Tuesday, November 13, 2018

How Overconfidence Derails Our Trading

Here's an observation I've made of both traders and investors--those with little experience and those who have been doing this all their lives:

They are at their best when they treat their ideas as hypotheses and continually update their hypotheses as price action, news, and fundamental data emerge.  Their focus is on what they would need to see to disconfirm their hypotheses.  That allows them to exit quickly and limit risk in adverse conditions.  It also enables them to take the opposite side of a trade should they observe a meaningful disconfirmation of their ideas.

The traders are at their worst when they treat their ideas as conclusions and dig in their heels in these views in the name of "conviction".  This leads them to interpret market information with confirmation bias, looking at data that support their views and minimizing information that might not support their ideas.  Such an approach leads to a loss of flexibility and a situation where the only effective stop level is pain.

One way we turn confidence into overconfidence is by crystallizing our observations into narratives.  Among portfolio managers trading global markets and strategies, this is sometimes pejoratively referred to as "macro story telling."  The trader observes information--perhaps fundamental, perhaps monetary, perhaps intermarket, perhaps price-action based--and turns these observations into a narrative.  "Stocks are going higher because economic conditions are improving and sentiment is bearish."  That could be a simple narrative.  It is not a tested set of relationships, and it is not treated as a hypothesis.  It is a conclusion drawn from limited pieces of information.

It's surprising how often traders with bullish or bearish biases can find information to weave into bullish or bearish narratives!  

Once the narrative has crystallized, it organizes our perception.  We see the world through the lenses of our narratives.  That makes us less sensitive to other, possibly more relevant lenses and information.  Seeing the world through our story-telling--and then justifying that in the name of confidence--is the height of overconfidence.  What we want instead are multiple hypotheses, each with shifting odds as information comes out.  At some point, the odds shift sufficiently that we can put on a trade.  But we are always updating those odds, and we are always aware of what would lead us to reverse that trade.

A great exercise is tracking your self-talk during the course of a trade.  Is your internal dialogue information-based, or are you grounded in a single narrative?  Are you flexibly assessing odds and possibilities, or are you looking for information to support your fixed view?  Or are you so self-focused and P/L focused during the trade that you never get the chance to update your thinking?  That often occurs when our "conviction" views suddenly prove vulnerable.

This is one of the great ironies of trading:  It takes unusual confidence to believe that we can outperform the world's most experienced money managers.  Taken too far, however, that confidence can ensure our failure.

Further Reading:  


Sunday, November 11, 2018

The Role Of Creative Insight In Trading Success

In the Trading Psychology 2.0 book, I outline several new frontiers for improving trading performance.  One of the most interesting and promising is the enhancement of creativity.  Simply put, the success of traders and investors rests on their ability to perceive unique, distinctive market opportunities that are not apparent to others.  For the faster, shorter-term trader, this means detecting patterns in price action that reflect shifts in supply and demand.  For the slower, deeper-thinking investor, it means piecing together information about companies and economies and arriving at original theses that ultimately will drive the behavior of other market participants.

Having worked with very successful market participants who operate in both the faster and slower modes, I can attest to the role of creative insight in the trading process.  This not only pertains to the generation of ideas, but also their management.  During the life of a trade there are many decisions to add to positions, take them off, or hold them.  For the discretionary trader, all of these decisions are more or less informed by creative insight. 

Here are a few ideas relevant to the role of creative insight in trading success:

1)  Few trading processes--from market preparation to research/idea generation to risk management--are designed to maximize the creativity of the trader.  Indeed, common trading behaviors, such as discussions on trading floors and ongoing following of price action on our screens, actively interfere with creative outcomes.  When traders talk about "process", they often mean the repetition of helpful practices.  This is valuable, but the following of routines via habit patterns, will not in itself maximize the creativity of a trader's thought process and, indeed, may work against it.

2)  Maximizing creative thought requires an unusual degree of flexibility.  What we know about creativity suggests that multiple brain centers are at work in processing information, reflecting multiple cognitive processes.  Processing multiple, different sources of meaningful information and processing all that in different cognitive modes (analytical, reflective, etc.) aids the insight process.  Sitting in one place and staying in one dominant mode of analysis/thought is a great way to stifle creativity.

