Friday, September 30, 2016

Looking for Your Trading Edge

Just thought I'd update this post on what it means for stocks when we see a high degree of institutional participation in the US equity market.  Yesterday's reading was in the highest quartile, which has been associated with significantly above average returns over a next 10-day period.  Interestingly, we also saw an elevated equity put/call ratio, also associated with favorable next 10-day returns in SPY.

Meanwhile, several of my cycle measures have been pretty toppy.  

There are times when things line up and there are times when they don't line up.  A useful psychological exercise is to assume that, at some point, everything will line up.  What would you need to see for such a line-up to occur?  Anticipating potential price paths is a first step in preparing to trade them.  Being aware of when things aren't lining up is a great way to avoid overtrading.

Further Reading:  When to Exit Winning Trades

Thursday, September 29, 2016

What Quant Models Can Teach Us About Trading Psychology

Above we can see SPY (blue line) plotted against a six-variable trading model that I developed using ensemble modeling.  When we have a positive score, the model is deemed to be bullish over a next 10-day horizon.  When we have a negative score, the model is deemed to be bearish.  The model is flat as of yesterday's close.  The model includes such variables as market volatility, breadth, buying/selling participation, and market cycle status.  

When the model has been at a score of +2 or higher, the next 10 days in SPY have averaged a gain of +2.08%.  When the model has been at a score of -3 or lower, the next 10 days in SPY have averaged a loss of -.83%.  Between scores of +1 and -2, the next 10 days in SPY have averaged a small loss of -.08%.  

The model has a couple of important implications for trading psychology:

1)  Out of the 573 days of my in-sample and out-of-sample periods, nearly half are scores less than +2 and greater than -3:  in other words, days with essentially no edge 10 days out.  That doesn't mean sources of edge can't be found on different time frames with different models, but this finding is important.  Even with a solidly researched source of edge, there are plenty of occasions when not trading is the best trade.

2)   The model signals have been good, but even with their edge, there is plenty of noise.  Note, for example, that the model was bearish during much of mid-2015, when prices chopped around quite a bit.  We were also bullish during fall, 2015 during a volatile bottoming period.  A trader could have an edge with a model but be unable to survive the noise around signal, especially if sized quite large.  

3)  I suspect the model works because it's exploiting cyclical behavior in markets at a time frame that is too long for active traders and too short for true investors.  A key to trading the model, as we've seen, is not placing trades when there is no clear signal.  There have been no solid signals from the model in the last 14 trading sessions; such periods are not rare.  It's the selectivity of the model that might be its greatest advantage.

4)  Such models don't have to be traded mechanically.  For instance, a short-term trader could use the model to decide when to trade with a directional bias and when to take short-term setups without such bias.  More fundamentally grounded traders could use models such as these to help with the execution of longer-term positions.  Good models provide good information; that information can be useful in discretionary decision making.

The act of developing models itself gives one a feel for markets.  The model inputs are there for a reason: the model simply captures when those reasons line up.  It is interesting that the most rational of analyses can feed the deepest intuitions.

Further Reading:  The Psychology of Quant Analysis

Wednesday, September 28, 2016

Trading Success and Calculated Risk Taking

There are risk-averse traders who never make significant money.  There are risk-seeking traders who blow up.  Then there are smart traders who take calculated risks.  They make selective bets.  Like the skilled poker player, they know when they have a good hand and they know how and when to bet that hand.

But to take calculated risks, you have to know how much risk you're truly taking.  Several factors impact the risks in your trading:

*  The sizing of your positions - It's not uncommon for small traders to have big dreams and take positions that are unusually large for the amounts of capital they're trading.  Any trader can experience strings of losing trades merely by chance.  When position sizes are too large, those strings of losers incur a risk of ruin.  Once you're down 50%, it takes a doubling of remaining capital just to return to break even.  

*  The volatility of your markets - Volatility can change dramatically from day to day, week to week, depending on the participation in your markets.  This can be particularly true around major events, such as central bank meetings, earnings reports, etc.  You want to size your positions, not only for the current volatility of the market you're trading, but also for the expected "vol of vol":  the expectable variation in volatility over the life of your intended holding period.

*  The correlation of positions you are trading - When the positions you are trading are negatively correlated, the overall risk in your book can be smaller than the risk associated with each of the positions.  Conversely, when you trade multiple positions that become correlated, your total risk exposure can grow exponentially.  Some short-term traders only hold one position at a time, but can experience correlation-related risk if they habitually lean one way in markets (long or short, for example).  They end up taking bets that are not truly independent ones.  Traders of individual equities often treat their positions as independent when, in fact, those positions can respond very similarly to large moves in the overall market.

Risk is important because it impacts trader psychology.  If the amount of risk you're taking dramatically expands or shrinks, you're likely to react to the change in the ebb and flow of your P/L.  In order to take calculated risks, you have to be able to estimate and calculate risk--and the possible ways risk can shift over time.  We often think of trades as directional bets, when in fact they are also implicit bets on *how* markets move.

Further Reading:  Risk Intelligence and Trading Success

Tuesday, September 27, 2016

Mind Shift: A Different View of Trading Psychology

One take on trading psychology says that we should control our emotional experience so that we stick to our processes and our discipline.

