Traders engage in a lifelong quest for the secret to stock market success. They do a tremendous amount of work studying fundamentals and charts. They consider macroeconomics and a host of other issues that will give them an edge. Sometimes all that study and work does pay off and helps them produce good returns, but there are plenty of folks that trade stocks that are willing to do the hard work of analysis.
Hard work combined with intelligence is not enough to produce consistently great results. What is it that separates the best traders from all the others?
Strategic Sophistication
The answer is strategic sophistication. Strategic sophistication refers to the extent to which traders consider the structure of the market and the other players' behavior. The best traders develop strategies that consider the emotions that drive what stocks do. The focus is not just on the attributes of the picked stocks but on how other traders view those stocks and how market conditions will impact their movement.
Strategic sophistication melds game theory, psychology, and old-fashioned street smarts. It is next-level thinking that goes beyond simplistic logic.
One very common example is contrarian strategy. There is a theory that when sentiment is excessively bullish or bearish, then there is the likelihood that a reversal will occur soon because many people have already acted on their feelings, and there are fewer buyers or sellers left to drive the prevailing trend.
The logic here is straightforward, but applying this strategy is extremely difficult. For example, there is widespread negative on the current bear market, but the most important is to what degree people have acted on their negative. If there is extreme bearish but investors have not yet capitulated, then then the risk of more downside is higher than the potential for a bounce.
The Big Winners
Time frames, news flow, and other issues will impact this strategic thinking as well, but those traders that can best understand the dynamics at work and how they will impact the price action are going to be the big winners.
The issue of strategic sophistication was recently studied by the Federal Reserve Bank of New York in conjunction with researchers at the University of Southern California and University College London. In a paper titled "Strategic Sophistication and Trading Profits: An Experiment with Professional Traders," the authors concluded that "strategic sophistication" was highly correlated to trading success.
The study recruited professional traders and compared trading results in computer-stimulated games to students' results. They then evaluated the skill sets of the various participants to determine the strongest correlations to trading success. The conclusion was that cognitive skills are important for students, but they are not for traders. Strategic sophistication is what determines success for traders more than anything else.
The study is quite complex, but the essential point is that professional traders tend to have high cognitive skills and do much hard work. Those attributes do not help them nearly as much as strategic sophistication.
Once we understand and acknowledge the great value of strategic sophistication in trading, the question becomes whether this is something we can learn and cultivate.
The answer is that some people have innate strategic sophistication, but it is largely a product of mindfulness. Simple awareness of the value of strategic thinking will make you much better at it. After finding a stock with a great chart and fundaments, then the focus should be on the overall market context and the emotions and feelings of other traders. It is important not to trade the stock but to trade the traders that trade the stock.
Strategic sophistication is the secret power of great traders.
