From Duke Basketball Player to Market Psychologist

Welcome to The Big Saturday Interview. This week, I am delighted to have Brett Steenbarger join me for a candid conversation about his life as a trader, psychologist and educator. Brett is a psychologist who has been involved with financial markets for almost 30 years. He is the author of The Psychology of Trading: Tools and Techniques for Minding the Markets.

The following interview of Brett Steenbarger was conducted on September 21, 2005 by Eddie Kwong, Editor-in-Chief of TradingMarkets.com. At the time of this interview, Hurricane Rita was three days away from reaching Texas.

Eddie: Hi, Brett. How are you doing?

Brett: Very well thank you; a lot better than the market today. Looks as though fears of another Gulf hurricane are spooking the markets.

Eddie: Are you doing some trading today?

Brett: No, I’ve gone to a full-time writing mode to finish a new book on the psychology of the markets. It’s very difficult for me to be absorbed in writing and follow the markets closely enough for short-term trading. The quality of my concentration has a major impact on my trading performance, so I’ve learned to stand aside when other things require my attention.

Eddie: Yeah, I'm sure that many professional traders step away from their screens when there are distractions. But I bet you're still keeping one eye on the market. What do you see going into the coming week? Got any bias?

Brett: This really seems to be a news-driven market, with oil and the hurricane taking front and center stage. No big surprises there: if the weather reduces refinery capacity further and we see new highs in oil, it’s hard to see how we’ll sustain an uptrend. If we catch a break with the storm, I’d expect a relief rally. There were a number of divergences at the recent market highs, as I noted on my website. So far, however, I see no indication that this is anything but a normal correction, similar to others we’ve seen. The two things on the horizon that could change that are oil and avian flu.

"...It seemed as though basketball was my major at Duke..."

Eddie: Brett, you have an interesting background. Tell me, are you a trader who also happens to be a psychologist? Or are you a psychologist who happens to be a serious trader?

Brett: I’m a psychologist first and foremost. I happen to work with traders, and I trade the equity indexes on a short-term basis. In many ways, I view myself as an educator, whether I’m helping people with personal problems or trading ones.

Eddie: In terms of your trading, what's a typical day like for you? What are you trading and what time of the day are you usually in the markets?

Brett: My pattern is to trade the morning hours in the ES, catch one or two moves if I can, and then devote the rest of my day to other activities.

I once traded on a truly full-time basis and actually was doing pretty well at it, but had to quit. I missed the other activities—teaching and working with people—too much. I found that my emotional equilibrium requires those other activities. I’d love to go at it full-time, but, like Bob Dylan said, “It ain’t me, babe.”

Eddie: Well, I know of many full-time traders who have that isolation syndrome, but they put up with it, and from what I can see, it takes its toll. Now, Brett tell us a little bit about your background...how you wound up where you are today.

Brett: I first became interested in the markets after a class exercise in the eighth grade. I knew that my grandfather had been involved in the markets, losing money during the Great Depression, and my father had a passing interest. I didn’t do much with trading in college—it seemed as though basketball was my major at Duke—but in graduate school at the University of Kansas I began trading stocks on a small, part-time basis, conducting my own fundamental research. I continued that off and on in the 1980s and became very serious about quantitative research in the late 1990s, while teaching at the medical school in Syracuse. That’s when I began assembling a large historical database, which I maintain to this day. With the shift toward stock index trading, both E-minis and ETFs, I moved to shorter timeframes and less fundamentally based trading methods. I started my blog in 2003, and it’s been a great way to think aloud and track the evolution of my research and trading.

Eddie: And I see in your bio that you eventually stepped from your medical school faculty position to become involved in the financial markets. What led you to do this?

Brett: I left my full-time position at the medical school to pursue an opportunity to work with professional traders full-time at a large proprietary firm in Chicago. It seemed like a perfect opportunity to apply the ideas I had written about in my book, so I embraced the challenge of leaving the ivory tower. Nothing substitutes for the experience of working with traders in real time, as they are trading. You really can help people with their patterns when you see them unfolding in front of you.

