A theme I emphasize with new traders is that it is important to trade like a scientist. The scientific mindset is one that can be rehearsed and cultivated--and eventually internalized.
What do scientists do? First, they observe regularities in nature. They look for patterns: repeated sequences of events and commonalities among structures. Those regularities differentiate what is meaningful from what is random.
After observing regularities, scientists attempt to explain these. Explanation is the role of theory. The theory is the scientist's way of making sense of the world. Theory is not truth; it is a first approximation at truth.
Scientists gain confidence in their explanations by testing them. If a theory is meaningful and accurate, we should be able to use it to generate future observations. These predictions are hypotheses for the scientist. By testing hypotheses, we keep an open mind with respect to our observations and explanations.
Finally, once empirical tests provide fresh observations, scientistsrevise their explanations of nature and use these to generate further hypotheses, observations, and revisions. Knowledge, for a true scientist, is always provisional: that is what separates science from dogma.
The scientific mindset is one of humility: a recognition that our best theories are only approximations and that many of our tests of hypotheses are apt to fail. When we trade, we have an implicit or explicit theory about the current market, and our trade tests a hypothesis that we frame around our explanation. That is why a scientific trader never wagers too much on any single trade. Nature will always be more complex than our science, and our understanding will always be partial. Such a perspective is a powerful antidote to overtrading and overconfidence.
What do scientists do? First, they observe regularities in nature. They look for patterns: repeated sequences of events and commonalities among structures. Those regularities differentiate what is meaningful from what is random.
After observing regularities, scientists attempt to explain these. Explanation is the role of theory. The theory is the scientist's way of making sense of the world. Theory is not truth; it is a first approximation at truth.
Scientists gain confidence in their explanations by testing them. If a theory is meaningful and accurate, we should be able to use it to generate future observations. These predictions are hypotheses for the scientist. By testing hypotheses, we keep an open mind with respect to our observations and explanations.
Finally, once empirical tests provide fresh observations, scientistsrevise their explanations of nature and use these to generate further hypotheses, observations, and revisions. Knowledge, for a true scientist, is always provisional: that is what separates science from dogma.
The scientific mindset is one of humility: a recognition that our best theories are only approximations and that many of our tests of hypotheses are apt to fail. When we trade, we have an implicit or explicit theory about the current market, and our trade tests a hypothesis that we frame around our explanation. That is why a scientific trader never wagers too much on any single trade. Nature will always be more complex than our science, and our understanding will always be partial. Such a perspective is a powerful antidote to overtrading and overconfidence.
Perhaps I notice that, as selling hits the market, volume is declining and fewer individual stocks are making fresh price lows. I also notice that one sector of stocks, the semiconductors, are actually moving higher and gaining money flow. Bonds, which had been falling with stocks, are now catching a bid. I hypothesize that the market is running out of sellers, that we are in the process of bottoming, and that we will likely see short covering as a result. That should propel the market higher.
Having formed this hypothesis, I make note of a recent short-term high price in the semiconductors and the low price. I say to myself, in essence, "I think we will hit this price (prior high) before we touch that price (recent low)." In other words, I am willing to risk a possible move back to the low in order to participate in the hypothesized move to the high.
This is only a hypothesis, however; it is not truth. For that reason, as a scientist, I must remain open to data that tell me my hypothesis is not supported. A fresh influx of sellers hitting bids; a fresh drop in bonds--many factors could alert me to a potential problem with my hypothesis. I also must keep my bet on this hypothesis modest: to risk much of my capital on the idea is to treat the tentative formulation as absolute truth.
It is in this context that every good trade tests a hypothesis. When we observe a pattern, frame an idea, test the idea with a trade, and actually profit, our idea--our theory--is supported. That may lead us to another trade that extends this idea. Conversely, if we do not profit from our theory, we may need to go back to observation mode and revise our explanations.
Thus it is that a scientific trader will gain confidence and become a bit more aggressive when his or her ideas are confirmed; a bit more cautious when ideas do not pan out. When you trade like a scientist, every good trade provides you with information, because every good trade is a solid test of your market understanding. For this reason, the scientific trader values losing trades. They, no less than the winners, are data to be assimilated and can push you to further market insight.
