Sunday, April 20, 2014

Yoga for the Mind

Suppose you spent dedicated time each day searching your failures for success lessons; reflecting on your anger to identify your vulnerabilities; dwelling on your prejudices to reach a point of empathy; eating only when you are hungry; observing your impulses before you acted; tying seemingly unrelated thoughts together; changing your daily routines; etc.

In doing what doesn't come naturally, we build mindfulness and create a kind of mental yoga

Might it be possible to train ourselves for cognitive and emotional flexibility the way we can train our bodies?

And might it be possible that a significant portion of the effects of aging come from failing to retain flexibility: physically, emotionally, cognitively?

Flexibility workouts for the mind could be great training for the cognitive and emotional flexibility needed to respond to ever-changing markets.

Further Reading:  Cognitive Flexibility and Trading

StockSpotter as a Trading Tool

John Ehlers and Ric Way are far too professional to pump me for a recommendation of their StockSpotter service, which is always something I look for in a market service with integrity.  I was first impressed with John's longtime work on market cycles and then discovered that he and Ric had assembled the StockSpotter site.  

Above is an algorithmic, cycle-based forecast for Boeing stock ($BA) that Ric had shared recently on StockTwits (@StockSpotter).  In addition to the forecasts, StockSpotter tracks where individual stocks and ETFs stand in their dominant cycles and identify both trade setups (stocks poised to give buy or sell signals within a few days) and actual trade signals.  

Particularly impressive is the fact that John and Ric track the accuracy of their signals in real time and report the P/L of each of their recommendations.  Because they track the broad universe of U.S. shares, they can make far more recommendations than an individual trader is likely to implement.  A Monte Carlo simulation feature shows how their forecasts performed if one were to take one or several random recommendations from their lists.  The Sharpe Ratio of 1.3 for the strategy is quite good; a separate Monte Carlo drawdown analysis helps identify the risks of the strategy.

There are many ways to use the information.  You could create a long/short strategy of the names that give buy and sell signals or you could trade a basket of shares with signals against a sector or index ETF that does not give a signal.  You could also use the cycle-based research as a second opinion for your own trade ideas.  I've found, for example, that when the StockSpotter forecasts and my own model signals point in a particular direction at the same time, that's a high probability entry signal.

As I've emphasized many times, trading is a team sport.  Finding the people who do good work and making them part of your team is a great success strategy.

Further Reading:  Visualizing Market Sentiment

Saturday, April 19, 2014

Turning Learning Into a Learning Culture

One of the occupational hazards of trading can be isolation.  Even within trading firms, portfolio managers and traders can operate in silo mode.

As this post notes, there is much to be said from building your own learning culture.  That means, not only learning from your successes and failures, but also leveraging learning by reaching out to likeminded traders and benefiting from their experience.

The goal is to accelerate the learning curve and fuel creativity.  Fresh inputs from the right colleagues can turn your efforts at improvement into a shared learning culture.

Identify who is already sharing their work:  when someone is continuously innovating, they are not threatened by the idea of sharing innovations. Those are potential teammates.  Just one fresh conversation a week with the right people over the course of a year can get the idea factory working at full capacity.  That sounds like a best practice worth turning into a best process.

Further Reading:  Become Your Own Trading Coach



Trading, Creativity, and Becoming an Idea Factory

As I've mentioned in the past, discipline in trade execution and risk management is one part of the success equation in trading. Another part of that success equation is generating new ideas and fresh perspectives on markets.  Discipline and process orientation keeps us doing the right things.  Creativity enables us to discover those right things.

There are many ways of becoming an idea factory.  In a recent post, I described a method I use for establishing the price targets for trades.  Quantifying targets helps with the discipline and process orientation because it keeps me grounded in an updated appraisal of risk/reward.  But I find that quantification also helps with idea generation.

