CHAPTER 1

The Power of the Gut

“The intuitive mind is a sacred gift and the rational mind is a faithful servant. We have created a society that honors the servant and has forgotten the gift.”
—Albert Einstein

George Soros, one of the greatest traders alive, trades from the gut. He has widely remarked on the correlation between his backaches and trading choices. In the autobiographical Soros on Soros, he wrote:

 I rely a great deal on animal instincts. When I was actively running the fund, I suffered from backache. I used the onset of acute pain as a signal that there was something wrong in my portfolio. The backache didn’t tell me what was wrong—you know, lower back for short positions, left shoulder for currencies—but it did prompt me to look for something amiss when I might not have done so otherwise.

Some traders might scoff at the idea of making decisions based on “feelings” or intuition. They see the trader’s role as one who remains calm and collected, rationally choosing the right course while those around them are tossed about by their emotions. They believe that Soros is either lying or fooling himself. They don’t see how gut instinct can help. Yet many successful traders feel otherwise. Who is right? Is one approach better than the other?

If you are one of those traders who doesn’t believe that gut instinct or intuition has any place in trading, I invite you to keep an open mind. I, too, once felt as you did. After all, I was trained to take a very systematic and logical approach to trading as a Turtle. I believed that it was important to keep your emotions in check. I ­didn’t believe in trading from the gut.

Trading from your gut is a way of tapping into the extra power of the right hemisphere of the brain.

What I didn’t realize at the time, however, is that there is a big difference between trading emotionally and trading from your gut. Trading emotionally means reacting to fear and hope, which can destroy your trading decisions. Trading from your gut is different. It is a way of tapping into the extra power of the right hemisphere of the brain, which can be a powerful, effective, and entirely rational addition to any trader’s repertoire.

Trading comes naturally to some people, as it does to Soros or my trading mentor, Richard Dennis, for example. They seem to have a knack for it that comes from a well-developed sense of intuition. This gut intuition can be developed through training and the right kind of experience. In this book, I teach you how to incorporate expert-level gut instinct in your trading.

Before I go further, it is important to further define exactly what I mean by intuition and gut instinct.

Intuition

In mid-November 2007, when the Dow Jones Industrial Index was above 13,000 and the S&P 500 Index was above 1,450, I attended the Trader’s Expo conference in Las Vegas, Nevada. The Trader’s Expo is the largest trading conference in the country; people come from all over the western United States to attend the conference. I had been invited to speak at the conference in conjunction with the publication of my first trading book, Way of the Turtle.

While I was at the conference, I was asked to do an interview with MoneyShow.com, which had set up a video recording studio in one of the conference rooms. The interviewer asked me what I thought of the markets over the previous several weeks. Normally, my standard response is that I don’t try to predict the markets. I had grown weary of giving advice and had found that specific advice is not generally useful to others when not considered in context.

This time was different. I decided to go out on a limb and advise that viewers be very cautious in their stock investments. I told them that I thought there was a higher than normal chance that the markets would go down a significant amount, that we were coming off a long period of steady gains, and that there was a good chance we had seen the end. The timing was prescient. It turned out to be the beginning of the downturn that would see the market lose more than 50% of its value over the next 16 months.

You may think my instinct had told me that the market would soon decline. This is only partially true. I thought the market was risky at that moment, for some very specific reasons that had nothing to do with my instinct as a trader. Where my intuition came in was in breaking my longstanding rule not to talk about what I thought might or might not happen. I just had a feeling that this time was different, that I should voice my concerns.

If you asked me, I could probably come up with some reasons I felt obliged to share my thoughts on the direction of the market, but these reasons would be somewhat contrived. The truth is, I didn’t really know why I spoke up; I had an intuition, a gut feeling, but one without a logical basis that I could readily articulate. In fact, the rational side of my brain was arguing for me to keep quiet because I knew that predicting market movement was a fool’s game. In ­retrospect, I hope that sounding this early warning benefited the traders who saw the video.

