What are the Factors That Drive Short Term Returns in the Stock Market?

What are the factors that drive short-term returns in the stock market?  

It's an important question for short-term traders obviously, but also for longer-term market participants, as the execution of one's positions ultimately has a significant role in determining profitability.  This is especially true in situations where longer-term participants face a mandate to keep losses at a minimum.  The demands of high Sharpe-ratio trading often necessitate shorter-term management of the price paths of one's trades, making entry and exit execution a meaningful part of trading returns.

I consistently find that traders do not think intelligently about short-term market returns.  They either make the blanket assertion that short-term returns are random, or they attribute short-term returns to single sources without having tested those sources.  So, for instance, short-term returns may be attributed to particular chart patterns or simply chalked up to loosely defined notions such as "trend".  When tested, those explanations can be shown to be weak:  very often, they apply to some market periods and not others.  

As for the notion that short-term returns are random, that falls by the wayside when one has directly observed and worked with successful short-term market participants.  They may be rare, but their superior returns can be documented across hundreds if not thousands of trades per year, year after year.  As one of the few trading coaches that has worked for trading firms on a full-time basis, with full access to traders' returns, I can personally verify the existence of persistent market talent/skill among an elite set of short-term traders.

Here is where short-term trading can learn from the research into longer-term investment.  That research suggests that longer-term market returns can be explained as the interplay of a number of factors.  Bender et al identify six factors that explain longer-term market returns based upon considerable academic research.  Capturing returns from these factors is an important principle behind asset management and can produce returns well in excess of active management.

The recent post on teasing apart buying and selling activity in markets suggests that buying and selling may separately account for two factors that account for short-term returns:  momentum (the tendency of price direction to persist) and value (the tendency of price direction to reverse).  I am currently operating with a third factor in mind that we can call "rotation".  This is a factor in which trader/investor funds are shifted from some market groups to others with relatively little impact upon broad market averages.  

The challenge of short-term trading is that all of these factors yield positive returns over time, but none of them produce positive returns across all market periods.  Traders who identify with a single factor inevitably perform poorly when other factors are dominant, resulting in frustration.  This is a great example of a situation in which a logical trading problem is mistaken for a psychological one.  A worthy challenge is understanding the range of factors that impact short-term returns, so that trading style can flexibly accommodate those regime shifts in which one group of factors takes over from another.

Further Reading:  The Momentum Curve
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Measuring Buying and Selling Power in the Stock Market

Recent posts have focused on improved versions of standard market indicators, including sentiment, Bollinger Bands, VWAP, and ticks.  One of my most challenging projects, however, has focused on the creation of measures of buying and selling pressure in the stock market.  My goal in creating this measure was to follow an intuition and treat supply and demand as separate, independent dimensions, rather than a single blended measure.  

My alpha version of this measure disaggregates moment to moment upticks and downticks across the broad list of NYSE stocks.  Unlike the standard NYSE TICK, which monitors upticks minus downticks across stocks, the new indicator measures upticking and downticking separately on a high-frequency basis and then assembles them into measures of buying and selling interest.  From 2012 to the present, the resulting measure of Buying Power correlates with Selling Power by -.22.  In other words, less than 5% of Buying Power can be explained by Selling Power and vice versa.

This is important because it suggests that buyers and sellers are different entities, behaving relatively independently.  We can have days in which buyers and sellers are both active; days in which buyers are active and sellers are not; days in which sellers are active and buyers are not; and days in which both buyers and sellers are inactive.  This differentiation opens the door to unique analyses, in which direction and volatility can be tracked as a function of the interplay between buyers and sellers.  

For example, the market might move to new highs because of a surplus of Buying Power or because of an unusually low level of Selling Power.  Those scenarios have led to different price paths over the near term.  When we made a price high in the latter part of July, Selling Power was very low, but Buying Power was also well off its peak.  The market held up, not because buyers were aggressive, but because sellers were on the sidelines. 

Here's another interesting observation:  Since 2012, when Selling Power has been in the top half of its distribution (high levels of selling pressure) over a four-day period, the next four days in SPY have averaged a gain of .45%.  When Selling Power has been in the bottom half of its distribution (low levels of sellers) over a four-day period, the next four days in SPY have averaged a gain of only .04%.

Also since 2012, when Buying Power has been in the top quartile of its distribution (high levels of buying pressure) over a four-day period, the next four days in SPY have averaged a gain of .43%.  All other occasions averaged a gain of only .18%.

Together, these findings invite the hypothesis that stock market strength can be attributed to two factors:  momentum effects from high levels of buying and value/mean reversion effects from high levels of selling (capitulation).  By independently parsing Buying and Selling Power, it may be possible to better anticipate momentum and reversal in the market.

Of course, much more investigation remains, especially over longer periods of market history.  There are also interesting questions that remain to be addressed, such as Buying and Selling Pressure measures for other indexes and for individual stocks and ETFs.  

