Hope your weekend has been a good one. Here are a few topics that might get us started for the week to come: * I've heard from several traders who have taken position sizes well outside their comfort zones, lost money, and shaken their confidence. As we learned from Naomi (above), recovering from a traumatic event is not something you can just talk yourself into. My experience is that the traumatic responses of traders--while not on the scale of extreme anxiety-producing events that occur in military combat--have some similarities to what soldiers go through in wartime. This is partly because the stress symptoms often precede the specific traumatic event and because second guessing, anger, and grief are common after the event. This is why prudent risk management is so crucial to trading psychology: it is the best preventive measure we can take to avoid overloading ourselves emotionally. Otherwise, it becomes all too easy for drama to turn into trauma.
As a rule, good entry execution in stocks means waiting for pullbacks if you're going long; bounces if you're looking to be short. The exception to this rule are is the trend day, in which the market moves consistently in one direction for the entire day session. For traders on short time frames particularly, good entry execution on a trend day--such as we saw yesterday--means entering early in the day and benefiting from the day's directional tendency. Please review this post from May; it summarizes key ingredients of an upside trend day. All of these were present in yesterday's session. This earlier post also provides a number of trend day signposts; see also this 2009 post.
In the chart above, I track yesterday's ES futures versus the number of stocks trading across all exchanges that are making fresh day session highs minus those making fresh day session lows. (Data were obtained via e-Signal). This is an interesting measure, as it begins tracking new highs/lows from the market open. For that reason, values tend to be elevated during the early minutes of trading relative to later in the day. During uptrend days, we see two things:
* The difference between new intraday highs and lows stays positive throughout the trading session;
* We get spikes in new highs well into the trading session, as a large proportion of stocks are trending. Conversely, during rotational days, we'll see some stocks making fresh highs for the day session and some making fresh lows. As the market oscillates, the difference between intraday new highs and lows will cycle from positive to negative and back again. Along with the indicators outlined in the above posts, the intraday new highs/lows give a good sense for whether there is a directional bias to the day's trade. With a bit of testing, relatively early in the session, we can identify the probability that we are operating in a trend environment or a rangebound one. This not only benefits daytraders, but also aids the entry and exit execution of longer timeframe participants.
Surveying the literature on the behavioral biases of investors, it does indeed seem as though the model of infinite stupidity is closer to the truth than the model of rational market participants! The list of such biases is impressively long: Barry Ritholtz offers this list; see also this overview from Morgan Housel and this particularly thorough list from the Psy-Fi Blog. Abnormal Returns highlights the problems associated with positive thinking; Stammers focuses on 3 biases that impact investments; and Above the Market offers this summary of biases. A very interesting study from the University of Pennsylvania finds that neither investor sophistication nor investor experience, by themselves, is sufficient to overcome the behavioral bias known as the disposition effect. This is a bias to sell winning investments and hold onto losing ones. Investors who are both sophisticated (knowledgeable) and experienced are able to sell losing investments appropriately, but they still display a tendency to prematurely sell winners. This phenomenon, known as the bias blind spot, reflects the fact that knowing about biases does not prevent people from falling prey to them. Indeed, we typically perceive biases in others more readily than in ourselves, as this Stanford study finds. This happens, in part, because we tend to focus more on our introspections than on our behavior, leading us to assume that we are not biased because, subjectively, our thoughts do not seem biased! Here is a telling anecdote: I have worked as a performance coach for traders for a number of years. People have sought me out for a variety of concerns, ranging from emotional interference with trading decisions to challenges in learning new markets. How many--of the many hundreds of people I've interacted with in a coaching capacity--have expressly sought help for their cognitive and behavioral biases? None. Traders are much more likely to attribute trading problems to emotional, psychological sources, external distractions, or evil market manipulations than they are to illusion, bias, and statistical artifact.
What does that mean?
A staple of trading psychology wisdom is that one should trust their "processes" and remain grounded in them at all times. But what if those processes involve subjective impressions from second-hand sources of unknown accuracy, poorly constructed statistical tests, or conclusions based upon limited, recent samples of experience? The advice to stay process-driven presumes that traders operate in a bias-free manner--which is itself a beautiful example of the bias blind spot! Suppose a trader's base case was that his/her own thinking could very well be biased. In such an event, the trader's process would be replete with routines that test assumptions, validate sources, and explicitly entertain counterfactual scenarios and alternate explanations. The trader seeking to minimize bias blind spots would be vigilant, questioning and even doubting all trade ideas. How many of us do that in a structured manner and on a routine basis? (Hat tip to the hyperrational colleague who inspired this question). So who is more likely to be hired at the average trading firm: the bold, confident trader who expresses great conviction in his ideas or the cautious, questioning trader who makes special efforts to avoid bias blind spots? The answer to that question goes a long way toward explaining why average trading firms rarely sustain above average trading results.