Another take on trading psychology says that we should become better at listening to the feelings that represent intuition and gut feel for markets.

This recent article, however, suggests a different approach altogether:  we become able to see and trade markets better when we can make mind shifts that allow us to experience markets differently.

Like a car, we can make a mind shift by changing gears, allowing us to approach the world with more torque, greater intensity.

Also like a car, we can achieve a mind shift by changing lanes, opening a new path.

The key idea of the article is that what we see and what we can act upon is a function, not only of the information we process, but also the state we're in.  When we achieve a mind shift, we not only can process new information, but become better at processing old information in new ways.

In short, emotional and physical creativity are paths to achieving fresh, creative trading ideas.  This opens the door to entirely new techniques for self-mastery in trading.

We see markets better when we shift from passive information processing to active:  actually playing and experimenting with the information.

We see markets better when we shift from active processing to interactive processing:  encountering information from multiple perspectives.

We see markets better when we shift from interactive processing to multi-active processing; processing multiple perspectives through multiple modalities. 

If we always stayed in one lane, in one gear, we'd be quite inefficient in our travels.  Trading psychology should not be about dampening your feelings or enshrining them.  The mind that can shift is one more likely to effectively reach its destination.

Further Reading:  Becoming More Creative 

Monday, September 26, 2016

Viewing Strength and Weakness as Different Dimensions of the Market

When assessing the market, I find it helpful to treat strength and weakness as independent variables.  In other words, we can have markets in which many stocks are strong and few weak; many weak and few strong; few strong and few weak; and many strong and many weak.  The latter is possible when correlations among sectors and stocks are relatively low.

Let's take the Parabolic SAR indicator system developed by Wilder.  One way I track market strength and weakness is to take a cumulative running total of Parabolic SAR buy signals minus sell signals for all NYSE issues (red line, above).  This has been helpful in capturing cyclical behavior in SPY (blue line). (Raw data from  

But we can also consider the buy signals from the system separately from the sell signals as proxies for market strength and weakness.  For example, since mid-2014, when I first began collecting these data, when we divide the sample into quartiles, we find that, after a single day of many new buy signals (top quartile), the next 10 days in SPY have averaged a loss of -.23%.  After a single day of few buy signals (bottom quartile), the next 10 days in SPY have averaged a gain of +.80%.

When we've had very few sell signals (bottom quartile), the next 3 days in SPY have averaged a gain of +.26%, compared with a -.01% loss for the remainder of the sample.  Over a next 10-day period, however, when we've had many sell signals (top quartile), the next 10 days in SPY have averaged a gain of +.52%, compared with an average gain of +.09% for the remainder of the sample.

Overall, the percentage of variance in daily sell signals accounted for by buy signals is only about 10%.  They indeed are more independent than one might expect.  It is in the interplay of waxing/waning buying and selling that we can sensitively track cycle dynamics.

Combined perspectives can have their use, as well.  Suppose we look at the total number of buy *and* sell signals each day.  Interestingly, when we have many buys and sells (top quartile), the next 10 days in SPY have averaged a gain of +.33%.  When we've had very few buys and sells (bottom quartile), the next 10 days in SPY have averaged a gain of +.59%.  All middle occasions have averaged a loss of -.06%.

Think about how momentum and value operate, and then think what it means to have many versus few trading signals.  Think about cycle structure and when you'd expect to have many and few trading signals.  We can learn a lot once we tease apart strength and weakness and view markets multidimensionally.

Further Reading:  The Dynamics of Stock Market Cycles

Sunday, September 25, 2016

The Mistake Traders Make When They're Not Making Money

There are those that follow their hearts when they trade.

There are those that lead with their brains.

One trades based upon seeing patterns play out in real time and having a feeling for those patterns.

The other trades based upon analyses and having an understanding of how markets should respond.

Both styles require an ability to tune out noise and focus on what is important.  Both styles require an ability to act on the information being processed.

When we don't see opportunities, it can be tempting to look to others for answers: to see what patterns they are noticing, to check out their analyses.  At that point, we become externally focused, no longer attuned to our own information processing strengths.

In challenging times, the challenge is to double down on our strengths and become more of who we already are at our best.  Looking outside ourselves for answers is the surest strategy for turning drawdowns into slumps.

Further Reading:  The Two Brains of Trading

Saturday, September 24, 2016

How to Find Your Trading Biases

One of the exercises I've found most helpful for traders and portfolio managers is a thorough review of trading performance.  Many times, the ups and downs of profit/loss reveal biases and patterns in our trading.  Some of the patterns worth looking for include:

*  How you trade after you've made money versus after you've lost money:  Do you trade more?  Larger?  Do you trade differently based on recent P/L?  Do you become risk averse after recent losses?  Does that affect your future P/L?

*  How do you trade when you're taking more risk versus less risk?  Does different size/risk exposure cause you to trade differently?  Are you actually making more money when you're taking more risk? 

*  What kinds of markets and market patterns provide you with your greatest profits?  Losses?  Do you trade selectively to maximize your best opportunities?  Do you overtrade markets that are not ones providing you with opportunities?

*  What is your ratio of winning to losing trades?  What is the ratio of the size of average winners to the size of average losers?  How successful have you been in finding large winners?  In preventing large losers?

