Trader10P3: Principle #7 - Teamwork

If performance is a team sport, who is on your team?  How do your teammates make you better, and how do you make them better?  How do you lead and inspire the team toward a dream?

Trader10P3: Principle #6 - Adaptation

How much of your time is explicitly devoted to understanding and adapting to changing market conditions?  If market trends, volatility, and correlations were to shift dramatically in the next week, how would you adapt your trading?

Trader10P3: Principle #5 - Learning Curve

Do your trading results reveal a positively sloped learning curve?  What specific skills have you learned--and do you employ--over the past year that have made you a better trader?

Trader10P3: Principle #4 - Rationality

To what degree is your trading grounded in ideas that are observable and objectively verifiable?  How does your trading process keep you self-aware and as free as possible from emotional and cognitive biases?

Trader10P3: Principle #3 - Well-Being

How much of your day--inside and outside markets--is spent in frustration and how much in the flow state?  To what degree is your work energizing you and to what degree is it leaving you depleted?

Trader10P3: Principle #2 - Talent

What are your distinctive strengths and talents as a trader?  How, specifically, does your approach to trading make the most of them?  How do you make sure you are playing to your strengths each trading day/week?
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Trader10P3: Principle #1 - Deliberate Practice

How much time do you spend each week practicing trading-specific skills, obtaining feedback about your performance, and consciously working on improving your performance?

Further Reading:  10 Principles of Peak Performance

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Ten Principles of Peak Performance for Traders - Trader10P3

I will be on vacation and away from markets and blogging for the next ten days.  During that time, TraderFeed will feature 10 Principles of Peak Performance for Traders (Trader10P3).  Each day, a new principle will be posted as a question for reflection.  Together, the list will make for a thought-provoking score card by which you can assess your performance.

One of the great challenges of trading is that it requires intense and singular concentration on markets, but also an equal focus on one's performance in those markets.  That combination of market awareness and self-awareness enables traders to make the most of their "edges" in markets while also cultivating fresh sources of edge.

It is interesting that very successful traders usually don't achieve monetary success and then walk away from markets.  That is because what drives them is not just the outcome, but also the process:  the ongoing challenges of market mastery and self-mastery.  Even after the money has been made, the game retains its appeal.

If your motivation is primarily to make money, you probably won't get to the point of career success, because the inevitable periods of drawdown will sap whatever drive is present.  When the motivation is mastery, losing periods provide fuel for reflection, learning, and improvement.  

Money is the score card, but the performance engine is love of the game.

Further Reading:  Trading as a Performance Activity
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Four Keys to an Upside Trend Day

For daytraders as well as swing traders, identifying a trend day early in its lifespan can be a profitable strategy.  Here are four things I look for in identifying upward trend days, such as we had on Monday:

1)  The cumulative NYSE TICK on the day stays positive and rising through the session;

2)  The percentage of NYSE stocks trading above their day's VWAP remains above 50% through the session (see chart above);

3)  The number of NYSE stocks making new daily session highs vs. fresh daily session lows remains positive throughout the session;

4)  Major indexes stay above their opening price ranges throughout the session;

Not all of these conditions will fire perfectly on each uptrending occasion, but most of them will.  Note that each of the conditions is measuring an initial thrust upward and then sustained buying pressure with consistent, positive breadth.  The key is recognizing these conditions relatively early in the trading session.  I obtain my data from my e-Signal feed and use historical research to identify the degree of thrust and buying pressure that is most likely to lead to a trending outcome.

Note that the failure to meet the above conditions can also serve as an alert to a potential range day.  Identifying likely day structure as early in the session as possible is a very helpful skill for traders on the day timeframe.

Further Reading:  Identifying Day Structure

Reminder:  9 AM EST Podcast With Michael Covel Today
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When the Stock Index Is Strong and Stocks Are Weak

I recently posted a few observations about how the underperformance of small cap stocks relative to the large caps.  Even more concerning to me has been how stocks making new lows have dominated new highs despite the large cap indexes hovering near their highs.  As the chart above shows, we have consistently seen fresh three-month lows outnumber three-month highs across the broad universe of common stocks.  Indeed, if we just look at the NYSE universe on Friday--a day in which the DJIA touched fresh highs--we see that 69 stocks made 52-week highs and 60 made annual lows.  That is pretty poor breadth.

