Dynamic Hedge blogs about correlation, relative value and quantitative analysis at http://www.dynamichedge.com
This market is awesome. Many observers see this market as a broken discounting mechanism shattered by the hand of Dr. Ben Bernanke. I see the rising market as a sigh of relief. I’m happy that people are back to coveting shiny Apple products and German sedans. It’s a lot better than the spotlight products of 2008-2009: dried foodstuffs, ammunition, and MREs. I welcome a rising market because it generally means more abundance and prosperity for the population as a whole.
Spread traders don’t really sweat a continuous rising market. We’re less rabid than the uber-bulls and less depressed than the perma-bears. A relative value approach helps you keep your sanity in a market like this. Some of my spread relationships are getting disconnected but that’s what risk control is for. Big value disconnections are also opportunities in the making for patient traders. The same spread you get stopped out of today will be ripe for profits in a couple weeks.
The bulls have been on an EPIC winning streak lately, while the bears are numbed by the effects of cortisol. Feels like a perfect time to revisit the science of success-sabotaging brain chemicals:
The effects of hormones on trader decision making is well documented. Evidence suggests that the hormones testosterone and cortisol take turns flooding the trader’s brain in accordance with reactions to outcomes and the relative uncertainty of trader decisions.
All men have varying levels of testosterone as a baseline depending on their age and other factors. When participating in any type of competition, testosterone levels are elevated in anticipation of the event. The winners of these events experience even more elevated levels of testosterone, and the loser’s testosterone is reduced. Increased testosterone is associated with better performance and thus the better your past results the more you win in the future. This positive feedback loop is known as the ‘winners effect’ in sports. Unfortunately, trading is not an athletic sport even though your brain sees no difference in competitive endeavors with regards to its hormonal regulation. More testosterone does not necessarily help a trader win more trades in the same way that it will help a runner win more races. In fact, problems arise when the winning trader experiences too much much testosterone at elevated levels for too long. This leads to impulsive decisions and extreme risk-taking which can in turn create volatility, uncertainty, and losses.
Cortisol is introduced as a way to cope with stressful or uncertain events. It alters the way that people perceive and store memories related to stressful or uncertain experiences. The parts of your brain that store factual details and emotional significance both have cortisol receptors. Cortisol combats the effects of testosterone by recalling negative events in a different way and thus reducing risk appetite. Evidence suggests that cortisol is not necessarily a result of direct losses, but a result of increased volatility, or anticipation of losses. This can be detrimental to trading because times of significant stress or uncertainty often produce the best trading opportunities.
There is a certain hubris and feeling of invincibility associated with long winning streaks. Each winning trade makes you feel stronger and validates your strategy even further. After a sting of wins the first loss seems insignificant, a speed bump as opposed to a warning sign. Traders in this state are under the firm influence of increased testosterone levels. Conversely, every trader has been in a state of uncertainty while holding on to a losing or volatile position. There is a gut wrenching feeling in the pit of your stomach which intensifies as the loss gets bigger or the swings in PnL increase. An unshakable urge to retrench from risk. New opportunities are ignored and winning trades are attributed to luck. This is the effect of cortisol.