The recent post on improving your cognitive environment suggested that performance is not only a function of talent, skill, and effort, but also one's surroundings. Those surroundings include at least three elements: 1) Our physical environment - How our space is laid out; the resources available in that space; the degree to which the environment is comfortable, quiet, stimulating, distracting, etc. 2) Our social environment - Who we are surrounded by and who we choose to surround ourselves with; the interactions we have with others, virtual and actual; the degree to which we benefit or are hindered by our interactions. 3) Our cognitive environment - The information we process; the degree to which we filter vs. seek information; the ways in which information we format and process our information; the sources we seek for our information. Rarely are our environments optimized for the work we undertake. Partly this is because we tend attribute performance outcomes to internal factors: our decisions, our psychological states, our research, etc. Because we don't systematically vary our environments or focus on the impacts of naturally occurring environmental changes, we generally don't appreciate the ways in which the world around us impacts our decision-making and performance. A simple example is the quality and quantity of sleep we get each night. We know from research that getting the right kind of sleep, as well as the right amount of sleep, is important to mood regulation, concentration, learning, and performance. We also know that sleep is affected by what and when we eat and drink, our exercise level, and our nighttime routines. Keeping a phone at the bedside to check on nighttime quotes is a common environmental choice for many money managers--and it's one that can rob us of the deep restorative sleep that aids next day performance. One challenge traders have in structuring the environment optimally is that trading consists of multiple activities, each of which typically requires a different environment. For many traders, quiet periods of deep analysis--whether by reviewing charts, reading research articles, or analyzing data--are an important part of their understanding of markets. Such work is best undertaken in distraction-free environments that promote sustained focus--not on the desk with multiple distracting screens and phones. Conversely, most traders need to stay on top of breaking developments during the trading day and so stay closely connected to news, chats, and interactions with colleagues. The quiet, distraction-free environment, so helpful to deep thinking, is not so useful for the fast thinking of keeping up with and understanding the implications of news releases and the dynamics of real-time market movement. And how about those activities in which traders piece together the elements of market puzzles, integrating the results of both deep analysis and fast market pattern recognition? Such synthesis--quite different from the deep dives of market analysis--benefits from processing information in multiple ways. We can write journals, carry on conversations with valued colleagues, or simply remove ourselves from the work environment and ponder the world while on a hike. The creative process of synthesis benefits from fresh interactions, fresh settings, and fresh ways of piecing together our observations--and those of others. What is unlikely is that sitting at a desk, in front of a trading screen, will optimize all our efforts at analysis, observation, and synthesis. Each is a different process, and each of us engages in those processes in different ways. If you find yourself distracted, inefficient, a step behind in understanding markets, frustrated with performance, and/or undisciplined in your work routines, consider the possibility that there might be a suboptimal fit between you and your work environment. Tracking shifts in your environment and their impact upon your performance is a worthwhile first step in discovering what works best for you. It's amazing how much we can pick up when we process the right information the right ways in the right settings. Further Reading: Where to Find a Trading Career
.
The recent post distinguished between financial bubbles and manias, suggesting that blowoff tops and eventual crashes occur when overpriced assets--instead of returning to fair value--become the object of frenzied speculation. The above graphic from Jean-Paul Rodrigue captures this dynamic quite nicely, suggesting that the phases of blowoff and crash are accompanied by participation from different segments of investors. Enthusiasm, he suggests, turns to greed and eventually to the delusion that we are living in a new paradigm. This dynamic has caught the attention of researchers, as it is so completely at odds with the common view of efficient markets and rational investors. Indeed, Rodrigue refers to bubbles as "misallocation engines", as lax credit provides the fuel for the paradoxical situation in which higher asset prices lead to greater investor demand. Hence the phenomenon of rising volatility and volumes even as prices move higher, noted in the previous post. In 2007, I cited the momentum life cycle work of Lee and Swaminathan, which suggested that there are common patterns linking share prices and volumes. Specifically, stocks go through phases of rising volume, which correspond to short-term momentum effects (strength leading to further strength) and longer-term reversals (strength leading to correction). Following such corrections, stocks typically show low volume characteristics and behave in a value (mean-reversion) manner, rather than a momentum one. These momentum life cycles help to explain why value and momentum strategies work--and why each does not work uniformly. From this perspective, the bubbles researched by Kindleberger might represent exaggerations of the normal cyclical behavior of assets. The role of lax credit in these exaggerations would help to explain why, in the wake of low interest rates policies across the globe, Colombo finds current evidence of bubbles across multiple markets and regions. Recent research suggests that the dynamics underlying the transition from normal, cyclical behavior to bubble creation may lie in the brain. Participants in a simulated trading market underwent brain scans via fMRI while trading that market. Overall, participants displayed activity in the pleasure centers of the brain as prices rose. Successful participants, however, received a warning signal from the brain when a market was in its manic phase, leading them to exit before boom led to bust. Less successful participants did not receive such a signal and continued to act on their pleasure signals well after the market had turned.