My initial work in this area suggests that it is fertile ground for the development of new and valuable market measures.  For instance, during the recent market decline, Selling Pressure hit a peak several days before we hit the ultimate low price in SPY; that is also when Buying Pressure bottomed.  Price continued to make new lows, but the dynamics were already shifting away from Selling and toward Buying.  With the market bounce on August 8th, Buying Power absolutely swamped Selling Power and the conditions were set for momentum continuation.

I will be updating this research--and its application--in future posts.  It's a great example of how one of the best strategies for adapting to changing markets is to adapt quicker.

Further Reading:  When is There Significant Buying and Selling in Stocks?
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Tomatoes and Fruit Salads: What Predicts Day Trading Success

Does day trading skill really exist?  The recent post took a research-based look and found evidence both for the existence of day trading skill and for its rarity. 

What might account for day trading success and failure?  Another valuable study was conducted in the Korean futures market, with the Kospi index.  Ryu studied the day trading results for the Kospi over a more than three year period.  He found that 91% of the day traders were domestic individuals and these traders accounted for over 85% of all transactions.  Foreign institutional day traders and domestic institutional day traders made up most of the remainder of the activity.  On average, these institutional day traders traded much more frequently--with much larger average volume--than the domestic individuals.

Ryu found that the domestic individual traders lost significant money on average.  He refers to them as "uninformed and noisy".  Conversely, the institutional day traders made money on average.  Perhaps most interestingly, domestic individual traders who traded more lost more money; they seemed to be overconfident.  Foreign institutional day traders who traded more made more money.  They seemed to be exploiting a genuine edge.  Ryu surmises that:

"This implies that foreign day traders and money managers are generally better equipped in terms of their wealth, sophistication, specialty, and trading experience than ordinary day traders." p. 9.

What does this mean?  Perhaps this:

Resources make a difference.

Knowledge matters.

Experience counts.

Most of all, wisdom is crucial:  the ability to act on the awareness that sometimes, the edge conferred by knowledge and experience simply isn't there.  There's no edge to putting a tomato in a fruit salad.

Consider this example of successful day trading from someone I knew years ago:  He cultivated relationships with the sell side and had access to the major forecasts for earnings releases for companies.  He also polled money managers and equity sales professionals quarterly.  This told him the "true consensus" for each release.  He tested which earnings releases were movers of stocks based upon several factors, including deviations from consensus.  Some deviations were worth trading on a same day basis; others provided a longer-term edge.  For the day trades, he and his team developed a rapid execution algorithm that entered orders into various stocks as soon as releases came out and deviations from consensus could be calculated.  Those trades were always closed out by end of day.

He was a successful day trader.  He had specialized knowledge and a clearly defined edge.  He also had the wisdom to make bets only when the consensus was off sides and all other factors lined up in his favor.  Many days he did not trade.  That alignment of knowledge and wisdom was the best predictor of his profitability.

Success is possible in trading, but not, as Ryu notes, to the uninformed and overconfident.

Further Reading:  Tackling the Challenge of Day Trading
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What Proportion of Daytraders Actually Makes Money?

I strongly recommend reading the research study of speculator skill from Barber, Lee, Liu, and Odean.  They studied the returns of daytraders over a 15-year period, the largest sample I am aware of in such a study.  Their study is also unique in that it looks at the ability of traders to make money in a second year after having made money in the first.  

The authors conclude that "there is clear performance persistence."  The very top traders who make money net of fees tend to continue to make money going forward.  The traders who lose money tend to continue losing money.

Here is the most important conclusion, however:

"In the average year, 360,000 individuals engage in day trading.  While about 13% earn profits net of fees in the typical year, the results of our analysis suggest that less than 1% of day traders (less than 1,000 out of 360,000) are able to outperform consistently." (p. 15).  

In other words, 87% of day traders in a given year lose money after fees are taken into account.  About .28%--one in 360--is able to make money after fees year over year.

To be sure, that small group of very successful day traders earns a significant return.  After expenses, they average +28 bps per day.  Compare that to the 350,000 out of 360,000 daytraders who average a daily loss of 5.7 bps per day after expenses. 

The authors conclude that day trading skill genuinely exists.  They also conclude that it is very, very rare.  

Further Reading:  Can Day Traders Be Successful?
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Why Ugly Stock Markets Provide Pretty Returns

The recent post on the relative equity put/call ratio highlighted the importance of sentiment in near-term stock market returns.  In this post, let's take a look at the interaction between two factors:  overbought/oversold and sentiment.

First, definitions:  I am using as an overbought/oversold measure the percentage of SPX shares trading above their five-day moving averages.  (Data available from Index Indicators).  For sentiment, I am looking at the put/call ratio for all equities on all exchanges that have listed options.  (Data available from e-Signal).  For this exercise, we'll look at the period from 2010 to the present.

If we just break the market down by a median split on the overbought/oversold measure, what we find is that the next five days in SPX average a gain of .12% when we've been overbought and .38% when we've been oversold.  In general, chasing strength or weakness on the short-term has been a bad idea:  if we waited for several days of "price confirmation" before entering long or short, our near-term results suffered.

