A Preview of Trading Psychology 2.0: From Best Practices to Best Processes

One of the great disappointments I encounter when I read writings on the topic of trading psychology is that they invariably touch upon the same themes:  discipline, controlling emotions, etc.  Having worked with traders and portfolio managers for over a decade now, there is so much more to the psychology of trading than "sticking to your process" that I decided I had to write a book about what I was experiencing but wasn't reading.  The title reflects that interest:  Trading Psychology 2.0:  From Best Practices to Best Processes.

I think Ted Hayes hit on something important in his recent interview.  He pointed out that the personality traits relevant to success among early career traders are different from those that generate success for experienced ones.  Perhaps so much writing concerns discipline and emotional control, because those are the dominant concerns of the new traders who buy the books, haunt the websites, and seek the help.

At several of the firms where I work, no one even gets an interview unless they have years of experience managing significant capital with a solid track record of profitability and risk management.  So by the time those traders join the firm, discipline and emotional control are not screaming priorities.  Instead, they deal with other challenges.  In Trading Psychology 2.0, I refer to these challenges by A-B-C:

*  Adapting to changing markets

*  Building on strengths

*  Creating creativity

In adapting to different markets by leveraging their strengths and generating new ideas, successful market participants are not so different from successful businesses in fast-changing industries, such as technology or social media.  When markets change from year to year, stasis is a formula for failure.  The successful trader, like the successful tech firm, must constantly innovate.  Moreover, once traders generate those innovations, they must turn best practices--what they do that is successful--and turn them into robust, best processes.

I think this is very, very important:  What makes a trader successful is discipline:  doing the right thing with fidelity.  What keeps a trader successful is innovation:  doing new things and turning them into disciplines.  Conscientiousness makes for success, but it is openness that makes for adaptation.  Trading psychology as a field has done a fine job of articulating the importance of discipline.  My hope is that the new book will broaden the discussion to include a research-informed look at mastering change and innovation.

Further Reading:  Being Your Own Trading Coach
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Interview With Ted Hayes, Ph.D., Part Two: A Surprising Finding About the Development of Trading Performance

The first segment of the interview with Dr. Ted Hayes identified two drivers of performance:  cognitive ability and personality.  In this next segment, Ted draws upon his extensive research and identifies specific personality traits associated with peak performance:

Brett:  What does research tell us about personality traits and performance success?

Ted:  The current best model of personality is known as the “big five” factors of personality. This is an approach in which five personality aspects based on adjectives can predict what you’ll do. The five aspects go by the acronym OCEAN: Openness to new experience, Conscientiousness, Extraversion, Agreeableness, and Neuroticism (or its opposite, emotional stability). You can find these adjectives in all languages and culture groups.

Conscientiousness predicts work performance in all jobs, thus one should be curious about what it is. Conscientiousness includes planfulness, rule abidance, goal-setting, achievement orientation, and focus on details. In short, it’s self-control. And that is important for many aspects of life where orderliness, hard work, and avoiding distractions is valued. So in trading, especially at the entry levels, we need conscientiousness to help establish and follow routines, attend to details, etc. Traders who aren’t careful to chart assets, make journal entries, etc. are ineffective. Traders who get out of their routines (e.g., after the birth of a child, after illness, after a divorce) need to re-establish them before they can become productive again.

Emotional stability plays out through the more apt term resilience. You will lose money in trading at some point; you will, we hope, have some huge winning positions; there will be days when nothing happens, and there will be days where everything happens seemingly all at once. These events will test you. The capacity to modulate one’s one emotional state, maintain perspective, pull back after surging ahead and pull up when in a spiral — all are aspects of resilience.

A great example of someone with both extraordinary conscientiousness and emotional stability is Charlie Munger, Vice-Chairman of Berkshire Hathaway. Even his boss, Warren Buffet, has expressed his awe at Mr. Munger’s ‘hyper-rationalism.’

Brett:  That is very interesting, Ted.  It calls to mind the Angela Duckworth research at the University of Pennsylvania.  She and her team found that "grit"--resilience in the face of setbacks--and self-control were the two most powerful predictors of success. 

Ted:  Related to resilience, particularly in trading, is one’s comfort with taking risks (I refer to this as ‘risk tolerance’ though I appreciate that term might be misconstrued). It’s a combination of openness to new experience with emotional stability. In chess, for example, sometimes you sacrifice a knight to take a bishop. In trading you might lose some trades to test out a new market model you’ve developed. Some people prefer the tried and true, and can build a trading approach around that comfort zone. In either case, the extent to which you can come to terms with a balanced approach to risks for the sake of rewards will benefit you and build your own mental Sharpe Ratio.

Extraversion, which refers to being energize by having a broad network of friends and associates, and agreeableness, which refers to the extent to which you seek and create and enjoy harmonious situations, can be important in some careers such as trading in building one’s reputation for trustworthiness and collegiality.

