Upcoming Topics for TraderFeed Posts

The TraderFeed queue keeps growing.  Here are topics for upcoming posts; additional suggestions for topics are always welcome via comments to posts:

*  An Explanatory Framework for Pulling Together Market Observations

*  Finding an Evidence Basis for Technical Analysis

*  Best Practices in Market Tweeting and Social Media

*  Taking Professional Networking to the Next Level

*  What We Can Learn From Overnight Trading

*  An Advance Look at Dr. Brett's Next Book

The theme across these posts is looking at markets--and market opportunity--in new ways that can generate fresh trading edges.  Many psychological problems of trading are the result of a failure to innovate in the face of shifting market opportunities.

I greatly appreciate the interest and support--

Brett
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A Few Good Reads to Kick Off the Market Week

*  Mia's story about overcoming adversity and Mali's story about surviving the lean times.

*  A surprising number of stocks--in the NASDAQ and Russell 2000 indexes--are in bear markets.

*  I like how Abnormal Returns is now archiving the best of trading and investment podcasts.

*  Nice view from Reformed Broker on how markets keep expecting rates to rise, only to find we stay lower for longer.

*  Gary Stone on why it's important to never stop growing and ensure a positive trading environment.

*  This idea of indexing creating market inefficiencies is a very interesting one.  A case for stock pickers?

*  Thoughtful post from Math Trading on misconceptions re: quant approaches to trading.

Have a great start to the week!

Brett
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The Challenge of Cultivating Trading Intuition

If we are to ground our investment and trading decisions in sound understanding and prediction, what, then, is the role of intuition in decision-making?

The recent post on intuition began with an interesting quote from Einstein, in which he described the rational mind as a faithful servant and the intuitive mind as a sacred gift.  Indeed, to those who achieve creative insights, it does indeed seem as though those flashes of insight come from an other-worldly source.

The problem in financial markets is that so many participants lack both faithful servants and sacred gifts.  I have met many traders who claimed an edge in markets due to their superior ideas and/or their superior gut feel for markets.  In the majority of cases, it is difficult to identify a concrete process that would generate either superior insights or intuitions.  Too often, the ideas traded are casually derived and held by a consensus of participants.  What passes for gut feel is fraught with recency bias, overconfidence, and a host of other cognitive distortions.  

If I claimed to be a great sprinter but never won a race and could not demonstrate superior running times on the track, you might think me to be delusional.  Many traders, facing years of poor results, will make comparable claims.  When pressed to identify the source of their (seemingly hidden) talent, they frequently will cite intuition and a superior market feel.  If only situational forces--psychological ones, the evils of algorithmic market manipulators--could be tamed, they maintain, their talents would finally shine through.

Suppose we encountered an island tribe in which the natives looked to the shapes of passing clouds for clues as to their destiny.  Dark clouds foretold an ominous future; a cloudless sky suggested a sunny path ahead.  We would no doubt chalk up these practices as the superstitious beliefs of a primitive culture.  Now imagine we encountered a tribe of financial participants who look to ancient numerical sequences or shapes on charts for signs of the future of asset prices.  This we chalk up to "technical analysis" and place on the program of expo events.

I have never felt a particular desire for psychedelic drugs and other mind-altering substances.  Reality itself is weird enough.

And yet there is far more to intuition than superstition and cognitive bias.  Some of the most successful traders I've known have demonstrated--year after year, over thousands of trades--a superior ability to read short-term patterns in markets.  What sets these intuitive traders apart from those who are merely deluded?  Where do they get their sacred gift?

Let's consider an analogy.  Suppose I identified a person who had a superior intuitive ability to forecast the weather.  This person could tell when it was going to rain, when temperatures would become cooler, and when a storm was approaching--all with well-above chance levels of success.  If we were to dissect the success of our forecaster, we would find out that he or she had developed a feel for factors that truly are related to weather changes:  shifts in wind velocity, shifts in air pressure, changes in humidity, etc.  In other words, the intuition is grounded in pattern recognition, and the pattern recognition is grounded in variables that are objectively related to the intuited outcomes.

Compare this with a would-be weather forecaster who based predictions upon a preordained set of wave patterns linking temperatures and precipitation.  

I've had the honor of watching several skilled intuitive traders in the process of their trading.  To a person, they focus on market factors that (perhaps unbeknownst to them) have been extensively studied and documented in the academic finance research literature:  factors such as momentum and volatility.  They are like the skilled weather forecaster:  they have developed a sensitivity to changes in the environment and the correlation of those changes with future outcomes.  Their sacred gift is the result of experiencing so many situations that pattern recognition becomes their faithful servant.

As a psychologist for over 30 years, I have many intuitive insights into the people I work with.  I do not have intuitive insights into ice skating or plasma physics.  Intuition comes from experience--but it has to be the right experience.  Years of exposure to random inputs will not bring sacred gifts.  Intuitions are only valid if pattern recognition captures variables that truly are causally related to anticipated outcomes.

If this is true, much of traditional trader education is misguided.  To build a trader's intuition, we should expose the developing trader to truly predictive variables and their co-occurrence across many market situations.  Simple price and volume charts or depth of market displays are ill-designed for this purpose.  If the variables that are most predictive are ones like momentum, correlation, and sentiment, then we need to develop displays that capture how momentum, correlation and sentiment behave under a variety of market conditions.  It's not that price charts are wholly unrelated to these things; it's that if we wanted the clearest and least ambiguous displays of the most predictive variables, we would not rely upon a price chart. 

