Process-Driven Trading: Trading With Quality

We often hear that traders should be process driven and strictly follow their process as a way of avoiding psychologically-driven biases and poor trading practices.  This draws upon an analogy between trading and the running of a manufacturing or service business.  In the business setting, you are looking for consistent, high quality.  Variability of output = low quality.  For example, if you're manufacturing a drug, you want the production process to turn out the same pill all the time.  If you're a delivery service, you want consistent on-time delivery--and you standardize each step of the process to make sure that happens.

Essential to process-driven quality control are two ingredients: 1) measurement of outcomes and 2) identification of the activities that consistently generate those outcomes.  In the world of medicine, that has led to a focus on outcome research and the creation of evidence-based treatment protocols that standardize best practices.  If you receive surgery from an evidence-based treatment center, many of the decisions that are made, from the amount and type of anesthesia to the sterility of the operating room and the method of incision, will be laid out as protocols and derived from rigorous, controlled outcome studies.

When traders say that they are "following their process", what they should mean by that is that they have intensively studied what makes them money and what does not; identified their best trading practices; codified these best practices as protocols to follow; and then tracked their fidelity to these evidence-based practices.

In other words, a trader who is truly process-driven should demonstrate:

1)  Reliability - They do the same thing in the same situation each time;
2)  Validity - What they do is known to result in greater positive outcomes than following other procedures.

Most traders who speak of being process-driven do not truly track reliability and validity.  When they talk about being process-driven, what they mean is that they follow a routine.  Routines are necessary for quality control, but hardly sufficient.  Rowing a boat in a consistent manner doesn't help if you're headed in the wrong direction.  If traders don't track outcomes, identify the practices that generate favorable outcomes, and *then* ground routines in those practices, they are not trading with quality.

Trading with quality means putting as much time and effort into studying trading performance as studying markets.  The process-driven trader doesn't simply define a routine and follow it blindly.  Rather, process-driven trading means that you identify and understand what works and then systematically become more consistent in executing that.

Would you fly an airline that operated with the same quality control as you demonstrate in your trading?  

It's all about doing things right and doing the right things.

Further Reading:  Quality, Minds, and Markets
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Succeeding at Trading by Not Trading

In his recent research report, Peter Brandt offered a keen observation:  "Profitability comes from a trade finding you, not in you finding a trade.  The best trades are the ones you wait for, not the ones you find."  

I have found this to be the case in most areas of life:  the best opportunities find you.  When I first returned to blogging, I didn't write about markets; I wrote about our new cat.  That was one of the key lessons I wanted to convey:  she found us.

What was important to that discovery was that we visited many cat shelters and spent quite a bit of time with the three cats at home before Mia clung to my shoulder.  A lot of preparation took place before opportunity could find us.

So it is with discretionary trading:  we look at markets; we look at economic developments; we look at monetary trends; we study various indicators of market behavior--and all of that is preparation.

As Peter points out, at any juncture we can take a chart or piece of data and find a trade in it.  If we are in a mindset where we want to trade--and need to trade--we can find trades to do.

And we don't make money.

When we are patient and prepare and prepare and prepare, eventually a pattern presents itself to us.  All the analysis falls into place with a keen synthesis.  We might conceptualize the pattern in statistical terms, chart-based terms, macroeconomic terms, or some other terms.  There are many languages we can speak to capture the patterns in complex phenomena.

The reason patience is important to trading is that it allows us the time and space to synthesize.  We can never get to the point of trusting our gut if our heads are cluttered with what we want to do next.  It is when we stop doing that the things worth doing come to us.

Further Reading:  The Greatest Mistake Traders Make
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A Friday Potpourri of Trading and Market Views

*  On Thursday across the NYSE universe, we saw quite a few more stocks close below their lower Bollinger Bands than above their upper bands.  As you can see from the chart above, important intermediate-term lows have occurred in market cycles when we've seen a plethora of stocks trading below their lower bands.  I went back to the start of my data set (May, 2014; raw data from Stock Charts) and looked at all occasions in which we registered more than 200 stocks below their lower bands versus above their upper bands, where this was the first occasion in at least two weeks.  Interestingly, three days later, SPY was up twice and down five times for an average loss of -.54%.  Too small a sample to hang one's hat on, but the point is that markets can display short-term momentum to the downside as well as upside when there is a strong breadth move.

*  We often hear that your trading style should fit your personality, but what is your trading style and what aspects of personality are important to performance?  Too often traders lose money because they drift from one trading style to another, not mastering any and not truly leveraging their strengths.  I can think of few more important topics in trading psychology.

