Gildan Media, a division of recorded books presents The Laws of Trading, A Trader's Guide to Better Decision Making for Everyone by Augustine Lebron. Narrated by Timothy Andres Pobon. Limit of liability, disclaimer of warranty. While the publisher and author have used their best efforts in preparing this book, They make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to, special, incidental, consequential, or other damages. Forward by Aaron Brown. As old and as true as the sky. Both laws and trading are older than human history and older than humans. Back in 1894, Rudyard Kipling documented the laws he observed among wolves in the jungles of India. 4 of Augustine's 11 laws can be found among Kipling's 1st 6 stanzas. The law for the wolves. Rudyard Kipling, 1865 to 1936. Now this is the law of the jungle, as old and as true as the sky. And the wolf that shall keep it may prosper, but the wolf that shall break it must die. As the creeper that girdles the tree trunk, the law runneth forward and back. For the strength of the pack is the wolf, and the strength of the wolf is the pack. Law 9. Wash daily from nose tip to tail tip. Drink deeply, but never too deep. Law 2. And remember the night is for hunting, and forget not the day is for sleep. The jackal may follow the tiger, but cub, when thy whiskers are grown, remember the wolf is a hunter. Go forth and get food of thy own. Law 1. Keep peace with the lords of the jungle, the tiger, the panther, the bear, and trouble not Hathi, the silent, and mock not the boar in his lair. When pack meets the pack in the jungle, and neither will go from the trail, lie down till the leaders have spoken. It may be fair words shall prevail. Law 3. Jungles are places of sparse natural resources and the densest and most diverse life of any ecosystem. Everyone knows there is a law of the jungle and agrees what it is. Deserts are places of sparse natural resources and sparse life. Law of the desert is a less familiar term with many different meanings. We don't have a common law of the forest, law of the prairie, or well known laws for any other environment. Not only did you know that there's a law of the jungle, you also knew that it has a lot of overlap with the laws of trading. But why? Laws become important when a dense and diverse population competes aggressively for scarce resources. Deserts don't need as many laws because there are fewer individuals and species to interact. When there is plenty for everyone, there are fewer conflicts to resolve. But laws of the jungle and trading were not made by humans or wolves. They are the product of evolution. The wolf that shall break it must die. The trader that shall break it must fail and find other work, usually going on CNBC to give trading advice to others. These are not traffic laws with vines for those who break them and are caught by humans. They are not Newton's laws of motion woven into the fabric of nature. These are laws because everything contrary to them no longer exists. Another way to express the same idea is that the jungle and the trading market only exist due to their loss. Without the law of the jungle, the jungle would be a desert. Without the laws of trading, financial markets would be replaced by what John Law described as the state of barter back in 17 o 5. Money and trade considered with a proposal for supplying the nation with money. This state of barter was inconvenient and disadvantageous. 1, he who desired to barter would not always find people who wanted the goods he had and had such goods as he desired in exchange. 2, contracts taken payable in goods were uncertain for goods of the same kind differed in value. 3, there was no measure by which the proportion of value goods had to 1 another could be known. In this state of barter, there was little trade and few artsmen. The people depended on the landed men. The landed men labored only so much of the land as served the occasions of their families, to barter for such necessaries as their land did not produce, and to lay up for seed and bad years. What remained was unlabored or gifted on condition of vassalage and other services. The losses and difficulties that attended barter would force the landed men to a greater consumption of the goods of their own product and a lesser consumption of other goods. Or to supply themselves, they would turn the land to the product of the several goods they had occasion for, though only proper to produce of 1 kind. So much of the land was unlabored. What was labored was not employed to that by which it would have turned to most advantage, nor the people to the labor they were most fit for. Augustine makes similar points in more modern language when he defines financial markets as places with standardized products, many and heterogeneous participants, and low transaction costs. And people can try to create these qualities and they often do, but they fail unless they attract traders who know the law. And traders make markets. Markets don't make traders. While the laws of the jungle and trading can seem harsh to outsiders, Augustine reminds us that they are essential to prosperity. We may enjoy the austere beauty of the desert, but if we want the planet to support many billions of diverse people in comfort and freedom, we need the hyper efficient use of sparse resources we find only in jungles and financial markets. We may have romantic feelings about simple, self sufficient villages of organic farmers and craftspeople organized for mutual support, but that lifestyle is profligate in resources, something only the richest 0.1% or so of the population could ever afford. I would add only 1 thing to the excellent advice in this book. Augustine is a traitor to the core of his being and insists his laws are valid for all kinds of decisions outside financial markets. I agree with him that the laws of trading apply everywhere. But if you're not actually trading or in a jungle, there are other laws that can apply as well. Consider his example of choosing whether or not to jaywalk. Some trading laws are useful, such as law 7. If your costs seem negligible compared to your edge, you're wrong about at least 1 of them. Law 4, put on a risk using the most liquid instrument for that risk. Law 3, take only the risks you're paid to take. Hedge the others. 1 of the costs of jaywalking is constantly monitoring traffic for opportunities which may eat up more attention, missing out on productive thinking time, or tripping over obstructions in the sidewalk, then your average time savings are worth. If you are going to jaywalk, choosing a liquid opportunity, such as 1 with a median strip that allows you to change your mind halfway across the road, is smarter than an illiquid 1. Make sure that a successful jaywalk will actually save you time and not, for example, just get you sooner to a place to wait for the same traffic light or underground train. But there's a reason we have traffic laws. You must consider those as well. Look both ways before crossing the street. Wait for the light. Cross at the crosswalk. Keep to the right except to pass. Not only help keep you safe, they help all traffic flow as quickly and safely as possible. When you jaywalk, you may or may not be making a good trade of survival for prosperity, but you also should ask if your strategy would make you and everyone else less safe and fast if universally adopted. The laws of trading are all you need in places of dense competition

