Saturday, September 20, 2014

The Bull Market is Over for Much of the Stock Market

The recent post highlighted the unusually weak breadth in the recent stock market.  Above is an update.  You can see that the Cumulative NYSE TICK--a measure of upticks vs. downticks across all NYSE shares--has tailed off, even as we made fresh price highs in SPX (top chart).  This is the first time this has occurred since the start of the bull market.

Much of this weakness can be attributed to the unusually weak action among small caps and recently by midcaps as well.  As you can see from the bottom three charts (shout out to the Index Indicators site), the percentages of stocks trading above their 200-day moving averages have been making lower highs as SPX has made recent price peaks.  The midcaps made a double price top before turning down lately, and the small  caps fell well short of their early July peak.  

As of Friday's close, 74% of large cap stocks (SPX) traded above their 200-day moving averages.  For the midcaps, that number is 45%; for the small caps, it is 37%.  Incredibly, as we've been making all-time new highs in the large cap averages, the majority of other stocks have not been trading in uptrends.  Even within the large cap universe, fewer and fewer shares have participated in the strength.  At the recent peak, only 15% of SPX stocks registered new 52-week highs, down from 22% in early July.

The bull market grows narrower and narrower, but the real news is that the bull market is over for a significant portion of the stock market.

Life After Trading: Finding Your Future

The recent post cited research that found that overtrading was most common among traders with the least funds, elderly traders, minority traders, and men.  All of these are groups that could feel the most pressure to make a living from their trading.  Every year I hear from a number of traders who reach the conclusion that this is not possible.  They have put their heart and soul into trading--and sometimes their bank accounts--and they have determined that they simply cannot meet their financial needs and obligations through an uncertain trading income.

Here are a few vignettes of people I've worked with who have sought a life after trading:

*  Joe was a very sociable person who wanted to be a success in life.  He experienced success for a while in trading, but became unhappy with the lifestyle and his returns tailed off.  He went into the restaurant business, where he could work with people, and currently owns and runs a successful restaurant group.

*  Tom loved trading, but experienced ups and downs in his income.  That created stress for him and his family.  He knew a lot about markets and wanted to stay in the industry, so he built a career as a financial adviser and eventually became a knowledgeable and successful investor.

*  Alicia was an excellent student, with a solid knowledge of economics.  She became a junior portfolio manager at a hedge fund, but did not perform well under the pressure of having to produce short-term returns.  She joined a different firm as a research analyst and is now part of a successful team, helping to set investment strategy.

In all of these cases, the people had to struggle with the issue of "failing" at trading.  The important insight they came to is that they failed because of their strengths, not because of weakness.  Each had key strengths that did not fit well with a trading career.  They found their future by moving to an area of opportunity that made greater use of those strengths.  None of the opportunities seemed perfect at the time, but they found good organizations to be part of and grew into ideal positions.

In my life, it took several failed relationships before I figured out what would make me happy in a marriage.  Those were difficult experiences, but there would have been no success without those failures.  A career, like a romantic relationship, must capture your strengths, interests, and values in order to be successful.  If trading is not working for you, consider the possibility that trading does not capture all that you have to offer.  Understanding who you are, what fills you with energy, and what you are truly good at is the first step in discovering your ideal future.

Further Reading:  Succeeding by Failing

Friday, September 19, 2014

Maybe Overtrading Isn't a Discipline Problem

Research from Barber and Odean finds that men trade 45% more frequently compared to women and pay for their overtrading by achieving lower risk-adjusted returns.  A common interpretation of this finding is that men are more risk-taking than women and more aggressive in their trading, perhaps due to the impact of testosterone

Consider a different interpretation, however.  Research from Anderson and Stranahan found that overtrading is most common among elderly traders, minority traders, and traders with less wealth.  What's the common thread here?  Perhaps traders overtrade because they feel a greater need to make a living from their trading.  Elderly, minority, and poorer traders may not possess other sources of income and might pressure themselves to support themselves and families through trading.  Men are traditionally viewed as breadwinners for families and may also feel a heightened need to make trading succeed financially.  

It is ironic that those who feel the most pressure to make trading succeed are the most vulnerable to poor trading practices.  It is much easier to sit out quiet or noisy markets when you don't have to rely on trading as a primary source of income.  It is also easier to practice prudent risk management when you don't need to double your money or more from a small account.

We know from research that the great majority of traders are not able to sustain a living from trading.  Perhaps their overtrading is not so much the result of a lack of discipline as a sign of desperation.  Who addresses the needs of traders who can't trade for a living and need to find constructive alternatives?  It's not an area that brokerage firms, education vendors, or coaches have much interest in highlighting.  In my next post, I'll take a look at life after trading and what makes it successful.

