Irrational Escalation

This is the first article in a series on cognitive biases. As human beings we seem to have access to an almost inexhaustible supply of them. So let’s cover some the biggest culprits here, in particular the ones who stand in the way of us acquiring our ill-gotten gains in the financial markets.

sunk-cost

Today’s topic is the sunk cost fallacy, also known as ‘irrational escalation’ – no it’s not a term coined by Greenspan. This precious gem happens to be hard wired into our human psyche and it will haunt us to the end of our brief existence on this mortal coil (your mileage may vary given your consumption of donuts or Hefeweizen). So what does it do? Well, imagine yourself investing in your best friend’s company and he runs through all the funds without making any major progress. A few months later he’s back desperately asking for a reload. Your brain kicks in and whatever is left of your cerebrum (again, your mileage may vary) mutters that he’ll probably blow the next round on fancy office chairs and strippers as well. However almost immediately there’s this nagging thought in the back of your mind: Unless you give the guy more cash to get the job done and launch the product/service/prototype etc. the money already invested prior has been for naught. What to do?

Well, I leave that particular decision in your capable hands. I personally would invite him for a swim in my custom designed shark tank (yes, they have freaking laser beams) and make sure he finds a way to pay me back. But the topic at hand is that cognitive dissonance developing in your cerebral cortex: Damn it, I should have never gotten myself into this! Which is exactly what you’re thinking as you find yourself writing him another check. Why? Because the sunk cost effect is closely related to another cognitive bias we’ll cover in the future called ‘loss aversion’. Basically it’s the tendency for people to have a strong preference for avoiding losses over acquiring gains.

Yes, that one is a mind bender in its own right but it’s basic human psychology. Most people would rather take action to protect themselves from losing a Dollar than to spend the same energy earning that Dollar. And given the situation our plucky investor friend here finds that he’s more worried about losing his existing investment than to lose even more. I know that sounds strange – but if you mix in a potent cocktail of hope, self delusion, and guilt for doubting the vision of his good friend then odds are that he’ll convince himself that this new round of funds somehow will render his existing loss non-existent. And right here is the rub. It’s all about avoiding the feelings generally associated with loss, disappointment, failure, wasting time, etc. It’s all such a downer, so let’s just avoid it altogether and pretend it didn’t happen. And so you somehow wind up throwing good money after bad money.

And this doesn’t just apply to the financial arena. Back in the days, when I was working for the man as a software consultant (i.e. coding monkey for hire), I saw my share of failed projects. And most of them wind up as a furry mess of code exactly because of the sunk cost effect. Perhaps they hired some crew in India to wire up a solution for them (i.e. website, API, CC processing system, etc.) and it was full of bugs, security holes, and performance problems. The guys who inherited that mess spent months if not years fixing it with scotch tape and a mix of blood and tears. Of course they kind of got it working but as soon as some product manager brought up the topic of adding new features all kinds of alarms started to go off in the dev department. And so they wound up patching it up a bit more – adding more bad code to existing bad code.

Of course we all know what the right decision would have been. Scrap the entire thing and write it from scratch again – this time with a crew of people who knew what they hell they are doing. But that rarely happens – it’s simply against human nature and I dare you to propose to anyone to let go of a pet project they have nursed along for who knows since when without anything to show for. If you would have asked them today if they would take on an endeavor of such a magnitude without reward they’d tell you to stick that idea where the sun don’t shine. But human beings are strange creatures and we just love to watch those frogs boil.

In the trading arena I see this all the time. Someone drops by the blog and asked about a shitty campaign they are obviously trapped in. They should have never gotten to that point to begin with and the only thing left to to do is to close it out and take the loss. Knowing what we know that is the only logical solution and perhaps it’ll serve as a learning experience for the future. But people get trapped in bad decisions all the time and spend a lot of energy pretending to themselves that it didn’t happen. So they stay in bad trades (while cutting winners short – a.k.a. the disposition effect – topic for another day) and mentally contort themselves into impossible positions hoping to find a way out.

Ve careful criticizing those people because I guarantee you that it takes only one bad decision to find yourself in the very same spot. None of us are immune and that includes yours truly. The only remedy is to know ahead of time when your campaign needs to be closed out. Even better – expect to lose every time you take a new entry. This should be your default mind set when trading – expecting to be wrong and most importantly – actively preparing for that eventuality. Because statistically you will be proven right (about being wrong) the majority of the time. Unless you can embrace a bushido mind set during trading you will most likely be driven by fear and therefore are doomed to fail. Expect to lose each battle – fortunately, if you do it right (and that’s what we do) then it’s only a paper-cut and not a flesh wound.