Where efficiency is of great importance. Outside those domains, the same ideas apply. But don't forget there are other laws as well. Not just the kind that can put you in jail, but the ones that guide you to treat others as you would have them treat you. I predict this book will quickly become a minor classic. By that, I mean a book that will not hit the best seller lists, but that as you go through life, you will find that it has been read by most interesting people you meet who care about trading, risk taking, economics, or decision making, and that you will recommend it enthusiastically to the rest. Minor classics are short, clear, easy to read distillations of centuries of experience filtered through the logical brain of expert practitioners. Now these are the laws of the jungle, and many and mighty are they, But the head and the hoof of the law and the haunch and the hump is obey. Introduction. It's Monday, 02/24/2014. A trader at this point in my life, my job is to buy and sell securities on financial markets around the world and to do that profitably. Markets in London open at 8AM, so that's when my trading day starts. Today is going to be an interesting day since on Saturday, the Ukrainian parliament decided to remove its president from office. Trading is always busy after big news like this happens. And yet, if I think carefully, I can count 10 different trades that I did before markets even opened. 1, I got out of bed and went to work. 6AM is early, but I traded away a bit more sleep and a relaxing day off in exchange for the wages I'm going to be paid for my work. 2, I wore the heavier jacket. It would have been nice to find the thinner 1 in this unseasonably warm weather, but the risk of rooting around in the closet and waking up my wife was too great. I traded some comfort on the way to work in exchange for a smoother home life. 3. On the walk to the underground station, I got a notification that the old golf clubs I had put up on eBay had finally sold. I'd rather have the extra money than a backup set of old irons anyway. 4. When I saw a gap in the traffic, I decided to jaywalk in the middle of the block, saving myself somewhere between 2 and 30 seconds of waiting at the corner for the light. I bought those seconds with, a, the small risk of injury or death if I had misjudged the cap, and, b, the even smaller risk of getting a ticket. 5. I swiped my oyster card at the station, exchanging some hard earned money for the right to board the underground to work. It's entirely too far to walk, and taking a cab would be more expensive and likely slower too. 6. As the train came, I noted how full it was. I like to position myself so that I board the car that will be closest to the escalator at the arrival station. But this time, the train was busy enough that I probably wasn't going to get a seat if I boarded the optimal car. I moved 1 car over, trading those precious jaywalking seconds for a higher chance at getting a seat. 7. A few stops from my destination, a woman with a baby on board lapel button got on. I saw another man start to move, but I got up faster. I won the trade, giving up my comfortable seat in exchange for a smile, a warm feeling, and the social approval of a few random strangers. 8. Since it was the last Monday of the month, it was my turn to get coffee for my trading desk. The purchase was obviously a trade, but the fact that I bought coffee when I don't even like it is another 1. Better to create and maintain a good esprit de corps even if it means a small delay and a small expense for some smelly liquid I won't be drinking. 9. As we were setting up the systems for the day, my junior asked if we could confirm the vacation schedule. We can't both be out on a trading day, so we traded a couple of vacation days back and forth until we were both happier with the result than before. 10. At 07:57AM, I noticed that I would like to go to the bathroom before markets opened, but I judged the chance of missing the 1st few seconds of the opening was too high. So I traded away some small avoidance of discomfort in exchange for guaranteeing being at my desk as the opening bell rang. So there you have it. 10 trades, all done before any of the thousands of trades that constitute my real job as a trader. I bet you could come up with a similar list of decisions evaluating risk and reward, and that makes you a trader as well. What is trading? Trading is the act of buying or selling, and it's everywhere. Straight out trading has been occurring since before the beginning of recorded human history across continents and cultures. It comes naturally to us, and we start in an early age. Even children barely able to talk are able to negotiate complex futures trades with their siblings, ensuring a steady supply of just the right legos for their creations. All of our relationships involve trading at some level, even if that trade isn't monetary in nature. As you saw on my walk to work, we sometimes trade our time, our comfort, even our sleep in exchange for other things of value. You may not keep an explicit ledger of those trades or even realize you're making them, but you are. And when a relationship becomes too one-sided, like a friend who never calls or a cousin who always needs a favor, your trading instincts kick in, and you reevaluate the social trades you're making. The laws of trading apply to these implicit exchanges just as much as they do to the trades I make in financial markets every day. Now if trading is so common, then what's so special about trading on financial markets specifically? It is worth remembering that these sorts of markets are a relatively recent invention. Government debt began to trade in Venice in the 13th century, and common stock began to trade in Amsterdam in the 17th century. Commodity futures markets also organized themselves around the same time, and as it turned out, the innovations embedded in these markets were so useful that the ideas quickly spread. This eventually gave us the present day smorgasbord of organized financial markets, and the influence of these markets keeps growing even today. In the past 10 years, the world has seen a great deal of innovation in business models such as Google, Uber, and Airbnb based largely on the ideas that have been driving financial markets forward for the last half century. Yet for many people, possibly