My leaning is to interpret such divergences bearishly.  Still, with a VIX closing below 13 on Friday, it's far from clear to me that we're in bear territory.  So I decided to investigate.

Specifically, I went back to the start of 1990 and looked at all occasions in which the S&P 500 Index closed within 2% of its 200-day high under the following conditions:  a) VIX < 15; b) new 52-week highs under 100; and c) new 52-week lows over 50.  

My database spit back 38 occasions.  These included dates in:  November/December 1993; October 1994; January through March, 1995; October 1995; June 1996; November/December 2005; April 2006; June 2007; August/September 2013; and November/December 2013.  

That raised my eyebrows.  One advantage of being my age is that I've closely followed or traded all those markets.  Those were not bear markets--and they were not markets on the brink of the bear.

Indeed, looking across the 38 occasions, the next 20 trading sessions averaged a gain of 1.9% and the next 50 sessions averaged a gain of 3.51%, with only a handful of losing instances in each case.

Now, my conclusion is not to jump in with both hands and buy this market.  Rather, the data exercise has accomplished two things:  1) tempered my bearish leaning; and 2) illuminated the kind of market we are in.

I find this to be true of data exercises in general.  They offer a kind of perspective that checks assumptions and biases and can trigger new ideas as well.  The historical perspective is not always the correct perspective, but it often is a fresh one--and there is value in examining one's assumptions critically.

Further Reading:  Top Ten Reasons Traders Lose Discipline
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Inspirational Quotes to Start the Trading Week

A while ago, I posted insightful and inspirational quotes from legendary college basketball coaches. 

Here are some favorite quotes from famous athletes and coaches that are as relevant to performance on the trading desk as on the playing field:

Jack Dempsey - "A champion is someone who gets up when he can't."

Muhammad Ali - "It isn't the mountains ahead to climb that wear you out; it's the pebble in your shoe."

Vince Lombardi - "The quality of a person's life is in direct proportion to their commitment to excellence, regardless of their chosen field of endeavor."

Dean Smith - "What to do with a mistake: recognize it, admit it, learn from it, forget it."

Michael Jordan - "I've missed more than 9000 shots in my career.  I've lost almost 300 games.  26 times, I've been trusted to take the game winning shot and missed.  I've failed over and over and over again in my life.  And that is why I succeed."

Bob Knight - "Your biggest opponent isn't the other guy.  It's human nature."

Muhammad Ali - "I hated every minute of training, but I said, 'Don't quit.  Suffer now and live the rest of your life as a champion."

Michael Jordan - "Talent wins games, but teamwork and intelligence win championships."

Jerry Rice - "Today I will do what others won't, so tomorrow I can accomplish what others can't."

Marv Levy - "Football doesn't build character, it reveals character."

Arthur Ashe - "You are never really playing an opponent.  You are playing yourself, your own highest standards, and when you reach your limits, that is real joy."

Mario Andretti - "If you have everything under control, you're not moving fast enough."

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Underperformance of Russell 2000 Small Cap Stocks: What Does It Mean?

A number of people have been focused on the relative underperformance of small cap stocks versus large caps.  Indeed, while the Dow Jones Industrial Average (DIA) touched new highs this past week, the Russell 2000 Index (IWM) was trading near multi-month lows.  Particularly weak have been microcap shares (IWC).

As we can see from the chart above, tracking 100-day relative strength of the Russell 2000 and S&P 500 Indexes since 2000, it is not at all unusual for the smaller caps to go through extended periods of underperformance.  While the current relative relationship is oversold, it is not at the extremes we witnessed in May, 2011; October, 2008; or May, 2002.  Interestingly, those very oversold points in the relative relationship ended up heralding very good long-term buying opportunities for stocks.

If we just look at 100-day periods of relative outperformance versus underperformance of the Russell 2000 Index, what we find is that forward returns for both Russell and S&P have been superior following small cap underperformance largely due to the influence of the above three instances.  Occasions when we have been at points of Russell underperformance similar to the current level include March, 2004; April, 2006; April, 2010; and March, 2012.  Those were corrective periods--but not necessarily precise market lows--that ended up being good times to be long stocks for the longer term.  Similar occasions also include March, April, July, and October of 2007--a period when stocks were topping out longer term.