Many times, our greatest biases and psychological mistakes come through when we thoroughly review performance.  The decision to not review performance is perhaps traders' greatest bias blind spot.

Further Reading:  Training Yourself in Pattern Recognition

Friday, September 23, 2016

Why Traders Lack Creativity

So much of creativity is the ability and willingness to look and move in a direction different from the well-worn path.  After I wrote the most recent post on emotional creativity, I had the honor of speaking with Dr. James Averill who pioneered research in the area.  He made a very important point.  Much of the way the business world is structured (and I believe this includes the trading world) does not lend itself to emotional creativity.  If anything, emotions are dampened, not explored:  no one really focuses on identifying and cultivating unique emotional responses to daily challenges.

I recall speaking with a successful trader who told me that he was excited about the opportunity in the marketplace.  I responded by saying that he was the first person I'd spoken with to tell me that.  Everyone else was lamenting the lack of opportunity in markets.  He said, "That's right.  I've always made my money going against the consensus!"  That was shortly before the events of Brexit.  That trader was able to capitalize on opportunity because he not only saw the world differently, but experienced it differently.

Another skilled trader I know claims that his idea generation is aided by yoga exercises.  He believes yoga gets him into states where he sees the world more clearly.  This is in line with research that identifies a physical dimension to creativity.  In accessing different physical states, we create opportunities to see and experience the world differently.  

If I wanted to create an environment in which creativity was to be minimized, I would have people sitting or standing at desks, relatively stationary and rarely shifting their physical activity.  I would encourage little talking and insist that such talk be about the external world, not about internal experience.  I would encourage people to share trades and focus on the same research, rather than generate their own views.  That is the environment that typifies so many trading floors:  there is little in the structure to encourage and cultivate cognitive, emotional, and physical creativity.

A truly creative trader would create a radically different trading environment and a radically different set of routines for approaching the trading process.  Turning creativity into a routine rather than become prisoner to one's routines: that is a promising direction for development as a trader.

Further Reading:  Trading Psychology for the Experienced Trader

Thursday, September 22, 2016

Emotional Creativity: A New Theory of Trading Success

As Averill notes above, there are two views on emotions.  One, the most common, asserts that emotions are givens:  biologically wired.  A second view is that we can cultivate what we feel and how we express it.  That second view suggests that creativity is possible in our emotional responding as well as in our thought processes.  This emotional creativity is what enables people to adapt to situations and respond to them in novel and effective ways.
Averill's work suggests that emotional creativity has three components:

*  Preparedness - The ability to learn from the emotional experience of self and others;
*  Novelty - The ability to experience and express unusual emotions;
*  Effectiveness - The ability to express emotions honestly and constructively

Research suggests that emotional creativity is different from emotional intelligence.  Emotionally intelligent people--those who can read and respond well to the emotional experience of others--are not necessarily emotionally creative people.  The emotionally creative person responds uniquely to situations, enabling them to deal with those situations in fresh ways.

Four competencies are essential to trading:

*  Cognitive intelligence - The ability to process and understand market-related information and use research, analysis, and pattern recognition to identify trading opportunities;
*  Emotional intelligence - The ability to read the intentions of other market participants and use their sentiment and positioning as inputs to one's own decision-making;
*  Cognitive creativity - The ability to put market information together in unique ways and detect opportunities that others miss;
*  Emotional creativity - The ability to respond uniquely and effectively to market-relevant events.

I would argue that most traders have a reasonable degree of cognitive and emotional intelligence.  Their success or failure is more a function of the presence or absence of creativity.  Unsuccessful traders generate consensus ideas and respond to markets in line with "the herd".  The successful trader experiences the flow of market information uniquely, and that emotional creativity enables her or him to generate novel trading ideas.

This is a unique theory of trading success.  If it is correct, much of training in trading and much of coaching has been focusing on the wrong things.  Creativity can be cultivated.  Perhaps a key to trading success is not controlling one's emotions, but learning to view and respond to the financial world in novel ways.

Further Reading:  Cultivating Emotional Creativity

Wednesday, September 21, 2016

Trading With Your Signature Style

One of the things I've found among successful traders is that they develop ways of looking at markets that:  a) are original and b) that make great sense to them.  The originality of their perspectives helps them see what others don't.  The familiarity of the perspectives helps them align their cognitive strengths (how they best process information) with their decision making.  Very often this means that successful traders trade with a signature style, not a generic one.  Working with mentors and researching markets and market patterns are very helpful in developing the raw materials for one's signature style.

Above is a chart of the ES futures from August 22nd to the present (blue line).  Each data point represents 500 price changes in the contract; these are event bars, not time-based bars.  The red line is what I call the Power Measure.  It's a running correlation of price change and volatility.  In short, the Power Measure tells you when volatility is fueling directional moves:  when that fuel is waxing and waning.  That makes sense from my perspective, because I ideally want to participate in directional moves in which volatility is rising in the direction of my trade.

When you develop your own metrics and ways of looking at markets, the patterns that repeat themselves become ones that are intimately familiar to you.  It's because they are *your* patterns that you are able to follow them, test them, and ultimately trust them.  I have never met a successful trader who traded someone else's style, just as I've never seen a successful painter who copied others.  We see markets best when we cultivate our own vision.