Colin Camerer, researcher behind the study, noted that subjects were able to control the prices of the simulated assets through their decisions. "The first thing we saw," he noted, "was that even in an environment where you don't have squawking heads and all kinds of other information being fed to people, you can get bubbles just through pricing dynamics that occur naturally." Interestingly, the lowest earning group of traders in the study were momentum participants who consistently acted on their brains' pleasure signals. The best performing group bought early and sold while prices were still on the rise.
To return to the above graphic from Rodrigue, successful traders behaved more like the "smart money", while unsuccessful traders acted like the uninformed public, valuing the market more as its valuation rose. It is in this context that the advice of Abnormal Returns, to stand aside from bubble prediction and participation, makes good sense. What gratifies our pleasure centers is not necessarily what makes us profitable.
Still, as Tadas notes, citing Daniel Gross, there can be an upside to bubbles in the broader scheme of things: boom and bust in the short run--from gold rush frenzies to dot-com speculation--provide funding for frontier efforts that eventually lead to real development. Not all infatuations lead to lasting romance and not all speculations end in long-term, profitable investments. Without animal spirits, however, perhaps many frontiers would remain unexplored and undeveloped. Further Reading: Why Emotions Are Key to Trading Performance
.
From housing in 2007 to dot.com stocks in 2000 and all the way back to those infamous tulip bulbs, we've heard about and experienced market bubbles. While Eddy Elfenbein might indeed be right when he defines a bubble as a bull market in which we don't have a position, there have certainly been times in which financial assets have become so subject to speculative fervor that they have lost their anchoring to fundamental value. Consider Japan's Lost Decade following its real estate bubble; it's understandable that investors wish to both avoid bubbles and potentially profit from them. Can we actually identify bubbles while we are in them, however, and--more to the point--can we anticipate when they might burst? Abnormal Returns suggests that trying to crystal ball the end of bubbles is not a fruitful use of an investor's time, as peaks are only truly known in hindsight following the initial--and often harrowing--decline. We've all known market pundits who have predicted 12 of the last 2 market crashes, leaving phenomenal amounts of money on the table for their uncritical followers.
A different perspective, however, is offered by Forbes columnist Jesse Colombo, who provided a heads up on the 2007 housing decline and recently posted 23 eye-opening charts suggesting that stocks are headed for a crash. Indeed, with central banks seemingly outdoing one another in the race for lower for longer, Jesse finds evidence of bubbles across multiple global markets. It is difficult to think of another period in which we have not only had bubbles, but a bubble of bubbles. That has to be a sobering scenario for longer-term investors. From a psychological perspective, I find it useful to distinguish between bubbles and manias. A bubble is a financial phenomenon, in which valuations depart greatly from underlying fundamentals. A mania is a social-psychological situation in which assets are purchased recklessly, with the assumption that they can only go higher. The famous bubbles of financial history have also had elements of mania. Indeed, it is the herd behavior of crowds that has created the severe declines that have accompanied the popping of bubbles. It's possible, however, that bubbles can exist for a period of time before the manic buying and selling leads to a pop.
The useful Stock Charts site shows that the ratio of bullish to bearish investment advisers tracked by Investors Intelligence is higher now than it was at the time of the 2007 and 2000 peaks, suggesting that we are seeing a degree of unbridled enthusiasm. Per the Abnormal Returns caution, however, it is clear that such enthusiasm can last a while before it ends in tears. The highest level of bullish-to-bearish sentiment in the last 30 years occurred prior to the 1987 crash--but early in 1986, well before the eventual market peak. The distinction between bubbles and manias leads to an interesting thesis: because manias are, by definition, frenzied phenomena, we should expect market volumes and volatility to bottom prior to any manic price peaks. That, indeed, happened in the 1920s: average monthly trading volumes in 1925 and 1926 were in the neighborhood of 30 to 40 million. Monthly volumes in 1927 routinely broke 50 million and in 1928, they exceeded 80 million for 7 months out of the 12. Seven of the first nine months of 1929--just before the crash--exceeded 80 million, with several over 100 million. Volatility bottomed in 1986, well before the 1987 peak preceding the October crash, and we saw a bottom in VIX in 1995, well before the drops of 1998 and 2000. VIX also bottomed in 2006, considerably in advance of the market demise of 2008. In each of these cases, animal spirits began percolating during the period in which bubbles became manias, ahead of market crashes. Quiet markets are not manic ones, but bubble markets tend to eventually draw animal spirits, as Kindleberger documented. With volumes currently tame and VIX not so far from those 2006 lows, it is difficult to read the current stock market condition as mania. Should interest rates rise in the face of rising inflation, however, and the flood of money parked in bonds finally find its great rotation into stocks, we could see those animal spirits return to equity markets amidst the current optimism and lack of financial stress.