*  Banks are not providing the liquidity they once did.  This can lead to mini flash crash situations and is very relevant for risk management.

*  Two valuable professional activities are networking and not working.  Networking exposes us to new ways of thinking and new ideas; as James Clear suggests, not working allows us to renew and rejuvenate, so that we can generate our own fresh perspectives.  I'll be announcing a NYC networking event for active traders shortly.

Further Reading:  Pure Price Momentum
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Three Questions Crucial to Understanding the Day Behavior of Stocks

Three questions that are key to understanding the day behavior of stocks are:

1)  Who is in the market?
2)  Are they becoming more active in the market over time?
3)  Are they able to move the market directionally?

Above we see a chart of yesterday's price action in SPY (blue line), plotted against five-minute readings of relative volume (red line).  (Raw data from e-Signal; all calculations in Excel).  The relative volume is expressed in standard deviation terms.  Each five minute period's volume is expressed relative to the median five-minute volume and standard deviation for that same time period over the past two months.  So, for example, a reading of zero at 10:05 AM (all Eastern time) would mean that we traded exactly at the median volume for the 10:05 - 10:10 period.  A reading of 1.0 would mean that we traded at one full standard deviation above the median volume for that period.

What we're looking for relative to the three questions above are:

1)  Do we see significantly above average participation in the market?  If so, we have a good indication that speculative players in the market are active.  If not, we could have a slow market dominated by market makers.

2)  Do we see participation increasing over time?  We want to know if those speculative players are being drawn to the price action or whether the market's auction is shutting down as prices move from value.

3)  Do we see evidence of trending behavior corresponding to the participation in the market?  Are we getting two-sided action--action where both buyers and sellers are aggressive and keeping the market in a range--or do we see a dominance of buyers or sellers over their counterparts facilitating a market move away from value? 

Yesterday was a Fed day and we also had an important GDP number early in the morning.  As a result, we saw above average participation in the market early in the trading session.  Relative volume picked up with morning market weakness and dried up ahead of the Fed announcement at 14:00.  At that point relative volume spiked with the appearance of buyers.  Nothing in the Fed's announcement--and certainly nothing in the weak GDP report--led participants to think that monetary conditions would be altered in a way that would be harmful to stocks.

Yet what do we see for the remainder of the afternoon?  Apropos to points 2) and 3) above, relative volume tailed off steadily and price could not break above its early morning levels.  In other words, on a relative basis buying interest was drying up and there was no reason to move price above where value had been established on the day time frame.

What does that suggest?  Nothing in the Fed action was perceived as a meaningful game changer for stocks.  The interplay of volume, price, and time help us understand the demand and supply behind the market's action.  That provides us with meaningful reference points for the following day, as it will take fresh volume flows to move us out of yesterday's range.

Further Reading:  Relative Volume and Market Opportunity
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Pinball, Poker, and Trading: Perspectives on Going on Tilt

Bella at SMB offers some excellent perspectives regarding trading on tilt.  Tilt is a term that originated in poker and describes a state in which sheer frustration with the game takes over and distorts one's betting.  As I noted in an earlier post, trading on tilt is a function of our outcome expectations.  If we are not emotionally prepared for the possibility of losing, we are more likely to be thrown by losses.  We set ourselves up for the tilt state by needing and expecting to win, rather than letting probabilities play themselves out and accept that there will be winning and losing periods.

I recall becoming an avid pinball machine junkie in college and watching players become frustrated to the point where their own tilt led them to throw their machines into tilt.  My first book describes how I never really succeeded consistently at pinball until I discovered a quirk in the machine I was playing.  If I let the ball hit my left flipper and did absolutely nothing, the ball would bounce to my right flipper.  From the right flipper, I could swing the ball through an area of the table and it would ring up points and send the ball to my left flipper.  Once again I would do nothing, the ball would bounce to my right flipper, and I would swing the ball through the scoring alley.  One time I repeated this so many times that I won 32 free games in a row.

I never went on tilt and I never put my table into tilt.  The game became pretty emotionless, because I was repeating a technical maneuver over and over again.  I got to the point where I almost always won free games.  I never really mastered pinball machines; I just became good at finding and exploiting quirks in machines.  The best quirks came from doing something that no player would normally do, like not use your flipper when the ball came your way.

There's an important lesson there for trading.

Further Reading:  Regaining Self Control
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The Equity Put/Call Ratio: Why Sentiment Matters

Lately I've seen a variety of observations about stock market sentiment, ranging from bullish to bearish to neutral.  My favorite measure of sentiment is the put/call ratio for all individual stocks with listed options.  This excludes index option volume.  Above we see a five-day moving average of the equity put/call ratio (red) plotted against the SPX.  (Raw data from e-Signal).