Further Reading:  The Costs of Overtrading

Getting to the Next Level in Trading Through Professional Networking

I'm looking forward to being part of an excellent lineup October 3-5th in Las Vegas, when Traders4ACause holds their annual event.  It's a great idea:  proceeds from the event go to charitable causes.  So it's traders sharing ideas with other traders and also giving back to worthy organizations.

Working in the hedge fund haven of Greenwich and living in suburban Connecticut, I've grown to appreciate the value of professional networking.  Networking is always useful for job hunts, of course, but a lot of networking occurs simply out of the desire for enrichment.  By meeting other traders, hearing their ideas about markets, and learning about what they do, you expose yourself to a variety of inputs that you'd otherwise never encounter.

When I first started working at hedge funds, I thought that portfolio managers would be so secretive with their ideas that they'd never share with others.  The exact opposite is true:  money managers realize that, if they share their ideas with the right people, they'll wind up with many more ideas than they came with.  A huge part of sustaining creativity is generating fresh inputs.  By sharing with others--at conferences and at after work events-- traders can come away with many fresh inputs and lay the groundwork for creative idea generation.  One of the things I like about the Traders4ACause group is that their causes are both charitable ones and ones of sharing with colleagues:  you give and you receive.

The professional networking that takes place at trader dinners is quite different from the networking of social media.  Social media is extremely broad, but typically not deep.  It's a great way of touching base with people, but not such a great way to debate ideas, brainstorm industry trends, and share best practices.  There's something about meeting people in person that cements relationships and leads to a depth of sharing that would never occur via email or chat.  I have known many close professional collaborations that have begun through dinner meetings.

Trading can be challenging and rewarding, but it can also be isolating--especially for independent traders managing their own capital.  One of the real benefits of joining a trading firm is the opportunity to collaborate and learn from others, even as you teach them what you know.  The independent trader lacks that affiliation.  Without a continual stream of fresh observations and ideas, the isolated trader finds it much harder to keep up with changing markets than the networked trader.  The key is networking with the right people.

In coming weeks, I will be organizing a trader networking event in the greater New York City area, where the focus will be on sharing ideas and building collegial relationships.  I will share my own research, and each participant will agree to share one or more ideas with the group.  There will be no fee for the gathering: the price of admission is bringing a worthwhile idea to share.  In a future post, I will provide details.  The goal is to come away with many more valuable ideas than you brought--and to come away with professional relationships that can last well beyond the dinner meeting.

If you have suggestions regarding a networking event, please feel free to offer those via comment to this post.  I believe it will be a great way to leverage your talents and keep up with changing markets--and should be a lot of fun!

Further Reading:  Core Ideas of Trading Psychology

Thursday, September 18, 2014

The Psychology of Stop Loss Levels

Price changes in the stock market do not follow a normal distribution.  Rather, they are leptokurtic, which means that we see more small changes (higher peak) and a larger number of extreme changes (fatter tails) than we would see in a normal distribution.  Because of those fat tails, markets can move against us more than we would expect if markets followed normal distributions.  A two standard deviation event is a relative rarity in a normally distributed world, but occurs with surprising frequency in markets.

It is because of this ability of markets to move in extremes that traders rely upon stop loss measures.  A stop loss is a way of avoiding catastrophic loss.  It is also a way of trying to capture a favorable relationship between reward and risk. 

When we set stop loss points on trades, our positions reflect bets on both an idea (for example, stock prices will rise) and on a path of price movement (the rise will occur with point X being hit before point Y).  It is conceivable that our idea could be right--stocks could move higher over time--but we could be wrong on the path and stopped out for a loss.  That is understandably frustrating for traders--so much so that some traders turn to options and bet relatively small amounts of premium on their ideas so as to avoid setting stops.  Their trades will either hit their target and they'll be profitable, or they'll lose their premium.  Risk management is thus achieved partly via position sizing, rather than through stop losses and the prediction of price paths.

One reader asks the question of how we can get ourselves to honor stop levels.  He points out that it's very tempting to allow a trade to move beyond a stop, hoping it will return to breakeven.  

The problem is that the stop out is viewed as a loss--and the loss is viewed as a failure.  If the loss is viewed as the avoidance of a potentially catastrophic loss of capital and as an honorable fiduciary duty to investors (whether you're investing other people's capital or your own family's), then the stop out becomes part of good trading.  Being stopped out means that you were wrong about the anticipated price path.  It doesn't necessarily mean that your underlying idea was wrong.  The loss can be a prod to help you better manage price paths, and it can also be a prod to take a fresh look at your idea. In both cases, the loss can help make you better.

Psychologically, the trap to avoid is equating loss with failure.  Loss is a function of human fallibility; it is inevitable when trading markets.  The key question is whether you learn from losses or become threatened by them.  If you embrace losses as opportunities to learn, they won't be fun, but neither will they become the threats that lead you to avoid prudent risk management.

In general, I find that traders place stop loss points too tightly and don't anticipate the random moves likely in a given volatility regime.  The problem is not with placing stops per se, but with setting them so perfectionistically that they're almost guaranteed to be hit. Wider stops with smaller positions often allow an idea to play out--and still serve an essential risk management function.

