Monday, April 20, 2015

Resources for Traders and More to Kick Off the Market Week

*  Above is my intermediate-term measure of market strength (red) charted against the cash SPX going back to the beginning of 2014.  The strength measure takes the sum of 5, 20, and 100-day highs and subtracts the sum of 5, 20, and 100-day lows specific to the SPX stocks.  It then smooths this number with a 10-day moving average.  (Raw data via the excellent Index Indicators site.)  Note that the strength measure has been waning since late 2014 and has recently turned downward from a relatively low peak.  When strength has been above zero going back to 2012, the next 20 days in SPX have averaged a gain of +.86%.  When strength has been below zero, the next 20 days in SPX have averaged a gain of +2.34%. 

*  Here's a very important Forbes article on performance co-written by Ted Hayes, Ph.D.  It explains why the single most important thing you can do to improve trading is develop and implement a strengths-based performance framework.  Some excellent links to strengths-based tests and resources. 

*  What to look for in market bubbles and other great reads for the week from Abnormal Returns.

*  Here are some great resources for you quant types out there:  

-- A very impressive collection of market stats from Vic Scherer.

-- Great breadth data and an impressive query engine from Kora Reddy.

-- My long time source for breadth data, Index Indicators also has a query engine.

-- A new primer on quant analysis from Adam Grimes.

Have a great start to the week!


Sunday, April 19, 2015

Bayesian and Static Reasoning in Markets: Trading With an Open Mind

In a recent post, I highlighted the range trade in the ES futures over the past several months.  My point was that the market has been showing diminishing breadth at successive highs and also less weakness at successive lows during that range.  Generally, lengthier ranges lead to lengthier directional moves, as they are part of longer-term market cycles.  So the breakout from the current range should ultimately be a significant one.  Will the market break out of its range imminently, or will the range continue for another month or more?  Will the ultimate breakout be to the upside or downside?  Will we see a fakeout, false breakout prior to an eventual move to new highs or lows? 

My worst trading--and the worst trading I've observed of many traders--has been the result of what could be called static reasoning.  Static reasoning takes a variety of evidence, assembles the evidence into a conclusion, and then places trades based on that conclusion.  Risk taking is often a function of one's degree of belief in that conclusion.

Static reasoning is problematic for two reasons:  1) it is subject to overconfidence bias, as we take a firm stance on a view that we own; and 2) it is subject to confirmation bias, as we tend to process new, incoming information in the light of our convictions.  When I've seen traders take larger than desired losses, it's generally not been because they've held onto marginal views.  Rather, they have sized up their preferred views, stuck with those views in the face of contrary market information, and ultimately lost the position when drawdowns became uncomfortable.

I have found my best trading to result from what could be called Bayesian reasoning:  a thought process that reflects a Bayesian, probabilistic way of thinking.  Bayesian reasoning begins with a hypothesis, but it is a flexible hypothesis that updates with new, incoming information.  One's confidence in the hypothesis waxes and wanes with new information, and one's hypothesis can quickly change with new information.

With static reasoning, a market view is something you have and trade with.  With Bayesian reasoning, a market view is fluid and continually evolving.  

Trading leading up to and including this past Friday was a good case in point.  We traded firm for most of the week, with relative strength in small cap shares.  Volume had been coming down in recent sessions and, by April 15th, we saw new highs in the broad NYSE Composite Index not accompanied by an expansion in the number of stocks registering fresh highs.  With each observation of low volume and diminished new highs, my confidence in an upside breakout diminished.

Friday saw new information come into the market regarding China and Greece.  There was a strong selloff in pre-market hours.  Volume expanded, as did volatility.  New market participants were joining the fray, and they were joining with a downside bias.  That led me to sell an early, pre-opening bounce in the ES futures.  At that point, the evidence tilted toward continuation of the range and a short-term handoff from bullish to bearish control of the market.  I reasoned at the time that investors would not want to risk bad headlines over the weekend and so would be likely sellers in early New York trade.