Lesson learned: Treat trading just like dating on POF.com. There is always always another campaign out there, so don’t get married to any of them. If one turns out to be a loser, don’t sweat it and simply cut your losses. And if nothing else (while we’re on the topic) – photoshop your picture, deduct 10 pounds, add one inch, skip five years, and always wear a condom ;-)

It’s not too late – learn how to consistently bank coin without news, drama, and all the misinformation. If you are interested in becoming a subscriber then don’t waste time and sign up here. The Zero indicator service also offers access to all Gold posts, so you actually get double the bang for your buck.

Cheers,

Don’t Crawl Down That Rabbit Hole

It doesn’t happen very often but every once in a while the lowly Mole is handed a lucky break by Mrs. Market. A good portion of my original short positions are still in the running but had the bids pushed higher by just a tick I would have gotten stopped out. If nothing else the price action we have seen on the equities side over the past few days should serve as a learning experience on how to manage campaigns near price inflection points. And most importantly on how now not to let your imagination, fears, or personal biases take over your trading activities during interim periods I call information vacuums. So let’s review our ongoing campaign step by step:

Monday I posted this entry for my subscribers during my Tuesday morning briefing. The general idea was to exploit a temporary weakness on the equities side which had presented itself on the three major equity index futures. Many of my subs and of course yours truly grabbed a few short positions near 1968 with a stop above 1970. Mine actually was at 1971.25 – sufficient to sit out a quick spike higher. At that time I was not aware that Wednesday would be another FOMC day – probably better that way as I may have skipped the campaign altogether.

From the onset I was aware that the odds were mixed but the correlated price action across the three major index futures contracts convinced me to take the entry. What was working against us was this volume hole on the E-Mini near 1965. In my assessment a push below it was supposed to drive us lower.

We actually dropped below 1953 the day after (Wednesday) but almost immediately price recovered and launched what would turn into a slow grind to the upside. I watched it for a while and then decided to gradually take some short positions off the table around 1962 and to lower my ISL to my break/even point at 1968.5. I made it clear to my readers that this campaign had started out as a short term trade but given various momentum measures had the potential to turn into a daily campaign, perhaps even more. As a matter of fact if you read the intro blurb I post every morning – it says it right there:

Here we are reviewing short term setups ahead of the NYSE opening bell. If you are a scalper or swing trader then these setups may be of interest to you. As usual keep in mind that these are short term setups although they could be used as early entries for more longer term positions.

Otherwise there was not much for us to do. The FOMC announcement was due late in the session and our charts had not yielded us with any additional context which would serve us to manage our positions. And that right there is some of the most difficult learning experiences for any trader. You have your system rules,  you got your entry, you set your stop. And then you wait while the market just churns around, quite often slowly robbing you of paper profits. As I mentioned above – I call these periods information vacuums and they are a silent killer because the human instinct is to not sit idly by – you want to do something. You look around for clues and you don’t find much. So you head over to your favorite trading blog and start posting things like:

Anyone still short here?

Of course depending on your psychological make up what you hope to hear in response are reasons to either stay in your trade or  reasons as to why you should do what that little voice inside your head has been screaming all morning:

LOCK IN THOSE PROFITS BEFORE IT’S TOO LATE!!

Yes the rabbit hole is deep and it takes quite a bit of discipline to not be led down all the way. There’s no way to kill the rabbit – it’s always there at your weakest moments, just waiting for when things become so frustrating that you let your emotions get the better of you. Now if you were lucky smart enough to visit Evil Speculator instead then you may have been slapped in the face with some tough love, just as you would deserve:

As usual I did my best to remind ridingwaves to grasp the futility of the mental masturbation he was exposing himself to (or is it a her?). Seems he got the general idea but it’s also clear to me that he was fighting quite an emotional battle. I sincerely hope the evil rabbit didn’t get him in the end because…

… this morning I see equities markedly lower and my remaining short positions are quite nicely in the green. The GBP/JPY is pointing down which doesn’t guarantee success but it’s a step in the right direction. So far so good.

I also had to realize how close I had come to a stop out – fortunately I do use bids during my short campaigns as overnight b/a spreads often unjustly kick you out of good positions. That holds true in particular if you’re trading through brokers with trading desks that may actually trade against you. This is a subject we’ll cover in much detail here in the near future – in the interim I encourage you to start a daily log of what b/a spread variations you see on your respective platforms.