Here's an example:  A staple of my market analysis is to identify stable regimes in a market and a core group of drivers that account for a significant portion of variance in forward price movement during those regimes.  The models so derived did a nice job of anticipating the recent market strength, but did not do a great job of anticipating the prior market weakness.  This led me to investigate the current market and look for drivers of market action that I hadn't accounted for in the models.  Sure enough, it turns out that intermarket behavior was an important factor that I had neglected in the earlier modeling.  This led to new investigations and insights.  

One need not be quantitatively oriented to become an idea factory.  A hard-nosed review of losing trades will often identify where you have either misread markets or traded them suboptimally.  Either is fertile ground for learning and adaptation.

Henry Carstens is someone who I've cited as an example of an idea factory.  Take a look at the very creative idea he posted as a comment to the recent post.  This is a great example of the power of priming.  By posting to his computer screen the various elements of problems he wishes to solve, Henry stimulates the creation of new combinations and associations.  These are the foundation of fresh ideas.

Discipline and process orientation are necessary for success, but they are not sufficient.  As any business in a fast-changing market knows, it is not enough to execute stale ideas faithfully.  When you are an idea factory, you continuously renew your sources of edge in markets.

Further Reading:  Success and Failure Quotes

Friday, April 18, 2014

Personality and Character in Trading

Our personality is revealed in our trading.  If we are successful, how we engage markets is an expression of who we are:  our skills, our interests, our traits.

Our character is revealed when markets are closed.  It's when we can't put on trades and follow markets that we find out who really works on their game, who actually reviews their performance, who truly sets goal and pushes themselves further and higher.

Lots of market participants love trading.  It's the love of what it takes to sustain trading success that makes all the performance difference.

Further Reading:  Assessing Trader Personality

Determining Price Targets for Trades

I find that many traders are better at setting their entry points in markets than their exits.  In that sense, they are like archers who take great care to position the bow properly on their shoulders and pull the arrows with just the right amount of tension, only to lack proper targets.

There are many ways of defining price targets.  One might rely upon charts and define range extremes or price levels based upon wave relationships.  One might be fundamentally grounded and establish targets based upon a researched notion of fair value.  If every trade is to have a favorable relationship of reward to risk, it is important to have a target clearly in mind.  

My method of establishing targets in the stock market is statistical/mathematical.  Two things we can know from tests:  past volatility is positively and significantly correlated with future volatility and volume is positively and significantly correlated with volatility.  Volatility tells us how far we are likely to move in either direction over a given time period.  

So what I do is estimate today's volatility from recent volatility and identify the percentage probabilities of hitting particular upside and downside targets given that volatility level.  The key is estimating upside *and* downside targets.  These estimates have nothing to do with any directional view of markets I may hold.

Let's take an example.  If we were to open trade in SPY at 186.39 on Monday, my volatility model suggests a 78% likelihood that we would touch either the 187.13 level or the 185.65 level in that day's trade.  The odds of touching either 187.99 or 184.79 are a little under 25%.  So basically, think of a chart and next to each price level above and below where we're at, there's a probability estimate of hitting that level.

Again, this has nothing to do with my opinion about markets or my subjective reading of chart patterns, sentiment, the nation's politics, astrological formations, etc.  

Now, let's add an element to the estimation:

As the day's trade proceeds, we can identify if the current volume coming into the market equals, exceeds, or falls short of the volume that is typical for that time period.  So, for example, Thursday's first half-hour volume did not differ significantly from Wednesday's, but was lower than the average volume during preceding days.  Because volume and volatility are correlated, the updating of volume in real time allows me to adjust my estimates of reaching nearer and more distant price targets.  I identified quite early on Thursday (especially with it being the day before a holiday!) that we were unlikely to hit a distant, lower probability target.

This ability to adjust targets in real time is exceedingly useful, as participation during the day may greatly expand or contract based upon situational developments, such as an upcoming Fed announcement or a next day holiday.

