Where to Find a Stock Picking Edge

Quick: Which of the following statements is true:

a) The S&P 500 Index is trading above 1500, making up its losses from the 2000-2003 bear market.

b) The S&P 500 Index is trading near 3000, recently hitting all-time highs and trading well above its 2000 highs.

As we see above in the chart from the highly recommended Decision Point service, both statements are true. The standard, weighted version of the S&P 500 Index ($SPX) is trading above 1500, near its 2000 highs. The unweighted S&P 500 Index, however, has nearly doubled the performance of its weighted counterpart, and its relative strength (bottom panel) has been in a long-term uptrend.

The stock picking edge in the S&P universe hasn't so much been in whether you're invested in one sector or another. Rather, the big edge has come from being in the smaller, lesser-known names. The highly visible mega-cap issues, the favorites of institutions due to their liquidity, have dramatically underperformed their smaller counterparts.

Indeed, if we limit our view to the S&P 100 Index ($OEX), we find that the unweighted version has more than doubled the performance of the standard, weighted index since 1999. And the unweighted NASDAQ 100 Index ($NDX) has outperformed the weighted version by 2-1/2 times over that period.

Quite simply, the largest, most visible names in the stock index world have been the worst performers. It's the stocks that are not on the radar of most watchlists that have enjoyed the stock picking edge.

Interestingly, the dynamic between weighted and unweighted indexes appears to occur at very short time frames as well. Going back to 2004 (N = 877 trading days), we find 139 relatively flat occasions in which the S&P 500 Index (SPY) has been up by .10% or less and down by -.10% or more in a single trading session.

When the unweighted S&P 500 Index (RSP) has outperformed the flat SPY (N = 72), the next two days in SPY have averaged a gain of .15% (42 up, 30 down). When RSP has underperformed the flat SPY (N = 67), the next two days in SPY have averaged a gain of only .03% (35 up, 32 down). The health of the smallest S&P 500 components appear to be related to the index's near-term prospects.

Over time, markets reward prudent risk assumption. In relative terms, the safest, bluest chip stocks do not receive these rewards.

RELEVANT POSTS:

RSP and SPY: Unweighted and Weighted S&P 500 Index

The Safest Times to Trade Offer the Least Rewards
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Worth Checking Out on a Friday Afternoon

* Pulling It Together - Trader Mike provides a test drive of the MyTrade.com service; nice way to organize your data and feeds.

* Mind and Money - Here's a book I'll be digging into this weekend that looks promising. Richard Peterson has written an interesting synthesis of behavioral finance and neurofinance research that looks quite readable.

* Excellent Macro Perspectives - Barry Ritholtz offers views from the Knights of the Roundtable: rates, the economy, housing, and commodities.

* Top All Around Stocks - TheStreet.com and StockPickr take a look at five top stocks based on fundamental, technical, and economic factors.

* Stock Picks From a Savvy Money Manager - I continue to like the VesTopia site for its coverage of the real time ideas and trades of money managers. Particularly check out the blog for Mark Hines. His stock picking ideas are solid, but it's his reasoning that you want to model as a trader/investor. Great job of theme-based thinking.

The Trader Coach Project: Formulating the Focus

My last post regarding the coaching of Trader C featured an assessment of the trading problems that led him to seek assistance. Recall that Trader C is a professional trader at an established firm. He has a long track record of successfully trading for a living, but his results for 2007 have been subpar. He attributes these performance problems to being too aggressive in his trading. This, he feels, causes him to lose his discipline, costing him significant money. In his words:

"What I have been doing right is my feel for the turning point, or breakout, or direction of a group, but my drawback is the initial sizing in them."

What we know from research in psychology is that any kind of counseling is most likely to be effective--especially in a relatively short time frame--if it is highly focused. For that reason, it is important to move from an assessment of strengths and weaknesses to a specific set of targets for improvement. These targets must be jointly determined by trader and coach: they form the game plan for the work to come.

Many times the focus that coach and trader arrive at is different from the focus initially held by the trader. For example, Trader C might initially frame the focus in terms of "discipline problems". This definition of the problem has led Trader C to attempt a variety of solutions on his own, none of which have proven wholly satisfactory. An important--and rarely appreciated--function of the coach is to help traders in reframing problems, opening the door to fresh solutions.

In the case of Trader C, I do not share the view that he lacks discipline. Or, more specifically, I see any discipline problems in trading as the result--not the cause--of his concerns. Moreover, as I mentioned in my recent post, I see Trader C's strengths--not his weaknesses--as the source of many of his problems. Allow me to elaborate.

Trader C and I have now held several lengthy phone conversations to help us come to an understanding of his situation. He has evolved into a sophisticated trader, combining intermediate-term, theme-based trading with short-term scalping. For example, he will research and select individual stocks that he believes will benefit from current, fundamental trends (an example would be companies involved in oil services). These positions might be held for many days at a time. On the other hand, he began as a daytrader and has considerable market timing skills.

As I reflected in one of our conversations, Trader C has been making the transition from being a trader to being a portfolio manager. He is much more diversified in his positions, much more aware of the value of holding simultaneous long/short positions, and much broader in his thinking about risk management than he was when he first arrived at his firm. His success, in no small part, has been a function of this evolution.

But his firm has not evolved similarly. The firm emphasizes short-term trading and manages risk on very short time horizons. This makes it difficult for Trader C to fully exploit his longer-term ideas. Even when his entries are good, he can be stopped out of his positions because the firm's intra-day risk levels are exceeded. The result is an understandable frustration for Trader C. He is naturally aggressive in his trading style, and he has many positions worthy of pursuing at any given time. His firm, however, is managed quite conservatively and cannot provide him with a risk management framework that he might find, say, at a large hedge fund.

This is not to say that Trader C's firm is poorly run. Not at all. There is simply a mismatch between his evolved trading style and the trading framework supported by the firm. Unwilling to simply give up on his valuable ideas, Trader C has been struggling to stay underneath the risk radar for the firm. This, however, is a constant battle for him: it is like asking a competitive downhill skier to limit himself to cross-country skiing.

The obvious solution to the problem--for Trader C to pursue trading for a hedge fund or prop desk at a bank with wider risk parameters--is not so simple. Getting a foot in the door without a prior track record of successful portfolio management and/or a pedigreed finance MBA can be quite a challenge. And with Trader C's recent trading treading water, he is not exactly in the best position to be knocking on doors at the moment.

What I proposed to Trader C--and what seemed to make sense to him--was to turn his aggressiveness from the goal of making as much money as possible to the goal of becoming the best trader he can be in risk-adjusted terms. In other words, instead of grading himself by his P/L--which leads him to bump up against the risk parameters at his firm--we will grade him based upon his Sharpe Ratio and similar statistics that assess how much he makes as a function of the risk that he takes.

Once he achieves consistency in risk-adjusted terms, he will be highly marketable to other firms should he decide to pursue such a course. I gave him my assurance that I would use my industry contacts to help him open some doors once he reached his consistency goals.

What this will mean in practice is that Trader C will size his longer-term positions quite small in order to stay in the positions long enough to benefit from his ideas. He will also diversify his shorter-term positions so that he is not taking highly correlated risks when he has a directional bias. Finally, each of his positions will come with highly explicit position size limits and stops, so that he is not placing huge bets on any one idea.

All of these measures are simple extensions of the evolution he has already made as a trader. We are taking the aggressiveness that he has been channeling into trading and directing it toward risk management. If we're successful, his metrics will show a shift, such that the size of his average losing trade will not exceed his average winner.

Instead of working on a problem, we're working on extending a strength. We're going to make Trader C into the best portfolio manager he can be in his current setting. Once he succeeds at doing it small, he'll be positioned to manage more capital either at his present firm or elsewhere.

So how do we pursue this focus? That will be the topic for my next post in the series.

RELEVANT POSTS:

Solution Focused Trading

Finding Solutions to Your Trading Problems

A Solution Focused Linkfest
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How To Regain Your Trading Consistency

A reader recently wrote to me the following:

I was a successful consistent trader who always hit singles and doubles ($1000-$3000 a day) for 48 months in a row without having a losing month (1999-2003).Then one day I struck out. I lost $38,000 in one stock and had my first losing month as a trader ever. Since then I have not had two consecutive winning months and in fact have only had a handful of profitable months since then. I am still looking for the road back to consistency. No matter how close I get I always find a way to screw it up even if it is on the last day of the month. Or I give back the month with just some silly unimportant trade that turns into a disaster. It is like I subconsciously look for these situations just so I can mess up.

This is not such an unusual scenario. One large loss can trigger a cascade of attempts to make back the money, further mistakes, and expanding losses. The key is breaking this cycle of losing money, attempting to make the money back with aggressive trades, and continuing to lose.

The first thing I'd have our trader look at is where he is placing stops and targets for his trades. Note that his successful period was 1999-2003. That was a period of much higher price volatility than we've seen since then. What constitutes "singles and doubles" in a high volatility environment is a home run trade in a slow, low-volatility market. It is entirely conceivable that our trader is placing targets too far from his entries, allowing small gains to reverse on him. Similarly, he may be letting trades get too far away from him simply because he is calibrated to a higher level of volatility.

A good way to test these hypotheses would be to study trades over the last several months. If losing trades are larger than winners on average, and if many losers start out as winners, that would suggest that our trader needs to adjust to the post 2003 environment.

To break the cycle mentioned above, the first step is to drastically reduce trading size. I would cut size to 1/4 the average at the most. The goal is to keep a little skin in the game, but take P/L (and the push to make back money) off the table temporarily. The initial objective is not to make money, but to regain a trading rhythm by getting back to singles and doubles.

The next step is to identify those singles and doubles. That means deconstructing the account statement and identifying which trades are making money and which aren't. I would break the data down into time of day, stock/index being traded, long/short, and size. I would also look to see if there are large outlier trades to the downside that are pulling down P/L, and if there are some trades that are making money consistently.

Once our trader has identified what's working, the idea is to keep position size fixed and *only* trade those setups that have been working. This is the foundation to build upon. These setups can be written down and mentally rehearsed ahead of the trading day to build consistency. The idea is to not increase size *and* not trade other patterns until consistency is achieved with smaller size and the most successful setups.

There is only one cure for trauma, and that is repeated experiences of control and safety. We want trading to be routine, not highly emotionally charged.

Finally, I would encourage our trader to take a look at how he is viewing his situation. Note above that he talks of the $38,000 loss and the silly trade that "turns into a disaster" as if these are things happening to him, not things that he is actively doing. A simple strategy would be to have the trader write down the four things he is responsible for prior to each trade:

* The Entry
* The Target(s)
* The Stop
* The Position Size

We can't control whether any individual trade will be a winner, but we can control how much we are willing to bet on each trade. Outsized losses don't happen to a trader; they are actively caused. It is harder to allow those things to occur if you're talking aloud those four trade parameters and have them written in front of you.

So there it is in a nutshell. My advice is to get small, get selective, and take responsibility for what can be controlled.

Do readers have additional advice? Let's see if we can help a reader. Thanks!

Brett

Assessing Your Personal Strengths: What They Mean For Trading

A common perspective is that traders run into problems because of personal (or personality) flaws. My experience with successful traders in professional settings, however, finds that the successful traders often have as many of those shortcomings as other traders. The difference lies in their personal strengths--and how they bring these to bear in their trading.

It's only been fairly recently--with the rise of "positive psychology"--that research has taken a hard look at strengths and subjective well-being. One excellent compilation of this research is the large text "Character Strengths and Virtues" by Christopher Peterson and Martin E. P. Seligman. It is an attempt to pull together everything we know about such qualities as wisdom, courage, love, kindness, justice, leadership, modesty, optimism, spirituality, and much more.

Another effort to study strengths are the Values in Action questionnaires that evaluate 24 positive personal qualities. (Interested readers can register on the research site and take the questionnaires for themselves).

My experience is that many trading problems occur, not because of traders' weaknesses, but because their strengths do not align properly with their trading. In an upcoming post, I will update the Trading Coach project and illustrate this concept. Interestingly, very few trading coaches/psychologists seem to spend a great deal of time assessing specific trading and personal strengths. The assumption seems to be that, if you address a weakness, you'll then succeed.

The opposite approach is that, if you build strengths, you can work around your shortcomings.

Let's try a little exercise. Below is a list of strengths from the VIA survey. Identify what you consider to be your five greatest strengths from this list and jot them down:

creativity, curiosity, open-mindedness, love of learning, wisdom, bravery, persistence, integrity, vitality, love, kindness, social intelligence, citizenship, fairness, leadership, forgiveness, modesty, prudence, self-control, appreciation of beauty, gratitude, optimism, humor, spirituality

Once you've written down what you believe to be your five greatest strengths, now--next to each of these strengths--write down how you specifically employ that strength in your day to day trading.

What I find is that, sometimes, how a trader is trading does not make concrete use of his or her greatest strengths. As a result, the trader is pulled two ways: toward what he or she "should" do according to the chosen trading style and toward what comes most naturally as a personal interest and strength. This is not a problem with discipline per se; it is a problem of a lack of fit between trading approach and personal competencies.

It is not necessary for trading to actively engage all your strengths. If many of your top strengths are not regularly utilized in your trading, however, two consequences are likely to result: a) you will not be as successful as you could otherwise be; and b) you will likely find trading less than fully satisfying and will not sustain the motivation to develop yourself fully.

