What is the right mindset for best trading? Here are five ideas, drawn from successful traders I've known and admired: 1) An open mindset - Traders succeed when they see things that others don't. Sometimes those are overarching themes and trends; sometimes they are short-term patterns in market behavior. To see things differently, we need a mind that is open to new and different information and open to shifts in market behavior. 2) A quiet mindset - Minds filled with noise can't process new information. When we're focused on ourselves and our profits/losses, we're no longer focused on markets. We can't exercise self-control in our actions if we are not able to sustain control over our thought processes. 3) A constructive mindset - Losses happen. We miss opportunities. The great trader learns from mistakes and embraces the lessons from drawdowns. If every day brings wins from trading or wins from learning, there is always something of value to be taken from each day. 4) A positive mindset - It's because we cannot count upon our profits and losses to make us happy that we need to lead a fulfilling life outside of trading. A life that is filled with meaningful activities, fun activities, activities that bring us close to others, and activities that give us energy is most likely to provide us with the emotional fuel needed to power through challenging market times. 5) An action mindset - All the best ideas and intentions will get us nowhere if we aren't prepared to act upon them. The action mindset is one focused on plans, translating excellent ideas into excellent risk/reward opportunities. Preparation is idea-focused, but also execution-focused. It is as important to work on our implementation of ideas as our generation of them. The above criteria form a useful checklist for making sure you're in peak performance mode. The right mindset won't, in itself, bring profits, but the wrong mindset can ensure losses. At the end of the day, trading requires skill in the processing of information. When we work on our mindset, we keep our information processing engine well-tuned. Further Reading: The Essence of a Trading Process
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Here's an insightful post from Mike Bellafiore of SMB, summarizing a savvy trader's perspective on what you need to know to be a successful trader. The key point is that the actions of market participants speak loudest. When you can read the flows of buying and selling, what people say about their positions or views becomes irrelevant.
This was especially relevant to Friday's trade in stocks, which gave us a multi standard deviation move on much higher than usual volume. Selling pressure, as measured by upticks/downticks was continuous through the day, suggesting that those additional market participants were executing one way dominantly.
If you came into the day lulled by recent (low) volatility or locked into pre-existing views about the market, you were unlikely to have been able to pounce on the unique flows going through Friday's trade. As the savvy trader in Mike's post pointed out, you didn't need to know anything else.
Friday's trade was a great reminder that the time series of price changes in markets are not always stationary. The distribution of those changes can change significantly from one time period to another. This means that a different process is generating that series; something has materially changed in markets. The one thing you want to look for as a trader is whether the market you're seeing today is similar to the market of the past X days (i.e., stationary with respect to), or whether it's radically different. It's those radically different occasions that can give us trend days, as many will be caught offsides.
Markets can change quickly. That is why adaptability is a cardinal trading virtue.
Two versions of fear impair traders: the fear of losing money and the fear of missing opportunity. Out of fear of losing money, traders will avoid buying weak markets or selling strong ones; they will stop out of long trades on weakness and exit short trades on strength. Out of fear of missing opportunity, traders will buy markets when they're up and sell them when they're down. Both forms of fear have negative expected return, particularly in low volatility market conditions, when moves are least likely to extend. Of course, it's these same low volatility conditions that lead traders to lament that there are no market moves and no way to make money. Maybe, however, low volatility conditions lead traders to want to catch breakouts and thus act on fear. When we make new highs or lows, they're afraid of missing the (finally!!) big move. It's the same fear of a big move that leads those traders to exit long positions on weakness and short positions on strength. With one trader I coached a while back, we took at look at what his P/L would have looked like had he added a unit of risk every time he stopped out of a trade. Sure enough, he would have been very profitable. His ideas were fine. But he managed his positions on fear, not opportunity. As a little demonstration, I went back to the start of 2015 and constructed a measure of relative breadth. I created an index of the percentage of SPX shares trading above their three and five-day moving averages (raw data from the excellent Index Indicators site). I compared the index value to its average value over a lookback period and expressed the result in standard deviation units. Thus, I could see when short-term breadth was significantly strong or weak in relative terms. Simply dividing the data in half based on a median split, we find that when relative breadth is strong, the next five days in SPX have averaged a loss of -.13%. When relative breadth has been weak, the next five days in SPX have averaged a gain of +.33%. Two people could have the same exact idea; how they execute their entries--on fear or not--makes the difference between loss and profitability. Even under high VIX conditions for the sample, five-day returns are much better following periods of breadth weakness (+.80%) than breadth strength (+.25%). Interestingly, high volatility and high breadth weakness represents the kind of market most people are fearful to buy. When we've had low volatility and strong breadth, the next five days in SPX have averaged a loss of -.40%. It's a nice illustration of how success lies at the intersection of trading psychology and market understanding. Further Reading: How Success Can Be Found on the Other Side of Fear