So what now? I did actually add a few more shorts this morning at 1960 but my stop for all positions remains in place at 1968.5. If I wind up getting stopped out I will happily live with that knowing that I stuck with the rules throughout this campaign. Frankly speaking I haven’t given all this very much thought – took me a lot longer to actually spell it all out for you. The reason why I’m logging each step on the way is for you guys to realize that trading can be a lot more systematic and relaxing than you probably have come to experience.

You don’t need to spend hours perusing the news for more clues. You simply monitor your watch lists and strike the iron when an opportunity presents itself. From there on it’s all about self management, which is the most easiest if you simply stay away and don’t futz with the established rule set.

Truth be told – I should have probably not even taken partial profits yesterday given that I had already decided to make this a daily campaign on Tuesday. Did I allow myself a quick stroll down the rabbit hole? Maybe. So as you can see – it’s an ongoing battle and nobody is completely immune to the evil rabbit. As a matter of fact it’s waiting for you right now. You cannot ever kill it but you can learn how to tune out its relentless voice. The best remedies against its detrimental influence are rules and discipline – so the more Vulcan you can become in your daily trading activities the better.

 

It’s not too late – learn how to consistently bank coin without news, drama, and all the misinformation. If you are interested in becoming a subscriber then don’t waste time and sign up here. The Zero indicator service also offers access to all Gold posts, so you actually get double the bang for your buck.

Cheers,

Don’t Ever Chase The Tape

Boring markets usually lull hapless victims into a sense of safety and complacency. I see it here in the comment section all the time – time and over again retail is looking for ‘action’ and perhaps a bit of drama instead of leveraging the market cycles I described yesterday. Case in point is today’s whipsaw move on the spoos:

Our Zero indicator provides an excellent way to visualize/understand what has been happening over the past few days. Make no mistake – strong hands got positioned a long long time ago, probably near the recent bottom of SPX 1926. They have been riding the bus higher in style and are not in a great hurry to get out of their longs – at least up until now.

Weak hands however have been watching the advance with envy, patiently waiting for a dip to materialize – which of course has not happened. Some of them may have even jumped on board in the past few days as we were painting new highs. And those are the same folks who you just saw run for the hills in panic when the tape suddenly went divergent and then reversed.

Look at the volume profile on the E-Mini – you do NOT want to get into long positions here. Yes, it is possible that the tape jumps higher but is it probable? That’s actually what a professional gambler would ask before committing any assets to a new play. Many traders however remain blissfully ignorant on how intrinsic market behavior. This is nothing new – these things have been playing out day after day, week after week, month after month, and year after year.

The only reason to be long right here and right now is because you have already been long and can afford to sit out any bumps in the road. Most likely your stops are sitting somewhere a comfortable distance away. You probably sleep better as well as you don’t worry about risky trades which you regretted placing minutes after doing so.

I have been trying to drive this concept into your heads for a long time now. Boring time (a.k.a low velocity/volatility cycles) are there to watch, observe, and if the odds seem to be in your favor – get positioned. Funky time when things move is usually when retail traders show up for all the excitement but very few actually put in the hard work in order to get positioned properly. Trading somehow devolves into a random activity based on your daily whims and today’s favorite charts. Does that sounds like you – perhaps even a little bit? Well, then you have work to do – we have all laid it out here before – if in doubt check the ‘goodies’ page on the very top. Plenty of material there and it will be time well spent.

Technically speaking today’s spike higher provides us with additional context bear ES 1948.25 where we now have a brand spanking new Net-Line Sell Level. Unless we continue dropping today and pass right through that it ought to be good for at least some support tomorrow.

On the hourly I’m looking at ES 1950 as we have the 25-hour and 100-hour SMAs nearby. Right now we also have a NLSL right below which should be good into the close.

As you know we have been expecting for a little shake out although there has been little evidence to support dipping into short positions. Which was good policy as you may have been quite nervous as we were pushing into new highs today. Frankly speaking there is very information here to justify major activity. If you are still long from further below then you simply are advancing your trailing stops higher a respectable distance away. If you’re waiting for a short opportunity, well – I’m seeing some issues on the volume profile chart but it’s not enough to justify a major reversal.

Before I am tempted to trade against the daily trend I need to see more evidence – period. As a matter of fact – I’m seeing us near 1950 right now as I’m typing this and I will use this for a small short term long position with a stop a handle or so below.

It’s not too late – learn how to consistently bank coin without news, drama, and all the misinformation. If you are interested in becoming a subscriber then don’t waste time and sign up here. The Zero indicator service also offers access to all Gold posts, so you actually get double the bang for your buck.

Cheers,





    Zero Indicator


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