A few years ago, I met with a new client at a hedge fund. This individual defied every stereotype of how one might assume a hedge fund portfolio manager may be. He was a highly nervous and anxious individual. Unlike many of his colleagues at this fund, who mostly took medium-term relative-value type trades or long-term macro positions, this individual day-traded FX, something generally assumed the domain of the home retail trader. What was more remarkable however was his incredible track record. In a typical year he made around USD 40-50 mio of profit, approximately a 16-20% return on capital, though for reasons which will become apparent, this understated the strength of this returns. That year he had made around USD 100 mio, a large chunk of it in the space of a few moments when the Euro v Swiss Franc FX rate plunged after the Swiss National Bank pulled its peg versus the Euro.
What really stood out for me though, was that this London based trader never traded or carried any positions after 1pm UK time. I asked him, “What if you have a strong signal in the afternoon which suggests taking action, wouldn’t it mean that you will be leaving money on the table by not doing anything?” He said that often it was the case that he had good signals in the afternoon, however his performance record keeping and analysis of his trades suggested strongly that he was better not to act. He said that over the years, there is an increasing divergence between what his system says he should make, and what he actually makes as the day wears on. He said that historically his afternoon trading provides him with a net loss, even if you included the trades that made money on strong signals.
This fascinated me because it was a live example of a theory that I had about afternoon trading. This theory was formed from research I had read about and my own trading experiences over many years. The theory argues that our ability to make effective decisions and to exert self-control in our actions diminishes the longer the day goes on. In a trading sense this suggests that 'whilst a trader may have an edge early in the day, that edge often erodes throughout the day to the point where it turns negative'.
Decision Fatigue, Mental Bandwidth and Trading
The research which led me to this belief was produced by a group of psychologists who had analysed the decision-making performance of parole-board judges. The research looked at the time of day of decisions to grant or deny parole of over 1000 cases over a period of nearly a year. The decisions were aggregated and placed into a single time of day chart. This chart can be seen below:
Source: Extraneous factors in judicial decisions https://www.pnas.org/content/108/17/6889
A positive (considered a good choice, since each individual up for parole was believed to be there on statute and merit) was given a score of 1, a sub-par choice ‘denying parole’ was given a score of 0. The quality of the choices can be seen to deteriorate as the day wears on, and indeed as each section of the day wears on without a break. only improving for a short period after intraday breaks.
This research highlights the role of ‘Decision Fatigue’ in people’s decision-making. The mental work of ruling on case after case, whatever the individual merits, wore the judges down leading to lower quality decisions as the day moved on. This sort of decision fatigue makes people involved in repetitive high stakes decision-making prone to dubious choices as the day progresses.
This sort of fatigue differs from ordinary physical fatigue where you are conscious of your tiredness. With decision-fatigue, your mental bandwidth is stretched, but you are not conscious of it. Thus, you carry you carry on making decisions and choices regardless, though you are not aware you are more prone to making progressively lower quality choices.
Decision fatigue manifests in many ways, however some of the most familiar to traders will be:
The following chart looks at the percentage of trades in five currency pairs that closed with a profit at broker FXCM from 10/01/2009 to 09/30/2010. I have assumed that most of these trades refer to day trading clients.
Source: https://www.dailyfx.com/forex/technical/article/special_report/2013/01/24/forex_education_do_hours_i_trade_matter.html
The most profitable period of the day was from midnight to around 5am NY Time. This is around 6am to 11am Central European Time. Since by far the highest proportion of Forex trading occurs in the European time-zone, this suggests that most Forex traders were profitable in the first few hours of their trading day. However, as the day progressed the trader’s profitability levels drop. Levels of profitability appear to return to balance late in the evening, which one presumes coincides with most Forex day traders having packed up as European and East Coast US markets close and the day moves into the lower liquidity Asian/Pacific time-zone.
Whilst there may be many reasons for this pattern in FX day trader's performance, I'm hazarding a guess that it suggests there is some credence to the possibility that ‘Decision-Fatigue’ could be at play.
This fascinated me because it was a live example of a theory that I had about afternoon trading. This theory was formed from research I had read about and my own trading experiences over many years. The theory argues that our ability to make effective decisions and to exert self-control in our actions diminishes the longer the day goes on. In a trading sense this suggests that 'whilst a trader may have an edge early in the day, that edge often erodes throughout the day to the point where it turns negative'.
