Saturday, May 23, 2015

Trading, Backwards

A shoutout to Bruss Bowman for pointing out this truly insightful video on backward bicycle riding.  Engineers made a simple change to a bicycle, such that turning the handle bars made the bike move opposite the expected direction.  Sure enough, that made the bike impossible to ride.  The video demonstrates this with humor and insight.  It turns out that it doesn't take much to disrupt the algorithms in our brains!

A somewhat similar experiment was conducted in the 1950's by Ivan Kohler, who had subjects wear prism glasses that distorted their vision.  Since that time, prism adaptation has become a well-studied phenomenon.  There is typically a period of disorientation, in which subjects wearing prism glasses cannot execute simple hand-eye coordination tasks.  Then, gradually, they adapt to the changed world and can function with the glasses.  When the glasses are removed, however, they return to a short period of disrupted functioning.  

Fascinatingly, people who wear the glasses but do not interact with the world during that period do not adapt to the new perceptual world.  It takes repeated experience to learn from errors and recalibrate one's perception.

Think about ever-changing financial markets.  Markets change in their patterns of volatility, sometimes moving a great deal, sometimes quite little.  Market shift in their patterns of correlation, sometimes moving in concert with other markets and other times moving more idiosyncratically.  Markets change their directional behavior, sometimes reversing moves within ranges, sometimes extending ranges within trends.

It is as if the market's handlebars continually change; as if traders constantly put on new glasses with different prisms.

If that is the case, then we would expect disorientation to be a natural part of the adaptation process.  We would also expect losses to be a natural part of adaptation.  Traders *can* adapt to changing markets, but only after a period of interaction with those markets.  

Anticipating those periods of disorientation is helpful to trading psychology:  one need not take them as threats if they are part of adapting to changing conditions.

Anticipating periods of disorientation is also helpful to risk management.  If we know that markets will change, we can keep bet sizes small enough to weather those periods when markets trade with backward handlebars. 

Not long after we seem to master markets, we become students again:  expertise over time is a function, not just of learning, but the capacity to relearn.

Further Reading:  Adapting by Becoming a Better Thinker

Friday, May 22, 2015

The Power of Apprenticeship in Trading

The recent post discussed how we can turn our defeats into development.  Since writing that, I received an email from an accomplished prop trader who leads a group within the larger organization.  That trader had just sustained the worst losing day of his career.  So what did he do to address the situation?

He stayed constructive.  He wrote a detailed analysis of what he did wrong and how he will learn from the mistakes going forward.  His focus was on making sure this doesn't happen again, not on blaming external forces for his drawdown.  He took responsibility, but didn't stay mired in self-blame.

He reached out.  He sent his analysis to me and to the heads of his trading shop.  His commitment to improvement and learning from the setback thus became public.  He asked for a phone chat with me.  Done.  You can tell the workhorses from the show horses, because show horses will never show you their ugly side.

He role modeled.  This is the best part of all.  He sent his analysis to the members of his team.  He used his setback to help his teammates learn.  Instead of trying to look like a guru, he showed them how to handle loss.  That is a lesson far more powerfully delivered than in any textbook or blog post.

I predict this trader will be a rock star.  By turning his loss into learning for all, he showed leadership, not just management.  And, of course, that could never have happened if his firm did not promote team building, learning at the desk, and apprenticeship.

At one hedge fund where I work, portfolio managers are encouraged to build out teams by hiring junior professionals who have particular areas of experience and knowledge.  Those developing managers add value to their teams and learn the skills of trading and portfolio management at the desk.  The hit rate on their success is unusually high.  Why?  Because they learn through apprenticeship, not through a classroom or through unguided experience in front of a screen.

When you have a team and can learn from the successes and failures of others, your learning curve is multiplied.  Whether you work at a trading firm or independently, a key to success is surrounding yourself with others who are capable of turning losses into lessons.  Sharing your experiences with others transforms those lessons into commitments.