There are many trading psychology lessons in all of this, and I'll address some of them in my next post.  From a trading perspective, let me simply mention that defining target probabilities is also very relevant to the setting of price stops and that this approach is scalable with respect to time.  Estimating the probability of hitting a particular target in the coming week or month draws upon the same process as estimating targets for the current trading day--and can provide a rational basis for holding vs. folding positions.

And, yes, this method can be used to estimate price targets for individual equities as well as indexes.  Indeed, it is relevant to any market in which volume and past volatility information provide a statistically valid basis for estimating future price movement.

My trading goal is to identify occasions in which my models provide a high probability directional view on the market and then to implement this view in a sound risk/reward structure with a) the calculation of price targets; b) the real-time (Bayesian) updating of the likelihood of reaching particular objectives; and c) continuously updated, real-time market indications of a directional bias to the day's trade by tracking the relative dominance of buying and selling pressure.

For those interested in the initial price targets, I will post a first approximation for SPY early in the trading day via StockTwits (@steenbab) as part of my market PREP posts.  Please note: my current method for determining targets is a refinement of my prior process, which is linked below.

CORRECTION TO THE POST:  Thanks to David Ayer for his helpful comment and correction to this post.  I identified the source of my error and the fifth paragraph above should read that, if we open at 186.39, we have a 72% probability of hitting either 187.38 or 185.40.  On the other hand, we have a 23% likelihood of touching either 188.37 or 184.41.  I am using something a bit different from 5-day ATR, so my numbers may differ from David's, but they should be in the same ball park.  I hereby amend the quote at the top of the post to read, "The odds of hitting your target go up dramatically when you calculate it properly."  :)

Further Reading:  My Previous Method for Calculating Targets

Thursday, April 17, 2014

On the Dangers of Chasing Trades and Losing Yourself

That's a great quote from Will Smith.  Substitute "ideas" for people and you have a pretty good recipe for success in markets.

When we doubt ourselves, it's easy to chase other people's ideas.  After drawdowns, it's not at all easy to do your own thing and sustain hard work.

Drawing down by chasing trades or other people's ideas is a double loss:  the loss of capital and the erosion of self-confidence that comes from placing the judgment of others ahead of one's own.

To pursue your best work and lose money is frustrating.  To fail to pursue your best work and lose money is self-betrayal.

When trading becomes difficult, you want to double down on who you are and what you do best.  It's amazing how ideas come to you--and stay--when you do your own thing:  the things that brought you success in the first place.

Further Reading: The Reason I Don't Partner With Your Firm

Best Trading Practices Through Crowdsourcing

Thanks once again to SMB Options Tribe for hosting yesterday's webinar on best practices in trading.  For those who could not attend live, here is the recording of the session

In that session, I suggested that a review of one's performance can be a great way to identify trading strengths and best practices.

But suppose we make that review a social process and ask a number of experienced traders to share a best practice.  While not every idea will resonate with every one of us, the crowdsourced list of worthwhile practices would provide fertile ground for expanding one's own processes.

So let's try a little crowdsourcing:

There is a tremendous amount of information on the financial web.  None of us could possibly read it all.  If, however, a number of informed traders suggested their favorite expert sites on particular topics, the result would be a nicely vetted set of information sources that could feed one's market intelligence.

I'll start with an example:

I mentioned a little while back that the website Abnormal Returns is part of my daily market preparation.  I have found that Tadas is both thorough and discerning in his selection of daily links across the landscape of financial journalism.  It doesn't make sense for me to review everything out there when someone with an informational edge is already doing a good job of curating content.  Yes, there are things I look at independently, but if I'm looking for fresh perspectives, an efficient solution is to start with the pieces selected daily by Abnormal Returns.

My best practice is to go with an assumption:  Somewhere in the collection of daily links, there is something I should know to help with my idea generation.  My job is to scan the array of links and articles and find the one, two, three items that provide me with a fresh perspective.  I don't leave the site until I have found content that can feed my brain.  So, for instance, this morning, I was checking out articles on housing starts, inflation, and the distribution of returns across market sectors.  I am very interested in the expectations of traders vs. what markets are actually telling us and pricing in.