And if you want to simply trade your ideas and not play the game of predicting price paths?  Perhaps stops are not for you and a judicious use of options could allow you to better weather choppiness and uncertainty. 

Further Reading:  Risk Management and Stops in Trading

Why Do Traders Go on Tilt?

Here's a good article from a poker site that explains the phenomenon of "going on tilt":  allowing anger and frustration to so dominate one's play that decisions are made reactively and irrationally rather than on the merits of one's hand.  It's not so different from what can happen to traders when losses lead to poor trading and further losses.

So why do people become frustrated?  Frustration typically occurs when there is an outcome we very much desire and we experience obstacles to reaching that outcome.  For example, we can become frustrated when traffic jams prevent us from getting to work on time.  We can become frustrated when a trade sets up well, only to be undone by price action resulting from a random news headline.  We can become frustrated when we want peace and quiet in a theater, but a nearby person continues to make noise. 

It is common for us to identify external factors as sources of  frustration, such as the traffic jam.  Very often, however, the frustration is set up by our outcome expectations.  If our expectations are unreasonable, we unwittingly place ourselves in a situation in which frustration can mount.  I know, for example, that if I try to drive into or out of Manhattan at a rush hour time, I'm likely to encounter traffic.  If I accept that and give myself double the normal travel time to reach my destination, I'm unlikely to be overcome with frustration.  By keeping my expectation realistic, I take away a reason for going on tilt.

Many times the expectations of beginning traders are unrealistic.  I routinely hear from traders who have taken a course on trading or gone through a training program and now experience frustration in their desire to "trade for a living".  They wonder what they can do psychologically to stop going on tilt.  The problem is that they expect an outcome that would be unthinkable in just about any other performance domain.  Would we really expect to make our living on the PGA tour after taking a series of golf lessons?  Would we expect to take courses in acting and then make our living on Broadway or Hollywood?  Would we take piano lessons and then look to make a living as a concert pianist?  

In no field does someone quickly go from being a relative beginner to being a master who makes a living from their craft.  Typically we build competence before we develop expertise--and competence takes significant practice and learning.  Think of how athletes or performing artists develop:  by the time one goes "pro", there has been a learning curve that has lasted years.  Why would the trading of financial markets be any different?  Studies tell us that knowledge and experience are key to trading success, and those can only be achieved over time.

By expecting to always make money; or to have an always-high hit rate on trades; or to make a consistent, comfortable living from a small portfolio--all of these set us up for disappointment, frustration, and the emotional disruption of going on tilt.  They also derail learning, because no one learns best if they aren't enjoying the process and immersing themselves in it.  Framing expectations in terms of progress, rather than as lofty attainments, is a great way to sustain focus and positive emotional involvement in the developmental process.

Further Reading:  What Makes an Expert?

Wednesday, September 17, 2014

The Extraordinarily Weak Breadth in the Stock Market

With DIA and SPY touching bull market highs intraday today, I couldn't help but notice that we were registering 418 fresh one-month highs across all exchanges and 547 lows.  (Data from the Barchart site.)  That is extraordinarily weak breadth.

As the chart above shows, the high-low breadth has been trailing for a while now, but has become unusually weak recently.  My data show that new 52-week highs for all NYSE shares were 370 in early June of this year; 365 on July 1; and 231 on September 2nd.  Small cap shares are well behind their bull market highs.  Incredibly, only 39% of SP 600 small cap stocks are trading above their 200-day moving averages, while that number is 55% for SP 400 mid caps and 73% for SP 500 large caps.  (Data from the Index Indicators site).  Plenty of stocks are not in bull markets, though you wouldn't know it from the large cap averages.

Meanwhile, the US Dollar is ripping higher, as investors anticipate higher rates in the US than in Japan and Europe.  Bonds have been selling off, also in anticipation of higher rates.  Most international stock markets are well off their highs (FEZ, EFA).  

Important shifts are occurring across asset classes and stock market internals have been weakening in response.  With my cycle measures near peaks, the chips have come off the table.

Two Proven Methods for Building Your Happiness

In an interesting study of positive psychology, Seligman and colleagues identified two exercises that increase happiness and decrease symptoms of depression for six months above and beyond placebo effects.  Here are the two exercises:

1)  Subjects took a test to identify their top five "signature" personality/character strengths.  They were then instructed to use one of those strengths in a new way every day for a week.  

2)  For a week, subjects were asked to write down three things that went well each day and why they went well.

The more faithfully the subjects carried out the exercises, the greater their increase in happiness over a forward six month period.  Although subjects were told to do the exercises for only one week, a number of them continued beyond that time.  Those that continued displayed the greatest increases in happiness.