Eddie: I see many people in the medical profession who have an interest in the markets. They trade part-time, some times in-between surgeries. Some of the doctors I know, have received the proper training and have become excellent traders.

Tell me, through all the consulting you've done, have you noticed any correlation between the professional background a trader has outside of trading and their performance as a trader? For example, how well do doctors perform as traders versus, say, engineers?

Brett: Actually, I know of very good traders who have an engineering background. Many have the quantitative and research skills to develop trading systems, and they also have an emotional groundedness that helps them with trading. I can’t really say that I have found education or IQ to be great predictors of trading performance. So much of trading boils down to rapidity of mental processing and pattern recognition skill. Intellectual ability doesn’t guarantee either, though I suspect one cannot be significantly lacking in intelligence and hope to succeed at trading.

Eddie: What about differences in trading performance between men and women? Are the differences because women are more "right brain" oriented vs. men, who are "left brain" oriented?

Brett: I have noticed a difference between working with men and women, but it’s not related to hemispheric dominance. Rather, women—as a whole—seem to have an easier time putting trading into the broad context of their lives. They don’t live, eat, and breathe trading, and they don’t get their egos tied up in trading. Many men, socialized by pressures for financial achievement, find it harder to separate who they are from how well they do at trading. A very interesting behavioral finance study by Terence Odean found that men are significantly more likely to overtrade than women—and achieve worse trading results. I believe ego involvement in trading, not left/right brain differences, is responsible for that.

Eddie: Yes, I definitely see the truth in that statement. Now, let's say you look at the top of the heap...the very, very best traders in the world, regardless of their backgrounds or genders...what do they have in common? What separates them from all those traders you hear about who spend years losing money, making the same mistakes over and over again?

Brett: I find that there’s a significant learning curve to lasting trading success. I know of newbies who are successful early in their careers only to crash and burn once market trends or volatility patterns change. I think it’s every bit as challenging—and takes just as long—to reach high levels of success in trading as in athletics, chess, or other performance fields. Many people keep losing money and making mistakes because they are tackling a demanding performance domain on a very part-time basis with little or no mentorship. They would do no better at golf, acting, or fighter piloting. The people who make their livings in performance fields are not the casual part-timers. They receive intensive education and undergo extensive coaching and practice.

Eddie: For traders who lose consistently and who keep coming back for more punishment, I see elements of addiction. Do you see that?

Brett: Yes. many traders trade for the action, rather than for profit per se. You can see that among traders when they face very slow markets that lack volatility (and therefore lack tradable moves). They cannot sit in front of the screen without putting on trades. I predict that if someone developed a system that was highly successful and that made one trade per day on average, the majority of traders either wouldn’t trade it or would tinker with it to make it more active. I find this dynamic as common among professional traders as part-timers.

Eddie: How can you tell self-destructive trading addict from a trader who is genuinely learning from his mistakes and ultimately has a good chance of succeeding? I mean, both traders may be producing the same horrible results.

Brett: The trading addicts won’t want to practice trading on simulators and won’t want to spend time watching markets. They need the action. Real students of the markets will put time and effort into their learning. Addicts don’t want to learn; they want to trade.

"I trade the S&P and occasionally the NASDAQ indexes, almost entirely intraday."

Eddie: Brett what exactly do you trade and what time frame (intraday or daily) do you trade it in?

Brett: I trade the S&P minis and occasionally the NASDAQ minis, almost entirely intraday. I go for 2-3 point swings typically, with an average holding time of under 30 minutes.

Eddie: Do you have any investment account that you swing or long-term trade?

Brett: No, my investments are in fixed income and aren’t used for trading. I think of trading and investing as very different things.

Eddie: Brett, can you tell us about your strategies and methodologies for daytrading the E-minis?

