In the last three trading sessions, yields on the 10-yr Treasury note have plunged from over 4.7% to 4.5%. At the same time, the Yen has soared from 8550 to 8700. Meanwhile, the S&P 500 Index has fallen about 2%, from 1575 to 1545.
Readers will recognize the risk aversion themes and high intercorrelation among markets that we saw during August. Note also the resumed weakness in financial shares over that time, with $BKX down over 4%.
Are traders and investors buying risky assets or fleeing them? That has been the key sentiment question for short-term traders. When money flows into Treasury notes and out of financial stocks, large traders and investors, it would seem, are playing for safety. That's an indicator worth following.
RELEVANT POST:
Last Hour of Trading as a Sentiment Measure
.
Thursday, October 18, 2007
Wednesday, October 17, 2007
A Note of Thanks
I want to thank all who have commented to the recent post on trading resources. If you read through those comments, you'll find a wealth of online and print resources. Some are new to me, and I look forward to delving into them. I very much appreciate those who have taken the time to share with others; if I can ever be of help to you, please let me know.
Brett
Brett
How To Change Yourself
People come to psychologists to make changes in their lives. Sometimes, those changes are to build upon strengths. Other times, the changes are to solve problems.
We have a “real” self—the person we think we are—and an “ideal” self: the person we would like to be.
The psychologist’s job is to bring us a bit closer to that ideal self, either by changing our real selves, redefining our ideals, or both.
But how do people change? How do we move closer to our ideals?
A most important psychological principle is that everything we do and everyone we interact with is a kind of mirror. We experience ourselves through our activities and contacts and, over time, those experiences are internalized and become part of our self –concepts.
A work task mirrors for us whether or not we’re capable, creative, and reliable. An interaction with a valued person mirrors for us whether or not we’re liked, loved, and valued.
People do not change in a vacuum. They change because they enter into situations that mirror new experiences of themselves. Being in a loving relationship after having been in bad relationships or being in a fulfilling job after having been mired in low-level work can be profound change experiences.
This is why counseling and therapy works: it provides a significant relationship as a medium for fresh, positive mirroring experiences. A depressed or abused person who feels worthless finds in therapy a validating experience that gradually becomes part of the self.
This is a key principle: We are the sum of our mirroring experiences. If we are in unfulfilling, frustrating situations in work and love, we will experience ourselves negatively. If we are in situations that bring out the best in us, we will develop positive views of ourselves.
The psychologist George Kelly realized the power of mirroring and developed an approach to change that he called “fixed-role therapy”. In a nutshell, he asked his clients to invent a person who represented their ideal self in some fashion. This fictional character was given a name and described (in writing) in great detail.
Once this ideal character was defined, the challenge was to play-act that character in a variety of life situations. In other words, Kelly had people role-play their ideals, making sure they stayed strictly in character.
What Kelly found was that, over time, people received positive feedback about these enactments that made them easier to sustain over time. Eventually, the ideal behaviors didn’t feel like an act at all. They became part of the person’s repertoire.
If you want to make a change, you won’t do it by talking yourself into it or through motivation. Rather, find a social context in which you can be the change you want to make. The resulting feedback will be the mirror by which you’ll experience yourself as your ideal and make that ideal a genuine part of you.
A big part of being happy and successful is finding the right set of life mirrors. And *that* is why finding your trading niche is so important.
RELEVANT POSTS:
The Devon Principle
.
We have a “real” self—the person we think we are—and an “ideal” self: the person we would like to be.
The psychologist’s job is to bring us a bit closer to that ideal self, either by changing our real selves, redefining our ideals, or both.
But how do people change? How do we move closer to our ideals?
A most important psychological principle is that everything we do and everyone we interact with is a kind of mirror. We experience ourselves through our activities and contacts and, over time, those experiences are internalized and become part of our self –concepts.
A work task mirrors for us whether or not we’re capable, creative, and reliable. An interaction with a valued person mirrors for us whether or not we’re liked, loved, and valued.
People do not change in a vacuum. They change because they enter into situations that mirror new experiences of themselves. Being in a loving relationship after having been in bad relationships or being in a fulfilling job after having been mired in low-level work can be profound change experiences.
This is why counseling and therapy works: it provides a significant relationship as a medium for fresh, positive mirroring experiences. A depressed or abused person who feels worthless finds in therapy a validating experience that gradually becomes part of the self.
This is a key principle: We are the sum of our mirroring experiences. If we are in unfulfilling, frustrating situations in work and love, we will experience ourselves negatively. If we are in situations that bring out the best in us, we will develop positive views of ourselves.
The psychologist George Kelly realized the power of mirroring and developed an approach to change that he called “fixed-role therapy”. In a nutshell, he asked his clients to invent a person who represented their ideal self in some fashion. This fictional character was given a name and described (in writing) in great detail.
Once this ideal character was defined, the challenge was to play-act that character in a variety of life situations. In other words, Kelly had people role-play their ideals, making sure they stayed strictly in character.
What Kelly found was that, over time, people received positive feedback about these enactments that made them easier to sustain over time. Eventually, the ideal behaviors didn’t feel like an act at all. They became part of the person’s repertoire.
If you want to make a change, you won’t do it by talking yourself into it or through motivation. Rather, find a social context in which you can be the change you want to make. The resulting feedback will be the mirror by which you’ll experience yourself as your ideal and make that ideal a genuine part of you.
A big part of being happy and successful is finding the right set of life mirrors. And *that* is why finding your trading niche is so important.
RELEVANT POSTS:
The Devon Principle
.
Tuesday, October 16, 2007
What Resources Have Helped Your Trading?
Once again, I'm going to tap the collective wisdom of the readership to see if we can generate a very useful post for developing traders. (By the way, I also want to express my appreciation for the feedback regarding trader strengths. I will be back from my road trip with traders tomorrow and will synthesize that feedback into a post for self-assessment).
This time I'll ask readers to offer their comments to this post by recommending the trading books, websites, and other resources that have been most helpful to your development. Please send in your ideas as comments to this post (not as emails to me), so that everyone can benefit from your insights.
My own list of trading resources can be found on my Trader Development page and also as a resource list at the end of my book on trader performance. You may have also noticed that there are certain blogs and sites that I particularly like, generally because these unique and useful views of markets and market themes. Some of these include:
* Abnormal Returns
* Bloomberg
* Financial Times
* The Big Picture
* The Kirk Report
* Trader Mike
* WSJ MarketBeat
But what do *you* find helpful? Books, sites, blogs: you name it. In my response to reader suggestions, I'll add a few of my own, including some favorite books. My hope is that, by sharing resources, we can help each other get to that proverbial next level of performance.
Thanks!
Brett
This time I'll ask readers to offer their comments to this post by recommending the trading books, websites, and other resources that have been most helpful to your development. Please send in your ideas as comments to this post (not as emails to me), so that everyone can benefit from your insights.
My own list of trading resources can be found on my Trader Development page and also as a resource list at the end of my book on trader performance. You may have also noticed that there are certain blogs and sites that I particularly like, generally because these unique and useful views of markets and market themes. Some of these include:
* Abnormal Returns
* Bloomberg
* Financial Times
* The Big Picture
* The Kirk Report
* Trader Mike
* WSJ MarketBeat
But what do *you* find helpful? Books, sites, blogs: you name it. In my response to reader suggestions, I'll add a few of my own, including some favorite books. My hope is that, by sharing resources, we can help each other get to that proverbial next level of performance.
Thanks!
Brett
Emotional Resilience in Trading: Three Keys
I can think of no psychological characteristic more important to long-term trading success than psychological resilience. Resilience has been defined in a number of ways, sometimes as a process, other times as a trait. In all cases, resilience presumes exposure to stressful conditions and an ability to maintain high levels of social, emotional, and vocational functioning throughout this exposure.