Decision Fatigue, Mental Bandwidth and Trading
The research which led me to this belief was produced by a group of psychologists who had analysed the decision-making performance of parole-board judges. The research looked at the time of day of decisions to grant or deny parole of over 1000 cases over a period of nearly a year. The decisions were aggregated and placed into a single time of day chart. This chart can be seen below:
Source: Extraneous factors in judicial decisions https://www.pnas.org/content/108/17/6889
A positive (considered a good choice, since each individual up for parole was believed to be there on statute and merit) was given a score of 1, a sub-par choice ‘denying parole’ was given a score of 0. The quality of the choices can be seen to deteriorate as the day wears on, and indeed as each section of the day wears on without a break. only improving for a short period after intraday breaks.
This research highlights the role of ‘Decision Fatigue’ in people’s decision-making. The mental work of ruling on case after case, whatever the individual merits, wore the judges down leading to lower quality decisions as the day moved on. This sort of decision fatigue makes people involved in repetitive high stakes decision-making prone to dubious choices as the day progresses.
This sort of fatigue differs from ordinary physical fatigue where you are conscious of your tiredness. With decision-fatigue, your mental bandwidth is stretched, but you are not conscious of it. Thus, you carry you carry on making decisions and choices regardless, though you are not aware you are more prone to making progressively lower quality choices.
Decision fatigue manifests in many ways, however some of the most familiar to traders will be:
- Acting impulsively instead of expending the energy to first think through the consequences. We see these in knee-jerk trading responses, and unplanned reactive trades.
- Straying away from your method or system and the processes which are part of it.
- Random or boredom trading.
- Failing to remain disciplined, and trying to finesse your trading.
- Decision avoidance: not taking an action but procrastinating or hesitating.
- Greater vulnerability to our natural human biases.
Day Trading in FX Trading Markets.
The following chart looks at the percentage of trades in five currency pairs that closed with a profit at broker FXCM from 10/01/2009 to 09/30/2010. I have assumed that most of these trades refer to day trading clients.
Source: https://www.dailyfx.com/forex/technical/article/special_report/2013/01/24/forex_education_do_hours_i_trade_matter.html
The most profitable period of the day was from midnight to around 5am NY Time. This is around 6am to 11am Central European Time. Since by far the highest proportion of Forex trading occurs in the European time-zone, this suggests that most Forex traders were profitable in the first few hours of their trading day. However, as the day progressed the trader’s profitability levels drop. Levels of profitability appear to return to balance late in the evening, which one presumes coincides with most Forex day traders having packed up as European and East Coast US markets close and the day moves into the lower liquidity Asian/Pacific time-zone.
Whilst there may be many reasons for this pattern in FX day trader's performance, I'm hazarding a guess that it suggests there is some credence to the possibility that ‘Decision-Fatigue’ could be at play.
A Good Night's Sleep and Decision-Making.
Returning to the story of the fund trader. Seen in this light, his practice of not trading into the afternoon seems a wise one. He is a seasoned trader; he knows when he is strong and when he is compromised. He knows he has no edge in the afternoon so why play when you have no edge, for him it was just playing to lose.
Returning to the story of the fund trader. Seen in this light, his practice of not trading into the afternoon seems a wise one. He is a seasoned trader; he knows when he is strong and when he is compromised. He knows he has no edge in the afternoon so why play when you have no edge, for him it was just playing to lose.
This story has further implications, since it also alludes to the benefits of a good night's quality sleep. We all know how grouchy we are when we had a poor night's sleep. But what we don't consider how we are likely to make sub-par decisions after a bad night's sleep. I know some traders, who won't trade at all if the quality of their sleep was poor. For them, their edge is lost even before the day starts.
This concept of decision fatigue does not just lend itself to day-trading. I once read how Warren Buffett said he never makes big decisions late into the afternoon. His view was that if a decision is that important, sleep on it and consider what it is like in the fresh light of a new day.
This is an updated version of an article originally produced by Steven Goldstein of AlphaMind for FXStreet.
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The AlphaMind podcast is co-hosted by Steven Goldstein and Mark Randall, market veterans with over seven decades between them in the financial markets. To find out more visit the AlphaMind podcast website.
The AlphaMind Podcast is produced in partnership with 'The Society of Technical Analysts'.
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The AlphaMind Newsletter is a free bi-weekly email, that explores how people develop, cultivate and grow optimal mindsets, behaviours and attitude for better and more productive performance when engaged in risk taking activities in Financial Markets. Sign-up here.
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