3)  Creativity is never maximized in our normal, routine states of consciousness.  Research into creativity suggests that a variety of moods and levels of cognitive focus/awareness impact creative thought.  There is a very strong case to be made that many of the commonly noted psychological problems experienced by traders--from performance anxiety and overtrading to frustration and lack of discipline--stem from states that actively inhibit creative thought. 

In short, a major problem with trading performance is that traders focus on what they perceive to be their "edge" in markets when in fact "edge" is the result of a process, not a static set of market relationships.  Where there is no creativity, there can be no edge.  Reducing "edge" to a rote series of patterns virtually ensures that the trader will fail when market regimes change.  It is the ongoing creative process that fuels our adaptation to evolving market conditions. 

The implications of this perspective are profound.  The most useful self-coaching traders can do is reverse-engineering their best trades and especially the processes that led to the relevant decisions.  A solution-focused perspective suggests that all experienced, reasonably successful traders already are tapping into creativity at various points in the trading process.  The key is distilling *your* ingredients of creative insight and turning those into robust routines that can provide you with an actual, ongoing edge.

Further Reading:


Thursday, November 08, 2018

Strategies For Overcoming The Big Losing Days

It's not uncommon to find traders who make money more often than they lose it, only to wind up with negative P/L due to the presence of a relatively small percentage of big losing trades.  Bella of SMB recently wrote a post on five ideas of how to minimize the damage on your worst trading days.  These same principles apply to longer time frame managers, who can see many portfolio gains erased by a single outsized loss in one position.  Let's see if we can build upon Bella's insights and figure out ways of overcoming large losing days.

1)  Risk Management - I'm convinced that one of the great advantages of trading at a hedge fund, prop firm, etc. is the presence of external risk management.  A good risk manager will not only hold you to loss limits, but can catch you in the process of losing too much.  Even better, a risk manager can play a proactive role by letting you know when you might be vulnerable, perhaps by holding multiple correlated positions or by holding a large position going into a major news event.  As I've mentioned in the past, no baseball pitcher is expected to take himself off the mound.  That is the job of the pitching coach.  Sometimes it's not your day, but that can be tough to recognize in the heat of battle.  The risk manager is your pitching coach.

So what do you do if you don't have a dedicated risk manager?

Substituting for the risk manager, as Bella notes, are hard and fast rules for how much you can lose in a single position; how much you can lose in a day/week/month; how much you can lose across positions.  It is important to make these rules explicit--written down and in front of you--and it is important to size all positions so that, if they are stopped out, they will not exceed the limits you set.

For portfolio managers, that means knowing your risk per position and acceptable risk across the portfolio.  For day traders, it means knowing your risk per trade as well as your risk per day.  For active day traders, I like the idea of having separate risk limits for the morning trade and then again for the afternoon, effectively breaking the day into two trading days.  For active portfolio managers, I like having risk limits for each month or quarter.  

The idea is to never lose so much in one period that you can't come back in the next one.

2)  Psychological Management - The big losing days are typically the result of snowballing.  One loss leads to another leads to frustration leads to imprudent trading.  Or, overconfidence and directional bias leads to oversizing trades, which leads to vulnerability and frustration.  At such points, the problem is not just the shift of mindset, but the lack of awareness of this shift.

Look, we expect competitive people to not like losing, to have periods of frustration.  And, for all of us, the ego can sometimes get in the way of doing the right things.  We are fallible; that we can't control.  What we can do is become better and better at *recognizing* our fallibility.  This is why preparation before we begin trading is so important, allowing us to identify in advance what would tell us our positions are the wrong ones.  On my trading screens, overlaid on charts are various indicators, including short-term RSI, moving averages, regression lines, etc.  Do I think those are predictive?  Not really.  They are there because, if I'm trading directionally, those weather vanes should be pointed in my direction.  If we dip below a key moving average while I'm long, I want to mentally rehearse my stop scenario.  The idea is to anticipate loss and cement in your mind what you'll do about that loss.

Why is that effective?  It is difficult to become frustrated about an outcome you've rehearsed many times.  It's difficult to go on tilt and trade poorly if you've clearly laid out your plans for a losing position.  This is why, when a position is on, I want to rehearse my exits in detail.  I want to know where to take profits, where to get out.  That becomes a kind of mantra while the trade is unfolding.