Bottom line is that:  a) the underperformance of Russell 2000 stocks has tended to occur during corrective market periods; b) such periods have often led to superior longer-term returns; and c) underperformance similar to current levels can become greater underperformance during true bear markets before they lead to superior returns.  Given that the current underperformance is occurring in a low VIX environment, it is not clear to me that we are witnessing a repeat of 2011, 2008, late 2007, or 2002.  The underperformance of small caps has not been a precise timing measure for stocks but on average has occurred during periods of risk aversion that have yielded positive forward returns for investors over the medium term. 

Further Reading:  Risk Aversion in 2006
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Brett Steenbarger Trading Psychology Podcast With Michael Covel

Looks like I'll be doing a podcast at 9 AM on Tuesday morning (May 13th) with Michael Covel of trend following fame.  Mike is up to 236 podcast interviews over the years with many interesting market participants and observers.  It's a unique resource worth checking out.

If there are topics you'd like me to touch upon in the interview, feel free to suggest them in the comments section.  Thanks!
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Resources for Market Preparation

I've been posting preparation (PREP) tweets most mornings via StockTwits that include a number of the market measures that I look at to help me gauge the coming trading day.  Because of a very busy work and travel schedule, I won't be able to keep up those tweets, so here is a summary of how you can obtain the information for your own preparation.

SPY targets:

R1 = SPY opening price + (median five-day true range expressed in SPY points * 0.5)
S1 = SPY opening price - (median five-day true range expressed in SPY points * 0.5)

R2 = SPY opening price + (median five-day true range expressed in SPY points * 0.65)
S2 = SPY opening price - (median five-day true range expressed in SPY points * .0.65)

New Three-Month Highs and New Three Month Lows:

Available on the Barchart website.

Real-Time Equity Put/Call Ratio:

Available in real time via e-Signal and on end-of-day basis for CBOE at the Index Indicators site.

Percentages of Stocks Trading Above Their Moving Averages:

Available, along with other breadth measures, at the Index Indicators site.

Advance-Decline Lines Specific to Stock Market Sectors and Indexes:

Available, along with other breadth measures, at the  Decision Point site.  Note: Decision Point is merging with StockCharts.com.



Further Resources:  Preparing to Win
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Sector Money Flow and Other Trading Perspectives and Resources

*  Money flow, sector by sector, is measured by multiplying ETF price by the number of ETF shares outstanding and tracking over time.  Since the start of the year, money has flown out of SPY.  The consumer discretionary sector has seen the greatest percentage outflows; the utilities sector the greatest inflows, followed by the two commodity-related sectors.  Sector rotation has dominated the year to date, with small caps and NASDAQ shares recently underperforming large caps and yield-related sectors (consumer staples, utilities) recently outperforming growth sectors (technology, consumer discretionary).

*  Useful links on sector performance and more from Abnormal Returns.

*  Hats off to the Macro Man blog for excellent perspectives on markets and macroeconomics, including this recent post on global influences on wage growth.

*  Into stock screening?  Here's a useful tool from FinViz.  Here's a useful tool from MSN. 

*  Worth a read and a re-read:  what makes money managers successful, from Howard Marks.

*  Nice example of scenario building and preparation from SMB's Steve Spencer.

*  A pill for trading performance?  Here's a unique direction in the search for trading profits.

Further Reading:  Gaining Access to Inner Expertise
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Knowledge, Wisdom, and Mindfulness in Trading

In video form, here are some worthwhile collections of market wisdom assembled by Igor Marinkovic:

Collection Part One

Collection Part Two

The rookie trader fails because of an absence of knowledge.  The experienced trader fails because of an absence of wisdom.

Many market failures occur when people enter cognitive and emotional states that override their wisdom.  

A mindful trader retains access to both knowledge and wisdom.  Many trading failures are failures of mindfulness.

Further Reading:  Objectivism and Trading
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Why Emotions are Key to Trading Performance

The first post in this series took a look at how emotional experience impacts risk-taking and decision-making.  As the above quote suggests, discussions of emotions and trading often focus on fear and greed.  Two important, but lesser appreciated emotions that impact trading are frustration and fulfillment.  The frequency with which you are in a flow state--a state in which you are wholly absorbed in what you are doing--is probably the best psychological test of all.  The reason for this is that we are more open to experience when we are in the flow state; it is a mode of enhanced information processing.  

The flow experience occurs when there is an optimal balance between the challenges we face and our level of talent and skill.  When challenges overwhelm our abilities, we experience frustration.  When we are insufficiently challenged, we experience boredom.  Both frustration and boredom keep us outside of our doing.  In the flow state, we are immersed in the doing, so much so that time can pass without our notice.  As the diagram above indicates, much of what we experience in performance situations can be explained by the match or mismatch between skills and challenges.

