This was Mali at 2 AM this morning. It's not much of a conflict when part of you wants to sleep and another part of you wants to cuddle a blind, purring cat. The purr is worth a tired day! It's all about staying focused on what's essential in life. In markets, it's easy to become focused on non-essentials. We tell ourselves stories about the state of the world or the state of market charts. Far more essential is what buyers and sellers are actually doing in markets. Are there many buyers participating in today's market? Many sellers? What is the relative balance of buyers and sellers, and is that changing? It's all about the auction process. So let's go to the data. We'll go back to 2012 and look at every transaction in every NYSE stock each day. Those occurring on upticks we will categorize as initiated by buyers. Those occurring on downticks we will categorize as initiated by sellers. The total number of transactions occurring on upticks and downticks, we will call participation in the market. Participation differs from volume, because a given unit of volume can be broken into many transactions or fewer depending upon the sophistication of the execution platform and the urgency of the traders. Increasingly, we're seeing volume broken into pieces, creating multiple transactions. How these transactions occur--on upticks vs. downticks--provides a useful sense for the flow of supply and demand moment to moment. So at the end of the day, we have a total score of transactions occurring on upticks (buying pressure) and a total score of transactions occurring on downticks (selling pressure). What can we learn from these measures? If we divide the sample from 2012-present into quartiles, we find out that when daily upticks are lowest, the next 10 days in SPY have averaged a loss of -.05%. When daily upticks have been highest, the next 10 days in SPY have averaged a gain of +1.02%. Heavy buying tends to beget further buying. That's a momentum effect. If we then look at when we have the fewest downticks, we find that the next 10 days in SPY have averaged a gain of +.13%. When we have the greatest number of downticks, the next 10 days in SPY have averaged a gain of +.96%. Heavy selling tends to beget future buying. That's a value effect. If we now combine total upticks and total downticks to create our participation measure, we find that when we've had the lowest participation, the next 10 days in SPY have averaged a loss of -.10%. When we've had the highest participation, the next 10 days in SPY have averaged a gain of +1.33%. So this is what's essential: There are value participants in the marketplace that scoop up stocks when they have traded weakly. There are momentum participants in the marketplace that buy shares when they're moving sharply higher or lower. Market lows are created when value and momentum participants are interacting with one another, first selling falling shares, then scooping up the fallen assets, and then picking up the rising stocks. Market highs are created when prices get to the point where they no longer attract value participants and lose their momentum. There is relatively low participation at those times. This is why, when SPY volume has been lowest, the next 10 days in SPY have averaged a loss of -.24%. When volume has been highest, the next 10 days have averaged a gain of +1.15%. Who is in the market? What are they doing? How is their behavior shifting over time? Those are keys to understanding markets. Now I'll focus on another essential: sleep!
"I'm in a rut." That's what we hear when someone finds themselves doing the same thing and getting unsatisfying results. Trading can be in a rut. Relationships can be in a rut. We can be in a rut with respect to our social lives, our physical well-being, or our spiritual lives. A rut is a habit that has outlived its usefulness. At one time, it may have had value. Now we've outgrown it, but it remains a habit. Because ruts are habits, each time that we fall into the rut, we reinforce the wrong habits. The rut grows a bit deeper and starts to look more and more like a grave. The best way to break habits is to create new ones. The things we're doing now that are useful--that bring happiness, success, fulfillment--those are the things that we should be looking to habit-ize. But do you want to know the true key to staying out of ruts? It's to turn habit breaking into a habit. If we get into a routine of identifying strengths and making them automatic, then habit breaking and the creation of new, positive habits itself becomes a habit pattern. That is why we can never innovate occasionally. The people who innovate have made a habit of innovation. They make a habit out of rut-finding and creating new paths.
We can't necessarily move mountains or climb over them, but we can get to the other side if we turn our ruts into tunnels.
What is the rut you're in now? What is on the other side of your mountain? Life is so much more satisfying when we stop digging and start tunneling. The only difference between a rut and a tunnel is the direction of the digging. Further Reading: How to Find Your Trading Talent
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Here's an interesting set of statistics. During 2016, the correlation between today's volume and tomorrow's volume in SPY has been about +.68. The correlation between today's true trading range and tomorrow's has been above +.60. Both are in line with long-term averages. The correlation between daily price change today and daily price change tomorrow in SPY is -.11. In other words, the recent past tells us much more about who will be in the market and how much the market will move than which way the market will move.
But wait, you might say, perhaps there is more consistency of price movement on an intraday basis. During 2016, if we look at 5-minute bars for SPY, we find an almost identical pattern. The correlation between the current bar's volume and the next bar's volume has been +.75. The correlation between the current bar's range and the next bar's range has been +.69. But the correlation between the current bar's price change and the next bar's change has been -.03. Given these stats, as a trader you'd want to have an open mind as to market participation (after all, about 50% of the variance in volume is *not* accounted for by prior volume), but especially as to price behavior. We might think one thing or another with respect to market trend or mean reversion. The reality is that only about 1% of the variability in price direction in the next period is accounted for by the price movement in the present period.