Brett:  What I've found is that extraversion and agreeableness very much influence how traders work.   More introverted market participants often engage markets via research and study.  More extroverted traders are more apt to source ideas via personal contacts, social media, and other interactive means.  Some of the most extroverted and agreeable traders I've met have been quite effective working as part of teams. You've conducted a number of research projects concerning traders in financial markets and what makes them successful.  What findings have been most interesting and surprising to you?

Ted:  The dynamism of trading. You’re competing with and against people world-wide all the time and work in markets beyond your control, and this places extraordinary demands on traders at different points in their psyches.

Trading seems to have multiple levels based on maturity and style. For example, I work with Zolio where we have ‘pre-traders,’ 20- to 28-year olds who are not professionals engaging in trading on a simulated platform. Among them, mechanics and resilience are critical for success, but they’re also on a very steep learning curve. We also see pre-traders overly risk-seeking, with predictable results. Entry-level traders at firms I’ve worked with do better with, again, conscientiousness and resilience. But more senior traders are distinguished by their emotional approach to risk. That’s because these people have survived to that point, but usually they also have a sizable portfolio and it’s about gaining enough returns relative to the leverage and size of one’s positions.

It’s unusual to see different talent models predominate at different points in a career. Again, a very similar dynamic compared to intelligence analysts.

So let's step back for a moment.  Ted is saying something extremely important that, to my knowledge, has not been emphasized in the trading psychology literature.  "Different talent models predominate at different points in a career."  In other words, the traits that make a beginning trader achieve profitability are different from those that make a profitable trader a world-class talent.  It is possible to have the skills and traits needed to learn trading and become competent, yet other abilities and qualities may be needed to turn competence into proficiency.

This very much fits with my experience working with traders.  Early career traders I worked with in Chicago struggled with issues of discipline (conscientiousness) and taking/growing appropriate risk (resilience).  The experienced portfolio managers I've worked with more recently already have developed risk management skills and solid work routines and have demonstrated an ability to take appropriate risk.  Their greatest challenge has been adapting to changing market conditions, which Ted would subsume under Openness to new experience.

Each developmental level seems to call upon different success ingredients.  In the third and final segment of the interview, Ted will identify some of the implications of his research observations for traders and trading firms.

Further Reading:  How Personality Affects Trading Performance
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Multiperiod Breadth: Capturing Short-Term Market Strength and Weakness

Above is a way of looking at breadth in the SP500 Index that I have found useful in tracking short-term market cycles.  Breadth bottoms at or near cycle price lows and tends to top ahead of cycle price peaks, providing a nice heads-up on weakness.  The recent waning of breadth was an important factor in anticipating the latest market weakness.

The indicator is a multiperiod breadth measure.  It consists of the number of stocks in the SP500 Index that are making fresh five-day highs minus five-day lows added to the number making fresh 20-day highs minus 20-day lows and the number making new 100-day highs minus 100-day lows.  (Data via the excellent Index Indicators site).

Going back to 2012, when the multiperiod breadth has been strong (in its top quartile of daily readings), the next five days in SPX have averaged a gain of only +.05%.  When multiperiod breadth has been weak (in its bottom quartile of readings), the next five days in SPX have averaged a healthy gain of +.78%.  With the recent selloff, the breadth measure is now in that bottom, weakest quartile, consistent with oversold levels that have averaged rallies over the subsequent week.

Further Reading:  The Structure of Market Cycles
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Unappreciated Weakness in the Financial Sector

As bond prices (AGG) have failed to make new highs along with stocks in recent months (top chart), we see sectors of the market dependent upon interest rates showing lagging relative performance from the bond peak forward.  Those include housing (XHB); real estate (IYR); and regional banks (KRE). 

I notice some people have made a bullish case for this market based upon recent strength in the financial ETF, XLF.  That, of course, is dominated by large cap stocks and those have been the recent outperformers, as we've seen in the recent post. The broad list of financial shares has not fared as well, per the recent performance in KRE.  Indeed, the small cap financials ETF (PSCF) failed to confirm recent new highs and have gone nowhere since late last year.  Even within stronger sectors, we're seeing evidence of thinning participation in the market strength.

Further Reading:  Sector Money Flow
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Interview With Ted Hayes, Ph.D., Part One: The Two Drivers of Elite Performance

Ted Hayes, Ph.D. has spent a career studying human performance and what makes successful people tick.  Most recently he has been studying trading success as part of a research effort at Zolio.  Zolio is unique in that it is a real-time simulation trading platform that enables talented up-and-coming traders to demonstrate their skills for investment banks, hedge funds, and other trading firms.  Ted is leading an effort to study trader success at Zolio, and he has arrived at some interesting conclusions.  

Ted is also an Adjunct Assistant Professor of Organizational Sciences at George Washington University and has served as a Senior Research Director for the Gallup Organization.  My interview with Ted will be in several installments, as he had a great deal to share.

Brett:  Hi, Ted.  Perhaps you can tell readers a little bit about yourself and your areas of interest as a researcher and psychologist.

Ted:  Sure, thanks for this conversation Brett! My name is Ted Hayes and I am a research psychologist based in Northern Virginia. My interests are in the nature of human performance, especially among higher performing people. The one question I want to answer is, what is it that makes people successful?