The British novelist and philosopher Colin Wilson observed that acts of will--often brought on by crisis--can overcome frustration and boredom and transport us to a flow state.  "We spend most of our lives in monoconsciousness," Wilson writes, "a narrow state in which we are only aware of the present moment.  It could be compared to being in a picture gallery but being forced to stand with your nose within an inch of the canvas."  When we can stand back from the picture and truly apprehend its beauty, our narrow state is expanded: the petty worries and concerns of the present no longer matter.  This can only occur, however, if the picture absorbs our attention.  It is the act of focusing--and sustaining a focus--that turns mere seeing into perceiving.

It turns out that there are physiological factors that account for Wilson's observation and the flow state.  Our attentional focus is improved when our brain's prefrontal cortex receives a jolt of dopamine.  When we experience something as intrinsically interesting, fun, and/or challenging, that jolt keeps us engaged in what we are doing.  In an important sense, highly productive, creative people who have cultivated the ability to sustain flow states do so because of positive addictions.

A recent post by Abnormal Returns offers trading rules for new retail traders.  Tadas makes the excellent point that there are many opportunity costs associated with developing trading mastery.  The time and effort required necessarily eat into other potential productive and rewarding activities.  It only makes sense to forgo those opportunities if one can find in trading the quality of emotional experience that comes from the flow state.

We can best learn and master markets if we are absorbed in them and their patterns.  We can best sustain absorption if we structure our learning so that tackling challenges provides us with shots of dopamine, not frustration.  It's not just about fear and greed:  emotional experience is essential to trading mastery because it provides the conditions under which we best learn and perform.

Further Reading:  What We Can Learn From Sport Psychology
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How Emotional Experience Impacts Our Trading

What is the quality of your emotional experience when you are trading?

Are you typically in a state of mind in which you make good decisions or bad ones?

What factors contribute to the quality of your emotional experience as a trader?

This post will kick off a series that examines emotional experience and why it is an important determinant of success across performance fields.

Research suggests that emotions influence risk-taking decisions differently--and the same emotion may increase or decrease risk taking depending upon the nature of the risky situation.

How people channel their emotional experience also impacts their subsequent willingness to take risk, with those suppressing emotional expression showing more risk avoidance than those using cognitive strategies to reappraise situations.  

Such research questions the simplistic generalization that control over emotions is good for performance; experience of emotions is bad.

Indeed, positive moods influence risk-related decision making differently than negative moods.  Anticipated emotions also can influence the choices people make.  

In general, people perform better under conditions of positivity than negativity.

How you approach markets helps shape the emotional experience you derive from markets, but the quality of your emotional experience also helps shape trading decisions.

Here is a simple survey of emotional experience in trading that I posted a while ago.  After you take the short questionnaire, here is a discussion of what the results mean and a look at what you can do about it. 

The next post in this series will take a unique look at trading experience and why it is vital to performance success.
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Honing Your Trading Process - Part Two

The first post in this two-part series took a look at process orientation and why it is important to trading.  By breaking trading into component elements and identifying effective routines for each, traders can remain grounded in best practices that impart a profitable edge.  That mapping of process elements to outcomes is crucial:  devotion to process in the absence of a demonstrated edge can only make randomness routine.  Effective process components are evidence-based.  But how do successful traders develop those components? 

An interesting commonality among the Market Wizards interviewed by Jack Schwager is that they have generally held strong beliefs about how markets behave and what is necessary for trading success.  Their theories are different, but they serve a similar function:  orienting traders or investors to unique opportunity.  Indeed, market theories are the Wizard's attempts to explain how asymmetric opportunities exist within otherwise efficient financial markets.

A good example of an orienting theory are the Principles outlined by Ray Dalio.  As Dalio explains, "...those principles that are most valuable to each of us come from our own encounters with reality and our reflections on those encounters--not from being taught and simply accepting someone else's principles."  

An important implication of Dalio's insight is that principles spring from experience; they do not precede experience.  We discover truth, rather than simply receive it.

This means that elaborating your processes and strengthening them requires observation and testing:  seeing what works and what doesn't; seeking explanations for why something works or doesn't; revising approaches based on observation and testing; etc.