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In the last post, we took a look at negative patterns that impact trading and how we can disrupt them and gain greater control over decision making. But what are some ways of building positive patterns for ourselves? When I assembled a cookbook of time-tested self-help strategies for traders, three approaches stood out: * Behavioral - Here we teach ourselves strategies to enhance our focus and to slow ourselves down physically. Meditation can be very helpful for this, as can relaxation exercises, especially when paired with biofeedback. The idea is that we learn to sustain states of mind and body that are incompatible with the fight-or-flight responses of stress. When we slow down our bodies and focus our minds, it is very difficult to overreact to situations and make impulsive decisions. In the calm, focused state, it's also easiest to view our situations from a different perspective, as in the cognitive approach below. An advanced behavioral method is exposure therapy, in which we expose ourselves to stressful situations (either in real life or through vivid imagery) while sustaining our calm, focused state. This helps to literally reprogram our emotional responses to situations, which is very helpful in dealing with performance-related stresses. * Cognitive - As the Aurelius quote above illustrates, the cognitive perspective on stress is that it is our interpretations of events--and not the events themselves--that turn normal trading stress into the kind of distress that could impair our decision-making. In cognitive work, we use journaling and other methods to become better observers of the habitual thought patterns that can interfere with sound performance. Some of us have learned perfectionistic ways of thinking; others have learned worry patterns or overconfident ways of processing information. When we use a journal (or meetings with a coach) to think about our thinking and actively challenge non-constructive thought, we unlearn those distorted ways of viewing situations and can learn to replace them with more helpful self-talk. Cognitive exercises can also be used for brain-training: developing greater resources for willpower and purposeful behavior. * Solution-Focused - In behavioral and cognitive methods, we learn to change negative patterns that interfere with trading. Solution-focused methods come at self-development from the opposite angle: identifying occasions in which we are *not* experiencing problems and looking to those occasions for what we're doing right. Often, when we're performing at our best, it's because we're drawing upon our best practices and our greatest strengths. What are we doing when we're managing risk well, following plans effectively, adapting to market changes, and generating great trading ideas? In reverse engineering our successes, we can often find the solutions to the problems that impact our current trading.
Of course, these three approaches can be integrated very easily. For instance, we can mentally rehearse our best practices (solution-focus) in our calm, focused state (behavioral) and then imagine ourselves using those best practices in challenging trading situations (cognitive). That would help turn those best practices into our best routines. There is so much more to trading psychology than writing in a journal and telling ourselves to be more disciplined or more attentive to our gut. It is through behavioral, cognitive, and solution-focused methods that we can truly become our own trading coaches. Further Reading: Every Great Trader is a Player-Coach
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Our psychology interferes with our trading when patterns we have learned--and overlearned--are triggered by events and play themselves out without our full awareness. These can be behavior patterns, patterns of thinking, emotional patterns, or--as is often the case--an amalgam of all of these. Very often, the triggering of these patterns is state-dependent and situation-dependent. Most of the time, we exercise a reasonable degree of free will. It's under conditions of frustration, loss, fear, or greed that we find ourselves behaving in ways that are contrary to all our plans and best intentions. The first step in changing any pattern is becoming a good self-observer and recognizing when the pattern is starting to play itself out. Often, we can become aware of common triggers to our patterns, so that we can respond more mindfully to challenging situations. For example, if I recognize that certain topics tend to lead to arguments at home, I can quickly recognize myself become tense when one of those topics is raised and take a short break. It's when we can observe patterns beginning to unfold that we become able to short-circuit the process and interrupt the negative cycles.
This is why keeping a psychological journal can be very useful in making changes. We can use the journal as a tool for self-observation, writing in real time what is happening, how we're feeling, and how we'd like to respond. It's at those times we can remind ourselves of the consequences of the negative pattern and the benefits of responding more constructively. Such a journal becomes a mindfulness tool.
Here are common patterns impacting traders:
* Negative thought patterns--worry and self blame--following losses; * Overtrading out of frustration following losses; * Becoming paralyzed and unable to act on opportunity out of fear of loss; * Becoming overconfident and overtrading after wins; * Procrastination and failure to prepare properly for the day; * Trading too small due to lack of confidence; * Trading impulsively out of a lack of patience.
The common element among these patterns is that emotional, physical, and cognitive states lead to suboptimal decision-making. It's when we can recognize these patterns in real time that we can interrupt them, shift our states, and return to best trading practices. In becoming observers of our patterns, we distance ourselves from them, and gain potential control over them. Good psychological trading is staying fully conscious and self-aware, even during challenging situations.
Your trading psychology--its best and worst aspects--reveals itself in the heat of battle, when positions are on that will make a difference to your profitability. If you want to understand the mindsets of traders, watch them at two times: when markets aren't trading and when positions are on. It's when markets aren't trading that we observe work ethic, productivity, creativity, and the ability to generate ideas. It's when positions are on and P/L is moving that we observe focus, discipline, and the ability to act upon well-crafted plans. In the last post, we took a look at cognitive processing during the life of a trade. We enter a position when we see a shift in flows, such that there is a waning of buying or selling and evidence that sellers or buyers are beginning to take control. That ongoing updating of odds that a market will move your way doesn't end when orders are filled. Rather, there is continued updating of probabilities and an openness to exiting positions if flows shift adversely and adding to positions if odds of success continue to rise. This is the period of trade management: active, real-time decision-making to minimize losses and maximize gains.