My experience with traders suggests that even the most successful ones go through periods of drawdown. Sometimes these drawdowns are extended, either in time or in the amount of money lost. Some traders bounce back from these losses; others don't. Here are three factors that seem to distinguish the most resilient traders:
* Flexibility - The resilient traders, interestingly, seem well aware that there will be dry periods in their trading. They realize that slumps happen and that market conditions change. This anticipation enables them to respond swiftly when their good ideas are no longer panning out. They reduce their risk, cut back on their trading, and wait to get a feel for things again. This prevents them from drawing down too deeply--even the most resilient trader will have difficulty coming back from a loss of half or more of their capital. The flexible mindset also enables the resilient trader to not take slumps and losses personally. By adopting a mindset that anticipates dry spells, the trader achieves a kind of psychological inoculation.
* Problem-Focused Coping - The resilient traders, when losing, delve deeper into themselves and deeper into the markets. They gain motivation to figure things out. Lesser traders become mired in discouragement and frustration, spinning their wheels by venting (or acting out) their emotions or by avoiding trading altogether. I find that a competitive spirit is a key part of this resilience: the successful trader uses this drive to draw upon motivation during slumps. Many traders, surprisingly, are not competitive at all: they're drawn to trading because of a perceived easy lifestyle. These are among the least resilient traders. As soon as it becomes clear that trading out of a hole means real work, they lose motivation and interest.
* Prevention and Preparation - I consistently find that traders who live on the edge financially--including those who ratchet up their lifestyle as they make money--are among the least resilient traders. It is stressful enough to go through a trading slump; to have to worry about making mortgage payments or supporting a family is too much pressure. The resilient traders prevent the pressures from becoming too great by maintaining healthy cash reserves for those dry periods and by having secondary sources of income wherever possible. Conversely, when the trading losses become a source of stress in the home life, this impairs resilience.
Stresses that are anticipated, on average, will generate less distress than those that come out of the blue. Each individual losing trade can be a psychological preparation for larger drawdowns when a trader engages in problem-focused coping and manages risk proactively. It is in this sense that resilience is a process, not just a quality that people either have or lack. By rehearsing elements of resilience with each trade, it is easier to find emotional reserves during those more extended drawdowns.
RELATED POST:
Assessing Your Coping Style as a Trader
.
My experience with traders suggests that even the most successful ones go through periods of drawdown. Sometimes these drawdowns are extended, either in time or in the amount of money lost. Some traders bounce back from these losses; others don't. Here are three factors that seem to distinguish the most resilient traders:
* Flexibility - The resilient traders, interestingly, seem well aware that there will be dry periods in their trading. They realize that slumps happen and that market conditions change. This anticipation enables them to respond swiftly when their good ideas are no longer panning out. They reduce their risk, cut back on their trading, and wait to get a feel for things again. This prevents them from drawing down too deeply--even the most resilient trader will have difficulty coming back from a loss of half or more of their capital. The flexible mindset also enables the resilient trader to not take slumps and losses personally. By adopting a mindset that anticipates dry spells, the trader achieves a kind of psychological inoculation.
* Problem-Focused Coping - The resilient traders, when losing, delve deeper into themselves and deeper into the markets. They gain motivation to figure things out. Lesser traders become mired in discouragement and frustration, spinning their wheels by venting (or acting out) their emotions or by avoiding trading altogether. I find that a competitive spirit is a key part of this resilience: the successful trader uses this drive to draw upon motivation during slumps. Many traders, surprisingly, are not competitive at all: they're drawn to trading because of a perceived easy lifestyle. These are among the least resilient traders. As soon as it becomes clear that trading out of a hole means real work, they lose motivation and interest.
* Prevention and Preparation - I consistently find that traders who live on the edge financially--including those who ratchet up their lifestyle as they make money--are among the least resilient traders. It is stressful enough to go through a trading slump; to have to worry about making mortgage payments or supporting a family is too much pressure. The resilient traders prevent the pressures from becoming too great by maintaining healthy cash reserves for those dry periods and by having secondary sources of income wherever possible. Conversely, when the trading losses become a source of stress in the home life, this impairs resilience.
Stresses that are anticipated, on average, will generate less distress than those that come out of the blue. Each individual losing trade can be a psychological preparation for larger drawdowns when a trader engages in problem-focused coping and manages risk proactively. It is in this sense that resilience is a process, not just a quality that people either have or lack. By rehearsing elements of resilience with each trade, it is easier to find emotional reserves during those more extended drawdowns.
RELATED POST:
Assessing Your Coping Style as a Trader
.
Monday, October 15, 2007
The Role of Regret in Trading
Cognitive researchers emphasize that our emotional responses are mediated by appraisals: judgments about ourselves and the world. Two people might take the same examination. One feels capable and prepared; the other assesses himself to be incapable of passing. It’s the latter student who will be likely to experience test anxiety.
In that sense, emotion is an experiential barometer that connects us to our evaluations of events and situations in real time.
One of the most fundamental appraisals we can make is whether we have been right or wrong in our decisions and actions. When we deem that we have acted properly and effectively, we experience satisfaction and pride. When we perceive that we have fallen short in our actions, the result is frustration and regret.
When we experience regret, we act as our own judge and critic. For most people, this makes regret an aversive state. The desire to reduce or eliminate regret thus becomes a powerful motivation.
Consider the trader who exits a trade and takes a small profit, only to have the position move further in his direction. Although the trader has taken a profit, the dominant perception may be, “I should have held the position longer.” Topmost of the mind is not the amount earned, but the amount left on the table.
Our trader is in a situation in which he may very well use the next trade to reduce his regret. Perhaps he will chase the market to get in on the move. Perhaps he will fade the market’s move in hopes of undoing the missed opportunity. In either case, his trading decision is colored by his need to reduce his aversive state. It will not be a decision made solely on the basis of opportunity.
Some of the most painful trading incidents of regret occur when a trader misses a top or bottom in the market and then refuses to get into an indicated trade, hoping that the market will pull back and provide another opportunity for the perfect entry. Many times this leaves the trader on the sidelines for an extended move that had been anticipated, magnifying regret many times over.
Perfectionism is the close cousin of regret. When we set perfectionistic goals, we set ourselves up to fall short. This leaves us with plenty of opportunity for regret. It is difficult to experience confidence in trading when our self-appraisals chronically tell us that we're falling short.
Because we are fallible and markets are not perfectly predictable, there will always be opportunities for regret in trading. We will take profits too early and miss moves; we will hold on for large gains and see our paper profits eroded. At best we will take pieces of moves and participate in only a fraction of the moves generated by markets. Every trader must learn to live with a certain amount of regret.
That is not necessarily a bad thing. Regret can be a positive motivator as well as an emotional trap. When we look back on mistakes we make or opportunities we miss, regret can lead us to learn from those experiences so that we will not repeat them.
Regret is one of the prime motivators behind my position size management, which often has me scaling out of trades. It’s not uncommon that I will have both a near-term price target for my trades (perhaps the midpoint of a trading range that we’ve re-entered) and a longer-term target (the opposite range extreme or the prior day’s high or low). I’ve learned to take a portion of my profits at the initial target and leave a small position for the more extended move (with stop moved to breakeven).
What this accomplishes is the opportunity to be paid out when I’m right on a move and also the opportunity to benefit from the larger move. I avoid the regret of losing paper profits by waiting for the larger move and having the market reverse on me, and I avoid the regret of missing out on a larger move. My position management thus becomes a tool for maintaining psychological equilibrium.
If I experience a strong degree of regret during the trading day, I almost always shut my trading down. I’ve learned from hard-earned experience that trades tinged with regret rarely work out. When I’m trading well, I’m focused on the market and what it’s doing. When I’m trading with regret, it’s about me and “getting even”. Indeed, when I find “should have” entering my thoughts, that’s become a cue for me to step back from the screen.