In an interesting recent post, Mike Bellafiore from SMB draws upon a recent TED talk to make the distinction between thinking like a scout and thinking like a soldier. The scout reads the terrain and looks for what is happening now. The soldier defends terrain and follows battleplans. In an environment characterized by high uncertainty, the open mindset of a scout is necessary. If we become too locked into what has just happened, we can easily fail to see what is going on now. Conversely, if we're following battle plans as a soldier, we must be mentally prepared for the "fog of war" and uncertainties of battle. Those statistics tell us that, in terms of directional price movement, noise is very high relative to signal. Regardless of our time frame, we will face uncertainty during the life of our trade. How we deal with that uncertainty greatly impacts how we manage our positions. The wise trader might follow a plan, but never stops being a scout. It's when markets significantly deviate from their normal noise that opportunities arise. Further Reading: Bayesian and Static Reasoning in Markets
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Stocks have traded in a volatile range lately, with significant moves frequently reversed. This has proven challenging for those looking for trends. If we think of markets as auction processes, we can identify volatile and non-volatile markets based upon the amount of participation in the marketplace. We can also identify trending and non-trending markets based upon the relative balance of buyers and sellers. Our job is to read the auction process and adapt to the conditions before us. We are in a very different environment than several months ago. When we have a volatile range, we have large participants active as both buyers and sellers. The move in rates and uncertainty over central bank direction has created a different auction process. How do we talk to ourselves about market conditions? Do we frame the situation as a challenge and as a problem to be solved, or do we frame ourselves as victims of unknowable market forces and passively hope that things will change in our favor?
Victim self-talk is the surest way of disabling ourselves when opportunities arise. How we frame situations determines how we respond to them...and how we will be prepared for the future.
We all know the saying, "No risk, no reward." In markets especially, we cannot make money if we're not willing to take risks. Frankly, however, my experience working with traders is that the greatest problem is not with taking risk, but with the intelligence of risk taking. Traders take risks that, ultimately, they are not emotionally prepared to handle. I recall the trading days in which you could get filled on a long position at the market's bid price and either get out a tick lower or wait and see if you could get a larger gain when it traded at the offer price. Most trades could be scratched that way and you got plenty of free looks at larger moves. Once market making became algorithmic, that level of risk control--the hallmark of true scalping--became impossible. The noise was simply too great for the amount of signal traded. The same has been happening at larger time frames. The most common concern I hear from active traders is the "choppiness" or noise of markets. High Sharpe, trending moves are the exception. Very often, the market will take out previous highs before moving to lows and vice versa. This makes it easy to stop out of trades at poor levels. Risk taking becomes unintelligent when the amount of risk we take is ultimately more than we can handle, either emotionally or business-wise. The trader who routinely gets stopped out of good ideas--ones that often work out in the end--is trading more size and taking more risk than they can handle, given the market's signal to noise ratio. Traders overestimate the precision of their entries, leading them to seek trades that seemingly give them a reward-to-risk ratio of 2:1, 3:1, or even higher. The reality, however, is that this becomes a losing strategy if the ratio of winning to losing trades is even higher. The problem is magnified many times over when traders, out of overconfidence from a winning streak, take greater risk--particularly when market volatility has itself expanded. The increased market movement and greater P/L volatility from the increased size places an emotional magnifying glass on moves against the position, increasing the odds of a bad stop out. How do you know if you're taking risk that is not psychologically sustainable? One simple yardstick is to observe your behavior during the life of a trade. If you have a highly diversified portfolio; if you have moderately sized positions with wide stops; if you express trades in risk-limited ways with options or relative structures, you should not be hanging on every tick in markets. If you're glued to screens, if you're constantly checking your phones, if you're unable to conduct market research and attend to your trading business because you're preoccupied with market movement during the life of your trades, you no longer have emotional control. You are much more likely to make reactive trading decisions that have low odds of success.
Risk taking that is threatening is not emotionally intelligent risk taking. We cannot control markets, but we can control the risks we take. When we size positions larger than we can ultimately tolerate given market noise, we give up our control--and that surrenders any edge we may have possessed.