Further Reading:  Managing and Leading Your Trading Business

Thursday, May 21, 2015

Assessing Demand and Supply in the Stock Market

By now readers are aware that measures I track closely are buying pressure (demand) in the market versus selling pressure (supply).  My measures are derived from a decomposition of the NYSE TICK, which is issued by the New York Stock exchange.  The TICK is a running total, updated many times per minute, of the number of stocks trading on upticks versus the number trading on downticks.  My buying pressure and selling pressure measures separate upticking from downticking in the time series, treating strength and weakness as distinct variables.  While demand and supply are reasonably well correlated in the short-run, that is not the case over a period of days.  Any given period can show high amounts of buying and high amounts of selling; high amounts of buying and low amounts of selling; low amounts of buying and low amounts of selling; and low amounts of buying and high amounts of selling.  Indeed, the interplay among buying and selling pressure is a useful way of tracking phases of intermediate-term market cycles.

As you can see from the charts above, we've recently made fresh highs in SPY.  During that period, we've seen below average buying pressure (the zero level is average) and more than average selling pressure (values below zero show heavier selling).  That suggests that more stocks have been trading on downticks than upticks, even as the broad market average has risen to new highs.  This is the first divergence we've seen in the cumulative NYSE TICK in many months.

This excess of supply pressures over demand helps account for the weak breadth of the recent rally.  Interestingly, yesterday we hovered at new highs in the index, but only 500 stocks across all exchanges traded at fresh one-month highs, while 389 touched fresh one-month lows.  Volume in SPY has also been unusually low during the past several sessions.  Since 2013, when SPY volume has been in its lowest quartile, the next ten days in SPY have averaged a loss of -.08%.  When volume has been in its highest quartile, the next ten days in SPY have averaged a gain of 1.41%.

A break to new highs on expanded volume and breadth would clearly violate the pattern of weakness noted above.  Until that point, I don't see an edge in chasing the upside.  More on this topic at this evening's gathering.

Further Reading:  Tracking Market Dynamics

Wednesday, May 20, 2015

Randomness and Returns: A Market Lesson From Peter L. Brandt

I'm looking forward to being part of a very special trader's conference in September featuring Jim Dalton, Jack Schwager, and Peter Brandt.  Details on the conference will be coming shortly.  In upcoming posts, I'd like to highlight a few things I've learned from these seasoned professionals.

One of the best posts on trading that I've encountered in years is Brandt's analysis of how randomness affects trading profitability.  The same exact trading methodology can yield winning or losing outcomes over a limited time horizon simply due to the random strings of winning and losing trades.  This is demonstrated extremely well by Brandt's post, where he assumes a given win rate and ratio of average winning size to losing size and then shows how those metrics can lead to profitability or unprofitability over a run of 100 trades.  

There are two important implications of Brandt's analysis:

1)  If you ramp up your trading size, the increased risk over a random series of losing trades can devastate your account.  Your trading size should not be a function of some high target return that you hope to make, but rather a function of the random strings of losers that you can survive.

2)  Just because you're going through a losing period doesn't mean you're trading a losing methodology.  Changing sound methods in the middle of a random string of losing trades would be like a batter changing his swing after striking out a few times.  That is what helps turn normal setbacks into prolonged mental and performance slumps.

The bottom line is that we can read far too much into short-term trading outcomes.  Losing trades don't necessarily mean we're trading poorly and winning trades don't necessarily suggest that we have a hot hand.  We can gain knowledge from analytical mistakes and creative insights, but it's also important to retain the wisdom that sometimes we will trade well and lose and other times we can trade poorly and win.  

Not every move--of markets, or of profit/loss--is meaningful.

Further Reading:  Lessons From a Successful Trader

Tuesday, May 19, 2015

Thursday TraderFeed Gathering in NYC

Well, I have a choice.  I can either go through my emails (all 16,606) or I can post to the blog a reminder about Thursday's get together for daytraders and other assorted dubious characters.  Not one of life's more difficult choices...

We'll convene at 5 PM in NYC at the tasting room of the Whole Foods at Columbus Circle (lower level of the shops at 59th and 8th Ave.)  Hope to talk about trading, markets, craft beer, and of course craft beer.  Look forward to seeing some of my good colleagues at SMB there as well as a good friend who's quite an experienced prop trader.

Now to those emails...

Joining a Prop Group or Hedge Fund

I frequently hear from two groups of traders interested in affiliating with trading firms:  early career traders interested in experience, learning, and access to capital and experienced traders looking to grow themselves.  Two of the types of firms they most often consider for affiliation are proprietary trading groups and hedge funds.  Since I've held full-time jobs at both types of trading firms and been involved in the hiring process, I can offer a few perspectives for those contemplating those career directions.