In the heat of battle, some traders lose their focus and engage in little constructive trade management. They may become passive and stop looking for opportunities to scratch a trade gone wrong or add to a winner. They may become emotional and wrapped up in each tick, eventually overreacting to small moves. They may become risk averse, never looking to get bigger and exiting on the first whiff of movement against them. They may become too aggressive and overtrade, adding to positions at poor levels. It's when trades are on that our mindsets are likely to shift, our bodies are likely to go into fight or flight mode, and our trading psychology is likely to come out. The skilled trader sustains the mindset during the trade that was key to planning that trade. The skilled trader knows that as much P/L comes from managing the position as entering it. A review of your trade management will likely serve as a useful review of your trading psychology and identify what you do at your best and what you need to do to get to that next level of performance. Further Reading: What Distinguishes Winning Traders
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Bella recently posted excellent observations on finding another way to make more from the trading we do. Very often traders will look at peak and trough prices in a move and fault themselves for not having participated from one extreme to the other. There's a sense, however, in which selling top ticks and buying bottom ones does not represent optimal trading. Let's take a look at the skilled trader's reasoning during the life of the trade.
As noted in the recent posts, short-term traders profit when they track buying and selling flows and detect shifts in those flows created by the actions of large participants. At the top and bottom ticks of market moves, those shifts have not fully occurred. Indeed, my work suggests that the best time to be long is when we see meaningful selling flows that cannot move price meaningfully lower and the best time to be short is when we see meaningful buying flows that cannot move price meaningfully higher. This is true across time frames and is pertinent to longer-term as well as intraday trading.
At the highest and lowest ticks of a move under way, the conditional probabilities that you've actually detected the ultimate price high or low are relatively low. As you see flows unfold and result in diminished upside or downside, those probabilities begin to rise. At some point, the probabilities that a high or low have already been made become sufficiently great that a trade short or long is warranted. Although I'm not a trader of chart patterns, I find it useful to think about moves as having a left shoulder (a momentum peak), a head (a price high or low), and a right shoulder (a failed bounce or dip). The high probability trade lies in fading that right shoulder and participating in the move that results when buyers or sellers have to exit their positions.
In factor terms, you're a value buyer/seller (fading price extremes) profiting from momentum in the other direction.
But wait. In terms of Bella's issue regarding how to get more out of our trades, our probabilistic reasoning process does not end once we've entered a position. My experience is that, if I'm wrong in the trade--if the trade is going to be a loser--I'm going to go underwater relatively quickly. Why is that? I have identified my entry as a value entry, where movement in one direction has petered out and movement in the opposite direction is going to benefit from momentum. If I'm wrong, what I thought was a "head-and-shoulders" was merely a pause in a larger move and momentum in the initial direction resumes. I can see that on my screen by a sudden surge to the upside or downside in the uptick/downtick numbers.
If we don't see the market gain a second wind after our having made an initial entry, the conditional probabilities of getting the move in the other direction continue to increase. We are getting further confirmation that buyers can push the market no higher or sellers can push prices no lower. It is when we see that our initial position is not getting torched and subsequent market behavior is in line with our thesis that we can add a second unit of risk to the trade. We extract more from our trading by being largest when we're "rightest" and smallest when we're wrong.
Your reasoning process during the life of the trade has to be aligned with the reasoning that got you into the trade if you're to truly trade intentionally. In the next post, we'll take a look at what gets traders out of alignment.