This is important, because positive emotional experience has been linked to improvements in health, creativity, and productivity.  When we focus on building positive experience rather than minimizing our weaknesses, we create new ways of experiencing ourselves that open the door to fresh ways to tackle life and markets.

Notice the common thread between the two exercises:  focusing on what we have, rather than what we lack.  So often, when traders seek coaching, they focus on their weaknesses and what they're doing wrong.  What if, instead, they adapted the two exercises above and consciously set about using their strengths in new ways in their trading and identifying what they did right during good trading?  

Over time, who will build the stronger confidence:  the person who is strengths and solution-focused, or the person immersed in weaknesses and problems?

You're most likely to work on your trading if your trading brings you positive experience.  Cultivating strengths and solutions--and building processes around those--is a powerful way of accomplishing that.

Further Reading:  Keys to Solution-Focused Trading

Tuesday, September 16, 2014

Finding Opportunity in Stock Market Cycles

The recent post suggested that a variety of market observations can be pulled together by drawing upon an explanatory framework.  A good theory not only helps us understand what has happened in markets; it also suggests what we might observe in the future.  Science begins with observation.  Until we link our observations and make sense of them, they remain isolated data points.  Theory is a big part of what transforms data into explanation.

What my observations suggest is that a limited number of variables, such as buying and selling pressure; volatility; breadth; sentiment; and correlation, uniquely predict short-term price movement in the stock market.  An ongoing research interest has focused on the structure of cycles in the stock market and the co-movement of these variables at different phases of market cycles.  In general, I find that market cycles can be broken down into several phases:

1)  Bottoming process - At market lows, we tend to see an elevation of volume and volatility and a high level of market correlation, as stocks are dumped across the board.  Selling pressure far exceeds buying pressure and sentiment becomes quite bearish.  At important market bottoms, we see price lows that are not confirmed by market breadth, as strong stocks begin to diverge from the pack and attract buying interest.  At those bottoms, we also find a rise in buying pressure and a reduction of selling pressure, as fresh market lows fail to attract new selling interest.  

2)  Market rise - With the drying up of selling, low prices attract buying from longer timeframe participants as well as shorter-term opportunistic ones.  The market rises on strong buying pressure and low selling pressure, and the rise generates sufficient thrust to generate a good degree of upside momentum.  Volatility and correlation remain relatively high during the initial lift off from the lows and breadth is strong.  Dips are bought and the rise is sustained.

3)  Topping process - The market hits a momentum peak, often identifiable by a peak in the number of shares registering fresh highs.  Selling from this peak generally exceeds the level of selling seen during the market rise, but ultimately attracts buyers.  Weak stocks begin to diverge from the pack and fresh price highs typically occur with breadth divergences and lower levels of correlation.  New buying lacks the thrust of the earlier move from the lows and volatility wanes.  By the time we hit a price peak for the cycle, divergences are clear, volatility is low, both buying pressure and selling pressure are low, and sentiment remains bullish.  

4)  Market decline - Fresh selling creates a pickup in correlation and volatility, as short-term support levels are violated and selling pressure exceeds buying pressure.  Breadth turns negative and the bulk of stocks now move lower.

The thorniest problem I have encountered in my work with markets concerns the timing relationships among these phases of market cycles.  I am convinced that the cycles are aperiodic (they do not adhere to rigid timetables; there is no invariant x-day cycle), and I am also convinced that there is a non-random proportionality among the phases that occurs within and across time frames.  Capturing this proportionality has been the greatest challenge in the research.

The nesting of larger and smaller cycles creates periods of apparent trending and periods of apparent range-boundedness in markets.  Optimal trading strategies conform to the parameters of the cycles operating in markets at a given time.  Problems occur in trading when a trader's holding period greatly differs from the operative cycle period(s).  A common problem in trading today's stock market is that the operative cycles are much longer than most active traders' time horizons.  This leads to chasing nickles in front of larger move steamrollers. 

By tracking the ongoing changes in market sentiment, volatility, breadth, correlation, and buying/selling pressure, we can identify where we stand in a market cycle and adjust trading strategies accordingly.  During market rises and declines, we want to be holding positions and going with momentum; during topping and bottoming processes, we want to be fading range extremes and trading more tactically.  In general, we want to be aligned with the largest operative cycles, as these greatly impact the shape and timing of smaller cycles.

I am mindful that it is easy to find "cycles" in hindsight, with little explanatory benefit.  The cycle concept only has value insofar as it organizes observations among key market variables and suggests observations to come.  I will be elaborating the explanatory and predictive value of cycles in future posts; it is the major focus of my market research.  For an excellent example of cycle research creating profitable trading strategies, check out the StockSpotter site.