Now suppose each of us that has a go-to site that feeds the head offers their favorite site in the comments section for this blog entry, along with a short summary of how they find the site useful.  Across the readership crowd, we should be able to source good information that can prove useful to understanding markets and trading.  So please feel free to share your favorite sites as a comment below and I will follow up with a post that pulls together the ideas.  

Thanks!

Brett

Further Reading:  Five Virtues and Best Practices


Wednesday, April 16, 2014

Is There a Formula for Trading Success?

This afternoon's webinar hosted by SMB's Option Tribe featured excellent questions from participants.  Two in particular have me thinking, and I hope to share thoughts soon:

1)  How does the developmental phase of the trader (age, marital status, kids/no kids, other career activities) affect how the trader approaches markets?  Might there be different best practices for traders in middle and later years compared with those in early years?  Are the motivations of older traders different from those of younger ones?

2)  How do the best practices of longer time-frame traders differ from those of shorter-term ones?  Is the learning process for longer-term traders different from that of shorter-term ones?  How can longer-term traders achieve the deliberate practice needed for the development of expertise, given that they place far fewer trades than daytraders (and hence have fewer learning trials)?

There are many paths to success.  Traders vs. investors; younger participants vs. older ones; intuitive pattern traders vs. research-oriented ones--all may have very different best practices and work processes.  Trying to mimic the practices of traders unlike oneself might be a formula for frustration.

Further Reading:  A Solution Focus to Trading


Creating Change Through Corrective Emotional Experience


There are two very important principles of psychological development that are relevant for traders.

The first is the use/disuse principle:  Use it or lose it.  We grow in the capacities that we challenge and exercise.  What we don't challenge and exercise, we lose.  There is no stasis over time, only development and decay.

The use/disuse principle forces us to examine our daily and weekly activities and ask ourselves which life functions we are using and which we are losing.  Are we growing and developing physically?  Emotionally?  Intellectually?  Spiritually?  Socially?  Professionally?  

When we are in a use spiral, the energy we gain from growing in one or two of those areas catalyzes efforts to develop the others.  

When we are in a disuse spiral, the energy lost from neglecting one or two of those areas gives us less fuel for growth in the others.

Much of performance is creating processes that ensure use spirals.  Much of aging is living out disuse spirals.

The second principle is the mirroring principle:  We are what we eat, and we are always consuming life experience.  Everything we engage in life--the people we deal with, the activities we undertake--acts as a mirror, reflecting something about ourselves.  

Over time, we internalize what is mirrored to us:  if we have successful experiences, happy experiences, loving experiences, and affirming experiences, those emotions are what we internalize.  If we are mired in unfulfilling work, hurtful relationships, and frustrating activities, the sense of self that we internalize becomes much more negative.

Much of life success comes from creating and maintaining the right mirrors.

And, of course, the very best life experiences are ones that push us to "use it" and, in so doing, create positive mirroring experiences--or what therapists call "corrective emotional experiences."

We don't change via motivation.  We change by reshaping life experience.

Further Reading:  Creating Change With Corrective Experiences

Tuesday, April 15, 2014

PREP: Bottoming Stock Market or Gain Before Eventual Pain?

I've received quite a few questions from traders about stocks and whether we're putting in a bottom here.  The question is understandable.  If you look at a chart of the NYSE Composite Index ($NYA), for instance, you'll see that we've bounced off a support area.  Too, you can see from the number of fresh three-month highs minus lows among all common stocks (charted above), that we are at levels consistent with pullbacks during the past year or so.

What the chart doesn't show is that pullbacks in 2012 (early June, mid-November) occurred with well over 1000 issues making three-month lows over three-month highs.  While we did bounce off lows today, that occurred after new three-month lows had expanded from their April 11 levels:  782 vs. 621.  