including you, financial markets often seem impenetrable and opaque. For 1, the finance people in suits like to act important just like anybody else. Add the tendency to overuse jargon, bulls, bears, shorts, and longs, and it's clear that trading deserves some of its reputation for impenetrability. But this lies in the face of the fact that we're all natural born traders, So there's no good reason for it. The 11 laws of trading I present in this book are distilled from my own experience, learning from and working with some incredibly sharp minds. The laws themselves aren't exactly my own invention. Versions of some of them can be found in the great works of literature from Macbeth to Alice in Wonderland. I had a vague sense of them even before I started trading, and you may read them in the table of contents and say, I know that. This trader is willing to bet that you don't. Not really. Learn from my experiences as a trader, from my many mistakes and occasional successes. In so doing, you'll learn to apply these laws successfully in finance or anywhere else, even walking across the street. Why study trading? Considering the universal role of trading in human affairs, it's shocking how easily it's misunderstood. Even educated people can be seduced by the view that trading is a 0 sum game, where 1 person's win is their counterparty's loss. But in order to have functional markets in the long run, the opposite of this assumption must happen. If trades were a 0 sum pursued, over time, markets would wither and die. In fact, in nearly every trade that takes place in modern financial markets, both parties to the trade are better off for having made it. Pension funds invest in stocks by trading with market makers. Farmers hedge their crop risk by trading futures against speculators, and both sides are happy to have done the trade. Over 240 years ago, Adam Smith published The Wealth of Nations, a study that describes in great detail and with piercing clarity the ways in which trade makes both parties better off. The majority of his examples center on labor markets and how specialization and division of labor emerge from trade between people. But the principle that trading makes both parties better off applies much more broadly.

This very persuasive view is the key mechanism through which countries' economies grow and people prosper. And yet, though trade as engine of progress is as close to scientific fact as is possible in the social sciences, the myth of the 0 sum trade persists. This belief is actually reinforced every time there's a financial crisis, which according to many, once again proves that financial markets are a drain on our modern societies. Incredibly, this happens despite the fact that everyone knows buying and selling food so that we don't all have to grow our own wheat, for example, is good for the world. This may be obvious to a large portion of the population, but time and again, I hear that it is obvious that the securitization of mortgages, for example, is bad for the world. This misguided view is apparently compelling to many, so it's necessary and important for us to understand more thoroughly how trading actually happens, especially in financial markets, and to reconnect again with the great benefits that result. I see trading as practically a human universal and a powerful force for good. But 1 of the arguments of this book is that trading, especially on financial markets, is an activity where you can develop useful mental tools for dealing with a wide variety of situations. The ability is to perceive the competitive world accurately, to understand risk and uncertainty, and to register both our motivations and those of the people around us are critically important for making good rational decisions and hence profitable trades. As you will see, these mental tools forged in the competitive fire of financial markets help us make good decisions in all other areas of life, from buying a new car to finding a new job. The principles behind good trading teach us how to make better decisions in all sorts of situations. What are financial markets? Financial markets are the different sorts of markets you hear about when you turn on CNBC. Stock or shares or equity markets, commodities markets, foreign exchange, and many others. We can and do talk generically about the process of trading, generalizing across many financial markets because these markets have certain common characteristics as follows in roughly decreasing order of universality. 1, standardized products. Let's consider the market for shares of Apple Inc, denoted by the symbol AAPL, which relies on the fact that all AAPL shares are the same. This is unlike the market for used cars, for example. Everyone agrees on what 1 share of AAPL means, and there's no chance of either buying a particularly good share or getting stuck with a bad share. The interchangeable nature of stock shares is in fact a property of all products that trade on financial markets worldwide. A case in point, the crude oil price that you read about refers to a very specific kind of crude oil that's delivered at a very specific time and place. Everyone has agreed to trade crude oil under those specific conditions, and this standardization is a key reason that financial markets are as liquid, goods quickly bought or sold, and pervasive, quickly spreading as they are. Liquidity will be discussed extensively in chapter 4. 2. Many participants. At any given time during market hours, there are probably a dozen entities willing to buy AAPL shares and another dozen or so willing to sell AAPL shares. If 1 looks at the totality of trades over a given day, there are probably thousands of different individual entities who transacted in AAPL. This high availability of trading partners, counterparties, is another defining characteristic of financial markets. 3, heterogeneous participants. Classifying participants into categories by organization, retail investor, pension fund, hedge fund, investment bank, market maker, etcetera, or by function, investor, speculator, hedger, indexer, you find there is an immense variety of people who are active in financial markets. While this is less true in more uncommon products, such as institution to institution swaps, for example, it's still much truer than in the market for a new car. In that market, if you wanna buy a new Honda, you must buy it from 1 of a small number of local Honda dealers. The seller is the same or virtually the same, and the buyers are nearly all people who wanna buy a Honda to drive themselves. 