Charlie Munger – Cognitive Biases – Reward and Punishment

Incentives or rewards are powerful motivators for us.  They drive us to start & stop behaviors we enjoy or dislike.  This powerful concept affects us every day we trade both explicitly and implicitly.

Explicit incentives.  It’s very simple the more money we make the more we are incentivised to repeat those behaviors.  There is no boss that, says, “If you make double what you risked today, I’ll give you a 10% bonus.”  We do however, have a voice that tells us we’d be better off with more money

Implicit incentives: These, I believe, is what really motivates us.  Knowing that if you make more money you live a better life.  This illusion or fiction that you create incentivises you to make more money at trading.  This can be a dangerous path to take.  Because we may not be associating the correct behaviors with profitable trading.  A great counter example of this is over trading.  When we believe that trading for the sake of trading will yield a profitable result.  An example of a proper correlation with good profitable trading behaviors is typically, finding your patterns and playing those.

Let’s go Freud… The repetition compulsion.  You are not always rewarding your self with what is considered “good.”  You will see this with the popularized movie 50 shades of grey.  Being hit isn’t necessarily a “good” thing to most people but to some it’s rewarding.  The same thing can happen while trading.  If you have an underlying belief that, “You’re a bad trader,” or “I’m no good, i can’t do anything right.” You are rewarding the most powerful part of your brain (the unconscious)  every time you may a bad trade. You repeat this stressful pattern repeatedly, this is the repetition compulsion.  It’s my belief, that you repeat it, so you can become aware of it, so that you can have that cathartic moment to finally release it.  Sadly, however, this often is not the case.

Don’t ever underestimate the effects of rewards & punishment on your behavior.  They operate within and without our awareness.

Intregral Theory – Market Algorithmic Development

Integral theory. Never leave home without it.  The new algorithm I’m testing is the 5-34 strategy.  I found it on a website a long time ago and the gentleman seemed to speak highly of it.  It’s a simple exponential moving average crossover strategy.  Before I go and tweak risk parameters, entry & exit locations, and overnight holdings I consult the integral framework.  Here is how.

Lines: What set of “skills” / Attributes does the stock need?  If we can define something as intangible as a “spiritual” line of development I can certainly define a volume line of development and a price line of development.  What attributes do I want this stock to have? High volume? Price great than $10? Strong beta? strong correlation with the sector?  All of these questions are valid as you do the same filtering when selecting a mate. Is she smart? Do they care for themselves, etc.

Levels: I sort of touched on this in lines by stating qualities of the lines such as High, low, medium, strong, and weak.  What level of development is the beta at? 0.02 or .95 beta?  How level of volume exists? Average of less than 1,000,000 or great than 10,000,000 on average?

States:  States are often temporary, and in my opinion, are expressed in terms of intra-day fundamentals.  Was it downgraded or upgraded? Did it just release earnings and is now in a state of frenzied buying? Are buyout rumors circulating?  These temporary bursts of volatility I  define as state dependent movement.  The stock will not move the same after earnings unless there is something that helps maintain that exuberant state.

Types: I define type as a sector.  Is it in the financial sector, technology sector, etc.  When someone asks “what type of stock it is” often people define it in a qualitative form.  Someone may ask “what type of stock is AAPL.”  “A technology company that makes computers…” a person may reply.  I don’t often hear people define stocks in terms of their lines & levels such as It’s an extremely (level) volatile (line) stocks.  They may go on to describe these attributes if asked for more information, but this is beyond the “Oh yes, Jerry is a nice person.”

Quadrants:  This section holds the bulk of my development.  We’ll go through each quadrant separately.  I have changed the order of the quardrants to make the most challenging one last (Upper-left).  We’ll start with the easiest, Upper-Right

  • Upper-Right: The external behavioral space.  How does this stock behavior.  Is it forming patterns? Does it respect those patterns? How does the stock move? Does it trend or chop?  In the upper-right quadrant, you can witness the behavior of the stock, it’s verifiable and real.
  • Bottom-Left:  What does the collective “us” think about this stock today?  I am going to repeat myself and say, does it form patterns & does it respect them. We must discriminate between these two statements in the different quadrants though.  When we look at at chart we can all see different patterns emerge, but the difference with the quadrant is do we as a collective agree that we see a head & shoulders or double top.  This is what will change the emergence of a pattern and it’s ability to fulfill it’s “destiny” from simply noticing their existence in the chart.
  • Bottom-Right:  The collective system.  Is the stock hard to borrow? Are there any regulatory or tax rules that impede or assist me trading this stock?  Are there any technology systems that I can take advantage of?  This section also holds the concept of relative strength.  Is this stock strong or weak compared to it’s sector and compared to the broader market.
  • Upper-left:  The internal space.  What does this stock think about itself?  This is a challenging conception. Does the stock even think?  I believe it does and here is why. As humans, we’re conditioned by the other quadrants to form internal conceptualization.  A “spoon” is not a spoon if we are never taught it’s a spoon.  So we can’t hold up a “spoon” and say, “it’s a spoon.” I believe the stock equivalent is the formation and fulfillment of patterns.  Since stocks can not speak (like animals) we look for patterns that define an internal state.  This dog has a wild temperament while this one likes to sleep & is very calm.  This stock is wild, volatile and usually, drops after creating a double top.  It has an identifiable unique pattern different from every other stocks.  The real philosophical issue with this quadrant in terms of stocks is that you can never enter someone elses internal state.  It’s sometimes impossible to know it exists since you never have direct access to it from an objective standpoint.  However, as humans, we can get close to understanding someone’s internal state and we call this concept integrity.  Are they telling me what’s really going on in their head?