Discussions about psychology among traders tend to focus on the emotional challenges of making sound decisions in the face of risk and uncertainty. Less appreciated are the cognitive challenges of trading. Thanks in large part to the online medium, today's trader is not at all like the tape reader of yesteryear, hunched over a ticker tape spitting out transactions. Today we have multiple screens that display multiple charts, multiple indicators gracing each chart, and an endless barrage of news reports, tweets, and chats. Early traders lacked timely data and therefore operated with very incomplete information. Today's traders are overwhelmed by data, with few ways of distinguishing which of the data constitute relevant information. To use Kahneman's terms, we spend so much time thinking fast--keeping up with the data barrage--that we rarely think slowly, deeply, uniquely, creatively. This leaves us data rich, but information poor. It's not surprising that a knowledgeable observer of the financial media such as Tadas Viskanta of Abnormal Returns counsels in his book that market participants should go on "a media diet." In a world swimming in data, the challenge is focusing on the right information, filtering out the rest. I strongly suspect that Abnormal Returns is popular precisely because Tadas serves as an effective filter for readers. Just as we rely on curators to decide what to include in museums and what to exclude, we rely on the curation of expert websites to help us channel our limited resources of time and attention. In some cases, the filtering expertise of websites draws upon the wisdom of crowds: Trip Advisor for restaurant and hotel suggestions; Rotten Tomatoes for movie reviews; and Beer Advocate for ratings of craft brews. While the crowd may deliver wisdom about such matters as best IPAs and imperial stouts, it's less clear that it possesses a distinctive edge in areas of specialized expertise, such as medical diagnoses or portfolio construction. For those needs, filtering expertise relies upon the wisdom of individual expert curators. (A site like Stock Twits is unique in that it captures both the expertise/folly of crowds via social sentiment analyses and the insights of experts who develop reputations within the community. In a future post, I will explore the curation of tweets--a particular challenge given the sheer volume of content generated daily.) The value of information filters is that they minimize distractions and interruptions from sources with low signal-to-noise ratios. Research suggests that such distractions and interruptions actually make us dumber: we're less able to perform basic tasks with divided attention. Just as having a cluttered physical environment can interfere with concentration and information processing, the ability to avoid distraction can help us process information more intelligently. Might it be the case that traders make poor and impulsive decisions, not because of intrinsic emotional conflicts or lack of discipline, but because their unfiltered cognitive environments leave them less able to identify and act upon valid information? This is a neglected area of inquiry and one I will be tackling in a future post. Further Reading: Finding Your Optimal Environment
.
While posting to the blog the other day, I noticed that TraderFeed is closing in on 4000 posts. It struck me that 4000 is a large number. If I wrote a blog post daily for 10 years, I still wouldn't accumulate 4000 posts. Now someone observing that amount of writing might marvel at the level of motivation, passion, and discipline it takes to maintain such a blog. In point of fact, however, motivation, passion, and discipline have little to do with the writing productivity. And therein lies an important, but underappreciated reality for trading psychology. The recent posts on turning success into a habit and the importance of small wins suggest that the right habits are crucial in cultivating a positive sense of self. Many small wins, strung together, become winning habits. When we have winning habits, we don't need to rely on discipline or passion or motivation to do the right things. I take a shower every morning without fail. No one lauds my motivation or my passion for cleanliness. The truth is that taking a shower in the morning has become an automatic act...the day wouldn't feel right if not begun with a shower.
That makes sense from an evolutionary vantage point. Habits enable us to do what we want/need to do in more or less auto-pilot mode, while saving limited attention and willpower resources for novel tasks and demands. Because of that, we can engage in relatively complex tasks--driving in NYC traffic, for example--while carrying on a conversation with a passenger and watching for the next freeway exit. A look at my recent blog posts reveals the times at which they were written (Central, US). Going from most recent to older posts this month the times have been: 1:41 AM; 4:24 AM; 3:53 AM; 4:01 AM; 3:05 AM; 3:25 AM; 2:07 AM; 5:14 AM; 4:38 AM; and 6:40 AM. You get the idea. I start my day with writing, just as I start my day feeding my cats and taking a shower. It's not the result of coaching, counseling, journaling, discipline, motivation, or any of those other staples of trading psychology. It's the result of cultivating positive habits.
We can create habits for productivity, habits for happiness--habits for most any positive outcome we care to generate, according to recent research. Charles Duhigg, who wrote the excellent book The Power of Habit, suggests that there is a "golden rule" of habit change: retain the cues that trigger a habit and the rewards that sustain the habit and find fresh, constructive routines to link these. I used to write journal articles and books while at home, but I found that when I needed to take breaks, I inevitably drifted mindlessly to the refrigerator. I got my writing done--and I put on the pounds to prove it! That's when I hit on the idea of doing my writing at coffee shops and grocery stores. My breaks consisted of coffee and whatever small snack I purchased--no more grazing at the fridge.
When I first began attending open AA meetings as a community psychologist in Upstate New York, I joked with a colleague that the members had retained their drinking habit: they had simply replaced alcohol with coffee. Little did I appreciate that habit truly is the backbone of 12-step programs. Does AA seek to cure alcoholism with willpower, motivation, or planning? Not at all! Indeed, one of the prime tenets of AA is the member's declaration that they are powerless against alcohol. It's not about willpower.