4, low transaction costs. The ease and low cost with which investors, even retail ones, can trade in financial markets is phenomenal, and it's improving all the time. Buying $500,000 of the SPY ETF would cost a sophisticated investor less than $20 in fees and spreads, and a retail investor not significantly more than that. Compare that to the process of buying an equivalently priced house with its seemingly endless agent fees, escrow fees, legal fees, and significant time cost. Buying a car is little better in percentage terms. Think of the dealer fees and the hassle of having to repeatedly state you don't want the rust proofing. In fact, buying half $1,000,000 of SPY probably costs less than buying a hammer at Home Depot once you factor in all the costs, time, taxes, store profit, gas to get you to the store, and so on. Lesser known products such as options do carry higher trading costs, but even these costs are quite low when compared to their high volatility competitors. Betting on good AAPL earnings by buying some upside call options, more on this later, is significantly cheaper. And until very recently, considerably more legal than going to a bookie and betting on your team to win the Super Bowl. While not all of the characteristics are true of all financial markets, they're general enough that the rare exceptions will be noted when they're relevant. Vested interests. In most of the developed world, operating in markets like the ones described is straightforward, even for people with no prior knowledge of trading. It takes less than 15 minutes to open an account at a retail brokerage and around a day to fund it. Once funded, a few clicks on a website are all that separate a fresh faced investor from a shiny new position in any of thousands of possible financial products. But which products? Buy, sell, what price? These are not easy questions, and they're not made any easier by the fire hose of data and opinion sprayed out by financial markets every day. Remember the saying, a fool and his money are soon parted? Well, predictably, this overload of information has given rise to a huge industry of professionals who make it their business to usher us through the maze of financial markets. Many, if not most, of these helpers are well meaning professionals who genuinely try to help their customers. Still, they do have an incentive to make the world of investments in trading seem more complicated than it actually is. These facilitators come in a few broad categories. 1, investment manager. Managers take on many forms. Most visible to the retail investor are a, the portfolio managers of the actively managed mutual fund into which retirement savings are frequently invested, and b, the personal investment advisers who banks and brokerage firms provide for retail clients. Creating a cloud of complexity helps hide the fact that the vast majority of these investment managers provide no value. In fact, their value is almost universally negative value once you subtract the inevitable and often hard to find fees. 2, broker. Since the advent of online and low cost retail brokerages, e trade and the like, most people no longer deal with a human whose job title is broker. Nevertheless, the economics are the same as ever. The more you trade, the more they make. It's certainly not clear how retail clients get value from up to the millisecond trade data, research, phone calls, so called robo advisers, and ever changing trade recommendations. Naturally, people will trade more than they otherwise would, and in this way, pay more broker fees than they probably should.

3, financial press. Shouty CNBC analysts love to explain the world of trading by providing a meaningless narrative, after the fact, of course, behind the random movements in the prices of securities. Human brains are suckers for a narrative. This keeps people watching and keeps advertisers, such as the aforementioned brokerage houses, happy. 1 of the main arguments of this book is that these segments of the financial world mostly provide a disservice to the retail investor to the extent that considerable attention is paid to them. Of course, willful over complication isn't exclusively a phenomenon of the financial world. Wherever there is opportunity for someone to filter information, as well as an incentive for them to do so, it pays to be wary. Are real estate agents always acting in your best interests? What are the downsides of that 1 year gym membership contract? How can you get a good deal on health insurance? This book will provide you a set of tools and ways of thinking that will help you identify poor arguments, cut through over complication, and ferret out hidden self interest. What makes trading such a wonderful world in which to learn these tools is not just how intrinsically useful they are while trading, but also how frequently you need to use them. Once you know how to use them well, these mental tools will help you outside the world of trading and financial markets and all those situations where we have to make good, reasoned decisions. Who this book is for. I hope that the examples, arguments, and analysis in this book will appeal to a wide variety of readers. Those interested in a career in trading or more broadly in finance, It is exceedingly difficult for outsiders to get a good sense of what goes on in investment banks and trading houses. That is why lifting the veil should help prospective traders understand if this is a career for them. Interested outsiders for the same reasons. Much ink has flowed recently on subjects surrounding trading, and the vast majority of the writing has been done by people who are clueless about what goes on in the trenches. Retail investors, whose need for reliable information about financial markets is the greatest. Almost always, the most useful trading tip for retail investors is do less. And this book aims to explain why, a, that's so difficult, and yet, b, so critical. People whose job it is to make rational decisions. Management broadly considered as the job of making good decisions under uncertainty. The ideas and techniques in this book can help people think about those decisions more clearly and powerfully. People who work in trading adjacent markets whose numbers have exploded in the last decade, Areas as diverse as advertising, power generation, and even the new gig economy require a good knowledge and understanding of trading concepts in order to be navigated safely and profitably. Rationalists, and indeed anyone interested in the process of making rational decisions. Since decision making is the essence of trading, financial markets are the most competitive cauldron in which to test ideas about how to make decisions. People who make financial decisions, I e, virtually anyone, the world of trading provides a clean venue in which to learn about quite universal thought processes useful in any financial decision. Whether it's buying a car or a house, figuring out where to live or looking for a job, the world of trading has much to say about how to think about important decisions. What this book will not do for you and what it will. This book will not teach you specific trades that make money, nor will it teach you how to create such trades, at least not