Core principles spring from basic ways that we approach the world.  As a brief therapist, my solution-focused work emerged from a perspective of contextualism:  what we observe is a function of context, not necessarily an intrinsic and enduring state of affairs.  A person can be depressed in one set of life circumstances and happy and fulfilled in another.  Contextualism means that I will not expect the same patterns to show up at work, home, and parties, but may observe regularities within each of those social settings.

In markets, one expression of contextualism is the identification of "regimes":  stable, but transient market periods that often follow identifiable "rules".  Just as I sought to understand the emotional and behavioral patterns of clients as a function of their life context, I naturally understand market behavior as a function of drivers that operate in a given regime.

But what are these "drivers" and how can we objectively determine whether they are uniquely correlated with future price movement?  A great deal of defining and redefining drivers, testing and retesting them, occurs before they can become legitimate elements of process.  Those drivers are discovered, not simply lifted from books or the pronouncements of gurus.  Such discovery starts with the observation of regularities that exist within identified regimes.

Once you have anchored yourself in theory and used your principles to guide discovery, those market understandings become truly your own.  It is much easier to sustain conviction in your trading if your trading is grounded in what you have directly experienced. 

When process begins with first principles, theory becomes quite practical, guiding our encounters with reality.  In an important sense, how we trade is an expression of who we are. 

Further Reading:  Toward a Cognitive Theory of Trader Performance
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Honing Your Trading Process - Part One

We often hear of the importance of having a "trading process".  But what goes into such a process and what is it so important to be process-driven?  This two-part series will offer perspectives.

In such fields as manufacturing and health care, a process orientation is essential to quality control.  Surgeons, for example, operate under the guidelines of best practice routines to reduce complications and maximize outcomes.  Reliance upon a standard set of procedures reduces the variability of outcomes.

When Margie and I visited the Two Roads brewery in Stratford, CT, we were surprised to see how few people were involved in the brewing process.  Almost everything was computerized and automated.  This automation ensured that each step of the brewing occurred at exactly the right temperature, for exactly the right amount of time, with exactly the right amount of ingredients.  Once the brewer has the desired recipe, the key to successful production is standardization:  making the same excellent product every single time.

From a quality control vantage point, replacing subjectivity with objectivity is generally a desirable outcome.  The expert chef can get away with estimating ingredients by adding "a pinch here", but most of us are not experts.  If a machine can add the precise pinch, a potential source of error is removed.

In an activity such as trading, where emotions in the heat of battle can introduce wild elements of subjectivity, a process orientation is essential to success.  Algorithmic trading is the Two Roads version of money management, where every decision is precalculated and automated.  Yet even discretionary trading can be made rule-governed and process-guided.  An analogy would be playing poker or chess:  there are rules for making good and bad bets and good or bad moves on the board, even as there is considerable room for individual judgment.  Similarly, a football quarterback may call an audible at the line of scrimmage to take advantage of a defensive alignment, but the play called will have been pre-structured and well rehearsed.

The areas of trading that can typically be made more process-driven include:

1)  Research and idea generation:  Procedures for coming up with good trade ideas and investment theses;

2)  Trade expression:  How to structure the trade to achieve optimal reward to risk;

3)  Risk management:  How to bet enough on the idea to achieve a desired return on capital, but also to avoid an undesired drawdown;

4)  Trade management:  How to handle the position once it is on, including points to stop out, scale in, scale out, and take profits;

5)  Portfolio management:  How to allocate capital across trades to diversify returns and optimize equity curves;

6)  Self-management:  Procedures you implement to keep yourself in an optimal state for recognizing opportunity/threat and making decisions under time and emotional pressure.

Each of these areas can be mapped out and distilled into principles and checklists.  The checklist for an equity long/short investor will necessarily differ from that of the daytrader, but the categories will be similar.

If you are a process-driven trader, you can write a substantial essay for each one of those categories.  Indeed, if you were seeking capital for your trading, questions about each of the six categories above, along with detailed examples, would anchor an effective interview.

If your essay or interview responses would consist of a few sentences of generalizations, you know that your processes can be elaborated and tightened up.  Ultimately, your responses to the above should map to a distinctive and demonstrable edge in the marketplace. 

The goal is to figure out your best trading and then help you become as consistent as possible in enacting what you do best.  Your process should be the distilled essence and procedural expression of your greatest strengths.

In the next post in this series, we'll take a look at how you can elaborate your processes and make them more robust.

Further Reading:  Reflections on Trading Process
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