In general, we've tended to see elevations of the ratio at relative market lows.  Over the last few weeks, the ratio has dramatically declined as we've percolated to new highs.  We are currently in a zone where traders are bullish in their options-related behavior.

Since the start of 2014, sentiment has been an important tell for forward market returns.  If we simply conduct a median split of the daily data, we find that when traders have been relative bullish (N = 160), the next 10 days in SPX have averaged a loss of -.28%.  When traders have been relatively bearish (N = 160), the next 10 days in SPX have averaged a gain of 1.18%.  In other words, if you followed the sentiment herd and bought the market when traders were bullish and sold when they were bearish, you lost significant money.  Essentially all the market's returns have come from time periods when traders did not believe we were going to get good returns.

There's an important lesson there.

Further Reading:  The Index Put/Call Ratio
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More Good Stuff to Begin the Trading Week

*  Above we see a cumulative running total of the number of NYSE stocks giving buy versus sell signals with respect to their Bollinger Bands.  This is one way of looking at the breadth of strength versus weakness over time.  After notable weakness going into the October, 2014 drop, we have been working our way higher in this measure.  More stocks have been showing strength than weakness, as much because of the relative absence of sell signals as the high presence of buys.  

*  This is a very important concept for developing traders:  How we are wired socially, emotionally, and cognitively defines where we will find our edge in markets.  We are best positioned to know markets if we first know ourselves.

*  I've been making increasing use of the Investing.com site.  I like the feature that tracks advancing and declining stocks across international as well as U.S. averages.  I also like the coverage of international markets, FX, and the international commentary.

*  Of the top posts tracked by Abnormal Returns this past week, I especially like the one that outlines problems that frequently accompany backtests.  Another great link is Meb Faber's post on diversification and protecting against an overvalued stock market.

*  Great series of posts on mindfulness in trading by SMB Training and Bruce Bower.  The clearest problems with mindfulness occur when we are caught up in emotional reactions to market action.  Less appreciated is that we can lose self-awareness as a function of good trading.  If we're absorbed in markets, we're not focused on our best trading of those.  It's that transition from market awareness to trading awareness that is key.  Many great traders use post-it notes for reminders on their screen precisely because it's when they're most focused on markets that they're least focused on best trading practices.    

*  Are we trending on a day time frame?  Stats provided by Vic Scherer are quite relevant.  I've also been looking at volume as a relevant measure.  It's tough for short-term moves to extend if volume is drying up.  Note that trend on an X time frame is dependent upon momentum at the Y time frame, where Y > X.  If you have a measure that has a momentum edge, you can generally define a winning trend strategy at a lower time frame.

Have a great start to the week!

Brett
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Sharing Great Ideas Via $STUDY and #tradingpsychology

One of the joys of social media is the opportunity to discover people who are doing good work.  True, you have to wade through quite a few emo and self-promotional posts and tweets to find the nuggets of insight and talent, but all you need is to find one per month and over time you build quite a stimulating and meaningful network.

Are you doing good work?  Are you looking at markets in fresh and rigorous ways to generate better trading ideas?  Are you looking at yourself in fresh and rigorous ways to better improve yourself?  If so, I encourage you to make use of two symbols to facilitate your networking with other creative, productive market pros:  $STUDY and #tradingpsychology.  

$STUDY is the symbol for educational tweets posted to the excellent StockTwits site.  These may consist of insights in themselves or may link to original posts that contain insight into markets and trading.  A great way to see who is doing good work is to punch up $STUDY and find the people who are talking more about ideas than about themselves. 

#tradingpsychology is an underutilized hashtag.  I've been making greater use of it in my tweets in hopes of making it a better archive for original insights posts that deal with the psychology of trading.  Again, there's a bit of wading through the self-promotional stuff, but by and large people who are posting good things on trading psychology topics are not making use of the #tradingpsychology hashtag.

So here's the deal:  I will be making conscious and consistent use of $STUDY and #tradingpsychology when I have ideas and posts to share about markets and the trading of those.  If you're doing good original work, I encourage you to do the same.  I will go out of my way to then favorite, retweet, and link to the best of your work.  Over time, this will be a great way to facilitate networking among likeminded professionals and allow the workhorses to stand out from the show horses.  

I look forward to organizing a greater NYC craft beer event this spring for those of us sharing via $STUDY and #tradingpsychology.  After all, there's a reason it's called social media!