directly. Moreover, it will not teach you about specific trades that don't make money. It will become clear that any book that purports to provide this sort of specific information, a, doesn't. And even if it did, b, wouldn't be particularly valuable over the long term. What I'm after is a set of ideas that lets us figure out if and how a trade makes money. This allows us to go for the trades that do make money and not so much for the ones that don't. Understanding the world of trading and how to think about it provides a valuable set of mental tools that have far reaching applications. Anyone who loves markets and understands the way in which they make the world a better place should wanna see the tenants that underpin it spread more broadly. There's a lot of inefficiency in the world, and there are many people who earn a living without providing much value in return. Hopefully, this book will help you learn how to spot these inefficiencies wherever they may lie, and to use a technical term, to arbitrage them out. A succession of small improvements can make the world a better place. Why laws? Ideas and tools are only useful if they're available when needed. This book is organized around the principle that remembering a few pithy laws and key points makes it easier to keep these tools accessible in daily life. Thus, the goal of this book is to present a few simple, memorable laws based on observed and documented facts that help us think about trading. As I've said, trading ends up serving as a useful case study for a wide range of decision making processes that at some point in our lives, we all have to engage in. Thinking about these laws of trading and internalizing their lessons will help us think about all sorts of decisions. Carrying around this mental utility belt of ideas, always at the ready, will make you a formidable trader and decision maker. I'll begin the story with the most important person involved in the trades you do, yourself. It turns out that understanding your own motivations and how they affect your actions is more difficult and confusing than you could ever believe. Chapter 1. Motivation. Know why you are doing a trade before you trade. Why are you trading? David, a well-to-do dentist, is settling into his home office on a Friday morning. He usually takes Fridays off from work. In the morning, he likes to trade stocks, and in the afternoon, he plays golf. David has CNBC on the TV in the corner, and he settles in to read The Wall Street Journal and Feet Alphaville. He mostly likes to bet on quarterly corporate earnings announcements, usually by trading short dated options. David's wife, Rachel, comes into the home office. Rachel, going to pick up some things at the supermarket. Want anything? How are things going by the way? David, good. Earning season is heating up. Got a good feeling about some of these picks I've made. Rachel, how have you been doing so far this earning season? David, I made a couple of good calls yesterday. Decent. Nothing like that awesome streak from last year, but pretty good. Rachel. So you're making money? David. Look. There's a lot of variance, so it's hard to say for sure. What I do know is that when I get in the zone like I did those couple of weeks a year ago, I make all the correct calls. It's like Neo from the matrix. Rachel. Neo traded options. David. No. He didn't. But when he got in the groove, time slowed down and he couldn't miss. That's how it feels when you're trading and you're feeling it, like you almost can't lose. Rachel. Can't lose? I thought there was a lot of variance. David. You just don't get trading. Shouldn't this chapter be short? If people were perfectly rational, profit maximizing, highly capitalized entities, This chapter would be quite short. Why are you trading? To make money. But the real world is more complicated. Even if we were perfectly rational profit maximizers, there would still be very good reasons to trade other than to make money. For example, when you buy home insurance, you know, and in fact, that the expected value of that transaction is negative. However, you buy the insurance anyway because it decreases the risk of a huge loss if your home ever goes up in flames. You are said to be hedging your home loss risk, and it's perfectly rational to do so. When we cover this idea in detail in chapter 3, you will learn that the quantity you want to maximize is not profit but utility, a sort of risk adjusted notion of wealth. So are people who trade in financial markets motivated by utility? In a trivial sense, anyone can answer yes after the fact, Much like a child who trips and falls and says, I meant to do that. Utility is what we claim it is. But

Are complicated, and perceived utility comes in many forms that differ from actual utility. In fact, as described in great detail in various recent works, especially Daniel Kahneman's Thinking Fast and Slow, humans are an unreconstructed bag of cognitive biases that cloud our judgment of utility. There is a whole field of social science called behavioral economics that seeks to identify and understand all the ways in which we fail to behave as perfectly rational decision makers. And it turns out that by and large, we humans are quite poor decision makers. We underestimate small probabilities sometimes, the chance of getting hung up in traffic and arriving late to an appointment, and overestimate them other times, the chance of dying in a plane crash. We consistently overestimate our knowledge, a cognitive blind spot known as the Dunning Kruger effect, and abilities. Well over half of surveyed people think they're better than average drivers. When suitably framed, we consistently say that a and b occurring is somehow more likely than a only occurring. When we do this, we're violating a basic principle of logic without even noticing it. Many of our motivations, our sources of utility, aren't even about profit or risk adjusted profit. This is obviously true in general, but it's even true within the narrower world of trading. We really do need to examine these trading motivations in detail since they surface most clearly in the world of financial markets, but they can also appear in other trading like contexts. This fact alone should make the following classification of human foibles useful even if you've never dabbled in financial markets. Let's take a tour of the irrationality that characterizes the human mind and the sometimes odd places it finds utility. Greed and fear. Greed and fear are the famous emotions of trading and of financial markets in general. Recall Gordon Gekko in the movie Wall Street or the Duke brothers in trading places and how they were motivated by greed and fear. Many books have been written about these emotions and how they relate to trading, how to mitigate their effects, how to use these emotions positively, how the induced herd like behaviors affect the markets themselves, and