Now let's break down the overbought occasions by a median split of daily sentiment readings.  When we've been overbought and sentiment has been bullish, the next five days in SPX have averaged a gain of only .01%.  That is a paltry return, considering the bull market.  (For the sample overall, the average five-day gain was .25%.)  When we've been overbought, but sentiment has been bearish, the next five days in SPX have averaged a gain of .22%--nearer the sample average.  In other words, overbought readings have only led to diminished returns on average when they've been accompanied by bullish sentiment.

Next, we'll break down the oversold occasions by a median split of sentiment.  When we've been oversold but sentiment has been bullish, the next five days in SPX have averaged a gain of only .09%.  When we've been oversold and sentiment has been bearish, the next five days in SPX have averaged a whopping gain of .68%.  In short, the best time to buy stocks is when people have been dumping them and sentiment is bearish--precisely when stocks look their ugliest.  The trader who bought stocks when they were their prettiest earned almost no positive return over the past 4-1/2 years.

One takeaway:  The very same ideas in the stock market yield wildly different returns depending upon how they are executed.  You could have been a bull the last several years and still not made money in U.S. stocks if you needed the reassurance of price confirmation and could not take the heat of short-term price disconfirmation.  Buying when the market has been pretty and selling when it's been ugly has guaranteed losing returns.

Further Reading:  Volume and Volatility in the Stock Market
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Supercharging Your Trading Journal

Trading journals are used for many purposes, from tracking markets and trade ideas to working on performance.  The recent post on the learning process of chess masters suggests a particularly powerful application of trading journals.

Suppose you were to treat each market day (or week, depending upon one's time frame and frequency of trading) as a separate chess game.  You would follow the market move by move and annotate your observations at each key juncture:  what was happening with important market indicators; what was occurring in related markets; how the market responded to news and economic reports; etc.  Of particular importance would be key turning points in markets and how those set up.  

Such a journal would consist of multiple charts, as well as commentary.  Actual trades logged during the market day would also be depicted, along with comments on the strengths and weaknesses of the trades.

Right away, there would be two distinct advantages of such a journal:

1)  It would be dynamic.  A journal that treats each day/week as a chess game would be the equivalent of the sports practice in which coach and player watch the video recordings of past games, review performance, and provide feedback.  The review could include replays of key market junctures and would provide a much more dynamic and engaging approach to learning than writing static prose entries. 

2)  It would be structured. As with chess education, the journal would help traders work on their openings (entry execution); their midgames (position management); and their endgames (exit execution), as well as their offensive (idea generation) and defensive (risk management) strategies.  Most written journals are mere summaries of a trading day or week.  A journal that captures each trading day/week as a chess game invites very concrete development for the skills central to each phase of the trading process.

Imagine further that such a journal was shared with valued colleagues via social media, so that each trader is learning many lessons every single day or week and working together on building strengths and correcting weaknesses.  By treating markets as chess games, we create new routines for viewing and re-viewing performance and adapting to changing markets.

Further Reading:  The Power of Trading Journals 
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Replicating Talent: What Trading Can Learn From Chess Education

The recent post suggested that there is a meaningful overlap between the cognitive talents required by chess and trading.  Where traders can probably learn the most from chess is in the learning process.  While the cognitive strengths of the two domains overlap, the ways in which they are channeled and developed is typically quite different.

How does someone learn to play chess at a high level?  A look at a site devoted to the educational process provides some insight:

1)  Developing chess masters view and review games and key moves in a hands-on way- This is a staple of chess learning.  Illustrative games are archived for future players to review.  Many times, accomplished players annotate the games, providing insight for the learner.  Learners do not simply read the games from a text or watch a video.  Rather, they play the games move by move on a chess board, so that they actually see situations set up and actively think through each move.  This viewing and re-viewing provides the chess student with many, many games worth of relevant experience before he or she ever sets foot in a chess tournament.  This is not only deliberate practice, but deliberate practice guided by recognized experts. 

2)  Developing chess masters break the game down into key components and build their skills one component at a time - Once players master the basics, they hone their skills with different facets of performance.  They work on their openings, their midgames, and their endgames; they learn various defenses and how to play against them.  Computer applications offer targeted learning opportunities and provide relevant feedback, as can live lessons with a coach/mentor.  Just as an American football team would devote training time to specific plays, offensive sets, and defensive strategies, the budding chess master works in a focused way on specific parts of the game to master domain-specific skills.

3)  Developing chess masters learn from true masters - This is very important.  Accomplished chess players carry a ranking based on their performance in tournaments.  That ranking is publicly verifiable and based upon objective performance.  A developing student can learn from the world's top talent through live lessons, but also through training materials assembled by recognized experts.  Because each tournament game is publicly recorded move by move, every person has access to what the greats do--and have done.  