Further Reading:  A Different Kind of Trading Group
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Questioning Strong and Weak Markets

One of the best ways to generate fresh ideas is to question accepted wisdom.  What is often assumed among traders and market writers is just not the case.

Technical indicators are generally regarded as measures of market strength and weakness.  When price action has been strong over a lookback period, the technical indicator is viewed as bullish and vice versa.  At extreme values, the indicator may be regarded as an "overbought" or "oversold" measure.  

Since the middle of last year, I have been tracking the buy and sell signals for all NYSE stocks for several technical indicators.  (Raw data compiled via the Stock Charts site).  Three indicators I've looked at in particular detail are Bollinger Bands, MACD, and Parabolic SAR.  Since June, 2014, the correlations of buy signals across the indicators have been positive, ranging from +.23 (Bollinger:MACD) to +.56 (MACD:Parabolic SAR).  Similarly, the correlations of sell signals have been high, ranging from +.22 (Bollinger:MACD) to +.75 (MACD:Parabolic SAR).  Clearly, different indicators are not measuring completely different things.  Indeed, an argument can be made that indicators are simply implementations of different moving average rules.  When we look at which indicator is best, we're really fitting past market behavior to a particular moving average, which may or may not be predictive on a prospective basis.

On Friday, we had buy signals outnumber sell signals for all three of the above indicators, reflecting the recent market strength.  Going back to June, 2014, when this has occurred (N=62), the next five days in SPY have averaged a gain of only +.01%, compared with an average five-day gain of +.26% for the remainder of the sample.  Clearly, strong readings have not brought near-term strength--though neither have "overbought" readings reliably led to market declines.  The failure of strength to be followed by strength is yet one more reflection of the distinction between trend and momentum outlined in the recent post. 

Conversely, when we've had all three indicators yielding more sell signals than buys (N=49), the next three days in SPY have averaged a gain of +.33% versus +.04% for the rest of the sample.  Market weakness has tended to reverse in the near term, though much of that relative performance boost tends to fade over subsequent trading sessions.

It is human nature to extrapolate from the recent past to the immediate future when we are trying to anticipate events.  In the case of the stock market, failing to question "strength" and "weakness" has been hazardous to our wealth.

Further Reading:  The Breadth of Strength
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Using Relative Volume to Assess Short-Term Market Opportunity

Here is something I watch closely while trading.  The blue line is the SPY ETF; the red line takes the SPY volume for each five-minute period and expresses that relative to the average SPY volume at that same five-minute period (30-day lookback).  The ratio is expressed in standard deviation units.  When the ratio is above 1.0, we're seeing above average flows come into the market for that five-minute segment.  When the ratio is below 1.0, we're seeing below average volume participating in that period.

Because volume correlates highly with volatility, this ratio gives a nice real-time updating of how much movement we can expect in the stock index.  Note that the couple of times we bounced above zero during the morning, relative volume tailed right back off.  It's when we see persistence of high ratio readings that we generally see range extension and short-term momentum.  In the low volume environment, we're more likely to see moves reverse before possibly continuing in their initial direction.

In the case of this morning's market, the tailing off of volume represented a pulling back of buyers; there was no influx of sellers.  While low volume is not good for momentum trades, it is not necessarily a bad thing for trend trades.

Further Reading:  Momentum and Trend Trades
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Why FOMO Fails: Trending Markets Are Not Necessarily Momentum Ones

As I speak with traders, I notice a common mistake that is responsible for quite a few losses:  the confusion between trend trading and momentum trading.  They are not the same thing.  Traders who fear missing out on a trending move and chase strength or weakness frequently get whipsawed and stopped out.

Let's define our terms:

An asset that is trending is making higher highs (lower lows) and higher lows (lower highs) during a given lookback period.  If you imagine a regression line for price as a function of time, the line would be the trendline and there would be a noticeable positive or negative slope over that lookback period.

An asset that is trading with momentum tends to continue in the direction in which it has been trading.  Strength tends to be followed by strength; weakness by weakness.  Think of that regression line that is the best fit for a given trend.  If price oscillates widely around that line (i.e., the fit is not great), this is because the trending asset is not trading with momentum.  When price is strong, it tends to fade and vice versa.  A line that is a very good fit suggests momentum in the direction of the trend.

When traders assert that there is a trend and then buy strength (or sells weakness) to ride the trend, they are assuming that the trend also displays momentum.  That ain't necessarily so.  Buying strength in an uptrend and selling weakness in a downtrend is a great way to underperform in a trend market that is not a momentum one.