Further Reading:  Market Profile as a Practical Theory

Monday, September 15, 2014

Upcoming Topics for TraderFeed Posts

The TraderFeed queue keeps growing.  Here are topics for upcoming posts; additional suggestions for topics are always welcome via comments to posts:

*  An Explanatory Framework for Pulling Together Market Observations

*  Finding an Evidence Basis for Technical Analysis

*  Best Practices in Market Tweeting and Social Media

*  Taking Professional Networking to the Next Level

*  What We Can Learn From Overnight Trading

*  An Advance Look at Dr. Brett's Next Book

The theme across these posts is looking at markets--and market opportunity--in new ways that can generate fresh trading edges.  Many psychological problems of trading are the result of a failure to innovate in the face of shifting market opportunities.

I greatly appreciate the interest and support--


A Few Good Reads to Kick Off the Market Week

Mia's story about overcoming adversity and Mali's story about surviving the lean times.

*  A surprising number of stocks--in the NASDAQ and Russell 2000 indexes--are in bear markets.

*  I like how Abnormal Returns is now archiving the best of trading and investment podcasts.

Nice view from Reformed Broker on how markets keep expecting rates to rise, only to find we stay lower for longer.

*  Gary Stone on why it's important to never stop growing and ensure a positive trading environment.

*  This idea of indexing creating market inefficiencies is a very interesting one.  A case for stock pickers?

Thoughtful post from Math Trading on misconceptions re: quant approaches to trading.

Have a great start to the week!


The Challenge of Cultivating Trading Intuition

If we are to ground our investment and trading decisions in sound understanding and prediction, what, then, is the role of intuition in decision-making?

The recent post on intuition began with an interesting quote from Einstein, in which he described the rational mind as a faithful servant and the intuitive mind as a sacred gift.  Indeed, to those who achieve creative insights, it does indeed seem as though those flashes of insight come from an other-worldly source.

The problem in financial markets is that so many participants lack both faithful servants and sacred gifts.  I have met many traders who claimed an edge in markets due to their superior ideas and/or their superior gut feel for markets.  In the majority of cases, it is difficult to identify a concrete process that would generate either superior insights or intuitions.  Too often, the ideas traded are casually derived and held by a consensus of participants.  What passes for gut feel is fraught with recency bias, overconfidence, and a host of other cognitive distortions.  

If I claimed to be a great sprinter but never won a race and could not demonstrate superior running times on the track, you might think me to be delusional.  Many traders, facing years of poor results, will make comparable claims.  When pressed to identify the source of their (seemingly hidden) talent, they frequently will cite intuition and a superior market feel.  If only situational forces--psychological ones, the evils of algorithmic market manipulators--could be tamed, they maintain, their talents would finally shine through.

Suppose we encountered an island tribe in which the natives looked to the shapes of passing clouds for clues as to their destiny.  Dark clouds foretold an ominous future; a cloudless sky suggested a sunny path ahead.  We would no doubt chalk up these practices as the superstitious beliefs of a primitive culture.  Now imagine we encountered a tribe of financial participants who look to ancient numerical sequences or shapes on charts for signs of the future of asset prices.  This we chalk up to "technical analysis" and place on the program of expo events.

I have never felt a particular desire for psychedelic drugs and other mind-altering substances.  Reality itself is weird enough.

And yet there is far more to intuition than superstition and cognitive bias.  Some of the most successful traders I've known have demonstrated--year after year, over thousands of trades--a superior ability to read short-term patterns in markets.  What sets these intuitive traders apart from those who are merely deluded?  Where do they get their sacred gift?

Let's consider an analogy.  Suppose I identified a person who had a superior intuitive ability to forecast the weather.  This person could tell when it was going to rain, when temperatures would become cooler, and when a storm was approaching--all with well-above chance levels of success.  If we were to dissect the success of our forecaster, we would find out that he or she had developed a feel for factors that truly are related to weather changes:  shifts in wind velocity, shifts in air pressure, changes in humidity, etc.  In other words, the intuition is grounded in pattern recognition, and the pattern recognition is grounded in variables that are objectively related to the intuited outcomes.

Compare this with a would-be weather forecaster who based predictions upon a preordained set of wave patterns linking temperatures and precipitation.  

I've had the honor of watching several skilled intuitive traders in the process of their trading.  To a person, they focus on market factors that (perhaps unbeknownst to them) have been extensively studied and documented in the academic finance research literature:  factors such as momentum and volatility.  They are like the skilled weather forecaster:  they have developed a sensitivity to changes in the environment and the correlation of those changes with future outcomes.  Their sacred gift is the result of experiencing so many situations that pattern recognition becomes their faithful servant.

As a psychologist for over 30 years, I have many intuitive insights into the people I work with.  I do not have intuitive insights into ice skating or plasma physics.  Intuition comes from experience--but it has to be the right experience.  Years of exposure to random inputs will not bring sacred gifts.  Intuitions are only valid if pattern recognition captures variables that truly are causally related to anticipated outcomes.

