Uncertainty

Uncertainty is the name of the trading game.

You’ve got to acknowledge it

7 January 2019

When a novice trader Joe buys a stock and the very next morning it falls hard by 3% before open, Joe immediately feels uncertain about prospects of that trade. When he bought the stock yesterday he was certain it was a great deal because he followed a call made by a trusted expert. He had been following that trader for weeks before he decided he could trust him. After an extended drop that lasted for weeks the stock finally arrived into a demand zone, a level at which it reversed in the past.

This morning, in sharp contrast to the initial sense of confidence, Joe perceives that situation as a an immediate threat. He did not expect that drop and was not emotionally prepared for it. He does not have a plan and the trader who called for this trade has not post any updates. Joe’s heart races and his palms get sweat. His stomach gets upset and he experiences a sudden hot flash.

Those automatic reactions to threatening situation including sweaty palms, racing heart, and upset stomach is how our body makes “fight or flight” preparations. We react to any unexpected negative situation in this way because we inherited it as an involuntary survival mechanism from our prehistoric ancestors. Tens of thousands years ago any noise from outside a cave inhabited by prehistoric humans meant danger and threat to their lives. They had to get ready either to fight or run away to save their lives. Accordingly, the heart pumps faster to send more blood to arms and legs, the main tools in fighting or running, the eyes dilate for better vision and any process unrelated to fight like digestion in stomach gets temporarily turned off.

The main problem why it is so difficult to cope with emotions in trading is that our brain has not evolved much since those ancient times! Our body keeps overreacting even to minor but unexpected stressors when our life is not threatened anymore. Our brain is wired to anticipate the worst outcome because paranoids have better chances to survive and transfer their genes to the following generations.

Joe immediately imagines some horrible events that might explain why the stock he had bought dropped before the open of a trading day. He experiences uncontrollable worries about negative “what if…” scenarios. The company may go out of business and the price of the stock could go to zero. So after a 3% drop he focuses on a scenario where he will most likely lose 100% value of his investment! His next natural reaction is self blame for following that expert and buying that stock. Now he remembers that some traders shared negative views on the stock. He ignored that information back then and now he feels stupid.

Joe experiences stress that causes his body to tense and he begins to breathe a little more shallowly. A shallow breath lowers oxygen levels in his blood. And deficit in oxygen makes things worse because it becomes more difficult to think logically and keep focus on incoming information. He rushes to find any information that could explain that unexpected drop. And there are dozens of articles available and they are full of opinions of why that did happen. Joe quickly overloads his brain with tonnes of irrelevant information all with negative connotation. Instead of reviewing the chart to find the next important support and resistance he now wastes his time reading about financial results of the company that were disclosed two weeks ago. Yes, the company reported worse than expected results but this is exactly why stocks fell down 15% since then. So all that information has been known to market participants for a long time and it does not explain this particular move down that morning. He focuses his attention on information that is irrelevant for the task at hand. And as a result he does not pay attention to the fact that the morning drop was accompanied by miserable volume of trading. He does not see that price has tagged a 200 day moving average that is perceived by many traders as a very important support level. All he wants at this point to get out of that stock. He wants to run away from uncertainty.

Having avoided exploring the situation, Joe is left with greater unresolved uncertainty about the main problem that causes spike of anxiety. What normally happens to novice traders in that situations is that they either throw in the towel being unable to cope with the stress and sell stocks at loss right at the open of a trading day. Or they decide to hold that stock until it gets back up to the level where they bought it. And if stock raises to that level they happily sell it at the same price they paid.

Now let’s have a look at David, that expert whose bullish call was followed by Joe. David has been trading for years and knows that sometimes you get lucky to nail the very bottom of a move down. But he also saw many times when a stock would accelerate drop at the very last stage of an extended multi-week decline. That is why he never buys a full position at once but start with 25% of his normal position. Even though his main scenario was that stock did hit the bottom he knew he might be wrong and the stock might extend its drop lower. Therefore he wanted to have available funds to buy more of that stock at lower price. That is why he prepared a plan B. Even before he bought a starter he had examined lower important levels of support and added another order to buy another 25% of his normal position right above the next lower support level. His additional buy order is valid until cancelled. David knows that the last drop may come as a spike and you would miss it if you did not have it in a system.

