Lessons from the Pros

Do Strong Biases Hinder Performance?

How often do you start the trading session with a strong conviction of where the market is headed? And as the day progresses, the price action of the market clearly contradicts your bias, yet you stubbornly cling to the notion that the market "has to do this "or "should do that." If this has happened, or continues to happen to you, it’s not just you; it’s a common occurrence among traders.

The reason so many traders tend to have strong biases can simply be ascribed to human nature. We humans tend to form strong opinions, and then go out searching for every piece of evidence to support those opinions. Moreover, when the evidence begins to mount against our thesis, we bury our heads in the sand by ignoring or dismissing the information as nonsensical. That is until our fear of loss overcomes our desire to be right.

The way we form these opinions can be interesting. Most investors and money managers have a bullish bias quite simply because they own stocks, and it’s in their best interest that the market goes higher. Then there are the Perma–bears that will always find something that will spoil the mood. I personally have known a few of these doomsayers. One in particular made a lot of money in the crash of 1987 and that experience has tinged his bias to his detriment.

As traders, one of the toughest challenges we have to overcome is to remain objective. Being objective entails having the flexibility to change our minds, and face the fact that we sometimes will be wrong in our analysis. The hallmark of a great trader is the ability to change his or her bias when circumstances change. In my personal experience, rigidity is a big factor in destroying account balances.

In today’s market environment, in particular, there are many strong opinions. This type of discord is typical in consolidation periods. The bears have a litany of reasons (technical and fundamental) why the market is headed lower, while the bulls have very cogent arguments as to why the S&P will be at 1500 by the end of the year.

One of the technical signs that the bear cohort points to in their negative assessment of the market is the trend reversal pattern commonly known as the head and shoulders. In the chart below, we can see the S&P 500 E-mini displaying this formation. Now, I don’t want to belabor all the implications because this pattern has been widely publicized, but it needs to be pointed out that for those who practice pure technical analysis, there is strong belief in the reliability of this signal.

Figure 1

Aside from the technicals, there’s the recent spate of lackluster economy data, which has induced some foaming of the mouth by those big furry animals (bears), and spurred the notion of double dip recession.

On the other side of the argument, there are the value investors who believe that when the market falls sufficiently, the stock market is on sale and bargains are to be had. They believe that for every bear market, there’s a longer bull market that ensues, and history tends to be on their side.

From a bullish technical perspective, if we measure the S&P 500 from the March 2009 lows to the April 2010 highs and place Fibonacci grid lines (chart below), we may conclude that we are merely retracing to the 38.20 level.

Figure 2

For those of you familiar with Fibonacci studies, it’s understood that this is a common and reasonable retracement level in an ongoing uptrend; hence, the bullish case.

Therefore, you see, we can build a good case either way, and that is what makes a market.

The truth is that no one really knows with any certainty in which direction the market’s next big move will come. What we can do is try to maintain our objectivity, stay patient, and work our plan, because in this market environment, only the most disciplined and flexible traders will be rewarded. And as you’ve probably surmised, yes, a strong bias will hinder your performance.

If you have questions or comments, please email me at gvelazquez@tradingacademy.com

- Gabe Velazquez