If this is true, much of traditional trader education is misguided.  To build a trader's intuition, we should expose the developing trader to truly predictive variables and their co-occurrence across many market situations.  Simple price and volume charts or depth of market displays are ill-designed for this purpose.  If the variables that are most predictive are ones like momentum, correlation, and sentiment, then we need to develop displays that capture how momentum, correlation and sentiment behave under a variety of market conditions.  It's not that price charts are wholly unrelated to these things; it's that if we wanted the clearest and least ambiguous displays of the most predictive variables, we would not rely upon a price chart. 

Intuition can be a controversial topic.  On one hand you have advocates of intuition who claim a mystical source for their insights.  On the other hand, you have rationalists who deny the validity of intuition altogether.  There is a science to cultivating intuition, but I suspect it's in its infancy.  We can only develop a valid feel for things if we are systematically exposed to things of demonstrable validity.  The recent posts on identifying drivers of short-term markets is but the first step in a larger developmental effort to cultivate sacred gifts from faithful servitude. 

Further Reading: Underconfidence and Overconfidence in Trading

Sunday, September 14, 2014

Overcoming Impulsivity and Procrastination

Perhaps the two most common psychological concerns of traders are impulsivity--doing things without clearly thinking through the rationale--and procrastination, failing to act upon our plans and intentions.  Most commonly, impulsivity is the result of frustration and excitement:  our body's arousal impels us to action, even when it might be best to stand aside.  Procrastination is most often a function of worry and anxiety.  It is a way to avoid potential negative consequences.  Both behaviors lead to situations in which traders fail to act upon their ideas and plans.

It is common for traders to work on these problems by trying to control themselves (to reduce impulsivity) and by trying to motivate themselves (to reduce procrastination).  In both cases, there is a divided self:  one side that pushes the "good" behavior and the other side that gravitates toward the "bad" behavior.  Not only does this self-division not work; in fact, Wegner's research suggests that trying to suppress unwanted behaviors can actually make them stronger.  It is a bit like trying to make yourself not think about a pink elephant or trying to make yourself go to sleep.  The more you make the effort, the more you reinforce in your mind the consequence you're hoping to avoid.

This is where habit formation is most useful.  When we break desired behaviors into chunks and turn those into routines, we take ourselves out of the realm of control and motivation and instead enact the behaviors automatically.  For me, a good example is market preparation.  Before each trading session, I update dozens of spreadsheets that inform me about current market conditions, from breadth to sentiment.  That process is a very well-worn routine--so much so that I haven't missed a spreadsheet update in quite a few years.  The key is that I enact the updates in the same way, at the same time of day, in the exact same manner.  Because it is a habit, I don't expend mental capital on the exercise, trying to get myself to finish the task or making sure I perform the updates diligently.  Once behaviors are automatic, there is no division of self.  That saves considerable energy and emotional wear and tear.

When the essential elements of trading are distilled into routines, the result is a trading process.  A robust process is nothing more than a coordinated set of habits.  There are many benefits to being process driven, including grounding oneself in best practices.  The major psychological benefit, however, is consistency.  If we are not at war with ourselves, we can devote full attention and focus to the battle for profits.       

Further Reading:  Making Sound Decisions Under Conditions of Fear

Saturday, September 13, 2014

Three Top Reasons Why Traders Fail to Trade Their Plans

A reader recently asked for perspectives on the issue of difficulty following trading plans.  If only we could faithfully follow our plans, the logic goes, we would be positioned for success.


Scanning my work with traders, here are the three top reasons traders fail to act upon their plans:

1)  The plans are not worth acting upon.  This is a very common reason, but no one seems to talk about it.  I believe people frequently veer from their plans because of intuitive wisdom.  They sense that markets have changed and their plans are no longer relevant; they sense that their plans are not grounded in solid understanding and prediction and therefore do not trust them; and/or they sense that the plans are ones that they have merely mimicked from others and not ones they truly have confidence in.  The presumption in trading psychology discussions is that one should reliably follow one's plans.  My leaning is to question the premise.  Plans are only worth following if they are well crafted and reflect approaches to markets that have a demonstrable edge.  If you don't stress test your plans, markets will stress test you.

2)  We are intellectually prepared with plans, but not emotionally prepared to act upon them.  This is very relevant to the issue of performance anxiety.  When we plan in one state of mind (calm, focused), but execute our plans in a state of flight/fight (aroused, impulsive), we are much more prone to cognitive biases and reactive behavior.  This is particularly the case when our plans call for one level of risk management, but emotionally we can tolerate only a lower level.  It is very common that traders target one level of risk taking (hoping for large profits), only to "overreact" when their position sizing leads to unanticipated losses.  One of the great benefits of visualization and exposure methods is that they allow us to emotionally prepare for stressful events.  As I discuss in the Trading Coach book, it is easier to follow our plans if we have already faced likely challenges to those plans.