Further Reading:  Calculating Power Measure

Tuesday, September 20, 2016

Understanding Gut Feel and Trading Success

A great recent research article documents the role of "gut feel" in short-term trading.  Traders who are more self-aware with respect to their bodies tend to outperform those who lack such awareness.  Interestingly, if you read the report carefully, you'll see that a second variable predicted trading success independently of body self-awareness:  heart rate variability.  We've encountered heart rate variability before in explorations of biofeedback as a means to developing calm focus and increasing access to intuition.  The recent study hints at the possibility that these two factors indeed work in tandem:  the ability to sustain a calm, focused state during turbulent markets provides access to our gut feel, which in turn helps us sustain sensitivity to market patterns that emerge in real time.

If this is the case, then access to our intuitive capabilities indeed can be trained and cultivated.  This may not help trading that relies upon explicit reasoning and analysis, but would be very useful for active daytraders and those looking to use short-term market patterns to achieve superior entry and exit execution of longer-term trades.  It was interesting to see in the study that medical students in the sample scored lower in their body self-awareness than the successful traders.  Medicine requires careful analysis and synthesis of information to arrive at diagnoses and potential treatment options.  It is less purely intuitive than scalping short-term patterns in stock index futures.

The key takeaway is that different strengths predict success in different fields, and different strengths predict success in different forms of trading.  Much of trading success comes from aligning your strengths with your approach to markets.  It may well be that the greatest success comes from the ongoing strengthening of our strengths, training ourselves to become better in utilizing our signature modes of processing information.

Further Reading:  Improving Your Trading Toolkit

Monday, September 19, 2016

What is Most Essential in Markets

This was Mali at 2 AM this morning.  It's not much of a conflict when part of you wants to sleep and another part of you wants to cuddle a blind, purring cat.  The purr is worth a tired day!  It's all about staying focused on what's essential in life.

In markets, it's easy to become focused on non-essentials.  We tell ourselves stories about the state of the world or the state of market charts.  Far more essential is what buyers and sellers are actually doing in markets.  Are there many buyers participating in today's market?  Many sellers?  What is the relative balance of buyers and sellers, and is that changing?  It's all about the auction process.

So let's go to the data.  We'll go back to 2012 and look at every transaction in every NYSE stock each day.  Those occurring on upticks we will categorize as initiated by buyers.  Those occurring on downticks we will categorize as initiated by sellers.  The total number of transactions occurring on upticks and downticks, we will call participation in the market.  Participation differs from volume, because a given unit of volume can be broken into many transactions or fewer depending upon the sophistication of the execution platform and the urgency of the traders.  Increasingly, we're seeing volume broken into pieces, creating multiple transactions.  How these transactions occur--on upticks vs. downticks--provides a useful sense for the flow of supply and demand moment to moment.

So at the end of the day, we have a total score of transactions occurring on upticks (buying pressure) and a total score of transactions occurring on downticks (selling pressure).  What can we learn from these measures?

If we divide the sample from 2012-present into quartiles, we find out that when daily upticks are lowest, the next 10 days in SPY have averaged a loss of -.05%.  When daily upticks have been highest, the next 10 days in SPY have averaged a gain of +1.02%.  Heavy buying tends to beget further buying.  That's a momentum effect.

If we then look at when we have the fewest downticks, we find that the next 10 days in SPY have averaged a gain of +.13%.  When we have the greatest number of downticks, the next 10 days in SPY have averaged a gain of +.96%.  Heavy selling tends to beget future buying.  That's a value effect.

If we now combine total upticks and total downticks to create our participation measure, we find that when we've had the lowest participation, the next 10 days in SPY have averaged a loss of -.10%.  When we've had the highest participation, the next 10 days in SPY have averaged a gain of +1.33%.  

So this is what's essential:  There are value participants in the marketplace that scoop up stocks when they have traded weakly.  There are momentum participants in the marketplace that buy shares when they're moving sharply higher or lower.  Market lows are created when value and momentum participants are interacting with one another, first selling falling shares, then scooping up the fallen assets, and then picking up the rising stocks.  Market highs are created when prices get to the point where they no longer attract value participants and lose their momentum.  There is relatively low participation at those times.

This is why, when SPY volume has been lowest, the next 10 days in SPY have averaged a loss of -.24%.  When volume has been highest, the next 10 days have averaged a gain of +1.15%.

Who is in the market?  What are they doing?  How is their behavior shifting over time?  Those are keys to understanding markets.

Now I'll focus on another essential: sleep!   

Further Reading:  Reading Market Footprints

Sunday, September 18, 2016

What is Your Rut?

"I'm in a rut."

That's what we hear when someone finds themselves doing the same thing and getting unsatisfying results.

Trading can be in a rut.  Relationships can be in a rut.  We can be in a rut with respect to our social lives, our physical well-being, or our spiritual lives.

A rut is a habit that has outlived its usefulness.  At one time, it may have had value.  Now we've outgrown it, but it remains a habit.

Because ruts are habits, each time that we fall into the rut, we reinforce the wrong habits.  The rut grows a bit deeper and starts to look more and more like a grave.

