Risk Management With Kathy Lien

Dr. Indre Viskontas:

Hello, and welcome to Inside the Mind of a Trader, the show where we explore how brilliant traders are wired for success. I’m Doctor Indre Viskontas, neuroscientist and professor of psychology at the University of San Francisco.

On this episode, I’ll be talking to Kathy Lien. Kathy is a world renowned expert in trading currencies and the co-founder and managing director of BK Traders. But when she’s not trading, she can be seen on CNBC, Bloomberg and her own popular Forex YouTube channel. Hi Kathy.

Kathy Lien: 

Hi.

Dr. Indre Viskontas:

So I feel like I already know you because I’ve seen inside your brain.

Kathy Lien:

I hope you found some things that are interesting.

Dr. Indre Viskontas:

Oh, so much, so much. But I want to start with asking you what it was like to be a prodigy. At 13, you started college.

Kathy Lien:

Well, it was definitely something that was unexpected, but to be honest, Indre, I didn’t feel that much different. I felt like it was second nature. I’m in an industry where I am often the only female, the only minority, and I was the only 13-year-old at New York University at the time. And I think, from very early on, it was just part of who I am. I’m not afraid to be the only one in the room doing what I’m doing.

Dr. Indre Viskontas:

So when you were growing up, did you know that your thinking was different from, say, the other kids in your class?

Kathy Lien:

No, I wouldn’t describe myself as a prodigy. I would basically say that I learn things a lot faster and I pick up things a lot faster than most people, and I think that helps me understand concepts. And thank God New York University made you take classes and many different topics, and one of them was macro, microeconomics. And who knew? It just made perfect sense to me. And it’s from there that I really felt like this was second nature.

Dr. Indre Viskontas:

When I look at your brain, I can certainly see some of the things that you’re describing. Do you want to tell me a little bit about the kinds of cognitive skills that you’ve developed over time that you think make you a good trader?

Kathy Lien:

I react much more on instinct. And once I’ve developed a trading system, I have a trading system that I’ve used for over 10 years now, and it’s almost second nature to me. So for me it’s just about developing the habit and repeating the habit over and over again.

And it’s a complicated process because for me, I’m a trader that fuses what we call fundamental analysis and technical analysis. So I dissect all of the incoming news flow, I take a look at what the market sentiment is, whether it’s a positive day, a negative day, I take a look at whether investors are bullish or bearish, and I combine that with chart analysis, but it happens very quickly for me. This whole process could happen in 10 minutes maximum.

So I think it goes back to my initial learning process. One of the ways that I was able to go to college at 13 and graduate at 18 was because I took, during summer programs, accelerated math learning classes where I learned different ways to do mathematical equations very quickly. And I think, taking that type of thinking into the real life scenario and trading, I’ve been able to recognize the shortcuts and be able to process them quickly so that I can make fast trading decisions.

Dr. Indre Viskontas:

It’s really interesting. You mentioned intuition, and a lot of people think of intuition as something that you just have a gut feeling, either because you have this literal, physical response, or that you’re not consciously aware of what it is that’s coming into your decision-making, it just kind of feels right. And I think a lot of people don’t understand that that instinct, that intuition is built up over time through learning. And it sounds like that’s what you’re describing, this building up over time of this knowledge base that now you can quickly query as opposed to just going with a feeling that may or may not be based on any actual reality.

Kathy Lien:

I agree. I mean, this is true of many careers out there. I just got off the airplane. A pilot, by instinct, knows how to react in certain types of turbulence and environment. And you call it instinct, but it’s also experience over time.

Dr. Indre Viskontas:

Yeah.

Kathy Lien:

And I think that comes in everything that we all do. And for me, that’s trading.

Dr. Indre Viskontas:

So this is a statistical map of your brain of what it looks like in terms of its activations while you were doing the fluency task, so where you were thinking of either trading-related words, so we gave you a prompt like high frequency, and then we asked you what were you thinking about or like beach, like what you think about when you go to the beach. So in yellow that’s how your brain was active during the beach and unrelated questions. And then blue, is trading-related. And what you can see is that there’s a lot more blue than there is yellow, and especially in these kind of frontal parts of the brain and around this whole area in the temporal lobe, which is where we store concepts. So it suggests that when you’re thinking about things that are trading-related, you activate a lot more representations in your brain, you have a lot more concepts to draw from.