In our Trading Coach project, Trader C. is running into some difficulties that have reduced his profitability. As we shall shortly see, it is his strengths that are getting in his way. In an upcoming post, I'll show what we're doing to remedy that situation.

RELATED POSTS:

Subjective Well-Being: Why It's Important For Traders

Three Steps Toward Improving Your Well-Being

Understanding Lapses in Trading Discipline

Top Ten Reasons Traders Lose Their Discipline
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How Can I Learn Trading?

A blog reader recently asked me this simple, but not-so-simple question. My book Enhancing Trader Performance is an attempt to describe the process by which traders (and professionals in other fields) develop expertise, and I know of quite a few traders who are using ideas from the book to guide their own development.

It's difficult to know where to start, however. There are many mentoring services out there, but many are quite pricey. That's a real problem for beginning traders who may be flush with ambitions, but not necessarily with cash.

My own bias, as long-time readers are no doubt aware, is that learning how to trade is not a matter of finding the ideal indicator or trading pattern. Rather, trading is a performance skill, not unlike chess or baseball. That means that trading consists of component skills that must be practiced and refined over time. No amount of self-help psychology or trading seminars can substitute for screen time and the cultivation of skills related to pattern recognition, execution, and risk management.

Here are a few thoughts regarding ways of initiating this learning process:

1) Start With a Framework - At the mentorship program I developed for a Chicago prop firm, we used Market Profile as a framework for understanding bids, offers, the market auction, trends, consolidation areas, how markets establish value, and the interplay of time, price, and volume in the establishment of value. That isn't to say that there aren't other possible, valuable frameworks out there, but I find Jim Dalton's introduction to the markets to be user friendly and highly practical. It's a way to think about markets. Too often new traders try to start by learning technical patterns and setups, without really understanding how markets operate.

2) Start With Observation - I say this so often traders must get tired of hearing it. But protect your capital and protect your psyche during the learning process! Jumping into markets and trading against the pros without proper preparation is the way to learn bad trading and emotional habits. When I began my own learning process, I printed out charts every day of the ES, NQ, and ER2 markets; volume; and NYSE TICK. To this day, those charts fill several drawers of a filing cabinet in my office. Reviewing them every single day helped me *see* ranges and breakouts and patterns of confirmation and non-confirmation in market moves. Train your eye before you risk your capital. Learn one or two patterns well and build on those. Trading blogs and books are good sources for patterns that you might want to start with. Don't be too much in a hurry to "trade for a living". That's more performance pressure than most people can bear.

3) Start With Simulation - Yes, yes, I'm very aware that simulated trading (paper trading) is not the same as the real thing. But there's a reason basketball and football players engage in scrimmage games, and there's a reason chess champions practice their game outside of tournaments. Simulation enables you to make your mistakes and learn from them *before* you risk losing in the real performance. It's also helpful to first practice skills without the pressure of making money. If you can't make money in simulated trading, you certainly are not going to succeed going live. Simulation is the bridge between learning and doing; it's an important skills-builder. Check out programs, such as Ninja Trader, that offer free simulation versions. They help you practice, but also help you keep score and track your progress.

4) Start Thinking Like a Trader - That means knowing what traders look at when they assess markets, the economy, news events, etc. I subscribe to the Wall St. Journal, Financial Times, and The Economist for U.S. and global perspective among print publications. I also follow the linkfests of several of the best financial blogs, including The Kirk Report, The Big Picture, Trader Mike, Abnormal Returns, and Seeking Alpha. They do a great job of sifting through the news and current events. If you're learning stock picking, avail yourself of the excellent resources out there, such as Kirk's Screen Machine and the StockPickr site. Consider joining a community of traders that shares trading ideas, such as StockTickr. If you're learning market timing, consider tools such as Market Delta and Trade Ideas/Odds Maker. To see how other traders are doing it and learn from their examples, check out the VesTopia and Covestor websites and such online trading rooms as Woodie's CCI Club. (Please note that I have no financial affiliation with any of these sites or services).

If I were starting out as a trader now, I would keep it very simple. Along the lines of my recent post, I'd learn to identify ranges in markets and ways of determining when markets are likely to remain range bound vs. break out and trend. I'd practice just those two setups: breakout trades and "mean reversion" trades that move from one end of a range toward the other. I'd start very small, and I'd learn to set stops and target levels based upon repeated experience with these patterns.

If you were to aspire to join the PGA tour and compete against the best golfing pros, you'd undergo a lengthy process of preparation and practice. The stock market is the PGA tour of trading professionals and no less spade work is needed for success. You're most likely to succeed if you have a curriculum, a way to practice skills, and a way to learn from your successes and shortcomings. I've been trading since the late 1970s, and I still feel like a student of the markets. You're always learning, you're always developing. The successful traders are the ones that sustain this learning curve by embracing it.

RELATED POSTS:

Six Keys to Trading Success

Pain and Gain in a Trader's Development

What Contributes to Profitability?
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Great Example of a Breakout Trade

I waited quite a bit this AM to catch this trade and it paid out handsomely. Note on the Market Delta chart (click on chart for greater detail) that selling is terminating at higher price lows and that we get a pickup of volume at the offer prior to the breakout. Down on the bottom, X-axis, you can see how total volume expanded on the breakout, indicating institutional participation. The key, however, was seeing the prior trading range and the shift in distribution of volume as the range progressed. If you study many examples of such moves, you can become increasingly sensitive to them in real time.

The Importance of the Overnight Range in the S&P Emini Futures

The stock market, first and foremost, is a valuation machine. Its purpose is to establish and update value on a relatively continuous basis. The problem is that the U.S. stock markets are not open for trading on a truly continuous basis. This creates overnight gaps that show up on daily barcharts.

Fortunately, we have relatively continuous trading in the electronic futures markets; most notably the S&P 500 emini futures (ES contract). Tracking the futures during the overnight session is extremely valuable in framing morning trades once the stock markets open.

The reason for this is that the overnight range for the emini S&P reflects shifts in valuation that are attributable to: a) overnight news events; and b) the behavior of Asian and European markets. When the overnight range falls squarely within the range of the prior day's trade, we can conclude that nothing happened overnight to fundamentally alter the market's assessment of value. That generally has me thinking in range bound terms. Conversely, sharp moves to new highs or lows relative to the prior day suggest that overnight events were significant, suggesting a trend may be under way.

My research suggests that the volatility of price behavior during the overnight session is positively correlated with morning trading volatility once the markets open. In the Market Delta chart above (click chart for greater detail), we see the overnight action for today. The range of nearly 7 full S&P points is quite a bit larger than we normally see--not so unusual, given recent market volatility. As a result, I'm prepared for some good price swings this morning.

Also notice that we took out the closing lows from Tuesday during overnight trade, but then snapped back into Tuesday's trading range. An attempt to break to new highs during the next to last bar found no influx of buyers (note how volume above 1500 tailed off, especially relative to the volume we saw during the 3:42 bar), and we moved back into the overnight range. This range gives us an important reference point for the morning trade. It represents the market's most updated assessment of value. Very often my first trade of the day will gauge early buying/selling sentiment (NYSE TICK, distribution of volume at bid/offer in the Market Delta chart) and play for a test of the overnight range.

Once we approach one side of the range, we want to see what large traders are doing. On the Market Delta chart, the first number within the bar is the ES volume transacted at the bid. The second number is the volume transacted at the market offer. We want to see if total volume (the sum of these two) is expanding, and we want to see if this expansion is occurring asymmetrically at the bid vs. offer. If volume does pick up and is one sided at the bid (near the range lows) or at the offer (near the range highs), we look for a range breakout and possible start of a short-term trending move. This occurs because all the short-term traders leaning the wrong way during the range have to exit their positions to limit their losses. For this reason, as a rule, the longer the range--and the greater the volume within the range--the more significant the subsequent trending move on a breakout.

Conversely, if volume dries up on attempts to move above or below the range (as happened at the 6:27 AM bar), we want to think about the possibility of a false breakout and a movement back to at least the midpoint of the range. That puts us in "mean reversion" mode, fading the market move.

Knowing your ranges enables you to anticipate these breakout and mean reversion moves. Knowing how large traders are behaving at range extremes enables you to handicap the odds of sustaining moves outside the ranges. Even longer time frame traders can benefit from this information, enabling them to get better prices on entries and become alert to situations in which their anticipated moves are confirmed or disconfirmed.

This morning, I'll be playing off the overnight range data. Given the recent market weakness, I'll be especially alert to tests of the range lows and whether those are confirmed by sentiment (TICK) and volume (Market Delta) or whether they will lead to a snap-back into the range due to a drying up of selling.

RELEVANT POSTS:

A Context for the Market Open

Tracking the Large Trader

Anatomy of a Market Breakout
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Catching Up With the Blogosphere

* Fading Momentum - According to Decision Point, after Monday's decline, only 45% of NYSE stocks and 43% of S&P 500 issues are trading above their 50-day moving averages. That number has tended to go below 30% during most of the intermediate-term corrections during the recent bull market. Only 26% of S&P 500 financial stocks are trading above their 50-day MA and 32% of health care issues. Energy remains the stronger sector, with 69% of stocks trading above their benchmarks.

* Options Sentiment Elevated, But Not At Bearish Extremes - I see that the equity put/call ratio has been hovering just below 1.0. While that is elevated compared with average levels, it is not at the extremes that we've seen at recent market bottoms such as March, 2007 and June, 2006 when we had multiple readings above 1.0. While on the options topic, check out Adam Warner's perspectives and why he thinks index options are overpriced relative to the options of individual stocks.

* Understanding Sector Rotation - A book overview from the Afraid to Trade blog takes a look at the relationship between sector movements and the business cycle.

* Good Reading - Trader Mike offers updated links, including a review article on gaps; check out the screening post from Charles Kirk, drawing upon the MSN StockScouter. There are some stocks worthy of investigation in the post.

* Most Admired Companies Perform Most Admirably in the Stock Market - Great summary of a study from the CXO Advisory Blog.

* Housing Market, City by City - A nice summary of data from Bespoke Investment Group shows where there's greater strength and weakness. See also their innovative advance-decline line for economic indicators posted to Seeking Alpha.

* Gold as Money - Very educational post from Trotsky and Mish. Excellent quote: "In the end, such price fluctuations in gold are a bit like Warren Buffet's famous remark about the stock market being a 'voting machine in the short term and a weighing machine in the long term'. In the short term, all sorts of considerations can be used to 'explain' movements in the gold price, but in the long term, gold acts as the aforementioned barometer of confidence in central bank issued fiat money."

* Not the Apple of Their Eye - WSJ Online raises questions re: the iPhone.

Should I Chase Stocks After They've Risen?

It's a dilemma. You have a great trade idea, but before you can get on board, the stock or index makes its move. Now you've got to decide to wait for a pullback or chase the rising prices.

I'm finding the money flow data to be valuable in addressing this question, particularly when moves are to the upside.

Recall that I track 40 highly-weighted S&P stocks that are evenly divided among eight sectors: Materials, Industrials, Consumer Discretionary, Consumer Staples, Healthcare, Energy, Technology, and Financial. Each day I assess the raw money flows into these 40 issues.

As a quick reminder, money flow starts with each trade in each stock. The price of the stock is multiplied by the volume of that particular trade. If the trade occurred on an uptick, the dollar volume is added to a cumulative total. If the trade occurred on a downtick, the dollar volume is subtracted from the total. At the end of the day, we look at the cumulative total for each stock and sum across the 40 stocks.

Going back to 2005 (N = 617), when the average money flow over a five day period is below 75 million (N = 121), the next five days in the S&P 500 Index (SPY) average a gain of .37% (73 up, 48 down). When the average money flow for the 40 stocks exceeds 150 million (N = 180), the next five days in SPY also average a gain of .37% (117 up, 63 down).

By contrast, all other occasions in the sample--occasions in which average five-day flows are between 75 million and 150 million--average a five-day gain of only .06% (174 up, 142 down). In other words, when we look at a five-day horizon, we see bullish implications when money flows for the S&P stocks are very weak (reversal effect), but also when they're very strong (momentum effect). Gains are subnormal following periods that don't feature either very weak or strong money flows.

Another way of looking at the data is to examine rising five-day periods in SPY as a function of money flows. Going back to 2005, we've had 268 periods in which SPY has gained more than .50% over a five-day period. Following these periods, the average five-day change in SPY is -.08% (136 up, 132 down).

When we divide the sample in half based on money flows, however, a pattern emerges. Five-day gains on strong money flows (N = 134) average a subsequent five-day gain of .13% in SPY (77 up, 57 down). Five-day gains on weak money flows (N = 134) average a five-day loss of -.29% in SPY (59 up, 75 down).

What that suggests is that traders might not want to chase rises on weak money flows, but rises on strong flows tend to persist in the short run. Note in my latest post to the Trading Psychology Weblog that we've had very strong money flows in the 40 S&P stocks and that this corresponded to a persistent price rise in the index. In a rising market, it has paid traders to go with the money flows.

RELATED POSTS:

Dow Returns Following Extreme Money Flow Days

What's Behind the Bull Market

Reverse Psychology in the Stock Market: Six Consecutive Lower Lows

I notice we've made six consecutive lower lows in the S&P 500 Index (SPY). That has only occurred on five other occasions since 2004. Five days later, the market was higher four of those five occasions, with three of the gains exceeding 1% and the one loss under half a percent.