There’s a time and place for “should haves”, usually during after-action reviews of the day’s trade. Regret can be an effective prod to examine and improve trading, but it makes a poor rationale for placing trades.
RELATED POST:
The Role of Appraisal in Stress and Coping
In that sense, emotion is an experiential barometer that connects us to our evaluations of events and situations in real time.
One of the most fundamental appraisals we can make is whether we have been right or wrong in our decisions and actions. When we deem that we have acted properly and effectively, we experience satisfaction and pride. When we perceive that we have fallen short in our actions, the result is frustration and regret.
When we experience regret, we act as our own judge and critic. For most people, this makes regret an aversive state. The desire to reduce or eliminate regret thus becomes a powerful motivation.
Consider the trader who exits a trade and takes a small profit, only to have the position move further in his direction. Although the trader has taken a profit, the dominant perception may be, “I should have held the position longer.” Topmost of the mind is not the amount earned, but the amount left on the table.
Our trader is in a situation in which he may very well use the next trade to reduce his regret. Perhaps he will chase the market to get in on the move. Perhaps he will fade the market’s move in hopes of undoing the missed opportunity. In either case, his trading decision is colored by his need to reduce his aversive state. It will not be a decision made solely on the basis of opportunity.
Some of the most painful trading incidents of regret occur when a trader misses a top or bottom in the market and then refuses to get into an indicated trade, hoping that the market will pull back and provide another opportunity for the perfect entry. Many times this leaves the trader on the sidelines for an extended move that had been anticipated, magnifying regret many times over.
Perfectionism is the close cousin of regret. When we set perfectionistic goals, we set ourselves up to fall short. This leaves us with plenty of opportunity for regret. It is difficult to experience confidence in trading when our self-appraisals chronically tell us that we're falling short.
Because we are fallible and markets are not perfectly predictable, there will always be opportunities for regret in trading. We will take profits too early and miss moves; we will hold on for large gains and see our paper profits eroded. At best we will take pieces of moves and participate in only a fraction of the moves generated by markets. Every trader must learn to live with a certain amount of regret.
That is not necessarily a bad thing. Regret can be a positive motivator as well as an emotional trap. When we look back on mistakes we make or opportunities we miss, regret can lead us to learn from those experiences so that we will not repeat them.
Regret is one of the prime motivators behind my position size management, which often has me scaling out of trades. It’s not uncommon that I will have both a near-term price target for my trades (perhaps the midpoint of a trading range that we’ve re-entered) and a longer-term target (the opposite range extreme or the prior day’s high or low). I’ve learned to take a portion of my profits at the initial target and leave a small position for the more extended move (with stop moved to breakeven).
What this accomplishes is the opportunity to be paid out when I’m right on a move and also the opportunity to benefit from the larger move. I avoid the regret of losing paper profits by waiting for the larger move and having the market reverse on me, and I avoid the regret of missing out on a larger move. My position management thus becomes a tool for maintaining psychological equilibrium.
If I experience a strong degree of regret during the trading day, I almost always shut my trading down. I’ve learned from hard-earned experience that trades tinged with regret rarely work out. When I’m trading well, I’m focused on the market and what it’s doing. When I’m trading with regret, it’s about me and “getting even”. Indeed, when I find “should have” entering my thoughts, that’s become a cue for me to step back from the screen.
There’s a time and place for “should haves”, usually during after-action reviews of the day’s trade. Regret can be an effective prod to examine and improve trading, but it makes a poor rationale for placing trades.
RELATED POST:
The Role of Appraisal in Stress and Coping
Regret Trading and Other Ideas to Start the Week
* Trading by Regret - We often think of trading in terms of risk aversion and risk seeking, but there is good reason to believe that many trading decisions are made to minimize regret. Moreover, regret following trading decisions is an important psychological factor in shaping the next trading decisions, sometimes leading to risky decisions to undo regret. Moreover, I know many traders who sit on the sidelines during a good market move, simply because they regret not having caught the market top or bottom. I'll be pursuing this topic shortly; it gets too little attention.
* Perceptual Distortions - What you see in trading is not always what you get.
* The Week Ahead - Barry Ritholtz scouts out the coming week, including an interesting perspective on a stock price explosion. The movement of money by sovereign funds into equities makes this not such a far fetched possibility, IMO. See also this post on the amazing surge in money supply in the U.S.
* Riding Out Emotions - Thanks to Corey for the generous link to my trading principles post. Check out his interesting views on riding out emotions by timing them.
* The Next Market Crash - Trader Mike's updates include a view on systemic failures in markets and what they could mean for traders and investors.
* Reviewing Your Trading - This post from Globetrader is a great example of the kind of analysis that can improve trading performance. See also his reviews of his trades. Excellent model.
* Trading by Trend - The Trade by Trend blog publishes the results of its trading model and also offers the system's current positions.
* Walking the Line - BZB Trader notes the Q's following a neat regression line.
* Market Update - The Trading Psychology Weblog summarizes major indicators and offers a view on the current U.S. equity market.
* Perceptual Distortions - What you see in trading is not always what you get.
* The Week Ahead - Barry Ritholtz scouts out the coming week, including an interesting perspective on a stock price explosion. The movement of money by sovereign funds into equities makes this not such a far fetched possibility, IMO. See also this post on the amazing surge in money supply in the U.S.
* Riding Out Emotions - Thanks to Corey for the generous link to my trading principles post. Check out his interesting views on riding out emotions by timing them.
* The Next Market Crash - Trader Mike's updates include a view on systemic failures in markets and what they could mean for traders and investors.
* Reviewing Your Trading - This post from Globetrader is a great example of the kind of analysis that can improve trading performance. See also his reviews of his trades. Excellent model.
* Trading by Trend - The Trade by Trend blog publishes the results of its trading model and also offers the system's current positions.
* Walking the Line - BZB Trader notes the Q's following a neat regression line.
* Market Update - The Trading Psychology Weblog summarizes major indicators and offers a view on the current U.S. equity market.
Sunday, October 14, 2007
Global Performance as a Gauge of Trader Psychology
My previous two posts have investigated sector performance and performance across asset classes as sentiment measures. In this post, we'll look at global performance as a gauge of trader psychology.One of the most important issues in trader sentiment is whether market participants are primarily risk-seeking or risk-averse. If they are risk-seeking, they will gravitate toward the more volatile, but less established equities of the emerging markets (EEM). If they are risk-averse, they will prefer, in relative terms, the more stable and established U.S. large cap stocks (SPY).
As we can see from the chart above, from 2004 to the present, investors have had a good risk appetite for emerging market equities. Indeed, at the start of 2004, EEM was trading around 56 and SPY around 111. Today they trade at very similar prices.
One measure of risky sentiment is to compare the performance of EEM vs. SPY. Since 2004, when the ratio of EEM:SPY has risen over the past 20 trading sessions (risk-seeking environment; N = 645), the next 20 trading sessions in SPY have averaged a gain of .51% (407 up, 238 down) and the next 20 sessions in EEM have averaged a gain of 1.83% (436 up, 209 down).
When the ratio of EEM:SPY has declined over the past 20 trading sessions (risk-averse environment; N = 287), the next 20 days in SPY have averaged a gain of 1.07% (201 up, 86 down) and the next 20 days in EEM have averaged a gain of 3.28% (211 up, 76 down).
Indeed, when the ratio of EEM:SPY has risen by more than 5% in a 20-day period (risk-seeking environment; N = 172), the next 20 days in SPY have actually averaged a loss of -.37% (86 up, 86 down) and the next 20 days in EEM have averaged a loss of -.99% (83 up, 89 down).