That indeed materialized, but then something interesting happened in mid-to-late afternoon.  We had seen steady selling in stocks, as measured by the NYSE TICK.  When I ran a study of lopsided selling days such as the one in progress, I noticed a tendency for the market to bounce higher the next day or two.  At the same time, I noticed continued selling pressure in stocks (negative TICK values), but now the ES futures were holding above their lows for the day.  Selling was no longer able to get price higher.  I still liked the range-based view but the trade no longer looked great from a risk/reward perspective and I took profits.

Am I a bull?  Am I a bear?  Not really either, and the question presumes a degree of static reasoning.  What made Friday a good day in the market was the fluid transitioning from waning bullishness to waxing bearishness to waning bearishness.  We could indeed gap lower in the near term and take out Friday's low, but that's not where the odds were at the time.  Let's let the bulls take their turn and see what they can bring to the market.  Should we get a feeble rally and a lower high, there will be plenty of opportunity to resume a downside trade targeting the lower end of the recent range.  Should we get a more substantial rally, then we can update evidence for continued topping in the range or even upside breakout.

Bayesian reasoning means trading with an open mind and staying flexible in the face of new information.  Think of it this way:  we're in an ongoing conversation with markets.  In any conversation, if you stay locked in what you want to say, you become less sensitive to the other person.  A good conversationalist is a good listener, picking up on subtle cues and adjusting one's own tone and response accordingly.  In markets as in conversations, closed minds and strong views lead to tone-deaf interactions.

Further Reading:  The Importance of Emotional Creativity

Saturday, April 18, 2015

Breakout in the Making?

Here are the ES futures over the past several months.  Somewhat volatile and in a range.

A few interesting stats:

Stocks across all indexes making fresh 3-month highs and lows:

2/13/2015 - 510, 86
3/2/2015 - 513, 158
3/20/2015 - 708, 113
4/15/2015 - 570, 89

1/29/15 - 172, 449
3/10/15 - 137, 440
3/26/15 - 82, 213
4/17/15 - 131, 167

Fewer new highs, fewer new lows from March to April.  

Not strengthening.  Not weakening.

So far.

What I Learned By Studying My Exits

An interesting question posed on the Tradeciety site asks the one thing you wish you had known when you started your trading career--and gives the responses of a number of experienced traders.  Most of those responses focus on sound trading practices and ways of learning trading--sound universal lessons.

A worthwhile variant of that question is:  what's the one thing you wish you had known at the start of the year?  In other words, what have you been missing in the last few months of trading?

I recently conducted my own trading inventory and examined in detail what has worked and not worked.  The results were illuminating.

My exits have been bad.  In some cases, they've been really bad.  What I mean by that is that:  a) they've been less rigorously thought through than the entries; b) they've been reactive to the pain of drawdown and not the risk/reward at that moment; and c) they've been at poor locations.  A surprising proportion of my trades would have been profitable had I held the position with a wider stop.  The seemingly good risk management significantly hurt profitability.

The problem--and I see it with traders I work with--is the misalignment of goals for the upside and risk management on the downside.  At a given, reasonable, but positive Sharpe ratio, a trader seeking X% returns is going to draw down a meaningful percentage of X% at some time.  Traders--including myself--feel the desire for the X% upside, but cannot psychologically or practically tolerate the accompanying drawdown.  It is not coincidence that my hit rate on trades placed with smaller size (less risk) has been quite good.

Ultimately this is a problem of lack of diversification.  A well constructed portfolio consists of many relatively independent bets, each with positive expected return.  This smooths the equity curve while allowing the trader to place a higher proportion of capital at work.  Diversification requires ongoing research and development--and the ability to see multiple edges in the market.  It is much easier to allow trades to breathe and hit relatively wide stops when there are multiple trades working for you.  A great deal of the challenge of dealing with emotions in trading is a function of poor money management.  It's tough to trade dispassionately when all your eggs are in one basket.

Further Reading:  Diversifying Your Emotional Portfolio

Friday, April 17, 2015

Quick Insights With Deep Meanings

J.C. Parets on the value of homework.