So how to AA members overcome their destructive habit? They start with 90 meetings in 90 days. "Bring the body and the mind will follow," is a popular slogan. By the time 90 days are over, the coffee urn has replaced the barstool and AA buddies have replaced the drinking ones. One member put it very well:
"What I’ve learned is that taking action is almost always the gateway into feeling better.
Rarely have I been able to think my way into different behavior or
results, instead it’s only when I take action (especially when I don’t
want to) that things begin to shift, and I begin feeling better.The program, like life, doesn’t work when I’m into thinking, only when I’m into action." It isn't that we think ourselves into new action patterns. Rather, new ways of acting create new ways of experiencing ourselves, which cultivate new--and potentially constructive--habits. Doing changes our viewing. Action, harnessed to routine, is a gateway. Further Reading: Turning Goals Into Habit Patterns
.
Let's say an explorer discovers gold in the mountains of Alaska. The initial group of miners prospecting the territory has a pretty wide open field of opportunity. They don't need sophisticated equipment to see and extract the gold from river beds. As more prospectors move in, the low-hanging fruit is gone. Now gold must be extracted from rocks and from deeper in the ground. This requires special equipment. The single miner with his pan, combing through the river bed debris, no longer has an "edge" in discovering gold. Still later, as more of the territory is mined, extracting what remains becomes a more complex task. Deep drilling into the ground and exploration of more remote mountain areas is required to make the investment of time and effort worthwhile. Individual miners, picking through areas that have already been explored, have almost no advantage in discovering gold--even though they still recount the stories of big strikes just a few years prior. A well-mined area means that either you have to find new areas to explore or you have to find new means of exploration. In the case of natural gas and oil, fracking has been a new mode of exploration. Drilling in the Arctic would be an example of finding new areas to explore. Either way, ingenuity is required to find value once others have been searching for a while. Financial markets have been well-mined for a while. Excellent traders, portfolio managers, and system developers around the world have been attracted to the gold rush of markets. While looking for nuggets of profitability in new ways and in new places does not guarantee success, looking for them where others have been searching for years with sophisticated tools inevitably invites failure. I recently have been posting on the topics of understanding vs. predicting markets; looking at markets in new ways; and using quant processes to aid discretionary expertise. The common theme is becoming better at the exploration for profits by looking at new things and looking at old things in new ways. Above is a chart of what I call the Momentum Curve. It takes every stock in the SPX and gauges whether it is trading above its 3, 5, 10, 20, 50, 100, and 200-day moving averages. The aggregated data are charted (available through the excellent Index Indicators site), so that you can see how the percentages of stocks shift over time. Observe from the graphic that--going into Friday's session--we had been undergoing a meaningful short-term correction (most stocks moving below their 3, 5, and 10-day averages) in a strong uptrend (most stocks above their 100 and 200-day averages). It turns out that the shape of the Momentum Curve is important in forecasting future stock market returns. The return profile looks very different depending on where the kinks are in the curve, whether the curve is steep or flat, etc. I find it useful as a qualitative tool--it provides a quick visualization of where we stand across multiple time frames--and also as a source of quantitative hypotheses regarding curve shape and forward price movement. Some of the best market tools don't generate conclusions. Rather, they suggest hypotheses worth testing. The first step in finding fresh answers is asking fresh questions. Further Reading: The Psychology of Quantitative Analysis
.
The chart above runs from May 6th, 2014 to yesterday morning: it's one of the things I was tracking closely at the start of Thursday's trade. Each point on the chart represents 500 price changes in the ES futures. So, in other words, every time we get 500 ticks higher or lower in the ES front month contract, we draw a new bar. So time is measured in units of market movement, not in movement of the clock. What that does is create many bars during busy, volatile market periods and fewer ones during slow, non-volatile ones. Suppose we get very little price movement during the course of 500 ticks in the index. What that tells us is that price change is occurring within a very narrow band: there is a high degree of consensus in the market at that moment regarding the location of value. If we get a great deal of price movement during the course of 500 ticks, it means that price change is occurring within a much wider band. That suggests a higher degree of uncertainty in the market regarding the location of value. The above chart measures current value uncertainty versus its longer-term moving average. When we have values above 1.0, there is relative uncertainty regarding the location of value. When we have values below 1.0, there is relative certainty. As with traditional measures of volatility, you can see the tendency for there to be greater levels of uncertainty at relative market bottoms and greater levels of uncertainty at relative market peaks. The normalization of the X-axis and the construction of the indicator around its recent moving average--creating a measure that is relative, rather than absolute--makes that relationship easier to identify. One certainly could test this measure in- and out-of-sample and use it as part of a trading system. Indeed, I have conducted such tests and have found the value uncertainty tool to be helpful. My use of it, however, is more qualitative and discretionary: I'm using it simply to identify whether the market environment is becoming more or less uncertain. So, for example, I closed out a long position late Wednesday because, although we had a bounce that day, the market uncertainty was rising, not falling. At the same time, I could see that some sectors of the market--most notably small caps--were not participating meaningfully in the bounce. Indeed, all told we had only about 500 more advancing stocks on the day than declines. Stock sentiment was bullish--the equity put/call ratio was a relatively low .76--but that bullish tide was not lifting all boats. Nor was market action suggesting greater certainty in the location of value. Notice in this example that I am using tested market measures to anchor a reasoning process. My goal is as much understanding as prediction. (Indeed, I did not predict Thursday's sharp overnight decline; I simply identified Wednesday's absence of strength). I want to understand what is happening in the market and why; not just blindly predict future movement on the basis of an algorithm linking variables that happen to fit a given lookback period. A major turning point in my trading occurred when I stopped predicating trades on predictions and instead used predictive inputs to inform a process of understanding. Trading systems and tested indicators are most useful when they reflect an underlying understanding of markets; they cannot substitute for such understanding.