Brett: Yes, I’m looking for short-term situations where there is significant buying and selling in the marketplace (traders are hitting bids or lifting offers), but price cannot move to new highs or lows. Those situations offer excellent reversal opportunities. I also look for breakout moves where large traders are participating in the breakout. Those moves have the best likelihood of continuation.

Eddie: And how do you detect where those big players are coming in?

Brett: The NYSE TICK is a measure of the number of stocks in the New York Stock Exchange Composite Average that are trading at their offers minus the number trading at their bids. Thus, if we have a TICK reading of +500, it means that 500 more issues are trading at the offer than at the bid.

On my website, I maintain a cumulative line of the NYSE TICK adjusted to create a zero mean. Notice in the chart how intermediate-term swings in the ES futures are led by turns in the cumulative TICK. That tells us that short-term trader sentiment is actually leading intermediate-term market moves. By keeping abreast of the psychology of traders--their sentiment, as measured by their ongoing willingness to transact at bids and offers--we can achieve a deeper understanding of market movements.

Eddie: You've got a systematic approach, but you're using discretion in the trading decisions you make, right?

Brett: Yes.

Eddie: There are many traders who consider themselves to be discretionary purists. They look at patterns and they trade off those patterns. How do you see that as different from someone who uses a systematic approach, but who, like you, still mixes in discretionary inputs? I mean, even a discretionary trader has a system or methodology they're using.

Brett: Well, it’s not clear to me that discretionary traders are using systems or methodologies. Many that I’ve worked with are highly intuitive and rely on a feel for momentum shifts. System traders tend to be more analytical, more explicit in their reasoning. They are looking for structured signals or patterns. Often they trade longer time frames than the “gut” traders. The difference between the two groups, often, is how they process information. The shorter the time frame, the more discretionary and intuitive is the style. There just isn’t time for reflection and analysis.

Eddie: Do you think it's possible for someone to be a successful pure system trader?

Brett: I personally know successful system traders. A big part of their success is not just their modeling of markets, but their ability to remodel when markets change. The really good system developers are tinkerers.

Eddie: What's your definition of a really good system? You can't avoid using historical data to develop a system, but that exposes you to the danger of having something that is merely curve-fitted. It looks great in the past, but it doesn't work with future data. How do you get to the point were you have a system that has a great potential for working in the future?

Brett: The best systems seem to have a limited number of inputs, a sound overarching rationale, and testing that includes real-time, audited results. I worry when I see systems that are developed and backtested on a single data set, with no independent confirmation from either fresh historical data or real time trading. That having been said, I admit to being no expert in systems development, although systems intrigue me. Nor do I trade mechanically.

Eddie: Tell me about some of your favorite methodologies.

Brett: Actually I don’t think there are a lot of methodologies in the popular trading literature. Most use of charts and indicators is simply a way of tracking changes in momentum. The big methodological gap is between traders who are quantitative (who conduct statistical analyses of historical and current markets to gain an edge) vs. traders who are not. I have a bias toward using quantitative analyses to supplement one’s feel for markets. Having multiple, independent sources of edge can produce those gonzo trade ideas when they all line up.

Eddie: Is trading fun for you?

Brett: Absolutely; I love the challenge, the learning process, and the opportunity to test myself each day. Even for a market shrink, it’s frustrating to lose money, but I try to keep in mind what I tell new traders: There are two kinds of trades: winning trades and trades that you learn from. The best trades are those that teach you about yourself and about the markets.

"...Impulsivity is the number one trading problem I’ve encountered, with overconfidence a strong second..."

Eddie: What do you see as the most common problems that traders have in terms of their psychology?

Brett: I would say that impulsivity is the number one trading problem I’ve encountered, with overconfidence a strong second. Even when traders have highly structured plans (which I find to be a rarity), they often deviate from these plans in the heat of market action. Traders also tend to identify much more opportunity in markets than is actually there. While markets are not random, they surely aren’t so inefficient as to leave high probability setups throughout the trading day.