Using Gut Instinct: Left Brain Versus Right Brain

Relatively recent advances in psychology and neuroscience show that human intuition can indeed serve as the basis for powerful rapid decision making. Our brains can make decisions using thousands of individual inputs almost instantaneously. This type of rapid parallel processing occurs in our right-brain hemisphere. Because of the speed of the right brain, it can be a powerful tool in the hands of an experienced trader. Unfortunately, too much reliance on an untrained gut can prove disastrous for the inexperienced trader. This makes proper training very important.

Analysis, linear thinking, ordering, and the need to find structure dominate left-brain thinking. We try to make sense of the world with our left brains and bring order to it. We categorize, theorize, rank, and file with our left brains. When you think out loud, you are using your left brain. Put another way, when you think consciously, you are using your left brain.

The right brain, in contrast, is concerned with the whole picture and the spatial relationships between each of its parts. The right brain is quick and intuits instead of reasons. If you’ve ever felt uncomfortable or unsafe but couldn’t pin down the reason, this was your right brain’s sense of intuition generating that feeling. The right brain excels at reading patterns and interpreting their meaning in the context of a larger picture, and it moves much more quickly than its counterpart.

 Although the right brain can quickly come to a conclusion or recognize danger, it cannot generally explain the reasons why it has arrived at that conclusion.
This speed comes at a price. Although the right brain can quickly come to a conclusion or recognize danger, it cannot generally explain the reasons why it has arrived at that conclusion. This often puts it at odds with the left brain because that analytical part of the brain wants explanations for its decisions.

To better understand how the right brain works, it’s worth looking at the processes embedded in neural networks.

The Artificial Brain: Neural Networks

In the 1970s and 1980s, researchers in computer science attempted to re-create the brain’s function using simulated neurons connected through computer software. They created the first artificial neural networks. As research in neural networks continued, this technology proved to be excellent at recognizing patterns. However, the downside of neural networks was the same as that of the right brain and the speed at which it arrives at conclusions. Neural networks can rapidly reach conclusions, but it is impossible to examine a neural network to understand the assumptions it is drawing from.

The right brain works a lot like a neural network. It draws upon experience to reach suppositions, but we generally don’t know the reasons for those conclusions, except as a feeling. So if the left brain wants to explain and the right brain cannot offer explanations, which side wins in a battle of decision making?

The answer depends on personality.

Thinking Versus Feeling: Can’t We All Just Get Along?

Psychiatrist and pioneering psychologist Carl Jung developed a theory that measured one’s personality in three different areas. In each area, individuals had a personality that fell somewhere on a continuum between one extreme and the other. One of these is a continuum between thinking and feeling; scores on a test of this personality aspect measures the extent to which the right brain or the left brain dominates decisions.

Isabel Briggs-Myers and her mother, Katharine Cook Briggs, subsequently developed Jung’s work. Their work has been popularized as Myers-Briggs personality types. The Thinking and Feeling axis (generally abbreviated as T or F) of the Myers-Briggs test is often equated with rational decision making and emotional decision making. Sometimes those who make decisions using their left brains (the T’s) look at those who make decisions with their right brains (the F’s) and think that the F’s are being unreasonable when they cannot explain exactly why they make particular decisions.

Most schools are geared toward developing and training the left brain. Math, science, reading, writing, and rote memorization are all left-brain activities. This emphasis leaves some would-be traders with a relatively overdeveloped left brain and underdeveloped right brain.

A balance between left-brain analysis and right-brain intuition is critical for optimum trading.

A balance between left-brain analysis and right-brain intuition is critical for optimum trading, so training must overcome any disparity a trader has in his cerebral development. Every trader has a dominant hemisphere, but recognizing the nondominant hemisphere is also important, especially if this is the right brain.

The Two Trading Camps

Consider another way in which the fight between the left and right hemispheres affects trading, in the ideological battle between discretionary (gut) and system (left-brain) approaches. The trading world is divided into two fairly distinct camps. The largest camp consists of traders who consider trading an art, those who are called discretionary traders. A smaller group consists of traders who use a specific set of rules to make their trading decisions. These traders are known as system traders.

Often when traders first meet each other, they ask if the other trader is a discretionary or system trader. For most successful traders, the answer is rarely black and white, because trading styles generally fall on a continuum between the purely intuitive discretionary trader and the purely rule-oriented system trader. Individuals who think of themselves as discretionary traders range from shoot-from-the-hip traders who buy and sell when it feels right, to more methodical traders who use combinations of chart patterns and mathematical indicators to trade only when a set of conditions have been met. Investors who think of themselves as system traders range from traders who use such a ­specific set of rules that they can be programmed into a computer, to those who use a loose set of rules in combination with their own ability to recognize certain patterns and market conditions.

