Forex Trading And The Theory Of Mind

Imagine you are part of a group of 100 participants playing a game for a cash prize.

The aim of the game is to guess a number between 0 and 100, and the winner is the one who picks the number that is closest to two-thirds of the average number.

What number would you pick?

Make your choice now, and don’t proceed until you’ve done so.

(Play along! It will be fun and perhaps even educational).

..

.

Done?

..

.

Let’s see how you did.

If you picked…

Any number larger than 66

Sorry, you either didn’t understand the rules of the game, or you really didn’t think this one through.

Since the largest possible winning number is 66 (two-thirds of 100), you’ve picked a number that automatically disqualifies you from the cash prize.

50

You presumed that the other participants would randomly pick a number, which would average out to 50.

However, two-thirds of 50 is 33. So you either forgot about the two-thirds part, or you didn’t think this though.

Either way, you’re unlikely to win the cash prize.

33

Now we’re getting somewhere. You presumed most of the participants are idiots and would randomly pick numbers (which would average out to 50), and multiplied that by two-thirds to get 33.

This is the number most people pick.

22

You realize that most of the participants would assume that everyone else are idiots, and so picked a number that is two-thirds of the number they would pick (two-thirds of 33).

15

But wait… you realize that there are people who realize that other people think that everyone else are idiots.

And so on…

If the participants in this game were purely rational, the theoretical winning number would be either 0 or 1 (long story).

In practice however, the winning number tends to be 22.

Theory Of Mind

This game is related to the philosophical/psychological hypothesis called the Theory of Mind.

Wikipedia describes it as “the ability to… understand that others have beliefs, desires and intentions that are different from one’s own.”

To win at this game, you would have to correctly guess what the other participants are thinking.

Their “beliefs, desires and intentions” determine the number you should pick.

Trading Works The Same Way

It is commonly believed that the market is driven by economic fundamentals and/or technical analysis.

But in reality, it is actually the market participants’ reaction┬áto those factors that causes the price to move.

See a moving average crossover? Well, so do many other traders. If you took a trade based on it, who exactly are you counting on to push the market price in your direction?

Where The Battle Is Fought

This is why I keep saying that trading systems based solely on technical indicators don’t work.

By focusing on technical indicators, a trader ignores the most important factor: his competition. He has no idea of even who that is.

You see, the game of trading is not played out on a trading chart, but in the participants’ minds.

The only way to make money in trading is upon the current, or future losses of other traders.

So any strategy that fails to account for the thoughts and actions of the competition is practically useless.

Perhaps, this is what Warren Buffet meant when he says he likes to be greedy when others are fearful.

By |2018-12-17T18:56:05+00:00December 2nd, 2018|Philosophy|10 Comments

10 Comments

  1. Rudolf September 24, 2014 at 7:55 am - Reply

    Dear Chris,

    your point of view regarding this guessing may look correct and is interesting – there sentiment indis for that. I admit I didnt calculate 2/3 of any assuming figure … I only took it from my stomach – 67 … But I only disagree with your view to techn. indicators … Techn. Indis are the reflection of the market-participants .. so should we then trade with only 2/3 of that direction-power ? No – Because of that I like semi automated EAs with possibilities to adjust. And if we miss one train or it doesnt pay…we take the next train. Our only competition is our own success rate and not others- or?
    kind regards
    Rudolf

    • Chris September 24, 2014 at 3:10 pm - Reply

      Hi Rudolf,

      I’m afraid this post might have caused some misunderstanding.

      The point is not to tell you “how to trade”, but rather to suggest “how to think” about trading.

      Also, the portion about “paying attention to the competition” refers to the consideration of how other traders might be positioned in the market (and their viewpoint), so we can benefit from them.

  2. Okeke September 24, 2014 at 8:53 am - Reply

    Okay Chris. I’m trying to wrap my head around the objective of the game you presented above but I still don’t understand it. And so I couldn’t play. But I guess what you’re trying to say is that candlesticks are the only technical indicators that reflect the emotions of the trader. Unlike the moving average, it’s the only indicator that doesn’t lag.
    But moving averages are not totally useless. They do not lag in all cases and give you timely signals sometimes.

    • Chris September 24, 2014 at 2:43 pm - Reply

      Hi Okeke,

      The point of the game is to predict what the winning number will be, which ultimately depends on the number(s) that you think the other participants will pick.

      The idea is that trading works in a similar way. If you can approximate how other traders think (and act), you stand a pretty good chance of understanding how to “predict” the market, so to speak.

      Technical indicators (like the moving average) can be useful, as long as they are not the sole reason/criteria for taking trades. That’s my opinion.

  3. Andrew September 24, 2014 at 1:50 pm - Reply

    Well I went for 20 since two thirds of 60 is easy to calculate and i figured most people would start with a number > 50.

    As to the use of technical indicators and your MA example. Hhmmm… Trying to judge where the collective mind of several million hobby traders and thousands of professional traders is likely to take the market is to me more problematical for the vast number of part-time traders as partially relying on lagging indicators like MAs to choose direction.

    And of course you have to make a choice. Automated trading based on indicators so that you can still have a life; or manual trading where you (might) become a slave to your computer screen and where the psychology of trading may play havoc with your mind.

    I have made my choice and am happy with it. And each to their own.

    • okeke September 24, 2014 at 4:51 pm - Reply

      Andrew if you know the trade set up you’re looking for, you needn’t stare at your computer screen for hours. it comes with a lot of practice, patience, and discipline. When you’re able to locate strong set ups, it becomes second nature to you. Staring at your screen for too long means what you are looking for most likely isn’t there.

  4. odibeli September 25, 2014 at 2:26 pm - Reply

    The real question consists of 1,average of 100=50,2,closest to 2/3 of the average.So 2/3 of 33.33=22.22.
    Moving averages are lagging,& wouldn’t get you in the trade at the right time. Many people talk of “price action” without the understanding what it is all about.The PRICE is embedded in the candlesticks.
    I leave it at that,because Chris Lee,is the ONLY ONE,that has told us the TRUTH without concealing or without HIDING ANYTHING.
    Thanks chris & God bless u

    • Chris September 25, 2014 at 3:20 pm - Reply

      Hi Odibeli,

      Thank you for the vote of confidence.

      I should emphasize that that technical tools (such as moving averages) can be useful, as long as they are not the sole criteria for taking trades.

      • okeke October 30, 2014 at 3:09 pm - Reply

        Chris how can I tell which time frame I am trading on? If I place a trade on a four hour time frame for example, how do I know I am trading on a four hour time frame? I am asking because I placed two trades on two different time frames. One on a four hour chart and the other on a daily chart but I can’t tell one from the other.

        • Chris October 31, 2014 at 6:24 am - Reply

          Hi Okeke,

          The time frame charts are just different ways of looking at the same price data, so when you enter two trades in different time frame charts, you are essentially taking two trades on the same currency pair.

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