What do trading the financial markets have to do with the game Rock, Paper, Scissors?
In this article I look at why researchers organised a competition at a university in China and how their analysis of the competition showed about people’s instinctive bias. This bias casts a light onto an important reason why traders succeed or fail.
The importance of psychology to successful trading has been discussed and written about for many years. If a trader in unable to control his emotions he will not be able to trade successfully over the long-term. This does not mean he cannot have emotions, but rather he must be able to control them when it matters.
For me, one of the key aspects of psychology in trading, is the ability to keep doing the right thing, even when it is producing the wrong results.
The difficulty with trading and investing, is that the financial markets are unlike most other things that people come across. The markets may appear random, but in reality they are being pushed and pulled by countless participants with different convictions, different purposes and different sized accounts.
The markets may not be random but they are not knowable either. Fundamental and technical analysis can only ever understand part of the reason why prices move. Therefore, it is not possible to know what the true odds are for any particular trade, in the way that we could for a casino game. Even following the best possible strategies will usually deliver results that can be confusing and unfair seeming.
The challenge for traders is to adopt an attitude of controlled optimism. Getting the balance between continually challenging our methods and assumptions, while remaining as consistent as possible in the face of the caprices of the market.
Rock, Paper, Scissors
Scientists at Zhejiang University in China organised a rock, paper, scissors tournament.
Full Story: http://www.bbc.co.uk/news/science-environment-27228416
After analysing the results they found that the players’ behaviour was not completely random. It turns out that, after winning a round, players have a tendency to repeat the winning move. After losing a round, players have a tendency to switch, moving in order of the name – Rock, Paper, Scissors.
This “win-stay lose-shift” strategy is a very common response to game situations and the scientists believe it may be hard-wired into human brains.
Trading with the Win-Stay, Lose-Shift Methodology
I expect that anybody that has ever traded can identify with the behaviour of the students at the rock, paper, scissors competition. For beginner traders, a few losses has them doubting their system, broker or themselves. Even experienced traders can be unnerved by a long sequence of losses.
At this point many people will succumb to the need to start researching new systems. Having done this they might trade the market in the other direction, only to find that the market snaps back and moves in the direction of their original trade.
This situation is unfortunate and probably all traders need to go through these moments to find out about themselves. However, it is an absolute certainty that continually trying new trading systems after a loss will not be successful.
How Can This Improve our Trading
Be Aware of Our Behaviour
A big part of improving our trading psychology is being aware of what we are doing.
The scientists investigating rock, paper, scissors showed that people have a tendency to behave in certain ways in certain situations. If an individual is aware of this tendency, and responds by making his actions random, he should have an even chance of winning any game.
So for a trader, if he is aware of this tendency, he can deliberately act in a way that prevents him from behaving this way. The first thing to do is only trade in accordance with a trading plan. Whatever the markets are doing, keep things simple by sticking to the plan. Secondly, be patient with losses. If the strategy is sound and backtests show that the strategy is profitable, stick with it until there is sufficient data to make a decision.
Be Aware of Other People’s Behaviour
If a rock, paper, scissors player is aware that his opponent is acting in a predictable way then he can change his strategy accordingly. This is true for a chess player, poker player or tennis player. For traders this is more difficult because the markets are very difficult to predict.
However, there are times when the market moves to an extreme and this can provide us with a good opportunity trade. An example of this is a short or long squeeze. A squeeze occurs when a majority of short-term traders are positioned on one side of the market. When a move starts against the short-term traders they respond by selling their positions and adding to squeeze. The image below shows a short squeeze that occurred on the EUR/USD in June 2014.
It is much easier to analyse our own behaviour than it is to analyse the market’s behaviour. Therefore the first thing we must do is be aware of the tendency to react differently to winning trades and losing trades. Both of them are an inevitable part of trading and both are required to develop a successful strategy. Once we have dealt with this in ourselves, we should also be aware that other individuals engaged in trading the markets are vulnerable to this behaviour. Therefore we should look for opportunities to take advantage when the market behaves in this way.