Let's go to the excellent Paststat site for a couple of illustrations.  A technical indicator is a useful and familiar measure of price strength and weakness.  If an asset shows momentum effects, it should demonstrate significant strength following high indicator readings and significant weakness following low readings.  Different indicators incorporate different lookback periods, so a look at several is useful if we want to gauge momentum over differing time periods.

To start, let's say we buy SPY when it closes above its upper Bollinger Band and hold for five trading days.  Over the past three years, this has resulted in 40 trades.  Of those, 24 have been winners and 16 losers for an average gain of +.04% and a profit factor of 1.13.  Meh.  No distinctive upside edge to buying strength, but also no significant weakness.  This fits with my research:  when price strength occurs with positive breadth thrust and elevated momentum, there is a greater probability of upside follow through than when the strength occurs with little oomph.  Averaged together, we see no meaningful tendencies.

Now let's buy SPY when it closes below its lower Bollinger Band and hold for five trading days.  Now we have 43 trades:  28 winners and 15 losers for an average gain of +.98% and a profit factor of 3.14.  That's a meaningful bullish tendency.  It suggests anti-momentum following weakness.  When price has dropped significantly, we've tended to bounce.

The trader who bought strength and sold weakness during the last three years lost money on average.  It has been a trending market, but not a momentum one.  Executing based on momentum has turned a normally winning trend strategy into a losing one.  Think about traders who trade with a "fear of missing out", and you can appreciate why that emotional pattern is so costly!

OK, so let's buy SPY when its RSI is above 70 and hold for 5 days.  Now we have 122 trades over a three year period:  60 wins, 62 losses, for an average gain of +.02% and a profit factor of 1.08.  Meh.  If we buy SPY when its RSI has been below 30, we have 24 trades:  18 up, 6 down for an average gain of +1.79% and a profit factor of 7.08%.

It's interesting that traders often emphasize trading with the trend but not chasing trades.  That's an implicit realization that a directional bias doesn't have to be a momentum bias.  Many trends are traded best when they look as though they're ending.

Further Reading:  Price Momentum and Cycles
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Market Profile as a Fresh Perspective on Markets: Useful Resources for Traders

Last year I wrote about Market Profile as a practical theory that helps traders achieve a fresh perspective on markets and trading.  Market Profile stems from the early work of Peter Steidlmayer, which was grounded in an innovative approach to charting.  (See this early manual for an overview).  This approach tracks the market's auction process by identifying where markets set value and gauging whether current trading is accepting or rejecting a given value area.  Markets rotate in and out of balance as they oscillate within value areas and create new ones.  

Since this early work, a variety of new tools for understanding the market's auction process have become available.  Market Delta is a unique charting format that helps identify when buyers and sellers are dominant in markets based upon whether transactions are occurring dominantly at the current bid or offer price.  This can be an effective way of visualizing how volume is behaving as we depart from a value area--a nice tell for whether we are likely to rotate back into a value range or trend and establish fresh value.

WindoTrader is an unusually flexible charting and analytics package that helps traders visualize value relationships at different time frames within a single graphic, as well as value relationships among different instruments.  (See their list of reading resources and trading blog.)  It is not at all uncommon to see a market move out of a shorter-term value range to the value area of a longer timeframe auction.  Visualizing this activity in real time is quite valuable.

I don't know of anyone who has done more to popularize Market Profile and educate traders in its application and interpretation than Jim Dalton.  He has archived a great number of articles and videos for his students and has developed training programs both by DVD and live.  I notice that he is conducting a summer intensive, in which he presents fresh developments in Market Profile application, including "signature trades" that result from an understanding of the auction process.  His current work builds on the excellent foundation of his Mind Over Markets book. 

Jim makes an important point:  when you look through the lens of the profile, you begin to think in terms of market structure and value, not price.  When we focus on price alone, we lose the context of that price movement.  Markets make sense as auction processes, providing us with a unique perspective on how markets move.  Many trading problems occur when we spend so much time and effort trying to predict the next market move, when it would be far more helpful to truly understand the market's movement to that point.

Further Reading:  Market Profile as a Best Practice
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You Can't Win If You're Not Playing The Right Game

Mark Minervini makes an interesting point: the market is like poker in that the most important element of success is knowing which game to sit in on.  All too often, I find that traders in a slump focus on the hold 'em versus fold 'em choices of trading when, in fact, they're sitting at the wrong table.

