I'm currently working on creating better indicators of stock market sentiment. Above is a five-day moving average of the equity put/call ratio: the ratio of put volume traded for all listed individual stocks divided by their call volume (no index volume included; raw data from e-Signal). You can see that spikes in the ratio have corresponded pretty well with buying opportunities in the past year.
Of course, the put/call ratio is influenced by price change. In fact, the correlation between the percentage of stocks trading above their five-day moving averages and the five day equity put/call ratio is less than -.56. In other words, when markets have been strong over the short term, there has tended to be call buying relative to put buying and vice versa. Perhaps the most important takeaway here is that sentiment in stocks has been very fickle with traders/investors shifting over surprisingly short time horizons. Looking at 2014 to the present based on a simple median split, if you bought the SPX when the proportion of stocks that closed above their five-day moving averages was high, the next five days averaged a gain of +.14%. If you bought when the proportion of stocks above their five-day averages was low, the next five days averaged a gain of +.38%. If you bought when the five-day equity put/call ratio was in the top half of the distribution, the next five days averaged a gain of +.44%. If you bought when the ratio was low, the next five days averaged a gain of only .08% In short, over the past year, short term weakness has led to relative bearishness and superior short term returns. Short term strength has led to relative bullishness and inferior short term returns. Teasing apart sentiment and concurrent price change could provide a purer view on sentiment that might inform short-term trading decisions and the execution of longer-term positions. Further Reading: Stock Market Sentiment
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A little while ago, I met with some traders and asked them to bring in everything they had prepared for the new year of trading. All of them brought a list of goals for the new year. Most of them brought lists of what they had done right and wrong during the previous year. None of them laid out concrete plans that detailed how they would take the learning from the previous year and use it to work toward their new year's goals. In other words, they took the time to set goals, but didn't drill down to create plans for achieving those goals. How likely do you think they were to achieve their ideals for the new year? Yet all of them felt that they were working on their trading. Today's best practice comes from an experienced observer of both markets and traders, Tadas Viskanta, author of the well-known Abnormal Returns blog. In this excerpt from his Abnormal Returns book, he emphasizes the importance of planning in trading and highlights the use of checklists in the planning process:
"One of the problems novice traders have is that they don't treat their trading with the same rigor and seriousness that they do with any other sort of business endeavor. However, trading is just like any other business in that it has revenues, overhead, variable expenses, etc. Trying to trade off the cuff without a plan or a means for measuring your performance is a recipe for disappointment. Many traders balk at the idea of formulating a trading plan because they feel it might stifle their creativity or ability to react to rapidly changing market conditions. As well, in the wider world of startups, the detailed business plan seems to have gone into disfavor. In the world of trading, it never really seemed to catch fire. However, traders are well served to think about how they plan to go about generating profits. A trading plan that lays out the instruments they will trade, when they will trade them, and the methodology they will use to enter and exit trades is essential. Maybe even more important is a strategy to limit losses both on individual trades and in an overall portfolio. And as important as an overall trading plan might be, a trade-by-trade plan might be even more important. Some traders find it useful to have a checklist they consult on an ongoing basis when they trade to ensure they are not missing anything along the way. As Atul Gawande, author of The Checklist Manifesto, writes: 'In aviation, everyone wants to land safely. In the money business, everyone looks for an edge. If someone is doing well, people pounce like starved hyenas to find out how. Almost every idea for making slightly more money--investing in internet companies, buying tranches of sliced up mortgages--gets sucked up by the giant maw almost instantly. Every idea, that is, except one: checklists.' Checklists don't dictate what a trader does; rather they ensure that what a trader is supposed to do actually gets done. The hallmark of a well-designed trading system may be the actuality that a checklist can be created. The more experienced and successful the trader, the simpler his or her trading system becomes over time...Experienced traders have spent a lifetime whittling down ideas into a plan that works for them--and maybe nobody else."
