Saturday, May 23, 2009

Reasoning, Preparation, and Trading Success

A recent post described a framework for trading in which evolving market action (the behavior of price, volume, and volatility around key price levels) is used to form ongoing estimates of the odds of touching predefined profit targets. By observing how volume and volatility behave on upward and downward movements—and by gauging the degree of participation in those movements—we can obtain a feel for whether trade is directional or non-directional and anticipate continuation and reversal moves accordingly.

Underlying this framework for trading is a reasoning process that synthesizes ongoing information within and across markets and time frames. Much of what is learned during the process of obtaining market expertise is a refinement of this reasoning process. Psychology becomes important to trading outcomes insofar as it promotes or interferes with the reasoning needed to adapt to the flows of market-generated information.

The reasoning process, however, begins before markets open as part of the trader’s daily preparation. By observing how markets trade overnight, evaluating the behavior of correlated asset classes prior to the open, and by assimilating economic data, news, and earnings releases (and market responses to these), the trader gains a feel for the market day before the opening bell rings.

Key to the trader’s reasoning is an elaboration of “what-if”scenarios that review hypotheses regarding likely market action. What if we open with low volume, near the previous day’s pivot level on a day with no scheduled economic releases? What if we open weak in the S&P 500 Index, but see firmness among the small cap stocks and a mixed open among the major stock sectors? What if the market breaks above a key price level, with bullish behavior in bonds, the dollar, commodities, and the more speculative stock sectors? What if the market breaks below support, but breadth remains mixed?

Each of these scenarios calls for a specific trader response. Each offers potential trading opportunity. By mentally reviewing the scenarios in advance, the trader becomes more prepared to act upon them. The trader also becomes more sensitive to their unfolding, so that trading opportunities can be properly anticipated and mapped out.

Two sources of hypotheses for the day ahead can be especially useful to preparation. First, by tracking indicators such as stocks making new highs and lows; momentum measures such as Demand/Supply; and the percentage of stocks trading above their moving averages, we can gauge whether a market is gaining or losing momentum to the upside or downside (or whether it is trading in a range with little momentum). Drawing on the principle that strong momentum moves in one period will tend to carry over into subsequent intervals (and weak momentum moves will tend to reverse), we can formulate ideas as to whether markets are likely to hit particular targets today as a function of yesterday’s trade.

Second, historical market patterns—queries as to how markets have traded in the past under the present set of conditions—can help us formulate hypotheses for the coming day. For example, we might find that a low momentum up day yesterday which is also a five-day closing high has a relatively poor chance of closing higher today. That provides us with a hypothesis that enables us to anticipate weakness should we be unable to hold a particular upside price level.

From this perspective, the successful trader is one who formulates meaningful hypotheses prior to trading and then processes unfolding action quickly and accurately to determine whether or not those hypotheses are finding support. Not all traders trade this way; nor should they. What I am describing is a framework that I have cultivated over years of trading and working with traders that makes use of my cognitive strengths in synthesizing information into meaningful patterns and themes.

Your challenge is to learn what you can from my way of viewing markets, but not to mimic what I do. Good things happen when discover where your cognitive strengths lie and adapt the styles of others to create your own niche.