How does David feel the following morning when he sees that the stock fell by 3%? First, he is not surprised because he acknowledged that potential negative scenario in the back of his mind yesterday. This is the main reason why that event did not create any uncertainty for him. He does not even perceive that event as a negative one this morning. When he opens his trading platform in the morning he sees that his order to buy got filled 10 cents above the lowest price of that spike down when he was peacefully sleeping at 4 AM early morning. He does not look for explanations of why that drop happened. He employs technical analysis meaning that he looks for reliable repeating patterns in the stock charts. And he sees that the price landed onto an important support level. He does not pay attention to news because news is just a catalyst for market moves. When market is in the bull trend nobody cares about bad news. And when market breaks down important support levels good news is not enough to cure wounded bulls.

David feels good about himself this morning because he is in control. He expected that drop and that is why he did not buy 100% of the position at once and even benefited from that drop adding to his position on emotional spike down. He also keeps available funds to double his position in case the market keeps going lower without breaking major support level. So after spending 5 minutes checking the market he walks away from screens to have breakfast with his kids leaving behind any worries about that morning 3% drop. He saw such unexpected drops before and he does not see any reason to break his morning routine.

How uncertainty about future makes us anxious

There was a psychological experiment with novice parachutists in 1978. The subjects of the experiment reported fear before their first ever jump. However, only after one session the level of fear reported before the next jump reduced. It was not possible to explain such a stress relief by improvement of their skills. One jump could not improve their performance. The more reasonable explanation was that they did not longer faced uncertainty. Once they jumped the first time they got to know what to expect and how it feels. Experience of getting through a situation that might look threatening at first establishes expectancy that we will be able to handle a similar situation without any damage to our life or health.

Imagine two skiers at the top of a hill. One of them is a novice skier and another one is an expert. They look down and see an icy steep hill they are about to ride. Both skiers feel psychophysiological arousal including strong emotions, faster heart rate and quick but shallow breathing. But the expert feels rather excited. He has skied such dangerous slopes before and he feels confident that he has enough skills to do that again. In contrast, the novice skier considers that slope as a threat to his life. He might never rode such a slope before. He feels like he is not qualified yet for such a challenge. And that creates a strong feeling of anxiety.

Anxiety is a future-oriented emotional state that is experienced by all humans. We feel anxiety when we receive some information from environment about potential unpredictable threat. It is like a gut feeling about something negative event coming our way that may harm us physically or psychologically. This is when we respond with myriad anxious “What if …” mental representations of possible future events and their potential consequences.

Building perception of controllability

One of the important takeaways from this story is that if you believe that you are mentally prepared for a negative outcome and you have a back-up plan in response then you feel like you are in control.

Thus, even when you are unable to prevent negative events from occurring, increased certainty about the future build a subjective perception of control over adaptive anticipatory responses that can mitigate negative impact of that event. Uncertainty, conversely, precludes you from exercising this form of control. You first feel anxiety that then develops into self-blame and rumination. Instead of focusing on objective available information you go inside your mind trying to find what you did wrong and why it happened to you. And when you let your mind go inward you lose connection to what happens around you and may miss important clues that can help you to solve the problem.

Markets are impossible to predict

Every day you buy or sell any financials assets including stocks, futures, bonds or crypto currencies you face uncertainty. Some traders buy because they think the price will go up. And some other traders sell because they are convinced the price will drop. But nobody knows for sure what is going to happen. Any form of market prediction is just one or a set of possible outcomes.

When professional traders analyse the market they always build an array of potential scenarios. And some of them pull the trigger only when they get confident about one of them. More sophisticated guys will wait until two or three potential scenarios have similar outcomes. Getting that picky let them trade more confidently and improve their winning rate. But they always keep in mind a potential negative scenario that may happen. That gets them mentally prepared and protected from being caught off-guard when that low-probability negative event happens. They have a plan B in mind so they do not have to look for answers under emotional pressure at a critical moment.

Novice traders, in contrast, do not accept the hard truth about natural uncertainty of the markets. They want a bullet proof prediction with 100% accuracy that simply is a “mission impossible”. And when some expert offers them such a simplified version of reality beginners are happy to marry that scenario. They buy and hold no matter what. Even when the expert who brought them into tre trade would be long gone after break of support and invalidation of once good setup they will keep hope for the better.

In conclusion, let me give you advice. First, stay away from experts who are 100% sure about some single scenario. Always ask what support is critical for a long setup or what resistance level has to hold to keep a short scenario alive. Second, think in advance about your plan B. What is the next important support? What you are going to do if you wake up tomorrow and the stock opens with 10% gap down. The trick is even if you do not come up with a sound plan by acknowledging that scenario you will prepare your mind for a potential negative event. And that will let your brain not to consider that as a threatening uncertainty and protect you from “run-away” reaction.

The photo is by Javier Garcia on Unsplash.

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