On the other hand, when the ratio of EEM:SPY has declined by more than 5% in a 20-day period (risk-averse environment; N = 63), the next 20 days in SPY have averaged a strong gain of 1.74% (46 up, 17 down) and the next 20 days in EEM have averaged a whopping gain of 3.46% (42 up, 21 down).
In sum, returns have been more favorable over a one-month horizon when we've been in relative risk-averse environments than in risk-seeking ones. Once again, we see the dynamics of market sentiment at work: the relative performance of equities across the globe provides us with information about optimism and pessimism--and useful clues for the contrarian.
RELEVANT POSTS:
EEM and Speculative Sentiment
Split Personality in Emerging Market ETFs
.
Gold as a Sentiment Measure for Technology
Gold, with its price denominated in U.S. dollars, can be considered a sentiment measure for the dollar. Gold has long been considered a storehouse of value, attractive during times of inflation (falling value of dollar). Some equity sectors also benefit from a weak dollar, including large cap technology, which enjoys multinational sales. As the chart above shows, gold (GLD) and large cap technology (XLK) have both been on the rise over the last few years. Interestingly, the correlation between daily changes in GLD and XLK was only .02 between late 2004 and 2006. During 2007, however, that correlation has been .32.
I decided to take a look at dollar sentiment and its effect on large cap tech by examining five-day changes in GLD and what happens over the next five trading days in XLK.
When gold has been up on a five-day basis (bearish dollar sentiment; N = 408 trading days), the next five days in XLK have averaged a loss of -.09% (214 up, 194 down). When gold has been down on a five-day basis (bullish dollar sentiment; N = 282 trading days), the next five days in XLK have averaged a gain of .58% (179 up, 103 down).
As with my prior post concerning the relationship between price changes in consumer discretionary and consumer staples stocks, it appears that the price of gold is a kind of sentiment measure that may possess some value as a short-term contrary indicator. It's once again an illustration of the interconnectedness of markets across sectors and asset classes.
RELATED POST:
Making a Friend of the Sentiment Trend
.
Saturday, October 13, 2007
Using Sector Relationships to Catch Trader Sentiment
A reader recently emailed to ask for an example of what I had called "relational reasoning" in trading. Here's a simple example from my own trading:When traders and investors are relatively optimistic about economic growth, they will favor Consumer Discretionary stocks (XLY) over Consumer Staples issues (XLP). Similarly, when there are concerns over economic slowdown and recession, fears regarding a pullback in consumer spending lead portfolio managers to seek the safety of staples over discretionaries.
Accordingly, we can view the relative performance of XLY and XLP as a kind of sentiment measure. As you can see in the chart above, drops in this ratio have tended to correspond to buying opportunities for SPY as negative sentiment about the economy is overdone. Similarly, peaks in the ratio of XLY:XLP have corresponded to market peaks in SPY.
Interestingly, we are at relatively modest levels of XLY:XLP despite the recent rise in stocks.
As a specific illustration, going back to April, 2004 (N = 860 trading days), when XLY:XLP has shown a positive change over a five-day period (N = 445), the next five days in SPY have averaged a gain of only .04% (239 up, 206 down). When XLY:XLP has fallen over a five-day period (N = 415), the next five days in SPY have averaged a gain of .33% (255 up, 160 down).
When the ratio of XLY:XLP has been relatively strong (top half of its distribution since April, 2004), the next 20 days in SPY have averaged a gain of .34% (262 up, 168 down). When the ratio of XLY:XLP has been relatively weak (bottom half of its distribution), the next 20 days in SPY have averaged a gain of 1.20% (306 up, 124 down).
When XLY:XLP has been < 1.4 (N = 287), the next 20 days in SPY have averaged a gain of 1.64% (220 up, 67 down).
In short, the XLY:XLP ratio seems to behave like many equity sentiment indicators: as an indication of excess optimism and pessimism that can be viewed in contrary fashion by savvy traders.
RELATED POSTS:
Sentiment and Short-Term Cycles
What Drives Sentiment
Trading With Sentiment Bars
.
Trend Following by Market Theme
In this chart, we decompose the S&P 500 Index (SPY) into eight of its sector components for the last week of trading. For easy comparison of performance, I have set each sector to an equivalent price at the start of the week.Although SPY was up on the week, we see that not all sectors participated in the strength. Specifically, we see relative weakness in XLF (Financials), XLI (Industrials), XLY (Consumer Discretionaries), and XLV (Health Care). Indeed, those four sectors were down on the week.
Meanwhile, note that much of the SPY strength came from XLE (Energy), which was up about 3% on the week. Also up on the week were XLB (Materials), XLP (Consumer Staples), and XLK (Technology).
Note, interestingly, that by Tuesday the sectors had already separated themselves out by performance. The top sectors for the week were already outperforming; the worst performing sectors were already at the bottom of the heap.
You don't have to be in a trend to be a trend follower. When you notice the sectors and themes driving the market averages, you're in a good position to follow the flows of capital. Weak dollar themes and concerns over economic slowdown continue to define trends *within* the market averages.
RELEVANT POST:
Relational Thinking and Trading Success
.
Friday, October 12, 2007
At the Fringe of Trading Psychology and Other Friday Insights
* Better Living Through Chemistry - This is *not* one of the trading psychology techniques I use with traders.
* Better Growth From Reforms - Eye-opening estimate of possible growth in India should that country pursue market reforms.
* Who Is Gaining Clout in the Financial Markets? - Great post from Research Recap on how power has been shifting away from mutual funds, hedge funds, and pension funds toward a new set of players.
* New Way to Invest in Commodities - Perspectives on new products from Index Investor and Seeking Alpha, including three important commodity sectors.
* What He's Thinking - Jon Markman's portfolio results, holdings, and his take on ethanol.
* Better Growth From Reforms - Eye-opening estimate of possible growth in India should that country pursue market reforms.
* Who Is Gaining Clout in the Financial Markets? - Great post from Research Recap on how power has been shifting away from mutual funds, hedge funds, and pension funds toward a new set of players.
* New Way to Invest in Commodities - Perspectives on new products from Index Investor and Seeking Alpha, including three important commodity sectors.
* What He's Thinking - Jon Markman's portfolio results, holdings, and his take on ethanol.
Ten Generalizations That Guide My Trading
1) When you see a market extended to the upside or downside, in which many new buyers or sellers pile in at the new highs or lows, be on the lookout for opportunities to fade the move. The market, on average, doesn’t reward those who chase highs or lows or who panic out at price extremes.
2) A market that trades above or below its value area on weak volume is likely to return to that value area. A breakout turns into a trend when higher/lower prices attract market participation.
3) A broad, high volume breakout move to new highs or lows from an extended range is more likely to continue in its breakout direction (and move significantly in its breakout direction) than a narrow, low volume breakout move from a briefer range. Such moves are sustained by the larger number of traders on the wrong side of the market who will have to cover their positions, thus accentuating the breakout move.
4) A breakout move accompanied by a fundamental catalyst (earnings report, news event, shift in interest rates, currency movement) is more likely to continue in its breakout direction than a breakout move that occurs without other asset repricing. Large institutional traders are more likely to reprice equities in the face of significant fundamental drivers in correlated markets.
5) Don’t chase price highs or lows; sell when buyers take their turn and can’t move the market highs; buy when the sellers take their turn and can’t move the market lower. Measures such as the NYSE TICK will tell you when buyers or sellers are going against the price trend. Fade weak TICK moves against a dominant price (and TICK) trend.
6) Identify what the market’s largest traders are doing and go with it on weak countertrend action. The large traders account for the majority of the market’s volume and volatility. If they are buying or selling stocks, you don’t want to get caught fighting them. Wait for pullbacks to enter in the direction of the institutions.
7) If it’s a slow market (relatively few large traders), consider the possibility of range bound action. Low volume means low volatility, and that is generally associated with relatively narrow price ranges. Take profits quickly in such markets and set targets modestly; moves tend to reverse readily.