Perhaps even more interestingly, new three-month lows (at 782) are getting close to the level we saw early in February (968), even though SPY is well above its early February price.

All of this suggests deterioration from my perspective.  Small cap and growth-oriented NASDAQ shares are underperforming, contributing to the new low heaviness.  In a bottoming market, you'd like to see fewer shares participating on the downside, as stronger, pro-risk sectors begin to assume leadership.  So far, that is not happening.  It's the defensive names and sectors that are near their year's highs.

My models weigh the 2013-2014 experience strongly and so have been bullish lately.  And, yes, we have gotten some bounce.  I am mindful, however, that we may be breaking recent regimes--hence the close watch on breadth and downside participation.  Those measures suggest we're not getting stronger.

Further Reading:  An Earlier Read on Market Strength

Succeeding by Failing: The Art of Messing Up

If you haven't read the latest Howard Marks memo on the topic of daring to be great, I heartily recommend it.  

In it, the Chairman of Oaktree Capital makes the case for the importance of being different--and the importance of daring to look wrong.  The memo makes a strong case for creative thought being crucial in the generation of superior financial returns.

The recent post on signature strengths suggested that sustained trading success is an expression of our distinctive abilities and our application of those to markets. By definition, this means that there is an idiosyncratic component to success: it is a function of what makes us unique and distinctive. 

To a person, when I think of highly successful traders, I can identify something quirky and original in how they approach markets.  They are the antitheses of those who purchase trading software, stick with the preset values, and expect to make money.  How they view and trade markets is closely aligned with who they are.

Howard Marks makes the excellent point:  Everyone is willing to dare to be great.  Few people, however, have the fortitude to stand out and dare to do the things necessary to be great.  "You can't take the same actions as everyone else and expect to outperform," Marks observes.

Creativity--the generation of unique and distinctive ideas--springs from what is unique and distinctive in us.  It pushes us to innovate:  try new things, find new ways of doing old things.  Creativity ensures that we will make mistakes and fall flat on our faces.  Creativity sounds noble and beautiful, but in reality it is a messy process, filled with dead ends and new things that don't work.  What we don't typically see is the many prototypes of the inventor that don't work; the drafts of a book manuscript that have to be deleted by the author; the canvasses of the painter that never see the light of day.

Can't lose goes hand-in-hand with can't win, Marks points out.  Nothing expands without a push of boundaries--and a willingness to look wrong and be wrong.  A great way to assess your trading process is to ask yourself, "How often am I conducting failed experiments?  How often am I innovating and finding truly fresh ways to be wrong?"  

It's much easier to trade fearlessly when you embrace failure as your teacher.

Further Reading:  Creativity and Trading Success 


Monday, April 14, 2014

Treating the Mind by Minding the Body

A growing body of research suggests that physical activity brings both health and emotional benefits.  Indeed, exercise may help emotional health by increasing neurochemicals in the brain that help to buffer stress.  By reorganizing the brain, physical activity can help us become more effective in dealing with a variety of life demands, including those in financial markets.

Psychotherapy research suggests that change is most likely to occur when people undergo shifts in their states of awareness.  Staying our habitual frames of mind helps support our habitual behaviors.

What if one of the best ways to make those state shifts is shifting the body?

That can occur through meditation, through yoga movements, through Crossfit workouts, etc.

The idea is that giving your body fresh energy may fuel the mind's awareness by adding to emotional well-being.  

We can fill out trading journals, talk with coaches, and try the latest hot trading setups.  If we're sitting in a chair, hunched over a computer, however, we may be placing our bodies in the absolute worst position to energize the changes we're trying to make.

Further Reading:  Shifting Emotional Gears as a Trader

Signature Strengths and Trading Success

Humility spurs practice; confidence spurs performance.  To have the confidence that you have what it takes to sustain good risk-adjusted returns *and* to retain the humility to know that you always need to practice to retain and renew your edge:  that's a rare and challenging combination.