In coming posts I'll be exploring the use of data and quantitative tools to aid the discretionary decision making of traders. Like anything powerful, quant methods can be used to great advantage or misused in destructive ways. The goal is not to supplant individual decision making, but to inform it. Just as aircraft pilots, physicians, and engineers rely upon data-driven methods to aid decision-making, traders can use well-constructed tools to identify valid trading opportunities. Those same tools can lead traders to become fixed in their views, however, and fall prey to confirmation biases. Tools are only useful if employed for the right tasks in the right ways. When discretionary decisions are grounded in proper research, the benefits are psychological as well as financial. It's easier to have real conviction in an idea if you've studied it, run the numbers, and seen how signals behave "out of sample" and in real time. It's like buying a car once you've conducted a compression check of the engine and taken it for a spin. Surely our trade ideas deserve as much due diligence as our automotive purchases! Selecting a car has strong intuitive components of pattern recognition: we sense what we like in a vehicle and know when it feels right. That doesn't stop us, however, from reading reviews of the car, checking its reliability, and running those road tests. The best decisions occur when head and heart are aligned.
Research suggests that the best way to achieve large gains is to make sure you experience small wins. What is a small win? Achieving a tangible step toward an important goal generates a small win. Many times we fail to attain our large goals because we don't pave the path with small successes.
Why are small victories so important? It turns out that progress in work you find to be meaningful gives energy and fuels creativity. This is tremendously relevant to goal-setting. If you fail to set goals, you deny yourself the small wins that come from reaching daily and weekly milestones. If you set goals that are too distant or ambitious, you can unwittingly set yourself up for frustration and a loss of the momentum that small wins can bring.
Small wins can be very small--as small as engaging in a positive behavior to start the day or maintaining a better posture. One reason engaging in exercise first thing in the morning is effective is that the energy of the workout also taps the energy of starting the day on a constructive, successful note.
Imagine yourself surrounded by small wins day in and day out. The mirroring effect of so many wins means that you begin to experience yourself as a winner--which in turn energizes you to further set yourself up for success.
Conversely, consider perfectionists. Because nothing ever reaches their expectations, they never achieve small wins. Indeed, they continually experience small losses--frequent episodes of falling short. What the research tells us is that you cannot internalize the sense of being a winner unless you set yourself up for frequent wins. When each day is pursued as a masterpiece, over time you experience yourself as an artist. The trading week to come may be a profitable one or it may not. If you are focused on small wins and the processes that generate profits over time, however, the coming week can always be a successful one. And that fuels the drive for truly big wins.
In the course of writing my next book, I've been reading The Power of Habit by Charles Duhigg. It's an excellent read, citing a wealth of real-life examples and cognitive neuroscience research to explain how making life changes often boils down to making habit changes. This flowchart provided by Duhigg explains the structure of habits and illustrates what must be done to change them. Habits begin with cues that lead people to anticipate rewards. Once cues are activated, the routines that bring the rewards become relatively automatic. It is the automatic nature of habits, grounded in the brain's basal ganglia, that makes them difficult to change. Only by restructuring the routines that connect cues and rewards can we channel automatic efforts in constructive ways. Interestingly, this can be done by finding small, consistent ways to disrupt an existing habit, rather than by trying to overhaul bad habits in general. For the most part, the problem is not that traders lack positive trading behaviors, but rather that they have not been able to turn those behaviors into routines. To the extent that we rely on willpower to do the right things, we are vulnerable to inevitable lapses in willpower. The beauty of habits is that they take on a life of their own, freeing the conscious mind to tackle fresh challenges. That life of their own, however, is precisely what traders lament when they find themselves reacting to cues in unintended--but habitual--ways. Once upon a time, psychologists tended to operate with the conceit that talk therapies were somehow deeper and more profound than other change modalities. Brain research suggests that precisely the opposite might be the case: talking to people about their habits is a singularly ineffective way to change those habits. If the action patterns are coded non-consciously in the basal ganglia, engaging the reasoning, conscious mind to initiate change is less likely to be successful than initiating fresh action patterns that reprogram the relevant brain region.