These three characteristics of chess education rarely occur in concert in the world of trading and investment.  Yes, there are valuable simulation platforms that allow practice trading, and there are review features for those platforms that enable the learner to learn from recent experience.  What is typically missing, however, is the expert input that breaks trading down into meaningful components, models successful skill deployment, and provides immediate and relevant feedback for learning.

This is why I find the best learning occurs within trading teams at established hedge funds, banks, and proprietary trading firms.  When an accomplished trader brings on junior talent--often junior talent with specific areas of expertise that contribute immediately to the business--the whole of the team becomes more than the sum of its parts.  The team becomes a dynamic start-up business within an established business. 

Imagine, for example, a senior portfolio manager hiring a junior team member with experience in options.  The junior hire helps with the structuring of positions in the portfolio, creates appropriate hedges, and provides insight to the team in terms of options-based sentiment measures.  The senior manager provides daily instruction to the junior member, helping build skills in such areas as idea generation and risk management.  This is a powerful model, because the learning occurs in real time, in real situations, from real experts, with real integration of coaching and mentorship.  It's also a sustainable model, because there are tangible benefits to mentors and students.

Suppose those teams archived and annotated their experience the way that chess masters do.  Over time, multiple teams could contribute to a central learning database that captures the wisdom of the experienced traders--and also their core skills.  The model of "siloed" traders operating in isolation is inefficient.  Can any one individual truly stay on top of a complex, global financial world?  In leveraging talent the right way, all parties benefit:  talent becomes replicable.

Further Reading:  A Different Kind of Proprietary Trading Group
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Relative Equity Put/Call Ratio: What We Can Learn From Stock Market Sentiment

One of the psychological curiosities of the stock market is that we tend to see euphoria when shares are their most overvalued and despondency when they are trading at greatest value.  It's for that reason that sentiment gauges can be useful in tracking market cycles.  One of my favorite measures is the ratio of put options traded to call options traded for every stock with listed options across all options exchanges.  Note that this is an equity put/call ratio only; it does not include index options.  The latter, I've found, are more frequently used as hedging vehicles and thus are not as reliable as sentiment gauges.  (Data available via e-Signal; ratios derived from CBOE listed options are available from Index Indicators). 

Going back to 2010, let's express each day's sentiment as the ratio of the current day's equity put/call ratio to the average ratio of the prior 40 days.  When this relative put/call ratio has been in its lowest quartile (current put/call ratio low relative to prior 40 days), the next five days in SPY have averaged a gain of only .04%.  When the relative put/call ratio has been in its highest quartile (current put/call ratio high relative to prior 40 days), the next five days in SPY have averaged a gain of .62%.   Overall, from 2010 to the present, the average five-day gain has been .29%.  

Being a buyer when others have been particularly bearish has been a winning strategy in recent years.  We saw this most recently when put/call ratios became elevated several days ago following the market drop, leading to the rally of the past two trading sessions.  Interestingly, yesterday's put/call ratio dropped to below average following highest quartile readings on July 31, August 1, and August 5.  Such rapid shifts in sentiment have helped make stocks noisy to trade on a longer-term basis.  More on this topic in an upcoming post.

Further Reading:  Stock Market Social Sentiment
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Elite Performance in Chess and Trading

Many a trading firm looks for a history of athletic participation in the search for trading talent.  While athletics, as performance domains, share some characteristics with portfolio management and trading, the overlap is far from perfect.  Both athletics and trading are competitive activities, and both require practice and disciplined performance.  It is not surprising that the personalities that gravitate to competitive sports are also drawn to market competition.

What differentiate athletics and trading, however, are the requisite cognitive skills.  The pattern recognition and deep analyses typical of short-term traders and investors are not necessarily skills required of sprinters, weightlifters, baseball outfielders, or football linemen.  Many sports require rapid hand-eye coordination; not necessarily explicit decision-making under conditions of risk or uncertainty.  Across many trading firms and types of trading, I have not found a strong correlation between athletic achievement and trading success.

So where are tomorrow's trading champions to be found?  I would argue that chess is a far better breeding ground for trading talent than sports.  If you take a look at the characteristics that distinguish successful chess players, you'll see an uncanny overlap with the qualities typically attributed to successful traders.  Most important, there is a sizable overlap in the cognitive skills required for mastery of chess and trading:  the blending of tactical and strategic thinking; the role of deliberate practice and studying past games (markets) to foster performance-based learning; the ability to quickly size up complex patterns of risk and opportunity--all are part of both fields.

It's not surprising that Wall St. firms have shown an interest in elite chess players and that several successful money managers have cut their teeth on the chessboard.   Indeed, thinking of trading days as chess games, with their own openings and endgames, might inspire strategies of trading education that mirror the training of chess champions.  And development as a chess player might just provide the gymnasium for exercising the cognitive skills needed for success in financial markets.

