Saturday, August 22, 2015

Why Trading Financial Markets Is So Difficult

Yesterday was one of my better days of the year trading ES, and a large part of the success consisted of *not* following my process.  Therein lies a tale and why so much common wisdom in trading psychology is horseshit.

First off, there is an underlying message you'll hear from every furu:  trading markets is really easier than you think.  Why is this the meta-message?  Because the furu needs to appeal to the quick money crowd.  There's no sexy message if you tell people that trading is difficult; that even the world class traders have losing periods; that it takes years to master any craft.  So the furu goes after the people who *don't* want to work for a living.  After all, what more alluring message to send than, "it's really easy...all you need to focus on is X."

Well, it's not easy and there's one major reason for why markets are so difficult to trade:  they are always changing.  The market you traded two weeks ago is not the market that traded for the past two days.

Above is a chart where each data point represents 50,000 ES contracts.  It covers the period from 7/1/15 to the present.  Note how the rules that would have made you money very early in the period are different from the ones that succeeded in the middle of the period and extremely different from what has succeeded most recently.

I build quantitative models of the ES market.  The backtests for those short-term models have gone back to 2014, as this has been a relatively stable (stationary) regime (i.e., a stable set of rules has been predictive of forward price movement).  As we went from trading Thursday to Friday, it became clear that the models (which generally put you long in oversold, higher volatility environments and short in overbought, lower volatility periods) were not working.  They were not working because the price action in the market was not typical of the price action from which the models had been derived.  Only the October 2014 period was similar, but even there important differences were present.

(Parenthetically, we closed Friday with fewer than 5% of SPX shares trading above their three- and five-day moving averages and fewer than 10% trading above their 10-day moving average, with VIX having soared to 28.  That price action is much more similar to 2010 and 2011 conditions than 2014-2015 ones).

So I disregarded the model output and instead turned to my research that identifies when we have a likely trend day.  The persistent hitting of bids on expanded volume was indeed present and led to a good afternoon short trade.  If anything, the models would have had me hunting for bottoms.  

I did not follow my process because I have a meta-process for adapting my process.  In other words, I am constantly scanning to see if this time really is different so that I can adapt to changing conditions as quickly as possible.  I don't want to be trading mean-reversion (which worked well through much of the period of the chart above) when we're now in a trend/momentum environment.

This is why trading is so difficult.  In most performance fields, we can count on stability:  the pitching mound does not go from 90 feet from the plate to 60 and then 120.  The basketball hoop does not go from 10 feet high to 12 and then 8-1/2.  The rules of chess are constant throughout tournaments; the rules of markets can change over the course of a week.  

Success can come from faithfully following your trading process.  Ongoing success comes from quickly recognizing when that process needs to adapt.

Further Reading:  Trading Coaches as Whores