If we loosen the criteria and examine all periods in which we've had 5 out of 6 days making lower price lows (N = 61), we find a similar bullish edge five days out. Specifically, SPY averaged a gain of .59% (44 up, 17 down).

I took the pattern all the way back to 2000, identifying all occasions when five out of six days in SPY made lower price lows (N = 165). Once again, we see a bullish edge five days out, with SPY averaging a gain of .84% (100 up, 65 down). By contrast, the rest of the occasions in the sample averaged a five day loss of -.03% (891 up, 814 down).

On a related note, I see that, as of Monday's close, we were down on a five, ten, and twenty day basis in SPY. That has occurred on 170 occasions between the start of 2004 and the end of May, 2007. Twenty days later, SPY has averaged a solid gain of 1.47% (124 up, 46 down). By contrast, the remainder of the occasions in the sample averaged a 20-day gain of .53% (440 up, 245 down).

Finally, I see that we made 751 new 65-day lows on Monday across the NYSE, NASDAQ, and ASE. As noted in the most recent entry on my Trader Performance Page, this pattern has had very bullish implications going 50 days out.

We'll want to see signs of selling drying up on Tuesday, with Monday's price lows holding, to aggressively act on these bullish historical patterns.

RELATED POSTS:

Reversal Effects for Swing Traders

Five Day Reversal Effects in the Market

The Market Is Rigged Against Human Nature

Trading by Regimes

A regime is a relationship that exists in recent history between one or more variables and prospective price changes in a trading instrument.

Some regimes describe intermarket relationships. For instance, we recently saw a period in which falling bond prices were associated with falling stock prices.

Other regimes describe relationships between market indicators and price change. For example, we could see how prices behave following instances in which we hit a threshold number of stocks making new price highs or lows.

Regimes do *not* attempt to describe relationships that will be present forever, or even for long periods of time. For that reason, regimes are not meant to be mechanical trading systems. Regimes come and go; that is their nature.

The proper way to think of regimes is as "the rules that the stock market has been playing by in recent market history". Recent history could be anything from the past several years to the past several days. Regimes identify the variables that have been associated with directional price movement during market periods that are similar to today's market.

When trading a regime, you make the base assumption that today's (upcoming) market will behave like the markets from recent history unless:

1) There are fundamental, market-breaking news items or economic reports moving markets sharply;
2) Volume and volatility today are meaningfully different from the recent past;
3) Interest rates, currencies, oil, etc. are behaving abnormally relative to their recent past.

In other words, you assume the very near-term future will look like the recent past *unless* there are distinctive indications to the contrary.

Regimes provide trading ideas; they are a heads up that tell you to take note: The market has behaved this way in the recent past. Sometimes regimes keep you out of a bad trade idea; sometimes they confirm ideas you develop from other sources.

Looking back over the past two weeks of trading (N = 4034 trading minutes), I found that, when the raw 60-minute average NYSE TICK was -100 or less (N = 210), the next two hours in the ES futures averaged a gain of .27% (204 up, 6 down).

At the other end of the spectrum, when the 60-minute TICK averaged +500 or more (N = 252), the next two hours in the ES futures averaged a gain of .33% (164 up, 88 down).

Across all other occasions over the last 10 days (N = 3572), the ES futures averaged a two-hour loss of -.01% (1657 up, 1915 down).

In other words, we've seen a bullish edge when the TICK has been very weak (reversal effect) and also when it's been very strong (momentum effect). Everything in between has led to subnormal returns.

There are many other regimes at play involving the TICK and other market indicators. When you see different regimes pointing to similar conclusions (reversals of weakness; continuation of broad strength), that becomes a useful trading concept for the coming session. Such a concept was particularly helpful to me in this morning's trade.

Markets play by rules. The rules change. The key is figuring out when fundamental shifts in markets are creating rule changes and when regimes will persist at least one more day.

RELEVANT POSTS:

How to F*** Up a Trade Setup

Oil Prices and Stocks

Historical Patterns as a Heads Up in Trading

Themes and Ideas to Start the Week

* Money Flows Continue Strong - I recently posted re: money flows among the Dow stocks; my update to the Trading Psychology Weblog tracks flows in the S&P 500 and finds considerable strength, despite weakness in several sectors and waning strength among my main indicators. The Weblog summarizes my basic view on the stock market at this juncture.

* Hedged Rally - If you get a chance (and I may post separately on this topic), take a look at volume patterns among the Proshares Ultra Short ETFs, such as SMS, QID, and TWM. Volume spiked hard on the Feb. 27th market plunge and has stayed elevated ever since. Recent market action has elevated volume even further. If I'm reading this correctly and my volume data are accurate, it suggests quite a bit of hedging--perhaps a bit of that wall of worry that bull markets are said to climb.

* Great Reading to Start the Week - The Big Picture offers its Weekend Linkfest, including a very interesting piece on a possible clean-tech revolution that may sprout from growing environmental concerns in China. A theme worth tracking.

* Excellent Post on Buybacks - This one is from Laurel Kenner and Victor Niederhoffer, finding an edge among stocks purchased by insiders. A screening criterion worthy of inclusion.

* Move Toward Leadership - Trader Mike tracks the major averages and notes how the NASDAQ has behaved quite well, holding above trendlines. The Semiconductor Index has looked especially strong. Oil/Energy, Materials, and Industrials have been strong sectors for a while; Technology has recently joined their ranks.

* ETF Perspectives - Check out the readings at Abnormal Returns, including a look at BRIC ETFs how differences in ETF structures could affect tax treatment.

* Yield Curve and Stocks - Bespoke Investment Group and Seeking Alpha note a negative correlation between the curve and stock prices, an interesting dynamic given recent steepening.

* MidCap Picks - The excellent StockPickr site highlights five highly-rated midcap issues; check out Tesoro and Varian in two sectors with good money flows.

Art and Science in Trading and Psychotherapy

Note: The following is my post to an online discussion group that had taken up the issue of art vs. science in trading:

The art/science debate/dichotomy has dogged the field of psychotherapy as well. There we've seen two stances taken toward reconciliation. The first is to identify effective treatments from controlled outcome studies and then create treatment manuals around these. Practitioners are then expected to follow the manuals with fidelity, so that treatment remains "evidence based".

The second approach is to assess outcomes among practitioners who employ subjective methods in talk therapy, relying on clinical judgment and experience. Those studies find that some therapists are consistently more effective than others, that much of their efficacy is independent of the specific treatment approaches they take, and that much of their efficacy is wrapped up in their ability to forge positive working relationships with patients.

In the first instance, insurers attempt to steer patients toward evidence-based approaches to maximize outcomes. In the second instance, insurers attempt to steer patients toward practitioners with the best outcomes. Both represent attempts to bring science to bear in a field that is highly discretionary and subjective.

I believe we see the same thing in the trading world. At hedge funds that I work for as a psychologist, we see a first approach, which is the development of automated trading systems based upon backtested historical patterns in the markets. These address the need for scientific money management by eliminating as much of the human element of trading as possible. Their mechanical trading systems are the equivalent of the therapist's evidence based treatment manual.

The second approach taken by the funds is the collection of copious metrics on traders who employ discretionary judgment. From these metrics, it is possible to determine which traders are achieving results beyond their peers and beyond what would be expectable by luck. Just as insurers track the risk-adjusted outcomes of practitioners and determine, say, who are the best heart surgeons, funds similarly trace the outcomes of their discretionary traders and allocate more capital to their all-stars.

Both of these modes strike me as legitimate applications of science. I don't think all psychologists need to work from treatment manuals, and I don't think all traders need to trade backtested systems. If, however, those psychologists and traders make claims of efficacy, the burden of proof is upon them (and the assessment of their objective outcomes).

Note that even once discretionary practitioners are found to be efficacious, that doesn't necessarily mean that they are successful because of their chosen orientations (Freudian, behavioral, etc.). Indeed, studies have found that specific orientations account for only about 10-20% of outcome variance. Specific practitioner skills and characteristics of patients account for far more variance in outcomes.

Similarly, I suspect that whether a successful trader adheres to one form of TA or another or some other analytical method accounts for surprisingly little variance in P/L outcomes. Specific trader competencies and characteristics of markets being traded may well account for the lion's share of profits. But these are meaningful questions and raising them can only further the cause of science in trading, even as it refines discretionary practice.

Added Note From Dr. Brett: Once we treat traders as trading systems and objectively measure their performance, the dichotomy between what is scientific and subjective falls away. Subjective methods in trading, as in psychotherapy, are objectively valid if they can be shown to produce results beyond those expectable by chance.

The Rarest of Trading Virtues

Having had the privilege of interacting with many independent traders, prop traders, and traders at funds, I've come to the conclusion that most of them are overleveraged. In the pressure to generate profits, they trade size that is too large relative to the losses they or their firms are willing or able to sustain. One result is undue performance pressure on the trader, but another is the inability to take heat. Raising leverage leads to a shortening of time frame in an effort to contain drawdowns. This, in turn, leads to an inability to ride winning trade ideas.

The rarest of trading virtues is simply the ability to persevere with positions when winning.

If many traders are overleveraged, there is a potential edge to an expansion of holding periods. When others are shaken out, you can ride a longer-term move.

In the latest update to the trader performance page, I illustrate how returns are improved simply by basing trading strategy on the number of stocks making fresh 65-day lows. It's a trading dynamic worth checking out. But the strategy requires the ability to hold the resulting position for many weeks, not days or hours.

Many traders simply can't do that. Maybe they need the action of in-and-out trading. Maybe they're trading so large that the drawdowns associated with longer holding periods shake them out. Or maybe they just can't muster sufficient confidence in their market views.

It's so rare to see traders fully milk their trades.

Perhaps it takes a unique independence of mind to tune out others and stick with your convictions. This evening I was looking at returns after the S&P 500 Index (SPY) makes a 50-day high vs. a 50-day low. Going back to 2004 (N = 824), we've had 31 occasions in which we've had 50-day lows. Twenty days later, SPY was up by an average of 1.98% (24 up, 7 down)--not bad odds.

Conversely, when SPY has made a 50-day high (N = 124), SPY has averaged a 20-day gain of .04% (76 up, 48 down).

There are so many reasons to avoid the market when we've made 50-day lows; so many reasons to jump aboard a trend when we've registered 50-day highs. Even in this persistent bull market, it's taken independence of mind to make a winning trade--and then it takes fortitude to ride it to its potential.

Now that I think about it, those sound like the same rare virtues found among successful entrepreneurs. It makes sense: every trader truly is an entrepreneur, aggressively pursuing niches of opportunity unseen by the established business giants, while keeping a close eye on the bottom line.

RELATED POSTS:

The Most Common Problem Faced By Traders

Techniques For Overcoming Performance Pressure
.

The Spouse of a Trader: What Makes Marriage Work

In past posts, I've written about daughter Devon (above, front left) and her principle, and I've shared the story of son Macrae (above, front right) and our multicultural experience. This one is about the mom, Margie (right rear) and what it takes to succeed as the spouse of a trader. (Mad props to photographer Rob Grego for the Vermont stream shot).

Much has been written about trader personality and what it takes to succeed in markets. I can't say I've encountered any serious discussion of the psychology of the trader's spouse. And yet, my work with professional traders suggests that trading can take a meaningful toll on spouses and marriages.

The fundamental challenge, I believe, is that traders are rewarded for sound decision making under conditions of risk and uncertainty. These very conditions ensure that traders do not have regular, predictable earnings streams. When I was teaching full time in Syracuse, I had a fixed salary and a tenured position with the medical school. While Margie and I certainly dealt with other challenges, money was not one of them. We had fine employee benefits, two secure incomes (she was a tenured teacher at the time), and very reasonable living expenses.

The trader at a professional firm (investment bank, hedge fund) will typically have a base salary, but most of potential earnings will come from performance. Because these firms are often located in such high living cost locales as Manhattan and suburban Connecticut, the base salary is not perceived as adequate total compensation. Many proprietary trading firms have no such salary structure at all. At best, they offer a "draw" against future profits that must be repaid eventually. Too, the proprietary firm may very well not offer full benefits to its traders, as they are customers of the firm (the prop shop acts as their broker), not employees.

It's when the trader is self-employed and independent that we find little financial security whatsoever. There are no benefits and no income guarantees. The risk and uncertainty in markets create risk and uncertainty for family income. Very, very often it is the spouse--concerned about children and home--who suffers from this uncertainty. The trader may thrive in such an ambiguous environment; the spouse/significant other often does not.

Research tells us that the absence of perceived control over outcomes is one of the most crucial mediating conditions of psychological stress. The spouse of a trader has no control over markets, trading results, or monthly income. I've generally found--even with traders who have had careers spanning decades--that their income levels are cyclical: there are lean years along with good ones. All too often, couples make financial decisions during the flush times, only to experience pressure when market trends and volatility shift.

Yet another challenge faced by the trader spouse is that one of the qualities that makes for trading success--the ability to absorb oneself in markets--is also a quality that can pull the trader away from family involvement. The trader may come home to relax, zone out, and then prepare for the next day; the spouse may be looking for interaction, help at home, and involvement with the children. Many traders describe trading in terms of pursuing a dream. Too often, while one partner is pursuing the dream, the other is getting by from day to day keeping up a home, making ends meet, and providing a stable income. Rarely does the trader realize that the spouse may desire a different dream: one based more on the factors that initially produced the marriage vows.