A large percentage of emotional problems among traders, I believe, are the result of poor trading, not the cause. Traders become frustrated when they’re not successful, and this leads them to freeze with anxiety or impulsively trade out of anger. But the reason they’re not successful is that they have no real, validated edge. If people practiced golf, tennis, or chess as little as they practice trading, they wouldn’t expect to be successful, much less make a living from it. Yet somehow people get it in their heads they’re going to be successful by following a few trading patterns and writing a few words in a journal. I’ve been doing this for years, and it still boggles my mind.

Eddie: How do you help people overcome these issues?

Brett: Well, that touches the issues that led me to write The Psychology of Trading. I saw that trading problems are not so different from life problems, and I realized the possibility that developing ourselves as traders could also further ourselves as people. Trading teaches planful behavior, it teaches self-control, and it teaches decision-making under conditions of risk and uncertainty. The market is a wonderful teacher and a phenomenal resource for self-development.

Perhaps the method that I’ve found most useful for traders is exposure therapy. This is a cognitive-behavioral technique in which you expose traders to situations that normally elicit their problematic behaviors, such as impulsive trading. During this exposure, you have traders rehearse self-control strategies, such as imagery, deep breathing, restructuring of internal dialogues, and biofeedback. The idea is to help people develop control in real time, facing real life challenges. Therapy that involves talking about problems is one step removed from reality. By placing traders in actual, challenging trading situations and working on self control in real time, we can greatly accelerate learning and self-change.

The other strategy that I’ve found to be phenomenally helpful is solution-focused therapy. I focus on traders’ positive behaviors—their successful trading—and help them do more of what is already working for them. Out of their frustration, traders have a way of becoming fixated on their problems, forgetting all they’ve learned and accomplished. Ultimately, we succeed by building on strengths, not by venting about our shortcomings.

Eddie: Without naming names, can you tell me some of the crazy and extreme things that you've seen in working as a consultant?

Brett: I’ve seen traders do some pretty wild things, but nothing is as crazy and extreme as some of the conferences and seminars run for aspiring traders. The presenters are generally compensated for their efforts with promotional space and time -- nothing more. As a result, their presentations are little more than infomercials. Few of these folks trade; even fewer have worked in a hands-on way with successful traders.

My favorite incident came when I was invited to talk at one of these events. As soon as I mentioned the efficiency of the markets and the challenges of trading, the organizer asked me to “tone it down”, so that I didn’t discourage attendees. Perversely, I spent much of the remainder of my talk explaining why most people should not give up their day jobs to pursue trading. Needless to say, I haven’t been invited back.

Eddie: Who are some of the traders that you admire or model yourself after?

Brett: No question, the greatest influence on my trading life has been Victor Niederhoffer. More than any writer or money manager I’ve encountered, he has a keen appreciation for the value of the scientific method and the need for creative thinking in generating trade ideas. There are more good ideas on his website, www.dailyspeculations.com than in a hundred of the crazy seminars I was telling you about. Although my trading differs from his, he really taught me how to think about markets.

Eddie: What about outside the trading profession? Anybody you think that serves as a great role model?

Brett: Intellectually, Ayn Rand has been a huge influence, particularly with respect to her heroic vision of life’s possibilities. Her articulation of the relationship between reason and political and economic freedom was a major achievement and a tremendous personal inspiration.

At a personal level, I would have to count my father as my best role model. A self-made, successful businessperson, he really displayed character during the recent period of my mother’s illness, becoming a care giver for someone who had always taken care of him. I think about what it means to be a man and realize what a great example I had growing up—and what a great exemple he remains to this day. Thanks, Dad.

Eddie: If you wanted to advise somebody how to stay calm, relaxed and resourceful even when under heavy pressure, what would you tell him?

Brett: Keep putting yourself under heavy pressure, and then rehearse specific activities that are geared toward producing a calm focus. You can’t learn to stay controlled under pressure by working on the problem in an unpressured way. It’s back to that idea of exposure therapy.

"...Most of the best traders I’ve known are quite absorbed with their trading, to the point that they
sometimes ignore the niceties of social interactions...."

