Binary thinking

16/12/2017 | By | Reply More

Imagine you are a caveman meandering through a landscape, you hear a rustle in the bush. “What’s that…?”

Your brain kicks into action and provokes a flight or fight response. It could be lunch, or it could kill you! Your primitive brain makes a really simple judgement and decides that the payoff here for ‘kill you’ is pretty bad, -100% in fact. The pay off for food is there as well, but it can’t offset the negative. So you walk away, cautiously.

The curious thing about this instinct, is that it still persists today; in two forms. The first one is how we treat losses, but it also kicks in with how we treat outcomes.

Profits and losses

The first most notable apparition of our primitive mind pervading our modern world, is that we treat losses with far more severity than profits. It’s not that we don’t value profits, it’s just that our mind is trying hard to avoid losses.

This manifests itself in a number of ways. Think about how stupid you felt when you made an unexpected loss, but also think about when that person cut in front of you when you were in line or on the road waiting patiently. Perhaps it was just a loss of face when you didn’t put across an argument very well. Losses come in many forms and humans tend to do what they can to avoid them. When it comes to losses the quickest way to get rid of one is to double your stake and lump on the next good thing of course. Then again………

Most losses can be contained, either by forward-thinking or by managing the pay off on the other side. There is no real need to think about the rustle in the bush being a threat in the modern world, especially when trading. Successful risk-taking is all about a balance of risk and reward. Unless you are totally reckless, then the chance of something that will wipe you out should be a far-off situation and preferably, almost impossible.

When I risk money it’s purely a question for me of what the potential long-term payoff is and I try to skew that in my favour and repeat.

Binary thinking

Another thing that has been transported over the millennia is binary thinking. The thought that there are only two outcomes to an event. Most people struggle to come to terms with an answer that isn’t yes or no and often base their decision on a definitive result. I rarely do.

If a politician said there was a 60% chance a policy would work, they would come under attack as being indecisive or having failed to rigorously think things through. But the fact is, at a fundamental level, that is how the universe works.

When people ask me if something will happen, I’ll always give a probability back. People hate that. I once sat in a business meeting where a business plan was being agreed for the following year and I said we probably have a 70% chance of hitting that number. The MD just wanted a Yes or No, so I replied that I could give a Yes if the number was lower as it would be more certain. Nobody in the room really understood what I was saying.

If you try and tip a sports result, you should also say ‘There is a 65% chance of XXXX’. That would allow the punter to know how certain you are and allow them to bet the edge and manage their staking. But of course, absolutely nobody wants that, so people just nominate an outcome as though it’s a certainty. I suspect this will never change.

The problem with trading

I’ve spent a lot of the last 20 years solving puzzles, mainly in the market, but the latter part of my career has been focusing on the why and how. For that I’ve often looked to psychology.

The problem with trading is that it does the exact opposite of what your mind seeks. You have to deal with uncertain outcomes, with uncertain payoffs which only balance out over time. You have to actively find rustling bushes and stick your hand in with the view that it will get bitten off frequently, but that the bushes where that doesn’t happen will help provide the meat and bones to repair your partially eaten arm. You have to get used to getting eaten, but avoid your head getting ripped off.

Trading will also nag your binary thinking mode, making your believe with certainly one thing or another when you can’t really know the outcome. This leads to mistakes in judgement. People believe that thinks can’t happen or definitely will happen. Neither of those is the correct answer. People migrating from matched betting to trading often struggle with this, looking for some definite answer when one doesn’t exist. Losses hurt, a lot. But trading is full of them and your long term goal is more or less to welcome them and move on. That’s really hard for people to do.

Summary

I once had a conversation with a new trader. To my surprise he published his thoughts and felt I was evasive and holding something back. Nope, that’s the uncertain feeling you get when you trade properly. There are no easy answers just set-up’s, payoffs and risk / money management. He also spoke to somebody else who gave him a slam dunk, ‘binary’ trading process, he seemed to quite like them. Unfortunately the latter strategy was well know, fundamentally flawed and impossible to profit from. The latter however keeps your mind happy, but not your bank balance. He will find out in time I guess.

If you want to know how to get and keep an edge, just avoid the thought processes that most people go through. Once you identify it, you see it everywhere and see the flaws it produces. When you start thinking differently some people wont understand you or your judgements, but in a market that’s more or less exactly what you want. Those are the people you will win money from!

It’s quite enlightening when you can stop thinking like everybody else. You can see the true colour of things, it’s not black and white or should I say ones and zeros. It’s was a transformative moment for my trading when I discovered this way of thinking.

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Category: Trading strategies

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