One of the most common problems I hear from married traders is that bringing trading stresses home creates problems with the spouse. It creates problems precisely because the absorption in those problems prevents the trader from fully participating as a partner and parent. Over time, that can only lead to conflict and resentment. It is in such a situation that spouses then find it difficult to be supportive of their partner's challenges. Many times I've heard that traders dread coming home after a losing day, fearing recriminations from a stressed-out and undergratified partner.

I asked Margie for her view on the most important quality of a trader spouse and she immediately responded: "resilience". By that, she meant the ability to ride bad times with good and maintain some emotional distance--and even a sense of humor--through the challenging times.

And yet, I believe there is much traders can do to promote the resilience of their partners. Two principles that make marriage work in general are especially crucial to the well-being of the trader spouse:

1) Take Responsibility For Your Partner's Well-Being - Where I've seen the marriages of traders work out very well, it's been because the trader has gone the extra yard to ensure that the spouse has a career or other outlets for involvement and expression. The trader has picked up the slack at home, enabling the spouse to also participate in fulfilling activities. The trader has also made particular efforts to not bring trading pressures home and to ensure that there is enough "rainy day" capital at home to weather lean market conditions. In turn, the spouse has sustained the self-sufficiency to allow the trader to have time at home to engage in research or just unwind from a tough day. When the marriages have worked out, the trading career has been a partnership, not just the trader's job.

2) Find The Best In Your Partner - Psychologist John Gottman has found that four patterns of communication predict divorce with 91% accuracy: criticism, defensiveness, contempt, and stonewalling. Successful couples view their past positively and view each other's character with admiration. Unsuccessful couples attribute problems to flaws in the spouse's personality and character. They see the worst in each other. To a successful couple, a flaw may be a lovable quirk; for the couple headed toward divorce, it is an insurmountable gap. Among the keys to marital success mentioned by Gottman is the ability to create shared meaning. The spouse is not going to be a trader in most cases; nor will the spouse necessarily have an interest in markets. It is crucial to have a shared sphere of interest and activity that continually yields fresh experiences of intimacy. These shared interests will also enable each member of the couple to direct perceive the best in each other.

I did not learn these things from my graduate training as a psychologist. No, I learned them by observing Margie, who is easily as good as being a mother and spouse as I am at being a trading psychologist. This post is for her and all she's done to sustain close to a quarter century of happiness through many personal and joint ups and downs. When we had our wedding rings engraved, we chose the phrase "Perpetual Passion".

It's a formula for success in love as at work.

RELATED POST:

A Dozen Reflections on Life and Markets

What Trading Teaches Us About Life

.

Trading 2.0: More Investment and Trading Resources

* Mining the Blogosphere: Once again Douglas McIntyre of 24/7 Wall Street has created a list of 25 best financial blogs, and it's a fine array. It contains a number of sites you might not be familiar with and many that you'll want to add to your reader for daily updating. I notice that Doug also offers a free trial to his stock picking newsletter that draws upon his research.

* Distributed Expertise: Unlike the VesTopia site that I recently described in my last Trading 2.0 post, Covestor does not track the trades of a preselected group of investment managers. Rather, traders are invited into the site and permission Covestor to upload the data from their online brokerage accounts. This means that traders obtain real time track records automatically and can demonstrate their skills. It also means that members of Covestor can access the trades of other members, as well as their overall performance ratings. If a trader wanted to audition for a position with a proprietary firm, for example, this would be a fantastic medium. If you're a regular reader of this blog/experienced trader and would like to share your trading (and have access to others) via Covestor, drop me an email at the address in the "About Me" section on the blog homepage.

* Finding Winners: A major Trading 2.0 theme is that you have control of data. The ability to aggregate and manipulate information online enables the average investor to become a sophisticated stock picker. This post from Charles Kirk nicely illustrates how stock screening can be used to differentiate strategies and obtain superior returns. Kirk also highlights a valuable stock screening tool, the StockScouter from MSN Money and Jon Markman. But if you're into screening, consider a membership with The Kirk Report for its Stock Screen Machine. A recent listing, for instance, highlighted the most consistent performers from Kirk's favorite screens--something that could easily save hours in research.

Catching Up With The Stock Market: Part Two - Strength and Momentum

My last post looked at money flows among the Dow stocks and found a generally positive, though moderating picture of funds being committed to equities. When we look at strength and momentum, we're examining how broadly those inflows are being committed.

Note in the chart above that the number of stocks making fresh 20-day new highs vs. lows among the NYSE, NASDAQ, and ASE issues has been making lower highs since April. Indeed, going back to May 1st, we've seen approximately equal numbers of new 20 day highs and new 20 day lows.

Thursday's market closed not so far from bull market highs, but we had 559 stocks make 20-day highs against 1226 new 20-day lows. The picture was similar with momentum: my Demand measure (index of stocks with significant upside momentum) ended Thursday at 59; Supply (indicator of stocks with significant downside momentum) was 91.

What that says to me is that the moderating dollar volume flows noted in the most recent post are translating into greater selectivity during market rises. Bullish money flows, in short, exist, but they are directed toward a narrower base. The rally, as a result, is more selective.

Among S&P 500 stocks, we registered only 13 new 52-week highs on Thursday and 43 the day before that. We're well off peak new highs from the end of May/very early June and well off the April peaks. Among S&P 600 small cap issues, we had 12 new 52-week highs on Thursday and 11 new lows.

Perhaps most tellingly, across all exchanges, 664 stocks made fresh 65-day lows on Thursday, against only 332 new highs. That tells us that many stocks are in correction mode, even as the market churns with dollar flows near the 200-day average. Only 59% of S&P 500 stocks are above their 50-day moving averages, down from over 85% in April. Similarly, only 55% of S&P small caps are trading above their 50-day averages as of Thursday, well down from April and May peaks.

My initial take on all this is that we've been in a corrective mode since April, but it is a correction that is more extended in time than price. Sectors that are interest rate and housing sensitive have lagged; energy issues continue to shine. I do not see evidence at this time that the correction is over; nor do I see evidence that it will become a full-fledged bear move.

This weekend I will update the Weblog and track further indicators and see if we might find some historical edges in any of these observations.

Catching Up With The Stock Market: Part One - Dollar Volume Flows

As you know from my recent post, I've been away from the markets for a while. Let's turn that into an opportunity, so that I can illustrate how I use the various indicators from this blog to assess the market's prospects.

One of the major points I tried to make in my posts on trading like a scientist is that science begins with intensive observation. We then look for patterns in those observations and arrive at tentative explanations for those patterns. When we're trading, we're really testing our understanding by hypothesizing that patterns observed in the past will persist in the near-term future because the drivers of those patterns have not materially altered.

So when we've been away from markets for a while, what we want to do is observe, observe, observe.

Above is a chart of money flows into the 30 Dow Industrial stocks from 1/3/06 to 6/21/07. Several observations are relevant:

1) Money Continues to Flow Into This Market - The 200 day average of raw dollar volume flows into the Dow stocks has been in a sustained uptrend. The pullbacks in relative dollar volume flows (how 10-day flows compare with their 200-day average) have occurred at successively higher prices.

2) The Pace of Money Inflows Has Slowed - Of late, we've been oscillating around the zero level on the above chart, which means that money flows have been equivalent to the 200-day average. That is a slowing of inflows from the torrid levels of late 2006, but still a level of investor interest in stocks that has been associated with rising prices.

3) Flows Have Been Solid For Most Stocks - Dow stocks with positive inflows above their 200-day average include: AIG, BA, C, CAT, DD, GE, GM, HON, IBM, JNJ, JPM, MMM, MO, MRK, PG, UTX, VZ, and XOM. Those with positive inflows but below their 200-day average include: AA, AXP, HPQ, MCD, MSFT, T, and WMT. Dow issues with net outflows include: DIS, HD, INTC, KO, and PFE.

4) Strong Sectors Continue Strong - We're seeing fine, consistent inflows into oil/energy stocks such as XOM. Above average money flows have supported good price moves in CAT, GE, GM, and UTX.

In sum, the money flow data are neither supportive of the bears, nor are they roaringly bullish as in late 2006. Money continues to flow into Dow stocks and, as of Thursday, 18 of the Dow 30 issues are sporting 10 day flows above their 200-day average. That continues to support the policy of buying pullbacks in overall Dow flows below the zero line as long as those occur at higher price lows. But let's gather more observations before jumping to conclusions. My next post will examine the new highs/lows and stock momentum.

RELEVANT POST:

Overview of the Dollar Volume Flow Indicator

Three Life and Trading Lessons From a Personal Crisis

I was in Vermont on a family reunion and had just picked up a couple of snacks for the hotel room. Oddly, I couldn't find them when we returned to our resort. Only later in the day did I realize that they had been left in a storage compartment in our Jeep. I quickly took them out. One item was a container of egg salad. I didn't want that to go bad.

I didn't know it at the time, but I was 48 hours away from a medical emergency that could have been fatal.

The trip home from the reunion was not pleasant. It started with a small stomach ache in the morning and then became a fever and then developed into nausea. I was sick through much of both legs of the trip. By the time I returned to my Naperville home, however, the fever had subsided and my nausea was gone. All that was left was some stomach cramps. It was food poisoning, I reasoned, and the egg salad was the likely culprit.

Monday morning, and I'm scheduled for a flight to NY to meet with hedge fund traders. Still some cramps, but no fever, no nausea. I debate whether to call off the trip, but decide I'd rather not alter my plans. It was a fateful decision that would land me in a hospital.

The Monday meetings went well, and I took a car from the trading firm to my airport hotel. By this time the stomach pain had moved to a more specific area: the lower right side of my abdomen. I was increasingly concerned that this was appendicitis, not food poisoning. I checked into the hotel, took a look around my room, and turned right around with my bags. I asked the hotel clerk for the nearest, good hospital. She called a cab for me and away I went.

I've never seen neighborhoods like the ones the cab went through. Most of the signs on the stores were in languages other than English. I truly felt as though I was in another country. One sign alerted me to my location: Jackson Heights, Queens. Shortly after, the car dropped me off at the emergency room. There were few places to sit in the triage area; people with everything from primary care problems to broken bones to heart ailments to gunshot wounds came through here. I was the only Caucasian American in sight.

The pain grew over the next hour of waiting, and I alerted the triage nurse. She became interested in me when I told her I taught at a medical school and worked with ER staff. She moved me to the head of the queue, and I was wheeled into a holding area. A medical resident asked me questions, and now I felt on familiar turf. I explained my own medical background and why I thought the symptoms might be appendicitis.

Two hours later, I was interviewed by the full medical team, and two hours after that I received a CT scan. A friendly surgical resident with great bedside manner delivered the news: acute appendicitis. I would not be making my flight home. An hour later, I was in surgery.

It turned out, the surgeons told me, that the appendix was not merely infected, but actually gangrenous. Two-thirds of the tissue was already dead. The organ was "tissue thin" when they operated, a situation that could have spread bacteria throughout my body cavities and led to peritonitis.

Recovery was slow. Once again, I found myself the only native English speaker on the floor. The staff didn't ask what insurance I had; they asked if I had insurance. Police guards were placed throughout the hallways; many patients were loud and disruptive. Just about every bed was filled; my room was one of the few with vacancies. The nursing staff was continually on the go; it was clear that, in this community hospital committed to serving everyone, there just weren't enough hands to go around.

Still, the staff was extremely supportive. There were a number of mistakes in the system: I was brought meals that weren't appropriate for post-surgery, and I was not given the IV antibiotic the surgeon had recommended. When I called these items to the staff's attention, they eventually were remedied. When my roommate arrived--an engaging man who described himself as having major psychiatric problems--similar oversights led him to become extremely agitated. I told the nurses that I was a psychologist, and I explained how they could calm the situation. They did so, and I wound up with an excellent and appreciative roommate.

As I got on my feet, I wandered the floors and met many patients and staff: a kind man from Colombia who also had his appendix removed; an Irish security guard who told me of his own recent hospitalization and confided his frustration with the overwhelmed health care system; a third year medical student who went out of her way to find out how I was doing; a graveyard shift nurse from Poland who found a friendly way to wake up patients in the middle of the night for their care; a clearly burned out nurse from India who withheld simple comforts from a disruptive patient. After a while, I stopped noticing people's nationalities. We were all in this together.

By Wednesday I was ready to leave, and I flew home on Thursday. The outpouring of support from blog readers, friends, and family members was incredible. Several times I found myself on the verge of tears. I hadn't really eaten much in several days, and I hadn't stepped outside from Monday evening through Wednesday afternoon. Food tasted unusually good; the sky seemed especially blue. I was grateful to be alive and to enjoy these simple pleasures.

Perhaps the strangest experience of all, however, followed my release from the hospital. I needed to get a prescription filled, and the local pharmacy wouldn't take my insurance. The nearest Walgreen's pharmacy was 14 blocks away. Without hesitation, I shuffle-walked the 14 blocks through a neighborhood that only days before would have struck me as incredibly menacing. Again, I was the only Caucasian within view. But I had no problem with the walk or communicating with the helpful Asian clerk who worked everything out for me so that I could have my pills. By this time, I was part of the neighborhood.

