Friday, January 19, 2018

When Trading Psychology Is NOT The Problem

I recently spoke with an active trader of the S&P 500 Index market who had been experiencing difficulty in his trading.  He had sought coaching and the coach worked with him on mindfulness strategies to help him tune out market and emotional noise and more clearly implement his ideas.  The trader felt he made good strides in gaining self-awareness, but his profitability still wasn't there.

As part of our conversation, I had the trader present me with his metrics.  We took a look at his number of winning and losing trades and the average sizes of these.  We examined the P/L specific to his long trades and short trades, and we examined profitability as a function of holding period and time of day.  Finally, I took a look at serial correlations in his daily profitability: whether there were distinct patterns of winning/losing periods being followed by winning/losing periods.

Nothing uncovers trading problems better than a hard look at trading metrics.  

Well, it turns out that two metrics stood out:  the average size of losing trades was greater than winners and most the losing trades were on the short side.  Surprise, surprise.

So I walked the trader through a little exercise.  I explained that it only made sense to look for patterns to trade if you were operating in a stable market regime.  That is, if recent market history is unstable, with widely varying means and standard deviations of price changes, then there is no basis for using the past to guide the future.  On the other hand, if you have a stable regime, it's possible that patterns occur during that period that can guide trading decisions in the near future.

I showed the trader how there has indeed been a stable regime since September of 2017 and I illustrated how several variables displayed short-term trading promise in that regime, including the percent of stocks trading above their short-term moving averages and VIX.  When these variables lined up, the next two days in SPY averaged a nice gain of +.41%.  All other occasions displayed an average price change of +.21%.

Wait a minute, I noted!  When the variables line up, you get better near-term returns.  When the variables don't line up, you still have had positive returns during this regime.  In other words, the linear (trend) component of the regime is so strong that the indicators provide some upside  advantage on the short term, but no downside advantage.  In a more cyclical regime, we would see the indicators anticipate both positive *and* negative returns.

Bottom line, I explained, is that, even trading the best indicators I can find, I can't objectively identify any sell signals.  Going short only makes sense if you assume you have a crystal ball and can figure out to the day when the regime will shift.  That has not been a good bet for the trader.

The big takeaway is that if the patterns you're trading don't fit the patterns existing in the marketplace, you are not going to make money.  All the emotional awareness, discipline, mindfulness, and motivation in the world won't make a losing strategy win.  We are much too quick to assume that trading problems are psychological in nature and much too slow to truly drill down into the metrics and the markets and see if our strategies make sense.

Imposing your trading "style" on markets regardless of regime can be hazardous to your wealth.  Assuming that all you need to do to make money is double down on your "style" and work on your mindset only compounds the problem.  Sometimes markets are not stable; sometimes markets are stable, but display no predictive patterns within their regime.  Does it really make sense to actively trade during those occasions?  A passion for markets is best channeled through a clarity of vision.