Mark Yusko on the power of our social environment.

Derek Hernquist on backtesting.

Brian Shannon on investing's key lesson.

Urban Carmel on the market's sentiment.

Ambrose Evans-Pritchard on deflation.

Steve Burns on the greatest challenge in trading.

*  Think about the meaning of this:  Since 2014, when SPY daily volume has been in its lowest quartile, the next 20 days in SPY have averaged a loss of -.06%.  When SPY daily volume has been in its highest quartile, the next 20 days in SPY have averaged a gain of +2.71%.  

Further Reading:  Evaluating Your Trading

Thursday, April 16, 2015

Sleep and Performance: The Quality of Our Nights Affects the Quality of Our Days

I find that a surprising proportion of what sets traders up for success during the day is what has happened the previous night.  We know from research that the proper quantity and quality of sleep aids concentration and learning and that disordered sleep can impair our cardiovascular health.  Sleep also has a beneficial impact on our mood and is associated with improved thought and memory.

It is fascinating that sleep disturbances are present in over half of patients with psychiatric problems--a far greater percentage than in the general public.  This has led to the observation that sleep disruptions are not only symptoms of problems such as anxiety, but active contributors to those.  One in five patients with depressive disorders are suffering from sleep apnea--disrupted sleep often associated with snoring. 

One study found that financial decision making was meaningfully impaired when subjects were sleepy due to poorer judgment about the task being undertaken.  It is when tasks are complex and challenging that we're most likely to be impaired by poor sleep.

Here is an excellent article from Maria Konnikova on how our performance is impacted by how we wake up in the morning.  Sleep inertia, she reports, significantly affects our cognitive functioning.  It appears that being process-driven in how we sleep is as important to our functioning as being process-driven in our work during the day--and indeed may set us up for either success or failure in our ability to work in disciplined and productive ways.

Further Reading:  Three Things to Improve Your Life Now

Wednesday, April 15, 2015

Historic Market Strength or the Start of a Bear Market?

Jesse Felder looks at the stock market from the vantage point of historical valuation and finds us in rarefied territory.  Using other measures, Jesse Colombo arrives at a similar conclusion.  This strikes me as tremendously relevant for investors.  From a timing vantage point vis a vis shorter-term traders, I have more questions.  Prior to the large drops we saw in 1998, 2000, and 2007, for example, we saw a ramping up of volatility (VIX) and stocks making fresh new lows.  In other words, rises in volatility and weakness in leading sectors preceded those bear markets.  I'm not seeing those things at present, but the possibility that we're operating on borrowed time strikes me as a valuable one to entertain.  I'm just not sure we can expect historically normal market cycles when we have extraordinary global monetary policies. 

An extraordinary wealth of economic information and perspective is offered by Jeff Miller at Dash of Insight.  Measures he tracks suggest a healthy degree of strength in the economy.  He also raises the issue that bear markets tend to occur late in hiking cycles, not early.  Again, it may be difficult to extrapolate from past cycles to this present, extraordinary one, but Miller also notes that overvalued markets can become quite further overvalued before they run into trouble, citing data from Capital Speculator.

What we see is that intelligent market observers see the market quite differently.  My synthesis of all this is that we are historically overvalued *and* we're not yet seeing worrisome economic or market weakness.  Perhaps the best synthesis of all, however, is to go to websites such as the above and track down the original sources of data and the links from recent posts.  You are guaranteed to find intelligent perspectives that will broaden your own.  

Further Reading:  Creativity and Trading

Tuesday, April 14, 2015

A Simple Strategy for Developing Yourself as a Trader

Here is a simple formula for developing yourself as a trader:

Find the people who most consistently come up with the most original and useful observations and ideas, study their thought processes (how they're generating those ideas), replicate those ways of thinking for yourself, and take the time to begin thinking like them.  Imagine doing that across many virtual mentors over time so that you begin to integrate the best thinking of the best people.  That is how imitation turns into innovation.  