My first internship was to help study predictors of success for U.S. Navy Explosive Ordinance Disposal divers. Talk about a high-stakes environment! And in that study we found that measurable aspects of personality predicted training success. I was hooked on psychological measurement from then on.


Performance among traders is different from performance among EOD divers but the same types of human performance attributes are linked to positive outcomes. That’s one of the exciting parts of my work.

Brett:  What are some of the most important factors that determine a person's satisfaction and performance in a career field?

Ted:  I’ll start by defining some terms to ensure that we (you, me, the readers of your blog) have a common frame of reference.


Vocational interests are expressions of what an individual finds rewarding in terms of social interaction, external rewards (i.e. remuneration) and social status, and a sense of personal meaning. For example, many people go into finance or trading because they like the potential for high income; an example would be Charles Schwab. The same type of people, interestingly, would make great intelligence analysts, and in fact the traders and intelligence analysts I’ve worked with have very similar talent sets. But while the money certainly could and should be a factor in vocational choice, you, Brett, have written about how trading involves ‘the rage to master’ — I love that term. So one could find trading to be a rewarding career because of the desire for high income but maybe you’ll be happier longer term because you want to understand markets, enjoy being the master of your own fate, find satisfaction in calculating the right risk ratios.


In short, you will be happy in a field if you understand your motivations and then are able to match your motivations to an environment that will reward those motivations. Day traders might be more at one point of the scale while prop-desk traders at banks would be at another point. Both groups would be trading but possibly for different reasons, so satisfaction is a personal sense of accomplishment based on understanding what makes you ‘tick.’

Brett:  So what you're happy with and what you do well could be different things.

Ted:  Yes, performance is very different from satisfaction. For example, if you want to run a macro fund but you’re starting out in day trading, well, that won’t last long. So that’s why from a research perspective we expand the toolkit beyond vocational interests to measure the psychology of human performance.

Over 100 years of world-wide professionally conducted empirical research on human performance, combined with a few more decades of study on human cognition, could be summarized as follows:
 

Cognitive ability enables one to make sense of data, integrate new information with previously learned information, and retrieve information to create new work products. But before your readers with perfect SAT scores or A-level exams start congratulating themselves, let’s acknowledge that being among “the smartest guys in the room” doesn’t mean you’ll be successful; just look at what high IQ did for Enron. And as you and I know from our work with traders, a lot of successful traders think people with academic smarts are, well, stupid. What distinguishes “smart” from “successful” is good decision-making. So the question is, why and how do people make good decisions?


Two completely different strains of psychology converge to address making good decisions. First, research and thinking in cognitive psychology has converged on the two-stage model for judgment and decision making — as Daniel Kahneman puts it in his book’s title, “Thinking, Fast and Slow.” The Canadian psychologist Keith Stanovich also poses a two-stage model of rationality in which there are snap (‘fast’) decisions, which are prone to bias and heuristics, and deliberate (‘slow’) decisions, which in theory are based on data, subject to de-biasing, and ultimately more “rational.”

Brett:  So performance is tied to our abilities to process information. 


Ted:  Yes, but this is only part of the picture. One could ask, do people really only make judgments based on data and algorithms? Of course not. Deliberations and decisions reflect our tendencies, preferences, allegiances, anxieties, values, biases, temperament, and motives, or, in other words, our personalities. 


Personality drives behavior, especially in work settings. World-wide empirical research over the span of 100 years has settled this issue at least to that extent.

Personality reflects your interests, temperament, values, etc. as filtered by your social skills. In other words, your reputation is a proxy for your personality. In fact current research shows that other people’s ratings of you on personality tests are better predictors of your work performance than are your own personality test ratings of yourself.

************

Let's step back for a moment and reflect on what Ted is proposing.  He is identifying two broad factors that contribute to performance:  cognitive ability and personality.  Both are crucially involved in decision-making.  Cognitive ability breaks down into fast thinking--the kind of pattern recognition we see among successful short-term traders--and slow, deep thinking.  That's the kind of analysis that we see among global macro portfolio managers.  It is difficult to imagine that a trader can be successful without having at least one of those areas well-developed.

On the other hand, all the skills and knowledge in the world will not translate into performance if those cognitive assets are not supported by personality traits.  As Ted points out, we all know very smart people who are not top level performers--in markets or elsewhere.  It is the ability of personality traits to channel cognitive ability that contributes to world class performance.

In the next segment of the interview, Ted will shed light on the specific personality traits that are associated with performance success.

Further Reading:  The Best Predictor of Trading Success
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What Can Help You Identify Downside Trend Days in the Stock Market?

I quickly threw this chart up to show the price action in SPY and the percentage of NYSE stocks trading above their day's VWAP thus far today.  There are several clues to downside trend days; here are the ones I most focus on at present:

*  Lopsided advance-decline ratios on the day; many more stocks declining on the day than advancing.  This suggests the weakness is broad.  Note also it implies that correlations are rising among stock sectors.