8) If it’s a busy market (relatively many large traders), consider the possibility of volatile market action. A market with high volume means that large traders will be capable of pushing price up and down to a greater degree than average. Adjust your stops and targets to account for this incremental volatility.
9) If many sectors don’t participate in a new high or low for the broad market index, consider fading the new high or low. A trend with staying power will tend to lift or depress all major stocks/sectors. When many issues or sectors don’t participate in a market move, the buying or selling in the index is often confined to a few issues that are highly weighted. Such moves generally are not sustained.
10) If you anticipate a broad move by equities, consider trading the most volatile indexes and the sectors with greatest relative strength. What you trade is just as important to results as the timing of trades. Go with the dominant market themes unless you have tangible evidence that those themes have changed.
RELATED POST:
Trading Techniques
.
2) A market that trades above or below its value area on weak volume is likely to return to that value area. A breakout turns into a trend when higher/lower prices attract market participation.
3) A broad, high volume breakout move to new highs or lows from an extended range is more likely to continue in its breakout direction (and move significantly in its breakout direction) than a narrow, low volume breakout move from a briefer range. Such moves are sustained by the larger number of traders on the wrong side of the market who will have to cover their positions, thus accentuating the breakout move.
4) A breakout move accompanied by a fundamental catalyst (earnings report, news event, shift in interest rates, currency movement) is more likely to continue in its breakout direction than a breakout move that occurs without other asset repricing. Large institutional traders are more likely to reprice equities in the face of significant fundamental drivers in correlated markets.
5) Don’t chase price highs or lows; sell when buyers take their turn and can’t move the market highs; buy when the sellers take their turn and can’t move the market lower. Measures such as the NYSE TICK will tell you when buyers or sellers are going against the price trend. Fade weak TICK moves against a dominant price (and TICK) trend.
6) Identify what the market’s largest traders are doing and go with it on weak countertrend action. The large traders account for the majority of the market’s volume and volatility. If they are buying or selling stocks, you don’t want to get caught fighting them. Wait for pullbacks to enter in the direction of the institutions.
7) If it’s a slow market (relatively few large traders), consider the possibility of range bound action. Low volume means low volatility, and that is generally associated with relatively narrow price ranges. Take profits quickly in such markets and set targets modestly; moves tend to reverse readily.
8) If it’s a busy market (relatively many large traders), consider the possibility of volatile market action. A market with high volume means that large traders will be capable of pushing price up and down to a greater degree than average. Adjust your stops and targets to account for this incremental volatility.
9) If many sectors don’t participate in a new high or low for the broad market index, consider fading the new high or low. A trend with staying power will tend to lift or depress all major stocks/sectors. When many issues or sectors don’t participate in a market move, the buying or selling in the index is often confined to a few issues that are highly weighted. Such moves generally are not sustained.
10) If you anticipate a broad move by equities, consider trading the most volatile indexes and the sectors with greatest relative strength. What you trade is just as important to results as the timing of trades. Go with the dominant market themes unless you have tangible evidence that those themes have changed.
RELATED POST:
Trading Techniques
.
Thursday, October 11, 2007
The Cognitive Development of the Trader
Jean Piaget, the Swiss biologist who left his mark on psychology, is known for his research on cognitive development. His view was that such development progresses through a series of stages, during which our internal maps of the world become increasingly differentiated. Piaget viewed people as scientists, continually testing and refining their hypotheses about the world. We both fit our perceptions to our maps (schema) and adjust those maps to accomodate discrepant perceptions, according to Piaget. This provides cognitive stability, even as it facilitates growth and development.
Howard Gardner has added to the cognitive development literature with his recent text "Five Minds for the Future". He argues that five kinds of thought process are essential to successful functioning in a world of increasing information and complexity:
1) The Disciplinary Mind - Mastery of ways of thinking specific to particular fields of study and work;
2) The Synthesizing Mind - The ability to integrate ideas into a whole and communicate broad understandings;
3) The Creating Mind - The ability to generate novel questions, answers, and understandings and assemble existing information into new, illuminating frameworks;
4) The Respectful Mind - The capacity to appreciate and draw upon diverse forms and sources of knowledge;
5) The Ethical Mind - The understanding and discharging of personal and professional responsibilities.
Gardner's fascinating observation (that places him in the Piagetian camp) is that these forms of mind emerge in a progression. We start with a Respectful Mind and an openness to information and experience. Under tutelage and mentorship, we then acquire the knowledge and ways of thinking associated with a particular line of work or profession, the Disciplinary Mind.
As we accumulate knowledge, we learn to relate pieces of information to one another and develop larger understandings--the Synthesizing Mind. For example, medical students will draw upon their knowledge of biochemistry and anatomy to grasp principles of pathology, and they will synthesize their knowledge of pathology to help them diagnose diseases in patients.
With the ability to synthesize information and perceive larger patterns in nature, the advanced thinker becomes able to perceive new relationships: the Creating Mind. That medical student, for instance, might go beyond textbook definitions of illnesses to perceive an emotional component to a patient's presenting problems, opening the door to a fresh way to tackle a longstanding problem.
Throughout this developmental sequence, the learner acquires from mentorship a sense for the standards of a particular line of work or profession: obligations to self and others. This is the Ethical Mind, and it guides how knowledge is ultimately deployed. One distinguishing element of a profession is its formulation and cultivation of a set of ethical principles.
When I first read Gardner's account, I was struck by how well it fits the developmental process of trading that I experience in the best trading firms.
Developing traders are encouraged to approach their craft with an open mind, consulting multiple sources of information--from media to peers and original research--to generate trading ideas. They also are taught ways of thinking specific to the kinds of trading that they're doing. Market makers in derivatives, for example, think very differently about trading than do portfolio managers mutual funds.
Ultimately, whether the trader is piecing together order flow information at a bank desk or macroeconomic data for a fund, he or she engages in a synthesis of findings which helps transform them into actual trading and investment ideas that capture broader understandings of supply and demand.
The best traders think creatively about their markets, seeing relationships not obvious to the rookie observer. Currency movements are seen as connected to sector performance within equities; the pulling of offers in the order book for stock index futures is linked to a breakout rise in bonds. Traders will sometimes tell me, "This market reminds me of 1987 (or 1997)", and then weave the similarities and implications. That is the creative process at work.
Moreover, traders at the best firms acquire a sense of duty and responsibility that defines their ethical thinking. They have a responsibility for capital, a duty to investors, and certainly obligations to themselves and their families. Integrity is a watchword at firms that handle other people's money; without that, trust is lost--and so are assets.
A child thinks in simple ways with undifferentiated understandings. When my daughter Devon was very young, she watched a tape of herself on TV and her jaw dropped open. She turned to me and exclaimed, "Two Devons!" She did not understand, at her age, that the videorecording was of her. Instead, she assumed that there must be another Devon.
Similarly, traders begin their careers with very simple--and often equally magical--views of markets and market movements. Later, they understand that traders and investors operate at differing timeframes, that markets are interconnected, that themes abound in markets, and that probabilities and departures from value govern trading opportunities. With this development comes a richness of mental maps and the fivefold cultivation of mind noted by Gardner.
RELATED POST:
Pain and Gain in a Trader's Development
.
Howard Gardner has added to the cognitive development literature with his recent text "Five Minds for the Future". He argues that five kinds of thought process are essential to successful functioning in a world of increasing information and complexity:
1) The Disciplinary Mind - Mastery of ways of thinking specific to particular fields of study and work;
2) The Synthesizing Mind - The ability to integrate ideas into a whole and communicate broad understandings;
3) The Creating Mind - The ability to generate novel questions, answers, and understandings and assemble existing information into new, illuminating frameworks;
4) The Respectful Mind - The capacity to appreciate and draw upon diverse forms and sources of knowledge;
5) The Ethical Mind - The understanding and discharging of personal and professional responsibilities.