The best discretionary traders tend to be right-brain dominant, using their intuition to decide when to make trades. This tendency is especially prominent among discretionary day traders who look to profit from small intraday price movements. For these traders, the speed of their decision making is often a critical factor if they are to be successful. They might describe their approach as having a “knack” for the market or a “feel” for the direction of the market.

Left-brain traders know exactly why they put on certain trades. They generally have a very specific set of criteria that must be met before they initiate a trade. In contrast, purist right-brained traders, who use their intuition almost exclusively, often don’t understand exactly why they make certain trades; they just know when a trade feels right. This willingness to relinquish decision making to intuition or gut characterizes the hard-core right-brain trader.

System traders are most often left-brain dominant. They use a rational, systematic process to decide when to make trades. They often analyze their approach using computers to perform “what-if” analyses using historical data to determine the hypothetical results their trading methods might have earned in the past, a process known as backtesting. Left-brain traders don’t trade on their gut or intuition; they trade using rules and strategies. These traders often think in terms of signals and triggers, as specific events that determine when to initiate a particular trade. Systems traders will have identified these specific criteria earlier, when they performed their backtesting and historical analyses.

Whole-Brain Trading

After reading my first trading book, Way of the Turtle, which lays out a very rational approach to trading, some readers might think that I believe left-brain trading is better or more valid than intuitive right-brain trading. I don’t. Even though I got my trading education as a Turtle in a tradition that stressed a systematic approach to trading, I see plenty of value in the right brain’s ability to quickly process lots of information to arrive at an intuitive conclusion. In short, both approaches have merit.

Whole-brain trading involves both hemispheres and is a balancing act between the brain’s two primary types of cognitive function: logical reasoning, and intuitive feelings and impressions. The blend of right brain and left brain depends on the type of trading you are involved in. For extremely short-term trades, relying on the right brain is often the only practical approach. Traders simply do not have enough time to perform complicated analysis. Traders who are scalpers must trade mostly using their right brains. For longer-term trading, traders have plenty of time for analysis. Getting historical data for performing this analysis also is relatively easy. Therefore, longer-term trading is very suitable for the left-brain trader. Swing trading, in which trades are kept for a few days or a few weeks, is best addressed with whole-brain trading. Generally sufficient time exists for performing an analysis, but the data and tools available to the typical trader do not generally permit a completely systematic approach such as one might use for long-term trading. For this reason, whole-brain trading is virtually required for effective swing trading.

In this book, I show discretionary traders how to strengthen their intuition and gut instinct and how to incorporate analytical tools that systems traders traditionally use. I also show systems traders how to use many of the tools and techniques that discretionary traders use, to develop more robust trading methods. My approach to trading, and the philosophy that I share with you in this book, is what I refer to as whole-brain or whole-mind trading.

Mastering the Art of the Trade

To become a master trader, to be able to intuitively make good decisions, you must first gain enough of the right kinds of experience. This is why doctors and nurses go through extensive training and supervision when they are new to the profession. It is why firefighters train in fire simulations, and why airline pilots train in flight simulators. Through this constant exposure and consistent practice, experts build up a library of experiences that they can draw upon when making decisions.

To become a master trader, to be able to intuitively make good decisions, you must first gain enough
of the right kinds of experience.

The same holds true for the trader—the most effective training is trading itself. In this way, the experiences you encounter while trading train your intuition so that, in time, you can become an expert. Learning as a trader can be difficult, however, because of the price of mistakes. In trading, mistakes cost money. Fortunately, traders can develop their intuition to a high level of expertise without having to put their money at risk. I discuss several strategies for doing this in upcoming chapters.

Before I lay out these strategies, it is important to understand the pitfalls and dangers of relying on gut feeling and intuition if you have not yet received proper training. In the hands of a novice, gut instinct can be dangerous to your account balance. In the next chapter, “The Purpose of Gut Intuition,” I cover this important topic.