But the other thing that we found remarkable overall across all of your brain scans is that your brain had more, larger swaths of activation than the average undergraduate. But when we asked you to make decisions that were either based on a fake trading scenario that we made up, versus a fake other, hopefully, equally complex scenario like, “Who would you vote for in an election? And here’s the pros and cons of a particular stance,” you spent a lot more time thinking about the non-trading related scenarios, but for the trading-related, you were like within three seconds you had your response.

Kathy Lien:

Those were really interesting questions because I wasn’t sure whether I should be voting based upon what I think is going to be the successful result or what I think should happen on a moral basis. So I spent more time thinking about that, and I think that probably came through through the results. Because there’s one thing, you know what the outcome will be, the most likely outcome, you know what should be the outcome based upon your own ethics? And I think I was just toying with it.

Dr. Indre Viskontas:

Okay, so that makes a lot of sense. And then again, in the blue trading-related questions, what we see is a lot more activity here in the parietal regions where it’s about shifting attention. It’s about shifting your attention inward to your thoughts. So it seems like there you kind of had more of a strategic way of accessing the existing information you have in your brain rather than these kinds of islands of activity in the other decisions where it seems, although you were kind of maybe using different networks, probing different aspects of how you think in order to look at those. Is that kind of-

Kathy Lien:

I think a lot of the questions that were trading-related involved numbers, and so, it was easier for me to process. It’s something I’m very comfortable with. And as I said, the more non-trading related ones I felt were just whether I should make a decision about what should be done versus what I think personally will be the result, what people vote for.

Dr. Indre Viskontas:

That’s really interesting because of course, well, I guess I say of course because I know that, but you might not, which is that the arithmetic, the math areas of the brain are often in this parietal region. And so, it does seem like you’re doing some kind of actual calculations here-

Kathy Lien:

Yeah.

Dr. Indre Viskontas:

… even though… Okay, interesting. So in terms of just this way of looking across all of these slices in the brain, so yeah, what you see here is that you’ve got a lot more of this activity in these parts of the brain that are involved in strategic retrieval, math, those kinds of tools when you’re talking about those trading-related decisions.

Okay. So are you ready for the next one?

Kathy Lien:

Okay.

Dr. Indre Viskontas:

So this is where we asked you to do this task that involves pairing kind of risky decision-making versus something that is a control. Okay, so let’s start with the control task. We showed you a couple of stamps and we asked you which one do you like better, right? Totally random.

Kathy Lien:

Yes.

Dr. Indre Viskontas:

That is a control condition because we want to control for things like just making a decision, we want to control for a preference and also even just the button presses, like motor activities involved there. We want to be able to subtract that or take that away from…

The tasks that we’re really interested in is when we pair you with this choice. There’s a safe choice, so there’s always a 100% chance of, say, getting a dollar. And then, there’s a risky choice where it could be an 80% chance of getting $2 or a 20% chance of getting $10.

And we were interested in a number of things. First of all, which choices do you make? How do you strategize about those kinds of choices? So that’s kind of the behavior, and then, what’s happening in your brain when you’re making those decisions.

So when it comes to the stamp condition, we see the areas that we expect like here, which is your visual cortex. Basically, you’re just looking at those features of the image and then some motor, maybe a little bit of dorsolateral prefrontal cortex, which is kind of like you’re just pulling the trigger on making that decision.

But when it comes to this risk condition, here again, you can see, there’s a lot more blue than there is yellow. So you’re recruiting many more networks and regions when you’re doing that, and especially here at the front part of the brain where you’ve got your executive functioning skills, so these are the skills of a CEO of strategic planning and that kind of decision making on the basis of your prior knowledge. But you also have this big swath again here back in the parietal lobe where a lot of your conceptual information is stored. So it seems like you’re making this decision. Does this sound at all what you were doing?

