Friday, September 30, 2016

Looking for Your Trading Edge

Just thought I'd update this post on what it means for stocks when we see a high degree of institutional participation in the US equity market.  Yesterday's reading was in the highest quartile, which has been associated with significantly above average returns over a next 10-day period.  Interestingly, we also saw an elevated equity put/call ratio, also associated with favorable next 10-day returns in SPY.

Meanwhile, several of my cycle measures have been pretty toppy.  

There are times when things line up and there are times when they don't line up.  A useful psychological exercise is to assume that, at some point, everything will line up.  What would you need to see for such a line-up to occur?  Anticipating potential price paths is a first step in preparing to trade them.  Being aware of when things aren't lining up is a great way to avoid overtrading.

Further Reading:  When to Exit Winning Trades
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Thursday, September 29, 2016

What Quant Models Can Teach Us About Trading Psychology

Above we can see SPY (blue line) plotted against a six-variable trading model that I developed using ensemble modeling.  When we have a positive score, the model is deemed to be bullish over a next 10-day horizon.  When we have a negative score, the model is deemed to be bearish.  The model is flat as of yesterday's close.  The model includes such variables as market volatility, breadth, buying/selling participation, and market cycle status.  

When the model has been at a score of +2 or higher, the next 10 days in SPY have averaged a gain of +2.08%.  When the model has been at a score of -3 or lower, the next 10 days in SPY have averaged a loss of -.83%.  Between scores of +1 and -2, the next 10 days in SPY have averaged a small loss of -.08%.  

The model has a couple of important implications for trading psychology:

1)  Out of the 573 days of my in-sample and out-of-sample periods, nearly half are scores less than +2 and greater than -3:  in other words, days with essentially no edge 10 days out.  That doesn't mean sources of edge can't be found on different time frames with different models, but this finding is important.  Even with a solidly researched source of edge, there are plenty of occasions when not trading is the best trade.

2)   The model signals have been good, but even with their edge, there is plenty of noise.  Note, for example, that the model was bearish during much of mid-2015, when prices chopped around quite a bit.  We were also bullish during fall, 2015 during a volatile bottoming period.  A trader could have an edge with a model but be unable to survive the noise around signal, especially if sized quite large.  

3)  I suspect the model works because it's exploiting cyclical behavior in markets at a time frame that is too long for active traders and too short for true investors.  A key to trading the model, as we've seen, is not placing trades when there is no clear signal.  There have been no solid signals from the model in the last 14 trading sessions; such periods are not rare.  It's the selectivity of the model that might be its greatest advantage.

4)  Such models don't have to be traded mechanically.  For instance, a short-term trader could use the model to decide when to trade with a directional bias and when to take short-term setups without such bias.  More fundamentally grounded traders could use models such as these to help with the execution of longer-term positions.  Good models provide good information; that information can be useful in discretionary decision making.

The act of developing models itself gives one a feel for markets.  The model inputs are there for a reason: the model simply captures when those reasons line up.  It is interesting that the most rational of analyses can feed the deepest intuitions.

Further Reading:  The Psychology of Quant Analysis
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Wednesday, September 28, 2016

Trading Success and Calculated Risk Taking

There are risk-averse traders who never make significant money.  There are risk-seeking traders who blow up.  Then there are smart traders who take calculated risks.  They make selective bets.  Like the skilled poker player, they know when they have a good hand and they know how and when to bet that hand.

But to take calculated risks, you have to know how much risk you're truly taking.  Several factors impact the risks in your trading:

*  The sizing of your positions - It's not uncommon for small traders to have big dreams and take positions that are unusually large for the amounts of capital they're trading.  Any trader can experience strings of losing trades merely by chance.  When position sizes are too large, those strings of losers incur a risk of ruin.  Once you're down 50%, it takes a doubling of remaining capital just to return to break even.  