Further Reading:  Chess, Tai Chi, and Inner Learning
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The Power of Trading For A Cause

A little while back, I wrote about my work with traders in Madrid and the idea of moving forward by giving back.  The idea of furthering one's own development by developing others is central to medical education and the model of "each one teach one."  I see this at trading firms as well, where junior traders provide useful research to senior traders, who in turn provide helpful mentorship.  In "giving back", whether to a colleague or a worthy cause, we participate in something larger than our daily profits and losses, creating fresh sources of well-being from our work.  Over the years, I've found that successful people have a talent for creating sources of fulfillment.  We perform at our best when our emotional portfolios are well diversified.

You can imagine, then, that I was quite interested to hear about a group of traders that had formed around the idea of giving back:  Traders4ACause.  The group meets annually and conference profits go toward charitable causes.  But that's only the beginning.  The meeting features ample networking time, so that traders can share their work with other traders, and there are numerous presentations from participants, all with a practical trading bent.  It's an excellent idea for giving and getting in return.

The Traders4ACause group will be holding their meeting in early October in Las Vegas.  I'll be a keynote speaker and look forward to giving back to a group of like-minded traders.  Hope to see some TraderFeed readers there.

Whether it's through conferences or online connections via such sites as StockTwits, if you start with what you have of value to share with other traders, you'll be surprised at who you get to know and how much you receive.  The idea wheel turns faster when powered by multiple, dedicated minds.

Further Reading:  What It Means to be Free
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Happiness and the Power of Our Expectations

How much happiness--how much sheer joy--do you derive from your involvement in financial markets?

One measure of that is reflected in your market involvement during times when markets are not open:  evenings, weekends, holidays.  If you're a dedicated writer, painter, musician, entrepreneur, or scientist, your work knows no limitations of the clock.  It's not that you are tied to your work; it's that, when what you are doing is deeply rewarding, your work becomes part of you.

Even the greatest dedication, however, can be sabotaged by expectations and self-demands that create more frustration than fulfillment.  A recent study found that our expectations help to shape our experience of happiness.  When we are surprised by positive outcomes, we are more likely to respond with happiness than if we expected those outcomes all along.  Interestingly, when we hold negative expectations, this doesn't result in a positive surprise effect when outcomes don't live up to our fears.  Rather, we are happiest when we expect good things and then are pleasantly surprised when those good things turn out to be better than expected.

An interesting review of 20 years of research has led one investigator to differentiate between healthy and unhealthy forms of perfectionism.  Healthy perfectionism occurs when payoffs exceed costs and goals and expectations are high, but generally met.  Unhealthy perfectionism occurs when goals and expectations are set so high that payoffs inevitably fall short of costs.  The difference between healthy and unhealthy perfectionism boils down to expectations--and the psychological forces driving those.

A wealth of research shows that perfectionism of the less healthy kind reduces productivity and is even associated with poorer health outcomes.  One possible link between perfectionism and these adverse consequences is self-criticism.  Healthy perfectionism is about striving and moving oneself forward.  Unhealthy perfectionism is about living a life script of perpetually falling short.

It's not difficult to hypothesize that healthy perfectionism sets people up for positive surprises, whereas unhealthy perfectionism sabotages the conditions under which happiness is most likely to occur.  Our self-talk is nothing more or less than an internalized conversation.  If we're talking to ourselves in negative ways that we would never speak to others we care about, there's a good likelihood that we are undermining our own fulfillment.

Further Reading:  We Gravitate Toward Our Self-Talk
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Plasticity and Adaptability: Making Innovation a Habit

Some of the best traders I've known, like the best fighters in the Bruce Lee quote, employ a variety of skills to adapt to markets.  Sometimes they are short-term, opportunistic, and tactical; other times they are longer-term, thematic, and strategic.  They first seek to understand the market environment and opportunity set, then deploy the skills and strategies best suited for that environment.  This adaptability requires an ability to not become identified with any particular asset class or strategy.  Once we identify with any particular approach to markets, we fall into the trap of needing markets to fit our framework rather than the reverse.

In other fields of business, flexibility is essential to success.  A marketing professional knows that different strategies must be employed to reach Millenials vs. Baby Boomers.  Some demographic groups will care about brand name and image; others will emphasize value and price.  The successful marketer constructs multifaceted campaigns to reach segmented groups of consumers.  If the marketer were to become identified with a single strategy and expect all people to respond to that, the results would be mixed at best.   

My recent research has focused on the presence of aperiodic cycles in the stock market.  These are cycles that occur, not in chronological time, but in event time.  Imagine market cycles that can occur over periods from minutes to hours to days to months, depending on the unfolding of critical events.  A successful trader of such cycles would be neither a daytrader, nor an investor.  As Bruce Lee's insight suggests, that successful trader would be all of them--and none of them.  It is not a small challenge when the market's flexibility exceeds our own!

Check out Richard Peterson's excellent article on adaptability, where he uses the Turtle System to make important points about the need for openness--not fixed, rigid rules--when trading markets.  Research suggests that "plasticity"--the combination of openness and extraversion--is highly associated with creativity.  Interestingly, plasticity and stability (including conscientiousness) tend to be inversely correlated.  People who are highly disciplined and process driven may be the least open-minded and flexible.  What it takes to succeed in any one trading approach is, in some ways, the opposite of what's needed at times when it's necessary to change trading approaches.

