Saturday, September 17, 2016

The Importance of Trading With an Open Mind

Here's an interesting set of statistics.  During 2016, the correlation between today's volume and tomorrow's volume in SPY has been about +.68.  The correlation between today's true trading range and tomorrow's has been above +.60.  Both are in line with long-term averages.  The correlation between daily price change today and daily price change tomorrow in SPY is -.11.  In other words, the recent past tells us much more about who will be in the market and how much the market will move than which way the market will move.

But wait, you might say, perhaps there is more consistency of price movement on an intraday basis.  During 2016, if we look at 5-minute bars for SPY, we find an almost identical pattern.  The correlation between the current bar's volume and the next bar's volume has been +.75.  The correlation between the current bar's range and the next bar's range has been +.69.  But the correlation between the current bar's price change and the next bar's change has been -.03.

Given these stats, as a trader you'd want to have an open mind as to market participation (after all, about 50% of the variance in volume is *not* accounted for by prior volume), but especially as to price behavior.  We might think one thing or another with respect to market trend or mean reversion.  The reality is that only about 1% of the variability in price direction in the next period is accounted for by the price movement in the present period.

In an interesting recent post, Mike Bellafiore from SMB draws upon a recent TED talk to make the distinction between thinking like a scout and thinking like a soldier.  The scout reads the terrain and looks for what is happening now.  The soldier defends terrain and follows battleplans.  In an environment characterized by high uncertainty, the open mindset of a scout is necessary.  If we become too locked into what has just happened, we can easily fail to see what is going on now.

Conversely, if we're following battle plans as a soldier, we must be mentally prepared for the "fog of war" and uncertainties of battle.  Those statistics tell us that, in terms of directional price movement, noise is very high relative to signal.  Regardless of our time frame, we will face uncertainty during the life of our trade.  How we deal with that uncertainty greatly impacts how we manage our positions.  The wise trader might follow a plan, but never stops being a scout.  It's when markets significantly deviate from their normal noise that opportunities arise.

Further Reading:  Bayesian and Static Reasoning in Markets