But how do you practice if you don't know your best practices?  

Every very successful trader I've known has at least one signature strength:  some skill or talent distinctive to them.  That strength is not something specific to trading: it is something that defines who the person is across domains.  Super-disciplined people become super-disciplined traders; uniquely creative people approach markets in unique, creative ways:  success in markets comes from leveraging the best of who we are.

When you identify and enact your best practices in markets, you train yourself to become more of who you already are when you're at your best.

I am at my best as a parent when I'm emotionally intelligent, attuned to the communications of my children.  That is also when I'm best in markets and best as a psychologist.  No market research or chart study can help me if I'm so out of tune that I'm no longer attuned.

So some of my best practices are actions that I take that keep me open, responsive, and attuned.  Those will be different from your best practices.  Once you know your signature strengths, you have an opportunity to leverage them and consistently draw upon them.  That's what best practices accomplish for us.

Those best performances are guideposts, pointing you to who you are at your best.  Learn from your worst trades, but absorb the lessons of your best ones.  Inside those best trades is the best within you:  the signature strengths that will anchor your trading success.

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This Wednesday at 5 PM, I'll be doing a free webinar session hosted by SMB:  the topic will be best practices.  I look forward to building on this important topic.

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Further Reading:  Best Practices Submitted by TraderFeed Readers 


Sunday, April 13, 2014

Preparing to Win in Markets

I have been spending significant time each day for the past six months preparing for a return to active trading.  During that time, I've developed a method for identifying and analyzing aperiodic (non-time based) cycles in markets.  I've also refined a multivariate method for modeling stock index futures based upon a core set of technical drivers of price action and standardized my methodology for conducting historical market queries to greatly reduce bias and the odds of overfitting market data.  Finally, I've culled my intraday indicators to focus on the few that best track whether or not current market action is falling in line with the forecasts from the cycles, models, and studies.

It's a lot of work.  But that's how you build a business:  you spend days and months crafting your products before you ever make your first sale.  And the crafting never stops, because the marketplace never remains static.

In coming days, I will begin sharing a whole new set of posts.  These will be labeled "Preparation".  Some will be sent out as tweets from @steenbab via StockTwits; others will be included as short blog posts, depending on the content.  Preparation posts will be sent out only if I see distinctive potential opportunity in markets or have special observations that could be useful for traders.  All will be sent out prior to the U.S. stock market open.

Meanwhile, here are a few preparation resources I'll be relying upon to start my market day.  A more complete list will be the topic for a separate post:

Financial blog and journalism summaryAbnormal Returns - Take a look at the links for the day.  There are posts pertaining to markets, trading strategy, the economy, you name it.  You would have to spend hours to replicate the curation accomplished by Tadas.  Combine with your favorite news feed and you have a great resource for staying on top of current market thought.

Stock picking:  StockTwits - Punch up a stock or ETF and you get a chart.  Click on the tabs above the chart and you see the number of messages posted about the issue and the social sentiment for those shares.  Click on "heat map" on the top menu bar and you'll see social sentiment across sectors over varying time periods.  There is a lot of information here, folks--even apart from the content of the people you like to follow.

Charting:  FinViz - News, insider trading info, charts, stock screening, creative heat maps that track stocks and sectors, performance tracking by stock groups, tracking of futures and forex--and that's just their free information!  This is one of the best (and underappreciated) financial sites around.     

IndicatorsIndex Indicators - This is where I get my breadth data, but there is a lot more information on the site, including put/call data the ability to run basic queries.  Mo has done an excellent job of including technical perspectives on international indexes as well as U.S. ones.

Analysis:  Stock Spotter - John Ehlers and Ric Way track cycles and more on this site and include real time stock picks and a full track record of past picks.  The Swami charts take a bit of getting used to but incorporate quite a bit of useful information in a single view.   