In the last post, we took a look at a measure of upticking and downticking across all U.S. stocks as a way of gathering insight as to whether buyers or sellers were dominating market activity. By tracking the flows of buying and selling activity in real time, we can identify the dynamics driving the auction activity of the market and profit from shifts in supply and demand as they are occurring. The ability to perceive and act upon flows in real time is essential to the microanalysis that is an essential part of success for active traders. Notice that the U.S. TICK measure is constructed by tracking upticks and downticks across a broad universe of stocks. How can we track buying and selling flows for individual instruments, whether they are futures contracts or individual stocks? The seemingly obvious answer would be to investigate every transaction in the instrument and identify whether it's occurring on an uptick or downtick and then aggregate the information. There are several problems with that approach, however. First, when we have a composite tape for a stock traded on multiple exchanges, it is not entirely clear when a print occurring at the same minute and second truly preceded a print occurring at the exact same time. Second, how do we deal with transactions that occur at the same price? Do they count neither as upticks nor downticks, or do we categorize them based upon the most recent price change? Third, how do we distinguish between situations in which smart execution algo passively sit on bids and offers to buy and sell at best prices? In such a situation, price may not move, but the intentions of the market participants can be very different. To the degree that smart algos dominate execution and mask the intentions of participants, simple uptick/downtick rules can be misleading. A valuable way of tackling this problem has been offered by Easley, Lopez de Prado, and O'Hara in their paper "Discerning Information From Trade Data". This bulk volume classification method takes small clusters of volume or transactions and categorizes the price behavior within those to ascertain the intentions of market participants. This provides an efficient method for inferring buying and selling pressure without relying on the ambiguities of a composite tape or remaining blind to intentions when successive transactions occur at the same price. Above, we can see a simple implementation of this method for the ES futures (blue line) during the 9/1/2016 trading session. The Y-axis is constructed in standard deviation units, so that we can readily see when significant buying and selling activity (red line) is occurring during the day. Recall the questions that we can answer with the U.S. TICK data. Through the volume classification method, these questions can be addressed without needing to track transactions across all stocks. The questions can also be answered for individual stocks and futures contracts. Over time, we can see shifts in buying and selling flows and participate in market activity accordingly. The edge lies in the ability to read the footprints of large market participants, even when they make efforts to disguise their intentions. This work is a nice illustration of how quantitative approaches to markets can inform discretionary decision-making. It is also an important illustration of the value of information that occurs within any one-minute bar. Many traders fail to read markets properly because they want to use a telescope instead of a microscope. Understanding the flows occurring here and now is far more relevant to short-term trading than predicting those flows on the basis of remote events. Further Reading: Improving Your Trading Toolkit
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The above depicts trading in SPY during New York hours on 9/1/16. SPY is plotted in blue. The red line represents 1-minute closing values for the US TICK, which captures net upticks versus downticks for all listed stocks. When buyers are dominant across all stocks, we see net upticking. When sellers dominate, we see net downticking. Readings near zero represent a relative balance among buyers and sellers. As the day moves forward, we can ask meaningful questions: * Is there a significant amount of buying or selling coming into the market? * Is the relative distribution between buyers and sellers shifting in a particular direction? * Is the buying or selling activity able to meaningfully move prices in the index? * Cumulatively, over time, is the market trending toward buying or selling or is there relative balance? As you can see, as the day unfolds, we can update our views and identify patterns as they emerge. If we add to US TICK an overlay of other measures, we can ask further questions: * Is the buying/selling in stocks benefiting some sectors more than others? * Is the buying/selling for large cap stocks (DJ TICK) confirmed by broader buying/selling across stocks? * Is the buying/selling in stocks accompanied by significant expansion of volume? * At which price levels does buying/selling and volume expand vs. dry up? * Does a news item or data release lead to a significant shift in volume and buying/selling? * Can we aggregate these shorter-term measures to crystallize a longer-term market view?
Notice the psychological and cognitive qualities needed to trade this kind of information:
* Open-mindedness, to let market patterns unfold in their own time and in their own way; * Flexibility, to update market views as flows shift; * Quick processing, to see patterns unfold on short time frames; * Tolerance for ambiguity, to hang in when patterns are unclear or in transition; * Parallel processing, to see patterns unfold across multiple market measures; * Decisiveness, to act on short-term patterns at good price levels * Creativity, to see new patterns among different data * Persistence, to collect and study the above data over a period of years
At the end of the day, the market is an auction process. The best short-term trading exploits information that captures the ongoing activity of buyers and sellers, leveraging our psychological and cognitive strengths. Many trading failures occur, not because of a lack of those strengths, but because traders are processing the wrong information, blinding themselves to what is happening at the auction. Further Reading: The Three Most Important Questions Facing Traders
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A while back I was interviewed for a position as a trading coach and asked by a group of people attending the meeting to talk about myself. I told them that I had spent a very long weekend adopting our latest cat and finding rescue organizations worthy of our donations. I explained that Margie and I had adopted many cats during our 30+ years of marriage, that we had adopted two children, and that I routinely "adopt" the people I work with as a psychologist and the students I teach by making my personal phone available to them 24/7 and by becoming part of their extended family. If I were interviewing for a position right this moment, I'd talk about getting home from a vacation to Portsmouth, NH and having our youngest cat curl up with me in bed during the night, bringing me the toy mouse that she bonded with when she was sheltered as a semi-feral kitten. Creating and sustaining bonds: that's what it's all about. And in that interview, I'd talk about curiosity and learning about the world through reading, writing, and travel. I'd speak about how every development in my work, from what I do as a psychologist to what I write about in blog posts or books, is an expression of what I've learned and what has excited me. At the end of the day, the work we undertake and the relationships we build are expressions of our character. Our deepest motivations, values, and strengths define what we do and how we do it. If there's one piece of advice I can give, it's to make your character visible in all you do. Be who you truly are. That's what will attract the right people and opportunities to you, and that's what will allow you to look in a mirror and proudly see your self, not just yourself. Every day, we add a few paint strokes to our life's work.