Eddie: What kinds of personality characteristics do you find in great traders? From what I've observed of people outside of the trading, many of them seem well rounded and they have a myriad of outside interests. For example, Richard Feynman, who one the Nobel prize in 1965 for his work in quantum electrodynamics, was frequently seen playing bongos in clubs and, I believe, he did a lot of surfing. A lot of Bill Gates time at Harvard was spent playing poker. Do find this to be the case among the best traders?

Brett: I’d have to challenge you on this idea. Take a look at the book The Price of Genius by Arnold Ludwig. His historical studies of eminent persons find that very few of them are well rounded. Indeed, most of them are obsessed with their work, which is what allows them to be extraordinarily productive.

Eddie: Yes, I see where that makes sense. Some of these guys may have interesting hobbies, but their work still consumes the vast majority of their waking hours.

Brett: That comes at a cost, however, as many great individuals are not necessarily happy people or nice people. Most of the best traders I’ve known are quite absorbed with their trading, to the point that they sometimes ignore the niceties of social interactions. As a whole, however, I find traders to be surprisingly lacking in ambition as a group. Many are interested in trading as a means of making money quickly; they’re not attracted to the work and discipline involved.

Eddie: Between trading and working with traders, how do you find balance in your life?

Brett: Music has always been a great balancing force for me. I gravitate toward music that is up-tempo and serious, including Assemblage 23, VNV Nation, the Cruxshadows, and Informatik, as well as some darker sounds, such as Fields of the Nephilim and Empire Hideous. There’s something about music that hits the big emotional themes in life that I find uplifting. It provides a great soundtrack for my trading.

Eddie: Yeah, last night I downloaded some VNV Nation and played on the way to my kids' school open house...a nice change of pace from the smooth jazz I sometimes listen to!

Brett: One of my great musical inspirations is Myke from Empire Hideous and Bronx Casket Company (also former lead singer for the Misfits after Danzig left). He might be the only one who outdoes Rammstein when it comes to live shows. His book King of an Empire to the Shoes of a Misfit describes his journey through the world of rock. It's a great tale of inspiration, challenge, adversity, and integrity.

Eddie: Many of our readers probably don't know that you're a pretty funny guy. And one of your emails had me falling off the chair the other day. Do you have any stories you want to share right now for this interview?

Brett: Here's one of my favorite true stories when I was teaching in med school. It's a great example of how the answers we get depend on the questions we ask:

A med student was conducting a "wellness assessment" on a patient, running through the standard list of questions. The patient was a cooperative young woman with a history of smoking and a family history of lung cancer. The earnest student, trying to impress the attending physicians who were observing, got to the question: "Do you smoke after intercourse?" The young woman paused, deep in thought. "I don't know," she replied. "I've never checked." Needless to say, the young student did not make that part of the physical exam.

Eddie: (laughs) Brett what can you tell us about the new book you’re writing?

Brett: This one is purely about trading and the markets. My first book looked at the psychology of the trader. This book examines the psychology of markets, and how you can understand markets the way psychologists understand people. I present a number of trading tools and indicators and try to help people think psychologically about markets and trading.

My sense is that we will see a professionalization of trading and traders over time. Already we’re seeing that with graduate programs that specialize in trading, such as at the Illinois Institute of Technology in Chicago and Kent University in Ohio. Traders will need quantitative skills, and they’ll also need to think like behavioral scientists. Having a market feel will always be important, but the day of the college kid hitting the trading floor (or screen) right out of school is coming to an end. My hope is that my new book will make a modest contribution toward the broad education of traders as well as offer concrete trading guidance. That’s my project for 2006--with enough good coffee and music, I’ll get it written!

Eddie: Well, I can tell you one thing, my copy of your current book The Psychology Of Trading got stolen out of my office pretty fast. So you can be sure that I'm going lock up your new book away really fast! Thanks for joining us today, Brett!

Brett: You're welcome!