How can we sit at the wrong trading table?  Several variations of this challenge immediately come to mind:

*  You're a momentum trader and you're trading a slow, low volatility market;

*  You're a trend trader and you're trading a choppy, range market;

*  You're a research-oriented big picture trader and you're getting caught up in short-term price action;

*  You're a skilled short-term trader and you're locked in a longer-term directional market view;

*  You're a contrarian fader and you're getting run over in high volume directional flows;

*  You're an independent thinker, but you're distracted and influenced by the views of others;

*  You're a trader who reads others well at the table, but you're isolated from other traders;

I've seen people make money in markets two ways:  by investing and by trading.  Investing means generating a big picture view and riding out short term noise en route to seeing that view materialize.  Investors are top-down thinkers:  they're analytical and their skill lies in putting pieces of research together to form a picture that others haven't yet seen.  Traders are bottom-up thinkers:  they recognize patterns as they form and act on them quickly.  Where the investor thinks deeply about opportunity over time, the trader thinks broadly about what's happening in markets at a given time.

A great way to lose money is to not understand yourself and how you're wired cognitively.  If you're a deep thinker, you'll lose money sitting at the trading table.  If you're a fast thinker, you'll lose money dabbling with investment theses.  The route to success is to be who you are when you're functioning at your best.  Working on improving your discipline, controlling your emotions, and following your process is not helpful if you're sitting at the wrong table to begin with.

Further Reading:  Patterns of Reasoning in Markets
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A Good Way to Beat a Bad Attitude

Everyone knows what it's like to be in an attitude funk.  Perhaps it's been a long, slow drawdown; problems in your personal life; an overload of work; a lingering illness; or some combination thereof.  Nothing seems to be going right and nothing is making you particularly happy.  Thoughts and feelings shade to the negative, you're feeling grumpy, and you don't exactly feel like being around other people--especially if they're killing it in markets!

Research tells us that we perform best when we're drawing on strengths and are most vulnerable to burnout when the intensity of our work efforts crowd out the sources of our rejuvenation.  When our willpower is sapped and things aren't going well, it is difficult to access the positivity needed to emerge from an attitude funk.  An absence of positives, not just a surplus of negatives, can weigh on our mood and energy level.

One key to emerging from a bad attitude is making the transition from noun-thinking to verb-thinking.  In the noun-thinking mode, a negative attitude is something we have; we own it.  In verb mode, a negative attitude is something we're doing--we can control it.  More specifically, any attitude reflects our conversations with ourselves:  it is the direct result of our self-talk.  If we tell ourselves we're not doing well and nothing works, we will feel defeated and frustrated.  If we talk to ourselves in ways we'd never want to hear from others, we'll experience attitudes that we'd never want to be around.  

Once we switch lenses to the verb mode, we can see that our attitude is nothing more than the tone of our internal conversation.  Perfectionistic self-talk that emphasizes where we fell short leaves us feeling like we're falling short.  Worry talk about the future leaves us less than energized about pursuing the future.  Our attitude is our relationship to ourselves, made visible.  If we have a caring, supportive relationship to ourselves, we're more likely to face life with gratitude than attitude.

So, in the spirit of verb-thinking, here's a specific activity that can turn negative attitudes around:

Every time you catch yourself criticizing yourself or thinking negatively about your trading performance, write in a thought diary one or two constructive steps that you will take that day and week to make an improvement.  A great way to generate those constructive steps is to reflect on past positive experience and performance and identify what you did well at those times.  Those steps become your near-term goals and your subsequent focus.  It is important that what you write becomes what you do:  goals must turn into action plans. 

In other words, a good thought diary turns negative thinking into constructive thinking:  every self-criticism is answered with a positive change focus.  Negative thinking says, "I'm not doing good enough."  Constructive thinking says, "I'm making myself better."  

That's how we make positive experience a verb rather than a noun:  we can't always defeat a negative attitude with a positive one--sometimes things just aren't positive.  But we can always overcome a focus on what's bad with a focus on what we can improve.  Having a good attitude doesn't hinge on doing well; it is the result of appreciating the ways in which we're getting ever better.

Further Reading:  The Power of Opposites
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Resources for Traders and More to Kick Off the Market Week

*  Above is my intermediate-term measure of market strength (red) charted against the cash SPX going back to the beginning of 2014.  The strength measure takes the sum of 5, 20, and 100-day highs and subtracts the sum of 5, 20, and 100-day lows specific to the SPX stocks.  It then smooths this number with a 10-day moving average.  (Raw data via the excellent Index Indicators site.)  Note that the strength measure has been waning since late 2014 and has recently turned downward from a relatively low peak.  When strength has been above zero going back to 2012, the next 20 days in SPX have averaged a gain of +.86%.  When strength has been below zero, the next 20 days in SPX have averaged a gain of +2.34%. 