When traders become competent, they replace trading mistakes with best trading practices. When they become expert, they turn those best practices into positive habit patterns. Finding the right cues and rewards is half the battle in changing our trading routines.
I like this New York Times article on companies that pay employees well above prevailing normal wages in order to secure top talent and highest loyalty. It's an example of thinking outside the box. In this case, the box is that you have to minimize expenses in order to maximize profits. The out-of-box idea is that maximizing compensation and benefits secures the best workforce, provides the best service, and ultimately generates the best retention of customers. In the case of companies that provide premium compensation, values are an important driver of the business model change. One executive put it this way: "If we're talking about building a business that's successful, but our employees can't go home and pay their bills, to me that success is a farce."
Values enter the picture when the motivation driving the business is to do the right things, not just to do things right. Values drive the innovation; they are the motive force that nudge people out of the box. At several trading firms where I've worked, I've been part of the hiring process. Over the years, I've had a front row seat to who succeeds and who does not. The one conclusion that experience has taught me is that generic approaches to business cannot produce extraordinary results. If a trader describes a generic thought process in a recruitment interview; if a company's traders are generating consensus ideas from reading the same research and looking at the same information; if a company's management does not innovate in the running of the business, then why should we expect uncommon results from them? To innovate, however, you have to be willing to fall flat on your face. It was Edison, after all, who said, "I have not failed. I've just found 10,000 ways that won't work." It sure feels like failure when you're at the 5,000 mark, though, and it's likely to look like failure to others. The status quo seems far more secure; as Keynes observed, "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally." If your profit margins are suffering and you're paying employees premium wages, you come perilously close to looking like a well-intended idiot. It takes a deep level of commitment to values and vision to see any campaign through. Back when Big Data was not a big thing, I recall meeting a trader who hired dozens of college kids to surf online and check prices for hotels, car rentals, airfares at different times and across different locations. The kids spent hours and hours each week checking those prices and never once did they actually reserve anything. Instead, the trader assembled the data into pricing curves that expressed whether business was getting firmer or softer over time, region by region, industry by industry. The aggregated data provided a meaningful real-time window on consumer discretionary spending, which in turn had forecasting promise for the economy. You know when you are in the presence of talent, because the originality of their efforts smacks you in the face and you have the unmistakeable impression of, "Why didn't I think of that??!!" Looking at new information in new ways and assembling those data into fresh insights: that's what creates a trading edge. Those trading edges come from signature personality, social, and cognitive strengths. The trader with the college shoppers was a data junky and loved piecing data together into coherent pictures, whether or not they led to a trade. The values that drove his business were born of his strengths as an information processor: he loved learning and investigation. In a very real sense, the business was an expression of who he was as a person. When you're doing what you believe in--when you're expressing the very core of your strengths and what you love doing--you don't need discipline to work long hours or stick to your plans. You don't need to be pushed to do the right things when you're pulled by what you believe to be right. If a strong trading business is the expression of the trader's signature strengths and the innovations that embody those, there can be no question of greater importance to trading success than: "What makes me--and my trading--special?" Further Reading: Signature Strengths and Trading Success
.
According to this article, a shocking proportion of people don't like being alone. It's literally a shocking proportion, because they choose to undergo electric shocks rather than the stillness of solitude. As one news report put it, people apparently prefer negative stimulation to boredom.
There are many benefits to time spent alone, including time for deep and creative thought and activity. While loneliness can be a painful emotional state, there are ample historical examples of artistic, spiritual, and intellectual genius emanating from periods of solitude. Could this be why creativity is so often linked to introversion? Solitary work fosters deep concentration, which is essential to generating unique insight. Extroverts can dazzle us with charisma and leadership, but it is difficult to differentiate oneself from the herd if one is of the herd. That is why successful invention is so often a joint function of research in solitude and implementation through collaboration. Show me someone highly successful in a field and I'll show you someone who seeks alone time to engage in work in that field. That is because being alone is not necessarily being lonely; being alone is being all-one, in one's own company. In solitude, we have nothing but our thoughts, feelings, memories, ideas, plans, values, and interests. Whether that is appealing or aversive speaks volumes about an individual: active minds are rarely bored ones. Further Reading: Life Lessons From Great Inventors
.
Yes, I was there for the infamous HST presentation at Duke University. The backstory was that, after insulting his audience (he claims he hallucinated them as animated okra plants) , wrestling with his stage mike (he claims he hallucinated it as a snake), and tossing his bourbon onto the stage curtain, Mr. Thompson proceeded to meet with a smaller group of students on the university lawn and engage them in a completely sober and enlightening discussion. Not all who rave are divinely inspired, but there was at least a touch of inspiration amidst the ravings that day.
Having an "edge" as a trader: rarely has anything been so frequently discussed and so infrequently demonstrated. We can demonstrate a trader's edge through a long-term, real-time track record of trading; we can demonstrate a strategy's edge through properly constructed backtests. My preference is to trade a strategy that has displayed a historical edge and then let the track record display whether I have an edge in implementing it. Like Hunter once said, it's fine to pray, but row away from the rocks.