Kathy Lien:

I am definitely making a decision when I’m looking at the options given to me that are related to trading. I guess, I’m interested in finding out, well, how does this compare to someone else who is not necessarily in training. And is my brain activated in different ways than a college student would be, for example?

Dr. Indre Viskontas:

100%. 100%.

Kathy Lien:

Okay.

Dr. Indre Viskontas:

So it looks very different, but I’ll get to exactly how they differ in a minute. But first, when you took the risky option, you can see here in blue, there was a lot more decision making, a lot more of your brain that was involved. And when I looked at the response times that you used in order to make that decision, I found something really interesting, which is that the first 10 or 12 trials that you saw these different levels of risk, you seemed to take longer. And then, once you had seen that level of risk, the next time you saw it, it was real quick. So it looks to me like you decided, “Okay, when it’s a 35% risk, I’m always going to do X.” Is that what you did?

Kathy Lien:

Yes. I think it really comes down to my trading style as well. I’m a strong believer of trading defensively, which means that when I have profits, I protect my profits because at the end of the day, we want to walk home with more money in the bank than we left.

And in the beginning, in the program that you had, we did not necessarily see the money in the bank that was given later on. So it took more thinking in terms of do I want to start focusing on accumulating gradual, high probability profits or do I want to take the bet, and then, hopefully, generate that profit in the bank so that I can keep it later on? So there’s a lot of thinking involved in that.

Then once I saw the bank account and I saw how much was in the bank, I knew that I could react more quickly in order to retain that equity that was in the account. And at the end of the day, this is what I think traders, especially those of you that are trading for yourself should be thinking about, which is that once you’ve made money that maybe you want to take less risk in order to protect your profits, or you want to think about how if I made $100 already, the max loss I want to take is $50, at least I can walk away with some profits. So depending upon the risk profile, if that risk opportunity is $200 for a $50 bet, and it’s just your first trade, then maybe you do want to do that. So there’s a lot more thinking that goes into the decisions that I make that I think are reflective of my personal trading behavior.

Dr. Indre Viskontas:

And we see that in terms of the amount of brain activation, the amount of thinking that we literally see that you’re thinking. And I have one more really cool finding to show you, but let’s take a quick break and I’ll be back with Kathy Lien.

James Kostulias:

A lot of what we do and a lot of what we talk about at Charles Schwab and with our whole offering of Schwab Trading Powered by Ameritrade is the educational component.

Lorraine Gavican-Kerr:

We really like to teach our clients about risk management, about using a platform. I think that we really want to set people up for success for whatever they want to do. So traders have different aims, different goals, they trade different types of products.

Chesley Spencer:

Enabling them to see what they are able to do, particularly with things like derivatives or options where it’s not nearly so much a binary of, “Hey, you think this is good? Buy it, it’ll go up. You think this is bad? Sell it, and go down.” All of those have very particular actions one can take based on them. It’s a lot more nuanced than just a simple buy or a simple sale.

Lorraine Gavican-Kerr:

The people who work behind the product and experience are traders, they’re super engaged, they love what we do.

Chesley Spencer:

Advice is very much a part of the overall Schwab business, but in the trading space, it’s much more about empowerment.

James Kostulias:

Whether you’re somebody who’s more fundamentally based or more technically based, there’s so much to learn across how to trade different instruments across, how to trade different markets. And so I think from my perspective, what I would say is continue to learn and continue to educate yourself. There’s no sort of one playbook to trading.

Dr. Indre Viskontas:

Okay. So this is the finding I was most excited to show you, which is that when we give this task to undergraduates or basically anybody, what we expect to see is that their reward pathways, their sort of sense of motivation are activated by the level of risk, so the more risk they take or the more reward they get, the more activation they get in these reward pathways. We saw none of that with you.

So I would be expecting to see here in this region too, in the striatum, a lot of activity that is at least somewhat modulated by either the risky or sure choice or the level of risk. And as you can see, this is like the least activation that we saw.

And even when we look at your whole brain, when we compare the risk-taking trials versus the stamp trials, we don’t see any activation in these emotional or reward pathways like the amygdala and the striatum as if you don’t have an emotional reaction to what it is that you’re doing. And maybe it’s this task, but I suspect that that’s one of the ways too that you’ve become a really amazing trader. So how is it that you… What do you think about that?