*  Here's a very important Forbes article on performance co-written by Ted Hayes, Ph.D.  It explains why the single most important thing you can do to improve trading is develop and implement a strengths-based performance framework.  Some excellent links to strengths-based tests and resources. 

*  What to look for in market bubbles and other great reads for the week from Abnormal Returns.

*  Here are some great resources for you quant types out there:  

-- A very impressive collection of market stats from Vic Scherer.

-- Great breadth data and an impressive query engine from Kora Reddy.

-- My long time source for breadth data, Index Indicators also has a query engine.

-- A new primer on quant analysis from Adam Grimes.

Have a great start to the week!

Brett
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Bayesian and Static Reasoning in Markets: Trading With an Open Mind

In a recent post, I highlighted the range trade in the ES futures over the past several months.  My point was that the market has been showing diminishing breadth at successive highs and also less weakness at successive lows during that range.  Generally, lengthier ranges lead to lengthier directional moves, as they are part of longer-term market cycles.  So the breakout from the current range should ultimately be a significant one.  Will the market break out of its range imminently, or will the range continue for another month or more?  Will the ultimate breakout be to the upside or downside?  Will we see a fakeout, false breakout prior to an eventual move to new highs or lows? 

My worst trading--and the worst trading I've observed of many traders--has been the result of what could be called static reasoning.  Static reasoning takes a variety of evidence, assembles the evidence into a conclusion, and then places trades based on that conclusion.  Risk taking is often a function of one's degree of belief in that conclusion.

Static reasoning is problematic for two reasons:  1) it is subject to overconfidence bias, as we take a firm stance on a view that we own; and 2) it is subject to confirmation bias, as we tend to process new, incoming information in the light of our convictions.  When I've seen traders take larger than desired losses, it's generally not been because they've held onto marginal views.  Rather, they have sized up their preferred views, stuck with those views in the face of contrary market information, and ultimately lost the position when drawdowns became uncomfortable.

I have found my best trading to result from what could be called Bayesian reasoning:  a thought process that reflects a Bayesian, probabilistic way of thinking.  Bayesian reasoning begins with a hypothesis, but it is a flexible hypothesis that updates with new, incoming information.  One's confidence in the hypothesis waxes and wanes with new information, and one's hypothesis can quickly change with new information.

With static reasoning, a market view is something you have and trade with.  With Bayesian reasoning, a market view is fluid and continually evolving.  

Trading leading up to and including this past Friday was a good case in point.  We traded firm for most of the week, with relative strength in small cap shares.  Volume had been coming down in recent sessions and, by April 15th, we saw new highs in the broad NYSE Composite Index not accompanied by an expansion in the number of stocks registering fresh highs.  With each observation of low volume and diminished new highs, my confidence in an upside breakout diminished.

Friday saw new information come into the market regarding China and Greece.  There was a strong selloff in pre-market hours.  Volume expanded, as did volatility.  New market participants were joining the fray, and they were joining with a downside bias.  That led me to sell an early, pre-opening bounce in the ES futures.  At that point, the evidence tilted toward continuation of the range and a short-term handoff from bullish to bearish control of the market.  I reasoned at the time that investors would not want to risk bad headlines over the weekend and so would be likely sellers in early New York trade.

That indeed materialized, but then something interesting happened in mid-to-late afternoon.  We had seen steady selling in stocks, as measured by the NYSE TICK.  When I ran a study of lopsided selling days such as the one in progress, I noticed a tendency for the market to bounce higher the next day or two.  At the same time, I noticed continued selling pressure in stocks (negative TICK values), but now the ES futures were holding above their lows for the day.  Selling was no longer able to get price higher.  I still liked the range-based view but the trade no longer looked great from a risk/reward perspective and I took profits.

Am I a bull?  Am I a bear?  Not really either, and the question presumes a degree of static reasoning.  What made Friday a good day in the market was the fluid transitioning from waning bullishness to waxing bearishness to waning bearishness.  We could indeed gap lower in the near term and take out Friday's low, but that's not where the odds were at the time.  Let's let the bulls take their turn and see what they can bring to the market.  Should we get a feeble rally and a lower high, there will be plenty of opportunity to resume a downside trade targeting the lower end of the recent range.  Should we get a more substantial rally, then we can update evidence for continued topping in the range or even upside breakout.

Bayesian reasoning means trading with an open mind and staying flexible in the face of new information.  Think of it this way:  we're in an ongoing conversation with markets.  In any conversation, if you stay locked in what you want to say, you become less sensitive to the other person.  A good conversationalist is a good listener, picking up on subtle cues and adjusting one's own tone and response accordingly.  In markets as in conversations, closed minds and strong views lead to tone-deaf interactions.