So what are the life (and trading) lessons to be taken from all this? A few stand out for me:

1) A Little Knowledge Can Be Dangerous - I minimized my problems initially, sure that I had food poisoning. Only when I revised my view could I get the help I needed. If you're losing money in the markets, maybe it's a chance unlucky streak and a temporary phenomenon. But if it continues, make sure you consider alternative explanations--including the possibility that your trading ideas or methods are fatally flawed. Above all, be open to signs you're in trouble. I walked away from my hotel room when it was clear my pain was localized. When losses exceed normal drawdowns, go into defensive mode. It's the low-odds/high-risk events--those fat tails of risk--that can get you when your reasoning is following a normal distribution curve.

2) Advocate For Yourself - I'm sure some people at the hospital received excellent health care; I'm sure others did not. In a situation in which limited resources had to be devoted to the most pressing problems, many routine--but important--issues were sidetracked. The patients who received the best care were also the best self advocates. If you're an investor or trader, never assume that others will provide you with the tools and techniques you need for success. You'll only get out of forums, blogs, coaches, and seminars what you actively pursue and seek.

3) Networking Is Your Best Survival Tool - In a world of limited information and resources, you're best off networking with everyone who you can help and who can help you. I continually saw patients and staff help each other: it was in everyone's interest to share information and help each other out. Once I got that, the differences of culture and socio-economic class faded into the background. For traders, it means that knowledge is a social process; expertise is distributed. I "give away" information through my blog, but receive far more from like-minded readers.

I was in a multibillion dollar hedge fund working with traders; hours later I was in the holding area of a community hospital ER. Instead of walking Greenwich Ave., I hiked 14 blocks on Roosevelt Ave. Life is fragile; there are many twists and turns, and sometimes those offer life's best lessons. If you find yourself in an uncomfortable life situation, consider the possibility that you're meant to be there; that you can only expand yourself when you travel outside your comfort zone.

My deepest thanks to the fine professionals at Elmhurst Hospital Center. Many, many people in the schools, clinics, airports, and fire/police forces all across this country are quietly giving their best with strained resources. Theirs is a heroic story that deserves to be told.

And thanks again for all the warm support--

Brett

TraderFeed on Hold Temporarily

Dear Blog Readers,

On Monday, following a trip to meet with traders, I was hospitalized with acute appendicitis. It was not a good situation and required extended follow up care following surgery. Only now am I on my feet and able to make it to a computer. I hope to resume the blog and my personal site before too long. Thanks for your understanding.

Brett

A Look at the Stock Market to Start the Week

* Solid Momentum - On Friday, my Demand indicator (stocks with significant upside momentum) hit 161; Demand was 26. Given that momentum peaks tend to lead price peaks, I'd expect further upside this week.

* Broad Rally; Resilient Market - Just this past week, on Tuesday, we saw 1649 stocks make fresh 20-day lows. On Friday, however, there were 1388 new 20-day highs. These pullbacks in money flow toward the 200-day average, noted earlier, have been great buying opportunities.

* Strength in Small Caps - I notice that, on Friday, 80 S&P 600 small cap stocks registered fresh 52-week highs, the highest level in months. If this market were just going to turn around and crash, I wouldn't expect such broadening of strength. Fourteen NASDAQ 100 stocks also made 52 week highs on Friday, the highest level in months.

* Breakout Move in CRB Index - Note the multi-month upside breakout move in the CRB Index of commodity prices. Not something we'd expect from a weakening economy. The correlation between the move in stocks and commodities over the last few days is worth watching.

* Volatility Still Up - Trader Mike notes the whippy price action of late. Note that the VIX closed near 14 on Friday, well up from the low VIX numbers posted after prior price jumps. I continue to believe we've put in a long-term bottom in volatility.

* Rally in the Dollar? - Great weekend linkfest from Barry Ritholtz includes a perspective on a rising greenback. See also the excellent post on cognitive biases that affect our decision making.

* Good Reading - Abnormal Returns offers a view on the oversold bond market, a test of a popular trading system, and investments in wind as alternative energy source.

Trade Like a Scientist - Part Three: Three Common Mistakes of Traders

In the first two posts in this series, we examined a scientific mindset and how it affects trading practice. Let's now turn the tables and view three common trading mistakes through the scientific lens:

1) Mistake #1: Trading Without Understanding - Sometimes traders put their capital at risk without taking the time to observe market patterns and integrate these into a concrete explanation of what is happening in the marketplace. A number of traders I work with observed the recent rise in interest rates very early in the move and formulated ideas of shorting rate-sensitive sectors. They tested their understandings with initial positions and scaled into the idea as markets confirmed their views. How different this is from simply putting a position on because a market is making a new high or low!

2) Mistake #2: Oversizing Positions - Many psychological problems in trading can be traced back to excessive position sizing. Traders trade too large for their account size in order to make windfalls, not in order to test their ideas. Scientists conduct many tests before any hypothesis is truly supported, and they test many hypotheses before they accept theories as versions of truth. If you were a lab scientist, would you risk your entire grant funding on a single experiment? Of course not; a single study could fail for a variety of reasons, including experimenter error. Similarly, any single trade or idea can fail for a variety of reasons. A true scientist knows that his or her understanding will always fall short of reality. That is why scientists will conduct doable experiments to refine their ideas before they dedicate significant resources to large investigations.

3) Mistake #3: Not Knowing When You're Wrong - A scientist does not actually test his or her hypotheses. Rather, each experiment is framed as a test of the "null hypothesis": the proposition that variables of interest do *not* affect the outcomes under study. Scientists thus never accept their hypotheses; they at best only reject null hypotheses. Embedded in this perspective is the idea that it is crucial to know when it is necessary to accept that mull hypothesis and conclude that a view is not supported. Can you imagine a qualified scientist becoming emotional because an experiment produces no significant differences and then conducting numerous revenge studies?! Traders, however, sometimes do just that. They don't have rational stop losses identified and so can't terminate their "experiment" at a prudent time. That leads them to take on excessive losses and react out of frustration rather than understanding.

A simple checklist would aid many traders who would become their own performance coaches:

1) What is my understanding of this market and what is the evidence behind it?

2) How much of my capital am I initially willing to devote to my understanding of this market?

3) What outcome(s) would lead me to devote more capital to my idea and what is the maximum portion of my portfolio I'm willing to put at risk on this idea?

4) What outcome(s) would lead me to abandon my idea and how much am I willing to lose on this idea?

Many bad trades could be avoided simply by requiring oneself to answer these questions aloud prior to any trade.

Trade Like a Scientist - Part Two: Framing Trades Scientifically

In the first post in this series, we examined the process of science and its relevance for trading. In this post, we'll look more specifically at how we frame our trading ideas as scientists.

If I am trading like a scientist, I am carefully observing the market and watching for patterns. I already have observed many markets in many conditions and have some theoretical understanding of what makes markets move across different time frames--from interest rates and liquidity at longer periods to the aggressiveness of large traders at short ones.

Perhaps I notice that, as selling hits the market, volume is declining and fewer individual stocks are making fresh price lows. I also notice that one sector of stocks, the semiconductors, are actually moving higher and gaining money flow. Bonds, which had been falling with stocks, are now catching a bid. I hypothesize that the market is running out of sellers, that we are in the process of bottoming, and that we will likely see short covering as a result. That should propel the market higher.

Having formed this hypothesis, I make note of a recent short-term high price in the semiconductors and the low price. I say to myself, in essence, "I think we will hit this price (prior high) before we touch that price (recent low)." In other words, I am willing to risk a possible move back to the low in order to participate in the hypothesized move to the high.

This is only a hypothesis, however; it is not truth. For that reason, as a scientist, I must remain open to data that tell me my hypothesis is not supported. A fresh influx of sellers hitting bids; a fresh drop in bonds--many factors could alert me to a potential problem with my hypothesis. I also must keep my bet on this hypothesis modest: to risk much of my capital on the idea is to treat the tentative formulation as absolute truth.

It is in this context that every good trade tests a hypothesis. When we observe a pattern, frame an idea, test the idea with a trade, and actually profit, our idea--our theory--is supported. That may lead us to another trade that extends this idea. Conversely, if we do not profit from our theory, we may need to go back to observation mode and revise our explanations.

Thus it is that a scientific trader will gain confidence and become a bit more aggressive when his or her ideas are confirmed; a bit more cautious when ideas do not pan out. When you trade like a scientist, every good trade provides you with information, because every good trade is a solid test of your market understanding. For this reason, the scientific trader values losing trades. They, no less than the winners, are data to be assimilated and can push you to further market insight.

In the third and final post in the series, I'll look at three common mistakes traders make from the scientific vantage point.

Trade Like a Scientist - Part One: The Scientific Mindset

A theme I emphasize with new traders is that it is important to trade like a scientist. The scientific mindset is one that can be rehearsed and cultivated--and eventually internalized.

What do scientists do? First, they observe regularities in nature. They look for patterns: repeated sequences of events and commonalities among structures. Those regularities differentiate what is meaningful from what is random.

After observing regularities, scientists attempt to explain these. Explanation is the role of theory. The theory is the scientist's way of making sense of the world. Theory is not truth; it is a first approximation at truth.

Scientists gain confidence in their explanations by testing them. If a theory is meaningful and accurate, we should be able to use it to generate future observations. These predictions are hypotheses for the scientist. By testing hypotheses, we keep an open mind with respect to our observations and explanations.

Finally, once empirical tests provide fresh observations, scientists revise their explanations of nature and use these to generate further hypotheses, observations, and revisions. Knowledge, for a true scientist, is always provisional: that is what separates science from dogma.

The scientific mindset is one of humility: a recognition that our best theories are only approximations and that many of our tests of hypotheses are apt to fail. When we trade, we have an implicit or explicit theory about the current market, and our trade tests a hypothesis that we frame around our explanation. That is why a scientific trader never wagers too much on any single trade. Nature will always be more complex than our science, and our understanding will always be partial. Such a perspective is a powerful antidote to overtrading and overconfidence.

In my next post, we'll walk through a trade from a scientific perspective.
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Protracted Buying Interest in the NYSE TICK: What Comes Next?

A very sharp upward spike in the NYSE TICK is often a sign of buying panic; my general leaning is to sell those moves, as they're often overdone. That led to a nice short trade on Tuesday.

But what if we have prolonged high peak NYSE TICK readings? I went back to 2004 (N = 861 trading days) and looked at all occasions (N = 74) in which the five-day average of the highest TICK reading for the day was above 1300 (as was the case on Tuesday). Five days later, the S&P 500 Index (SPY) averaged a respectable gain of .59% (49 up, 25 down).

Conversely, when the five-day peak TICK reading averaged less than 1100 (N = 149), the next five days in SPY averaged a loss of -.18% (70 up, 79 down).

When the five day maximum TICK reading averaged 1100-1300 (N = 638), the next five days in SPY averaged a gain of .21% (380 up, 258 down).

Interestingly, prolonged buying interest tends to carry forward in the short run, while an absence of buying interest over five days has been associated with subnormal near-term returns. I will be exploring this pattern--especially in light of lowest TICK readings of the day--in a coming post.

RELATED POSTS:

NYSE TICK and Momentum

NYSE TICK: Does It Matter?

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Stock Market Correlations and Other Wednesday Ideas

* Excellent Book - I've started reading Richard Bookstaber's very engaging "A Demon of Our Own Design", an explanation of how the complex strategies utilized by the most sophisticated trading firms end up contributing to unforeseen market crises. I particularly like this quote:

"As the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is that you cannot always predict ahead of time if the correlation will be positive or negative." - p. 26

This dynamic--instruments becoming increasingly correlated during buying and selling panics--occurs on multiple time frames and across varying widths of asset classes. A simple panicky selloff in stocks may tank all sectors, for example, but not necessarily spread to bonds. One implication is that you can quantify panics by the breadth of the increased correlations and by their duration.

Bookstaber's observation is that such periods of unusual correlation can also represent "spectacular profit opportunities for those who can stand the heat" (p. 26). Might a multiple correlation indicator provide insight into those emotional periods when traders grab or toss aside all stocks indiscriminately, creating inefficiencies (temporary inflation of bad stocks/sectors; temporary depression of good stocks/sectors)? Food for research...

* A Number of Valuable Ideas - Take a look at the most recent links posted by The Kirk Report, particularly the articles on the prospects for rate hikes; cardboard box production as an economic indicator; hedge fund leverage as a recipe for market disaster; and a Senator's view on a major threat that could capsize the economy. Great stuff.

* How to Track Hundreds of Financial Blogs - Craig of TAZ Trader Blog very helpfully walks readers through the process of subscribing to a reader and adding favorite blogs for automatic updating. Also check out their post on action zones for swing trades, designed to capture market reversals.

* Another Stock on My Radar - ADBE has positioned itself very well for the digital publishing age. This includes such online developments as its Creative Suite, but also underappreciated potentials for Acrobat as a vehicle for rich multimedia publication. Analysts expect a good earnings report for Thursday; the chart above shows that we've had solidly rising dollar volume flows into the stock over the last 200 days--a good sign of institutional sponsorship. Money flows over the past 10 trading sessions have pulled back to their 200-day average: a situation that has marked recent buying opportunities.
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Ideas Floating Around on a Tuesday Morning

* On the Radar - A while back I blogged about INTC and the favorable money flows in that issue. Since that time, despite the recent market pullback, INTC has shown positive money flows and a 10-day flow well ahead of its 200-day average. I note that, thus far today in a weak market, INTC is holding its own. Worth keeping an eye on.