Take a look at who you're following in social media.  If you're spending much time reading material from those you don't want to internalize, you'll wind up with little cumulative development.  A great exercise would be to curate the $STUDY stream of StockTwits and immerse yourself in the educational offerings of only those you'd like to emulate.  

You can't elevate your game unless you surround yourself with the best out there to challenge you, inspire you, and inform you.  You win by studying winners.

The same is true for stock picking.  How many people truly study the best performers during any given period and reverse engineer that performance?  There are common features of best and worst performers among stocks and markets, just as there are common features of best and worst traders.  You learn to select the best trades and investments by studying the best trades and investments.

Kudos to @ivanhoff and @howardlindzon for their recent offering on identifying the next Apple among market performers.  The greatest investments don't start as the most optically appealing choices in many cases.  Similarly, great trades to the long side often start as scarily weak markets--October, 2014 being a recent case in point.  If you study one winning idea after another, however, you begin to see common threads.  You immerse yourself in winning trades and, after a while, you recognize patterns as they emerge.

It's great to focus on our mistakes and correct our errors.  Reducing the negatives of performance, however, will never in itself generate elite positives.  If you want to perform at high levels, you have to study--and internalize--high level performance.

Further Reading:  The Success Pyramid

Monday, April 13, 2015

Opening the Week With New Ideas

*  Here are three charts that I use to track demand and supply in the broad stock market.  I decompose the time series for the NYSE TICK (number of stocks upticking vs. downticking at each moment of the trading day) into a measure of Buying Pressure (top chart; a measure of upticks); Selling Pressure (middle chart; a measure of downticks); and Balance (bottom chart; the daily net of upticks vs. downticks).  In recent sessions, we've seen relatively restrained buying interest and also relatively restrained selling.  This is typical of low volume, low volatility markets.  On a net basis, we've generally seen more buying than selling pressure and stocks have drifted toward their highs over this period.  This is as much due to a relative absence of sellers as the positive presence of buyers.  Institutional players--those that drive volume as buyers or sellers of baskets of stocks--have been quiet of late, creating few surges of either buying or selling activity.

*  When academic reviewers took a look at the profitability of traders, they were shocked by how poor the results looked.  Here's my psychological look at what separates the winners from the losers.

*  More evidence that active fund managers as a group fail to outperform their benchmark indexes.  In fact, managers in every category fail to outperform.  You would think that half would outperform by sheer chance.  As the article emphasizes, however, the odds of such across-the-board underperformance occurring by chance are ridiculously small.  It's not that managers lack a positive edge.  They actually seem to have a significantly negative one.

*  It's very difficult to not find good posts on the Quantocracy site.   

*  It's also very difficult to not find something good in the weekly top clicks at Abnormal Returns, including an unusually good study of moving average rules--what works and doesn't work.

The $STUDY stream from Stock Twits invariably contains some gems.

*  Here are some coming resources from Adam Grimes, including a primer on how to study markets with quant tools.

 *  Great post from SMB on what golf teaches us about trading.

Have a great start to the week!


Sunday, April 12, 2015

The Three Paths to Success in Financial Markets

I propose that there are, at root, three basic paths to success in financial markets that correspond to three kinds of market participants.  These are very different approaches to markets and require quite different skills, knowledge, and talents.

The first path to success in markets is the path of the statistician.  The statistician is one who identifies the probabilities of outcomes as a function of current and past conditions.  A statistician, for example, might notice that two currencies are trading out of line with each other because of temporary flows attributable to mergers and acquisitions and place a bet that these will return to their historical relationship.  The idea for the statistician is to construct a portfolio that consists of many distributed bets, each of which has a favorable probability of paying off.  

The second path to market success is the path of the theorist.  The theorist is a big picture thinker who identifies an antecedent set of conditions that, over time, should drive the price movements of financial assets.  Macro money managers, those who look at geopolitical events and macroeconomic developments such as central bank policy shifts, are classic examples of theorists.  Their approach to markets is top down:  understand the big picture and then define a diversified set of bets from that understanding.  For instance, the theorist will notice that central bank policies are notably more dovish--providing more liquidity--in some countries than others and will buy stocks in those countries and sell stocks in the more hawkish regions.