Gardner's fascinating observation (that places him in the Piagetian camp) is that these forms of mind emerge in a progression. We start with a Respectful Mind and an openness to information and experience. Under tutelage and mentorship, we then acquire the knowledge and ways of thinking associated with a particular line of work or profession, the Disciplinary Mind.
As we accumulate knowledge, we learn to relate pieces of information to one another and develop larger understandings--the Synthesizing Mind. For example, medical students will draw upon their knowledge of biochemistry and anatomy to grasp principles of pathology, and they will synthesize their knowledge of pathology to help them diagnose diseases in patients.
With the ability to synthesize information and perceive larger patterns in nature, the advanced thinker becomes able to perceive new relationships: the Creating Mind. That medical student, for instance, might go beyond textbook definitions of illnesses to perceive an emotional component to a patient's presenting problems, opening the door to a fresh way to tackle a longstanding problem.
Throughout this developmental sequence, the learner acquires from mentorship a sense for the standards of a particular line of work or profession: obligations to self and others. This is the Ethical Mind, and it guides how knowledge is ultimately deployed. One distinguishing element of a profession is its formulation and cultivation of a set of ethical principles.
When I first read Gardner's account, I was struck by how well it fits the developmental process of trading that I experience in the best trading firms.
Developing traders are encouraged to approach their craft with an open mind, consulting multiple sources of information--from media to peers and original research--to generate trading ideas. They also are taught ways of thinking specific to the kinds of trading that they're doing. Market makers in derivatives, for example, think very differently about trading than do portfolio managers mutual funds.
Ultimately, whether the trader is piecing together order flow information at a bank desk or macroeconomic data for a fund, he or she engages in a synthesis of findings which helps transform them into actual trading and investment ideas that capture broader understandings of supply and demand.
The best traders think creatively about their markets, seeing relationships not obvious to the rookie observer. Currency movements are seen as connected to sector performance within equities; the pulling of offers in the order book for stock index futures is linked to a breakout rise in bonds. Traders will sometimes tell me, "This market reminds me of 1987 (or 1997)", and then weave the similarities and implications. That is the creative process at work.
Moreover, traders at the best firms acquire a sense of duty and responsibility that defines their ethical thinking. They have a responsibility for capital, a duty to investors, and certainly obligations to themselves and their families. Integrity is a watchword at firms that handle other people's money; without that, trust is lost--and so are assets.
A child thinks in simple ways with undifferentiated understandings. When my daughter Devon was very young, she watched a tape of herself on TV and her jaw dropped open. She turned to me and exclaimed, "Two Devons!" She did not understand, at her age, that the videorecording was of her. Instead, she assumed that there must be another Devon.
Similarly, traders begin their careers with very simple--and often equally magical--views of markets and market movements. Later, they understand that traders and investors operate at differing timeframes, that markets are interconnected, that themes abound in markets, and that probabilities and departures from value govern trading opportunities. With this development comes a richness of mental maps and the fivefold cultivation of mind noted by Gardner.
RELATED POST:
Pain and Gain in a Trader's Development
.
Identifying Historical Trading Patterns and More Thursday Thoughts
* Patterns With an Edge - I am getting a fair number of requests for posts re: how to conduct simple backtesting of market patterns using Excel. My own sense is that this would be best accomplished through a hands-on, skills-building teaching session rather than a blog post. If this would be of interest to you, please leave a comment for this blog post and let's see what we can organize.
* Hot Sectors - Excellent research from Charles Kirk on how stock screening illuminates sector strength.
* Is The Worst Over for Banks? Several excellent perspectives are linked by Abnormal Returns.
* Finding an Edge Among Stocks That Have High Short Interest - Fascinating findings reported by the CXO Advisory blog.
* Partying Like It's 1997 - Bespoke Investment Group finds a link between today's market and that of 1997.
* Rising Inventory - Trader Mike updates his links with some interesting views, including a look at the rising inventory of unsold homes from Countrywide.
* Finding Yield - StockPickr identifies companies that have increased their dividends lately and who is buying those shares.
* Hot Sectors - Excellent research from Charles Kirk on how stock screening illuminates sector strength.
* Is The Worst Over for Banks? Several excellent perspectives are linked by Abnormal Returns.
* Finding an Edge Among Stocks That Have High Short Interest - Fascinating findings reported by the CXO Advisory blog.
* Partying Like It's 1997 - Bespoke Investment Group finds a link between today's market and that of 1997.
* Rising Inventory - Trader Mike updates his links with some interesting views, including a look at the rising inventory of unsold homes from Countrywide.
* Finding Yield - StockPickr identifies companies that have increased their dividends lately and who is buying those shares.
Wednesday, October 10, 2007
A Trading Framework In Progress
Let ABC be a lookback period and P be a price level within ABC period. Over the next ABC period, what are the odds of the market touching P, given conditions XYZ.
Example: ABC is the overnight range and P is the volume-weighted average price for the preopening market. What are the odds of returning to P during the morning, given that the market opens above P on low volume?
Example: ABC is the previous day's trading range and P is the low price of that range. What are the odds of breaking below P during the present trading day, given weak upside momentum during that prior day?
Notice that ABC can refer to any lookback time frame and P can define any target price reached during the ABC period. The conditions XYZ define variables that affect the probability a move to P over a given historical period.
Because ABC can refer to any prior time frame, trades can be set up across multiple time frames based on observed, tested patterns.
More on this trading framework and the backtesting process in an upcoming post.
RELATED POST:
How I Trade
.
Example: ABC is the overnight range and P is the volume-weighted average price for the preopening market. What are the odds of returning to P during the morning, given that the market opens above P on low volume?
Example: ABC is the previous day's trading range and P is the low price of that range. What are the odds of breaking below P during the present trading day, given weak upside momentum during that prior day?
Notice that ABC can refer to any lookback time frame and P can define any target price reached during the ABC period. The conditions XYZ define variables that affect the probability a move to P over a given historical period.
Because ABC can refer to any prior time frame, trades can be set up across multiple time frames based on observed, tested patterns.
More on this trading framework and the backtesting process in an upcoming post.
RELATED POST:
How I Trade
.
A Contrary Look at Multinational Oil Shares
It's difficult to fault the performance of XOM stock (blue line above), as it has nearly tripled in the recent bull market. Interestingly, however, over the past decade, XOM--denominated in barrels of WTI crude--has actually fallen in valuation. In other words, crude oil has handily outperformed XOM stock.
Another way of viewing this relationship is that, given XOM's ability to at least replace reserves, investors are placing a lower value on each barrel of oil-equivalent owned by XOM. That fact is masked in the price action of XOM only because oil itself has been rising so quickly.
When we look at the bull market period of 2003 - present, however, we can see that XOM price has been trading at an average valuation of 1.1 x the price of a barrel of crude oil. The bull market in XOM is a function of the bull market in crude, not a richer valuation of XOM.
Why might the market not price XOM as a higher multiple of crude? Several reasons come to mind:
* Ecuador
* Venezuela
* Bolivia
* Nicaragua
* Russia
* Kazakhstan
All of these countries, to varying degrees, have moved toward nationalization of their oil assets. This has left the oil multinationals with fewer areas for exploration, particularly given competition from China in Africa and Southeast Asia and the failure to reach a privatization accord in Iraq.
What that means in practical terms is that the upside for share prices of multinationals such as XOM is increasingly dependent upon a continued rise in oil prices. Should the price of oil fall due to a slowing world economy, XOM's share price could take a hit even if it maintains a 1.1 multiple of crude. At a multiple below 1.0, which we've seen several times during this bull run, XOM could retrace a chunk of its bull gains during an economic slowdown.