The best way to break habits is to create new ones.  The things we're doing now that are useful--that bring happiness, success, fulfillment--those are the things that we should be looking to habit-ize.  

But do you want to know the true key to staying out of ruts?  It's to turn habit breaking into a habit.  If we get into a routine of identifying strengths and making them automatic, then habit breaking and the creation of new, positive habits itself becomes a habit pattern.  

That is why we can never innovate occasionally.

The people who innovate have made a habit of innovation.  They make a habit out of rut-finding and creating new paths.

We can't necessarily move mountains or climb over them, but we can get to the other side if we turn our ruts into tunnels.

What is the rut you're in now?  What is on the other side of your mountain?  Life is so much more satisfying when we stop digging and start tunneling.

The only difference between a rut and a tunnel is the direction of the digging.

Further Reading:   How to Find Your Trading Talent

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

Friday, September 16, 2016

The Psychology of Dealing With Choppy Markets

Stocks have traded in a volatile range lately, with significant moves frequently reversed.  This has proven challenging for those looking for trends.

If we think of markets as auction processes, we can identify volatile and non-volatile markets based upon the amount of participation in the marketplace.  We can also identify trending and non-trending markets based upon the relative balance of buyers and sellers.  

Our job is to read the auction process and adapt to the conditions before us.  We are in a very different environment than several months ago.  When we have a volatile range, we have large participants active as both buyers and sellers.  The move in rates and uncertainty over central bank direction has created a different auction process.

How do we talk to ourselves about market conditions?  Do we frame the situation as a challenge and as a problem to be solved, or do we frame ourselves as victims of unknowable market forces and passively hope that things will change in our favor?

Victim self-talk is the surest way of disabling ourselves when opportunities arise.  How we frame situations determines how we respond to them...and how we will be prepared for the future.

Further Reading:  Questions to Ask About Your Trading Psychology

Thursday, September 15, 2016

Replacing Risk Taking With Intelligent Risk Taking

We all know the saying, "No risk, no reward."  In markets especially, we cannot make money if we're not willing to take risks.  Frankly, however, my experience working with traders is that the greatest problem is not with taking risk, but with the intelligence of risk taking.  Traders take risks that, ultimately, they are not emotionally prepared to handle.

I recall the trading days in which you could get filled on a long position at the market's bid price and either get out a tick lower or wait and see if you could get a larger gain when it traded at the offer price.  Most trades could be scratched that way and you got plenty of free looks at larger moves.  Once market making became algorithmic, that level of risk control--the hallmark of true scalping--became impossible.  The noise was simply too great for the amount of signal traded.

The same has been happening at larger time frames.  The most common concern I hear from active traders is the "choppiness" or noise of markets.  High Sharpe, trending moves are the exception.  Very often, the market will take out previous highs before moving to lows and vice versa.  This makes it easy to stop out of trades at poor levels.

Risk taking becomes unintelligent when the amount of risk we take is ultimately more than we can handle, either emotionally or business-wise.  The trader who routinely gets stopped out of good ideas--ones that often work out in the end--is trading more size and taking more risk than they can handle, given the market's signal to noise ratio.  Traders overestimate the precision of their entries, leading them to seek trades that seemingly give them a reward-to-risk ratio of 2:1, 3:1, or even higher.  The reality, however, is that this becomes a losing strategy if the ratio of winning to losing trades is even higher.  The problem is magnified many times over when traders, out of overconfidence from a winning streak, take greater risk--particularly when market volatility has itself expanded.  The increased market movement and greater P/L volatility from the increased size places an emotional magnifying glass on moves against the position, increasing the odds of a bad stop out.

How do you know if you're taking risk that is not psychologically sustainable?  One simple yardstick is to observe your behavior during the life of a trade.  If you have a highly diversified portfolio; if you have  moderately sized positions with wide stops; if you express trades in risk-limited ways with options or relative structures, you should not be hanging on every tick in markets.  If you're glued to screens, if you're constantly checking your phones, if you're unable to conduct market research and attend to your trading business because you're preoccupied with market movement during the life of your trades, you no longer have emotional control.  You are much more likely to make reactive trading decisions that have low odds of success.

Risk taking that is threatening is not emotionally intelligent risk taking.  We cannot control markets, but we can control the risks we take.  When we size positions larger than we can ultimately tolerate given market noise, we give up our control--and that surrenders any edge we may have possessed.

Further Reading:  The Real Reason Traders Trade Emotionally

Wednesday, September 14, 2016

What We Need to Turn Goals Into Lasting Changes

The last post took a look at the importance of prioritizing our goals and the activities that help us pursue our goals.  An excellent post from James Clear discusses the importance of habit formation, so that the changes we seek become internalized parts of ourselves and built into our daily routines.  The post cites evidence that such habit formation is most likely to occur if we structure our pursuit of goals, specifying what we'll do each day, when we'll do it, and how we'll do it.  Interestingly, however, we are most likely to turn our specific plans into habits if we focus on one goal at a time.  Doing one new thing the same way over many days is much more effective in developing new habits than trying to do many new things at once.

Clear cites research that suggests it takes over two months of repetition on average for a behavior to become truly internalized and automatic.  That's a significant period of time (and commitment) and helps explain why relapse is so common among people seeking changes.  If we do not sustain consistent effort over time, the new behavior does not become a consistent part of us.  In those first days and weeks of effort, habits are like cobwebs--easily broken.  It's only with significant repetition that they gain the strength of cables.