The third path to success in financial markets is the path of the trader.  The trader is a pattern recognizer who exploits quick-developing shifts in sentiment, supply/demand, and relative movement.  A trader, for example, might notice that episodes of selling pressure in a a few, visible large capitalization stocks are not accompanied by significant selling pressure across the broad market.  When the selling slows down in the large caps and the broad market begins to catch a bid, the trader quickly joins that reversal for a move higher in the broad index.  Diversification is achieved, not necessarily by making many independent, simultaneous bets, but by making many independent short-term bets over time.

These three paths are extremely different.  Whereas the theorist is deductive in thinking, moving from big picture understanding to individual trades, the trader is inductive, noticing relatively minute patterns in order flow or price movement and generating trade ideas from those.  The statistician is highly analytical in a quantitative way, emphasizing prediction.  The theorist is more interested in a synthesis of information to achieve understanding.  The trader is more likely to be adept at intuitive pattern recognition--in Kahneman's terms relying on fast, rather than slow thinking.

These differences call on very different skill sets, knowledge bases, and personality strengths.  The action orientation of the trader is quite different from the analytical, cerebral orientation of the statistician.  The theorist needs confidence in his or her big picture understanding of the world.  The statistician relies on objective odds to take subjective appraisal entirely out of the trading process.  Statisticians gain expertise from intensive quantitative research; theorists gain expertise from the qualitative assembly of many different facts and trends; traders gain expertise from immersion in market patterns.

While it is popular to speak of "hybrid" traders that combine elements of these different paths, my experience is that a successful combination of approaches is much less common than is typically recognized.  Indeed, it is much more common for trading problems to emerge:  a) when market participants don't clearly identify their path to success and hence meander among different approaches; and b) when they attempt to blend paths and ultimately don't play to their strengths.

A classic example of this is when big picture macro traders become overly concerned with limiting their risk and end up behaving like short-term traders.  Similarly, statistical, quantitative traders can allow their priors to bias their research processes, skewing their results over time.  Traders with a good feel for markets can suddenly trade in tone deaf ways when they become locked into big picture views.  What generates success for one path can undermine success in the others.

Many market participants fail over time because they lack a consistent path to success and because they lack the self-understanding to chart the path that is right for them.  In markets as in relationships, success often requires a commitment to one path and a willingness to leave other ones behind.

Further Reading:  Three Winning Trading Practices

Saturday, April 11, 2015

The Market Is Not Getting Stronger, But Is It Getting Weaker?

The recent post tracked the diminished strength of the stock market, with fewer stocks making new highs over time.  But is a market with reduced strength necessarily one with increasing weakness?  This is a very important question, as it gets at the heart of when breadth is and isn't a problem for the market.

Above we see a chart of SPY from the start of 2014 to the present.  In red, we see the number of stocks across all exchanges that registered fresh one-month lows each day.  (Raw data from the Barchart site.)  Notice that we're only looking at new lows--a measure of weakness.  We are not combining the new highs and lows, which can muddle the views of strength vs. weakness.

What we see are sharp elevations of new lows around important cyclical bottoms.  What we also see is that new lows begin creeping higher before markets top out during these cycles.  This was dramatically the case during the second half of 2014 but also occurred leading up to the March top of this year.  While new highs have been waning per the recent posts, notice that we are seeing *very* few new lows most recently.  The market has not been getting stronger in terms of breadth, but neither has it been weakening.

On Friday, we saw 168 shares post new monthly lows across all exchanges.  That is well below the median value of 350.  When we have had fewer than 200 stocks post new monthly lows since the start of 2014 (N=58), the next five days in SPY have averaged a gain of +.34% vs. an average gain of +.13 for the remainder of the sample.  While a market without weakness might appear "overbought", in fact it is healthy in the short run.  In order for the broad stock market to roll over, we have to see some leading stocks and sectors display weakness.  At the moment, we are indeed "overbought", but not weak.

Further Reading:  Breadth and Market Cycles