A higher-order integration, of course, is to turn creativity into a robust, repeatable process.  If you have a structured methodology for generating, testing, and utilizing fresh inputs to your decision-making, then you have turned fluid adaptability into a reliable routine.  Innovation, too, can become a habit.

Further Reading:   Conflict and Creativity in Trading Performance
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Fresh Perspectives in the Financial Media: The Aleph Blog

This series of posts began with a look at The Reformed Broker, a financial blog that offers insight for investors and money managers, not just traders looking for the headlines du jour.  Many thanks to Josh for his kind tweet following the post.

This post covers another site that is distinguished by its broad perspective and especially its offerings of wisdom as well as information:  the Aleph Blog of David Merkel.  Traders are inundated with market data and have plenty of information to sift through.  Wisdom, however is special:  it's the distilled experience of knowledgeable market participants who have been there and done that. 

Check out David's perspective on hot and cold industries and when it makes sense to play momentum and when it makes sense to invest in value.  So often, equity traders and investors take either a momentum or a value approach to markets, failing to adapt when one strategy takes the lead from the other.  Having a way of thinking that enables you to invest flexibly can help traders and investors avoid the large drawdowns that result from being out of sync with markets.

Yet another valuable piece of market wisdom is contained in the post on why the substance of investments matters more than the form.  There are many vehicles available for investing in companies, from mutual funds to ETFs to hedge funds.  When markets become relatively efficient, what matters greatly are things like the fees charged by the managers and the track records of the managers.  What also matters is the dry powder kept uninvested during those efficient times, so that money can be put to work when valuations become less rational.

Most of all, check out the list of best posts within Aleph Blog.  When a savvy writer takes the time to survey his work and curate the best of the lot, the odds are good that wisdom is there to be found.  David's 2004 post on what to look for during market tops is as relevant today as then.  That's the nature of wisdom: it never goes out of date.
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Success Starts With Making Your Bed

If you want to read something good--really good--about the mindset needed for success, read the commencement speech given by Admiral William McRaven at the University of Texas, Austin earlier this year, recounting the lessons of his Navy SEAL training.  

One of the lessons contained in that speech concerned the importance of making your bed.  Here is the relevant excerpt from Admiral McRaven's talk:


Every morning in basic SEAL training, my instructors, who at the time were all Vietnam veterans, would show up in my barracks room and the first thing they would inspect was your bed.

If you did it right, the corners would be square, the covers pulled tight, the pillow centered just under the headboard and the extra blanket folded neatly at the foot of the rack—rack—that’s Navy talk for bed.

It was a simple task—mundane at best. But every morning we were required to make our bed to perfection. It seemed a little ridiculous at the time, particularly in light of the fact that were aspiring to be real warriors, tough battle hardened SEALs—but the wisdom of this simple act has been proven to me many times over.

If you make your bed every morning you will have accomplished the first task of the day. It will give you a small sense of pride and it will encourage you to do another task and another and another.

By the end of the day, that one task completed will have turned into many tasks completed. Making your bed will also reinforce the fact that little things in life matter.


As the Admiral notes, "If you can't do the little things right, you will never do the big things right."

When you start your day with a meticulous small act, you start the day on a note of excellence, with an achievement already under your belt.  If you can train yourself to make a perfect bed when you've just woken up, exhausted from the previous day's regimen, you will be just a little more able to summon your best efforts when life grinds you down.

Everyone talks about discipline and the importance of being process-driven.  But who will have the discipline to faithfully follow a sound, rigorous process if they can't make their bed, can't follow a healthy diet, can't keep themselves in shape, can't organize their day, can't maintain a simple trading journal?  

We don't rise to the challenging occasion; we revert to the level of our training.  As SEAL training exemplifies, every act can be one of training.

If we're unplanned and undisciplined in our small acts, will we really stay planned and disciplined for the big occasions?

Further Reading:  Why Can't We Trade Our Plans?
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Trading Education and Coaching: Are They Worthwhile?

One of the most common questions I field concerns whether developing traders should pursue (for a fee) trading education and/or trading coaching.  

Allow me to respond to that question with a different question:  "Should I go to a house of worship each week?"

Well, if going to a church, synagogue, or mosque is going to substitute for doing spiritual work on oneself--if it's merely one box among many to be checked off each week--then, no, there will be little benefit to attending religious services.  

Conversely, if you find a house of worship that speaks deeply to you and that concretely helps you in cultivating your spiritual life, then by all means that is useful.

So it is with trading education or coaching.

My fear is that too many people sign up for support services for traders in lieu of putting in the hard, deliberate practice time needed to gain expertise.  Good coaching and training guide the diligent efforts that take place between coaching and training sessions.  They cannot substitute for those efforts.

If you're contemplating the pursuit of training or coaching, here are a few posts that might help you make a good decision:

*  Should I Seek a Trading Coach?