*  The volatility of your markets - Volatility can change dramatically from day to day, week to week, depending on the participation in your markets.  This can be particularly true around major events, such as central bank meetings, earnings reports, etc.  You want to size your positions, not only for the current volatility of the market you're trading, but also for the expected "vol of vol":  the expectable variation in volatility over the life of your intended holding period.

*  The correlation of positions you are trading - When the positions you are trading are negatively correlated, the overall risk in your book can be smaller than the risk associated with each of the positions.  Conversely, when you trade multiple positions that become correlated, your total risk exposure can grow exponentially.  Some short-term traders only hold one position at a time, but can experience correlation-related risk if they habitually lean one way in markets (long or short, for example).  They end up taking bets that are not truly independent ones.  Traders of individual equities often treat their positions as independent when, in fact, those positions can respond very similarly to large moves in the overall market.

Risk is important because it impacts trader psychology.  If the amount of risk you're taking dramatically expands or shrinks, you're likely to react to the change in the ebb and flow of your P/L.  In order to take calculated risks, you have to be able to estimate and calculate risk--and the possible ways risk can shift over time.  We often think of trades as directional bets, when in fact they are also implicit bets on *how* markets move.

Further Reading:  Risk Intelligence and Trading Success
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Tuesday, September 27, 2016

Mind Shift: A Different View of Trading Psychology

One take on trading psychology says that we should control our emotional experience so that we stick to our processes and our discipline.

Another take on trading psychology says that we should become better at listening to the feelings that represent intuition and gut feel for markets.

This recent article, however, suggests a different approach altogether:  we become able to see and trade markets better when we can make mind shifts that allow us to experience markets differently.

Like a car, we can make a mind shift by changing gears, allowing us to approach the world with more torque, greater intensity.

Also like a car, we can achieve a mind shift by changing lanes, opening a new path.

The key idea of the article is that what we see and what we can act upon is a function, not only of the information we process, but also the state we're in.  When we achieve a mind shift, we not only can process new information, but become better at processing old information in new ways.

In short, emotional and physical creativity are paths to achieving fresh, creative trading ideas.  This opens the door to entirely new techniques for self-mastery in trading.

We see markets better when we shift from passive information processing to active:  actually playing and experimenting with the information.

We see markets better when we shift from active processing to interactive processing:  encountering information from multiple perspectives.

We see markets better when we shift from interactive processing to multi-active processing; processing multiple perspectives through multiple modalities. 

If we always stayed in one lane, in one gear, we'd be quite inefficient in our travels.  Trading psychology should not be about dampening your feelings or enshrining them.  The mind that can shift is one more likely to effectively reach its destination.

Further Reading:  Becoming More Creative 
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Monday, September 26, 2016

Viewing Strength and Weakness as Different Dimensions of the Market

When assessing the market, I find it helpful to treat strength and weakness as independent variables.  In other words, we can have markets in which many stocks are strong and few weak; many weak and few strong; few strong and few weak; and many strong and many weak.  The latter is possible when correlations among sectors and stocks are relatively low.

Let's take the Parabolic SAR indicator system developed by Wilder.  One way I track market strength and weakness is to take a cumulative running total of Parabolic SAR buy signals minus sell signals for all NYSE issues (red line, above).  This has been helpful in capturing cyclical behavior in SPY (blue line). (Raw data from StockCharts.com).  

But we can also consider the buy signals from the system separately from the sell signals as proxies for market strength and weakness.  For example, since mid-2014, when I first began collecting these data, when we divide the sample into quartiles, we find that, after a single day of many new buy signals (top quartile), the next 10 days in SPY have averaged a loss of -.23%.  After a single day of few buy signals (bottom quartile), the next 10 days in SPY have averaged a gain of +.80%.

When we've had very few sell signals (bottom quartile), the next 3 days in SPY have averaged a gain of +.26%, compared with a -.01% loss for the remainder of the sample.  Over a next 10-day period, however, when we've had many sell signals (top quartile), the next 10 days in SPY have averaged a gain of +.52%, compared with an average gain of +.09% for the remainder of the sample.