* 10-Year Rates Hit 5.225% - Tuesday AM has been another one of those periods where identifying and trading a dominant theme has paid off handsomely.

* Views From Trader Mike - His updates are a regular part of my daily reading; now he offers his own interview from TradingInteviews.com.

* Playing the Long Side Safely - Some stock ideas from Barry Ritholtz. His screening criteria are most informative.

* More Fine Idea Links - Abnormal Returns finds more nuggets in the Blogosphere, including a view on overvaluation in China.

* Overvalued ETFs - A hedge fund manager writing for Seeking Alpha offers his view on some sucker bets among ETFs. Great example of doing your homework and generating an idea.

* Dreams and Visions - Dr. Bruce Hong offers a valuable perspective on the difference between being a daydreamer and a visionary.

The Trading Coach Project: Coaching Gets Started With an Assessment

I recently announced that I would be coaching a single trader free of charge for a month and posting the process to the blog to illustrate how to improve trading performance. The trader selected for this round of the Project is Trader C, a professional trader who has worked for a trading firm for several years. He has a track record of success over those years, even as many other traders have had to leave the firm. Expenses at his firm (commissions, fees) are not cheap, so that his ability to make a living from trading after all costs is itself a noteworthy accomplishment.

Trader C. has a number of strengths beyond his profitability. Unlike many of the traders I've worked with in Chicago and more like traders I've worked with at hedge funds, he trades many different individual stocks. He also trades different time frames, holding many positions intraday, but also carrying longer-term swing positions. I was immediately impressed by his ability to detect and trade themes in the market. For example, he noticed early on the rise in rates and was quick to short interest-rate sensitive issues. He will hold such short positions at the same time that he is long other stocks and sectors, creating a diversified portfolio.

Trader C. tracks his profitability by spreadsheet daily and has numerous printouts of his trading metrics, including his largest wins and losses, average wins/losses, profitability by day of week, and profitability by the particular stock traded. He keeps a journal in his spreadsheet, commenting on the day, and he has utilized cognitive techniques to improve some of his trading shortcomings. These shortcomings are what brought him to volunteer for the Project.

The histogram above shows the distribution of Trader C's trades thus far during 2007. (X-axis is profitability of the trade in ranges or bins; Y-axis is the number of trades with that particular level of profit). This is taken directly from his trading log/spreadsheet. When I work with a trader, I don't start with their psychology and try to use it to improve their trading. Rather, I start with their trading and use that to understand what is happening for them in their thinking, feeling, and acting. Keeping accurate data on your trading is one of the most important things you can do to identify both strengths and weaknesses.

What we can see from the above distribution is that:

A) Trader C is making modest money for the year; he hasn't been as profitable as he has been in the past;

B) He has many small winning trades;

C) The left side of his distribution shows a good number of large losers that negate many of his small winning trades.

When I examined the distribution of his profitable and unprofitable trades as a function of time, what I found was that he was losing money for much of the early part of 2007 and only recently had turned profitable for the year. His last 18 trades were 12 winners and 6 losers with only one relatively large loser, but four large winners.

In Trader C's initial email to me, he stated:

"I tend to break my rules in position sizing, get careless about keeping my stops and keeping my losses small, and finally taking profits off the board when I have a windfall because i think I can "get more". With the elimination or reduction of these bad habits, I would probably triple my income."

Later he elaborated:

"What I have been doing right is my feel for the turning point, or breakout, or direction of a group, but my drawback is the initial sizing in them. I find that I tend to go full size and more after I see the confirmation, but I chase a bit and have quite a bit of heat before going my way."

What is happening, it seems, is that Trader C is getting too aggressive on his entries, sizing positions too large initially, and then taking larger-than-necessary losses when his ideas don't work out. This creates the distribution pattern from his above histogram and is observable in a single statistic: the average size of his losing trades has been greater than the average size of his winners.

So why would an experienced and sophisticated trader like Trader C fall into this pattern? It's not enough to simply say he's "losing discipline". Successful coaching demands that we understand *why* these lapses are occurring. Diagnosing the problem--and understanding his strengths--will be the topic of the next post in this series.

RELATED POSTS:

Coaching the Professional Trader

Performance Coaching: When It Works, When It Doesn't

Why Coaching Fails: Stages of Change

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Trading 2.0: Expertise Becomes Transparent

The rise of the Web as a social medium has changed the ways in which traders and investors manage their money. Growing social and information networks have provided us with greater information and more money management options than we've ever had before. It is this changed financial landscape that I'm referring to as Trading 2.0.

One of the important elements of Trading 2.0 is that expertise becomes transparent. Thanks to the online medium, we are now able to see exactly what expert traders are doing and how they're doing it.

Consider the VesTopia site, which is now in beta and offering free registration for traders. A group of pre-screened "investment directors" (experienced money managers with verified track records) post their strategies and their specific trades to the site. Site visitors can follow the directors whose strategies most interest them and develop trading/investment ideas from the portfolios of those directors. Best of all, blogs written by the directors explain their strategies, market views, and stock picks. This latter feature turns what would be a fine informational source into an educational one.

A great example of the educational content is Mark Hines' recent post in which he illustrates specific stocks to buy that enable investors to participate in hedge fund returns. It is rare that individual traders would get to hear ideas from managers of billion dollar funds and model their ways of thinking. That's a huge benefit of Trading 2.0: the opportunity to learn within a social network.

A different form of transparent expertise can be found in James Altucher's StockPickr site. Here stock picking becomes a social activity, as members share their portfolio selections. An added, unique feature, however, is that the site also tracks the portfolio maneuvers of leading money managers, so that you can see what the pros are doing. James constructs a variety of spotlight portfolios, such as "Great 5-Year Charts", which highlight stocks that have attractive technicals, fundamentals, and sponsorship.

The appeal of the StockPickr site is that it takes traders and investors down the path of thinking thematically. Instead of narrowly focusing on single markets and instruments--which may or may not have opportunity--visitors to the site can identify broad themes that are attracting professional interest.

Over time, I expect the Trading 2.0 wave to bring additional innovations, as trading and portfolio management become public activities that attract attention (and assets) by combining ideas and education. In upcoming posts, I will explore further changes to the financial landscape wrought by the social revolution in computing.

What's Behind The Bull Market: Breakout in Money Flows

Suppose we have an indicator that keeps a running total of every trade made in a stock. It multiplies the price of the stock times the volume of the trade to provide an indication of the dollars that go into the trade. If the trade occurs on an uptick, it is added to a daily cumulative total; if it occurs on a downtick, it is subtracted from the total. The resulting measure at the end of the day is a measure of money flow: the dollar volume that enters or leaves the market.

Above, I have gone back to 2005, calculated the daily dollar volume for the 30 Dow stocks, and summed them to provide a picture of the dollars entering and leaving the Dow Jones Industrial Average. The chart shows a five-day moving average of the Dow's dollar volume (pink line) vs. the Dow average itself (DIA; blue line).

We can see that dollar flows have pulled back of late in the Dow stocks on the heels of rising interest rates. Still, those flows remain net positive. Similar pullbacks of late have represented good buying opportunities.

More important, we can see that a major shift in investors' allocations occurred following the June/July, 2006 lows. There was a surge in dollar volume, suggesting that much more money was being put to work in the stock market. After the late February/early March pause, that surge continued. This shift in allocations is what bull markets are made of. In my latest update to the Trading Psychology Weblog, I chart the money flows specific to eight S&P 500 sectors. This shows us that, while flows have slowed, they remain at positive levels--and in some cases remain above their long-term averages, even after the market weakness of last week.

The chart above shows us that money flows into stocks broke out from a long-term range. That has created a sustainable rally. Do such money flow breakouts occur in individual stocks, and might that become a basis for stock picking? More to come on this promising measure.

RELATED POSTS:

Tracking the Dollar Volume Flows of Stocks

Dow Returns Following Extreme Money Flow Days

Idea Generation for a Sunday

* Money Flows Are Near A Buying Zone - I've updated my Adjusted Relative Dollar Volume Flow figures for eight S&P 500 sectors and for the S&P 500 Index as a whole. We've dipped below the 200 day average level of flow, a situation that has recently marked good intermediate-term buying opportunities.

* How to Track Trends on an Intraday Basis - My latest post to the Trader Performance page outlines my four favorite tools for staying on the right side of short-term trends.

* How You Think Affects How You Trade - IMO, this is one of my best TraderFeed posts of late. It helps to explain why traders can oscillate between overconfidence/overtrading and lack of confidence/anxiety.

* Diversifying Your Capital - Here's a very thoughtful post from Dave Johnson. Also take a look at Dave's backtest of a McClellan signal and what it's saying for the current market and Dave's discussion of market myths. Flat out great site.

* Three Perspectives on Peak Performance - Some of you might not be familiar with this free video from the Chicago Mercantile Exchange featuring Doug Hirschhorn, Denise Shull, and yours truly. Out of the talks, you might just come away with concrete ideas for working on your trading.

* Using a Tool to Improve Performance - Trade Ideas has posted a very interesting case study of a professional trader who consulted with their staff to develop new trading strategies. I see they are now making such consultation available to users. Their Odds Maker tool backtests strategies over a 3 week lookback period without users needing to do any programming--and then screens the market and issues alerts when the strategies are triggered. Interesting concept for discretionary traders looking to solidify a market edge.

* How to Test Market Ideas - Interested in testing your market ideas? Victor Niederhoffer reports on a promising book that explains correlational tests. See also his interesting review of a book that explains the benefits of free markets. I heartily suggest you scour the archives of the Daily Speculations site for a variety of interesting perspectives and reviews that you'd never find elsewhere. Hats off to Victor and Laurel Kenner for keeping the Spec List alive and well day after day for many years. Great resource for idea generation.

Short-Term Stock Market Trends and Intraday New Highs and Lows

In my recent post, I illustrated intermediate-term market patterns with 20-day new high/new low data. Above we see 60-minute new highs and new lows among a basket of 40 stocks evenly divided across eight S&P 500 sectors: Materials, Industrials, Consumer Discretionary, Consumer Staples, Energy, Health Care, Financial, and Technology. These 60-minute new highs/lows are updated every 5 minutes during the trading day. The pink line plots the difference between new highs and new lows vs the S&P 500 Index (SPY; blue line) for a bearish day (Thursday) and then a bullish rebound (Friday).

You can see how the levels of new highs minus lows identify the falling market, the transitional period in the middle, and then the bullish thrust. The key is tracking the proportion of time that the new highs/lows are above or below the zero line. In falling markets, we'll see readings hitting -30 and a majority of readings below zero. In rising markets, we see the reverse. It's when the new highs/lows oscillate around the zero level with a preponderance of readings between +20 and -20 that we see consolidation/transitional periods.

The new high/low measure is also helpful in identifying breakouts from ranges--we want to see readings above +20 and below -20 on sustainable breakouts--and is useful in identifying bounces in bearish trends and dips in bullish moves that will not be sustained (readings between +20 and -20 and often within +10 and -10).

The above data came straight from my real time feed (RealTick) and were archived and charted in Excel. Alternatively, a trader could create a basket of stocks within a screening program such as Trade Ideas and track new highs/lows in real time. Readers interested in the specific stocks that I utilize in my basket can check out my "Tracking the Trend" post to the Trader Performance page of my personal site, which will be uploaded later today.

RELATED POST:

Anticipating Market Turns With Intraday New Highs and Lows

Attribution and Bias Among Traders in the Financial Markets

Perhaps the cardinal contribution of behavioral finance research is the elaboration of the ways in which people depart from strict rationality under conditions of risk and uncertainty. How we process information affects our behavior, creating situations in which we can risk our capital more for psychological reasons than for logical ones.

Much of how we process the world consists of attributions: qualities that we attribute to ourselves and explanations that we attribute to events. As human beings, we are driven to make sense of our world, and attributions are an important element of that sense-making.

One of the most basic attributions traders make is to their gains or losses. Are profits and drawdowns attributable to the self; the result of positive or negative actions that we take? Alternatively, do we attribute gains and losses to outside forces or to sheer chance? How we attribute the outcomes of our trading performances will necessarily play a large role in what we do about those performances. If, for instance, we tend to attribute gains to the self, but losses to bad luck, we might stick with faulty trade ideas, exacerbating initial losses.

In point of fact, research finds that people are reliably biased in their attributions, a situation that cannot help but affect traders. Football fans, for instance, tend to attribute their team's successes to skill, but their opponent's victories to luck. When CEOs successfully complete acquisitions and attribute the success to their own skill, they tend to become overconfident and make further acquisitions--which then realize lower returns. CEOs also tend to be paid more money when the share price for their firms increase, as boards (falsely) attribute the price move to the executive's skill. This, too, is reliably associated with subsequent CEO underperformance.

It is when we indulge in self-serving attributional biases, however, that trading results are put most at jeopardy. Social psychologists refer to the "fundamental attribution error", which is the tendency to over-emphasize personality-based explanations for other people's behaviors and minimize situational influences. When we're subject to the "actor-observer bias", we tend to attribute our own outcomes to situational forces, rather than to fundamental personality traits.