So there's a chicken-and-egg problem here.  We need repetition over time to build a habit, but it's precisely the absence of the right habits that make it difficult to repeat activities over time!  How can we become better at the process of habit formation?  

At root, there are only two reasons for devoting the resources to making changes:  extreme fear or profound inspiration.  We will change if we absolutely need to:  if the consequences of not making the change are so scary and aversive that we'll do anything to avoid them.  That's how alcoholics change after hitting bottom; it's why people who could never diet suddenly make big shifts in eating after a heart attack.  Fear creates a sense of urgency.

But the sense of urgency can also come from very high levels of inspiration.  We can become so energized and excited by a potential outcome that its pursuit becomes our absolute priority.  That's the motivation that keeps the entrepreneur doing the right things, or the Olympic gymnast.  It's not about being pushed by fear, but being pulled by an ideal.

The bottom line, however, is that we need a sense of urgency to keep doing something, the same way, for over two months.  Urgency is the great missing ingredient in most change efforts.  This is why goals, to be achieved, must be meaningful, not mere shoulds.  If a goal is a mere desired outcome that finds its way onto a to-do list, it will neither inspire the fear nor the inspiration to become an urgent priority.  Inevitably, competing activities will take over and we'll become a victim of relapse.

This, ultimately, is why setting and pursuing multiple goals doesn't work.  Once we dilute our goal-setting and pursuit, no one goal sustains the specialness--the sense of urgency--needed to become an automatic part of ourselves.  We only change when change is truly important to us...when it becomes a need and a must, not just a preference.  If we're looking to make changes in our trading, finding the one change that will make the greatest difference and tapping into the urgency of making that change is the best way to turn our best practices into robust, best processes.

Further Reading:  Three Best Practices of Best Traders

Tuesday, September 13, 2016

Turning Goals Into Priorities

An insightful post from @ivanhoff lists his takeaways from the popular book The One Thing, including the importance of focusing on the one thing that matters the most in terms of reaching your goal.

Not goals.  Goal.

Not many things.  One thing.

That is prioritization.  

Too often, we set multiple goals and never drill down and truly accomplish any of them.  We try different things to reach our goals, patting ourselves on the back for multitasking, when in fact we never become distinctively good at any of the things we're doing.

In short, we take on too much and water down our priorities.

The idea is focus like a laser on what you want to achieve and the best way for you to achieve it.  That's more than goal setting: it's commitment.

If you don't have a singular, passionate, all-consuming commitment to a goal right here, right now, what will lead you to singular successes going forward?  

If your work is tiring you, it's not inspiring you.  It's time to stop prioritizing your schedules and start scheduling your priority.

Further Reading:  How to Make Big Life Changes

Monday, September 12, 2016

The Question to Ask When You're in Drawdown

If you're losing money in your trading, there is an important question that can help you figure out your next steps.  This is important, because sometimes traders become so interested in stopping their losses that they don't first figure out what is causing them.  They look to psychology for answers, when it's their trading strategy that is flawed.  They hop from trading approach to trading approach, never addressing the psychological issues that are sabotaging whatever they're doing.  If you're losing money, something has to change, but how do you figure out what that something is?

The question that helps sort out promising directions for those in drawdown is this: 

Are other people, trading similar strategies, also losing money?

That will tell you quite a bit.  If you were making money and suddenly go cold and others in the same markets, with similar strategies are doing the same, then you know that it isn't simply a psychological issue.  Everyone did not suddenly lose discipline or become an idiot at the same time.  Rather, the strategy is not working under current market conditions, or it has stopped working altogether.

If the strategy has stopped working under current conditions (as, perhaps, in the case of a breakout strategy in stocks failing to make money in conditions of low volume and volatility), then the answer is to pull back risk-taking and go into research-and-development phase.  Your goal is to find strategies that can supplement your existing ones and make money in the challenging environment.  For example, you might add a "value" strategy that sells overbought conditions and buys oversold ones to the breakout strategy.  The combination of the relatively uncorrelated strategies would potentially give you a smoother profit curve, allowing you to make money across regimes.

Only over time will you be able to identify if the strategy has stopped working altogether.  If, in conditions in which you (and others with similar strategies) have made money in the past, you (and others) remain unable to prosper, a plausible hypothesis is that a more fundamental shift has occurred in markets.  You're like the company that has made money selling laptops, only now to find out that the demand is for tablets.  The market has changed.  That's why the research-and-development efforts and pulling back of risk-taking are so important when you (and others) lose money:  we never know initially whether drawdowns are temporary or reflect structural market changes.

On the other hand, if you're losing money and others are succeeding with similar strategies, then you have real evidence that the drawdowns are more about you than about the market per se.  Perhaps your implementation of the strategies needs work; perhaps your psychology is undercutting your implementation; perhaps your analysis that feeds the strategies needs supplementation.  All of those can be fruitful directions for exploration.  It's often the case that, when psychology is the culprit, you'll fail to make money when your peers in similar strategies are prospering.  Keeping a psychological journal--what's happening in markets, whether you're making or losing money in trades, your frame of mind during the day, etc--can help you identify patterns underlying your successes and your drawdowns.