Overall, the percentage of variance in daily sell signals accounted for by buy signals is only about 10%.  They indeed are more independent than one might expect.  It is in the interplay of waxing/waning buying and selling that we can sensitively track cycle dynamics.

Combined perspectives can have their use, as well.  Suppose we look at the total number of buy *and* sell signals each day.  Interestingly, when we have many buys and sells (top quartile), the next 10 days in SPY have averaged a gain of +.33%.  When we've had very few buys and sells (bottom quartile), the next 10 days in SPY have averaged a gain of +.59%.  All middle occasions have averaged a loss of -.06%.

Think about how momentum and value operate, and then think what it means to have many versus few trading signals.  Think about cycle structure and when you'd expect to have many and few trading signals.  We can learn a lot once we tease apart strength and weakness and view markets multidimensionally.

Further Reading:  The Dynamics of Stock Market Cycles
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Sunday, September 25, 2016

The Mistake Traders Make When They're Not Making Money

There are those that follow their hearts when they trade.

There are those that lead with their brains.

One trades based upon seeing patterns play out in real time and having a feeling for those patterns.

The other trades based upon analyses and having an understanding of how markets should respond.

Both styles require an ability to tune out noise and focus on what is important.  Both styles require an ability to act on the information being processed.

When we don't see opportunities, it can be tempting to look to others for answers: to see what patterns they are noticing, to check out their analyses.  At that point, we become externally focused, no longer attuned to our own information processing strengths.

In challenging times, the challenge is to double down on our strengths and become more of who we already are at our best.  Looking outside ourselves for answers is the surest strategy for turning drawdowns into slumps.

Further Reading:  The Two Brains of Trading
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Saturday, September 24, 2016

How to Find Your Trading Biases

One of the exercises I've found most helpful for traders and portfolio managers is a thorough review of trading performance.  Many times, the ups and downs of profit/loss reveal biases and patterns in our trading.  Some of the patterns worth looking for include:

*  How you trade after you've made money versus after you've lost money:  Do you trade more?  Larger?  Do you trade differently based on recent P/L?  Do you become risk averse after recent losses?  Does that affect your future P/L?

*  How do you trade when you're taking more risk versus less risk?  Does different size/risk exposure cause you to trade differently?  Are you actually making more money when you're taking more risk? 

*  What kinds of markets and market patterns provide you with your greatest profits?  Losses?  Do you trade selectively to maximize your best opportunities?  Do you overtrade markets that are not ones providing you with opportunities?

*  What is your ratio of winning to losing trades?  What is the ratio of the size of average winners to the size of average losers?  How successful have you been in finding large winners?  In preventing large losers?

Many times, our greatest biases and psychological mistakes come through when we thoroughly review performance.  The decision to not review performance is perhaps traders' greatest bias blind spot.

Further Reading:  Training Yourself in Pattern Recognition
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Friday, September 23, 2016

Why Traders Lack Creativity

So much of creativity is the ability and willingness to look and move in a direction different from the well-worn path.  After I wrote the most recent post on emotional creativity, I had the honor of speaking with Dr. James Averill who pioneered research in the area.  He made a very important point.  Much of the way the business world is structured (and I believe this includes the trading world) does not lend itself to emotional creativity.  If anything, emotions are dampened, not explored:  no one really focuses on identifying and cultivating unique emotional responses to daily challenges.

I recall speaking with a successful trader who told me that he was excited about the opportunity in the marketplace.  I responded by saying that he was the first person I'd spoken with to tell me that.  Everyone else was lamenting the lack of opportunity in markets.  He said, "That's right.  I've always made my money going against the consensus!"  That was shortly before the events of Brexit.  That trader was able to capitalize on opportunity because he not only saw the world differently, but experienced it differently.

Another skilled trader I know claims that his idea generation is aided by yoga exercises.  He believes yoga gets him into states where he sees the world more clearly.  This is in line with research that identifies a physical dimension to creativity.  In accessing different physical states, we create opportunities to see and experience the world differently.  