*  Persistent low percentage of stocks trading above their day's volume-weighted average price (VWAP), per the chart above.

*  Many more stocks making fresh lows for the day session than highs throughout the session, suggesting that weakness is persisting.

*  Cumulative NYSE TICK negative on the day and trending lower, with relatively few TICK readings above +500 and numerous readings below -800.  

*  Weakness across stock sectors, generally with "beta" sectors weaker than defensive ones.

All you can do is put the odds in your favor.  When you see unusual weakness or strength early in the session, it is generally worth considering the possibility of a trend day.

Further Reading:  Keys to an Upside Trend Day
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Sector Correlations in the Stock Market and What They're Telling Us

Here is a chart of rolling 20-day correlations within sectors specific to SPX stocks, as highlighted in the recent post.  What you can see is that the sectors have become less correlated over the past year, but there have been meaningful swings higher and lower.  Specifically, we've seen correlations bump up when stocks have sold off and we've seen the lowest correlations during periods of market topping.  As mentioned in the prior post, low correlation markets have tended to produce flat returns in SPY during the recent bull market; superior returns have been achieved by buying relatively high correlation markets.

We can see from the chart above that we have recently seen unusually low levels of correlation, which have trended higher in the past few sessions.  Along with the failing breadth, this is consistent with a topping phase of a market cycle. 

Further Reading:  Correlations and Opportunity Sets in Markets
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Trading and Mindfulness: Training the Brain for High Performance

Mindfulness meditation is a practice in which we develop a non-judgmental present-centered awareness.  In the state of mindfulness, we observe what is, without reacting to it as good or bad and without coloring it with thoughts and feelings of past and future.  Mindfulness can be thought of as a means toward non-attachment, separating our desires and fears from what is.

Research suggests that mindfulness meditation lowers stress levels, brings health benefits, improves performance, and helps us regulate emotion and attention.  Research also finds that mindfulness leads to helpful changes in the brain, shrinking the amygdala--the brain's flight or fight center--and enhancing the brain's executive center, the pre-frontal cortex.  As one researcher concludes:

“The picture we have is that mindfulness practice increases one’s ability to recruit higher order, pre-frontal cortex regions in order to down-regulate lower-order brain activity,” 

Think about what this means:  In the heat of market activity, we are most likely to be activating those flight or fight centers that help us deal with emergencies.  Just as we want to be most planned and deliberate, the blood flows in our brain are moving away from the centers that would execute plans and toward centers that would lead us to be more reactive.  

The challenge is to stay mindful in the midst of fast moving markets and rapid shifts in P/L.  

A recent thorough research review found mixed evidence for the effectiveness of mindfulness meditation.  Mindfulness was more effective in reducing anxiety, depression, and pain than in improving positive mood and attention.  I find this interesting, as it suggests that achieving a detached awareness may be useful in reducing both physical and emotional pain.  It may well be that avoiding stimulation of those fight-flight responses is helpful in dealing with painful situations.

Mindfulness may yield benefits to traders above and beyond those studied in the research literature, including enhanced access to intuition and improved performance under stress.  A new book by Gary Dayton also suggests that mindfulness can be useful in reducing trader susceptibility to bias and in defusing negative emotions.  In my own work, I find a great overlap between mindfulness work and self-management exercises performed with biofeedback.  That makes sense, as early applications of biofeedback were directed toward children experiencing attention deficits. 

Mindfulness will not substitute for sound trading strategies with an edge, but it is difficult to imagine maximizing an edge without self-awareness and self-control.  Practicing mindfulness daily is a great way to exercise the brain's ability to stay grounded in executive functioning even during the most adrenaline-filled occasions.

Further Reading:  Why Controlling Emotions is the Wrong Goal for Traders    
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Weekend Market and Trading Psychology Reading

*  We can add the above to the recent evidence of weak market breadth:  The number of NYSE shares closing above their upper Bollinger bands minus those closing below their lower bands has been tailing off, failing to confirm recent price highs.  In a new blog, Worch Capital offers a different and worthwhile perspective on divergences.

*   Thanks to @SpareRisk for passing along this golf feature relevant to trading on what it takes to succeed.  Lots of good perspective on grit and deliberate practice.  Love the part:  "Hitting balls isn't necessarily practice.  Practice should be purposeful."  Great issue for reflection:  Do we turn our trading into practice, and how purposeful is our practice?  

*    Credit to @derekhernquist for noting this interesting article on how not all the returns from skilled money managers come from the same place.  Very relevant to understanding--and leveraging--our own strengths as traders.

*  Thanks to @brussbowman for pointing out this article on mindfulness and the brain.  Very relevant to trading:  shrinking the "fight or flight" brain centers and building the centers controlling attention and concentration.  More on this topic to come.

*  Excellent reading from Abnormal Returns, which does a great job of categorizing reads to help site visitors focus on the content most relevant to them, from investing and finance to health, football, and entertainment.  Check out the podcast array as well--amazing what's out there for free.