many other aspects. There are books and articles that purport to teach amateurs how to think like a pro with respect to these subjects and hence trade profitably. Without casting aspersions on specific works, almost all of these books are worse than worthless. They focus you on the wrong thing. The plain fact is that almost no professional traders think of their work in terms of greed and fear. The profitable trades they've developed, the systems they've built to trade them, and the social environment in which they work are all designed to make these emotions fade into the background. In a highly underappreciated paper from over a decade ago, the authors study a population of traders and correlate their results to their emotional states and personality types. The results show clearly that the traders whose emotional reactions were the most intense were the least successful ones. It didn't matter whether the emotions were positive or negative. It was the fact that these emotions weren't being modulated. Interestingly, the paper also shows that there was no apparent correlation between personality type and success at trading. Thus, the stereotype of the loud, hard charging, aggressive trader is not worn out in the data. All personality types can be successful in principle. Other studies of the emotional reactions to risk taking are found in the hour between dog and wolf. The story is similar. To the extent that trading and risk taking cause emotional reactions, Those reactions generally obscure clear thinking in those high pressure situations. This is not to say, however, that there is no place for emotion in trading. It's that the specific emotional reactions need to be trained just like every other aspect of your approach, and greed and fear just aren't terribly useful. In my own case, I know that I tend more toward the fear end of the spectrum. When I was 1st starting out in trading, I didn't have any real trading authority. I did what senior traders told me to do, learning as I went. But eventually, I got the opportunity to make my 1st real trading decisions. That 1st time I decided to buy those upside call options in Deutsche Bank, I knew intellectually that it was a good decision, but that didn't entirely inoculate me from the fear that I had either misjudged the situation or that the trade would go against me by random luck. There isn't much you can do about that latter situation, but tell that to your amygdala, the gray matter inside your head that experiences emotions while it's happening. Over time, as I got feedback and validation that I was making good decisions, I managed to retrain my emotional reactions into more useful forms. Boredom. Greed and fear are, in the world of trading, 2 extremes of the same emotional continuum. They are emotions related to high activity, winning or losing. Something's happening. But along another axis, we know that the level of activity in financial markets varies greatly. And most of the time, in modern financial markets, not much of anything is happening. Quick. Go Google trading boredom. If your results are anything like mine, the top few results will be articles on amateur trading blogs and websites that try to give people tips on avoiding boredom. Evidently, this is a common problem among amateur traders, as well it should be. And people frequently claim they're getting into trading because they wanna make money. But in fact, the reason is much closer to it gives me something to do, like our friend David at the beginning of the chapter. And often, there really isn't anything to do. The average amateur trader, no matter how prepared or sharp, is not going to find very many obviously profitable trades to do, assuming they're not fooling themselves. The result is long stretches of doing nothing, which is certainly not what they signed up for. The prevalence of articles trying to help amateur traders deal with boredom is all the evidence we need that many people indeed get into trading to avoid boredom. Boredom is probably what brought David to trading in the 1st place. The trading certainly gave him something to do on those free Fridays, and he sunk his teeth into it. He read reports, created spreadsheets, looked at historical data, and slowly built up an earnings based options trading strategy. The problem was, most of the time, the data told him to do nothing. Edge, your technical or strategy advantage over others in the trading arena, is hard to find after all. The boredom returned, and so David started dabbling in other sorts of trading. He wanted a feeling that comes with putting money in play. That feeling is frequently known as the zone. The zone. In the excellent book, Addiction by Design, Natasha Shull takes the reader into the world of video poker and slot machines. She describes the manner in which these machines are designed to take advantage of the predilections and desires of problem gamblers. This subpopulation is targeted specifically because compulsive gamblers are by far the most profitable segment of the gambling public. Particularly interesting is her description of the exact value that is the utility that problem gamblers derive from these machines, especially considering the often significant personal cost of their addictions. She describes in minute detail the fact that these problem gamblers aren't necessarily seeking wins exactly. What they're looking for is a feeling, a sensation of transcendence that playing these slot machines provides. The most common name for this feeling, 1 where time itself seems to melt away, is the zone. Consider Katrina on page 135 of the book. The best scenario is when the free spins have been coming around regularly, and perhaps normal gameplay has been good as well. This is where it particularly feeds into the zone where you can play for quite some time. You can just relax and lose your

Self. There are many other similar reports in the book. This zone that ensnares problem gamblers can also appeal to traders, especially active day traders. When caught in the zone, the goal of active trading isn't to make money. Rather, the motivation is the process itself of making decisions and living in the world of price movements and charts, escaping normal life. Of course, many books and marketers exploit this desire to enter the zone. Consider the highly popular book, Trading in the Zone. The following passage from the preface is particularly telling. While this may sound complicated, it all boils down to learning to believe that, 1, you don't need to know what's going to happen next to make money. 