Sometimes you don't really know where your edge lies until you go over it. We like to think that trading what fits our personality will provide us with our edge, but that can be a socially acceptable way of justifying a failure to move outside our comfort zone. Indeed, the whole reason psychologists get involved with traders is because trading one's natural predilections tends to mean trading one's perceptual and cognitive biases, acting out one's bad habits in markets, etc.
Getting on stage and imagining your audience consists of animated okra plants is considered crazy. Sitting in front of a screen daily, trading away with no demonstrated edge, and justifying it all by "trading my personality" and "following my plan"...well, that's considered a career.
Admittedly, going over your edge and seeing what lies on the other side is crazy. It's a lack of discipline. It's not trading your plan or being in your zone or beating one's breast with manly pronouncements of conviction. And what if what lies over the edge is *not trading*? Well, perish the thought: that would show a lack of passion for trading, and we all know how necessary that is for market success (and high commissions).
I once decided to play it brutally straight and, in a first meeting with a client, calmly explained that the strategy he was trading was based on randomness and a simple backtest would prove that. That, I suggested--more than any psychological problem--was responsible for his trading woes. Needless to say, the backtest was not requested and neither was my coaching. Throwing bourbon on people's stage curtains is a great strategy for getting yourself ejected from the auditorium.
So what brought all this on?
Let's go out on the lawn and get back to basics.
The time series of any market consists of a linear component and one or more cyclical components. When the linear component is near zero, we have a range-bound market. When the linear component is very strong, we have a trending market. When we have more than one significant cyclical component, we have a noisy, choppy market.
When we see a stable time series, what we're really seeing is consistency of linear and cyclical components. When the world changes in material ways, those components change and we shift from one regime to another. What makes trading so difficult is that the strategies that work well when linear components dominate are not those that work well when cyclical components dominate--and once a strategy works well, a shift of regime can undermine its efficacy. Trends change their slope; cycles change their frequency and amplitude: it's tough to trade your personality when the market is changing its own. Trading fixed "setups" in changing markets is perhaps a setup in ways that are unintended. In the current stock market, there is a strong positive linear component (uptrend) and a strong low-frequency cycle superimposed on it. That regime has persisted for some time. In such a regime, my "edge"--short-term trades of 1-3 days based on backtested predictors--has not been a particularly good edge when traded real time. Why? In essence, I'm trading a short-term cycle, when a short-term cycle is not dominant. I'm trading my personality and my predilection, not what the market is giving me. To borrow a phrase from a savvy trading friend, short-term strategies "get run over" when lower frequency cycles and strong trend components are highly dominant.
In other words, my dogma has been run over by my karma. If I take what the market is giving me, I'd trade a helluva lot less often and align the trades with the most significant components of the present regime. So, I've gone over my edge to see what's on the other side. I'm trading the direction and time frame suggested by the components that account for the lion's share of market movement. That means I'm not daytrading, I'm not swing trading, and I'm not watching screens nearly as much. I'm just making more money. Further Reading: Preparing to Win
.
So every morning I plant myself at the kitchen island at 4:00 AM and every morning I am joined by my feline company. Those are my most productive hours, connecting with four-legged friends, enjoying the quiet, and alternating between work and morning exercise. No phone calls, no emails, no messaging, no television, no errands to attend to: just free time to reflect and work at what I love. Half of productivity is proper structuring of your environment: interpersonally and at the office.
I wrote the majority of my first book at a Wegman's grocery store in DeWitt, NY. It was a perfect environment, with plenty of coffee, food, and available tables. There were always plenty of people around, but none of them were distractions. Being in public can be a great way to find solitude.
Some traders work well in teams and thrive on debate and discussion. Others work well apart from people and view discussion as distraction. Some traders fill their immediate environment with multiple screens and a variety of visual displays. Others have a very simple trade station and greatly tailor their information flow. In structuring our social and work environments, we can either draw upon our strengths or frustrate those.
One of the problems with our environments is that, too often, they are not flexible. The setting that is best for deep thinking and analysis is not necessarily the one that is best for processing real time market information. Traders intuitively recognize this when they speak of the need to "get away from the screens" periodically. The right environments, like my mornings, are ones in which you feel free, unencumbered, and truly at home. The wrong environments understimulate or overstimulate, leaving us frustrated. When I first meet with traders, I learn a great deal by observing their environments. The world we structure outside has an uncanny way of mirroring our internal realities--and helping shape those. Further Reading: Assessing the Right Trading Environment
.
Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab). I teach brief therapy as Teaching Professor at SUNY Upstate in Syracuse, with a particular emphasis of solution-focused "therapies for the mentally well". Co-editor of The Art and Science of Brief Psychotherapies (American Psychiatric Press, 2018). I don't offer coaching for individual traders, but welcome questions and comments at steenbab at aol dot com.
Posts
