Lions and lion-shaped bushes in financial markets: traders’ expertise in emotion regulation

Fight or flight

Ethnic groups - tribe at Kenya, Massai
Massai (Photo credit: Wikipedia)

Imagine you are one of our hunter-gatherer ancestors, walking across the African plains. Or perhaps, in more recent times a Massai tribesman in Kenya. The grass is long in places and punctuated by small trees and bushes. You are carrying no more than a long pointed stick to protect you from dangerous predators. At quite short notice you may need to fight or run fast to the nearest tree or defensible location.

Early in our evolution we developed a nervous system which allows our bodies to prepare to fight or flee. This sympathetic nervous system responds to threats and opportunities in the environment; it raises heart-rate, inhibits saliva flow, dilates the bronchi in your lungs, stimulates the conversion of glycogen to glucose in the liver, inhibits the action of your digestive system and generally gets your body ready to exert itself intensely with no distractions. So if you see a lion in the grass you are quickly ready to exert peak physical effort. This process takes a few seconds to kick in. After all, anaerobic respiration means you can run pretty fast for a few seconds without needing the extra oxygen.

Your emotions are very much involved in this process. It is the rapid recognition of the lion that translates into a burst of fear which starts this process going. You freeze momentarily, your heart pauses whilst you pay maximum focused attention to your senses, then the sympathetic nervous system readies you for action. The physical sensations as these bodily changes take place are an important part of your experience of emotion.

Regulating your reactions

Lion King's Mufasa
A lion shaped bush 🙂 (Photo credit: readontheroad)

All of this is quite energy intensive with a cost to your system; and that can be a problem. Not only are there lions out there in the long grass but also lion-shaped bushes; and sounds of movement which just might be a lion. If all these physical changes kicked in every time you caught a glimpse of a lion-shaped bush out of the corner of your eye, you would be exhausted before you had walked 100 metres.

Fortunately, your body has this covered. A later development in our evolution was the parasympathetic nervous system. In the immediate aftermath of your primary emotional response, your slower cognitive system starts to catch up; you pay closer attention to the sensory data and engage in a secondary evaluation. If you realise that what you saw was a bush not a lion, the parasympathetic nervous system damps everything down reversing the effects of the sympathetic response. This works pretty well because the parasympathetic nervous system operates quite fast typically taking around half a second to affect your body whilst the sympathetic system takes around 4 seconds.

Central autonomic nervous system (attribution unknown)

Central autonomic nervous system (attribution unknown)

You are constantly responding to your environment; the sympathetic nervous system carries the primary emotional response and generates the gross physical reactions. The parasympathetic system sculpts your responses to be appropriate to the situation. It is this interplay between the sympathetic and parasympathetic nervous systems that allows us to regulate our responses to the environment moment by moment. This is a primary process by which we regulate our emotional responses to the world. This interplay between the two nervous systems shows up in our physiological reactions. In particular it shows up as variability in heart rate.

Heart rate variability and emotion regulation

A quirk of our physiology means that the action of the parasympathetic nervous system on the heart is turned off once in each breathing cycle. This means that careful analysis of the element of a heart rate signal that is in the frequency band that relates to the breathing cycle can provide a good measure of the action of the parasympathetic nervous system. This means that if I measure your heart-rate I can get a pretty good measure of your moment by moment regulation of your emotional responses to the environment you face. This measure (high frequency heart rate variability) is high when you are reacting effectively and flexibly to the challenges of the environment.

However if you are very stressed, feeling rather like a rabbit in the headlights or have become so emotionally drained you are ignoring all but the most threatening situations, this measure will be low. One way of thinking of this is as a measure of your capacity to react adaptively to the challenges of the world around you.

Myself and colleagues have been very interested, in our research, in what makes up the expertise of traders. What skills do traders learn over time and with the benefit of training and deliberate practice, which allow them to develop reliably superior performance compared with novices? Of course there are important elements to do with knowledge of markets and trading systems, insights into patterns of demand and supply and economic fundamentals. As in many domains of expertise research it is also the case that traders often find it hard to articulate the skills they deploy when they recognise situations and react to them. Expertise is often less about the application of learned rules than recognising situations; based on a vast repertoire of previous experience and the rapid application and modification of automatic or semi-automatic behavioural experiences. What has been rather less studied has been the role of emotions and emotion regulation in various forms of expertise.

Measuring the emotion regulation of professional traders

In large numbers of interviews we carried out with traders, a consistent theme has been the important influence of emotions and the importance of learning to manage those emotions effectively (see research paper here). We began to reach the conclusion that financial markets are also full of lions and lion-shaped bushes. Given what traders told us about the importance of regulating emotions, we hypothesized that effective emotion regulation is an important element of trader expertise.

We persuaded 26 traders in two investment banks to let us wire them up with heart monitors as they traded. We were fortunate enough to get this access during a period with very large swings in market volatility following shortly after the financial crisis and during a period of great uncertainty about sovereign debt in Europe. VIX values, on days we collected data, ranged from 17.42 to 42.15: the VIX represents the degree of uncertainty in the market and is often known colloquially as the ‘fear index’.

trader HRV1

We found two straightforward results. First, all traders found it more difficult to regulate their responses to the market when prices were more volatile.  The colloquial name for the VIX, ‘the fear factor’ seems to have some merit. Second, we found a significant relationship between traders ability to regulate their emotional responses and experience. However, it was clear that learning this skill takes time.  The kind of experience associated with a standard deviation improvement in heart rate variability whilst trading was around 15 years. This is entirely consistent with the idea of emotion regulation as an aspect of traders expertise. Real mastery develops across the course of a career not in just a few months training.

You can find the full paper on our study here, but having talked about the data, perhaps I should let a trader have the last word. As one of our research participants told us:

Emotion and rationality are not at opposite ends, they co-exist the entire time. You buy in at 50, they go to 48, you refuse to believe it. Your rational side says you’ve got it wrong. Your emotional side says the market is wrong so you buy some more. They go to 46; you’re really pissed off now, you’re not going to sell them, you’re not going to take this. They go to 42 your rational side kicks in and says I got this wrong and I am out and it doesn’t necessarily – I  am not suggesting it happens in that sequence every time but the two always co-exist. The two always co-exist.

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