Brain-based trading (BBT) is a concept whose time has come. Using anatomy, physiology, thinking constructs and awareness molds a functional use of our own intellect to master trading. We have already dealt with perception and pattern recognition errors that are innately part of our brain evolution. Today we expand into our inherent awfulness in probability analysis.
Humans are terrible at probability. Our brains are very good at certain tasks, such as pattern recognition, but we have a horrible sense of probability, especially with large numbers. We appear to have evolved a good sense for small numbers like remembering a PIN code.
We tend to notice coincidence, when two events seem to have a connection with each other, and we see coincidence as highly improbable. This has led some people to speculate that there are no coincidences—that everything happens for a reason. This is part of another cognitive bias, the meaning bias, which is the need for the world to make sense or have some meaning. Often it doesn’t need to make sense but we lie to ourselves to maintain control and understanding.
While trading is not gambling let’s use gambling as a real-life example. Gambling is fundamentally an exercise in probability, and casinos thrive on the fact that most people struggle with understanding these probabilities. If you were to flip a coin and it landed on heads ten times in a row, the chance of flipping heads on the next toss remains 50%. But we internally think the next one must be tales. This is a classic example of the gambler’s fallacy, where people mistakenly believe that past outcomes affect future probabilities. Each coin flip is an independent event, and probability has no memory. We use our memories, which is where the fallacy resides.
Traders can learn a lot from this concept. Just like the coin flip, each trade is an independent event with its own risks and rewards. It’s crucial to recognize that past performance does not influence future results. By embracing this mindset, traders can better manage their expectations and avoid the pitfalls of overconfidence or unnecessary fear. Understanding and applying probability in trading can lead to more rational decision-making and improved long-term outcomes.
Do you expect a trade that has had a huge run to revert to the mean? Why? Why can’t the run continue? As you know, often it does. While the mean reversion may eventually take place, the timing is the real problem. Thus, we should often add position size to our winning trades, something that most traders fail to do. Our inherent fear of losing our winnings gets in the way.
Brain based trading is a new concept. It explains how successful traders carefully use their own understanding of their innate neural patterns and brain inherent flaws in thinking to their own advantage while trading. Careful observation and awareness of your own patterns and responses leads to better more profitable trading.
Enuf said.