3)  Distractions interfere with our follow-through on plans.  Not all disruptions of plans are emotionally triggered.  It is very common for traders to become distracted by their physical environments.  This includes noise levels, equipment failures, and unanticipated personal and market events.  A common example of distraction is staring at screens, following markets tick by tick, and then acting on a very short-term market movement that had nothing whatsoever to do with one's original plan.  I particularly like biofeedback training, not only as a means for gaining emotional self-control, but as a means for improving concentration, mindfulness, and the ability to tune out distractions.

In short, there is no single reason why traders fail to act on their plans.  Keeping a detailed trading journal can be very helpful in identifying when you do and don't follow through on plans, revealing patterns in your own trading psychology.  In general, my advice is to first make sure your plans are worth following before you worry about finding psychological methods for improving your discipline.

Further Reading:  Why Traders Plan Trades But Don't Trade Their Plans

Prediction and Understanding in Generating Market Returns

The recent series of posts have reviewed a number of stock market measures that I have found to be useful in anticipating short-term price movement:  buying and selling pressure; pure volatility; breadth; sentiment; and correlation.  The question now arises:  how do we make use of multiple measures such as these?  How do we put them together in a coherent fashion?

Let's address this by first surveying the territory.  Traders attempt to anticipate market behavior by engaging in one of four modes:  1)  bias; 2) superstition; 3) prediction; and 4) understanding.

Bias represents a way of thinking that is grounded, not in objective events as they are occurring, but in thoughts, feelings, and ways of processing information that are influenced by external and nonessential factors.  For example, I have met a number of traders who display a persistent bearish bias.  When asked for the reasons for their bearishness, they cite their disagreement with the political and economic policies of the government.  Their political and economic beliefs are so strong that they cannot see markets through any other lens.  Needless to say, this has led to disastrous returns over the long run.

Superstition is a set of beliefs that are not grounded in objective observation and measurement and--this is important--cannot be validated through such means.  A while back I encountered a market analyst who declared that the stock market was headed lower because it was completing a head-and-shoulders pattern on the weekly chart.  I quickly coded up market patterns of a similar nature and backtested the idea.  I found no predictive validity to the head-and-shoulders formation whatsoever.  I varied the coding to look at formations on different time frames and still found no predictive value to the pattern.  When I explained this to the analyst, he replied that technical analysis was an art, not a science.  The belief system that shapes on charts dictate forward price movement was grounded in superstition and--as a supposed "art"--was immune to attempts at validation.

Prediction is an attempt to quantify and systematize relationships among variables that we believe to be causal.  Suppose I were to take the variables listed above, such as sentiment and volatility, and enter them into a stepwise regression equation to see which uniquely predict forward price movement.  I might find, for instance, that one of the variables--say volatility--so overlaps with correlation and buying/selling power that it does not add significant predictive value whatsoever.  The variables that do add significant predictive value comprise a model that spits out predictions of future price movement.  While much prediction is quantitatively driven, a qualitative form of prediction occurs when experienced traders recognize recurrent market patterns and base quick decisions on the occurrence of these patterns.  Because such intuitive pattern recognition can look so much like superstition, it can be challenging to differentiate skilled intuitive discretionary traders from superstitious amateurs.  Ultimately, the arbiter of predictive value--whether quantitative or discretionary--is an objective, real-time track record. 

Understanding is quite different from prediction.  We can predict when the sun will rise in the morning, but not necessarily understand the reasons for the sun's apparent movement.  Understanding addresses the why" behind prediction.  Very often, we do not know precisely how causes lead to effects in nature.  We develop our understanding by generating a theory, which attempts to explain how variables of interest lead to observed outcomes.  Good theories account for existing findings, but also suggest new ones.  One pitfall in the investing world is generating complex predictive models through means such as neural networks.  The output of these models may not be clear--and certainly may not reflect any understanding of the underlying markets.  A very useful brake on the overfitting of trading systems and models is the use of input variables that make sense within a plausible theoretical model.  Otherwise, we have no way of determining whether our predictive model is truly grounded in an understanding of the world.

In important respects, the division between technical analysis and fundamental analysis in the trading world reflects a tension between the modes of prediction and understanding.  Just as the predictions of technicians can reflect little underlying understanding of markets, the inputs of fundamental analysts can lack predictive rigor.  A good example of the former is market queries that find a predictive edge when, say, we post a three-day high at the start of a calendar period.  There is no proposed mechanism that explains why such a pattern would hold true.  Conversely, when we hear a "macro" analyst declare that stock market returns will be dampened in Europe because of threats of war in the Ukraine, there is no predictive framework for testing and validating the assertion. 

Ultimately we master a domain when we can explain observations and validate our explanations through tests of our predictions.  Those tests either occur prospectively, as part of formal backtesting and forward testing, or they occur in retrospect via the analysis of real-time track records.  Such mastery is rarely demonstrated in trading, where a great deal of activity is dominated by bias, superstition, and disjointed efforts at prediction and explanation.  As a psychologist and trader for many years, my distinct impression is that much of what traders experience as emotional challenges in markets is the result of operating in an uncertain domain with less-than-adequate predictive and explanatory frameworks.  Anxiety and frustration are the understandable consequence of needing to predict and understand, but having few tools to achieve those ends.