*  Macro alert from Barry Ritholtz and David Kotok:  Why Turkey belongs on the radar. By the way, Barry has been assembling a very impressive lineup for the Masters in Business podcasts.

Have a great finish to the weekend--

Brett
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The Bull Market is Over for Much of the Stock Market

The recent post highlighted the unusually weak breadth in the recent stock market.  Above is an update.  You can see that the Cumulative NYSE TICK--a measure of upticks vs. downticks across all NYSE shares--has tailed off, even as we made fresh price highs in SPX (top chart).  This is the first time this has occurred since the start of the bull market.

Much of this weakness can be attributed to the unusually weak action among small caps and recently by midcaps as well.  As you can see from the bottom three charts (shout out to the Index Indicators site), the percentages of stocks trading above their 200-day moving averages have been making lower highs as SPX has made recent price peaks.  The midcaps made a double price top before turning down lately, and the small  caps fell well short of their early July peak.  

As of Friday's close, 74% of large cap stocks (SPX) traded above their 200-day moving averages.  For the midcaps, that number is 45%; for the small caps, it is 37%.  Incredibly, as we've been making all-time new highs in the large cap averages, the majority of other stocks have not been trading in uptrends.  Even within the large cap universe, fewer and fewer shares have participated in the strength.  At the recent peak, only 15% of SPX stocks registered new 52-week highs, down from 22% in early July.

The bull market grows narrower and narrower, but the real news is that the bull market is over for a significant portion of the stock market.
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Life After Trading: Finding Your Future

The recent post cited research that found that overtrading was most common among traders with the least funds, elderly traders, minority traders, and men.  All of these are groups that could feel the most pressure to make a living from their trading.  Every year I hear from a number of traders who reach the conclusion that this is not possible.  They have put their heart and soul into trading--and sometimes their bank accounts--and they have determined that they simply cannot meet their financial needs and obligations through an uncertain trading income.

Here are a few vignettes of people I've worked with who have sought a life after trading:

*  Joe was a very sociable person who wanted to be a success in life.  He experienced success for a while in trading, but became unhappy with the lifestyle and his returns tailed off.  He went into the restaurant business, where he could work with people, and currently owns and runs a successful restaurant group.

*  Tom loved trading, but experienced ups and downs in his income.  That created stress for him and his family.  He knew a lot about markets and wanted to stay in the industry, so he built a career as a financial adviser and eventually became a knowledgeable and successful investor.

*  Alicia was an excellent student, with a solid knowledge of economics.  She became a junior portfolio manager at a hedge fund, but did not perform well under the pressure of having to produce short-term returns.  She joined a different firm as a research analyst and is now part of a successful team, helping to set investment strategy.

In all of these cases, the people had to struggle with the issue of "failing" at trading.  The important insight they came to is that they failed because of their strengths, not because of weakness.  Each had key strengths that did not fit well with a trading career.  They found their future by moving to an area of opportunity that made greater use of those strengths.  None of the opportunities seemed perfect at the time, but they found good organizations to be part of and grew into ideal positions.

In my life, it took several failed relationships before I figured out what would make me happy in a marriage.  Those were difficult experiences, but there would have been no success without those failures.  A career, like a romantic relationship, must capture your strengths, interests, and values in order to be successful.  If trading is not working for you, consider the possibility that trading does not capture all that you have to offer.  Understanding who you are, what fills you with energy, and what you are truly good at is the first step in discovering your ideal future.

Further Reading:  Succeeding by Failing
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Maybe Overtrading Isn't a Discipline Problem

Research from Barber and Odean finds that men trade 45% more frequently compared to women and pay for their overtrading by achieving lower risk-adjusted returns.  A common interpretation of this finding is that men are more risk-taking than women and more aggressive in their trading, perhaps due to the impact of testosterone. 

Consider a different interpretation, however.  Research from Anderson and Stranahan found that overtrading is most common among elderly traders, minority traders, and traders with less wealth.  What's the common thread here?  Perhaps traders overtrade because they feel a greater need to make a living from their trading.  Elderly, minority, and poorer traders may not possess other sources of income and might pressure themselves to support themselves and families through trading.  Men are traditionally viewed as breadwinners for families and may also feel a heightened need to make trading succeed financially.  

It is ironic that those who feel the most pressure to make trading succeed are the most vulnerable to poor trading practices.  It is much easier to sit out quiet or noisy markets when you don't have to rely on trading as a primary source of income.  It is also easier to practice prudent risk management when you don't need to double your money or more from a small account.

We know from research that the great majority of traders are not able to sustain a living from trading.  Perhaps their overtrading is not so much the result of a lack of discipline as a sign of desperation.  Who addresses the needs of traders who can't trade for a living and need to find constructive alternatives?  It's not an area that brokerage firms, education vendors, or coaches have much interest in highlighting.  In my next post, I'll take a look at life after trading and what makes it successful.