What are the differences between prop groups and hedge funds?

Prop groups trade the (proprietary) capital of the firm's owners.  Historically, prop groups evolved from market making functions.  As algorithmic trading has taken over much of the true market making, most prop firms have retained their short-term roots and trade short-term (largely intra-day) opportunities, making use of significant leverage.  Prop firms can operate in futures markets or stocks; occasionally both. 

Hedge funds trade the capital of investors, some of whom may be owners/partners in the firm and others who will be high net worth individuals and/or institutional investors.  Hedge funds traditionally invest, not trade.  They run portfolios of positions, rather than trade in and out of a limited number of instruments daily.  Hedge funds trade a wide variety of strategies and often will run different strategies within a single fund to achieve diversification for investors.

A hybrid structure is known as the "family office".  This is an organization that manages money like a hedge fund, but trades only the capital of the friends and family of the founder.  Very high net worth individuals may establish family offices to avoid the regulation of hedge funds while retaining the practical benefits of hiring portfolio managers.

What are the advantages of affiliating with prop groups or hedge funds?

Access to capital.  This can be significant, as many early career traders simply lack the capital to earn significant dollar returns.

Access to other skilled traders.  This varies greatly from firm to firm and requires due diligence.

Access to superior tools and equipment.  Larger firms can afford to invest in software and trading platforms that help traders find opportunities and better manage risk.

Access to structured learning experiences.  This varies wildly across firms.  Some run actual training programs, some offer mentoring within groups, some offer little if any training.  This requires particular due diligence.

Access to markets.  Prop firms and hedge funds can open access to markets that might be too expensive or difficult for traders to trade on their own.  A prop firm that is a member of an exchange can pass along a favorable commission structure to its traders.  A hedge fund with strong relationships with prime brokers can meaningfully expand a trader's access to global markets.

What are the pitfalls of affiliating with prop groups or hedge funds?

Fees - Sometimes these can be onerous.  There are some bad players out there that make their money more from the commissions and seat fees they charge traders than from facilitating the success of their traders.  If you're paying high commissions, you are a customer of the firm you work for, not an employee.  Caveat emptor.

Payouts - If you trade on your own, you keep 100% of your profits before expenses.  If you trade at a prop firm, that payout may be closer to 50%.  If you trade at a hedge fund, it will typically be below 20%.  That isn't a problem if you have significant access to capital and if you're getting value in return for the profit-share.  But you want to make sure that's the case.

Job Security - If you cannot sustain profitability, these firms will not retain you.  That can make it difficult to find a new position.  One limitation of making trading a career is that it doesn't readily prepare or position you for alternate careers.  This is an important consideration to think through if you're contemplating raising a family and need a measure of stability in your career.

How do I break into a prop group or hedge fund?

Build your own trading track record - Even if it's with small capital, you can demonstrate good decision making, sound risk management, and trading skills.

Develop knowledge and skills that make you valuable to a firm - There is always a need for quantitative talent, programming experience, and specialized knowledge of specific markets or regions.

Join an existing group within a firm - This is my favorite way for young professionals to join a hedge fund, but it takes networking and that development of specialized knowledge and skills.  Increasingly, we're seeing prop firms build out groups as a way of leveraging their talent and offering ongoing mentoring of developing traders. 

Affiliating with a trading firm is definitely not for everyone.  You may not want to make trading your career, and you may have sufficient access to capital and other resources to build your own trading business.  One structure that is interesting is known as "arcades", where traders bring their own capital, enjoy higher payouts, but share office space and resources.  That can be a nice blend of affiliation and independence for experienced traders.

If you do decide to look into affiliating with a firm, watch for those sketchy players that take advantage of the hopes and dreams of unwitting early career traders.  If a group claims to offer education and training, get the details about their curriculum.  If the firm offers great payouts, check out the (hidden) fees and commissions.  If the firm promises access to capital, find out exactly how much access their experienced traders have.

Finally, culture matters.  Some trading firms care a lot more about their traders--and are much more devoted to growing them--than others.  Talking with traders already working within the firms is a great way to learn about the culture and the opportunities and pitfalls of affiliation.

Bottom line:  If you want to join a top firm, learn some top skills and get some specialized experience that will make you an asset to the company.  Going with no track record and no specialized skills and loudly proclaiming your "passion" for trading is a great way of failing to distinguish yourself to any solid organization.