The more I work with traders, the more I'm convinced that trading performance lies at the intersection between our approach to markets and our cognitive strengths. A while back, I shared on the blog that I had gone through a period in which I had been trading like an imbecile. Not only did I draw down from my P/L peak; I did so by doing something different than had gotten me to that peak. Hence the idiocy of my trading. I took a couple of breaks from trading from there and studied the hell out of my winning trades and winning periods in markets. What I found was that, in winning mode, I was processing markets moment to moment, gauging shifts in flows, riding those shifts, and identifying/exiting when those became extreme. In my losing mode, I was developing a larger-picture view of where I thought the market would go and placed trades in keeping with that picture--not in keeping with the market's moment to moment behavior. That led me to think about the difference between what I call macroanalysis--the top/down derivation of trades from the synthesis of analyzed data--and microanalysis, the moment to moment construction of a perspective based upon the recognition of emerging market patterns. I certain know and respect successful traders who approach markets from a macro perspective, and I also know and respect micro traders. After a successful period, I drifted from what was working to what does not work for me. Interestingly during this time, I felt as though I had completely lost my feel for the market. The market's behavior no longer made sense to me. When I returned to micro mode, it was as if a light switch had been turned on. My hit rate returned on trades, because what the market was doing made sense to me. All of us have different modes of sense-making. As a psychologist, I do form a larger picture view of what might be going on with a person I'm working with, but I don't intervene in a session until I've listened to what that person had to say and detected some theme or meaning to their communications. When I perform better in financial markets, I'm doing what I do when I perform better as a psychologist and what I do when I perform better as a father and husband. I draw on who I am in a cognitive way: I process information in a very particular manner. Personality plays a role in trading performance and, indeed, emotional factors can be among those nudging us from our cognitive strengths. My experience is that we tend to know more about our personalities than we know about our information processing styles and strengths. When markets make sense to us, it often is the case that we're doing our best sense-making. As in so many areas of life, doing well is a function of consistently doing what we do best. Further Reading: Understanding vs. Predicting Markets
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Many people set goals in their minds, thinking that the setting of the goal will somehow make things happen. If goal setting itself got things done, a lot more New Year's resolutions would be fulfilled by December 31st. The reality is that the setting of a goal is only the start of a productivity process. How we set and act upon goals will determine whether they in fact become realities.
Think of goal setting as operating on three levels. On the largest, longest-term level, goals should represent our visions, aspiration, and ideals. No one was ever energized by an item on a daily to-do sheet. What motivates us is what inspires us. It's the vision, the ideal, the dream that makes us jump out of bed in the morning.
The recent Forbes article is one of the most important things I've written, hands down. It explains precisely how large goals draw upon our reserves and energize us. When we tap into our deepest sources of motivation--our most fundamental ideals and values--we no longer have to push ourselves to do things. We are now pulled toward our desired future. It is the function of medium-term and short-term goals to divide and conquer, making the achievement of the grand goal challenging but doable. When we create short and medium-term goals that move us forward meaningfully, we create small wins that accumulate into a more general sense of winning. Those shorter-term goals organize us, but also ensure that we're not just doing things right, but also doing the right things. When you read about the woman who is running 50 marathons in 50 days in support of a cherished cause, you realize that the right goal setting makes us far more than we are in our ordinary, daily lives. The right goals form the structure of our days and weeks, but also transform us. The art of goal setting is knowing what will bring the best out of you and making that a meaningful part of your daily reality. Further Reading: How Goal Setting Helps Performance
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Great traders, like great poker players, know when to play and when to fold their cards and wait for something worth betting on. Too often, the love of trading expresses itself as a need to trade, and the need to trade leads players to play the wrong hands. Worse yet, the need to trade leads players to sit at the wrong tables. If you're at the wrong poker table, the hands you draw won't really matter. Folding your cards means that you're properly focused on opportunity, but the opportunity isn't present, right here and right now. Yesterday, I wanted to be a buyer of stocks, but volume was waning through the day. That tells me that momentum and follow-through on moves will be limited. I want to buy weakness, not try to ride breakout strength. If the market is showing me strength and I don't want to chase it, I've got the wrong hand and I'll wait for the pullback to give me better cards. A great poker player is a patient one. But let's say that I'm stumble onto a Vegas floor and plop myself down at the first table where I see an opening. Had I stood by and watched play for a while, I would have recognized that these are experienced sharks waiting for some bait. Instead, I start playing at the wrong table and become the bait. That happens in markets when we force our trading style onto markets that are moving a very different way. If I'm a trend following investor who places bets based on central bank policy and those policies have radically changed from their norm, I'm at the wrong table. I'm playing the wrong game. If you're in drawdown