Intuition can be a controversial topic.  On one hand you have advocates of intuition who claim a mystical source for their insights.  On the other hand, you have rationalists who deny the validity of intuition altogether.  There is a science to cultivating intuition, but I suspect it's in its infancy.  We can only develop a valid feel for things if we are systematically exposed to things of demonstrable validity.  The recent posts on identifying drivers of short-term markets is but the first step in a larger developmental effort to cultivate sacred gifts from faithful servitude. 

Further Reading: Underconfidence and Overconfidence in Trading
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Overcoming Impulsivity and Procrastination

Perhaps the two most common psychological concerns of traders are impulsivity--doing things without clearly thinking through the rationale--and procrastination, failing to act upon our plans and intentions.  Most commonly, impulsivity is the result of frustration and excitement:  our body's arousal impels us to action, even when it might be best to stand aside.  Procrastination is most often a function of worry and anxiety.  It is a way to avoid potential negative consequences.  Both behaviors lead to situations in which traders fail to act upon their ideas and plans.

It is common for traders to work on these problems by trying to control themselves (to reduce impulsivity) and by trying to motivate themselves (to reduce procrastination).  In both cases, there is a divided self:  one side that pushes the "good" behavior and the other side that gravitates toward the "bad" behavior.  Not only does this self-division not work; in fact, Wegner's research suggests that trying to suppress unwanted behaviors can actually make them stronger.  It is a bit like trying to make yourself not think about a pink elephant or trying to make yourself go to sleep.  The more you make the effort, the more you reinforce in your mind the consequence you're hoping to avoid.

This is where habit formation is most useful.  When we break desired behaviors into chunks and turn those into routines, we take ourselves out of the realm of control and motivation and instead enact the behaviors automatically.  For me, a good example is market preparation.  Before each trading session, I update dozens of spreadsheets that inform me about current market conditions, from breadth to sentiment.  That process is a very well-worn routine--so much so that I haven't missed a spreadsheet update in quite a few years.  The key is that I enact the updates in the same way, at the same time of day, in the exact same manner.  Because it is a habit, I don't expend mental capital on the exercise, trying to get myself to finish the task or making sure I perform the updates diligently.  Once behaviors are automatic, there is no division of self.  That saves considerable energy and emotional wear and tear.

When the essential elements of trading are distilled into routines, the result is a trading process.  A robust process is nothing more than a coordinated set of habits.  There are many benefits to being process driven, including grounding oneself in best practices.  The major psychological benefit, however, is consistency.  If we are not at war with ourselves, we can devote full attention and focus to the battle for profits.       

Further Reading:  Making Sound Decisions Under Conditions of Fear
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Three Top Reasons Why Traders Fail to Trade Their Plans

A reader recently asked for perspectives on the issue of difficulty following trading plans.  If only we could faithfully follow our plans, the logic goes, we would be positioned for success.

Maybe. 

Scanning my work with traders, here are the three top reasons traders fail to act upon their plans:

1)  The plans are not worth acting upon.  This is a very common reason, but no one seems to talk about it.  I believe people frequently veer from their plans because of intuitive wisdom.  They sense that markets have changed and their plans are no longer relevant; they sense that their plans are not grounded in solid understanding and prediction and therefore do not trust them; and/or they sense that the plans are ones that they have merely mimicked from others and not ones they truly have confidence in.  The presumption in trading psychology discussions is that one should reliably follow one's plans.  My leaning is to question the premise.  Plans are only worth following if they are well crafted and reflect approaches to markets that have a demonstrable edge.  If you don't stress test your plans, markets will stress test you.

2)  We are intellectually prepared with plans, but not emotionally prepared to act upon them.  This is very relevant to the issue of performance anxiety.  When we plan in one state of mind (calm, focused), but execute our plans in a state of flight/fight (aroused, impulsive), we are much more prone to cognitive biases and reactive behavior.  This is particularly the case when our plans call for one level of risk management, but emotionally we can tolerate only a lower level.  It is very common that traders target one level of risk taking (hoping for large profits), only to "overreact" when their position sizing leads to unanticipated losses.  One of the great benefits of visualization and exposure methods is that they allow us to emotionally prepare for stressful events.  As I discuss in the Trading Coach book, it is easier to follow our plans if we have already faced likely challenges to those plans.

3)  Distractions interfere with our follow-through on plans.  Not all disruptions of plans are emotionally triggered.  It is very common for traders to become distracted by their physical environments.  This includes noise levels, equipment failures, and unanticipated personal and market events.  A common example of distraction is staring at screens, following markets tick by tick, and then acting on a very short-term market movement that had nothing whatsoever to do with one's original plan.  I particularly like biofeedback training, not only as a means for gaining emotional self-control, but as a means for improving concentration, mindfulness, and the ability to tune out distractions.

In short, there is no single reason why traders fail to act on their plans.  Keeping a detailed trading journal can be very helpful in identifying when you do and don't follow through on plans, revealing patterns in your own trading psychology.  In general, my advice is to first make sure your plans are worth following before you worry about finding psychological methods for improving your discipline.

Further Reading:  Why Traders Plan Trades But Don't Trade Their Plans
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Prediction and Understanding in Generating Market Returns

The recent series of posts have reviewed a number of stock market measures that I have found to be useful in anticipating short-term price movement:  buying and selling pressure; pure volatility; breadth; sentiment; and correlation.  The question now arises:  how do we make use of multiple measures such as these?  How do we put them together in a coherent fashion?