Further Reading:  The Importance of Emotional Creativity
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Breakout in the Making?

Here are the ES futures over the past several months.  Somewhat volatile and in a range.

A few interesting stats:

Stocks across all indexes making fresh 3-month highs and lows:

2/13/2015 - 510, 86
3/2/2015 - 513, 158
3/20/2015 - 708, 113
4/15/2015 - 570, 89

1/29/15 - 172, 449
3/10/15 - 137, 440
3/26/15 - 82, 213
4/17/15 - 131, 167

Fewer new highs, fewer new lows from March to April.  

Not strengthening.  Not weakening.

So far.

What I Learned By Studying My Exits

An interesting question posed on the Tradeciety site asks the one thing you wish you had known when you started your trading career--and gives the responses of a number of experienced traders.  Most of those responses focus on sound trading practices and ways of learning trading--sound universal lessons.

A worthwhile variant of that question is:  what's the one thing you wish you had known at the start of the year?  In other words, what have you been missing in the last few months of trading?

I recently conducted my own trading inventory and examined in detail what has worked and not worked.  The results were illuminating.

My exits have been bad.  In some cases, they've been really bad.  What I mean by that is that:  a) they've been less rigorously thought through than the entries; b) they've been reactive to the pain of drawdown and not the risk/reward at that moment; and c) they've been at poor locations.  A surprising proportion of my trades would have been profitable had I held the position with a wider stop.  The seemingly good risk management significantly hurt profitability.

The problem--and I see it with traders I work with--is the misalignment of goals for the upside and risk management on the downside.  At a given, reasonable, but positive Sharpe ratio, a trader seeking X% returns is going to draw down a meaningful percentage of X% at some time.  Traders--including myself--feel the desire for the X% upside, but cannot psychologically or practically tolerate the accompanying drawdown.  It is not coincidence that my hit rate on trades placed with smaller size (less risk) has been quite good.

Ultimately this is a problem of lack of diversification.  A well constructed portfolio consists of many relatively independent bets, each with positive expected return.  This smooths the equity curve while allowing the trader to place a higher proportion of capital at work.  Diversification requires ongoing research and development--and the ability to see multiple edges in the market.  It is much easier to allow trades to breathe and hit relatively wide stops when there are multiple trades working for you.  A great deal of the challenge of dealing with emotions in trading is a function of poor money management.  It's tough to trade dispassionately when all your eggs are in one basket.

Further Reading:  Diversifying Your Emotional Portfolio
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Quick Insights With Deep Meanings

*  J.C. Parets on the value of homework.

*  Mark Yusko on the power of our social environment.

*  Derek Hernquist on backtesting.

*  Brian Shannon on investing's key lesson.

*  Urban Carmel on the market's sentiment.

*  Ambrose Evans-Pritchard on deflation.

*  Steve Burns on the greatest challenge in trading.

*  Think about the meaning of this:  Since 2014, when SPY daily volume has been in its lowest quartile, the next 20 days in SPY have averaged a loss of -.06%.  When SPY daily volume has been in its highest quartile, the next 20 days in SPY have averaged a gain of +2.71%.  

Further Reading:  Evaluating Your Trading
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Sleep and Performance: The Quality of Our Nights Affects the Quality of Our Days

I find that a surprising proportion of what sets traders up for success during the day is what has happened the previous night.  We know from research that the proper quantity and quality of sleep aids concentration and learning and that disordered sleep can impair our cardiovascular health.  Sleep also has a beneficial impact on our mood and is associated with improved thought and memory.

It is fascinating that sleep disturbances are present in over half of patients with psychiatric problems--a far greater percentage than in the general public.  This has led to the observation that sleep disruptions are not only symptoms of problems such as anxiety, but active contributors to those.  One in five patients with depressive disorders are suffering from sleep apnea--disrupted sleep often associated with snoring. 

One study found that financial decision making was meaningfully impaired when subjects were sleepy due to poorer judgment about the task being undertaken.  It is when tasks are complex and challenging that we're most likely to be impaired by poor sleep.

Here is an excellent article from Maria Konnikova on how our performance is impacted by how we wake up in the morning.  Sleep inertia, she reports, significantly affects our cognitive functioning.  It appears that being process-driven in how we sleep is as important to our functioning as being process-driven in our work during the day--and indeed may set us up for either success or failure in our ability to work in disciplined and productive ways.

Further Reading:  Three Things to Improve Your Life Now
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