mode, it's important to ask if the problem is with your betting versus folding or if the problem is sitting at the wrong table or playing the wrong game altogether. Are your tactics needing adjustment, or do you need a different strategy? The most important thing you can do when you're in an unusual drawdown is figure out why you're drawing down. There are three big reasons why people have big drawdowns: 1) They're trading a strategy that doesn't fit the present market; 2) They're trading the right strategy, but their head isn't in the game and they're not following their strategy; 3) They're trading the right strategy with a good mindset, but they're employing the wrong tactics and thus not implementing their strategy the right way. You can't cure a drawdown if you can't come up with the right diagnosis. Sometimes coming up with that diagnosis means you fold the cards for a while and focus on studying yourself and your trading rather than just studying markets. Risk management is key because it keeps drawdowns manageable, so that you're sure to have time to learn from them. The key is folding your cards before you lose your stack. Further Reading: Finding Your Trading Strike Zone
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Imagine you come late to a party and a group of your friends has already arrived and is involved in an animated discussion. What do you do? Chances are good you might join your friends and see what the conversation is all about. Only after getting a sense for what they're talking about might you jump in and participate. One theme I've discussed a number of times is that we can think of market activity as a conversation among various participants. The flow of prices captures the transactions occurring among market makers, active day traders, longer-term thematic participants, asset managers, etc. The skilled trader is the skilled listener, picking up on the nuances of the market conversation. As in the example of the party, that requires a willingness to stay silent and get a sense for the conversation before jumping in and participating. Too often, traders formulate their views and impose those on the market without truly listening to the flow of conversation. That is like the boor at the party who talks at you, not with you, hogging the conversation with what they want to talk about. Rarely does that work socially, and even more rarely does it provide an edge in financial markets. When we're full of ourselves and our own views, we become less sensitive to the flow of conversation in the market, missing what is often obvious in retrospect. That is why silence and a quiet, open mind are great tools for starting the trading day. It's also why the questions that are most important to ask about any market are those that pertain to the flow of conversation among participants. One heuristic I've found helpful is to divide recent market volume into quartiles: low volume, low-average volume, high-average volume, and high volume. At each quartile, a different class of participants has become active in the market conversation. What are the prices at which the conversation is picking up or dying out? When a new group enters the conversation, how "sticky" is their participation? Do they continue and pick up their involvement or fade away? If we look to upticks and downticks, volume occurring closer to the market bid side or offer side, how balanced is the conversation? Do we see a growing tilt to the direction of the conversation? If we do enter the market with a larger picture view, staying open minded with respect to here and now flows can provide us with valuable information for when our good idea becomes a good trade. The excellent trader is the sensitive listener; emotional intelligence helps us execute our intellectually intelligent ideas. Further Reading: Bayesian and Static Reasoning in Trading
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A reader recently asked the question of whether market movements are random. At an informal level, I am struck by the number of skilled traders at each firm where I've worked who have accumulated multi-year track records of success, making money with a high Sharpe ratio trading actively in markets. To be sure, these are not the majority of traders, but they are a distinguished minority. As a trading coach working with them, I'm able to appreciate their talent first hand and recognize that their success represents far more than luck. Of course, on a more formal level, there is an entire research literature in mathematical finance detailing the non-randomness of financial returns. These excess returns can be categorized by factors, such as value (the purchase of undervalued assets and sale of overpriced ones), momentum (the tendency of strength or weakness to persist), and carry (the returns that come from owning an asset, as in the case of dividends or interest rate differentials). A strength of asset management comes from harvesting expected returns from portfolios that cut across these factors. Balancing and rebalancing factor-based portfolios produces a level of diversification that smooths return streams and allows investors to count on returns superior, on average, to simply buying and holding a given asset or throwing darts at boards. Factor portfolios have no opinions about markets; they do not trade expectations regarding the Fed, the election, data releases, or world events. When individual traders ground their decisions on their opinions, they often are not factor neutral. They implicitly take a position in a particular strategy, such as momentum or volatility. Many naive traders, for example, trade from technical patterns that have them buying weak readings and selling strong ones (value) or buying/selling upside/downside breakouts (momentum). Their weakness is that they apply the same strategies across markets and market conditions. They are not diversified. They are like Maslow's holder of the hammer, treating everything as nails.
So how can active individual traders achieve diversification and yet stay true to their trading strengths? This is a challenge generally ignored in trading psychology. Too many trading coaches assume that you'll make money if you just stay in the right emotional state. If you trade a flawed strategy while keeping yourself in a calm, positive state, you'll most likely lose money with minimal emotional disturbance.