Let's address this by first surveying the territory.  Traders attempt to anticipate market behavior by engaging in one of four modes:  1)  bias; 2) superstition; 3) prediction; and 4) understanding.

Bias represents a way of thinking that is grounded, not in objective events as they are occurring, but in thoughts, feelings, and ways of processing information that are influenced by external and nonessential factors.  For example, I have met a number of traders who display a persistent bearish bias.  When asked for the reasons for their bearishness, they cite their disagreement with the political and economic policies of the government.  Their political and economic beliefs are so strong that they cannot see markets through any other lens.  Needless to say, this has led to disastrous returns over the long run.

Superstition is a set of beliefs that are not grounded in objective observation and measurement and--this is important--cannot be validated through such means.  A while back I encountered a market analyst who declared that the stock market was headed lower because it was completing a head-and-shoulders pattern on the weekly chart.  I quickly coded up market patterns of a similar nature and backtested the idea.  I found no predictive validity to the head-and-shoulders formation whatsoever.  I varied the coding to look at formations on different time frames and still found no predictive value to the pattern.  When I explained this to the analyst, he replied that technical analysis was an art, not a science.  The belief system that shapes on charts dictate forward price movement was grounded in superstition and--as a supposed "art"--was immune to attempts at validation.

Prediction is an attempt to quantify and systematize relationships among variables that we believe to be causal.  Suppose I were to take the variables listed above, such as sentiment and volatility, and enter them into a stepwise regression equation to see which uniquely predict forward price movement.  I might find, for instance, that one of the variables--say volatility--so overlaps with correlation and buying/selling power that it does not add significant predictive value whatsoever.  The variables that do add significant predictive value comprise a model that spits out predictions of future price movement.  While much prediction is quantitatively driven, a qualitative form of prediction occurs when experienced traders recognize recurrent market patterns and base quick decisions on the occurrence of these patterns.  Because such intuitive pattern recognition can look so much like superstition, it can be challenging to differentiate skilled intuitive discretionary traders from superstitious amateurs.  Ultimately, the arbiter of predictive value--whether quantitative or discretionary--is an objective, real-time track record. 

Understanding is quite different from prediction.  We can predict when the sun will rise in the morning, but not necessarily understand the reasons for the sun's apparent movement.  Understanding addresses the why" behind prediction.  Very often, we do not know precisely how causes lead to effects in nature.  We develop our understanding by generating a theory, which attempts to explain how variables of interest lead to observed outcomes.  Good theories account for existing findings, but also suggest new ones.  One pitfall in the investing world is generating complex predictive models through means such as neural networks.  The output of these models may not be clear--and certainly may not reflect any understanding of the underlying markets.  A very useful brake on the overfitting of trading systems and models is the use of input variables that make sense within a plausible theoretical model.  Otherwise, we have no way of determining whether our predictive model is truly grounded in an understanding of the world.

In important respects, the division between technical analysis and fundamental analysis in the trading world reflects a tension between the modes of prediction and understanding.  Just as the predictions of technicians can reflect little underlying understanding of markets, the inputs of fundamental analysts can lack predictive rigor.  A good example of the former is market queries that find a predictive edge when, say, we post a three-day high at the start of a calendar period.  There is no proposed mechanism that explains why such a pattern would hold true.  Conversely, when we hear a "macro" analyst declare that stock market returns will be dampened in Europe because of threats of war in the Ukraine, there is no predictive framework for testing and validating the assertion. 

Ultimately we master a domain when we can explain observations and validate our explanations through tests of our predictions.  Those tests either occur prospectively, as part of formal backtesting and forward testing, or they occur in retrospect via the analysis of real-time track records.  Such mastery is rarely demonstrated in trading, where a great deal of activity is dominated by bias, superstition, and disjointed efforts at prediction and explanation.  As a psychologist and trader for many years, my distinct impression is that much of what traders experience as emotional challenges in markets is the result of operating in an uncertain domain with less-than-adequate predictive and explanatory frameworks.  Anxiety and frustration are the understandable consequence of needing to predict and understand, but having few tools to achieve those ends.

So what does a sound explanatory and predictive framework look like?  One window on market success is offered via the Principles written by Ray Dalio of Bridgewater Associates, as well as his account of How the Economic Machine works.  Another window on successful prediction and explanation can be found in the work of Clifford Asness of AQR, including his published papers.  The dramatic success of these funds represents the power of joining prediction and explanation in a robust and replicable fashion.  That is the hallmark of science.

This brings us back to the original question:  Is there an explanatory framework that can bring together the variables covered in the recent blog posts?  And what is the proper role of intuition in the joining of prediction and understanding?  Those will be the topics of the next posts in this series.

Further Reading:  Qualitative Research and Science
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The Importance of Sector Correlations in the Stock Market

Recent posts have taken a look at useful market indicators, including buying and selling pressure; pure volatility; unique measures of breadth; daily sentiment; and intraday sentiment.  This post takes a look at the rolling 20-day correlations among key stock market sectors.  What I do in this measure is take 10 segments of the stock market and run pairwise correlations among their ETFs.  The final measure is the average of the entire correlation matrix.

Let's think about what that means.  Technical analysts commonly refer to "divergences" among stocks at market turning points.  That's one reason breadth measures are popular:  they identify occasions in which stronger stocks are becoming differentiated from weaker ones.  When we are making market lows, stronger stocks fail to follow the broad averages; when we are making market highs, weaker stocks fail to confirm the strength in the broad averages.  The correlations among sectors provide a way of quantifying this differentiation among stocks.

If you click on the chart above, you can see that correlations have been highest around intermediate-term market bottoms and lowest around intermediate price peaks.  During "risk off" periods, correlations rise considerably, as selloffs hit all sectors.  The initial liftoffs from market bottoms find buying interest from longer timeframe participants and take most stocks off their lows.  As rallies age, weaker stocks begin to lag and correlations fall.

If we go back to 2012 and create a median split of the data, we find that, when correlations are in the lowest half of their distribution, the next five days in SPY have averaged a flat performance.  When correlations are in the highest half of their distribution, the next five days in SPY have averaged a healthy gain of +.68%.  This pattern of subnormal returns for low correlation markets and superior returns for high correlation markets extends to 20 days out.  Interestingly, correlations are at very low levels in the current market, suggesting reduced upside potential.

So we have all these measures that appear to have usefulness in anticipating forward price movement.  How do we put them together to create truly evidence-based market indicators?  That will be the subject of the next post in this series.

Further Reading:  Intraday Sector Correlations
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Using Put-Call Ratios to Gauge Intraday Stock Market Sentiment

The most recent post took a look at the equity put-call ratio as a way of gauging market sentiment.  Suppose, however, that you are interested in gauging sentiment shifts that occur within the market day.  The figures reported by exchanges are the daily ratios updated throughout the day.  They do not tell you specifically how many put options and call options are traded uniquely during each segment of the day.

If you click on the chart, you'll see figures that don't typically appear with the data services.  I took the number of equity put options traded during each 15 minute segment of the market day and divided them by the number of equity call options traded during each of those segments.  The result is a unique put-call ratio for each 15-minute period, rather than a daily figure updated every 15 minutes.  (Data obtained from e-Signal and ratio calculated and charted in Excel). 

You can see how sentiment has shifted over the course of the last three trading days, with spikes in the put-call ratio at yesterday's market lows and rather bullish sentiment by end of day.  In general, I find value in the sentiment measures at extremes:  when readings are unusually bullish or bearish. 

Further Reading:  Visualizing Social Sentiment
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Measuring Stock Market Sentiment: The Equity Put-Call Ratio

The most recent posts have focused on several important dimensions of short-term stock market behavior:  Buying and Selling Pressure; Volatility; and Breadth.  Above we see yet another key dimension:  sentiment.  My favorite measure of sentiment is the put-call ratio specific to individual stocks trading listed options.  I have found this measure to be significantly better at predicting short-term price movement in SPX than the put-call ratio for index options.  

As you can see from the chart above, covering 2014 to date, spikes in the equity put-call ratio have been associated with good buying opportunities in stocks.  (Data from e-Signal and analyzed/charted in Excel).  Forward returns have been restrained following periods of low put-call ratios.  If we go back to 2007, when the equity put-call ratio has been in the lowest half of its distribution, the next 10 days in SPX have been unchanged.  When the equity put-call ratio has been in the highest half of its distribution, the next 10 days in SPX have averaged a gain of +.49%.

It's a great illustration of how following the herd produces suboptimal market results.  It's when stocks are most unloved that they've produced the best returns.  

Further Reading:  The Relative Put-Call Ratio
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Perspectives on Stock Market Breadth

The previous two posts have looked at variables that I have found useful in tracking short-term movement in the stock market:  buying/selling pressure and volatility.  A third variable I have found useful is the breadth of movement among stocks. 

There are many ways of tracking breadth.  Of all of these, I have found advance-decline lines to be among the least useful in predicting forward price movement.  This reflects my more general experience that the most commonly tracked market measures are among the least useful, perhaps precisely because they are so widely tracked.  

Above are three breadth measures that I have found to be useful.  The first (top chart) is the number of common stocks across all changes that are making fresh three month highs minus those making new three month lows.  (Data available from the Barchart site).  You can see that breadth has deteriorated in recent days, leading to the most recent market weakness.  You can also see that breadth has deteriorated since the early August decline, as the market rally grows increasingly selective.

The second measure (middle chart) covers all stocks listed on the NYSE and tracks the daily number that close above their upper Bollinger band minus those closing below their lower Bollinger band.  (Data available from the Stock Charts site).  This, too, shows a recent pattern of deterioration, even as stocks moved to new highs.  

The third breadth measure (bottom chart) is specific to the universe of S&P 500 stocks.  It is a composite measure of the percentages of SPX stocks trading above their 3, 5, 10, and 20 day averages.  (Data available from the Index Indicators site).  What we see again is a tendency for this measure to peak ahead of price, as has happened most recently.

In general, I find that strong breadth leads to short-term upside momentum, followed by reversal.  Weak breadth leads to short-term downside momentum at important market bottoms (i.e., bottoms of longer-term market cycles) and short-term reversal at market corrections.  In a qualitative sense, these measures give me a picture on whether markets are getting stronger or weaker day over day--very useful information for gauging where we might be at in a market cycle.

Further Reading:   Useful Trading Tools: Breadth
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Pure Volatility: A Measure of Stock Market Efficiency

The recent post took a look at a research-based measure I constructed for assessing buying and selling pressure in the stock market.  A different--and equally challenging--project has been the creation of a new measure of stock market volatility.  Across most time periods I've investigated, the volatility of SPY has been very highly correlated with the volume of trading--generally by .80 or higher.  For all practical purposes, the two are the same measure.

What I wanted to do is construct a volatility measure that is independent of volume.  This measure of what I call Pure Volatility represents the movement in the market per volume unit.  A high Pure Volatility market moves more for a given amount of volume than a low Pure Vol market.  If you click on the above chart, you'll see that zero represents average Pure Vol; values above and below represent high and low Pure Volatility.

Thus far in 2014, near term returns in SPY have been superior following high daily readings in Pure Volatility.  When daily Pure Vol has been in its highest quartile, the next day in SPY has averaged a gain of .14%.  Across all other quartiles, the next day in SPY has averaged a gain of only .01%.  Over longer time frames, the effect is even greater.  

What this suggests is that high Pure Volatility has tended to be associated with price momentum to the upside (high volatility strength leading to further strength) and reversal to the downside (high volatility weakness leading to rebound strength).  Backtests have been particularly promising when the Pure Volatility measure is combined with the measures of buying and selling pressure described in the previous post.  In particular, high buying pressure accompanied by high volatility has been associated with superior upside follow-through in SPY.  Odds for near-term reversals are higher when price strength is accompanied by low Pure Vol.

Markets with high Pure Volatility are relatively efficient, in that they move a great deal per unit of volume input.  Low Pure Volatility markets are inefficient:  they move little for a given amount of volume.  The tracking of waxing and waning market efficiency and inefficiency ends up being helpful in identifying intermediate-term turning points in the market--a topic I will address in a future post.

Further Reading:  The Volatility of Volatility and What It Means
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A New Measure of Daily Buying and Selling Pressure in the Stock Market

A while back I wrote about measuring buying and selling power in the stock market as separate variables.  This has been a project that has taken many months of trials and errors, not to mention countless spreadsheets.  The basic methodology is to disaggregate upticks and downticks for every transaction among NYSE stocks and then cumulate the upticks as a measure of buying pressure and the downticks as a measure of selling pressure.  The buying and selling pressure indexes are then set with zero as a mean.  High values indicate high levels of buying /selling; low values indicate low levels of buying/selling.

The backtests of the measures have been promising.  Going back to 2012, when buying pressure has been above zero, the next two days in SPY have averaged a gain of +.31%.  When buying pressure has been below zero the next two days in SPY have averaged a loss of -.09%.  As a rule, spikes in buying pressure have been followed by further index strength, suggesting that significant buying is important to upside momentum.

Also going back to 2012, when selling pressure has been above zero (above average levels of selling), the next day in SPY has averaged a loss of -.05%.  When selling pressure has been below zero, the next day in SPY has averaged a gain of .19%.  Interestingly, after that next day downside momentum, strong selling days tend to be followed by a bounce (average gain of +.44% over the next four days), while days with little selling show little subsequent price change (average gain of .07% over the next four sessions).  In short, spikes in selling tend to be followed by short-term downside (momentum) followed by subsequent recovery (reversal).

Daily levels of buying pressure correlate -.45 with daily levels of selling pressure, going back to 2012.  Buying and selling activity are thus not perfectly independent; nor are they wholly correlated.  Changes in buying (selling) pressure account for 20% of the variance in changes in selling (buying) pressure.  It is when buying (selling) pressure is unusually high or low for a given level of selling (buying) pressure that we see the most dramatic follow through in forward price movement.

Frankly this just skims the surface.  Aggregating the data over differing time frames and as a function of time of day yields quite promising findings.  Similarly, modeling markets as a joint function of buying and selling pressure increases the robustness of the backtests.  Much work remains to be done, as in-sample and out-of-sample backtests need to be validated by forward tests in real time.  I will be sharing data on the measures going forward and posting daily readings online if further tests bear fruit.

Further Reading:  Upticks and Downticks Across the Entire Stock Market
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Great Reads to Start the New Week

*  Here are top posts from the past week curated by Abnormal Returns.  Check out the listing of worthy finance podcasts. 

*  Jason Zweig's list of recommended sites for investors includes a few sources you may not be familiar with.

*  Interesting listing of traders actively posting to Twitter from Options Trading IQ.

*  Unique service from Rob Hanna looks at the edge in holding overnight trades.

*  Good reads from Barry Ritholtz, including what investors get wrong about risk.

*  For the quants:  determining optimal trading rules without backtests and other insights from Marcos Lopez de Prado.

Have a great start to the week!

Brett
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Performance Anxiety in Trading: A Common Cause of Discipline Lapse

Performance anxiety occurs whenever focus upon an uncertain outcome detracts from the process of performing.  Classic examples include "freezing up" when giving a public speech or when on stage; "choking" in clutch athletic situations; and difficulties performing in sexual situations.

What commonly occurs in performance anxiety is that performers notice their initial anxiety and then start to become worried about it.  This "secondary anxiety" sets a cycle in motion in which greater focus on anxiety leads to greater anxiety, which in turns further takes the focus away from performance.

Under conditions of performance anxiety, traders will make decisions to manage their emotional states rather than to properly manage their capital.  For example, in a state of performance pressure, a trader may stop out of a position prematurely, as the agony of watching profits and losses vacillate becomes too anxiety producing.  Performance anxiety also rears its head in those situations where traders fail to "pull the trigger" on valid trade ideas, or where they habitually size positions too small.

In no small measure, the common wisdom that traders should focus on trading process and not on profits and losses comes from the need to dampen performance pressure.  Traders often take breaks from their screens in order to not become overly caught up in the ups and downs of their positions.  Meditative and relaxation exercises can be particularly useful during such breaks. 

The most helpful techniques for managing performance anxiety are cognitive behavioral methods, particularly those that make use of exposure methods.  As those who have read my books know, I have found special value in the use of biofeedback to manage anxiety in trading situations.  Biofeedback simply is a strategy for using feedback about the body's level of arousal to stay calm and focused.  Exposure means that you expose yourself to stressful situations via imagery and in real life.  By using the biofeedback exercises to stay calm and focused while simultaneously exposing yourself to anticipated stressful situations you can literally train yourself to stay collected in the heat of battle.

In situations in which people start from a high baseline of anxious arousal, sometimes these techniques will not be sufficient to dampen anxiety.  Consultation with a primary care physician can be useful in those cases, as beta blockers can be used with success for dampening physiological arousal.  It is not at all unusual for people in the performing arts to make use of such medication--so much so that it has become a topic of concern in professional circles.  To be sure, beta blockers are prescription drugs and need to be prescribed and used thoughtfully.  My experience working with people suffering from performance anxiety is that beta blockers can be very useful in extreme cases, where the anxiety is so high that it interferes with the ability to carry out behavioral exercises.  I've also found it most helpful when it is used occasionally, in anticipated high stress situations, and not habitually (when it can be psychologically addicting and serve as a kind of crutch to normal performance).

As I often point out, traders will commonly point to "lack of discipline" as a cause of their bad trading.  Most often, there is a cause for the discipline lapses.  Sometimes the causes are simply bad trading practices; sometimes the causes are underlying emotional problems; and sometimes the causes can be traced to performance pressures.  In the great majority of instances, performance anxiety can be overcome with regular practice of mastery-based exercises, such as those described in the second chapter of the Daily Trading Coach book.  Preparing trading plans in one frame of mind (focused, relaxed) and executing them in another (scattered, anxious) is a recipe for frustration and suboptimal outcomes.

Further Reading:  My Favorite Techniques for Overcoming Performance Anxiety in Trading      
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When Trading Problems Are More Than Just Trading Problems

I recently wrote about how 90% of the mental game is a function of how we trade.  Our trading practices impact us emotionally, just as our emotions impact our decision-making.

Sometimes, however, there are realities we cannot avoid if we are to succeed in financial markets.  If we are going through emotional problems, such as depression, anxiety, and relationship conflicts, these can very much interfere with our concentration and our ability to weather the normal ups and downs of markets.

Addictive patterns also very much can create havoc in trading performance.  Sometimes we trade out of need and impulse, not from opportunity.

How do we know when emotional disruption of decision-making might be due to larger psychological issues?  Two factors are relevant:

*  DURATION - If problems have been occurring for an extended time, and especially if you have encountered them at different points in your life, the odds are good that they are not merely situational.  If you have experienced your problems prior to your involvement with trading, it's worth considering that the problems are not merely trading-related ones.

*  SEVERITY - The severity of a problem is the degree to which it interferes with many facets of life.  If a problem disrupts sleeping and eating, affects mood, and lowers overall productivity and social functioning, that's a good sign that it will pervade trading as well.  

Notice that a problem can be of relatively recent duration--such as a relationship breakup--and still have severe impacts.  Also, a problem may not be severe--we function adequately despite it--but it can still be of long duration and keep us from performing at our best. 

When emotional difficulties interfere with trading, the best course of action is to greatly (or totally) reduce risk-taking and devote attention to resolving the problems.  Blowing up a portfolio can only add to stress; if stress is interfering with trading, it makes sense to focus on the stress before the trading adds to it.

In situations where relationship problems, addictive patterns, depression, and anxiety/stress occur outside as well as inside of trading, seeking the help of a qualified professional is often a good step.  It is not necessary to pursue a trading coach for problems that predate trading and occur outside of trading--and, indeed, many coaches lack experience and expertise in these areas.  

If you find yourself more focused on your problems than on markets, the best trade you can make is to invest in your emotional well-being by getting the right kind of help.

Further Reading:  The Greatest Cause of Trading Problems No One Talks About
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Discovering Your Trading Psychology With Your Trading Metrics

We often focus on how our psychology can influence our trading.  A different perspective is to use your trading to illuminate your psychology.  One of my favorite exercises with active discretionary traders is to take their daily P/L numbers and treat them as a financial time series.  In essence, I'm developing a trading system, where the system is trading the trader!  

Very often, there are repeatable patterns in the profits and losses of traders that could lead an observer to know when to go long that trader and when to fade them.  In some cases, I have helped build alerts for traders that pop up on the screen when they are at a point where they typically have lost money in their P/L cycles.  It's a different way of building mindfulness about our patterns, so that we can control them rather than have them control us.

So what are the most common patterns that appear during such analyses?  Three immediately come to mind:

1)  Losing money on one's largest risk-taking - We all know that we're supposed to take our largest positions when we're most confident in our views, but that logic doesn't work for all traders.  Often, traders will take their largest positions after they've had a winning streak.  Now they're playing with house money.  Confidence begets overconfidence.  Once the position sizing is largest, perhaps the market moves are most extended.  Losing on your biggest bets is a great way to undo many gains with one or two large losses--not at all good for the psyche.  Before you assume that you should bet larger when you have your greatest conviction, analyze your P/L as a function of your risk-taking.  If your biggest bets don't have your greatest hit rate, is your confidence generating information?

2)  Losing money during quiet market periods - One analysis I like for stock market traders is to break P/L down by VIX periods.  How does the trader perform when markets are most and least volatile?  How well does the trader transition from higher to lower volatility periods and vice versa?  For daytraders, how does the trader perform during midday hours vs. early mornings and late afternoons?  During quiet periods with narrow ranges, does the trader make more trades or fewer?  It's not uncommon to see risk-prudent traders struggle when volatility rises and aggressive traders struggle when volatility is crushed.  

3)  Losing money with good market views - This one is a little more challenging to analyze, but very worthwhile.  What happens to traders' positions *after* they exit their trades--particularly after losing trades?  Very often, traders have a correct market view and still manage to lose money.  By placing stops too close to entries and by adding to positions when moves have already extended, traders generate good ideas but execute and manage them poorly.  A common variant of this problem is placing profit targets too far away during lower volatility markets.  Trades start out in the money and end up scratching or with losses--a frustrating experience to be sure.  Sometimes we see traders taking profits in trades that often ultimately extend far more in subsequent hours and days.  That occurs when ideas are generated on one time frame of analysis, but managed (for psychological reasons) on another, leaving plenty of money on the table.

Our trading results are a great way of studying ourselves.  If we are operating with cognitive biases and/or emotional disruptions, these will inevitably find expression in our P/L stream.  Because we are not always objective observers of ourselves, it helps to go to the objective data of our trading to find a mirror into our psyches.

Further Reading:  Metrics for Active Traders
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Managing Your Energy for Peak Productivity

Shout out to Terry and WindoTrader for the post on effectively managing your TEAM (Time, Energy, And Money).  The post points to a problem I've noticed in many contexts:  traders who are so busy following and trading markets that they fail to manage the personal resources essential to their longer-term success.

This is particularly problematic in the case of not effectively managing one's energy level.   There are several forms of positive experience that enhance productivity and creativity:  happiness, life satisfaction, energy, and affection.  When we deplete our energy, it is more difficult to sustain the activities that generate the other forms of positivity.  For that reason, a low energy level most often manifests itself in low positive experience, creating a downward spiral--decreasing energy, decreasing positivity--that impacts mood and behavior, and ultimately productivity and sound decision-making.  

How often do traders fail to follow their plans and act on their ideas simply because they are at low levels of willpower due to depleted energy?

Of course we can lose energy due to lack of sleep, overwork, lack of exercise, and poor eating.  A more subtle but significant loss of energy occurs when we fail to tap into our core strengths and values during our daily activities.  Activities that we experience as *meaningful* give us energy; activities that strike us as meaningless sap our strength.  Digging a ditch for no purpose whatsoever would be physically and emotionally draining.  If, however, we knew that digging the ditch in a certain amount of time would lead to a very large payday, we would find the motivation to get the work done on time.

Similarly, when we play to our strengths, we experience activities as affirming.  The exercise of signature skills is intrinsically rewarding:  we find enhancement in doing what we do best.  When we get away from our strengths, effort becomes just that:  labor with little psychological reward.  I will get up at 4 in the morning to analyze a data set that helps me better understand the market; the intellectual curiosity is energizing.  If I had to get up at that time to do household chores, I would find it difficult indeed to stay awake.

An important implication of this perspective is that your energy level in researching and trading markets is a reflection of the degree to which you are meaningfully engaged and challenged.  If you try to process information in a way that is not your strength--forcing yourself to read, for example, when you process material much better by hearing and discussing it--the effort will be taxing rather than energizing.  That, in turn, can lead to those willpower-based lapses in concentration and other seeming problems of "discipline".  The issue is not discipline, per se; it's one of leveraging core skills, interests, and values.

A while ago, I wrote about the core components of a trading process.  At a skill level, a trading process aligns us with best practices:  what we do well in markets.  At a purely psychological level, a trading process aligns us with our strengths and values.  In that respect, process becomes our energy regulator:  it allows us to renew our energy reserves by channeling our efforts toward ends that are meaningful and intrinsically rewarding.  A good process does more than manage energy:  it digs new wells and increases our reserves.

Further Reading:  The Laws of Psychological Energy
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Changing Our Doing By Changing Our Viewing

How we perceive the world determines how we respond to events.  If we view markets as unpredictable, dangerous places, that will help shape our risk management.  If we perceive excitement in directional price movement, we will respond quite differently.  Our doing is a function of our viewing:  we respond to the world, not just as it is, but as we perceive it to be.

A corollary of this perspective is that we cannot change our doing if we remain rooted in the same viewing.  We need to see the world differently to generate fresh response patterns.  The power of human relationships--whether romantic ones, therapeutic ones, or close friendships--is that they enable us to experience ourselves through another person.  Children are not born with a self-concept; they internalize experiences from parents and peers.  Good relationships help us see aspects of ourselves that we might not otherwise appreciate--and those fresh perspectives open the door to new action patterns.

Relationships are not the only ways in which we shift our viewing.  The right kinds of vacations expose us to new regions, new cultures, and new experiences--and those can open fresh life directions.  A recent trip to Alaska (see above) took us completely out of our daily routines and into a world of incredible beauty and glacier-filled adventure.  Not so surprisingly, the free time and inspiring setting led to reflections about life and markets that have stimulated my most recent research and trading.  

The power of books is that they enable us to experience a topic through the eyes of another.  I recall my first reading of Ilmanen's text "Expected Returns".  Viewing markets through the lens of various factors opened the door to structural ways of thinking that permeate how I approach markets to this day.  Far earlier, an encounter with Rand's classic The Fountainhead stimulated an interest in heroic perspectives on human development that would later shape my work as a psychologist.  One of the features I enjoy on the Abnormal Returns site is a listing of the books being read by readers.  It's a great way to source new perspectives from knowledgeable sources.