Further Reading:  The Costs of Overtrading
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Getting to the Next Level in Trading Through Professional Networking

I'm looking forward to being part of an excellent lineup October 3-5th in Las Vegas, when Traders4ACause holds their annual event.  It's a great idea:  proceeds from the event go to charitable causes.  So it's traders sharing ideas with other traders and also giving back to worthy organizations.

Working in the hedge fund haven of Greenwich and living in suburban Connecticut, I've grown to appreciate the value of professional networking.  Networking is always useful for job hunts, of course, but a lot of networking occurs simply out of the desire for enrichment.  By meeting other traders, hearing their ideas about markets, and learning about what they do, you expose yourself to a variety of inputs that you'd otherwise never encounter.

When I first started working at hedge funds, I thought that portfolio managers would be so secretive with their ideas that they'd never share with others.  The exact opposite is true:  money managers realize that, if they share their ideas with the right people, they'll wind up with many more ideas than they came with.  A huge part of sustaining creativity is generating fresh inputs.  By sharing with others--at conferences and at after work events-- traders can come away with many fresh inputs and lay the groundwork for creative idea generation.  One of the things I like about the Traders4ACause group is that their causes are both charitable ones and ones of sharing with colleagues:  you give and you receive.

The professional networking that takes place at trader dinners is quite different from the networking of social media.  Social media is extremely broad, but typically not deep.  It's a great way of touching base with people, but not such a great way to debate ideas, brainstorm industry trends, and share best practices.  There's something about meeting people in person that cements relationships and leads to a depth of sharing that would never occur via email or chat.  I have known many close professional collaborations that have begun through dinner meetings.

Trading can be challenging and rewarding, but it can also be isolating--especially for independent traders managing their own capital.  One of the real benefits of joining a trading firm is the opportunity to collaborate and learn from others, even as you teach them what you know.  The independent trader lacks that affiliation.  Without a continual stream of fresh observations and ideas, the isolated trader finds it much harder to keep up with changing markets than the networked trader.  The key is networking with the right people.

In coming weeks, I will be organizing a trader networking event in the greater New York City area, where the focus will be on sharing ideas and building collegial relationships.  I will share my own research, and each participant will agree to share one or more ideas with the group.  There will be no fee for the gathering: the price of admission is bringing a worthwhile idea to share.  In a future post, I will provide details.  The goal is to come away with many more valuable ideas than you brought--and to come away with professional relationships that can last well beyond the dinner meeting.

If you have suggestions regarding a networking event, please feel free to offer those via comment to this post.  I believe it will be a great way to leverage your talents and keep up with changing markets--and should be a lot of fun!

Further Reading:  Core Ideas of Trading Psychology
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The Psychology of Stop Loss Levels

Price changes in the stock market do not follow a normal distribution.  Rather, they are leptokurtic, which means that we see more small changes (higher peak) and a larger number of extreme changes (fatter tails) than we would see in a normal distribution.  Because of those fat tails, markets can move against us more than we would expect if markets followed normal distributions.  A two standard deviation event is a relative rarity in a normally distributed world, but occurs with surprising frequency in markets.

It is because of this ability of markets to move in extremes that traders rely upon stop loss measures.  A stop loss is a way of avoiding catastrophic loss.  It is also a way of trying to capture a favorable relationship between reward and risk. 

When we set stop loss points on trades, our positions reflect bets on both an idea (for example, stock prices will rise) and on a path of price movement (the rise will occur with point X being hit before point Y).  It is conceivable that our idea could be right--stocks could move higher over time--but we could be wrong on the path and stopped out for a loss.  That is understandably frustrating for traders--so much so that some traders turn to options and bet relatively small amounts of premium on their ideas so as to avoid setting stops.  Their trades will either hit their target and they'll be profitable, or they'll lose their premium.  Risk management is thus achieved partly via position sizing, rather than through stop losses and the prediction of price paths.

One reader asks the question of how we can get ourselves to honor stop levels.  He points out that it's very tempting to allow a trade to move beyond a stop, hoping it will return to breakeven.  

The problem is that the stop out is viewed as a loss--and the loss is viewed as a failure.  If the loss is viewed as the avoidance of a potentially catastrophic loss of capital and as an honorable fiduciary duty to investors (whether you're investing other people's capital or your own family's), then the stop out becomes part of good trading.  Being stopped out means that you were wrong about the anticipated price path.  It doesn't necessarily mean that your underlying idea was wrong.  The loss can be a prod to help you better manage price paths, and it can also be a prod to take a fresh look at your idea. In both cases, the loss can help make you better.

Psychologically, the trap to avoid is equating loss with failure.  Loss is a function of human fallibility; it is inevitable when trading markets.  The key question is whether you learn from losses or become threatened by them.  If you embrace losses as opportunities to learn, they won't be fun, but neither will they become the threats that lead you to avoid prudent risk management.

In general, I find that traders place stop loss points too tightly and don't anticipate the random moves likely in a given volatility regime.  The problem is not with placing stops per se, but with setting them so perfectionistically that they're almost guaranteed to be hit. Wider stops with smaller positions often allow an idea to play out--and still serve an essential risk management function.