Intelligence begins with asking the right questions.  Is it me, or is it markets?  We are most likely to find the cure to our trading ills if we first make the right diagnosis.

Further Reading:  Why Psychology is Central to Trading

Sunday, September 11, 2016

Five Keys to a Peak Performance Mindset

What is the right mindset for best trading?  Here are five ideas, drawn from successful traders I've known and admired:

1)  An open mindset - Traders succeed when they see things that others don't.  Sometimes those are overarching themes and trends; sometimes they are short-term patterns in market behavior.  To see things differently, we need a mind that is open to new and different information and open to shifts in market behavior.  

2)  A quiet mindset - Minds filled with noise can't process new information.  When we're focused on ourselves and our profits/losses, we're no longer focused on markets.  We can't exercise self-control in our actions if we are not able to sustain control over our thought processes.

3)  A constructive mindset - Losses happen.  We miss opportunities.  The great trader learns from mistakes and embraces the lessons from drawdowns.  If every day brings wins from trading or wins from learning, there is always something of value to be taken from each day.

4)  A positive mindset - It's because we cannot count upon our profits and losses to make us happy that we need to lead a fulfilling life outside of trading.  A life that is filled with meaningful activities, fun activities, activities that bring us close to others, and activities that give us energy is most likely to provide us with the emotional fuel needed to power through challenging market times.

5)  An action mindset - All the best ideas and intentions will get us nowhere if we aren't prepared to act upon them.  The action mindset is one focused on plans, translating excellent ideas into excellent risk/reward opportunities.  Preparation is idea-focused, but also execution-focused.  It is as important to work on our implementation of ideas as our generation of them.

The above criteria form a useful checklist for making sure you're in peak performance mode.  The right mindset won't, in itself, bring profits, but the wrong mindset can ensure losses.  At the end of the day, trading requires skill in the processing of information.  When we work on our mindset, we keep our information processing engine well-tuned.

Further Reading:  The Essence of a Trading Process

Saturday, September 10, 2016

The One Thing To Look For In Any Market

Here's an insightful post from Mike Bellafiore of SMB, summarizing a savvy trader's perspective on what you need to know to be a successful trader.  The key point is that the actions of market participants speak loudest.  When you can read the flows of buying and selling, what people say about their positions or views becomes irrelevant. 

This was especially relevant to Friday's trade in stocks, which gave us a multi standard deviation move on much higher than usual volume.  Selling pressure, as measured by upticks/downticks was continuous through the day, suggesting that those additional market participants were executing one way dominantly. 

If you came into the day lulled by recent (low) volatility or locked into pre-existing views about the market, you were unlikely to have been able to pounce on the unique flows going through Friday's trade.  As the savvy trader in Mike's post pointed out, you didn't need to know anything else.

Friday's trade was a great reminder that the time series of price changes in markets are not always stationary.  The distribution of those changes can change significantly from one time period to another.  This means that a different process is generating that series; something has materially changed in markets.  The one thing you want to look for as a trader is whether the market you're seeing today is similar to the market of the past X days (i.e., stationary with respect to), or whether it's radically different.  It's those radically different occasions that can give us trend days, as many will be caught offsides.

Markets can change quickly.  That is why adaptability is a cardinal trading virtue.

Further Reading:  Three Things to Look For in Any Market

Friday, September 09, 2016

How Fear Keeps Us From Trading Success

Two versions of fear impair traders:  the fear of losing money and the fear of missing opportunity.

Out of fear of losing money, traders will avoid buying weak markets or selling strong ones; they will stop out of long trades on weakness and exit short trades on strength.

Out of fear of missing opportunity, traders will buy markets when they're up and sell them when they're down.

Both forms of fear have negative expected return, particularly in low volatility market conditions, when moves are least likely to extend.  Of course, it's these same low volatility conditions that lead traders to lament that there are no market moves and no way to make money.

Maybe, however, low volatility conditions lead traders to want to catch breakouts and thus act on fear.  When we make new highs or lows, they're afraid of missing the (finally!!) big move.  It's the same fear of a big move that leads those traders to exit long positions on weakness and short positions on strength.

With one trader I coached a while back, we took at look at what his P/L would have looked like had he added a unit of risk every time he stopped out of a trade.  Sure enough, he would have been very profitable.  His ideas were fine.  But he managed his positions on fear, not opportunity.

As a little demonstration, I went back to the start of 2015 and constructed a measure of relative breadth.  I created an index of the percentage of SPX shares trading above their three and five-day moving averages (raw data from the excellent Index Indicators site).  I compared the index value to its average value over a lookback period and expressed the result in standard deviation units.  Thus, I could see when short-term breadth was significantly strong or weak in relative terms.  

Simply dividing the data in half based on a median split, we find that when relative breadth is strong, the next five days in SPX have averaged a loss of -.13%.  When relative breadth has been weak, the next five days in SPX have averaged a gain of +.33%.  Two people could have the same exact idea; how they execute their entries--on fear or not--makes the difference between loss and profitability.