RELEVANT POST:
A Little Known Energy Stock That's Powering Higher
.
Tuesday, October 09, 2007
Stocks and Oil: Charting a Burst Bubble
Above we see a daily chart of the Dow Jones Industrial Average priced in barrels of West Texas Intermediate crude oil (cash prices). We can see that from the mid-1980s through early 2000, we had a regime in which equity prices were rising considerably relative to energy prices. Since 2000, however, the regime has gone the other way, with crude oil handily outperforming stocks.When we price one asset class in terms of another, we gain a perspective on relative strength and where capital is flowing. The year 2000 marked a watershed in which capital flowed away from financial assets and into tangible, commodity assets.
When we think of a bubble bursting in 2000, we generally think of tech stocks. The chart above suggests that a larger burst of a financial asset bubble also occurred, obscured only by the fact that we tend to denominate stock indexes in dollars, not alternative assets.
RELEVANT POSTS:
A Mechanical Strategy That Has Consistently Worked
How Would You Like to Own This Stock?
.
How Do You Know You Have A Trading Edge?
Once again, the comments to recent posts have been most enlightening. The topic for the present post came from a penetrating set of questions asked by NQ Trader in response to my "Wonderland" post.
NQ Trader was asking an epistemological question: a question about the state of our knowledge as traders. We often hear of trading edges, but how do we *know* we have an edge when we trade? How do we know that results aren't merely the result of chance?
It seems to me that there are two answers to that question:
1) Defining Edge in Terms of Backtesting - One tradition examines trading patterns over a historical period that includes a variety of market conditions (bull swings, bear swings, high volatility, low volatility) and determines whether the distribution of price changes following these patterns displays a positive expectancy (i.e., a non-random directional bias). Such an approach is most commonly seen in the development and testing of mechanical trading system with such software as TradeStation. The definition of edge is thus historically based. True, the future may not mirror the past, and care must be taken to not curve-fit historical tests. Still, the backtesting of patterns over market history has led to significant profits for a variety of quantitative funds.
2) Defining Edge in Terms of Trading Outcomes - Defining the edge of a discretionary trader is a somewhat trickier matter. The discretionary trader, by definition, is not relying upon fixed signals for trading decisions. Instead, he or she is reading market patterns from experience and acting accordingly. The edge of the successful discretionary trader is something akin to the edge of a highly successful athlete: it may be felt, but it is ultimately known only in retrospect. When we analyze a discretionary trader's results, we can see if the trader differs from chance in terms of the proportion of winning trades, the earning of profits, etc. For a trader who makes, say, 1000 trades, we can even conduct simulations and determine the probability that a random series of 1000 trades would achieve or exceed that trader's results. Indeed, by treating the discretionary trader as if he or she was a trading system, we can analyze results and identify an edge.
Speaking solely for myself and my own trading, I occupy a space somewhat between these two definitions of edge. I investigate historical patterns in the markets and factor those into my decision making. Ultimately, however, this factoring is discretionary and my decisions to enter and exit trades are made on a discretionary basis as unfolding market conditions dictate.
Let's take an example from the current market:
I tend to seek patterns with an edge by asking myself: "What is distinctive about the market's recent behavior?" I then test to see how the market has behaved over the past several years when that distinctive element has been present.
On Monday, for example, we made an inside day. I went back to 2004 in the S&P 500 Index (SPY) and found 119 occasions (out of 945 trading days) of inside days.
The day after the inside day, SPY averaged a loss of -.09% (51 up, 68 down). That's notably weaker than the average one-day gain of .06% (470 up, 356 down) for the remainder of the sample.
What happens, however, when the inside day follows a strong up day (as is the recent case)? It turns out that there have been 31 occasions since 2004 in which an inside day has followed a daily rise in SPY of over .50%. The next day, SPY has averaged a loss of -.26%, with only 7 occasions up and 24 down. That is quite a negative skew (which can be formally established with the use of statistical tests).
When I find patterns such as this--particularly multiple patterns pointing in the same direction--that provides a framework for thinking about the next day's trade. I then wait for the market open and see how the market is trading relative to value, how traders are hitting bids and lifting offers, etc. If I see signs of early weakness--buying that cannot, say, move the market above its overnight highs--I will act upon the historical pattern and try to profit from the edge.
Do I *know* I have an edge with such a trade? I may feel confident in my reading of the current day's trading patterns, and I may feel confident in the historical pattern I'm leaning on. Ultimately, however, the arbiter of whether or not I possess an edge lies in my trading results. What is the likelihood that those results could have been obtained randomly? That, it seems to me, is the gold standard.
If my results are consistent with those achievable by chance, then either I'm trading methods and patterns without an edge or my execution is erasing the edge contained within my methods and patterns.
In other words, we either have a logical problem (no edge to our methods) or a psychological one (inability to capitalize on an existing edge).
In the end, edge boils down to non-randomness, whether we're testing historical patterns or present market performance--and whether we're testing mechanical systems or discretionary traders.
RELATED POST:
Historical Patterns as a Heads Up in Trading
.
NQ Trader was asking an epistemological question: a question about the state of our knowledge as traders. We often hear of trading edges, but how do we *know* we have an edge when we trade? How do we know that results aren't merely the result of chance?
It seems to me that there are two answers to that question:
1) Defining Edge in Terms of Backtesting - One tradition examines trading patterns over a historical period that includes a variety of market conditions (bull swings, bear swings, high volatility, low volatility) and determines whether the distribution of price changes following these patterns displays a positive expectancy (i.e., a non-random directional bias). Such an approach is most commonly seen in the development and testing of mechanical trading system with such software as TradeStation. The definition of edge is thus historically based. True, the future may not mirror the past, and care must be taken to not curve-fit historical tests. Still, the backtesting of patterns over market history has led to significant profits for a variety of quantitative funds.
2) Defining Edge in Terms of Trading Outcomes - Defining the edge of a discretionary trader is a somewhat trickier matter. The discretionary trader, by definition, is not relying upon fixed signals for trading decisions. Instead, he or she is reading market patterns from experience and acting accordingly. The edge of the successful discretionary trader is something akin to the edge of a highly successful athlete: it may be felt, but it is ultimately known only in retrospect. When we analyze a discretionary trader's results, we can see if the trader differs from chance in terms of the proportion of winning trades, the earning of profits, etc. For a trader who makes, say, 1000 trades, we can even conduct simulations and determine the probability that a random series of 1000 trades would achieve or exceed that trader's results. Indeed, by treating the discretionary trader as if he or she was a trading system, we can analyze results and identify an edge.
Speaking solely for myself and my own trading, I occupy a space somewhat between these two definitions of edge. I investigate historical patterns in the markets and factor those into my decision making. Ultimately, however, this factoring is discretionary and my decisions to enter and exit trades are made on a discretionary basis as unfolding market conditions dictate.
Let's take an example from the current market:
I tend to seek patterns with an edge by asking myself: "What is distinctive about the market's recent behavior?" I then test to see how the market has behaved over the past several years when that distinctive element has been present.
On Monday, for example, we made an inside day. I went back to 2004 in the S&P 500 Index (SPY) and found 119 occasions (out of 945 trading days) of inside days.
The day after the inside day, SPY averaged a loss of -.09% (51 up, 68 down). That's notably weaker than the average one-day gain of .06% (470 up, 356 down) for the remainder of the sample.
What happens, however, when the inside day follows a strong up day (as is the recent case)? It turns out that there have been 31 occasions since 2004 in which an inside day has followed a daily rise in SPY of over .50%. The next day, SPY has averaged a loss of -.26%, with only 7 occasions up and 24 down. That is quite a negative skew (which can be formally established with the use of statistical tests).
