Can Your Gut Give You Trading Signals?

Intuition In Trading And Investing: Can You Trust It?

This is a Guest Post by Alex @MacroOps which was originally posted HERE.

Do you ever get that feeling that a certain trade will be huge? That you should size up on it and go for the jugular? You can’t exactly describe why this trade is the “one”, but you can definitely feel it.

This feeling is what we call intuition.

Now the question is… should you trust your intuition? Or is it just another feeling the market will abuse? Let’s find out.

The Barking Up The Wrong Tree blog has a great article on intuition in which they introduce researcher Gary Klein. Klein has studied the use of intuition for over 30 years in various occupations from chess masters to firefighters. He’s worked with the US military to develop decision making programs for soldiers and even led the team that redesigned the White House Situation Room. He’s also written various books on intuition including The Power of Intuition: How to Use Your Gut Feelings to Make Better Decisions at Work and Streetlights and Shadows: Searching for the Keys to Adaptive Decision Making.

Mr. Klein will be helping us further explore the use of market intuition.

To start with a simple definition: intuition is derived from the patterns you unconsciously notice in a particular field of study. Over time you begin to automatically see that particular combinations of inputs produce certain outputs. In the case of intuition, these aren’t overtly definable patterns, but are instead processed in the subconscious mind.

From Klein:

A “pattern” is a set of cues that usually chunk together so that if you see a few of the cues you can expect to find the others. When you notice a pattern you may have a sense of familiarity— yes, I’ve seen that before! As we work in any area, we accumulate experiences and build up a reservoir of recognized patterns. The more patterns we learn, the easier it is to match a new situation to one of the patterns in our reservoir. When a new situation occurs, we recognize the situation as familiar by matching it to a pattern we have encountered in the past.

The big benefit of intuitive thinking is its clarity and speed. There’s no getting bogged down in painstaking logical analysis with multiple, closely managed steps. Intuition is quick and easy. Get a feeling and go with it. But is this effective?

It absolutelyis effective when it comes to complex systems.

Consider the market. It consists of billions upon billions of transactions, all distilled into market prices moving either up or down. The complexity created by these countless interactions is infinite. It’s impossible to make a fully defined list of steps to analyze it.

This is not to say that some defined steps won’t help, but they will never take you all the way. You can’t logically work through every aspect of the market to come to a perfect decision.

We’re playing a game of incomplete information when it comes to trading and investing. At most you can know maybe 60% of what’s going on in a certain situation. You then have to make an educated bet on which way price will move based off that knowledge.

Good luck using purely logical-based decision making systems in this type of environment. You’re gonna need some intuition.

Klein again (emphasis ours):

The reality is that the classical model of decision making doesn’t work very well in practice. It works tolerably well in the research labs which use undergraduate test subjects making trivial decisions, but it doesn’t do so well in the real world, where decisions are more challenging, situations are more confusing and complex, information is scarce or inconclusive, time is short, and stakes are high. And in that environment, the classical, analytical model of decision making falls flat… Considering all these drawbacks, it’s not surprising that decision researchers haven’t been able to demonstrate that analytical methods actually help people make better decisions.

So logical decision making fails in confusing and complex situations? With scarce or inconclusive information? Where there are high stakes with little time? Sound familiar to anyone…?

*Cough* Markets *Cough*

Now consider the brain, another infinitely complex system. Is it possible to logically list every conscious and subconscious process that leads to a particular feeling or intuition? Of course not.

But remember, your brain is a complex system analyzing another complex system — the market. There’s a lot of things going on inside our heads behind the scenes that we don’t know about. It would be foolish to ignore the results of this complex analysis.

In fact, there are studies that prove there are negative effects from ignoring your intuition and pigeonholing yourself to strictly logical analysis.

Klein:

There are data showing that when people ignore intuition, decision quality goes down. It also goes down when people are instructed to use decision analysis. Decisions are made subconsciously before people even start to perform the analyses, and the very act of articulating the factors can make decisions less reliable. The evidence is growing that those who do not or cannot trust their intuitions are less effective decision makers, and that as long as they reject their intuitions, they are destined to remain so.

Trying to prevent intuition can many times lead to destructive overthinking. Take Klein’s radiologist example:

Radiologists worry about overthinking. If they look at a film too long, they start seeing things that aren’t there. After about 38 seconds, they begin to overreact to slight irregularities in normal structures and identify non-existent malformations.