Participation in financial markets can be categorized broadly as trading versus investment. Holding period is part of that difference, but only part. Trading is predicated on microanalysis, the real-time construction of patterns by moving markets. The trader thrives on rapid pattern recognition: the recognition of what markets are doing as they are doing it. This requires fast, broad thinking and quick response times. The investor thrives on the macroanalysis of broad conditions that impact markets and an understanding of their unfolding implications for future market movement. To a large degree, trading/pattern recognition is about intuition and a feel for markets; investment is about formal reasoning and the understanding of patterns. Traders achieve diversification when they trade multiple, independent "setups". For example, they may trade momentum patterns in which price movement is accompanied by volatility breakout as well as reversal patterns in which price movement becomes exhausted, with a loss of volume and volatility. Because they trade many setups during the day, they achieve diversification--even though they may be trading a single instrument. The investor achieves diversification by participating in multiple, independent hypotheses about the world. For instance, an investor might buy crude oil based upon geopolitical conflict and seasonal factors and might sell U.S. assets in favor of emerging market ones based upon differential monetary policies. The investor places fewer trades across multiple markets for multiple reasons. The trader places many trades in a limited number of markets with a defined set of independent setups. Either way, whether you are an investor or trader, the smartest thing you can do to produce greater returns is to diversify. One trick ponies run out of tricks when market conditions don't favor their particular factors. A great strategy for your trading development is to identify the kinds of markets where you typically don't make money, figure out which factors are working during those occasions, and produce a strategy to allow you to participate in returns from that factor. There will always be a high level of randomness/noise in financial returns. We are most likely to find success if we can exploit multiple sources of signal amidst the noise. Further Reading: A Systematic Approach to Discretionary Trading
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Here is a great way to get better as a trader--and as a person: Identify the times in the past week in which you were most sorely tested. When did you face your greatest tests? When in markets did you experience your greatest challenge? When in your relationships? What were the most difficult situations you faced? Those are the situations in which life is giving you a test in order to teach you a lesson. We learn from our challenges; we develop by tackling what is difficult and expanding our boundaries. We gravitate to comfort. It's not fun or easy to be challenged and pushed to our limits. But that's where we'll grow. Certain market conditions are challenging for us. Certain situations test our patience and tax our concentration and mood. When you deliberately face testing situations, you are given many lessons. That's not a bad format for a trading journal: tracking the occasions in which you were tested, the lessons you learned from those, and how you will apply the lessons going forward. Development depends upon discomfort; what taxes us potentially enriches us. Further Reading: Supercharging Your Trading Journal
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What makes trading challenging is that being average is not good enough. You can be an average teacher, store manager, or contractor and you'll be able to make a living. In trading, however, what is average is losing. If you stay consistently average, you'll consistently go broke. In performance activities, ordinary is not good enough. The ones who make a living from their performances are extraordinary. Two factors define the ordinary trader: 1) Lack of innovation - The average trader looks at the same headlines, the same charts, and the same information as other traders. Years ago, a vendor of trading software shared with me that, when they helped customers via their support service, they found out that the vast majority of traders never moved the indicators off their default values. Even fewer utilized customized features of the software. 2) Lack of distinctive effort - Only in trading would keeping a journal be considered diligent effort. If an owner of a startup restaurant went from day to day and simply kept a journal to make improvements, the restaurant would be poorly equipped to exploit trends among the dining public. Many traders focus on central bank announcements and GDP reports. Of those traders, how many actually read the statements of Fed governors, study the papers from Fed symposia, or follow the inputs to the final GDP numbers? When a lack of innovation is combined with a lack of distinctive effort, the result is a passivity of perception. The ordinary trader is not in an active mode of processing information, and that ensures that new and deep learning will not occur. When traders look at new information and put information together in new ways and actively investigate the utility of the novel data, they exercise their creativity and their capacity for effort. Over time, deep learning--an internalization of meaningful patterns--occurs. Every day, your preparation for trading, your actual trading, and your review of your trading are trips to a gym. What makes you more than average is that each of those trips is an actual workout of your talents and skills. Innovation and effort are what turn routine activities into workouts that make you stronger. The chart above is what I call the Power Measure, which is a running correlation of price movement and volatility. The above version is constructed with event data; the bars are not time-based. The power measure is a way of visualizing whether buyers or sellers are having an easier time moving the market. Calculating the power measure with event bars takes volume out of the equation. It tells you more purely whether a given unit of volume is more likely to move markets higher or lower. There's a lot you can do with this information. A simple first derivative of the readings tells you if markets are getting easier or more difficult to the upside or downside. A moving average of the readings (depicted above) acts as a kind of overbought/oversold measure. A cumulative total of readings acts as a measure of whether demand or supply is dominating over time. You may or may not employ a power measure in your trading. The point is that creating measures that make sense to you, tracking them every day and within the day, and observing their patterns creates a depth of learning that is impossible for someone looking at the usual charts and canned indicators. Innovative trading begins with innovation in perception and effortful information processing. All of us take trips to life's gym; the question is whether those trips provide us with the workouts that make us stronger. Further Reading: Calculating the Power Measure