So what does a sound explanatory and predictive framework look like?  One window on market success is offered via the Principles written by Ray Dalio of Bridgewater Associates, as well as his account of How the Economic Machine works.  Another window on successful prediction and explanation can be found in the work of Clifford Asness of AQR, including his published papers.  The dramatic success of these funds represents the power of joining prediction and explanation in a robust and replicable fashion.  That is the hallmark of science.

This brings us back to the original question:  Is there an explanatory framework that can bring together the variables covered in the recent blog posts?  And what is the proper role of intuition in the joining of prediction and understanding?  Those will be the topics of the next posts in this series.

Further Reading:  Qualitative Research and Science

Friday, September 12, 2014

The Importance of Sector Correlations in the Stock Market

Recent posts have taken a look at useful market indicators, including buying and selling pressure; pure volatility; unique measures of breadth; daily sentiment; and intraday sentiment.  This post takes a look at the rolling 20-day correlations among key stock market sectors.  What I do in this measure is take 10 segments of the stock market and run pairwise correlations among their ETFs.  The final measure is the average of the entire correlation matrix.

Let's think about what that means.  Technical analysts commonly refer to "divergences" among stocks at market turning points.  That's one reason breadth measures are popular:  they identify occasions in which stronger stocks are becoming differentiated from weaker ones.  When we are making market lows, stronger stocks fail to follow the broad averages; when we are making market highs, weaker stocks fail to confirm the strength in the broad averages.  The correlations among sectors provide a way of quantifying this differentiation among stocks.

If you click on the chart above, you can see that correlations have been highest around intermediate-term market bottoms and lowest around intermediate price peaks.  During "risk off" periods, correlations rise considerably, as selloffs hit all sectors.  The initial liftoffs from market bottoms find buying interest from longer timeframe participants and take most stocks off their lows.  As rallies age, weaker stocks begin to lag and correlations fall.

If we go back to 2012 and create a median split of the data, we find that, when correlations are in the lowest half of their distribution, the next five days in SPY have averaged a flat performance.  When correlations are in the highest half of their distribution, the next five days in SPY have averaged a healthy gain of +.68%.  This pattern of subnormal returns for low correlation markets and superior returns for high correlation markets extends to 20 days out.  Interestingly, correlations are at very low levels in the current market, suggesting reduced upside potential.

So we have all these measures that appear to have usefulness in anticipating forward price movement.  How do we put them together to create truly evidence-based market indicators?  That will be the subject of the next post in this series.

Further Reading:  Intraday Sector Correlations

Thursday, September 11, 2014

Using Put-Call Ratios to Gauge Intraday Stock Market Sentiment

The most recent post took a look at the equity put-call ratio as a way of gauging market sentiment.  Suppose, however, that you are interested in gauging sentiment shifts that occur within the market day.  The figures reported by exchanges are the daily ratios updated throughout the day.  They do not tell you specifically how many put options and call options are traded uniquely during each segment of the day.

If you click on the chart, you'll see figures that don't typically appear with the data services.  I took the number of equity put options traded during each 15 minute segment of the market day and divided them by the number of equity call options traded during each of those segments.  The result is a unique put-call ratio for each 15-minute period, rather than a daily figure updated every 15 minutes.  (Data obtained from e-Signal and ratio calculated and charted in Excel). 

You can see how sentiment has shifted over the course of the last three trading days, with spikes in the put-call ratio at yesterday's market lows and rather bullish sentiment by end of day.  In general, I find value in the sentiment measures at extremes:  when readings are unusually bullish or bearish. 

Further Reading:  Visualizing Social Sentiment

Measuring Stock Market Sentiment: The Equity Put-Call Ratio

The most recent posts have focused on several important dimensions of short-term stock market behavior:  Buying and Selling Pressure; Volatility; and Breadth.  Above we see yet another key dimension:  sentiment.  My favorite measure of sentiment is the put-call ratio specific to individual stocks trading listed options.  I have found this measure to be significantly better at predicting short-term price movement in SPX than the put-call ratio for index options.  

As you can see from the chart above, covering 2014 to date, spikes in the equity put-call ratio have been associated with good buying opportunities in stocks.  (Data from e-Signal and analyzed/charted in Excel).  Forward returns have been restrained following periods of low put-call ratios.  If we go back to 2007, when the equity put-call ratio has been in the lowest half of its distribution, the next 10 days in SPX have been unchanged.  When the equity put-call ratio has been in the highest half of its distribution, the next 10 days in SPX have averaged a gain of +.49%.

It's a great illustration of how following the herd produces suboptimal market results.  It's when stocks are most unloved that they've produced the best returns.  

Further Reading:  The Relative Put-Call Ratio