Critical thinking applications in day trading

Jenna Doucet (April, 2010).

Applying Critical thinking to Day Trading

Authors Paul and Elder (2001) state, “There is nothing more practical than sound thinking” (p. 20). This statement cannot be overemphasized to day traders. In an industry where one makes hundreds of decisions a day, all of which need to processed quickly and all of which directly effect the individual’s profitability, critical thinking is a much needed skill that unfortunately very few posses. Many studies demonstrate that day traders are ruled by emotions such as greed and fear and rarely prescribe to rationale thinking when trading (Lo, Respin & Steenbarger, 2005). A strong application in critical thinking can enhance the trader’s bottom line and minimize losses incurred from emotional biases.

Critical thinking is defined as “ thinking explicitly aimed at well-founded judgment, utilizing appropriate evaluating standards in an attempt to determine the true worth, merit of value of something” (Paul & Elder, 2001, p.26). It is said that critical thinking encompasses three dimensions, which are, in effect, analytic, evaluative and creative components (Paul & Elder, 2001). Thus applying critical thought to decisions in the stock market would resemble carefully analyzing market conditions. Unfortunately, many stock traders do not abide by rationality their decisions are clouded by emotion. The National Bureau of Economic Research attests to this in their 2005 clinical study of day-traders, which shows that the main psychological drivers behind a day trader’s performance is based on greed and fear. The study also suggests that individuals whose emotional reactions are heightened by monetary gains or losses exhibit significantly worse trading performance (Lo, Respin & Steenbarger, 2005).

The critical thinker will make decisions based on careful analysis of the market which can include various strategies based on fundamental analysis, technical analysis and on economic analysis or a combination of all three. When one critically thinks several variables are considered (Paul & Elder, 2001). The markets can seem unpredictable and price movements in securities is speculative- that is the price of a stock is not necessarily a true representation of a company’s worth but rather a picture of what investors perceive the company’s worth to be (Canadian Securities Textbook, 2008). The key to critical thinking in the industry is “discipline” (Scriven, Paul, 1987), once a strategy has been developed traders should abide by the rules imposed and not let emotions step in. For example, in times of fear traders are compelled to sell their stocks, especially during periods of abrupt price changes and regardless of the overall outlook on of the market or analysis conducted. Selling off a stock too quickly can result in unnecessary capital losses or lost opportunities. On the other hand greed is characterized by strong optimistic agents and can cause traders in the pursuit of profit maximization to ignore important trends indicative of declining market prices.

Decisions to buy or sell securities should be based solely on trends identified in the market based on careful analysis and not on emotional responses to stock’s performance. When making decisions based on emotion the situation is skewed and the final decision may not yield the best outcome (Paul & Elder, 2001). Not all strategies are successful and the critical thinker understands that strategies and thinking in general should be re-assed over time. According to Paul and Elder (2001) the best thinkers “routinely take thinking apart” (p.17). Thus a critical thinker would not entrust following stock-trading strategies blindly and would routinely evaluate the success or failure rate of his or her applications. A few other characteristics about critical thinkers which can be used to develop a framework for critical thought in trading are to think purposefully, use intellectual tools, and to distinguish their thoughts from feelings and desires (Paul & Elder, 2001). For example when trading individuals should seek to understand the reasons behind their decisions and actions and have clear goals and priorities. Furthermore, traders should make use of intellectual tools to raise the quality of their decisions; these tools can include knowledge, current information or news in the markets, studies, proven strategies and other methodologies. The critical thinker knows how to check for accuracy and precision and they know to “expand their thinking to include insights from multiple perspectives” (Paul & Elder, 2001, p.16). Finally, the critical thinker will know when he is urged to make a decision to buy or sell a security out of an emotional drive or because of rationality. The ability to recognize the fear and greed within oneself can help the individual not succumb to unconscious decision-making.

Conclusion

The need for critical thinking aptitudes in day traders is fundamental to success. Critical thinkers take an analytical and evaluative approach to decision-making and are less prone to poor trade performance resulting from emotional biases such as greed and fear. Traders must be disciplined in their approach to trading and make decisions based on careful analysis of the market and adjust their positions to the market condition not on emotional attachments to the balance in the trader’s account. Day traders who exhibit critical thinking characteristics often re-evaluate their thinking and decision- making patterns, think purposefully, use intellectual tools to assist them in making well-formed decisions, and are able to distinguish rationality from emotional biases.

References

Canadian Securities Textbook (2008). Toronto: CSI Global Education.

Lo, A. W., Repin, D. V., & Steenbarger, B. N. (April, 2005). Fear and green in financial markets: a clinical study of day-traders. The National Bureau of Economic Research. 95 (2). 352-359. Retrieved March 27, 2010.

Paul, R. & Elder, L. (2001). Critical thinking: tools for taking charge of your learning and your life (2^nd ed.). Upper Saddle River, NJ: Prentice Hall.

Sriven, M. & Paul, R. (1987). Critical thinking. The National Council for Excellence in

Critical Thinking. Retrieved on April 15, 2010 from: http://www.criticalthinking.org/aboutct/define_critical_thinking.cfm