Tadas makes a key point here: You don't have a robust trading process unless it can be captured via checklists--and you can't truly claim to be process-driven if you have not codified those checklists and used them to guide decision making. Airline pilots check all systems before taking off and follow a well laid out flight plan. Physicians check their patients' systems before developing and following an evidence-based treatment plan. In both cases, winging it with unstructured decisions would lead to catastrophic consequences. The best trading plans are grounded in best trading practices--and those become a template for best performance. Further Reading: A Psychological Checklist for Traders
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One of the best ways to ensure a sound trading routine during the day is to construct a sound routine during the morning. How we start our day so often sets the tone for that day. That means we can either start the day focused or distracted; disciplined or lax; prepared or unprepared. I have long maintained that one of the best ways of identifying successful traders is to observe what they are doing when they're not trading. Today's best practice comes from Steve Spencer of SMB Trading, and it involves establishing a productive morning routine: one that prepares both the trader and the trading: "I have a routine that begins from the moment I walk into the office each morning. It is designed to both have me focused and prepared to trade the US equities market open at 9:30 AM. It has evolved over the past few years as my responsibilities have broadened outside of my own personal trading to include preparing the desk for the day and dealing with non trading matters as well. Here is the current list of things I do each morning after arriving at the office: 1) Fill up my water jug (hydration is one of the keys to mental alertness) 2) Restart computer 3) Open Gr8Trade (proprietary equities platform) 4) Open LiveVol (options platform); if any options trade ideas, open related Level II boxes 5) Open eSignal (external charting software) 6) Login to SMB RT (proprietary trading tools) 6a) Open game plan (form used to enter my trading ideas) 6b) Fill in 2nd day and technical plays (ideas based on prior research and preparation) 7) Enter alerts for 2nd day plays into Gr8Trade (pop up alerts if stock trades at key prices) 8) Open SMB Scanner (research tool for finding stocks in play) 9) Complete game play sheet with Stocks in Play ideas 10) Enter top trading ideas into journal (important for later review process) 11) Ideas must include entries/stops/targets/risk amount 12) Options ideas are entered in margin at the top of the page 13) Conduct AM meeting (discuss market and top trading ideas for the day) 14) Enter orders for Stocks in Play ideas discussed at AM meeting; input ideas into auto scripts to assist entries if market busy on open The following items help bring me back into focus for the market open: 15) Two minutes of breathing exercises 16) Put on RT microphone (audio feed for desk and SMB community) 17) Discuss top trading ideas and plan via audio 18) Share any stocks/important levels from the chat that are interesting So that is my entire morning routine. The thing that has changed the most recently is my ability to enter various scripts that will allow me to trade a variety of trading setups during busy market times that I otherwise might have missed. I find that in today's market, if you miss certain entries right at the open, it can impact your risk taking for the rest of the day. The scripts are also a great tool to support me on days where other responsibilities pull me off the desk." Notice how Steve's morning routine accomplishes two purposes. First, it organizes his day and decision making. He identifies and prioritizes opportunities during his preparation and thus is able to act quickly and decisively when trades actually set up. Second, the routine enables Steve to process an unusually large amount of information in a concentrated period of time. Note his use of custom tools for much of his preparation. These enable him to screen for opportunities and program them for action (via scripts and alerts). Finally, observe that Steve's routine is a combination of individual information processing and processing in a group. His preparation enables him to bring ideas to other traders, but also sets up conversations that bring him ideas. Over the course of a single day, Steve is simply encountering more trading opportunities than most traders--and that makes it more likely that he can focus on the best ones and maximize his results. Further Reading: Simple vs. Simplistic Decision Making in Trading
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* Note that the number of NYSE stocks closing above their upper Bollinger Bands vs. below their lower bands has stayed largely positive since the mid January lows. (Raw data from StockCharts). Typically rallies are imperiled not just when we see a reduction in strength (fewer shares closing above their upper bands), but when we see emerging leaders to the downside displaying actual weakness (closing below their lower bands). To this point, we've seen less strength, but not outright weakness. This is one important reason why I view divergences as necessary for market reversals, but not sufficient.
* Your answers to these three questions will tell a lot about whether you are operating in peak cognitive and emotional condition in your trading. Just because you're not operating in a negative state doesn't mean that you're truly functioning at your peak. * A wealth of views on the Apple iCar and much more from Abnormal Returns.
Victor Niederhoffer recently posted on the topic of "What is a Trader?" and then announced a contest for the best short essay on that topic. The winner will receive $1500 and, if my experience with a Niederhoffer contest many years ago holds true, something much more valuable. It was my winning of Niederhoffer and Kenner's contest on finding the best stock market indicator that led to a visit to Victor's trading operation and opened the door to a whole new way to view markets. (That winning indicator was a correlation of the average beats per minute of popular music and the level of the Dow Jones Industrial Average).