When I find patterns such as this--particularly multiple patterns pointing in the same direction--that provides a framework for thinking about the next day's trade. I then wait for the market open and see how the market is trading relative to value, how traders are hitting bids and lifting offers, etc. If I see signs of early weakness--buying that cannot, say, move the market above its overnight highs--I will act upon the historical pattern and try to profit from the edge.
Do I *know* I have an edge with such a trade? I may feel confident in my reading of the current day's trading patterns, and I may feel confident in the historical pattern I'm leaning on. Ultimately, however, the arbiter of whether or not I possess an edge lies in my trading results. What is the likelihood that those results could have been obtained randomly? That, it seems to me, is the gold standard.
If my results are consistent with those achievable by chance, then either I'm trading methods and patterns without an edge or my execution is erasing the edge contained within my methods and patterns.
In other words, we either have a logical problem (no edge to our methods) or a psychological one (inability to capitalize on an existing edge).
In the end, edge boils down to non-randomness, whether we're testing historical patterns or present market performance--and whether we're testing mechanical systems or discretionary traders.
RELATED POST:
Historical Patterns as a Heads Up in Trading
.
Monday, October 08, 2007
Trading Success: A Perspective From Wonderland
It's a particular joy for me when the comments to my blog posts are every bit as good--if not better--than the posts themselves. Such has been the case with my recent post on finding an edge in the currency markets. I heartily recommend that you read the comments to my post--particularly those of Ziad and Brandon (BW).
When I visit different proprietary trading firms, investment banks, and hedge funds, I feel a bit like Alice in Wonderland. The reality I experience at these firms is nothing like the one that is portrayed in the popular trading literature.
Trendlines? Oscillators? Chart patterns? Wave formations? Angles? All of those figure prominently in the books, seminars, and magazine articles that dominate the mass market.
Yet I have yet to see a successful trader at any of these firms use these tools. You would think, by sheer chance, having worked with well over 100 traders personally and closely, I'd find *someone* who trades the way the books and magazines describe.
But no. I have found none.
Rather, what I find is a kind of reasoning that might best be called "relational". The traders who are doing this for a living and making a successful living year after year invariably relate the instrument(s) they are trading to a broader network of market events.
This can take the form of intermarket analysis (i.e., developing a view on currencies based on interest rate differentials and yield curve dynamics across countries), but can take other forms as well. For instance, I notice short-term S&P traders at prop firms looking at what is happening in related markets (NQ, for example) and sectors (financial stocks) to get a handle on what their market is up to.
Somewhat defensively, a few readers have replied that it *is* possible to make money trading simple market patterns. To clarify (and also to apologize if I was unclear): I never meant to say that it is *impossible* to succeed without relational reasoning. Rather, I was passing along my observations over the last two years that I have not encountered a consistently successful professional trader who trades simple, linear relationships limited to their trading market.
It was not always thus. When I first came to Chicago, I saw many traders thrive simply by trading patterns in the depth-of-market displays for their instruments. As an increasing proportion of that trade became automated (and the automation exploited mispricings across instruments), that trade went away. It is now rare to see a highly successful short-term trader in Chicago trade in that market-making style.
Similarly, in the late 1990s, it was common to see traders thrive by trading momentum patterns among NASDAQ stocks. That trade also dried up as we moved to record low volatility. It doesn't mean that someone, somewhere *can't* make a living by trading short-term momentum, but the opportunity is not what it once was.
There is much to be said for trading a style that is congenial with your talents, skills, and interests. Still, such a style must be consistent with objective opportunity if it is to yield enduring success. Many of the trading approaches described by the popular trading literature (such as buying strength and selling weakness) not only have no edge in short-term trading of stock indexes, but actually run counter to objective opportunity.
I'll state my position baldly and take the heat as it comes: I think the individual, independent trader is being sold a bill of goods. There are firms that have a vested interest in making traders believe that success is easy and that the simple patterns offered by their software, trading courses, and publications will provide a road to riches.
It's no different from the "no-money down" real estate seminars or the pyramid marketing schemes. All promise great returns with little effort or knowledge.
The irony is that traders would love for me to validate their fantasies and tell them that untold wealth is around the corner if they just follow a particular set of indicators or self-help methods.
But I can't do that. I visit the traders who are truly successful--and whose success I can personally verify--and I see them doing something very different from what the seminars and magazines describe. Similarly, when I look at who is truly successful in real estate and in business, I find entrepreneurs who study and master their markets--not people who are acting upon a seminar, a wing, and a prayer.
Success *is* possible for the individual trader; I've seen it happen. But it's the result of a developmental process that includes a kind of cognitive development that transcends simplistic reasoning. More on that cognitive development in my next post.
When I visit different proprietary trading firms, investment banks, and hedge funds, I feel a bit like Alice in Wonderland. The reality I experience at these firms is nothing like the one that is portrayed in the popular trading literature.
Trendlines? Oscillators? Chart patterns? Wave formations? Angles? All of those figure prominently in the books, seminars, and magazine articles that dominate the mass market.
Yet I have yet to see a successful trader at any of these firms use these tools. You would think, by sheer chance, having worked with well over 100 traders personally and closely, I'd find *someone* who trades the way the books and magazines describe.
But no. I have found none.
Rather, what I find is a kind of reasoning that might best be called "relational". The traders who are doing this for a living and making a successful living year after year invariably relate the instrument(s) they are trading to a broader network of market events.
This can take the form of intermarket analysis (i.e., developing a view on currencies based on interest rate differentials and yield curve dynamics across countries), but can take other forms as well. For instance, I notice short-term S&P traders at prop firms looking at what is happening in related markets (NQ, for example) and sectors (financial stocks) to get a handle on what their market is up to.
Somewhat defensively, a few readers have replied that it *is* possible to make money trading simple market patterns. To clarify (and also to apologize if I was unclear): I never meant to say that it is *impossible* to succeed without relational reasoning. Rather, I was passing along my observations over the last two years that I have not encountered a consistently successful professional trader who trades simple, linear relationships limited to their trading market.
It was not always thus. When I first came to Chicago, I saw many traders thrive simply by trading patterns in the depth-of-market displays for their instruments. As an increasing proportion of that trade became automated (and the automation exploited mispricings across instruments), that trade went away. It is now rare to see a highly successful short-term trader in Chicago trade in that market-making style.
Similarly, in the late 1990s, it was common to see traders thrive by trading momentum patterns among NASDAQ stocks. That trade also dried up as we moved to record low volatility. It doesn't mean that someone, somewhere *can't* make a living by trading short-term momentum, but the opportunity is not what it once was.
There is much to be said for trading a style that is congenial with your talents, skills, and interests. Still, such a style must be consistent with objective opportunity if it is to yield enduring success. Many of the trading approaches described by the popular trading literature (such as buying strength and selling weakness) not only have no edge in short-term trading of stock indexes, but actually run counter to objective opportunity.
I'll state my position baldly and take the heat as it comes: I think the individual, independent trader is being sold a bill of goods. There are firms that have a vested interest in making traders believe that success is easy and that the simple patterns offered by their software, trading courses, and publications will provide a road to riches.
It's no different from the "no-money down" real estate seminars or the pyramid marketing schemes. All promise great returns with little effort or knowledge.
The irony is that traders would love for me to validate their fantasies and tell them that untold wealth is around the corner if they just follow a particular set of indicators or self-help methods.
But I can't do that. I visit the traders who are truly successful--and whose success I can personally verify--and I see them doing something very different from what the seminars and magazines describe. Similarly, when I look at who is truly successful in real estate and in business, I find entrepreneurs who study and master their markets--not people who are acting upon a seminar, a wing, and a prayer.
Success *is* possible for the individual trader; I've seen it happen. But it's the result of a developmental process that includes a kind of cognitive development that transcends simplistic reasoning. More on that cognitive development in my next post.
Subscribe to:
Posts (Atom)
Posts