I generally find that, if I start the day flexible and open-minded, rehearsing a variety of trading scenarios, I don't get too caught up in any one idea.  Excitement is just as much of a risk factor as pessimism and negativity.  I recently went in for routine surgery.  The surgeon was all business, clearly planning out the procedure with the team.  Do I want a surgeon who is excited about the procedure?  Do I want a surgeon who is full of "conviction" over his plan for the procedure?  Hell no.  As it turns out, the surgery discovered a couple of unexpected growths--fortunately nothing dangerous--that needed to be removed.  That's why they call it exploratory surgery.  All trading should be exploratory trading.

If you have firm risk limits and a process that keeps you aware of your thought processes and the unfolding of your trades, you'll have plenty of losses--but none that have to be debilitating to you or your account!

Further Reading:


Sunday, November 04, 2018

Becoming a Baby Bear: How We Can Do A Better Job Of Reaching Our Goals

As this video of a baby bear from @ziyatong graphically depicts, there is a lot to be said for motivation as a path toward our goals.  When the situation is urgent and the endpoint remains in front of us, we can summon great drive to achieve the seemingly impossible, just like that baby bear.

The problem is that situations are not always *so* urgent and goals are not always so clearly visible.  We make resolutions and goals in one state of mind only to find that urgency waning when our attention is taken elsewhere.  That is why motivation is necessary to reach challenging goals, but not sufficient.  

In the latest Forbes article, I outline two key factors that help us reach our goals.  In that article, I link excellent research resources that highlight ways in which we can move from the daily leading of our lives to becoming actual leaders of our lives.

A key, per Zig Ziglar's quote above, is turning motivation into a habit.  That is, we create routines--processes--for tapping into the values and visions that animate our lives.  This is why a religious person will start their day with prayer.  The morning prayer, at one level, is a habit.  At another level, it is a way of connecting with what is meaningful and motivating.

When we have habits that tap into motivation, suddenly our goals become urgent and visible--and we can be like that baby bear.  It's not enough to wake up our bodies in the morning; we also have to awaken spirit.  Without the habit of motivation, goals become little more than wishes...entries in our trading journals that show good intentions, but little more.

What is *your* process for becoming a baby bear?

Further Reading:


Friday, November 02, 2018

Finding Resources That Make Your Trading Better

An insightful market old-timer explained to me early in my trading career that technical indicators were more like weather vanes than weather forecasts.  In other words, they tell us how the wind is blowing; they don't necessarily tell us what the weather will be.  That doesn't diminish the value of a weather vane.  If we're flying a kite or sailing a boat, the weather vane is quite relevant!

As with sailing, traders make an implicit assumption:  the environment that has characterized the recent past will continue into the immediate future.  This is true whether we are anticipating trend continuation or the continuation of cycles/reversals.  Tools that provide unique information regarding recent regimes are useful weather vanes for guiding trades going forward.

At the recent Trade Ideas conference in San Diego, I was impressed with the VWAP tools introduced by Brian Shannon of Alphatrends.  Volume-weighted average price (VWAP) is a way of tracking the behavior a market or stock by placing the greatest weight on the prices that transact the greatest volume.  It's a true weather vane, telling us if we are staying consistently above or below VWAP or if we are cycling around an average price.  It also tells us if that average price is rising or falling--and if the rate of rising/falling (slope) is changing.  

Brian makes creative use of VWAP in two ways:

*  By anchoring the calculation of VWAP to key price levels, such as points of breakout or points of earnings releases (see here).  

*  By looking at VWAP at multiple time frames, to identify degree of convergence and divergence among the VWAP values (see here). 

If we think of it, the convergence of VWAPs across time frames is a nice way of visualizing the volatility of a market and anticipating possible breakouts.  The anchoring of VWAP tells us if a key level is truly acting as a key level:  for example, if a gap higher is truly leading to a trend.

The larger idea here is to continually grow your trading resources.  Physicians engage in continuing education; they keep up with new ideas and techniques.  Similarly, it's not enough for us to learn as beginning traders: we must continually learn and relearn to adapt to an ever-changing market landscape.

Further Reading: