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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Fresh Perspectives in the Financial Media: The Reformed Broker

In coming posts, I am going to highlight blog sites that provide perspective different from the standard fare of financial media and blogosphere.  As I mentioned in the recent post about shaking confirmation bias, fresh inputs help us see the world through different lenses and assess our own thinking from perspectives we ordinarily would never have taken.

Today's featured site is Joshua Brown's The Reformed Broker.  A great introduction to his writing can be found in his list of "greatest hits".

Worth a special read is Joshua's post on the great disconnect in the financial media.  In the search for eyeballs and traffic for advertisers, the financial media pays far too much attention on the headlines of the moment and the hype of late-breaking news than on the enduring needs and interests of the investors who make up a large part of the financial public.

Another eye-opening perspective is Joshua's recent post on interest rate risk.  The reach for current yield at some point will end poorly in terms of total return.  At some point, he observes, there are going to be difficult times for those who have migrated to the perceived safety of bonds.

Finally, check out the link selection from The Reformed Broker.  As I have noted with respect to the dedicated link site Abnormal Returns, when smart people select readings for you, you almost certainly will be exposed to views that fall outside your comfort--and bias--zone.

Further Reading:  What Distinguishes Creative Genius
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When Volatility Becomes More Volatile: What Does That Mean?

What does it mean, psychologically, when the volatility of a market, stock, or asset is high or low?  The purpose of markets is to establish value for buyers and sellers.  In a world of perfect unanimity, where buyers and sellers totally agree on value, there will be little or no volatility.  In a less certain world, there will be differences in the placement of value.  When those differences become extreme, we have volatility.  It is in that context that measures of the implied volatility of a stock index (the volatility implied by options pricing), such as VIX, can be considered a measure of uncertainty.  Each individual participant may feel certain regarding their assessment of value, but the assessments of participants overall are widely distributed and hence convey uncertainty.

When the volatility of volatility is elevated, then we see not only extreme differences in the placement of value, but frequent shifts among these placements.  Vol of vol is thus a good measure of the relative stability or instability of a market's basic function:  setting value.  It is not surprising that vol of vol becomes extreme during periods of great market instability, such as 2008.

If you click on the chart above, you will see SPY plotted against the five-day realized volatility of VIX from 2012 to the present.  As you can see, we have moved very quickly from a low vol of vol environment to a high one.  A look at prior, similar elevations in vol of vol finds that these have occurred during corrective periods in SPY and, on average, have been good points to hunt for stock market bargains.  Indeed, going back to 2012, we find that the top quartile of occasions of highest vol of vol have led to an average next five-day return of .63% vs. .27% for the remainder of the sample.  The market has rewarded those who have used periods of instability to buy bargains in stocks.

The challenge, of course, is that instability can become greater instability before prices move higher and markets become more orderly.  What is important is for traders and investors to decide whether the current instability is more of a transient fearfulness in markets (as has been the case since 2012) or whether it reflects more fundamental instability (as was the case in 2008).  At the very least, the rise in market volatility and the volatile moves in volatility should prod traders and investors to review the sizing of their positions and the correlations within their portfolios.  It's when those correlations move toward 1 and volatility and vol of vol spike that seemingly prudent risk-taking can suddenly pose a risk of ruin.

Further Reading:  Volatility of Markets and Moods
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U.S. TICK: Tracking the Stock Market by Tracking the Market of Stocks

Yesterday's trading session was interesting in that we started with early weakness, experienced a selloff that failed to break last week's lows for most stocks, and then rallied back to the open before breaking out and moving steadily higher.  Yesterday's post illustrated how we can track such shifts in strength by identifying the number of stocks making fresh intraday highs vs. lows.  

If you click on the chart above, you'll see the ES futures plotted against five-minute average values of upticks vs. downticks for every single U.S. stock.  This is similar to the NYSE TICK measure that I have written about in the past, but with one important difference:  it tracks all stocks, not just those listed on the New York Stock Exchange.  For that reason, this U.S. TICK measure is particularly good at capturing the strength and weakness of the broad market moment by moment.  (U.S. TICK readings obtained via e-Signal platform).

(A topic for another day is a comparison of readings for NYSE TICK and U.S. TICK as a way of gauging the relative buying/selling interest in smaller cap stocks.  During the recent period of Russell 2000 weakness, the relative ratio of U.S. TICK to NYSE TICK was an excellent tell and helped with trading IWM.  It is very important to continually innovate in trading and find sources of information that confer an edge.  I backtest a lot of market data and have never found standard indicators--particularly the presets on trading apps--to be especially predictive.)

Notice how downticks dominated upticks early in the session, alerting us to early weakness despite the fact that the market was up from Friday's open.  We sold off hard in the morning and then, from late morning forward, something interesting happened:  upticks on the day began to outnumber downticks.  We can see this visually by looking at the area of the chart that U.S. TICK spends above and below the zero line or we can create a cumulative line for the U.S. TICK.  Either way, what you'll see is that the distribution of U.S. TICK values shifted during the day--in advance of the market's upward break.  Buyers began to dominate sellers.

Any individual value for the U.S. TICK can be high or low depending on random flows of the moment.  When we see an ongoing shift in the distribution of values over time, however, that tells us that the dynamics of the marketplace have altered.

There is yet another way to identify shifts in supply/demand in the stock market:  When you study the distribution of U.S. TICK values over time, you know the levels that represent 2+ standard deviations in the positive and negative direction.  These significant TICK levels tell you when there is a meaningful surge in the participation of buyers or sellers.  Note that we saw precisely such a surge during the noon hour, again in advance of the market's price breakout.  Following the breakout, we saw additional surge values to the upside, confirming that buyers were in control.  Knowing this can help a trader avoid selling a steamroller market.

We can follow the stock market through indexes such as the ES futures, but measures such as U.S. TICK show us that it is also a market of stocks.  By tracking in real time what every stock is doing, we gain a perspective on market strength and weakness that is not possible simply by following a single index of capitalization-weighted large caps.

Further Reading:  More on Indicators and Trading Patterns Can Be Found Here
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Using Intraday Breadth to Gauge Breakouts and Fakeouts

If you click on the chart above, you will see 15-minute bars for the ES futures contract for the day trading session, 8/4/14.  At the top of each bar is the number of stocks closing that period at day session highs.  At the bottom of each bar is the number of stocks closing that period at day session lows.  This includes all U.S. stocks (NYSE, NASDAQ, etc.) and the numbers represent new highs or lows *just for the day session*.

Notice how we opened with weakness despite being up from Friday's close.  Note also how the upside breakout from the day's range to that point (at the 13:30 ET bar) was accompanied by a meaningful expansion of new highs and contraction of new lows such that new highs now led new lows on the day.

For the remainder of the day, new highs expanded, new lows contracted, and of course new highs outnumbered new lows.  (Chart was created manually from e-Signal data).

Sometimes the market averages can move higher or lower, with the moves dominated by a relative handful of highly-weighted large cap stocks.  Other times, the market averages can move to fresh highs or lows and the broad market fully participates.  The intraday new high/new low numbers nicely capture broad market participation during moves--and were helpful in validating the midday upside breakout.

Further Reading:  Identifying Trend Days With Intraday Highs and Lows
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The Golden Age of Trading and Investment--And Its Challenges

Tadas Viskanta, in 2012, made the argument that we are living in a golden age for individual investors because of the availability of data, the increased access to markets, and the ability to trade multiple asset classes and strategies via ETFs.  As Tadas observes more recently, costs have come down significantly for individual traders and new ETF products place individual investors in control of their fate.  If you take a look at Viskanta's Abnormal Returns site alone, you'll see an array of information that simply would never have been at the finger tips of a trader or investor when I began my involvement in markets in the 1970s.  

This is not to say that problems with markets don't exist.  Concerns over the impact of high-frequency trading strategies, as well as the distorting impacts of activist central banks, have affected traders and portfolio managers alike.  Still, the fact that we are so aware of these issues is a testament to the democratization of information via the online medium.

Allow me to point out developments and innovations in the trading and investment world that simply did not exist when many of us began trading:

1)   Punch up any stock symbol and you can identify how many people are talking about that stock and whether they are leaning bullish or bearish, via StockTwits.

2)  With a couple of keystrokes, I can identify how many stocks--and which stocks--are displaying buy and sell signals across a wide range of technical indicators via StockCharts.

3)  I recently identified a promising pattern in trading SPY, backtested the strategy and confirmed its success in- and out-of-sample, ran appropriate statistical tests, and produced the TradeStation code to automate the idea as a trading system--and the entire process took 20 minutes via Adaptrade.

4)  Individual investors can now trade baskets of stocks or ETFs and create/manage truly diversified portfolios for a single commission fee via Motif Investing.

5)  Developing traders and investors can trade any market in simulation mode, playback market action for review, and collect detailed performance data on their trading--then go live and place orders straight from their trading screen via Ninja Trader.

6)  Traders can screen stocks for any given pattern, backtest the effectiveness of the pattern, and obtain trading signals for that pattern in real time for any chosen group of stocks via Trade Ideas.

7)  Traders can see how much volume is occurring at market bid and offer prices and place that within the context of longer-term market action via such apps as Market Delta and WindoTrader.

8)  Want to listen to the world's greatest investors, traders, researchers, and market observers?  Interviews are archived for posterity via podcasts from Michael Covel and Barry Ritholtz. 

9)  Individual investors--not just ones with high net worth--can now participate in hedge fund and other investment strategies via such alternative mutual funds as Simple Alternatives. 

10)  Have trade ideas for several stocks?  Tools now enable you to use the pricing of options for your stocks to estimate the probability of hitting various targets and identifying best trades via Interactive Brokers.  

Indeed, where the individual investor and trader struggled in the past to obtain timely, relevant information, now we are awash in data, challenged to extract pertinent information.  Where investors were limited to a few basic types of investment in the past, now ETFs open the door to true global macro investment and trading for the individual.  

The challenge now is for greater financial literacy.  The next great strides for individual investors and traders may come, not from ever more products, but from innovations in education, training, and advising that help people make better decisions with the dizzying array of options and information now available to them.

Further Reading:  Resources for Continuing Trader Education
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The Psychology of Preparation: What Traders Can Learn From Dan Gable

Georges St.-Pierre, the mixed martial artist, once summarized his approach to workouts:  "I make my training so hard that it's impossible that the fight will be harder than my training."  In other words, the workouts for the body were also mental workouts.  What strengthened his body, toughened his mind.

No one has lived that philosophy more than championship wrestler and wrestling coach, Dan Gable.  Over the course of a high school and college wrestling career Gable achieved a record of 182-1, with an Olympic gold medal in 1972.  During that Olympic competition, Gable not only won decisively over the world's greatest competition; he did not surrender a single point to his opponents.  It is difficult to imagine a more dominant performance from an athlete.

But that is only half the story.  Following his ultra-successful wrestling career, Gable went on to coach the Iowa Hawkeyes and turn them into a dominant force in collegiate wrestling.  Over a 21 year career, he won 15 national titles and amassed a record of 355-21-5.  Not only did Gable have an "edge" as a wrestler; he was able to teach that edge to his students.

How does someone become that successful in multiple careers over such an extended period of time?

As Gable observes in this 1972 Olympic Special video, he trains so hard that he becomes mentally as well as physically tougher than his opponents.  This conditioning allows him to stay on offense at all times, taking control of the match from the outset.  That quote from Georges St.-Pierre captures an important aspect of Gable's success:  by exceeding his limits and challenging himself every day in training, Gable created one experience of mastery after another.  He was a winner in his training long before his hand was raised in the ring.  

The body builder Mike Mentzer popularized the concept of training to failure:  challenging your muscles by lifting just enough to hit your limits.  The muscles don't adapt and grow, Mentzer taught, unless they are pushed to their limits.  By pushing yourself to failure, you set the conditions for success.  Gable knew this well as a wrestler.  On many occasions he practiced and trained so hard that he literally could not get on his feet to make it back to the locker room.

In his book, Gable describes a visualization exercise he used to perform during his training on the cycle.  While cycling, he would imagine in vivid detail his entire workout routine.  As he relived the challenge, sweat, and exhaustion of his workouts, that pushed him to work harder on the cycle.  In every training exercise, his sole concern was pushing himself to his limits--making himself more than he already was.   When you hear people talk of Gable the wrestler or Gable the coach, the one phrase that recurs is "single-minded".

"If you know you haven't cheated, physically in your preparation, that makes you mentally tough," Gable observed for a 1973 Esquire article.

So what can a trader learn from Dan Gable?  Perhaps this:  if the day's trading session is more challenging for you than your preparation for that session, you will never reach elite levels of success.  If you have not pushed yourself to the limit before the opening bell, markets will find and test your limits for you.  Enter the ring with single-minded preparation and you will never compete with a divided mind. 

Further Reading:  The Role of Simulation in the Training of Traders
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A Hard Look at Our Trading Edge

For this post, I am going to ask you to take a look at the P/L Forecaster on Henry Carstens' site, a valuable tool I wrote about a few years ago.  The Forecaster is valuable, because it shows you how variable the paths of our profit/loss (P/L)  can be, even with a constant edge in the market.  

The top profit/loss curve represents no edge whatsoever.  There is a 50% hit rate on trades and the average size of winning trades exactly equals the average size of losers.  Over the course of 100 trades, we see plenty of ups and downs, but little ultimate return.  If you run the Forecaster many times with this scenario, you will see P/L curves of all possible shapes.  Some go up and down a lot; some less so.  Some rise early in the sequence; others fall.  For the most part, the ultimate P/L doesn't stray far from zero.  

(On the other hand, as this post demonstrates, if you have just a small positive edge--or a small negative one--the positive or negative results tend to play out after 100 trades.)

Possibly because of bias blind spots, traders without an edge may very well not acknowledge their lack of positive expected return.  Instead, they will look at the peaks and valleys in the top P/L chart and attribute those to "trading well" and "trading poorly".  They may even assume that they have hot hands during the rising periods and attribute the losing periods to slumps.  Raising their risk-taking after a winning streak and decreasing it after a losing streak--often recommended as sound practice--would almost certainly take a neutral P/L curve and turn it negative.

Let's assume that our hypothetical trader falls prey to the disposition effect and holds losers and sells winners, creating a situation in which winning trades are only 90% as large as losing trades.  Even with a 50% hit rate, we can see in the middle P/L chart that the negative edge manifests itself over 100 trades.  Again, you can run this scenario many times in Henry's Forecaster to show the variability of P/L paths, but similarity of ultimate outcomes.

Conversely, if our trader manages risk well and cuts losers and holds winners, creating a situation in which winning trades are 10% larger than losers, that same 50% hit rate now produces a positive P/L curve, per the bottom chart.  

It's a great example of how a small edge, consistently employed, makes all the difference between winning and losing.  When you have an edge, consistency is crucial for success.  The very successful traders are consistent in cultivating *and* deploying fresh sources of edge.

Conversely, falling prey to a single bias makes the difference between a positive or flat P/L curve and a negative one.  Think of all the biases that impact traders and you can see why consistency is so difficult to consistently achieve.

Finally, we can see that, even with the positive edge of the bottom P/L chart, there are plenty of streaks in profitability--up and down.  If you run the positive edge scenario multiple times, you will be able to appreciate how very different the curves look in spite of the constant and positive edge.  The takeaway is that there is more variability to profit/loss curves than we typically expect.  If we are unprepared for the strings of winning and losing trades that occur purely by chance, we are likely to alter our trading in ways that will erode whatever edge we may possess.

The bottom line is that you can be a great trader with a consistent edge and still have losing streaks.  You can be a trader with no edge whatsoever and still have winning streaks.  Only after many trades does one's edge become apparent.  That is an important lesson not only for traders, but also for the firms that hire them and allocate their capital.

Further Reading:  Papers From Henry Carstens
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Historical Market Queries and What We Can Learn From Them

I've received several questions about the recent market selloff and whether we are near a bottom.  Above you can see my intermediate-term measure of market strength.  As a rule, it peaks before prices top out; bottoms before prices make their ultimate lows at major bottoms (high VIX regimes); and coincides with market bottoms at the end of corrections in bull markets (low VIX regimes).  The intermediate-term strength measure consists of a moving average of the number of SPX stocks making short-term, medium-term, and long-term new highs vs. new lows.  Major props to the Index Indicators site for carrying these data.   