As the quote above captures, there is an entrepreneurial and competitive essence to trading. (Props to Henri and the Best Trading Tweets site for the card.) Many are drawn to trading because of its independent nature: you rely on your judgment, you work for yourself, and your rewards are a direct expression of your talents and skills. It is in that spirit that I offer the following perspective on "What is a Trader": I would define a trader as
"an intellectual entrepreneur: one who generates ideas and manages their
risk and reward within a competitive financial marketplace." This is
why the term "speculator" is an accurate one. The derivation of "speculator"
is from the Latin meaning "contemplation, observation" and by the mid
15th century came to mean "pursuit of the truth by means of thinking".
Ayn Rand regarded the trader as an ideal, as one who offers value for
value, rather than living off the efforts of others. The trader also
represents Rand's ideal of man as a thinking animal: one who relies on
his/her perception in pursuit of the truth and is willing to accept the
risks of that reliance to achieve superior returns. At its best, trading is an exercise in what makes us distinctively human: the ability to perceive reality and plan and execute our actions based upon that perception. Trading is not about making money, though that is a desired outcome; trading is also not about technical patterns or fundamental relationships. At its root, trading is entrepreneurship of the mind, one of the purest forms of intellectual competition in some of the most competitive global arenas. Further Reading: Trading as Entrepreneurship
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When I first tried my hand at developing quantitative models of markets, I was impressed by the predictive power I could gain by adding more predictors to my equations. Of course, that worked just fine on an in-sample basis, but completely fell apart when applied out-of-sample and especially in real time. Why? Because the complicated equations were custom fit to the historical data and thus not well suited to adapt to new data. That overfitting created a false sense of security. The equations with fewer, but powerful predictors were almost always the most robust--most able to provide predictive value going forward. They were simple in their sophistication. Today's best practice comes from a long time mentor of traders, Charles Kirk. He follows markets daily via The Kirk Report and conducts mentorship programs for groups of subscribers. Charles describes his best practice as "elimination", and his insight fits well with my early quant experience:
"Over 20 years I studied about every possible thing you can imagine about trading and investing. I accumulated so much knowledge, but eventually realized that the path toward greater profits and success was figuring out what to eliminate so I could focus on the things that really helped me when I was trading at my very best. All of us go through a period where we add more factors in our strategy. More things to watch, more indicators to use, more screens to run, more backtesting research to review, more people to listen to, and so on. The problem with doing that is that once you've been doing it for a while, the complexity itself becomes a huge distraction. Much of trading well is figuring out what things truly add value and which are actionable and then having the courage to eliminate everything else. There is a lot of noise and unhelpful factors out there that may be very interesting, but in reality are not helpful and often can present yet another obstacle for you to overcome.
Once you understand the steps you must take and information you need that leads you most often to successful trades, the next step is to eliminate everything you can that isn't absolutely necessary. In addition, once you have a strategy that works, as a rule you never add anything else into it unless you can at the same time take something away. That rule will prevent you from making things far more complicated than they need to be and allow you to focus on what truly matters. The best practice of all, in my view, is one of elimination."
Charles offers a great piece of insight when he points out that it takes courage to eliminate the nonessentials. In other words, you have to have confidence in the few, essential components of your success to lean on those exclusively. Too often, when we seek the crutches of things to add to our strategies, it's because we lack confidence in those strategies. Stripping down our performance to bare essentials forces us to commit--and then to put our money on that commitment.
The same wisdom holds true for how we present ourselves in public. If we are comfortable with who we are, we can present ourselves as we are--simply and straightforwardly. If we are not comfortable with who we are, we will add layers to our social presentation to try to appeal to anyone and everyone. We might adopt clothing or attitudes that aren't truly ours, or we may try to adapt our presentation to the social setting of the moment. In each case, adding layers of complexity is a confession of low self-confidence and low self-acceptance.
When we trade who we are, we reinforce who we are; we don't undercut it. And, as Kirk wisely observes, that's a great reinforcer of confidence.
