How to think like a successful trader

I am reading a terrific book which I recommend to serious traders: Thinking, Fast and Slow by the Nobel Prize-winning economist and psychologist Daniel Kahneman.

In it, he explains that we have two modes of thinking: system one, which is intuitive and is quick to come up with answers from limited information (gut reactions), and system two, which is more considered and oversees and modifies system one. Often, the two responses are in conflict – that is where most of us live.

But what is of great interest to traders is the chapter called “The illusion of validity”. In example after example, Kahneman relates how experts were often no better at predicting events than an application of a simple algorithm using inputs of only a few variables.

So today, I’m going to tell you about Kahneman’s findings and how this can improve your trading. Also, I’ll be giving an update on what’s happening in the gold market

Do good financial advisors just get lucky?

In one of Kahneman’s examples, he tells the story of when he was invited to speak at a seminar in front of the employees of a financial advisory firm with very wealthy clients. He asked for some data on their clients and was provided with eight years of the profit and loss statements of 25 clients, and which stocks they bought and sold with dates.

This data was used every year to determine employee bonuses – solid returns from superior stock-picking was supposed to be rewarded by fatter bonuses.

Kahneman was interested in seeing if there was a consistency from year to year between the advisors. He reasoned that if there was at least one advisor with a consistent performance, he could attribute it to skill. Basically, he found the correlation coefficient as close to zero as made no difference!

Naturally, at the seminar, the advisors were not overly thrilled to be told that stock-picking is largely down to luck – but there was the proof staring them in the face.

And this is the human part: the evidence was right in front of them, but the advisors chose to ignore it. This is totally understandable and rational: if they did not, they would likely get out of the business and have to find another career. And who wants to quit a very high-paying and secure job for a big unknown?

There are very few of us who would do that. So we push the system two response (conflict) under the rug and continue with business as usual.

The easy way to become a better trader

I am not going to knock financial advisors/gurus here (although I could!). The point is this: get yourself a simple trading system that is proven to work and follow tight money management rules with no exceptions. And do not become an expert!

The examples in Kahneman’s book show that most experts suffer from over-confidence in their predictions simply because their superior research and knowledge has resulted in naturally rather elevated egos.

This leads to them making predictions not based on evidence, but on wanting to be flamboyant and stand out. They become hyper-competitive – and that helps book sales!

Also, it is well-known that most people hate to admit they are wrong. They are lead astray by how they think. They cling to their statements/beliefs for dear life simply because they believe they would be destroyed if they admit error.


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There is also the herding effect, where many people believe in the preposterous simply because their chosen guru has uttered it, and it has been confirmed by so many others.

That is the basic dynamic behind my observation that bull markets always turn when bullish sentiment is at extremes (when most have bought into the bull’s story).

Incidentally, I disagree with Kahneman that trading is all down to luck (after all, he is an economist). My trading method is one that offers a logical means to successfully exploit the markets, as I show in these posts.

My very simple system is equivalent to the algorithm I mentioned above with only three input variables (tramlines, Fibonacci and basic Elliott wave theory). It is based on an objective reading of the price charts (system one and two are in harmony).

There’s unusual activity in the gold market

Today, I have a quick follow-up on my gold coverage from Friday. This morning, the market is heading towards my tramline target in the $1,240 area:

Gold price spread betting chart

Note the very accurate hits on my wedge lines – even the four spike lows on the lower line are accurate. This is unusual, especially in gold, and to be noted.

But now, there is a possible positive-momentum divergence growing and a warning that a counter-trend rally could start at any time. One way to play this is to use a trailing stop on your short trade.

But my other triangle target in the $1,200 area stands, and this would require a break of my lower tramline.

The market is headed down

How are the futures players lined up? Here is the latest commitment of traders (COT) report:

Non-commercial Commercial Total Non-reportable positions
long short spreads long short long short long short
(Contracts of 100 troy ounces) Open interest: 397,695
Commitments
155,615 82,224 35,612 162,078 240,716 353,305 358,552 44,390 39,143
Changes from 05/20/14 (Change in open interest: -1,676)
-1,783 21,317 -2,580 -2,211 -29,583 -6,574 -10,846 4,898 9,170
Percent of open in terest for each category of traders
39.1 20.7 9.0 40.8 60.5 88.8 90.2 11.2 9.8
Number of traders in each category (Total traders: 263)
107 81 70 58 48 199 171

 

This data is current to last Tuesday – the very day the market broke my lower wedge line. The previous week saw a big swing to the bearish side by the hedgies (non-commercials) as well as the small speculators (non-reportables).

But both groups of speculators remain net long, and my guess is that before this down move ends, there will be a further swing by the speculators to the bearish side.

And that will provide the fuel for the massive rally that I expect.

We shall see. But for now, the market is headed down.

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading
Advanced tramline trading
An introduction to Elliott wave theory
Advanced trading with Elliott waves
Trading with Fibonacci levels
Trading with 'momentum'
Putting it all together

• Don't miss my next trading insight. To receive all my spread betting blog posts by email, as soon as I've written them, just sign up here . If you have any queries regarding MoneyWeek Trader, please contact us here.

 

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  • anne

    Dear John, the low could be in for June gold at 1240.9. we shall see. anne

  • BenR

    I also thought 1240 Anne. I have been following your emails John and I find them very interesting and helpful but there are some things I find a little contradictory.

    For example you say have a system and stick to it and look for low risk trades. This email seems to suggest not going long at the tram-line but looking at 1200 based on a triangle and COT data. It also seems contradictory to be ‘flexible’ yet one of the sins of trading is changing your mind.

    Anyway keep up the good work.

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