Life is a team sport.  One key to success is selecting the right teammates and resources.  There is too much going on in the world--and in markets--to stay on top of it all by yourself.  Preparation is easier when you can also rely on the quality work of others.  I hope to be able to contribute quality work to your trading efforts.

Further Reading:  Three Myths of Trading Psychology

Dealing With Market Insanity

In The Psychology of Trading, I told the story of the psychiatric patient who repeated over and over that he was a department store.  One junior therapist after another tried asking questions of the man and he only repeated, "I'm Woolworth store!  I'm TG&Y store!"  Needless to say, the trainees thought the man was completely crazy and could not be a candidate for talk therapy.  Medications would be needed to bring him into contact with reality.

A senior trainee, however, sat patiently with the man.  When he proclaimed that he was a retail outlet, she calmly asked, "What's for sale?"  The man looked at her intently and said that nothing was for sale.  When she asked him why, he explained that the shelves were bare.  She then asked why he had no products and, lo and behold, a discussion about feeling empty ensued.  The man made perfect sense if you accepted him on his terms.

So it is with markets.

A trader recently told me that trading the markets was "insanity".  Nothing made sense, he explained.  None of the moves could be explained by fundamentals.  The economy was firming; rates remain low:  why are stocks selling off?  If the Fed is tapering and readying markets for a rate rise, why is fixed income rallying?  It's insane.

I thought of Woolworth Man.  So often, what doesn't make logical sense makes good psycho-logical sense.

When traders had the Fed at their backs, money flowed into speculative issues.  From the end of last year to late February alone, TSLA practically doubled.  It was up roughly 5x in the past year before moving down about 20% from that February peak.  The biotechnology ETF IBB rose over 50% in the past year, also hitting a peak in late February--and since is down over 20%.  But utility shares (XLU) and consumer staples stocks (XLP)?  They're not far off their highs at all.

Investors are acting as if the Fed no longer has their backs.  They are sticking with stability and selling momentum.  They started the year with the perception of tailwinds and now are behaving as if they're facing headwinds.  That makes them take risk off the table.

So the market falls, the growth companies drop, assets that were held for their strength move lower, and it doesn't make sense.  Insanity.

Except to the seasoned traders who calmly enter the room and ask the crazy market, "What's for sale?"

Further Reading:  Life Insights From Great Inventors

Saturday, April 12, 2014

How to Deal With the Uncertainty of Trading

Reader Eldad Nahmany asks the excellent question, "What if I can eliminate uncertainty by accepting the true range of results that can arise from each trade?  I guess everybody said it before: accept the loss before you even enter the same way you accept the winner, then I can become a true observer of information.  The question now is how do I accept the loss before i get involved? I need to believe in the trade, no?"

It's a dilemma on the surface:  how do you maintain confidence and conviction in a trade and, at the same time, embrace the trade's uncertainty by planning its failure?

If you were a retailer and you had perfect knowledge of demand, you would always order the right amount of product in each category and never maintain excess inventory.

Once we accept that we cannot have perfect foreknowledge, then we accept the necessity of inventory.  We order extra product, because we don't know if customer interest will expand or contract; if a particular offering will fly off the shelves or languish there.

Of course, you could ask the retailer, "How could you believe in your product and yet still plan for inventory?  Aren't you preparing for your own failure?"

The answer, of course, is that any specific product might succeed or fail.  If you are a good buyer and merchandiser, you succeed across a variety of products.  You carry enough different products and price them well enough to ensure that you'll have some hits as well as some duds.  The duds will lose you a limited amount of money; the hits will be restocked again and again and will make up for the duds--and then some.

So it is with trades.  You don't need blind confidence in each position.  You need enough confidence in your overall trading ability to put on a variety of trades.  Some will be duds, and you'll catch those quickly and minimize their losses.  Others will be hits and you'll add to those as they prove themselves.  Any particular trade can be a failure; it's the edge across trades that makes you successful.