Kathy Lien:

Well, I don’t think that being completely unemotional is the best way to describe my trading process. I mean, I’m only human, right? So I am watching my trades, there is some emotion attached to it, but the task, many of the tasks that were done, the questions related to trading basically presented me with a choice of something that had an 80 or a 100% accuracy versus a 20 or 30% likelihood of happening.

So for me, it’s second nature to pick the higher accuracy regardless of the amount of the reward, because my job as a trader is to just make money, and my job as a trader is just to accumulate profits and I want to do it in the most methodical, low-risk way possible. My job is not to go into the casino and gamble and hope that I’ll make $1,000. So I take it from a very methodical approach, and I think that’s what’s made me a great trader because not only am I looking at it from a probability perspective, but if something’s not working out, Indre, I’m cutting my losses and I’m just dropping the trade.

Most people go into trading and their only goal is to make money or to outperform the S&P, for example. My goal is to make 1% a week, and once I’ve achieved that 1%, then I’m focused on protecting my profits. And then, I do that again and again. And I think looking at it from that perspective, 1% doesn’t seem much, but it’s unlevered. And of course, leverage comes with risk, but it accumulates over the course of time because that could be 3 to 4% a month, 30 to 40% a year. Obviously, there’s going to be losses in there, that’s why it’s 30 to 40%. So taking it from a methodical approach, I think minimizes the emotions. And being able to get out of the trades when they’re not working out quickly also allows me to check the emotions at the door and to focus on just making those pips and keeping them.

Dr. Indre Viskontas:

But that’s something that’s really hard to do that people have to learn. We call it loss aversion, that it’s really hard to kind of get rid of the thing that you were hoping was going to make you money, but isn’t working out. And that’s a lot of the area where emotion comes in and people make trading mistakes.

Kathy Lien:

You’re absolutely right. The emotional aspect of trading is probably the hardest part because at the end of the day, I think every single trader has had the experience where they may be up a lot and they let the trade completely reverse and then go into losses, and they’re pounding the table and say, “I wish I took my profits.” And being able to recognize that and to basically take steps to prevent that happening, I think is one of the most important aspects of trading because anyone can make money, keeping the money is really key, and I think that’s the key to longterm trading success.

Dr. Indre Viskontas:

So how did you develop that? Is this something that you feel like you were naturally wired in the beginning or is this something that you actually took the time to develop as a skill?

Kathy Lien:

It came to be, to be honest. I mean, I traded in the beginning. I started trading in ’99 during the go-go days of the dot-com boom. It was all about big, triple-digit profits. And I think with time and also shifting markets to foreign exchange and currencies where the instrument is much more levered, and so, the ups and downs can be more significant, I think it’s important to take a methodical approach. So I guess goal-setting just came to me, but it’s through a long career of trading that I’ve come to realize that having that goal is probably one of the pivotal parts and transformational parts of my trading because very few people think about that, they just think about making money, and they just think about proper trade selection.

And that’s why I also always tell people that the exit, your targets and your stops should be just as important as your entry. Almost everyone focuses all their efforts on their trading strategy, on how to enter the trade, when to pick the right top and bottom. They focus very little effort on how to exit the trade. When should you exit? Are you going to double down? Are you going to scale in, scale out? Are you going to take a profit before the market close? Very few people think about that. They just think about, “I want to make money.”

Dr. Indre Viskontas:

Mm-hmm.

Kathy Lien:

And then they see, and this is particularly dangerous when we have a bull market that turns into a bear market where you see everyone floating these significant profits and they don’t want to take their profits for a variety of different reasons, then they start to see the profits eroded as we get a bear market happening. And the most dangerous aspect of that is that when you have a bear market, the moves are so much more aggressive and so much more intensive and so much sharper against you that it prevents you from acting because you freeze and you think, what should I do? Should I take the loss or should I hope that it’s going to recover again? And then, they end up blowing up their account.