*  Finding an Effective Trading Coach

*  Finding the Right Trading Mentorship

*  Finding and Transcending Mentors

*  Considerations Before Seeking a Trading Coach

*  Steps Toward Coaching Yourself

There are many good training and development resources out there for traders.  The challenge is not simply to sign up for the best ones, but to craft an ongoing process of learning that leverages those resources and turns them into daily best practices.
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The Bollinger Balance: Tracking Stock Market Strength and Weakness

Recent posts have focused on ways of gauging broad market strength and weakness by tracking the wide range of individual stocks, rather than by relying solely upon a stock index.  These market gauges include the percentage of stocks trading above their volume-weighted average prices; the upticks and downticks among all stocks trading in the U.S; and intraday new highs and lows among U.S. stocks. 

Such measures provide several advantages.  First, they are a check on the action of the capitalization-weighted stock indexes, which can appear strong or weak simply because of the action of a relatively small number of highly weighted shares.  A good example of this was the runup to the July 24th highs in the large cap market (SPX).  My measure of fresh three-month new highs among stocks listed on major exchanges was 636 on June 9th; 836 on July 1st; and 363 on July 24th.  That waning upside participation as a rally matures is a useful way to gauge the relative health of the market move that you can't get by looking at the chart of the index alone.

The second advantage of these measures is that they provide prisms through which I can view and understand the market.  This is where market analysis meets trading psychology.  I download, archive, and review all of these indicators every day and then on a larger picture basis every weekend.  Day after day of seeing the patterns in the data--and the relationships among the measures--provides an insight and feel into markets that is useful deliberate practice.  

Above is yet another market measure I look at daily that I've dubbed "the Bollinger balance".  (Credit to John Bollinger for insights into this indicator and to the Bollinger data tracked on the excellent Stock Charts site.)  In this measure, I simply take the difference between the number of NYSE stocks that close above their upper Bollinger Band minus the number that close below their lower band.  What I'm looking for is whether we see signs of expanding strength vs. weakness among the broad range of shares.

You can see from clicking the chart above that we saw a declining Bollinger balance from early June through later July as the market was topping.  This divergence, along with the many sector divergences and divergences in the new high/low data, was identifying the waning participation to the upside--a useful heads up that the rally was losing steam.  

Fast forward to the present and you can also see that the Bollinger balance has now been waning to the downside, even as we've made new lows in the major indexes.  We're also seeing fewer shares making fresh three-month lows over the past several sessions.  This suggests that selling is waning in terms of breadth--a potentially useful heads up for traders gauging the present market correction.

Further Reading:  Archived Posts on Market Indicators:  Volume One; Volume Two; Volume Three; Volume Four
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Gauging the Market's Intraday Strength and Weakness With VWAP

The volume-weighted average price for a stock or index (VWAP) is a useful statistic for market makers and intraday traders, as it provides a benchmark for current market price.  In a strong market, a stock or index will consistently trade above its VWAP and VWAP will have a rising slope.  In a weak market, we see the opposite.  In non-trending markets, it's not at all unusual to see a stock or index oscillate around its VWAP.

If you click on the chart above, you'll see a different application of VWAP.  Here we're looking at SPY on a five-minute basis through the day session for 8/7/2014 (blue line).  The red line represents the percentage of NYSE stocks trading above their day's VWAP.  The green line represents the percentage of Dow Jones Industrial Stocks trading above their day's VWAP.  (Data come from the e-Signal platform).

Generally, in an uptrend, we'll see more than 50% of stocks trading above their VWAPs.  In a downtrend, such as we had in today's market, we will get persistent readings below 50%.  More rangebound markets will tend to oscillate around that 50%-ish level, often reflecting a degree of sector rotation.

By comparing the percentage of NYSE stocks trading above their VWAP with the percentage of Dow stocks trading above their VWAP we can get a sense for how the broad market is trading relative to the large caps.  From relatively early in the session, we can see that large caps were weaker than the broad market.  That is useful information if you're structuring a short trade or a relative one.

The main value of the VWAP figures for the active trader is to help them stay on the right side of the market.  Even when we bounced during the afternoon yesterday, the vast majority of shares stayed below their average prices.  When VWAPs are declining and stock prices are staying below those even on bounces, that's a pretty good indication of weakness on the day timeframe.

Further Reading:  The NYSE TICK Environment
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One Testicle and One Breast: When Averages Are Misleading

Hat tip to the Index Indicators site, which is the source for the above chart of the Standard and Poor's 600 small cap index and the percentage of those 600 stocks trading above their 20-day moving averages.  As you can see from this measure, we were oversold on this measure as of Tuesday's close, with only a little less than 24% of small caps trading above their 20-day averages.

When I performed a 3-year backtest on the indicator on the site, I found 48 non-overlapping occasions in which fewer than 30% of small cap stocks were trading above their 20 DMA.  Over the next five trading days, there were 33 profitable instances and 15 losing ones, for an average gain of .93%.  During that three year period, the small cap average was up a little over 56%.  If one had simply bought the oversold occasions tested above, one would have earned almost 45%, with far less market exposure.