How does this affect traders? Traders with a self-serving bias tend to give themselves too much credit when trades go their way and rationalize situations that lose money. As a result, they are likely to become overconfident after a string of winning trades, raise their trading size/frequency, and place themselves at risk.

Indeed, a consistent predictor of trader failure in my own experience is the tendency to attribute losses to a shadowy "them": the large traders and institutions that supposedly manipulate the markets. In years of working with traders, I have never seen one succeed over the long haul who reliably blamed outside forces for losses. Those traders, in fact, are subject to considerable anger and frustration, which leads them to become impulsive--the well-known phenomenon of "revenge trading".

Reason dictates that there is a difference between a good trade (one placed with an edge in one's favor) and a winning trade (one that makes money), just as there is a difference between a bad trade (one that lacks an objective, positive set of expectations) and a trade that loses money. Sheer chance alone can create situations in which good trades lose money and bad ones happen to get lucky. The self-serving trader who overemphasizes the role of chance in losses creates a situation in which learning from experience becomes impossible.

But there is another kind of trader--one with an overinclusive attributional style--that tends to own losses and gains with equal fervor. By minimizing the role of chance, the trader attributes all outcomes to the self, feeling good when the profits are rolling in and becoming discouraged during (inevitable) periods of drawdown. This is the "illusion of control" documented in the research of a London Business School research team, who found that traders who thought they could predict markets shown to them (which were actually random price series) performed worse than less confident traders. The result is that you can reliably track traders' moods by their P/L statements.

Traders tend to blame their losses on such factors as "loss of discipline" and "overtrading" when, in fact, these are frequently the results of attributional biases. The majority of traders spend more time trying to understand market movements than trying to understand their own thinking about markets. An interesting line of research finds that individuals who experience increased emotion tend to shift their attributional styles, reducing their tendency to own negative outcomes. Successful traders not only need to be able to think about markets, but also think about their thinking. Awareness of a tendency toward bias can be a powerful antidote to biased decision-making.


RELEVANT POSTS:

How Traders Can Become Their Own Coaches

How Trader Personality Affects Trading

Stalking the Market With New Highs and Lows

Here is the five-day simple moving average of all stocks (NYSE, NASDAQ, ASE) making new 20-day highs minus those making new 20-day lows. (Click on chart for greater detail). We can see, going back to 2005, that pullbacks below -5000 have been excellent indications of intermediate-term market lows.

We can also see that deterioration in the new highs has preceded market corrections, including most recently. Intermediate-term bull runs have tended to see at least one dip well below the zero line prior to terminating. We have just made such a dip this past week.

Notice how we spend considerably more time above the zero line than below. That is the mark of a bull market: over time, stocks keep making new highs. Despite the recent correction, nothing in that dynamic has changed thus far.

RELEVANT POSTS:

New Highs and New Lows: What They Tell Us

The Four Legs of Market Psychology

New Highs and Lows in the Stock Market

Using Intraday New Highs and Lows to Anticipate Market Turns

Trading Ideas and Tools for a Friday

* Strong Downside Momentum - I found that the number of stocks closing below the volatility envelopes surrounding their short- and intermediate-term moving averages outnumbered those closing above the envelopes by 10:1 on Thursday. We've had only 7 such occasions since 2004; on six of those occasions the market continued lower in the short-term over the next several days.

* Easy Way to Track Your Performance - This plug-in feature for StockTickr enables traders to pull trades from their account statements directly into the program for analysis and charting. StockTickr then allows you to collect metrics on your trades, journal and track your goals, and share the information with selected peer traders.

* Nice Integration of Simulation Trading - I see Advantage Futures is offering the Ninja Trader platform with free simulation trading and collection of metrics. Excellent way to build skills; even the market data are free.

* Day Trading Indicator - Kevin finds a daytrading tool in the bond-stock relationship; excellent application of theme-based thinking at a short time frame.

* Ways to Review the Market Day - I like the recaps carried by Trader Mike, with clear, annotated charts. For review of news and market stats, Between the Hedges provides fine reviews of the day. For keeping on top of market blogs, I like the link selection at Abnormal Returns.

* Reviewing the Broader Picture - The links at the Kirk Report are comprehensive and never fail to turn up an interesting perspective; I also look forward to Barry Ritholtz's weekend linkfests and daily commentary and the intermarket and economic perspectives from Mish.

* Searching for Fresh Ideas - I appreciate the fresh take on economics and markets from Jeff Miller. For stock ideas, the portfolios at StockPickr contain very interesting themes and the theme-based screening from Charles Kirk on his Member's Site offers plenty of inspiration for further investigation. CXO Advisory can also be counted upon for a fresh take on market wisdom, with a research bent.

Extraordinary Opportunity - Suburban Chicago Area

I had the pleasure of joining a Chicago area money manager for coffee yesterday, and he shared with me his plans for developing an innovative new website. The site would blend elements of current events that move markets and stock picking.

He is looking for a Chicago area high school or college student interested in working on this project for a paid summer internship. The student should live near the Western suburbs of Chicago and should be computer and Web-savvy. It's an unusually good opportunity to see how a money manager operates and to help build a project from the ground up.

If you or someone you know and can recommend is interested, have them contact me at the email address on the blog home page, in the "About Me" section. I'll be happy to describe the position in greater detail and get the student connected. Thanks!

Brett

A Few Perspectives on the Recent Stock Market Weakness

* Pessimism Returns - As of Thursday, we once again see equity put volume exceeding equity call volume. That was one of the patterns that stood out during the late February/early March market decline. Since 2004 (N = 843 trading days), we've had 49 occasions in which equity put volume has exceeded equity call volume. Twenty days later, the S&P 500 Index (SPY) was up by a very strong average of 2.27% (42 up, 7 down), much stronger than the remainder of the sample (.63%; 514 up, 280 down). It has not been a winning strategy of late to sell into such pessimism.

* Swelling New 20-Day Lows - We registered 1999 stocks making fresh 20-day lows across the NYSE, NASDAQ, and ASE on Thursday. Since 2004 (N = 843), when we've had more than 1500 new 20-day lows, the next 20 days in the S&P 500 Index (SPY) have averaged a gain of 1.16% (43 up, 20 down), stronger than the average gain of .69% (514 up, 266 down) for the remainder of the sample. Again, it hasn't paid traders to sell into broad declines in which a large number of stocks are making new lows.

* Market Tells Tells All - Rennie Yang finds a number of very interesting historical patterns in the recent decline; his current issue of Market Tells is a must read. One interesting perspective: When we've had 10:1 negative breadth (as we did Thursday), there has been a tendency to see higher prices over the next three weeks.

* Overnight Interest Rates Hit Another Recent High - I see that September 10-year Notes pushed past 5.20%, sending stock futures lower overnight. That interest rate-stock market link noted yesterday continues to dominate trader concern; let's see if we can get to multi-year highs in rates.

* Huge Downside Momentum - My Demand indicator closed Thursday at 20; Supply was 225. So we have stocks with significant downside momentum outnumbering those with significant upside momentum by over 10:1. The normal tendency is to see some continuation of weakness prior to any sustained rally; that certainly was the case following Feb. 27th, another huge downside momentum day. It's when we see lower lows on improving momentum numbers (as we did in early March) that we start identifying a bottoming process: one of those longer-term transitional structures.

Trading By Intermarket Themes

Very large traders--those managing portfolios of 50, 100 million and more--cannot simply dump that kind of money on individual stocks or futures contracts without disrupting the market and getting terrible prices. What this means in practice is that, once you've gotten truly big, you have to trade themes, not just individual positions. Those themes can be expressed through multiple trades and markets, enabling the portfolio manager to put significant capital to work.

One of the themes emphasized on this blog recently has been the relationship between interest rates and equity prices. The above charts, taken from this morning's trade, illustrates how awareness of a theme can benefit even the short-term trader. Once ten-year rates blew through 5%, we saw significant selling pressure in the NYSE TICK and a move of the S&P 500 Index to multi-week lows.

You could play the theme by selling bonds, selling stocks, selling interest rate sensitive sectors vs. other, non-sensitive sectors, etc. Such themes wax and wane: sometimes they're sector themes (energy shares outperforming tech); sometimes they're market themes (international bourses outperforming U.S.); and sometimes they intermarket themes (falling bonds, falling stocks).

A savvy trader can think like a portfolio manager by observing the emergence of themes and generating alpha not only through market timing, but by shrewd selection of markets to trade. Once you begin to think thematically, it's easier to be long certain areas, short others. This creates natural hedges and diversifies your capital. I'll have much more to say on how traders can think like portfolio managers in an upcoming post.

RELATED POST:

Are Rising Rates Taking a Toll on the Stock Market?

Are Rising Interest Rates Taking a Toll on the Stock Market?

Here's a longer-term picture of 10-year interest rates. Note how the steep rise in 1999 choked off the stock market rally in 2000. It took a precipitous drop in rates to get the stock market going starting in 2003. Now we see rates once again rise over 5%, not far from multi-year highs.

What this tells us is that it takes some persistence of rising or falling rates to affect the valuation of equities. A single move higher in rates is not sufficient to induce a bear market. Still, the recent pattern of higher lows and higher highs is worth noting as a yellow flag for this market. Note that rises in rates early in 2004 and during mid-2006 were associated with stock market corrections.

Rates have risen from a low of approximately 4.6% to the current 5% over the past 20 trading sessions. I note that, as of Wednesday, only 434 stocks across the NYSE, NASDAQ, and ASE were making 20 day highs against 1001 new lows. My Demand indicator stands at 23 vs. 165 for Supply. That tells us that stocks with significant downside momentum (those closing below their short- and intermediate-term moving averages) outnumber those with significant upside momentum by about 7:1. It does appear that the rising rates are taking a toll on stocks.

In upcoming posts I'll look at which sectors are responding most notably to the rising rates, and I'll update my money flow indicators to see if the rising rates are leading institutions to withdraw money from the large-cap equities that have sustained this rally.

RELATED POST:

When Yields Are High, Should We Buy?

Stock Market Performance by Hour of Day

Here we're looking at the Dow Jones Industrial Average on a daily basis (light blue line) from 2004 to the present. I've broken the Dow down into three components and set these to equivalent prices as of 2004 to highlight differences in performance (click chart for greater detail).

The first component is the Dow's performance during its first hour of trading (dark blue line). Note the steady ascent, as we've seen solid performance during the Dow's first hour. Indeed, nearly three-quarters of the entire bull market since 2004 has occurred during the Dow's first hour of trading. Had you done nothing more than buy at the previous day's close and sell at the end of the first hour of trading the following day, you would have picked up almost 3800 Dow points.

The second component is the Dow's performance during its middle hours (pink line): the hours between the end of the first hour and the start of the last hour. Observe that this time period has not participated in the bull market whatsoever. In fact, from 2004 to the present, the middle hours have *lost* a total of about 42 Dow points. What that tells us is that a good part of the daytrading market has not seen a directional bias, despite the significant ascent of the Dow over that period.

The final component is the Dow's performance during the last hour of trading. Rennie Yang of Market Tells notes that this has been weak of late, which he interprets as caution on the part of the smart money. We can see that the last hour has underperformed over the last two years. About a quarter of the Dow's overall gain since 2004 is attributable to the last hour of trading; since 2005, however, the Dow's last hour has actually lost money.

My interpretation of these findings is that the U.S. market has been a follower, not a leader, of other world markets. When overseas bourses rise in value--and we've seen stronger gains in EAFE than in the States--that strength is reflected in the next day's open in the U.S. and thus the first hour of trading in the Dow cash index. If that is the case, then an important implication is that participation in the bull market has hinged upon the trader's ability to hold U.S. positions overnight and capture that overseas strength. My breakdown of S&P 500 returns by overnight vs. day session supports this conclusion.

The takeaway? Just because a market is trending overall doesn't mean it's trending at the time frame you happen to be trading. Extrapolating from the day to day market to shorter time frames can be hazardous to your wealth.

RELATED POSTS:

The Last Hour of Trading as a Sentiment Measure

Who Controls the Markets?

Update on Today Show Appearance

I just found out that my segment of the NBC Today Show will air at 8:38 AM tomorrow (Thursday, 6/7). The general theme of the segment involves the challenge of investing and weathering the market's ups and downs.

On a related note, I'm preparing a post on this new breed of Website that can automatically pull information from online brokerage accounts to document the performance of traders or portfolio managers in real time. The Investment Directors at VesTopia maintain blogs describing their market views; definitely worth a read--

Brett

Trading Patterns: Failed Opening Range Breakout

Here we see an annotated chart (click on chart for clearer detail) of the Russell 2000 (ER2) futures (white bars); NYSE TICK (red bars); and volume (bottom axis) for the morning of Friday, June 1st. Notice that we were trading in a pre-opening range of several points. An initial dip in the first minutes of regular trading stayed within that range and then a surge of buying (as seen by volume and the NYSE TICK) broke us above that range.

The preopening and opening ranges are extremely important, because they locate the market's estimate of value. By observing the preopening range, we see how economic reports and overseas trading have impacted valuation in the U.S. market. If we get a breakout from the preopening range on expanded volume and strong NYSE TICK, it means that the market is undergoing a new valuation: this is fresh buying from large traders.