And with trading, I think that’s much more important than investing because with investing, companies have value, with trading, especially when you’re trading a levered instrument, your value is only the size of your account. And so, that’s why having my target and getting out and making sure we just build that slowly, has been the real transformational part of my trading.

Dr. Indre Viskontas:

You use the word freeze, which is so apt because the amygdala, which is one of these areas of the brain that are involved in am ambiguity and uncertainty, when it’s activated, it can cause literal freezing. We see this in rodents that we study, they literally freeze, they don’t know what to do. And when I see that when you’re making these decisions, that is not into play, look, maybe our task isn’t the best representation of what you do, but it makes a lot of sense to me and it makes me think about how this has been wired up over time for you.

I do have a question because it looks like you have these strong executive functioning networks, executive control networks that are activated simultaneously. So did you play a musical instrument growing up or learn a second language?

Kathy Lien:

I played piano, not well. I don’t remember how to play piano now, but I do speak Chinese. I love foreign languages. I speak a little bit of Italian and French, and none of them well except for Chinese, but I do love foreign languages.

Dr. Indre Viskontas:

Because it turns out that the bilingual brain also has this feature, have all these high executive functioning skills that get developed through the development of a second language. So that’s really interesting.

And I think if you go to NYU and you’re 13, you have to be pretty goal-oriented or you have to have these networks in place to be able to keep track of all of the assignments and all of the things that 13-year-olds in general are pretty bad at.

Kathy Lien:

Honestly, I didn’t even think about it. I mean, I was just another student and I had the same homework, the same responsibilities, the same deliverables as every other student, and that’s the only way that I looked at it. And I feel like it just came second nature.

Dr. Indre Viskontas:

Mm-hmm. So getting just back to this exit strategy that you talked about how important it is to have that strategy laid out, one of the things I think can be really painful about loss is when you pull out of the market because you’ve made your 3 or 4% and now you see the stock or the trade go up so much more, how do you deal with that element of FOMO?

Kathy Lien:

That’s a very good question because I mean, that happens to everyone. I just move on. It happens to me, actually, every day. It happened to me today where I had a trade and I took my profit, it went much further. But I find relief and I find comfort in that I stuck to my goal and I exceeded that goal already this week. And so, I may not have made 100% of the profits, but at the end of the day, I went home with more money than I left. And that is my only job, which is to make the profits, keep them, and then do it again every single day.

I don’t trade in a way where it’s just about the big winners, it’s about the consistent, steady winners. And they will be smaller than the 10, 20, 30% gains that you’ve held for a year for, but they’re repeatable. And that, I think, is the most important aspect of it, because you don’t want to just get lucky. This is true of athletics. This is true of pretty much anything someone is good at. You find something that works and you just do it over and over again.

Dr. Indre Viskontas:

So as you’ve learned to regulate your emotions, is there some place that you let out steam? Do you take a sledgehammer to a wall once in a while or something like that?

Kathy Lien:

No, I don’t think that would work out very well, but I shut down in terms of trading at very specific periods of the day, and also, periods of the week. And I don’t look at it again until I have to restart.

So part of my trading process is I trade the environment that works best for my strategy, which is basically the market opens. And so, basically, I trade from 6 A.M. New York time to about 9:30 New York time. And then I trade the Asia open between 8 P.M. To 11 P.M. and then, that’s it. Between there, I don’t look at the markets at all. I’ll watch some news, now, maybe I’ll do some analysis, but I’ll just work on other things. And come Friday at 9:30 A.M. right after the New York equity market open, everything’s digested, I’m pretty much done. I am doing other things, catching up on other work. So I only focus on the periods that are most efficient for my strategy, and I just step away from the markets any other time.

Dr. Indre Viskontas:

Well, I can certainly see that strategic thinking in your brain activation. And I just want to thank Nina Dolfen and Lila Davachi at Columbia for helping me get these scans, and Yoed Kennett for the Alternate Uses and Alternate Questions Task. And of course, Kathy Lien, thank you for lending us your brain and telling us how you use it.

Kathy Lien:

Thank you for having me.

Dr. Indre Viskontas:

Join us next time as we inside the minds of brilliant traders.