The chart shows how we peaked in strength early in June and only recently crossed below the zero line.  Yesterday was an unusually weak day with respect to the intermediate-term strength measure.  Indeed, over the last 2000 trading days going back to 2006, we've only had 62 weaker readings.  Only 8 non-overlapping instances occurred during low VIX regimes (< 20); 5 of those 8 occasions were down after five trading sessions; 7 of the 8 were up 20 sessions later.  

For you market history buffs, the dates of recent weak market days similar to yesterday are:  2/27/07; 6/7/07; 6/3/11; 4/9/12; 11/8/12; 6/5/13; 1/24/14; and 4/11/14.  Note how these occurred in very different contexts--with very different longer-term outcomes.

I like such analyses, not because they predict the future, but because they illustrate the range of outcomes under similar market circumstances.  That can be a great check on our biases and bullish/bearish predilections.  Do the data suggest buying the weak day?  Not exactly.  Do they suggest selling?  Not really.  The modal course is lower in the short run followed by rally--but that can occur in topping markets, weak markets, and bull markets.  

The role of historical investigations is not to provide certainty, but to clarify--and encourage respect for--modal outcomes and the uncertainty surrounding those.  Once in a while those investigations confer a trading edge, but they invariably provide perspective and a check on overconfidence.

Further Reading:  Putting Markets in Historical Perspective
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The Enduring Value of Trading Wisdom

When we view the world from the trading desk, our perspective is too often limited to the lenses we wear at the moment.  Recency bias, hindsight bias, confirmation bias:  there are many obstacles that stand in the way of clear perception.  When we get off the desk and speak with colleagues, seek out new sources of research, and read novel views, we have the opportunity to wear new lenses and process the world in fresh ways.

One of the most powerful ways to shift our perspective is to speak with successful traders.  Those conversations are valuable, not so much for specific trade ideas, as for broader market-related wisdom.  Some of the most powerful lessons in my development have come from specific, eye-opening conversations with accomplished pros.

It was precisely such a conversation that first taught me about factor investing and ways of harvesting returns without engaging in market timing.

A walk through a university museum during a study break took me to a display of the works of Ayn Rand, and that led to the recognition that psychology could be much more than the treatment of disorders--and that trading could be more than profiting from market ups and downs; 

A conversation during my first visit to the trading office of Victor Niederhoffer led me to think of trading as a scientific activity that could be illuminated through the understanding of other disciplines.

A decision to read everything I could find on the topic of short-term approaches to therapy was intended to make me a better psychologist--and led to the writings on solution-focused work that taught me that exceptions to people's problem patterns are as important as those patterns.

I recall a casual conversation years ago with a very successful money manager who pointed out, "If it's not in your calendar, it's not part of your process."  That hit home.  The greatest of intentions, goals, and plans matter little if they aren't lived in daily life.

Watching an accomplished trader at work, I saw him take a quick loss on a trade and then flip his position and make far more money.  Before he changed his position, he gave me a smile and explained, "I just paid for information."  His losing trade was information, not a loss.  That stuck with me; to this day I search for information in losing trades so that I can extract some winnings from the day.  When dealing with uncertain markets, learning can be the one certainty.

In the office of yet another pro, I noticed very strict rules at work for adding to positions, taking positions down, and raising stops after favorable moves.  "The management of your trades counts every bit as much as the ideas you're trading," was the life lesson.  There are no touchdown passes if the blocking and tackling aren't solid.

It's great to seek knowledge, but the enduring lessons come from wisdom.  Markets are far too complex and challenging to be mastered from a desk.  There's a world of wisdom away from the screens in books, interviews, and conversations.  Teach yourself trading, spend the screen time needed to master market patterns, but also heed the advice of Mark Twain and make sure your schooling doesn't interfere with your education.  That might be the best wisdom of all.

Further Reading:  Life Lessons From Blogging
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