It’s just like charting in the markets. If you can’t immediately see a pattern when flipping through your screens, it’s likely not there. Studying a single chart for too long will lead to overthinking and the creation of imaginary patterns. Your initial reaction to a chart is usually best.

Now a logical decision making process does have its uses, especially in defined situations. Klein explains that “systematic analysis may work for well-ordered tasks”.

But again, with complex systems, intuition is a must.

So yes, intuition is a crucial tool in trading and investing. But that still leaves the question… should you trust your own intuition?

And here’s where we get the HUGE caveat that comes with trusting intuition in trading and investing: you need to be experienced in the markets to use your intuition successfully.

If you’re a beginning trader, whatever feelings you have will likely lead you into red. You can’t trust them.

Intuition works because the user has a deluge of experiences to draw from. Returning to Klein: “As we work in any area, we accumulate experiences and build up a reservoir of recognized patterns. The more patterns we learn, the easier it is to match a new situation to one of the patterns in our reservoir.

Market experience comes from years of being in the trenches. It comes from dedicated practice, day in and day out, taking hits, getting back up, and getting hit again. It’s not something that just happens.

That’s why as a beginner you’re better off trading a strict system or set of rules. At that stage, a logical system will help protect you from your “intuitions” that most likely belong under the greed, fear, and hope categories of emotions instead.

But over time, as you gain more experience, you’ll be able to add intuition on top of your logical system.

And that’s what we recommend to all traders when it comes to the intersection of intuition and logical/rational decision making in trading and investing.

Combine them.

Have a basic structure or strategy with a set of rules you generally follow. This will be your logical decision making base that will keep you aligned and disciplined. It will include key aspects like strict risk management that will keep you from blowing up.

But also understand that markets are infinitely complex with partial information, which means logical decision making won’t carry you the whole way. You’ll need to develop experience and with that experience, intuition. Know that you won’t be able to rationally define your intuition, but that you can still use it to enhance your trading. Trust the complex system you have chugging along inside your head to analyze the complex market.

This is what the greatest traders of all time do.

Take Peter L. Brandt (PLB) for example, a purely technical trader that our team has studied over the years. He uses a logical system as a base. The system includes specific rules such as restricting entries to classical charting patterns and sizing positions up and down depending on those patterns’ characteristics. These are rules that can be defined.

But what PLB can’t define, and what also seems to launch his performance from good to extraordinary, is all the finessing he does around these rules. The slightly early entry here, the sudden exit there… these seemingly random adjustments he makes are based off his feelings a.k.a. his intuition. Oftentimes PLB will admit that he doesn’t know exactly why he’s taking a certain action, but that it feels like the right thing to do. His intuition developed from decades of trading have helped him create over 40% compounded returns throughout his 40 year trading career.

You can follow PLB’s rules based strategy but you can’t replicate his intuition. That is what every trader needs to develop for themselves.

There are countless stories of the best traders getting feelings about the market and acting upon them. Whether it’s a dream the night before that makes a trader want to go long, or some back pain (as in George Soros’ case) that makes the trader want to exit, intuition helps them navigate the markets.

Another example is Market Wizard Michael Marcus. Marcus once said that “Gut feel is very important. I don’t know of any great professional trader that doesn’t have it.”

That gut feel is intuition.

In his Market Wizards interview, Marcus explained how he would take a lot of trades just to keep him entertained, even though he knew only a few trades that met his specific criteria would be the big winners. The big winners would have to have fundamentals, technicals, and market tone all going for them.

Marcus likely had some defined rules for his criteria, but a lot of it was feel or intuition as well. Try developing strict rules to measure something like market tone…it’s very tough.

Marcus would size up on these particular trades:

… when a trade met all my criteria, I would enter five to six times the position size I was doing on the other trades.

He had a basic system, but would use his intuition to know when to strike hard. And that’s how he turned $30,000 into $80 million over a 20 year period.

Remember what Albert Einstein said:

The intuitive mind is a sacred gift and the rational mind is a faithful servant. We have created a society that honors the servant and has forgotten the gift.

Don’t forget your gift of intuition when it comes to the markets. Use it. But make sure it’s credible intuition developed through lots of experience. Make sure it’s more than a feeling…

If you want to learn more about how to layer intuition on top of a logical trading strategy to earn superior returns, then check out the Macro Ops Handbook here.

For more posts and information about Alex @MacroOps  you can check out his website Macro-Ops.com. This post was used with permission and originally appeared as Intuition In Trading And Investing: Can You Trust It?