That looks like a decent edge, but one ingredient is missing from the mix:  What is the variability of outcomes around the average performance?

Averages can be misleading if considered in isolation, because the average of a highly variable distribution tells us little about specific outcomes we're likely to encounter.  There's the old joke about the person who couldn't swim but confidently entered the water because it averaged only 3 feet in depth.  Or, more crudely, there is little information in the truism that the average person has one breast and one testicle.

Let's look at the adverse excursions surrounding the oversold occasions involving the small cap stocks.  During the latter part of 2011, buying the oversold small caps and holding for five days would have exposed a trader to drawdowns of 13.97%, 4.94%, and 7.38% on August 2nd, 9th, and 16th, respectively.  That strategy on September 28th of 2011 encountered a drawdown of 6.02%.  On November 17th, buying the oversold market led to a drawdown of 6.85%. 

In the lower VIX markets of 2012, we still found five-day drawdowns for buyers of the oversold market of over 3% on May 14th, May 30th, and November 8th.  Had we bought the strategy when it first triggered on July 24th of this year, we would have experienced a drawdown in excess of 3%. 

Indeed, the average drawdown over this period was 1.84%, with a standard deviation of 2.84%.  Out of the 48 occasions, 19 drew down more than 1% during the subsequent five-day period and 14 drew down more than 2%.  Not exactly risk-free.

The moral of the story is that, when it comes to testing strategies or evaluating trader track records, the path matters as much as the endpoint.  That is why statistical tests are essential:  they tell us when an edge is meaningful relative to the variability surrounding the market outcomes.  That is also why trading firms and their investors look at risk-adjusted returns, not just absolute dollar gains.

When system developers assess their systems, they don't just look at hit rates and average sizes of winning and losing trades.  They also look at maximum adverse excursions and average adverse excursions.  How much heat does the system take before it produces its results?  There's no practical edge to an idea that requires more heat than traders can prudently take.

Further Reading:  Some Out of the Box Trading Metrics
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What's Down in a Bull Market?

This useful graphic from FinViz illustrates the variability of performance among U.S. stock market sectors thus far this year.  If you owned stocks in the basic materials, healthcare, or utilities sectors, you're sporting gains in the vicinity of 9% this year.  If you owned technology and consumer goods shares, your gains are a bit less than half that.  If you owned stocks in the industrial sector, you're down on the order of 3.5%.

Indeed, here are sector and index ETFs that, as of Wednesday's close, are down for 2014:

KRE - regional banking stocks

XRT - retail stocks

XLY - consumer discretionary stocks

XLI - industrial stocks

IWM - Russell 2000 stocks

IJR - Standard and Poor's 600 small cap stocks

IWC - Russell microcap stocks

XHB - housing stocks

VGK - European stocks

EFA - Europe, Asia, and Far East stocks

DBC - commodities

EWJ - Japan stocks

That's a pretty good chunk of the equity world.  The tide of central bank liquidity has lifted many boats this year, but not all of them.

Further Reading:   A Bit of Perspective
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How Oversold Are We in the Stock Market?

Hats off to the excellent someecards site for many useful psychological perspectives!

So, in the spirit of being both anxious and well-educated, let's ask:  How oversold are we and what has that meant in the recent past?

I noticed on the Index Indicators site that we have fewer than 30% of SPX stocks trading above their 50-day moving averages.  That is pretty rare for a sub-20 VIX market.

Indeed, going back to 2006, we've only had 11 non-overlapping occasions in which fewer than 40% of SPX shares have traded above their 50-day moving averages during a sub-20 VIX market.  Those dates were:  7/14/06; 3/2/07; 6/3/11; 4/13/12; 6/26/12; 10/24/12; 6/21/13; 8/27/13; 10/9/13; 1/24/14; and 4/11/14.  When we look 20 days forward, the cash SPX was up 9 times, down twice for an average gain of 2.98%.

I then looked at first time occasions in a month (same non-overlapping criteria) in which we registered fewer than 30% of stocks trading above their 50-day moving averages in a sub-20 VIX market.  It hasn't happened since 2006.  In the past week, however, we've seen two such readings.

When I extended the search to markets in which VIX < 22, then there were seven non-overlapping occasions in which fewer than 30% of stocks traded above their 50-day moving averages.  Four were up after 20 days and three were down.  Several of those occasions took place relatively early in the process of larger market selloffs:  7/22/08; 6/15/11; and 5/14/12.

Buying dips in market uptrends (low VIX) has generally brought positive returns.  When dips fail to sustain a bounce, however, it's one early sign that markets that are oversold on shorter time frames are in the process of becoming oversold on longer ones.  At least with respect to sub-20 VIX markets in recent market history, this market is not only oversold, but uniquely so.  

Further Reading:  Tracking Market Strength and Weakness
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