As I develop the 5-34 strategy I will continue to post in more detail about how each of these is expressed in my code.





Information Overload – An Integral Approach

In today’s society, we are bombarded with information. This is no different in the trading world.  Sqawk boxes, CNBC, Bloomberg, yahoo Finance the list goes on.  The world is so interconnected it’s difficult to spot why this setup works now and why it won’t work in the future.  For example knowing that the relative strength between the 10-year US bond futures was not able to make a new high in 2008 while the market did make a new high, signaled a top, however, this no longer works.

Integral theory is a beast if you want it to be and to mentally check off the 5 aspects is cumbersome, but I believe quadrants are the most useful when dealing with a lot of information with 4 very simple questions based on the philosophy of the quadrants.

  • Is this information going to change the behavior of the stock? (upper-right)
  • Is this information change the way WE as a collective view this stock? What are other people thinking potentially if they were already long or already short? (lower-right)
  • Is this information related to the entire sector? (Lower-right)
  • Will this change the stocks internal unique character? For example, will it trade less or more. (upper-left)

Information overload is a real issue.  Sometimes we get a piece of information such as, “Buy out rumor on TIF,” we rush to pull up the ticker and notice it’s spiking quickly, but if you take the time to answer the above 4 questions you’ll see how the answers may not invoke a buy.



Integral Theory – Types

What type of trader are you? Long-term, multiday swing, intra-day, or ultra short term scalping?  There are many types of traders out there.  A more common frame of typing would be astrology.  Are you a cancer, libra, capicorn, etc.  These don’t necessarily tell you specifics about who or what you do but in society, but we generally enjoy typing ourselves.

How does typing yourself effect your trading?  When we categorize ourselves into boxes such as, “I’m a scalper,” or “I’m a swing trader.”  These conceptions put the focus on an ideology and not on your setups.  Let’s illustrate with an example.  Marvin always buys the 3 bar pull back on the 5 minute chart he watches daily.  However, the next day he see’s the exact same setup on a larger time frame but refuses to take this trade because he is a “day trader.”  It’s these ideologies that can make a trader focus on the wrong aspect of trading.

It’s not who you are (day trader, swing trader, fundamental trader) it’s what you do.  Why do you take these setups, what candle patterns, fundamentals are you looking for and how do you repeat them.  When you begin typing yourself; being a “day trader” filters trades rather than letting you setups dictate the filters.

Integral Theory – States

Integral theory believes we enter different states of awareness, of consciousness, etc throughout any given day.   Have you ever been unable to break an angry mood? Your state was angry.  Have you ever been highly irrational for a long time? Your state was irrational.  Have you ever fell in love & were unable to fall out of it for a long time? Your state was in love.

States greatly effect the way we trade ever single day.  Author Denise Shull’s book Market Mind Games is essentially a book about emotional / psychology states.  Her book can be summarized as follows.  Be aware of your emotional context (state) it will greatly effect your trading decisions.  She’s correct.

This is a very basic overview of how states can effect you during trading.  Denise suggests writing down your emotional state as your are trading such as “I”m afraid to take this trade” or “If I lose on this trade I’m going to be very angry with myself.”  I added to this methodology by taking it a step further and after the bell has rung to go back and ask. What makes me afraid? or IfIi become angry with myself what would happen?


Integral Theory – Levels of development in trading

To again, continue my series on how I use integral theory to trade the stock market we now move onto levels of development on each of the lines I discussed.

This is the piece of Ken Wilber’s theory that he “borrowed” a lot from other traditions.  Personally, I think this is one of the coolest aspects of his theories.  The book Integral Psychology does a great job mapping out how all these different theories of development are talking about the same thing just at difference stages in life.  I highly recommend the book.

