Author: Ivanhoff

I’ve heard from many traders that they often take decisions based on instincts. Actually, all non-quants use intuition in some form or another. If you are not using a program that takes all signals that your system produces, how do you decide between several equally good looking trading setups with similar risk to reward? Do you take them all or do you concentrate on only a few? The odds are that you are doing the latter and your ultimate choice for capital allocation is subconscious.

Even though we are defined by our decisions, we are often completely unaware of what’s happening inside our heads during the decision-making process.

Feelings are often an accurate shortcut, a concise expression of decades’ worth of experience.

The process of thinking requires feeling, for feelings are what let us understand all the information that we can’t directly comprehend. Reason without emotion is impotent.

This is an essential aspect of decision-making. If we can’t incorporate the lessons of the past into our future decisions, then we’re destined to endlessly repeat our mistakes.

Nothing can replace personal experience:

Unless you experience the unpleasant symptoms of being wrong, your brain will never revise its models. Before your neurons can succeed, they must repeatedly fail. There are no shortcuts for this painstaking process.

This insight doesn’t apply only to fifth-graders solving puzzles; it applies to everyone. Over time, the brain’s flexible cells become the source of expertise. Although we tend to think of experts as being weighed down by information, their intelligence dependent on a vast amount of explicit knowledge, experts are actually profoundly intuitive. When an expert evaluates a situation, he doesn’t systematically compare all the available options or consciously analyze the relevant information. He doesn’t rely on elaborate spreadsheets or long lists of pros and cons. Instead, the expert naturally depends on the emotions generated by his dopamine neurons. His prediction errors have been translated into useful knowledge, which allows him to tap into a set of accurate feelings he can’t begin to explain.

The best experts embrace this intuitive style of thinking. Bill Robertie makes difficult backgammon decisions by just “looking” at the board. Thanks to his rigorous practice techniques, he’s confident that his mind has already internalized the ideal moves. Garry Kasparov, the chess grand master, obsessively studied his past matches, looking for the slightest imperfection, but when it came time to play a chess game, he said he played by instinct, “by smell, by feel.”

Our decision making depends on our expectations. Our expectations are defined by our experience, our memories in a similar situation. Intuition helps only if you have enough experience. The quantity of practice is certainly important, but the quality matters even more. The most effective way to get better at anything is to focus on your mistakes and learn from them. In other words, you need to consciously consider the errors being internalized by your dopamine neurons. This needs to become an ongoing process of constant reminding, because most of what we learn lives in our short-term memory, which by definition doesn’t last long.

WE CAN NOW begin to understand the surprising wisdom of our emotions. The activity of our dopamine neurons demonstrates that feelings aren’t simply reflections of hard-wired animal instincts. Those wild horses aren’t acting on a whim. Instead, human emotions are rooted in the predictions of highly flexible brain cells, which are constantly adjusting their connections to reflect reality. Every time you make a mistake or encounter something new, your brain cells are busy changing themselves. Our emotions are deeply empirical.

This doesn’t mean that people can coast on these cellular emotions. Dopamine neurons need to be continually trained and retrained, or else their predictive accuracy declines. Trusting one’s emotions requires constant vigilance; intelligent intuition is the result of deliberate practice. What Cervantes said about proverbs—”They are short sentences drawn from long experience”—also applies to brain cells, but only if we use them properly.

Source: Lehrer, Jonah; How We Decide – Houghton Mifflin Harcourt. Kindle Edition.

It seems that liquidity is a massively misunderstood subject as I am constantly getting questions from the type “Isn’t that stock too thin to be considered”. You have to ask yourself how much liquidity do you actually need for your account and market approach. Here is what you need to know about liquidity in order to answer that question.

1) Liquidity is cyclical and it follows price. Many big winners have started with trading under 100k shares a day or even under 50k. Volume comes with price appreciation. When there is a catalyst behind the price move like strong, unexpected earnings growth or new contract or change in regulations that will lead to strong earnings down the road, liquidity and institutional interest follow.

One of this year’s best performing stock is $ELLI. It traded about 20k shares a day at the beginning of 2012. It currently trades close to 350k shares a day.

2) The needed liquidity depends on the size you trade and the amount you manage. The really big institutions cannot afford to accumulate any positions in individual small cap names that trade under 1 million shares a day. The sheer size of their capital makes it impractical to even consider buying small caps. Even if they manage to scoop some shares of a small cap and it doubles, it won’t make a difference for their overall portfolio return.

When it comes to smaller firms that manage under $250 million, things look completely different. Smaller institutions understand the power of sudden acceleration in earnings and are not afraid to nibble on relatively low liquid names. Their cumulative buying power gives a start to new price trends and price appreciation attracts more liquidity over time.

3) You need a proper exit strategy when you deal with relatively low liquid stocks, especially if the move is purely momentum driven and there is no clear catalyst to support it. Smaller market cap, lower float and lower liquidity help tremendously on the way up and exacerbate the move, but turn into a huge disadvantage on the way down. Liquidity tends to disappear just when you need it most. Partial exits onto strength is a very rational approach when dealing with a stock like $AE.

4) Stocks with lower liquidity often trade cleaner and provide “text-book”-like setups that seem too good to be true. It happens every year and they become some of the best performers. They start slow and liquidity comes gradually as unusual price appreciation attracts more attention.

5) Dollar volume is a better measure of liquidity than volume alone. $MWIV used to be a $70 stock that traded about 70k shares a day, which amounts to a 5 million dollar volume. Most people don’t pay attention to stocks trading under 100k shares a day, when in fact $MWIV’s dollar trading volume is the same as the one for a $7 dollar stock that trades 0.7 million shares a day. A lot of good setups could be found among high priced stocks trading under 100k a day.