Wednesday, December 30, 2009

Mental Flexibility vs. Sticking to Trading Plans: Which is Correct?

Reader George raises excellent questions concerning my recent post on mental flexibility and trade planning. Citing Henry Carstens' ideas in the article "The Axiom of the Small Edge", George asks how one resolves the seeming discrepancy behind the notion of sticking to trade plans that have an edge and staying mentally flexible and adjusting plans as needed. Isn't being mentally flexible, he asks, just a nice way of describing getting scared out of a trade?

(By the way, do check out the huge collection of worthwhile articles on Henry's site. There's a lot of good and thoughtful reading there.)

I would argue that Henry is correct and that my post on mental flexibility is also correct. That is a key difference between mechanical systems trading and discretionary trading.

When one has a properly backtested system for trading, meddling with the parameters is usually going to degrade performance. The system is designed to exploit a relatively small edge over a large number of trades. Failing to take signals, taking extra signals, and sizing trades differently than in test conditions all invite a reduction in that small edge, as they introduce untested elements into the system.

A discretionary trader, on the other hand, is relying upon pattern recognition skills, research, and a feel for markets to make buying and selling decisions in real time. The performance of a discretionary trader is no different than that of a trading system: both can be analyzed for profitability, risk, and other performance parameters. If a discretionary trader maintains positive risk-adjusted returns across a range of market conditions over time, that trader has a demonstrated edge.

Getting scared out of a trade implies that a trader is reacting to emotional factors and not to objective characteristics of the real-time market. To be sure, that can be a major hindrance to performance. When one gets scared out of a trade idea, that emotional reactivity is substituting for informed discretion, eroding the discretionary trader's edge just as changing parameters can degrade the performance of a system.

There are times, however, where a discretionary trader will start with a plan or framework for a trade and then adjust the plan, not based on emotional upheaval, but upon the unfolding action of the markets themselves. This is part of a skilled discretionary trader's edge.

We see similar dynamics in other discretionary performance fields. A poker player may begin with a plan based upon the draw of cards, but will adjust betting and strategy with each new card drawn. A football quarterback will come to the line of scrimmage after calling a play in the huddle, but may call an audible to adjust the play based on the real-time read of the defense. A boxer will have a fight strategy, but will adjust that strategy round by round based upon the strengths and vulnerabilities of the opponent.

George touches on a very important point: it is all too easy for a trader to rationalize an emotional, reactive trade as an informed discretionary decision. The key difference is in the reasoning behind the decision. Let's take an example:

This morning I bought the S&P 500 Index early in the day when I saw that there wasn't enough selling interest to take out the overnight low. My plan was to hold the trade for as long as needed to test the bull highs, making this a swing trade idea. The Chicago PMI numbers came out and stocks popped nicely higher...and then sat there. I waited and saw a lack of follow-through buying interest, so I took my profit and told myself I'd get back into the trade at a better price. That did happen later in the day on a market pullback.

Had my swing trade idea come from a backtested system, Henry (and George) would be correct in chiding me for meddling with the system. In this case, however, the discretionary decision to take a quick profit and re-enter the longer-term trade at a better price added value to the original plan. Could I have been wrong and missed my move? Quite possibly. Over the years, however, I've found that my ability to read short-term shifts in sentiment, momentum, and strength generally serve me well. That's quite different from getting scared out of an idea, and it's quite different from meddling with a proven formula.

At least in my case, I can state without reservation that my greatest losses have come when I have lacked mental flexibility, not when I've modified existing trading plans based upon a reading of supply and demand. To be fair, however, I also have to say that my greatest growth as a trader has come from sticking with trade ideas after opportunistically trading around them (as in today's trading). It's easier to see losses in an account statement than lost opportunities: being mentally flexible is no advantage if it ultimately takes you out of sound longer-timeframe ideas.