How do development lines work?  If you ever heard of Freud’s psychosexual stages of development that is a developmental line.  Another example is Piaget’s stages of cognitive development.  The most popular set of development stages within the integral framework tends to be spiral dynamics.  This is metaset, in my opinion, of development that can be applied to any line.  I’ll illustrate an example below.

The Line of development will be pattern recognition.  The development stages of pattern recognition could be interpreted as follows.

Beige – Instinctive / survivalist: Reading books on technical analyse & finding patterns that match exactly what you have read.

Purple – Magical / Animistic: Believing you see the patterns in everything.  The street lights form a double top and every time frame you look at hold exceptionally strong cup & handles, for example.  You find a “holy grail” of patterns

Red – Impulsive / Egocentric:   The patterns no longer work and you are angry. You find failing example after failing example.  The belief in the “holy grail” has died.

Blue – Purposeful / Authoritarian: You seek more education believing someone must have the “holy grail.”  You take this person or educational doctrine word for word.  You start to relive the “holy grail” experience that you originally had but it is now done with a stronger authority figure.

Orange – Achievist / strategic : Acting in your own self-interest.  “This guy doesn’t know what he’s talking about but I do.”  This is where you may begin to turn heavily towards statistics to validate your patterns and see how often they do work.  You will turn to more scientific methods.  [Side note: this orange phased is theorized to have only begun 300 years ago]

Green – Communitarian / Egalitarian:  Seek peace with self & others.  You now realize you know what you don’t know and don’t know that which you don’t know.  You have accepted the idea patterns work and patterns fail. That there is no holy grail.  You may even begin to share your knowledge with others.

A picture below should help bring these ideas together.  Remember moving on to the next level does NOT mean you are no longer part of the lower levels.  As you transcend the previous level you include you! You never disregard the previous levels.  Even though you may recognize patterns at a “Green” level of development, it doesn’t mean that “beige” is no longer a part of you.

Integral Theory Lines of Development in trading

To continue my series of how I use integral theory to trade the markets we now move onto lines.

Lines define what skills we develop.  For instance, there is a mathematical line of development, there is a pattern recognition line of development.  These skills have varying levels from the novice to the expert, but we will get to that in a future post.

There are a couple core lines I believe are truly necessary for the development of all traders.

  • Mathematics
    • Why: The ability to analyze your own trading data, calculate company fundamentals, understanding the greeks of options and many others.
  • Pattern Cognition
    • Why:  Being able to spot patterns is critical for being a successful trader.  This extend far beyond technical analysis but also into the motifs that society indulges in to create Bull & Bear markets.
  • Patients / Emotional intelligence
    • Why: The market is unforgiving it will require you to keep your biology from overthrowing your mind with the chemical cocktail it will throw at you on a daily basis.

These are what I believe to be the core line of development that are needed to be a good trader. In future posts, I will write about how to develop them.

Daily Trading Goal: Choose Your Thoughts

Today’s Daily Trading Goal focuses on how to choose your thoughts.  Thoughts effect your biology and your biology greatly effects your ability to trade through hormones.   Which thoughts you choose to pay attention to is critical.  Listen & choose to think good thoughts.

How I use integral theory to trade the markets

Integral theory is a beast.  You can read Ken Wilber‘s works over a lifetime only to come back to read them again and realize how much you missed.  My friends who introduced me to the theory always found great ways to answer my practical application questions from this theoretical model.  This and other posts will be my attempt to do the same for stock market trading.

As I discussed in a previous post.  Quadrants a great way to know your current perspective on things.  But how do we use the other 4 tenants?

Quadrants: Great for perspective.  Figuring out where your thoughts are and most importantly where other people’s thoughts may be as well.  This is simply a matter of perspective taking methodically.

States:  Are you angry? Stressed? Joyful? Irrationally exuberant?  In Flow?  This is the current state of your being. What’s coloring your trading ideas.  Maybe even confirmation bias.

Lines:  These are the skills people obtain throughout life. Relevant to trading I see pattern recognition, math, probability and high social IQ as skills worth developing for this business.

Levels:  Each of these skills will have levels that will build on the next.  There is no stagnation unless you choose.

Types: Gemini or Capricorn? OCD or free spirited?  How do you type yourself as a trader? Do you believe the hype that you can put in 2 hours of work a day and walk away a millionaire? Do you believe it takes hard work and practice?  This is typing yourself.  It is also called priming in the field of psychology.

I will write about each of these in more detail in future posts.

Daily Trading Goal – Caught in Your Own Thinking

Today’s daily trading goal is to stop getting caught up in your thinking.  In psychology,  one aspect of this is the confirmation bias.  Where view almost all information as confirming our original thoughts.  Stop this by wearing aware it exists.  Be mindful of your thoughts.