And if you want to simply trade your ideas and not play the game of predicting price paths?  Perhaps stops are not for you and a judicious use of options could allow you to better weather choppiness and uncertainty. 

Further Reading:  Risk Management and Stops in Trading
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Why Do Traders Go on Tilt?

Here's a good article from a poker site that explains the phenomenon of "going on tilt":  allowing anger and frustration to so dominate one's play that decisions are made reactively and irrationally rather than on the merits of one's hand.  It's not so different from what can happen to traders when losses lead to poor trading and further losses.

So why do people become frustrated?  Frustration typically occurs when there is an outcome we very much desire and we experience obstacles to reaching that outcome.  For example, we can become frustrated when traffic jams prevent us from getting to work on time.  We can become frustrated when a trade sets up well, only to be undone by price action resulting from a random news headline.  We can become frustrated when we want peace and quiet in a theater, but a nearby person continues to make noise. 

It is common for us to identify external factors as sources of  frustration, such as the traffic jam.  Very often, however, the frustration is set up by our outcome expectations.  If our expectations are unreasonable, we unwittingly place ourselves in a situation in which frustration can mount.  I know, for example, that if I try to drive into or out of Manhattan at a rush hour time, I'm likely to encounter traffic.  If I accept that and give myself double the normal travel time to reach my destination, I'm unlikely to be overcome with frustration.  By keeping my expectation realistic, I take away a reason for going on tilt.

Many times the expectations of beginning traders are unrealistic.  I routinely hear from traders who have taken a course on trading or gone through a training program and now experience frustration in their desire to "trade for a living".  They wonder what they can do psychologically to stop going on tilt.  The problem is that they expect an outcome that would be unthinkable in just about any other performance domain.  Would we really expect to make our living on the PGA tour after taking a series of golf lessons?  Would we expect to take courses in acting and then make our living on Broadway or Hollywood?  Would we take piano lessons and then look to make a living as a concert pianist?  

In no field does someone quickly go from being a relative beginner to being a master who makes a living from their craft.  Typically we build competence before we develop expertise--and competence takes significant practice and learning.  Think of how athletes or performing artists develop:  by the time one goes "pro", there has been a learning curve that has lasted years.  Why would the trading of financial markets be any different?  Studies tell us that knowledge and experience are key to trading success, and those can only be achieved over time.

By expecting to always make money; or to have an always-high hit rate on trades; or to make a consistent, comfortable living from a small portfolio--all of these set us up for disappointment, frustration, and the emotional disruption of going on tilt.  They also derail learning, because no one learns best if they aren't enjoying the process and immersing themselves in it.  Framing expectations in terms of progress, rather than as lofty attainments, is a great way to sustain focus and positive emotional involvement in the developmental process.

Further Reading:  What Makes an Expert?
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The Extraordinarily Weak Breadth in the Stock Market

With DIA and SPY touching bull market highs intraday today, I couldn't help but notice that we were registering 418 fresh one-month highs across all exchanges and 547 lows.  (Data from the Barchart site.)  That is extraordinarily weak breadth.

As the chart above shows, the high-low breadth has been trailing for a while now, but has become unusually weak recently.  My data show that new 52-week highs for all NYSE shares were 370 in early June of this year; 365 on July 1; and 231 on September 2nd.  Small cap shares are well behind their bull market highs.  Incredibly, only 39% of SP 600 small cap stocks are trading above their 200-day moving averages, while that number is 55% for SP 400 mid caps and 73% for SP 500 large caps.  (Data from the Index Indicators site).  Plenty of stocks are not in bull markets, though you wouldn't know it from the large cap averages.

Meanwhile, the US Dollar is ripping higher, as investors anticipate higher rates in the US than in Japan and Europe.  Bonds have been selling off, also in anticipation of higher rates.  Most international stock markets are well off their highs (FEZ, EFA).  

Important shifts are occurring across asset classes and stock market internals have been weakening in response.  With my cycle measures near peaks, the chips have come off the table.
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Two Proven Methods for Building Your Happiness

In an interesting study of positive psychology, Seligman and colleagues identified two exercises that increase happiness and decrease symptoms of depression for six months above and beyond placebo effects.  Here are the two exercises:

1)  Subjects took a test to identify their top five "signature" personality/character strengths.  They were then instructed to use one of those strengths in a new way every day for a week.  

2)  For a week, subjects were asked to write down three things that went well each day and why they went well.

The more faithfully the subjects carried out the exercises, the greater their increase in happiness over a forward six month period.  Although subjects were told to do the exercises for only one week, a number of them continued beyond that time.  Those that continued displayed the greatest increases in happiness.

This is important, because positive emotional experience has been linked to improvements in health, creativity, and productivity.  When we focus on building positive experience rather than minimizing our weaknesses, we create new ways of experiencing ourselves that open the door to fresh ways to tackle life and markets.

Notice the common thread between the two exercises:  focusing on what we have, rather than what we lack.  So often, when traders seek coaching, they focus on their weaknesses and what they're doing wrong.  What if, instead, they adapted the two exercises above and consciously set about using their strengths in new ways in their trading and identifying what they did right during good trading?  