If I wanted to create an environment in which creativity was to be minimized, I would have people sitting or standing at desks, relatively stationary and rarely shifting their physical activity.  I would encourage little talking and insist that such talk be about the external world, not about internal experience.  I would encourage people to share trades and focus on the same research, rather than generate their own views.  That is the environment that typifies so many trading floors:  there is little in the structure to encourage and cultivate cognitive, emotional, and physical creativity.

A truly creative trader would create a radically different trading environment and a radically different set of routines for approaching the trading process.  Turning creativity into a routine rather than become prisoner to one's routines: that is a promising direction for development as a trader.

Further Reading:  Trading Psychology for the Experienced Trader
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Thursday, September 22, 2016

Emotional Creativity: A New Theory of Trading Success

As Averill notes above, there are two views on emotions.  One, the most common, asserts that emotions are givens:  biologically wired.  A second view is that we can cultivate what we feel and how we express it.  That second view suggests that creativity is possible in our emotional responding as well as in our thought processes.  This emotional creativity is what enables people to adapt to situations and respond to them in novel and effective ways.
Averill's work suggests that emotional creativity has three components:

*  Preparedness - The ability to learn from the emotional experience of self and others;
*  Novelty - The ability to experience and express unusual emotions;
*  Effectiveness - The ability to express emotions honestly and constructively

Research suggests that emotional creativity is different from emotional intelligence.  Emotionally intelligent people--those who can read and respond well to the emotional experience of others--are not necessarily emotionally creative people.  The emotionally creative person responds uniquely to situations, enabling them to deal with those situations in fresh ways.

Four competencies are essential to trading:

*  Cognitive intelligence - The ability to process and understand market-related information and use research, analysis, and pattern recognition to identify trading opportunities;
*  Emotional intelligence - The ability to read the intentions of other market participants and use their sentiment and positioning as inputs to one's own decision-making;
*  Cognitive creativity - The ability to put market information together in unique ways and detect opportunities that others miss;
*  Emotional creativity - The ability to respond uniquely and effectively to market-relevant events.

I would argue that most traders have a reasonable degree of cognitive and emotional intelligence.  Their success or failure is more a function of the presence or absence of creativity.  Unsuccessful traders generate consensus ideas and respond to markets in line with "the herd".  The successful trader experiences the flow of market information uniquely, and that emotional creativity enables her or him to generate novel trading ideas.

This is a unique theory of trading success.  If it is correct, much of training in trading and much of coaching has been focusing on the wrong things.  Creativity can be cultivated.  Perhaps a key to trading success is not controlling one's emotions, but learning to view and respond to the financial world in novel ways.

Further Reading:  Cultivating Emotional Creativity
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Wednesday, September 21, 2016

Trading With Your Signature Style

One of the things I've found among successful traders is that they develop ways of looking at markets that:  a) are original and b) that make great sense to them.  The originality of their perspectives helps them see what others don't.  The familiarity of the perspectives helps them align their cognitive strengths (how they best process information) with their decision making.  Very often this means that successful traders trade with a signature style, not a generic one.  Working with mentors and researching markets and market patterns are very helpful in developing the raw materials for one's signature style.

Above is a chart of the ES futures from August 22nd to the present (blue line).  Each data point represents 500 price changes in the contract; these are event bars, not time-based bars.  The red line is what I call the Power Measure.  It's a running correlation of price change and volatility.  In short, the Power Measure tells you when volatility is fueling directional moves:  when that fuel is waxing and waning.  That makes sense from my perspective, because I ideally want to participate in directional moves in which volatility is rising in the direction of my trade.

When you develop your own metrics and ways of looking at markets, the patterns that repeat themselves become ones that are intimately familiar to you.  It's because they are *your* patterns that you are able to follow them, test them, and ultimately trust them.  I have never met a successful trader who traded someone else's style, just as I've never seen a successful painter who copied others.  We see markets best when we cultivate our own vision.

Further Reading:  Calculating Power Measure
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