Even under high VIX conditions for the sample, five-day returns are much better following periods of breadth weakness (+.80%) than breadth strength (+.25%).  Interestingly, high volatility and high breadth weakness represents the kind of market most people are fearful to buy.  When we've had low volatility and strong breadth, the next five days in SPX have averaged a loss of -.40%.

It's a nice illustration of how success lies at the intersection of trading psychology and market understanding.

Further Reading:  How Success Can Be Found on the Other Side of Fear

Thursday, September 08, 2016

Three Techniques for Building Positive Trading Patterns

In the last post, we took a look at negative patterns that impact trading and how we can disrupt them and gain greater control over decision making.  But what are some ways of building positive patterns for ourselves?  When I assembled a cookbook of time-tested self-help strategies for traders, three approaches stood out:

*  Behavioral - Here we teach ourselves strategies to enhance our focus and to slow ourselves down physically.  Meditation can be very helpful for this, as can relaxation exercises, especially when paired with biofeedback.  The idea is that we learn to sustain states of mind and body that are incompatible with the fight-or-flight responses of stress.  When we slow down our bodies and focus our minds, it is very difficult to overreact to situations and make impulsive decisions.  In the calm, focused state, it's also easiest to view our situations from a different perspective, as in the cognitive approach below.  An advanced behavioral method is exposure therapy, in which we expose ourselves to stressful situations (either in real life or through vivid imagery) while sustaining our calm, focused state.  This helps to literally reprogram our emotional responses to situations, which is very helpful in dealing with performance-related stresses.  

*  Cognitive - As the Aurelius quote above illustrates, the cognitive perspective on stress is that it is our interpretations of events--and not the events themselves--that turn normal trading stress into the kind of distress that could impair our decision-making.  In cognitive work, we use journaling and other methods to become better observers of the habitual thought patterns that can interfere with sound performance.  Some of us have learned perfectionistic ways of thinking; others have learned worry patterns or overconfident ways of processing information.  When we use a journal (or meetings with a coach) to think about our thinking and actively challenge non-constructive thought, we unlearn those distorted ways of viewing situations and can learn to replace them with more helpful self-talk.  Cognitive exercises can also be used for brain-training:  developing greater resources for willpower and purposeful behavior.

*  Solution-Focused - In behavioral and cognitive methods, we learn to change negative patterns that interfere with trading.  Solution-focused methods come at self-development from the opposite angle:  identifying occasions in which we are *not* experiencing problems and looking to those occasions for what we're doing right.  Often, when we're performing at our best, it's because we're drawing upon our best practices and our greatest strengths.  What are we doing when we're managing risk well, following plans effectively, adapting to market changes, and generating great trading ideas?  In reverse engineering our successes, we can often find the solutions to the problems that impact our current trading.

Of course, these three approaches can be integrated very easily.  For instance, we can mentally rehearse our best practices (solution-focus) in our calm, focused state (behavioral) and then imagine ourselves using those best practices in challenging trading situations (cognitive).  That would help turn those best practices into our best routines.  There is so much more to trading psychology than writing in a journal and telling ourselves to be more disciplined or more attentive to our gut.  It is through behavioral, cognitive, and solution-focused methods that we can truly become our own trading coaches.

Further Reading:  Every Great Trader is a Player-Coach

Wednesday, September 07, 2016

How to Break Negative Trading Patterns

Our psychology interferes with our trading when patterns we have learned--and overlearned--are triggered by events and play themselves out without our full awareness.  These can be behavior patterns, patterns of thinking, emotional patterns, or--as is often the case--an amalgam of all of these.  Very often, the triggering of these patterns is state-dependent and situation-dependent.  Most of the time, we exercise a reasonable degree of free will.  It's under conditions of frustration, loss, fear, or greed that we find ourselves behaving in ways that are contrary to all our plans and best intentions.

The first step in changing any pattern is becoming a good self-observer and recognizing when the pattern is starting to play itself out.  Often, we can become aware of common triggers to our patterns, so that we can respond more mindfully to challenging situations.  For example, if I recognize that certain topics tend to lead to arguments at home, I can quickly recognize myself become tense when one of those topics is raised and take a short break.  It's when we can observe patterns beginning to unfold that we become able to short-circuit the process and interrupt the negative cycles.

This is why keeping a psychological journal can be very useful in making changes.  We can use the journal as a tool for self-observation, writing in real time what is happening, how we're feeling, and how we'd like to respond.  It's at those times we can remind ourselves of the consequences of the negative pattern and the benefits of responding more constructively.  Such a journal becomes a mindfulness tool.

Here are common patterns impacting traders:

*  Negative thought patterns--worry and self blame--following losses;
*  Overtrading out of frustration following losses;
*  Becoming paralyzed and unable to act on opportunity out of fear of loss;
*  Becoming overconfident and overtrading after wins;
*  Procrastination and failure to prepare properly for the day;
*  Trading too small due to lack of confidence;
*  Trading impulsively out of a lack of patience.

The common element among these patterns is that emotional, physical, and cognitive states lead to suboptimal decision-making.  It's when we can recognize these patterns in real time that we can interrupt them, shift our states, and return to best trading practices.  In becoming observers of our patterns, we distance ourselves from them, and gain potential control over them.  Good psychological trading is staying fully conscious and self-aware, even during challenging situations.

Further Reading:  Core Ideas in Trading Psychology