2, anything can happen. And 3, every moment is unique, meaning every edge and outcome is truly a unique experience. The trade either works or it doesn't. In any case, you wait for the next edge to appear and go through the process again and again. Couldn't such a paragraph have just as easily been written about successful slot machine play? It's clear that the focus is not at all on making money, but rather on getting the feeling of making decisions and then ignoring the results. What's important for our friend David at the beginning of the chapter is entering the zone of day trading. Profits really are secondary. Risk seeking. We live in an uncertain world. Whether it's winning the lottery or having a tornado flatten one's house, uncertainty rules our lives. Even everyday activities carry uncertainty. Will I get a ticket if I park in the fire lane for 5 minutes? Will I meet the woman of my dreams if I stay in the library an hour longer? You can think of every single action we take as a decision made to shape an uncertain future. So how do you make these hundreds of decisions a day? Do you carefully weigh all the costs, benefits, and risks? Of course not. Most of the time, you make largely automatic decisions because if you didn't, you'd be paralyzed by this careful weighing process. Behavioral economists call this automatic decision making process system 1, and the more deliberative process system 2. What concerns us in this section is how our system 1 works and how it automatically assesses risks and rewards. It turns out that we all carry deep within us a surprisingly well defined tastes or preference for risk, which we'll call our risk tolerance set point. In a study by John Grable and Abed Rabbani of the University of Georgia, the authors examine the question of whether risk tolerance is a broad based disposition, robust across many domains or whether it's domain specific. Using a large panel dataset from the National Longitudinal Survey of Youth in 2010, they discovered that indeed people's risk tolerance is quite robust across domains. A single risk tolerance factor explains the majority of variation for a variety of behaviors, from everyday risky situations such as smoking to financial and occupational decision making. So if indeed you have a well defined risk tolerance set point, an interesting question presents itself. What if the life you lead has a dramatically different risk profile than the 1 with which you're comfortable? What happens to you and to your decisions? Taking a page from biology, we can theorize a sort of risk homeostasis process. If Janine's life has more risk than she'd like, then she'll avoid additional risky situations in order to seek stability and certainty even if those situations are advantageous. If Leroy's circumstances are overly stable and riskless, we should expect him to seek out risky situations in order to get closer to his natural risk tolerance set point. My own risk set point was exposed when I started trading. Before my career as a trader, back when I was an engineer, I played a lot of online poker. I was good at it, and it evidently filled a need for some randomness in my otherwise stable life. Almost to the day that I started my job as a trader, my desire to play cards for money evaporated. My regular job had plenty of randomness for me, and I certainly didn't need any more. I'd found my risk set point in a different manner. You may argue that's just me, but the best screenwriters in Hollywood certainly believe in risk set points. Classic keeper movies, such as Ocean's 11 and The Italian Job, start with the lead character having just been released from prison. Free from their incredibly boring prison existences, Danny Ocean and Charlie Croker, respectively, immediately set about plotting their next heist. Far from setting them on the straight and narrow, their prison experiences pushed them strongly back in the direction of action of getting closer to their risk tolerance set points. The reason you believe in these characters and that you empathize with them, aside from their matinee good looks, is that you instinctively understand that the high risk lifestyle is fundamental to who they are. You may now argue that that's fiction, but real life provides plenty of similar examples. In the documentary film Free Solo, for example, we follow Alex Honnold as he attempts to scale the 3,000 foot tall granite wall known as El Capitan in Yosemite National Park, California. Rock climbing is already risky enough that most life insurance policies consider it a disqualifying factor, But Honnold goes a giant step further. He scales these massive walls with no ropes or other aids. 1 wrong move, and he would inevitably fall to his death as many of his fellow free solo climbers have done. What rational person could bring themselves to take such extreme risks? The film provides us some answers. An MRI scan of Hanold's brain shows no activation in his amygdala, the fear center. Honnold is, to all appearances, virtually incapable of feeling the sort of fear that would make our system 1 scream to stop a risky activity like free soloing El Capitan. Yet, Honnold has no death wish. He states, believably, that he'd much rather avoid dying. It's just that the only time he feels alive enough to be worthy of the term is when he's taking life threatening risks. You can't argue with your set point. This fact is not lost on the various financial intermediaries we learned about in the introduction. The financial services industry, at least at the retail level, clearly markets itself to affluent people with exactly the sort of language that will appeal to people motivated to seek financial risks. Our friend David at the beginning of the chapter, comfortable but somewhat bored in his comfortable life, is trying to increase the amount of uncertainty in it. It should come as little surprise that trading in high volatility stocks can be an excellent way of exposing yourself to financial risks. While the advertised and perceived goal of trading may be about finding good trades and making money, given what I've learned about risk tolerance set points, it's just as likely to be about finding ways to put money in play to expose yourself to profits and losses. Wanting a big score. We've established that different people's tolerance of risk varies and that it varies in consistent ways. But people's perceptions of the value of a trade vary in equally interesting ways. Consider lotteries. Why are lotteries as popular as they are? They pull in an exceedingly large amount of money. By some estimates, as much as $70,000,000,000 per year in The US alone. What is it about their structure that makes them so incredibly attractive? Consider a bet where you are asked to flip 8 fair coins. If they all come up heads, you win $255, and otherwise, you lose $1. Would you take this bet? What about paying $1 up front to play the following game, flip 8 coins, and if they all come up heads, you win $256? If you're like most adults in modern western society, the 2nd game sounds more attractive than the 1st, in spite of the fact that they're identical in every respect except the wording of the game. By changing the description of a bet, I can change your intuitive or heuristic system 1 perceptions of its attractiveness. Behavioral economists have, over the last 30 years, studied in great detail the ways in which the wording of uncertain outcomes

