Friday, February 13, 2009

Think Like the Herd, But Don't Follow the Herd

One of the most common trading problems I'm hearing about in 2009 is losing money by jumping aboard market moves (or adding to positions once they go their way) and then getting caught in reversals. We can think of markets as being either volatile or non-volatile and either trending or non-trending. In many ways, the most difficult trading environments are volatile and non-trending, because the moves can be sharp and yet won't follow through over the next time frame.

As I write this, we are trading at almost exactly the same price in the S&P 500 Index (SPY) as we traded on October 27, 2008. That is several months of going nowhere. During that time, however, intraday movement has been considerable, with a median daily high-low range of 3.8%. While this environment poses potential opportunity for nimble daytraders, it has proven challenging for those who hope to identify and ride short-term trends.

A key challenge for developing traders is learning to not overweight recent price movement in anticipating future movement. Just because a market is up during the overnight session doesn't necessarily mean that there is a bullish edge from open to close. Simply because the market is down over the last few days doesn't provide an edge for selling over the following several days.

It is human nature to fall prey to recency effects: what happened last often most stands out in our minds. We see a short term pattern of bars on a chart or a trendline, and our inclination is to see those extending into the future. With so many market participants trading at intraday and swing time frames--and managing their longer-term trades with shorter-term adjustments--by the time the market has moved in one direction for several days, the majority of players are already on board and leaning for further movement. When the market fails to go their way, they have to unwind their positions, adding to the reversal movement.

A big part of short-term trading success is recognizing when players are overloaded in one direction and about to reverse positions.

As a little exercise, I took a look at SPY when the market was up or down over 1% from the open two days ago to today's open. I call that the market context. I then examined what happened when the market was up from open to close following a bullish market context (up over 1% from the open two days ago to today's open) and when the market was down from open to close following a bearish market context.

Since 2000, when we had a rising day session following two days of good gains, the next five days in SPY averaged a loss of -.56% (113 up, 128 down). Conversely, when we had a falling day session following two days of good losses, the next five days in SPY averaged a gain of .46% (135 up, 103 down).

Particularly at short time frames, so much of trading success is being able to think like the herd, but act counter to the herd.



cordura21 said...

time to invent the "anti-exponential/keeping perspective moving average"?

Adam said...

This is another of Brett’s incredibly valuable posts, so full of insight it’s difficult to know where to begin. I’ll focus my comment in a very narrow vein:

I’m a living monument to the many traders susceptible to recency bias, which helps me in a trending market but made adaptation to the current regime, which I’ll call a volatile channel, moderately difficult.

While adjusting my underlying models to the new regime, I re-introduced a habit that has proven to be the single most profitable discipline in my toolbox: the checklist.

Rather than sitting all day with my hand on the mouse ready to pounce my way into a trap, I have a pencil in my hand and a printed checklist for each trade on my desk that leads me from entry, through the holding period, to exit.

If the checklist conditions are met, I act. If not, I don’t. Do I miss some opportunities? Yes. Have I avoided significant losses? I believe so.

Trading is a matter of repeating over and over again behaviors that trap errors before they are released into the market.

Other professions that need to limit identifiable risk employ error-trapping methodologies: health care, aviation and firefighting. In each of these, the checklist serves as an ultra-low-tech tool for decreasing risk exposure.

Jeffrey Skiles proved their value when faithfully executed his emergency engine-failure and water-ditching checklists aboard US Airways Flight 1549 on which he was serving as First Officer to Captain Chesley Sullenberger.

A filled in checklist provides a record that can be compared against outcomes and performance. Does it take time to develop effective check ists? Yes. Does it take some discipline to stick to them? Yes.

This is a small cost incurred for introducing systemization and repeatability and for resisting the siren song of recency: trapping of errors and limiting of losses.

If you think it might take too much time to fill one out while the market is moving on the screen before you, imagine how few seconds were available for the flight deck crew to follow the check lists of procedures that saved so many lives.


Sandor Tucakov Caetano said...

I tested almost the same strategy to Brazilian market (Yahoo: ^BVSP) and got similar results, but the results get "better" in the latter years (2007-2008)

As we are an "emerging market", we would expect significant serial correlation (trends) in our series and this results show that this kind of emerging market premium is diminishing (at least for now)

Kevin said...

Sandor Tucakov Caetano:

I tested almost the same strategy to Brazilian market (Yahoo: ^BVSP) and got similar results, but the results get "better" in the latter year (2007-2008)

Sandor, are you testing the index (^BVSP) or an ETF like EWC? The problem with using the index itself is that they don't generally reflect opening gaps because the first print is usually very close to the previous close.

That's why Dr. Brett ran his test on SPY rather than ^GSPC.

Sandor Tucakov Caetano said...


I use the real index, and you are right about the price gaps. To try to overcome this problem I only use Close prices in my studies.

Also, about ETFs we have two problems.

- as I trade in Brazil our ETFs only have 1 or 2 years of data(all the three!), and no liquidity at all
- using an international traded ETF could bias my results due to the BRL/USD parity


Dear Dr.,

I appreciate, and thank you for sharing your invaluable knowledge, and experience through your blogs. I came across your blogs rather late, but better late then never!

In your "Become your own trading coach" blog you very rightly said: "protect your capital and protect your psyche during the learning process". I did just the opposite, and messed up my life.

I have read about Jessie Livermore's life, and his book "How to trade in stocks", just a few weeks ago.

I am now in a similar but more complex life situation, having gained and lost huge sums of money trading NIFTY options.

I have learnt a lot about trading in the process, but now the odds are all against me. I have no choice but to treat my present difficult life situation, as probably my best trading lesson, and continue to trade.

I salute the spirit of Jessie Livermore, he was a real "Die Hard" trader in every sense of the word!

Curtis said...

Few things that helped me think..

Be bullish in a bull market and bearish in a bear market (and nice thing today is we have the best of it if you are in right market). The majority are right except at extremes.

People look back at a bull market and say anyone can make money in a bull market but can you?

Brett Steenbarger, Ph.D. said...

Great observations; thanks much for the comments. Finding where the herd is trapped when breakouts from ranges aren't sustained has led to some excellent trades at different time frames of late--