The key principle to keep in mind is that, if this revaluation is genuine, we should not return to the prior trading range.

We did indeed remain above the trading range in the minutes following the breakout, as upward momentum carried us further. Notice from the volume and TICK readings that quite a few traders jumped on this breakout bandwagon.

Whenever we get a surge of volume and extreme TICK values, we want to consider the possibility that a momentum peak is being put into place as part of one of those transitional structures described in my recent post. Indeed, we see just such a structure emerge: the momentum (volume) peak; the subsequent price peak on reduced upside momentum (but very strong TICK); and then the failure of positive TICK readings to achieve new highs (inefficiency). Throughout this transitional structure, we see a downward shift in the NYSE TICK distribution and a drying up of volume among buyers.

This drying up of buying emboldens the sellers and it becomes increasingly clear that this is a failed opening range breakout in the making. Knowing that, we can anticipate a move back to the midpoint of that opening range; i.e., a return to the prior level of valuation.

Notice how the chart above integrates a number of market dynamics over time: valuation levels, volume, TICK, and price. It is the shifting of these dynamics that are crucial to the market's short-term movements. With frequent chart review and simulation-based trading, you can become sensitive to these patterns as they emerge, enabling you to jump on board moves in the making. Rookie traders tend to get lost in each bar, looking for simple patterns of price. It is the broader shifts in demand and supply that create the larger trading swings.

RELATED POSTS:

Trading Patterns: Identifying Transitional Structures

Trading Opening Range Breakouts

Toby Crabel and the Epistemology of Trading Expertise

Anatomy of a Stock Breakout

Trading Ideas and Resources for a Tuesday

* The Themes Continue - In my weekly post to the Weblog I noted the inverse relationship between the Yen and the S&P 500 Index. Note how the theme continued on Tuesday, with strength in the Yen and weakness in U.S. stocks. Note also that we continue to move higher in the 10-year interest rate, per the recent post that warned of reduced stock returns with rising rates. (Rennie at Market Tells links inferior stock returns to 52-week bond lows; Trader's Narrative offers a contrary view).

* InstantBull Continues to Add Value - Nice to see that this excellent aggregator of blogs, news, and chat is receiving recognition in the business community. Now a new feature lists blogs by their popularity, as ranked by Alexa and Technorati. Great way of staying on top of the most popular blogs--and discovering some new ones. Also check out the "hot" tab on the home page (top left); it lists stocks that have received the most search interest over the past four days. I might just check out some of those issues vis a vis money flow and other trading patterns to generate trade ideas.

* Winning Streak for Stocks - Another aggregator I really like is Seeking Alpha, which organizes a wide range of posts by category, including ETFs, China, energy, market outlook, currencies, economy, and much more. This post from Bespoke Investment Group looks at what we can expect when the S&P 500 Index has been up 5 days in a row. My own results suggest that momentum within that five day period, as measured by my Demand/Supply Index, helps to identify whether prospects are bullish or bearish after five days of strength. We had been losing momentum going into Tuesday's dip, with Demand at 54 and Supply at 54; down from 121 and 36 on May 31st.

* Mean Reversion Among Portfolio Managers? - Charles Kirk has a fascinating observation regarding the portfolio selections of hot managers. This might be one way of identifying shifting themes in the markets: what was hot previously is now underperforming. Also check out the excellent links compiled by Kirk, including a provocative chart of the stock market denominated in gold.

* Trader Mike Nails a Theme - Thanks to Mike for his recent links re: Covestor and VesTopia, including this interesting piece from David Jackson of Seeking Alpha. This is Web 2.0 for investors, and the methodology of pulling trades from account statements is quite clever. Not as emphasized, for obvious reasons, are contrarian applications of the data. Great way to see which sectors/themes are drawing interest. See StockTickr for another Web 2.0 implementation, but for traders.

* A Blog Resource You Might Not Know About - The TraderBlogs site is a collection of blogs with a variety of themes, including some sophisticated perspectives from John Ehlers and trading wisdom from Ryan Jones. See also Robert Colby's tracking of top ETFs. Good stuff!

More fine links to come!

Is Money Flow Making This Market Go?

The market's rise continues apace. On Friday, we saw 1129 stocks make fresh 65-day highs across the NYSE, NASDAQ, and ASE. That is the highest level we've seen since mid-April. This is a function of the renewed strength among the small cap stocks, which had been lagging large caps. Despite a number of divergences in the market data and strong interest rates, we've been able to hold off a significant correction to this point.

The chart above helps to explain why. Only very recently have we seen money flows in the 30 Dow Industrial stocks (pink line) move below their 200-day average (the zero line on the chart). Flows thus far have not only been positive, but above the average level we've seen *during a bull period*. When institutions are pouring money into stocks, it is difficult to sustain a correction.

Note that dips below the zero line--periods of below average money flow--have represented good buying opportunities in the Dow (DIA; blue line).

I decided to look at the past 10 trading sessions and compare those to the past 200 trading days. Dow stocks showing positive 10-day flows that are above their 200-day average include AA, BA, CAT, DD, GM, JPM, KO, MMM, MO, MRK, PG, UTX, VZ, and XOM. Notice the preponderance of old line industrial names.

Dow stocks with outright negative flows over the past 10 trading sessions include MSFT, JNJ, and INTC.

Money flows have slowed in recent days, but remain very close to average. That average has been sufficient to sustain a market uptrend. Until we sustain below average readings, it's difficult to expect a major market correction. The adjusted relative dollar volume flows have proven their worth in my own trading, as they've consistently reflected the recent market strength.

RELEVANT POST:

Overview of Relative Dollar Volume Flow

Brett Steenbarger's Appearance on NBC Today Show

Just a quick note to let you know that I'll be part of an NBC Today Show segment on personal finance on Thursday, 6/7/07 at the 7:30 AM hour. Today's Jean Chatzky has done a fine job of addressing the psychological challenges faced by investors trying to navigate their way to retirement. Interestingly, many of these challenges are similar to those faced by active traders, particularly with respect to the need to cultivate self-efficacy. In upcoming posts, I hope to elaborate on the Today segment to further address the need for investors to take control of their finances and craft a secure retirement. At a time when Social Security appears to be less than secure and baby-boomers are hitting those retirement years, it's a crucial topic for those working Americans who will be supporting the system.

Trading Discipline: Cause of Problems or Effect?

Among the dozens of submissions for the Trading Coach Project, the issue of discipline--sticking to plans/stops--was far and away the most common problem reported by traders. My general experience is that lapses of discipline are usually the result of a problem, not a cause. A key challenge, then, for work on oneself is identifying the cause of the departures from prudent trading.

There are three frequent causes worth investigating:

1) Personality Traits - Some people score low on a trait called Conscientiousness. They do not plan and follow through well, and they can be impulsive. This, of course, can manifest itself as a problem with discipline in trading. The key to identifying whether or not personality is a cause of discipline problems is determining whether a similar loss of discipline occurs in other facets of life (outside trading). If a person is disorganized and lacking in conscientiousness in their work, social relations, personal finances, etc., then it makes sense that this trait would carry over to their trading. Such individuals frequently need external brakes on their trading, such as risk managers at a firm who will enforce a "drop dead" level (and prevent further trading) once a loss limit is hit. Individual traders with impulsivity and low conscientiousness benefit from very explicit, structured rules that they follow without variation and reinforce with mental rehearsals. If the lack of discipline is so great that even such rules and rehearsals can't work, I personally do not believe such individuals should be trading. This includes traders with clearly addictive patterns of behavior, both in their trading and in other facets of their lives.

2) Market Volatility - Many, many times traders are quite conscientious and self-controlled in most areas of their lives, but experience lapses of discipline specific to trading. When this happens, it's often the case that the trading itself--*how* they're trading--is artificially creating the failure to follow trading rules. A key culprit in all this is market volatility. Volatility changes from day to day and week to week. It also varies as a function of time of day. Frequently, traders trade a fixed size and set fixed targets and stops, heedless of the underlying market volatility. In a low volatility environment, they fail to hit their targets and get stopped out, criticizing themselves for leaving money on the table. In an environment of enhanced volatility, the market will blow through their stops or exceed their targets, leaving them feeling that they did not trade well. This is especially true when traders find themselves unable to take what is normal heat in an environment of raised volatility. In such cases, it really isn't a lapse of discipline causing the problem. Rather, the trader is not adapting to market conditions. Adhering to fixed rules in a variable environment is not necessarily a virtue. Changing markets can prevent us from enacting those fixed rules.

3) Position Sizing - It is very common that smaller traders or aggressive traders will see a good trade and place too large a bet (i.e., a bet that is large relative to their account size). This makes it difficult to ride out normal movements against the position and leads to frustration and emotional arousal that result in loss of discipline. A good way of determining whether or not this is the case is to compare your largest trades with your smaller ones. If discipline problems tend to occur on the largest positions, you know that the increased perceptions of risk are interfering with consistency. The answer to this problem is to size all positions in such a way that individual losses in a trade cannot prevent you from making money on the day; losses during a day won't prevent you from being green on the week. Large trades relative to position size run the risk of ruin: a series of losing trades can dig a monstrous hole for the trader and cause significant emotional damage. In a sense, trades should be boring--not so large as to create undue fear *or* excitement. It is easiest being consistent and maintaining discipline when those emotional factors don't kick in.

It is common for trading psychologists to emphasize that our psyches affect our trading. Equally true, however, our trading affects our emotions. Trading inflexible strategies with inflexible targets and stops; trading size that is too large for our personal risk tolerance and account sizes: both of these can create "discipline" problems even for conscientious traders. Trading well is often the best psychological strategy of all.

RELATED POSTS:

Top Reasons Traders Lose Their Discipline

Understanding Lapses in Trader Discipline

Controlling Emotions is Not the Goal of Trading Psychology

TraderFeed is Up and Running Again

Of all the indignities! Blogger's bots identified TraderFeed as a "spam blog" and shut it down for a couple of days. I don't mind if readers disagree with my posts, but to label them as spam?? That cuts to the quick... :-)

In any event, I'll resume posting shortly. Please note that several new posts appear on the Trading Psychology Weblog. In the future, if TraderFeed is ever shut down, I'll simply post to the Weblog.

Thanks, and sorry for any inconvenience!

Brett

Wall of Worry: Are Traders Getting More Bearish As The Market Acts More Bullish?

Rennie Yang, who authors the excellent Market Tells service, notes an interesting pattern. Despite the recent market rise, investors in the AAII survey are 33% bulls and 45% bears. He notes bullish implications when we have a surplus of bears in this survey during a rising market period. That's the classic wall of worry that bull markets are said to climb.

Above we see a pattern that seems to confirm Rennie's observation. QID enables traders to place double-sized bets on a market decline in the NASDAQ 100 Index. As such, it is an excellent speculative vehicle for traders. Note in the chart above that, as QID has declined (i.e., the NASDAQ 100 has risen), the volume in QID has exploded.

In other words, traders are making more and larger bets against the NASDAQ as that market grinds higher. That's more than a wall of worry; more like a wall of pessimism!

Interestingly, since July, 2006 (N = 217; when my price data for QID begins) when QID is down on the day (rising NASDAQ) and QID volume is up for the day (N = 67), the next day in QID averages a loss of -.51% (41 down, 26 up). That is much weaker than the average loss of -.07% (87 down, 63 up) for the remainder of the sample.

It appears that, at least in the near term, a rising NASDAQ (falling QID) with rising bets on QID has been bullish, as the market confounds the pessimists.

RELATED POST:

NASDAQ Volume as a Sentiment Measure

NASDAQ TICK and Other Market Insights for a Friday

* Using the NASDAQ TICK - The screenshot is a bit dim (click for larger view), but a reader asked me about using the NASDAQ TICK in trading the Q's. Here we have the NASDAQ TICK (red bars) plotted against the NQ futures (white bars) and volume plotted below. I find these overlay charts in RealTick very helpful for seeing how market and sentiment move together (or diverge). The chart is taken from midday trade on Thursday; note the divergences between price and TICK (yellow arrows), as buyers are lifting offers across fewer stocks prior to the dip and hitting bids across fewer stocks prior to the bounce.

* Charting the Course for GOOG - Trader Mike finds an interesting pattern at the recent market highs.

* Insightful Article - Abnormal Returns takes a very thoughtful look at making investment decisions by trying to ride the coattails of famous investors and institutions.

* Great Reading to Kick Off the Weekend - The Kirk Report has quite a few excellent links, including one worth reading on how trading chat rooms might help call the top in China's market.

* Pictures Worth a Thousand Words - They tell the story of the housing weakness at The Big Picture.

* Options Insight - Adam Warner reflects on the relationship between the S&P 500 Index and the Buy-Write Index (BXM), building on the work of VIX and More. That'll be one for my research mill this weekend; very interesting idea.

* A Look at China's Tax and How It's Affected Stocks - Yaser Anwar passes along a little history of how Chinese investors have responded to past shifts in the Stamp Duty.

* Utilities Off Their Highs - Rising rates taking their toll; the Afraid to Trade Blog passes along a relevant lesson regarding momentum and price.

* A Classic Buy Trade - Kevin finds a pattern worth tracking: an opening gap reversal that exploits trader fear.