Affects perceptions. But again, the manner in which the financial industry markets itself to retail consumers shows they understand these effects quite well too. In the 2 examples, you can calculate that your expected profit in the games is 0. Your losses in the majority of cases, when at least 1 tail comes up, exactly counteract the very rare win when all heads come up so that on average, you make no money playing this game. But if I can formulate the game so that the big rare win is more mentally salient than the small costs incurred to play, I will get many people interested in playing the same game, and if I can increase the cost to play by a small amount, say $1.10, then I've created a game that's actually profitable for me, the seller of the game, as well as attractive, though a losing proposition to the buyer. Lotteries are so successful at hacking the human brain's risk perceptions that governments typically claim a monopoly on the right to run them. But financial products with highly asymmetric payoffs like those of lotteries also exist. The most common of these, at least in The US, are options, especially out of the money options. These products have the payoff of small lottery tickets. They cost relatively little. Most of the time, they expire worthless, but every so often, they win. When they do, the payoff can sometimes be a multiple of their original purchase price. For example, let's say Amazon is trading at $2,000. Earnings are coming up, and you bet that they're going to be bad. So you purchase a $1,800 strike put, the right to sell, for around $16. Most of the time, Amazon will not drop below $1,800 upon earnings, and the put will expire worthless. But if Amazon drops to $1,700, then you've made a profit of $100 minus $16 equals $84. It's perhaps no surprise that deep out of the money options are consistently more expensive than their historical probabilities would indicate they should be. All of these products prey on the buyer's desire for a large payoff without exposing herself to a large loss. By hiding the probabilities of the various outcomes and by emphasizing the rare win, you are induced to lose a small amount of money. Aggregated across millions of people and repeat buys, this can be a very profitable business for the seller. As the old poker saying goes, you can shear a sheep many times, but you can skin it only once. Intellectual validation. Financial markets are some of the most competitive environments on earth. What's more, the winners and losers are determined with piercing clarity. Whoever made the money won the contest. Couple these characteristics with the already mentioned low barrier to entry, and 1 should expect a large number of aspirants to the throne of king of trading. In the same way that competitive sports appeal to the more athletic among us, trading appeals to the intellectually competitive. Being able to win at trading implies, in the popular imagination, having a sharp mind, good instincts, and a strong desire to win. The world of trading provides a compelling arena in which to test one's wits. In fact, even a quick perusal of academic literature shows all manner of scientists, mathematicians, economists, and psychologists writing papers purporting to show how to beat some market or other. Invariably, the theories and techniques of the source discipline are applied to financial markets, and attempts are made to show those techniques can be used to make money trading. In the great majority of cases, these papers exhibit fatal flaws, ones which mean they do not contain actual profitable trading strategies. From a distance, they should come as no surprise. If some obscure technique known only to a few algebraic geometers were capable of producing a trading profit, why would these geometers give it away to the world in exchange for a mere citation count? Using trading as a means of intellectual validation isn't restricted to academics, of course. In the same way that poker players find stimulation from playing games above their bankroll and skill level, people who do not have the capital, skills, or information to compete in financial markets try to do so anyway. Their primary motivation is not to make money, but rather to test themselves. If they make money, then that means they've successfully tested themselves. But in any case, the former is a secondary consideration compared to the latter. If I'm being perfectly honest, intellectual validation motivates me more than I'd like to admit. I enjoy reading mathematics and machine learning papers, and I enjoy thinking about ways to apply these ideas to trading. I tell myself that this was an important part of my job, and it was. But a lot of the motivation, perhaps too much of it, was finding a cool mathematical technique to apply to financial markets. It was about the math, not the trade. Why does motivation matter? You may have noticed that a common thread runs through the list. By and large, these motivations privilege a feeling or emotion, and the goal of trading becomes obtaining or satisfying that feeling. We can't say categorically that people are wrong for having these motivations, but to the extent that they are unaware that the true reason for our trading isn't to maximize profit. They're setting themselves up to be exploited by others who, a, do care about maximizing profit, and, b, know them better than they know themselves. Self knowledge, Aristotle tells us, is the most important kind of knowledge. As you've already seen, the world is full of people with varying degrees of scruples about exploiting human frailty for profit. By being aware of your own weak spots, you can more easily navigate these dangerous waters. Let's now restate the rule at the beginning of this chapter. Know why you are doing a trade before you trade. You can now see why such an obvious seeming rule can be so difficult to follow. As you've seen, knowing why can be fraught with danger and self deception because of who you is. Thus, the 1st way in which we should think about the rule is less as a rule about trading and more as a rule about self awareness. Does David the dentist really understand enough about himself to realize that deep down, his trading isn't about maximizing profit? Make peace with your motivations or change them. Let's say you've done a careful mental and emotional inventory and find that much of your motivation for trading and financial markets comes not from a profit motive, but from something else. Typically, this something else is a desire to achieve or change a particular feeling or emotional state. What do you do then? We hope you enjoyed this preview. To continue listening to this audiobook on Google Playbooks, use the link in the video description.