Friday, October 16, 2009

Intuition and Trading

By Van K. Tharp, Ph.D. - Van Tharp Institute

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I was recently asked to write the Foreword to Curtis Faith’s upcoming book, Trading from Your Gut, which is all about trading and intuition. This got me thinking about the different types of intuition that one can possess. Intuition is a concept with which I am quite familiar and which I believe is extremely important for trading success. Here’s a quick look at different types of intuition and how my trader coaching experience has proven to me why intuition is invaluable.

Despite all the advances in computers over the last 50 years, no computer comes close to a human brain. For example, I like to trade efficient stocks (i.e., stocks that trend with very little noise or random movement). A straight line going up at a forty-five degree angle would be a perfect example of an efficient stock; however, I’ve never see one that looks that good. Most trending stocks show a lot of whipsaws, which I define as representing the amount of noise in the movement. The graph below is a fairly good example of an efficient stock. It’s LQD, the long term bond ETF, since last March. It just keeps going up with very little noise.

No matter how hard I’ve tried, it’s been nearly impossible to program software that will give me a list of the most efficient stocks. The best I have been able to do is to compile a list of stocks to screen. I still have to look at the price chart of every stock to find the efficient ones. Anybody’s brain can easily pick out an efficient stock just by looking at it, whereas, a computer cannot. Trading such visual price patterns is often called discretionary trading and that’s the first form of intuition.

The second form of intuition helps us with lots of data. The amount of information our brains are exposed to just about doubles each year, especially since the advent of computers and the Internet. Your conscious mind, however, can only handle about seven chucks of information—plus or minus two chunks. To understand what that means, try this simple exercise. Have someone call out a long list of numbers while you have your hand raised. When you can no longer remember all of the numbers called out, lower your hand. You’ll find, unless you’ve mastered some advanced memory techniques, that you will probably only remember about five to nine numbers—right in the range of normal human capacity. But what happens when you are exposed to thousands or even millions of chunks of information? You develop some judgmental heuristics (i.e., mental shortcuts) to cope. There are many famous heuristics that have been documented by psychologists over the last 20 years.

A third form of intuition develops from thoroughly understanding a task and bringing lots of experience to it. Somehow, people with such experience do a superb job of sensing opportunity or danger quickly when no one else can imagine how they did it. Somehow traders who have developed this kind of intuition just know that the market is about to turn down and can get out quickly. Alternatively, some can sense when a massive opportunity is about to occur. John Templeton, for example used much of his fortune to short dotcoms at the beginning of 2000. Through the late 1990s, many were in agreement with Templeton basic logic: the dotcoms’ business models did not merit their lofty stock prices. Applying that logic and shorting the dotcoms six months earlier, however, meant those traders either had to cover their shorts at a loss or suffer through huge drawdowns. Templeton’s timing was impeccable. How did he know when to short the dotcoms? Intuition. Similar feats have been accomplished by others in 1929, 1987, and at other major market turning points. The timing was absolutely amazing, and the only explanation for these feats is intuition.

In a more personal example, I worked through some deep psychological processes with a retired engineering professor in 1994. As a result, he was able to connect with his internal guidance. Over the next 15 years that guidance directed him in many different directions including trading. In 1994, he already had a substantial trading account but by mid-2008, he had grown it by 5100%. And then his guidance told him to stop trading—right before the 2008 market meltdown.

I spent some time with him in mid-2008 and he showed me exactly how he traded. In fact, it was surprisingly similar to my preference for efficient stocks. It was sound, logical, and very simple. He looked at the top five industry groups for long stocks and the bottom five industry groups for short stocks. The first step involved intuition. He could generally look at a list of stocks and based upon volume, accumulation, and a few other variables, he could tell which charts from that group he needed to look at.

After his initial screen, he looked at stock charts in two different time frames: 1) a year’s worth of daily bars and 2) 30 days worth of hourly bars. His charts included two simple moving averages, momentum, plus DMI+ and DMI-. He couldn’t tell me exactly how he entered positions except to say that the price needed to be above both moving averages in both time frames. I had the impression that he often looked for a short term retracement in price to the short term moving averages and then a bounce back.

When did he exit the position? My impression was that he exited when the price reached the longer term moving average. When I asked him about his exits though, he totally flabbergasted me. He said, “I’ve done this so much that I can look at a chart and pretty much tell how long the stock will keep moving up—whether it’s going to be several months or just a few days.” “How?” I asked. He said, “I don’t know, I just can tell.”

So here was one of my better clients with whom I had worked to clear out enough psychological issues that he could plainly hear and follow his internal guidance. That guidance directed him toward this sort of trading. Then with experience following his guidance, he developed intuition in two additional ways. First, he could just tell when to enter into a position. Second, and more impressive, he could just look at the chart and have a pretty good idea of how long it was going to be moving in his favor. That is superb intuition, which helped him produce a 5100% return in 14 years. After trading for that period of time with those kinds of returns, he unquestioningly listened to his internal guidance in 2008 when it told him to stop trading. That is the power of intuition.

Unfortunately, developing your intuition and understanding the benefits for your trading psychology are the very kind of ideas that most traders want to pass over. They want facts and computerized methods that “work”. My experience of nearly 30 years as a trading coach, however, has clearly demonstrated that you cannot become a superb trader based purely upon mechanical trading methods. You must train your instinct to get the best results. Intuition is an integral component of the success for the best traders in the world.

About Van Tharp: Trading coach, and author, Dr. Van K. Tharp is widely recognized for his best-selling books and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at the Van Tharp Trading Institute