Further Reading:  Joining a Prop Firm

Monday, May 18, 2015

Thoughts and Ideas Going Into a New Week

*  Interest rate volatility has not been friendly to the stock market over the last few years.  Since 2012, when 20-day realized volatility in TLT has been in its highest quartile, the next 20 days in SPY have averaged a gain of +.35%.  That contrasts with an average 20-day gain of +1.35% for the remainder of the sample.  A weaker dollar, rising gold prices, a steepening of the yield curve, disappointing economic data releases:  are we seeing beginning concerns over stagflation?

*  We are all in the business of living; our success hinges on our self-management and leadership.

*  Ivanhoff Capital on the role of luck in success.  I would say that success is the result of putting yourself in enough promising situations where good luck can eventually come your way and staying out of enough unpromising situations that you can avoid bad luck.  This is why holding losers and selling winners quickly is so damaging:  it minimizes the odds of good luck and maximizes the odds of bad luck.   

*  Good book recommendations from Abnormal Returns.  I particularly like Ratey's book on exercise and the brain.

*  On the topic of books, I was pleased to host a craft beer gathering of portfolio managers last week with Maria Konnikova.  I will be posting on important topics from her excellent book Mastermind: How to Think Like Sherlock Holmes.  She also spoke about her upcoming book, The Confidence Game, which takes us inside the heads of con artists and their victims.  A worthwhile related topic: how we can con ourselves.       

*  Concerns over demographics in China and questions over its true growth rate;

*  The consensus for a Fed rate hike has shifted from June to September.  Interesting that 70% of economists think the Fed will wait too long to raise rates, not raise them too soon.  Is the rise of rates on the long end expressing that fear?

We're nearing a critical period for Greece and the possibility of default on its debt; some worthwhile tweets from @MrTopStep.   

Have a great start to the week!

Sunday, May 17, 2015

Volatility, Correlation, and What Makes For Good Trading

I'll be talking more about this topic at Thursday's NYC trader gathering:  how market volatility and correlation are related to forward price movement in the broad indexes.  The above chart tracks an index that I created that combines volatility and correlation across the major stock market sectors.  The bars represent average forward 10-day price change since 2012 when the volatility/correlation index has been in its various quartiles.  In general, we see subnormal returns when volatility and correlation are low and unusually strong returns when the two are high.  It is in the latter situation that we have seen selloffs, with everything taken down in a risk-off mode.  When volume and volatility are low and some sectors are showing strength and others not (weak breadth), that's when we've seen punk near-term returns.

We currently reside in the lowest quartile:  low volatility and low correlation.

The division of forward returns into quartiles based upon a candidate predictor is the start of market analysis, not an end point.  At least two further issues remain:

1)  What is the variability around the returns in the quartiles?  We're looking at averages, but perhaps these are skewed by a relative handful of very low or very high values.  Strong differences of means are far more significant when there is little variability around the means than when individual values are all over the place.  In practical terms, a given mean difference in returns may not be helpful if pursuing the difference exposes you to large drawdowns.

2)  Is your candidate predictor truly unique?  Maybe volatility and correlation are low and high simply because the prior X days have demonstrated a strong or weak return.  Just because you have a promising variable doesn't mean that the variable is *uniquely* predictive of forward returns.  A simple procedure is to construct a stepwise multiple regression where past price change is the first variable entered to see if it is predictive of the next X-day change in index prices.  Then add your candidate variable in the second step and see if this accounts for significant further variance in predicting the next X-day change.

Even if we pass the above two criteria, what we have left is a hypothesis, not a conclusion.  Any historical analysis assumes that the patterns of the past will play themselves out in the immediate future.  As a quantitatively informed discretionary trader, I will then look for evidence in the day's session that the predicted pattern is or isn't playing itself out.  When price action and market behavior lines up with what the model is predicting, there's the possibility of a trade.  When they don't line up, it means that something unique is happening in today's trading session, such that a historical pattern is not playing out.

That, too, is information to a flexibly minded discretionary trader.

Good trading occurs at the intersection of rigorous analysis and keen pattern recognition.

To be continued...