There is a close relationship between the volume traded in the stock market on a given day and the volatility of price movement during that day. Since the start of 2014, for example, the volume in the SPY ETF has correlated .87 with the true range for that day. When we trade more volume, it means that there is more speculative, directional participation in the market--and that tends to move prices. Savvy day traders realize that and will gravitate to stocks trading on elevated volume for the day, as these provide the greatest profit potential. The relationship between volume and volatility, however, is not a simple, linear one--and this creates challenges for traders. Here 's a simple example: During the last three trading days, SPY has averaged volume of roughly 72 million shares. The average true range during that period has been less than half a percent or roughly 1 SPY point. At the end of January, volume over a three day period averaged over 170 million shares. The average true range during that period was about 1.8 percent or over 3 SPY points. Volatility picked up by more than you would have expected as a linear function of volume.
The chart above of "pure volatility" represents the amount of volatility we obtain from a given unit of volume in the ES futures. Note that, at present, the same amount of volume is giving us one quarter of the movement as it did when we made a low in mid January. Not only do we see volume changing over time; as market cycles mature, the amount of movement provided by volatility changes.
The bottom line for the current market is that we are seeing less volume *and* each unit of volume is giving us less movement than earlier this year. That drying up of movement means that we can expect significantly less follow through on market moves than we might normally expect. That has huge implications for trade management: the sizing of positions, placement of stops, and establishment of price targets. It also has meaningful implications for trading psychology, as the lack of movement makes it easy to overtrade the market in the effort to get something going.
What that means in practice is that it's important to anticipate the amount of participation and movement in the market during your trade and factor that into your planning. Less volume means that the proportion of directional participants to market makers is reduced. That makes for a different kind of movement, with reduced momentum/increased choppiness in the short term. One of the most common trading mistakes I see is that traders do not make proper trading or psychological adjustments to shifts in volatility regimes.
Who are we as traders? The reality is that we fill many roles and engage in a variety of activities. It's rare to find traders who work diligently on becoming better traders. It's even more rare to see traders break down what they do into components and work on bettering themselves in every one of those. Today's best practice comes from Pier Luigi Pellegrino from Paris, France. He breaks down trading into four basic areas and then breaks down each of those into two sub domains and each of those into three specific performance elements. This creates a catalog of 24 performance functions of trading. Pier explains, "The daily trading routine is focused on a structured and regular implementation of the...24 performance elements." Here is Pier's breakdown: 1. Vision (The Fund Manager) INNER DRIVE 1). Focused Vision - create regularly the images of the financial goal to achieve 2) Intensity of Purpose - feel with intensity the will to succeed and the expectation to win 3) Intrinsic Motivation - being driven from within to reach high standards of performance ELITE MASTERY 4) Self Efficacy - act with self confidence and self efficacy and belief in winning 5) Rage to Mastery - sustain the conviction of being an elite performer driven to reach mastery 6) Implicit Action - execute the trading strategy by accessing implicit and intuitive knowledge 2. Strategy (The Portfolio Manager) PATTERN RECOGNITION 7) Portfolio Ranking - scan, select, and rank the best trend stocks with the proprietary screening tool 8) Pattern Monitoring - monitor price action and pattern development among the filtered stocks 9) Setup Recognition - detect playbook setups through implicit pattern recognition MONEY MANAGEMENT 10) Risk Analysis - perform due diligence and risk analysis of potential trades 11) Capital Allocation - determine the capital allocated to the trade (shares and stop level) 12) Trading Frequency - trade only the best setups with the greatest opportunity 3. Execution (The Head Trader) CONSISTENT ROUTINE 13) Mental Toughness - develop a strong and competitive mindset 14) Rituals - replicate consistently a structured and coherent daily routine 15) Zone State - enter on demand a zone state of focus and concentration during trading FLAWLESS EXECUTION 16) Trade Implementation - execute the trade flawlessly with clarity and intuition 17) Order Management - utilize adaptive exit tactic with trailing stops and profit targets 18) Performance Niche - focus relentlessly on your strategy and discard other methods 4. Feedback (The Performance Coach) DELIBERATE PRACTICE 19) Performance Training - train key performance skills with structured deliberate practice 20) Mental Rehearsal - isolate, rehearse, and integrate critical skills and optimal behaviors 21) Laboring Instinct - develop a mindset of continuous improvement and skill refinement PERFORMANCE ENHANCEMENT 22) Continuous Debriefing - Debrief, monitor, and measure performance 23) Performance Diagnosis - Detect factors limiting performance and enhancing success 24) Feedback Implementation - Correct weaknesses and repeat winning actions Now your breakdown of trading process might look different from Pier's (mine would be heavier on research processes and--ironically--less geared toward sustaining positive mindset), but the principle still holds: dividing trading into component actions enables you to look under the performance hood and observe what you're doing well and what could stand improvement. Indeed, a breakdown such as Pier's 24 performance functions could anchor an effective end of day or end of week report card that could anchor goal setting the next day or week. That would be a best practice that embraces best practices! Further Reading: The Rage to Master