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In a post a while back, I wrote about two proven methods for increasing your happiness. A very important idea from that post is "You're most likely to work on your trading if your trading brings you positive experience." It's when we feel happy and fulfilled that we're most likely to tap into productive and creative energies. It is understandable that competitive traders look to their winnings to bring them their positive experience. This is also where such traders most often lose their positive mindsets. When inevitable drawdowns in the P/L occur, they create drawdowns in energy and attitude. That's when traders often look for their happiness in the same place that they lost it. They hope to regain happiness by regaining profitability. Such an approach does not gain happiness; it loses control over one's happiness. That is why one of the most important performance principles is to approach performance in such a way that the process of doing is what brings fulfillment, not just the outcome. If trading is truly expressing and developing cognitive and personality strengths, it will be *intrinsically* rewarding, not just extrinsically so. Your great challenge as a trader is to develop a process that is so internally rewarding that it will not break down when external rewards aren't forthcoming. A skilled, successful trader wrote to me about knowing all the right things to do, but not cultivating the kind of routines that would routinely ground him in those right things. Traders in such a situation assume that "discipline" is their problem, and they push themselves harder to make themselves do the right things--only to have such a push take them further from the joy in what they do. If you want to follow a disciplined process, you have to find a way to make the process rewarding and enjoyable. The best way of doing that is to yoke what we *need* to do with what we're *good* at doing. We most often lose discipline because we're more concerned about being disciplined than being fulfilled. The first step to turning that situation around is to stop looking for our happiness in the very place we lost it. Further Reading: Two Proven Methods for Building Your Happiness
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Almost by definition, if you're pursuing your own, unique path--in life and in markets--you are going to face uncertainty. If we live life solely by following tradition and consensus, we'll find the security of the known, but will never have the adventure of finding our own path by tackling the unknown. As the recent post outlined, successful trading is all about standing apart from consensus and finding unique perspectives and edges in financial markets. But if you pursue uniqueness, you'll pursue uncertainty--and that requires a tolerance of what is uncomfortable and unfamiliar. Two ways of gaining perspective on markets are microanalysis and macroanalysis. In microanalysis, we break a market down into smaller pieces and look for clues to future activity based upon the patterning of those pieces. So, for instance, I might look at the alignment of sector behavior within the SPX to gain clues as to what is strong, what is weak, and what the patterns of strength and weakness might mean for the economy and stocks overall. A different form of microanalysis would be to break the price action of a stock or index into intraday pieces, as in the case of tracking volume flows or upticks/downticks over short intervals. Many times, beneath the surface, we can see evidence of accumulation or distribution that gives us a clue as to forward market behavior. Macroanalysis, on the other hand, places market activity in a broader context and looks for patterns among larger variables. We could aggregate global economic data, for example, and infer patterns of growing global growth and weakness that could impact the behavior of stocks. Similarly, we could look across the policies of world central banks and assess whether monetary conditions are skewed toward liquidity or tightness. In macroanalysis, we might view SPX as a sector itself within the broader universe of global equities. For example, since 2015, the correlation between daily moves in shares in Europe, the Far East, Australia, and Asia (EFA) has been about +.84 with the daily moves in the U.S. (SPY). The correlation between daily moves in emerging markets (EEM) and the U.S. (SPY) has been about +.80. Quite simply, markets are global and what happens in one part of the world is tremendously relevant for other parts.
If you find markets are unclear and/or you find yourself trapped on a consensus path, very often the answer is to take a fresh look through a microscope or a telescope. Looking beneath the surface of market activity by zooming in on short-term patterns can bring clarity. Stepping back from day to day activity and focusing on the big picture can also bring fresh understanding. To gain perspective, we have to shift perspective. Microanalysis and macroanalysis are two ways of accomplishing that. It is difficult to stay stuck in a perceptual rut if we have many microscopes and telescopes available to us.
At every trading firm where I've worked in recent years, I've observed winning traders and ones that struggle to win. What makes the difference? What are stand-out qualities of stand-out traders? Five characteristics are especially notable: * Successful traders trade uniquely - They look at markets differently from consensus. They process different information and they process the same information differently. They have found a way of making sense of markets that makes deep sense to them and that grounds their decision making. * Successful traders are multidimensional - They have ways of making money in different markets and in different market conditions. They are flexible; they find ways to win in difficult market conditions. * Successful traders work at their trading - They work on themselves and they work at markets. When markets are closed, they're still engaged in their work. Their focus is on self-improvement. They don't just set goals; they live them. * Successful traders know when to not trade - They wait for opportunities, they pull back their risk taking when they're not perceiving opportunity. It's not that successful traders are always successful. It's that their success springs from knowing how to not lose when they're not seeing the ball well. * Successful traders are self-aware - They know their limitations, and they know what they do well. They are quick to recognize when they're not "in the zone" and they also recognize when they are seeing unusually good opportunities. They are not afraid to say, "I don't know". A very significant proportion of successful traders have been mentored by successful traders. Success breeds success.
A very significant proportion work in teams, relying on others who they can mentor and make successful. Success becomes a team sport, with everyone making each other better.
There is nothing static about the successful traders I've known. They are continually learning and adapting, and they are continually searching for fresh opportunity. Performance is not simply something they are good at; it's a way of life.
Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), The Art and Science of Brief Psychotherapies (APPI, 2018) and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. Currently writing a book on performance psychology and spirituality. As a performance coach for portfolio managers and traders at financial organizations, 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.
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