The last post took a look at the importance of prioritizing our goals and the activities that help us pursue our goals. An excellent post from James Clear discusses the importance of habit formation, so that the changes we seek become internalized parts of ourselves and built into our daily routines. The post cites evidence that such habit formation is most likely to occur if we structure our pursuit of goals, specifying what we'll do each day, when we'll do it, and how we'll do it. Interestingly, however, we are most likely to turn our specific plans into habits if we focus on one goal at a time. Doing one new thing the same way over many days is much more effective in developing new habits than trying to do many new things at once. Clear cites research that suggests it takes over two months of repetition on average for a behavior to become truly internalized and automatic. That's a significant period of time (and commitment) and helps explain why relapse is so common among people seeking changes. If we do not sustain consistent effort over time, the new behavior does not become a consistent part of us. In those first days and weeks of effort, habits are like cobwebs--easily broken. It's only with significant repetition that they gain the strength of cables. So there's a chicken-and-egg problem here. We need repetition over time to build a habit, but it's precisely the absence of the right habits that make it difficult to repeat activities over time! How can we become better at the process of habit formation? At root, there are only two reasons for devoting the resources to making changes: extreme fear or profound inspiration. We will change if we absolutely need to: if the consequences of not making the change are so scary and aversive that we'll do anything to avoid them. That's how alcoholics change after hitting bottom; it's why people who could never diet suddenly make big shifts in eating after a heart attack. Fear creates a sense of urgency. But the sense of urgency can also come from very high levels of inspiration. We can become so energized and excited by a potential outcome that its pursuit becomes our absolute priority. That's the motivation that keeps the entrepreneur doing the right things, or the Olympic gymnast. It's not about being pushed by fear, but being pulled by an ideal. The bottom line, however, is that we need a sense of urgency to keep doing something, the same way, for over two months. Urgency is the great missing ingredient in most change efforts. This is why goals, to be achieved, must be meaningful, not mere shoulds. If a goal is a mere desired outcome that finds its way onto a to-do list, it will neither inspire the fear nor the inspiration to become an urgent priority. Inevitably, competing activities will take over and we'll become a victim of relapse. This, ultimately, is why setting and pursuing multiple goals doesn't work. Once we dilute our goal-setting and pursuit, no one goal sustains the specialness--the sense of urgency--needed to become an automatic part of ourselves. We only change when change is truly important to us...when it becomes a need and a must, not just a preference. If we're looking to make changes in our trading, finding the one change that will make the greatest difference and tapping into the urgency of making that change is the best way to turn our best practices into robust, best processes. Further Reading: Three Best Practices of Best Traders
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An insightful post from @ivanhoff lists his takeaways from the popular book The One Thing, including the importance of focusing on the one thing that matters the most in terms of reaching your goal. Not goals. Goal. Not many things. One thing. That is prioritization. Too often, we set multiple goals and never drill down and truly accomplish any of them. We try different things to reach our goals, patting ourselves on the back for multitasking, when in fact we never become distinctively good at any of the things we're doing. In short, we take on too much and water down our priorities. The idea is focus like a laser on what you want to achieve and the best way for you to achieve it. That's more than goal setting: it's commitment. If you don't have a singular, passionate, all-consuming commitment to a goal right here, right now, what will lead you to singular successes going forward? If your work is tiring you, it's not inspiring you. It's time to stop prioritizing your schedules and start scheduling your priority. Further Reading: How to Make Big Life Changes
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If you're losing money in your trading, there is an important question that can help you figure out your next steps. This is important, because sometimes traders become so interested in stopping their losses that they don't first figure out what is causing them. They look to psychology for answers, when it's their trading strategy that is flawed. They hop from trading approach to trading approach, never addressing the psychological issues that are sabotaging whatever they're doing. If you're losing money, something has to change, but how do you figure out what that something is? The question that helps sort out promising directions for those in drawdown is this: Are other people, trading similar strategies, also losing money? That will tell you quite a bit. If you were making money and suddenly go cold and others in the same markets, with similar strategies are doing the same, then you know that it isn't simply a psychological issue. Everyone did not suddenly lose discipline or become an idiot at the same time. Rather, the strategy is not working under current market conditions, or it has stopped working altogether. If the strategy has stopped working under current conditions (as, perhaps, in the case of a breakout strategy in stocks failing to make money in conditions of low volume and volatility), then the answer is to pull back risk-taking and go into research-and-development phase. Your goal is to find strategies that can supplement your existing ones and make money in the challenging environment. For example, you might add a "value" strategy that sells overbought conditions and buys oversold ones to the breakout strategy. The combination of the relatively uncorrelated strategies would potentially give you a smoother profit curve, allowing you to make money across regimes. Only over time will you be able to identify if the strategy has stopped working altogether. If, in conditions in which you (and others with similar strategies) have made money in the past, you (and others) remain unable to prosper, a plausible hypothesis is that a more fundamental shift has occurred in markets. You're like the company that has made money selling laptops, only now to find out that the demand is for tablets. The market has changed. That's why the research-and-development efforts and pulling back of risk-taking are so important when you (and others) lose money: we never know initially whether drawdowns are temporary or reflect structural market changes. On the other hand, if you're losing money and others are succeeding with similar strategies, then you have real evidence that the drawdowns are more about you than about the market per se. Perhaps your implementation of the strategies needs work; perhaps your psychology is undercutting your implementation; perhaps your analysis that feeds the strategies needs supplementation. All of those can be fruitful directions for exploration. It's often the case that, when psychology is the culprit, you'll fail to make money when your peers in similar strategies are prospering. Keeping a psychological journal--what's happening in markets, whether you're making or losing money in trades, your frame of mind during the day, etc--can help you identify patterns underlying your successes and your drawdowns.
Intelligence begins with asking the right questions. Is it me, or is it markets? We are most likely to find the cure to our trading ills if we first make the right diagnosis.
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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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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