Over time, who will build the stronger confidence:  the person who is strengths and solution-focused, or the person immersed in weaknesses and problems?

You're most likely to work on your trading if your trading brings you positive experience.  Cultivating strengths and solutions--and building processes around those--is a powerful way of accomplishing that.

Further Reading:  Keys to Solution-Focused Trading
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Finding Opportunity in Stock Market Cycles

The recent post suggested that a variety of market observations can be pulled together by drawing upon an explanatory framework.  A good theory not only helps us understand what has happened in markets; it also suggests what we might observe in the future.  Science begins with observation.  Until we link our observations and make sense of them, they remain isolated data points.  Theory is a big part of what transforms data into explanation.

What my observations suggest is that a limited number of variables, such as buying and selling pressure; volatility; breadth; sentiment; and correlation, uniquely predict short-term price movement in the stock market.  An ongoing research interest has focused on the structure of cycles in the stock market and the co-movement of these variables at different phases of market cycles.  In general, I find that market cycles can be broken down into several phases:

1)  Bottoming process - At market lows, we tend to see an elevation of volume and volatility and a high level of market correlation, as stocks are dumped across the board.  Selling pressure far exceeds buying pressure and sentiment becomes quite bearish.  At important market bottoms, we see price lows that are not confirmed by market breadth, as strong stocks begin to diverge from the pack and attract buying interest.  At those bottoms, we also find a rise in buying pressure and a reduction of selling pressure, as fresh market lows fail to attract new selling interest.  

2)  Market rise - With the drying up of selling, low prices attract buying from longer timeframe participants as well as shorter-term opportunistic ones.  The market rises on strong buying pressure and low selling pressure, and the rise generates sufficient thrust to generate a good degree of upside momentum.  Volatility and correlation remain relatively high during the initial lift off from the lows and breadth is strong.  Dips are bought and the rise is sustained.

3)  Topping process - The market hits a momentum peak, often identifiable by a peak in the number of shares registering fresh highs.  Selling from this peak generally exceeds the level of selling seen during the market rise, but ultimately attracts buyers.  Weak stocks begin to diverge from the pack and fresh price highs typically occur with breadth divergences and lower levels of correlation.  New buying lacks the thrust of the earlier move from the lows and volatility wanes.  By the time we hit a price peak for the cycle, divergences are clear, volatility is low, both buying pressure and selling pressure are low, and sentiment remains bullish.  

4)  Market decline - Fresh selling creates a pickup in correlation and volatility, as short-term support levels are violated and selling pressure exceeds buying pressure.  Breadth turns negative and the bulk of stocks now move lower.

The thorniest problem I have encountered in my work with markets concerns the timing relationships among these phases of market cycles.  I am convinced that the cycles are aperiodic (they do not adhere to rigid timetables; there is no invariant x-day cycle), and I am also convinced that there is a non-random proportionality among the phases that occurs within and across time frames.  Capturing this proportionality has been the greatest challenge in the research.

The nesting of larger and smaller cycles creates periods of apparent trending and periods of apparent range-boundedness in markets.  Optimal trading strategies conform to the parameters of the cycles operating in markets at a given time.  Problems occur in trading when a trader's holding period greatly differs from the operative cycle period(s).  A common problem in trading today's stock market is that the operative cycles are much longer than most active traders' time horizons.  This leads to chasing nickles in front of larger move steamrollers. 

By tracking the ongoing changes in market sentiment, volatility, breadth, correlation, and buying/selling pressure, we can identify where we stand in a market cycle and adjust trading strategies accordingly.  During market rises and declines, we want to be holding positions and going with momentum; during topping and bottoming processes, we want to be fading range extremes and trading more tactically.  In general, we want to be aligned with the largest operative cycles, as these greatly impact the shape and timing of smaller cycles.

I am mindful that it is easy to find "cycles" in hindsight, with little explanatory benefit.  The cycle concept only has value insofar as it organizes observations among key market variables and suggests observations to come.  I will be elaborating the explanatory and predictive value of cycles in future posts; it is the major focus of my market research.  For an excellent example of cycle research creating profitable trading strategies, check out the StockSpotter site.

Further Reading:  Market Profile as a Practical Theory
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Upcoming Topics for TraderFeed Posts

The TraderFeed queue keeps growing.  Here are topics for upcoming posts; additional suggestions for topics are always welcome via comments to posts:

*  An Explanatory Framework for Pulling Together Market Observations

*  Finding an Evidence Basis for Technical Analysis

*  Best Practices in Market Tweeting and Social Media

*  Taking Professional Networking to the Next Level

*  What We Can Learn From Overnight Trading

*  An Advance Look at Dr. Brett's Next Book

The theme across these posts is looking at markets--and market opportunity--in new ways that can generate fresh trading edges.  Many psychological problems of trading are the result of a failure to innovate in the face of shifting market opportunities.

I greatly appreciate the interest and support--

Brett
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