how you function. 

This will enable you to develop the skills need to ‘Guess’ more successfully, and thus move you towards becoming a 'Master of the Best Guess’. 

Article by Steven Goldstein

Steven Goldstein is a Performance, Team and Executive Coach who focuses on helping improve the 'mindset' aspects of Risk and Financial Markets' people and businesses.

Core to Steven's work is the belief that everyone has the potential, often latent or hidden within them, to surpass where they are and to grow into what they want to be. He views trading as two concurrent battles, one a person has with the markets and one they have with their self. To succeed a person must win both. As a coach, Steven works predominantly on helping his clients win the battle with their self.  

Prior to becoming a coach Steven worked for more than 20 years as a Rates and FX trader at some of the world’s leading investment banks. See Steven's Full Profile.

If you are curious about how Steven could help you or your business, please email him at info@alpharcubed.com. or call +44 (0)7753 446097. 

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