High Speed Decision Making
One of the most important competencies that an intraday trader need have is the ability to make high quality decisions in a high speed trading environment.
One of the key areas I see new intraday traders struggle with is the speed of the game.
Often taken for granted is the sharp learning curve that must take place to adapt from trading on the daily or weekly charts to trading on a lower timeframe or tick chart.
The errors that a high speed environment can throw off will trigger all manner of execution errors and cognitive biases in the unaware and unprepared trader.
Similarly even more experienced traders may struggle during transitional periods in the market when the underlying structure changes from range contraction to expansion, or when fundamental events occur like contract rollover or options expiry which change the pace of the market.
The net net result is that all traders can benefit from this idea of “slowing the game down” to make better decisions.
Turns out that all of us have 2 types of cognitive systems that interoperate simultaneously. Kahneman labels these System 1 and System 2.
“System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control.
System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice, and concentration.”
“The automatic operations of System 1 generate surprisingly complex patterns of ideas, but only the slower System 2 can construct thoughts in an orderly series of steps. ”
“The division of labor between System 1 and System 2 is highly efficient: it minimizes effort and optimizes performance. The arrangement works well most of the time because System 1 is generally very good at what it does: its models of familiar situations are accurate, its short-term predictions are usually accurate as well, and its initial reactions to challenges are swift and generally appropriate.
System 1 has biases, however, systematic errors that it is prone to make in specified circumstances. As we shall see, it sometimes answers easier questions than the one it was asked, and it has little understanding of logic and statistics. One further limitation of System 1 is that it cannot be turned off. If you are shown a word on the screen in a language you know, you will read it—unless your attention is totally focused elsewhere.”
As traders the useful takeaway from this is realizing that all of us float between using System 1 and System 2 thinking as we go about our trades.
System 1 is great at effortlessly recognizing patterns and ideas but its susceptible to biases.
System 2 is more rational yet is very lazy and expends a great deal of effort and energy when called upon.
The speed of the game
[Tweet “The most effortful forms of slow thinking are those that require you to think fast.”]
Let me start with a scenario that most of us can all relate to.
What you consider a lower timeframe is of course relative to your trading methodology and disposition so for some of you it may be a 15 minute chart and for others it could be a 500 tick chart.
Regardless, I’m sure the first time you opened up that lower timeframe chart it probably felt like you had just stuck your head out of a car racing down the freeway and everything was coming at you a thousand miles an hour.
At this point everything probably looked like noise and felt un-tradable.
However if you stuck it out, and were determined to learn the nuances and patterns of that timeframe then repeated and ongoing screen time probably got you acclimated and accustomed to the speed of the game.
Repeated study of the lower timeframe charts appeared to slow down price action until hour by hour, day by day you began to feel more comfortable with the pace and volatility.
This is also not too dissimilar of a process for a futures trader who looks at trading a new futures contract for the first time or an FX trader who looks at a new currency pair to trade.
In effect your deliberate study slowed down the speed of the game. Where you were blind before you now began to see possibilities and opportunities.
From repeated practice and study, a trader can begin to spot setups, learn where to set her stops and limits, and how best to manage the outcomes once in a trade.
This type of a planned, intentional thought process is “System 2” or slow thinking.
Now let’s fast forward, let’s say you’ve been studying your market for days and weeks and are now ready to finally take a trade off that lower timeframe.
Funny enough once you have the intention of taking a trade the world suddenly seems to move much faster.
Irregardless you put your hesitation aside and motivated by profits stepped into the trade and took a position.
What was once benign price action now seems aggressive and threatening.
Your deliberate pace of judging and analyzing the trade has been replaced by a whole host of new variables that require quick decisions.
How is this market trading in comparison to the SPY or VIX? Is there a divergence forming? Is this a pullback or is the direction of the trend changing? Should I take an early profit here? Should I take a small loss here? Where is my stop and is it going to be hit?
While it would be great to be able to pause the trade for a few seconds to analyze options, the reality of the situation is that the price action is threatening your stop and very shortly you will have no choice but to make a snap decision.
This automatic, reactive thinking is what Kahneman calls “System 1” or fast thinking.
Practice, systematize, and create rules to remove biases
All traders have heard of the importance of running in sim-mode or backtesting.
Where many traders get misaligned is around not setting up deliberate and intentional goals for practice.
The goal you must have for simulation is to practice, drill, and remove as many trade unknowns as possible as to get through the learning curve and move as many decisions as possible from System 2 to System 1.
With that said it doesn’t mean we’re out of the woods.
For inexperienced traders, the untrained System 1 thinking can sometimes fool him.
Kahneman lists many different tricks or biases that our brain plays on us.
For instance when we make a trade decision that seems correct, we might just be falling for the “availability bias” or just choosing the first option or most recent instance that comes to mind.
Likewise confidence and emotions also play a big part in rational decision making. Traders will often choose to avoid a loss rather than try for a big gain. In the “loss aversion bias”, the pain of a possible loss can prevent a trader from taking a difficult trade that could result in a big gain. We’ve spoken at length about this mindset of trading not to lose vs. trading to win here.
The major conclusion here is that in the heat of the trade you will have no time to call upon System 2 to analyze your options. You must defer to System 1.
System 1 is highly susceptible to biases as it tries to find shortcuts by relying on heuristics.
In effect we must train System 1 with a new set of heuristics in the form of our defined trading rules and systems to deliver us the outcomes we desire.
Conclusion and takeaways
While most traders don’t need to know the intricate details of Kahneman’s cognitive theory, all of us can take away these 3 main points.
The practice of studying and sim trading will slow the game down as you internalize your trading rules.
Do not try to make up the rules as you trade. Take as many unknowns as possible from your trade entries, exits, and trade management. Every extra decision point is one that calls upon a finite cognitive resource.
Offload some of the decision making by creating checklists.
Reduce the noise
Examine your screens starting from the far left and ending on the far right and document every single item on your screen. The goal is to try to remove at least 2-3 items from your current trading view.
“ .. two important facts about our minds: we can be blind to the obvious, and we are also blind to our blindness.”
Tell us where have you’ve struggled with your trading? Drop us a line in the comments.