There is an important role for habit and routine.  It's difficult to imagine that any of us could be efficient without having automatic processes that take care of daily responsibilities.  The problem occurs when those automatic processes take so much of our time and energy that we live life on auto-pilot.  With no fresh viewing, we remain stuck in the same doing--and that's how we are left behind when markets change.

What we read, who we speak with, what we study, how we spend our time--all, at times, need to take us out of our comfort zones.  If we're not stretching ourselves, we'll never expand our dimensions.

Further Reading:  Greatness, Creativity, and Trading
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Why 90% of the Mental Game is Your Trading

As I mentioned some months ago, mad props to anyone who can duplicate dubstep with regular instruments, especially with a bass guitar that plays a magnetic field theramin-style.  One way to stay creative is to stay in touch with people who are creative--across different fields.  

I was recently contemplating whether markets would bring us scary pullbacks or spritely rallies when an email came from a group interested in a webinar.  They were soliciting my participation, according to my contact, because--as we all know--90% of trading success is the mental game.  The group would be open to any topic I chose, he explained.

Until, of course, I chose the topic of how 90% of the mental game is skilled trading.

Now why is it that no one proposes to a brain surgeon that 90% of what he or she does is a mental game?  And if 90% of performance is a mental game, why do Olympic athletes spend 90% of their time on skill development?  

Is making an instrumental version of Skrillex the result of mastery of a mental game?  If you control your emotions and stick to a plan, will you generate music like they do?

C'mon.

But 90% of the mental game being trading well; there's a bass guitar worthy of a Hot Hand!

So here are three trading practices that reliably lead to emotional disruption:

1)  Poor risk management - Oversized positions; holding positions that are more correlated than you realize; failing to clearly define and trade a risk/reward relationship for each trade--all of these create outsized losses, which in turn generate outsized emotional responses and subsequent potential for disruption of trading.

2)  Failure to plan - Trading without an explicit process for clearly formulating an opportunity set; trading ideas and patterns that are untested and unproven:  these generate loss and frustration, which then color thought and action going forward.

3)  Failure to adapt - Markets become more volatile but trading sizes don't change; the trade becomes choppier but trading continues to pursue momentum:  doing the same thing when the environment changes is a sure way to become confused, then frustrated, then reactive.

Show me traders troubled by emotion and nine times out of ten I'll show you traders who are taking improper risk, who are underprepared, and/or who have been trading static methods in dynamic markets.  What those traders need is not counseling, coaching, or therapy.  What they need is to trade more intelligently.  If a chess player takes imprudent and uninformed risks early in a game, does not prepare for an opponent, or plays the same way regardless of the opponent's strategy, we would not attribute his or her losses to a failure of any "mental game."  

True, psychological variables become relevant once skills are honed.  Then mindset can help deploy them consistently.  But no amount of focus on the mental game can substitute for skill and preparation and the need for strategies that possess an objective edge in the marketplace.  Trading randomness with a positive attitude will make one a good loser, not a high performing winner.

That's the Scary Monster webinar no one wants to sponsor.  It's so much easier to believe the Nice Sprites that tell us we can all make money if we just have the right attitude.

Further Reading:  Ten Questions That Go Bump in the Night
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Are Discipline and Patience the Cure for Overtrading?

A while back, a post explained why quiet markets reveal the best traders.  Quiet markets require patience, as they offer less directional opportunity.  For competitive traders eager to make money, that can be bitter.  Recall the group of 11 studies that documented how people have difficulty spending just 6-15 minutes by themselves with nothing to do.  Given a choice between doing something that caused pain to themselves and doing nothing, many of the subjects in the studies elected the painful activity.  It seems as though some action is psychologically preferable to none for many people.

It's not surprising then that quiet markets invite overtrading.  Sitting, staring at screens, and following markets tick by tick without actively trading is exceedingly difficult for many people.  The more successful traders step back from screens and engage in other aspects of trading process:  research and idea generation, performance review, etc.  The less successful traders convince themselves that they see directional patterns setting up in the tick by tick action and, in common parlance, "get chopped up."

What is equally difficult for many traders is the patience required to let trades work out.  This is what traders commonly call "the pain of gain":  restraining oneself from taking profits too early in trades that have not yet reached their targets.  To sit still while market gyrate invites the fear of missing opportunity.  To not act while trades are working invites the fear of reversal.  Both forms of non-action place traders in the situation faced by the subjects in the above studies.  

Many so-called problems of discipline in trading boil down to the lack of ability to tolerate inaction.  Traders do the wrong thing because they feel the need to do some thing--and they act that need out in markets.  

I do know quite a few traders who do not have this problem.  They are only too happy to step back from markets and allow ideas to work out.  Almost to a person, these traders are immersed in idea generation and the search for opportunity.  They are happy to step back from markets because they are stepping toward something they enjoy more than risk-taking:  the creative process of discovery.  

If what excites you about trading is risk/reward and making money, it's not surprising that quiet markets will be noxious ones.  If what excites you about trading is the puzzle-solving of uncovering opportunity, quiet markets become opportunities to do what you love best.

As long as there are things in life that call you more strongly than trading profits, no discipline and patience are needed to avoid overtrading.  If you're looking to get rich from markets, it helps to have a wealth of interests outside of them.

Further Reading:  How Do I Avoid Overtrading?
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