When people wax poetic about their conviction in trades, my emotional reaction is:  Whatever.  A trade is a bet at the poker table.  Some bets will work, some won't; some you'll size up, some you'll fold.  Whatever.  Over time, if you play the odds, you'll do OK.  Beyond that, it doesn't make a lot of sense to beat the chest and invite overconfidence bias to replace normal confidence.

Every forecast of a statistical model can be wrong.  Every trading judgment is fallible.  If you have a 50% hit rate on your trades and you trade once a day, on average you're going to have an occasion in which you lose every day for a week during a trading year.  That doesn't mean you're in a slump; it doesn't mean you should change what you do.  It's going to happen and you can mentally prepare yourself--and size yourself in such a way that five consecutive losing days won't take you out of the game.

The goal is not to eliminate losses--that would require omniscience.  Rather, the goal is to  anticipate losses so that you're never surprised, never overwhelmed, never thrown onto the back foot.  True confidence comes, not from believing that you must be right, but from knowing that you can survive and even thrive if you're dead wrong.

Further Reading:  The Power of Uncertainty   

Friday, April 11, 2014

Three Best Practices for Turning Trading Stress Into Performance

In the recent post on trading stress and distress, I suggested the former was necessary for our development as traders; the latter was a potential impediment to our evolution.  Stress is the result of challenge; distress is the breakdown that occurs when we are overwhelmed by challenges.

So how can we keep the normal, inevitable, and ultimately constructive stresses of trading from becoming sources of distress?  Three best practices that I'll be touching upon in my upcoming webinar presentation are key:

1)  RISK MANAGEMENT - Trading losses should be planned and anticipated.  By limiting risk per trade and limiting drawdowns across trades, you ensure that any single period of poor performance will not impair your emotional or financial capital.  This means that proper trade construction, portfolio construction, and reduction of risk-taking during periods of poor performance are as important to success as generating the next great trade ideas.  One of the most common trading problems I see among less experienced traders is that they size positions and predicate their risk taking based upon how much money they want (need) to earn, not on how much they can afford to lose.  They take so much risk that they ensure an eventual emotional upheaval.  

2)  PERFORMANCE FOCUS - The ever-changing nature of markets ensures that they will test you.  They will test your research and understanding; they will also test you emotionally.  Turning the stress of challenge into fuel for growth is a great way of staying positive, constructive, and free of distress.  Look at it this way:  the market is your gym and it's going to give you a workout.  What trading muscles are you going to build this week?  This month?  Turning setbacks into learning lessons and goals for future trading ensures that you will use losses and drawdowns to make yourself better.  A positive performance focus starts with constructive self-talk:  how you process market challenges will very much impact your emotional responses to those challenges.

3)  LIFE BALANCE - There will be times when markets will not sustain you emotionally--and quite possibly not financially.  What will get you through the lean periods?  Having activities and relationships that nourish you emotionally, physically, and spiritually can make all the difference in sustaining the mindset needed for optimal performance during difficult times.  Having diversified income streams takes a great deal of pressure off P/L and makes it much easier to have the patience to wait for good trades.  We know that emotional well-being contributes to creativity, productivity, and positive performance.  The best way to avoid distress is to build a life buffer of well-being.

So, as I'm writing this, I'm not a happy camper.  My models gave useful buy signals in stocks late in March and sell signals in the first few days of April.  They also were premature in giving buy signals the last few days and were completely leaning the wrong way yesterday.  Intellectually I know that the best of predictive models in markets only reduce uncertainty, but when I get false signals, I go back to work and see what I can learn from them.  It is not fun to get something wrong when you've put days and weeks of long effort into crafting something.  But I know that's the only way the craft will get better.

(Note to self: you get different results when you model realized vs. implied market volatilities). 

"If it ain't broke, don't fix it," is the wrong approach.  In fixing breaks, we build our selves.  And that ensures we benefit from the stress of operating in uncertain, risky environments.   

Further Reading:  The Well-Being Hypothesis