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Treat Trading This Way And You're Not Far From Profit!

Top Wall Street Trader Mentor

Brett Steenbarger is a well-known American trading psychology instructor who has served as a trader psychology instructor at several top Wall Street training institutions. As a psychology professor and senior trader, Brett’s understanding of trading psychology is far superior to others. And the Exchange Business Jun also believes that in order to become a successful trader, relying on trading strategies alone is not enough. Almost all veteran traders also admit that trading psychology and skills can have a significant impact on their trading.

In today’s article, we’ll share one of Brett’s trading training lessons: Approaching Trading with the Rigor of a Scientist.

Approaching Trading with the Rigor of a Scientist

What I want to emphasize to new traders is that it is important to trade like a scientist. A scientific mindset is a mindset that can be trained and cultivated and eventually internalized. Let’s start by thinking about what scientists usually do. First, they observe the patterns of nature. They look for patterns: repetitive sequences of events and commonalities between structures. These patterns distinguish between what is meaningful and what is random.

After observing the patterns, scientists try to explain the phenomena. Explanation is what theories do. These theories are the scientists’ way of understanding the world. Theories are not truths, but rather the first approximation of truth. Scientists gain confidence in their explanations by testing them. If a theory is meaningful and accurate, we should be able to use it to see the future. These predictions are assumptions made about the scientist. By testing hypotheses, we keep an open mind about our observations and explanations.

Finally, once empirical tests provide new observations, scientists revise their explanations of nature and use them to generate further hypotheses, observations, and corrections. For the true scientist, knowledge is always provisional: this is what separates science from dogma.

The scientific mindset is one of humility: the recognition that our best theories are only approximations and that many of our hypothesis tests are prone to failure. When we trade, we have an implicit or explicit theory about the current market, and our trades test a hypothesis that surrounds our interpretation. This is why scientific traders never place too many bets on any single trade. Nature will always be more complex than our science, and our understanding will always be local. This view is a powerful antidote to overtrading and overconfidence.

If I were trading like a scientist, I would watch the market and the landscape carefully. I have made detailed observations of markets in a variety of scenarios and have some theoretical understanding of what makes markets move across different time frames – from longer-term interest rates and liquidity to the aggressiveness of large traders trading in the short-term.

Perhaps I will note that as the market sells off, trading volume is declining and fewer and fewer individual stocks are hitting new price lows. I would also note that stocks in a particular area are actually rising and gaining capital flow. I am assuming that the sell-side energy in the market has been depleted, is bottoming out, and that the result will likely be short-covering, which in turn will drive the market higher.

Having formed this hypothesis, I may have noticed the recent short-term highs and lows in the U.S. indexes. I say to myself, in essence, “I think we will reach that price (the recent low) before we hit that price (the prior high).” In other words, I’m willing to risk a possible drop to the low in order to participate in a hypothetical move up to the high.

However, this is a hypothesis, not a fact. Therefore, as a “scientist,” I must remain open and tell myself that the hypothesis is not supported. I must also take a moderate position on this hypothesis: to spend most of my capital on this idea is to treat the tentative statement as an absolute truth.

It is in this context that every good trade tests a hypothesis. When we observe a pattern, construct an idea, test that idea with a trade and actually profit, our idea – our theory – is supported. This may lead us to another trade that extends that idea. Conversely, if we do not profit from the theory, we may need to return to an observational model and adjust our interpretation of the market.

Thus, when the scientific trader’s idea is confirmed, it will gain confidence and become more aggressive. When ideas don’t work out, pay more attention to them. When you trade like a scientist, every good trade informs you, because every good trade is a reliability test of your understanding of the market. Scientific traders also take losing trades very seriously. They take data from them that they can absorb and push themselves to further their understanding of the market.

Exploring trading mistakes from a scientific perspective

Finally, let’s explore two common trading mistakes through a scientific lens.

Mistake #1: Starting a trade without knowing enough about the market – Sometimes traders rush to put capital at risk without taking the time to observe market patterns and integrate them into a specific interpretation of market conditions. The professional traders I have known typically take a more scientifically rigorous approach to trading.

For example, in the case of observing a recent rise in interest rates, they would propose the idea of shorting interest rate sensitive sectors, then test their understanding with their initial position and expand the trade as the market confirmed their view. This is very different from building a position simply because the market is making new highs or lows!

Mistake #2: Overpositioning- Many psychological problems in trading can be traced back to overpositioning. Traders trade too large on their account size in order to get a windfall rather than to test their ideas. Scientists perform many tests before they actually support any hypothesis and test many theories before they accept them as variants of the truth.

If you were a scientist, would you risk spending your entire grant on a single experiment? Of course not! A study can fail for many reasons, including the experimenter’s own mistakes. Likewise, any single deal or idea can fail for a variety of reasons. A true scientist knows that his or her understanding will always be unrealistic. This is why scientists will conduct viable experiments to refine their ideas before committing significant resources to extensive research.

trader'ss strory

Here is a short list that will help many traders.

  • 1) What do I know about this market? What is the evidence behind it?
  • 2) How much money am I initially willing to invest to understand this market?
  • 3) What outcomes would lead me to put more money into my idea, and what is the largest portfolio I am willing to risk on that idea?
  • 4) What outcomes would cause me to abandon my idea and how much am I willing to lose on that idea?

Many bad trades can be avoided simply by asking yourself to answer these questions before making any trades. Approaching trading like a scientist with bold assumptions and careful evidence can enable many novice traders to avoid many of the risks of being a trader, and is worth learning and learning from.