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Too many traders justify poor trading and overtrading by appealing to "intuition". There's no question that intuition and implicit learning are cornerstones of pattern recognition. That doesn't mean, however, that any trade one feels like putting on is a good trade! Intuition is the result of extensive exposure to a field. Without prolonged immersion and study, there is no building of pattern recognition skills. An effective way of ensuring that your trading truly represents sound trading is to construct a framework for your good trades that captures their essential elements. Today's best practice comes from reader Awais Bokhari, the co-founder and CEO of the OpenTrader training program and the eminiplayer trading site. Awais has been involved in training over 1000 traders, so he has worthwhile insights into the building of trading skills. He describes the trading framework he employs to aid execution and screen for valid trade ideas: "After working with numerous traders, one common challenge I've noticed is that even after they have developed a solid understanding of the market and its mechanics, they still struggle with trade execution, and can't objectively determine the quality of a trade setup in real time. So, even after they've developed a good trade plan, they're unable to execute that plan in real time. To improve execution, I provide our students with an Execution Framework and teach them The Anatomy of a Valid Trade Idea. The concept here is to break down the trading methodology/strategy and determine the common components that are at the base of every good setup. We then track those components in a trade journal/spreadsheet with simple Yes/No values. It's important that we're able to measure and track each component objectively. This means we can't include or track anything that relies on intuition. For our discretionary trading methodology, we follow four key components that make up a valid trade idea: 1. Good Trade Location: For a majority of trade setups, trade location is going to be important. In many situations, trade location alone can be enough of a reason to enter a trade. To make this an objective determination, you simply answer whether you took the trade at a predetermined support/resistance zone. 2. Intraday Control/Bias (short term directional bias): We can assess which side is in control on the day time frame by seeing where the market is trading in relation to the first hour high/low, midpoint, VWAP, VPOC (volume point of control), overnight high/low, and previous day's high/low. Trades in the direction of the intraday control have a higher probability of reaching their profit targets. When entering a trade that is counter to the intraday control, you should be more conservative with your trade location. 3. Momentum: We gauge momentum by monitoring the NYSE TICK in conjunction with price action. Trades in the direction of momentum have a higher probability of reaching their profit targets. When entering a trade that is counter to momentum, you should generally be more conservative with your trade location. 4. Larger Time Frame Control/Bias (trend): For the purpose of day trading, we assess the larger time frame control based on the 30-minute and daily charts. Trades in the direction of the larger time frame have a higher probability of reaching their profit targets. And, again, trades that are counter to the larger time frame/trend should usually be taken at more conservative trade location. Confluence: These four key components make up a valid trade idea. The more of these you stack in your favor, the higher the odds of the setup working out. As a rule, at least two of these components should be in your favor on every trade. Reward-to-Risk: R/R is used as a filter and is a prerequisite to entering any trade. Because R/R is subjective and every single trade must meet our minimum R/R criterion of 2:1, R/R can never be used as the only reason to enter a trade. It is necessary, but not sufficient on its own. We've found that this execution framework allows our traders to be more objective and quickly determine the quality of a trade setup in real time. Another benefit is that it allows the trader to objective assess trades at the the end of the day." Awais has created a guide to trade selection that can assist traders in real time decision making and also facilitate review of winning and losing trades. By applying these criteria to all trades all the time, the trader internalizes the basics of good decision making and turns excellence in execution into a positive habit pattern. Further Reading: How Many Daytraders Actually Make Money Consistently?
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* Note the persistent buying in stocks in recent months, as there has been considerably more lifting of offers than hitting of bids across the broad range of NYSE stocks. Although breadth has waned over that time, we have not seen a significant influx of selling pressure whatsoever. * One of the most important psychological changes a trader can make: transforming a negative focus on loss to a positive attitude toward learning; * Great weekly overview from Jeff Miller;
Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), and The Daily Trading Coach (Wiley, 2009) with an interest in using historical patterns in markets to find a trading edge. I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab).
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