Further Reading:  My Recent Trading Experiment

Saturday, May 16, 2015

Going From Managing to Leading Your Trading Business

There are few topics more important than that of self-leadership: how we guide and manage our lives.  This is particularly true when the business of life also includes a business as a trader or investor.  Managing our trading means that we are deploying our capital efficiently and effectively:  finding the right balance of risk and reward over time.  Leading our trading business is something different altogether.  When we are the leader of our trading enterprise, we determine whether we are pursuing the right risks and rewards.  Markets change; opportunity sets change:  do we change with them?  That is a question of leadership.

A major pitfall for active traders is that they spend so much time managing risk and opportunity that they fail to properly lead.  They work hard, but struggle to succeed if they're pursuing unfruitful directions.

But if you're an investor or trader, you're more than a manager and more than a leader.  You are also a venture capitalist.  You are funding your trading enterprise.

Here's a great exercise:

Put together a pitchbook proposal as if you're actually pursuing venture capital.  Your pitchbook will consist of four sections:

1)  Your background, history, and experience that qualify you for an investment of capital;
2)  Your core strategy or strategies and what, specifically, gives them a distinctive edge in markets;
3)  Your track record, including monthly profit/loss, drawdowns, and overall risk-adjusted returns;
4)  A detailed description of your trading process, from the generation of ideas to the management of risk, along with sample trades that illustrate the process in action.

Once you assemble the pitchbook, set it aside for a day or two and then read it with a fresh set of eyes, imagining that you're an investor being asked to invest in this trading business.

Would you make an investment?  Would you feel comfortable asking others to read your pitchbook and consider making an investment?  Would a savvy trader or investor invest in your business?

If not, what improvements and changes would you need to implement to justify an investment?

The answer to that question takes you from management to leadership.

Further Reading:  Self-Leadership and Success

Friday, May 15, 2015

Turning Your Defeats Into Your Development

One of the interesting commonalities among the Market Wizards interviewed by Jack Schwager is that many suffered blow ups early in their careers.  Those implosions turned into important lessons that shaped their future success.  Their success came, not just from winning, but from turning the downs in their trading into ups.  Without the failures, they would not have achieved their successes.

I find this is true in relationships as well.  It sometimes takes a seriously failed relationship to teach a person what they truly need in a good relationship.  Many a happy marriage has been preceded by an unhappy prior relationship.  The same is often found in career development.  One doesn't find the right direction until pursuing some wrong ones.  The downs in life provide fuel for the ups.  That is part of being alive.

Here's a great exercise for your trading journal.  Divide the page into three columns:

In the first column of the journal entry, identify your greatest trading failure during the past week.  Was it a missed opportunity that your process should have picked up?  Was it a trade taken that truly lacked an edge?  Was it poor implementation of a good idea or an idea that you simply took from the crowd?  

In the second column, assess the consequences of that trading failure?  How much did that failure cost you?  In actual losses?  In lost opportunity?  In your mood or focus?  In subsequent bad trading?  We don't change our patterns unless we sustain awareness of their costs.  When we emotionally recognize the consequences of our actions, we find the motivation to make changes.

In the third column, clearly formulate a plan of action for correcting that trading failure over the coming week.  This becomes your mandate, your overarching goal for the week.  You will assess the success of the week based upon your ability to turn trading defeats into your development as a trader.

Imagine sustaining such a journal project for an entire year.

Imagine a parallel project for improving yourself as a spouse, as a parent, or as a professional in your work.

Turning failure into success fuels growth.  Continuously turning failure into success fuels resilience.  This journal exercise, over time, builds the spirit as well as the performance.

Further Reading:  Five Features of Great Traders

Thursday, May 14, 2015

The Personal Side of Trading Performance

A worthwhile exercise for your trading journal:

Track physical variables, including sleep (quality and amount); exercise (amount and type); eating/drinking (amount and type); and overall energy level.

Track your daily productivity (amount of work you get done; quality of the work you get done); quality of your idea generation (how well you're seeing markets and generating trade ideas); quality of your trading (making right decisions at the right time); and quality of your learning from your trading (journaling, work on yourself).

Does better work lead to better attention to those physical variables?  Does more attention to the body lead to better performance in trading?  

How are you behaving during your best periods of trading?  Your worst?  How consistent is your lifestyle relative to optimal performance?

Are you like an athlete in training or do you lack training?

Further Reading:  The Performance Benefits of Exercise