The Emotional Market

How to Identify Emotion and Remove it

In a week that started with strong Chinese PMI data, and ended with a better than expected US NFP, stock and USD bulls were left rejoicing. There was enough for many to claim concerns over the global economy were overstated and that the market was about to demonstrate this with emphatic new highs on US stocks and the Dollar Index. However, continued lacklustre data from Europe, worse than expected US Retail Sales and ADP, reports of Boeing cuts, the RBA joining the chorus of doves, and a worsening Brexit crisis, was also enough for stock and Dollar Bears to scream caution. After all bond yields remains significantly below pre-December levels. Certainly, the emotional temperature of the market is rising.

 

A previously sentiment driven stock and USD uptrend appears now possibly to have some tentative fundamental justification. But it will need more than subdued inflation this week and probably a clearer resolution to the trade war to sustain such strength. Until then there will be enough for bulls and bears in what we believe will be increasingly emotional two-way volatility.

 

We are now at a stage where separating sentiment or emotion from fact will be crucial to trading success. This week’s newsletter focuses on the effect of emotion on analysis and trading. Next week’s will show how this has affected us but more importantly how we can and are turning this into profit and opportunity. Emotion can distort both analysis and trading.

 

We are passionate about markets and therefore analysis. That passion isn’t restricted to content but process as well: rigor. There are thousands of different forms of fundamental, intermarket, technical and sentiment analysis each with varying results depending on the instrument, the type of market (trending, correcting, reversing) and therefore where it sits within its broader cycle. It is one reason we attempt to identify the drivers of a market and which form of analysis is therefore most likely to produce superior results in isolation and combination. Although each form of analysis will have particular strengths and weakness depending on the prevailing conditions, they will have a ‘weak’ spot where either the collection and/or interpretation and/or the application of data will be open to subjective judgement and therefore bias.

 

There are 10 very common biases.

Analysts or the analysis side of a trader will naturally have a bias. Many of these biases are P&L driven for traders and kudos, self-esteem or ego for analysts. That is market participants will naturally follow what has proved successful before. This will not necessarily lead to poor analysis in itself. However, this predisposition will, if not properly recognised, encourage them to filter in data that fits with the bias and underestimate or ignore data that is not consistent.

 

But markets don’t remain the same for ever. Trends reverse, drivers and conditions change. But such biases, if not controlled reduce adaptability and the ability to recognise prevailing market conditions and therefore change.

 

How can an analyst avoid the biases? He or she SIFTS out emotion.

 

1. Self-awareness. The first and most important step is the actual recognition of the possible biases. You can literally use the list as a series of questions to challenge one’s analysis to see if there is a risk you are being selective in sifting data.

2. Impartiality. The second is the creation of impartial criteria divorced from emotion or the heat of the market. We intentionally created the (FITS) milestones in mania as criteria by which we could stay bullish throughout the uptrend until they were met. Now we have finally ticked all those boxes we have a series of new FITS criteria with which to manage a downturn.

3.Facts.What are the facts not people saying. The third step is to base analysis on price action and not price or noise. In other words, just because it is strong doesn’t necessarily mean it’s going higher. Sadly, the majority of analysis we see uses that as a starting premise.

4. Time Perspective. The fourth and related step is to top-down multi-time frame analysis rather than bottom up.  We always analyse the longer term down to the medium to the short term. This not only provides context and consistency but it helps fine tune trade entries and exits.

5. Support. The fifth and final step is seeking corroboration from other markets and other components of FITS. One of the preconditions of the final leg of the bull market was the break down in correlations we projected more than a year ago. That may be continued evidence of our overall view but renders correlation analysis a dangerous short-term tool unless you have separate well researched analysis such as the almost identical match with the almost bizarre 1987 intermarket set up.

 

Many analysts are aware of the power of divergence as a technical and intermarket signal. But few are aware of divergence as indicator between expectation and reality, between impartiality and emotion, between the quality of analysis and price.

 

The potential effect of emotion on a trader is even greater.

 

We are not robots. We have emotions. As a trader If you suppress emotion it will come out in another form and possibly at a worse time. By recognising we are emotional, we can enjoy and benefit from an emotional market and not be controlled by it.

 

There are many such clichés about emotional trading. It is a well-known but under researched subject. Traders would much rather spend their time analysing markets or more likely screen watching to filter information that is consistent or not with their view or trade. They neglect an arguably more important dimension – themselves.

 

This is partly because we all go through different emotions at different times depending on our positions and yet we are confronted by the same market. More than 99% of the available information is about the market and our potential profitability and not emotion and certainly not our particular emotional at the time.

 

Emotion necessarily affects all those who take risk. We are human after all. And yet one of the mainly correct clichés is that emotion cannot be allowed to influence our decision making or it may derail what is hopefully well argued and evidenced unemotional analysis. We must remain disciplined at all times and only act according to our predetermined plan or adjust/react in light of new evidence. We must remain in control and not be controlled by the market. And yet we operate in an environment that we cannot control. This uncertainty is why we inevitably experience emotion. Therefore, the key to successful trading is to recognise and embrace this fact in three ways… and get it off PAT:

 

1. Prepare – not just through thorough analysis or correct risk management procedures – but prepare emotionally and anticipate potential market movements – good bad or indifferent.
2. Awareness – detect changes away from this balanced condition.
3. Transference – either neutralise or transform potentially debilitating influences into an advantages.

 

PAT is a trader’s friend. If we shun him (or her) then we risk turning the inevitable stress – which can be a positive influence – into distress which can manifest itself in so many different negative ways that we may not or be willing to recognise it at the time (although we frequently do afterwards).

 

Again, it is helpful to know what cognitive biases there are in order to detect them and act accordingly.

 

Maintaining control in a market that seems out of control is the greatest challenge of all. Next week we will explain how to do that but turn adversity into an opportunity.

 

Here’s to making the very best.

Good Luck

 

 

Ed Matts
Founder
Matrix Trade

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