A very interesting summary of research on mood and creativity finds that people are most creative when they are in particular states. First, when mood is positive, people solve problems more easily and are more likely to think broadly and perceive fresh alternatives. We are most cognitively flexible when we experience positive vs. negative moods. Second, when people are moderately energized, they are most likely to engage in complex and creative thinking. When at low levels of arousal, we don't fully engage the world cognitively; high levels of arousal interfere with reflective thinking. It is when we are energized in positive ways that we display superior processing speed, focused attention, flexible thinking, and creative response. Finally, when we are in "promotion states"--states in which we seek positive outcomes--we are most likely to respond creatively. In "prevention states", we tend to narrow our cognitive focus and fail to see alternate courses of action. It is when we seek positive outcomes that our attention broadens and we become most flexible in our response patterns. If we put together these three conclusions, it is not difficult to see how negative emotional experience adversely impacts trading performance. When markets are behaving against our expectations and positions are moving against us, that is when we want to be most open, flexible, and creative in our thinking. Under the influence of negative mood, very high arousal, and prevention-oriented thinking, we become unable to clearly perceive all our alternatives and recruit our most flexible responses.
From this perspective, one of the most important psychological things we can do to improve trading performance is to sustain positive mood, high energy, and clear, constructive goals. We cannot eliminate the uncertainty of markets or the stresses of drawdowns. What we can do, however, is balance those pressures with our own positive internal environment, so that stress never turns into distress. In an important sense, bad trading results from a failure of creativity: the inability to think and respond in divergent ways when markets are behaving counter to our expectations. Maintaining an emotional and cognitive state conducive to broad information processing and flexible thinking helps ensure that we truly respond to markets, and not to our own fears and frustrations. Further Reading: Creativity and Finding Your Trading Zone
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Thought you might enjoy this graphic I picked up from the web. Admittedly, it's a bit extreme, but it captures something we all see in the trading world: the allure of getting rich quick and the willingness of some to exploit that allure. Nowhere is that more prevalent than in the world of day trading. We know from research that persistent success at day trading does exist, and we also know that it is rare. In a sense, that should not surprise us: by definition, elite talent is rare. What makes trading difficult is that, in many fields, we can make a living from our work even if we are not operating at elite talent levels. In day trading, as well as other forms of trading, making a consistent living from trading *is* elite talent. To illustrate some of trading's challenges, I ran a few numbers using SPY as my proxy trading instrument. From 2012 to the present, SPY has gained a little over 60 points. About half of those points were gained during overnight hours; half during U.S. day hours. The traditional day trader has limited himself/herself to about half the directional opportunity by trading only during U.S. hours. Should traders seek greater directional opportunity by extending the time frame, they will find that the correlation between overnight changes and day session changes in the stock market since 2012 has been -.01. They might as well be totally different markets. If the trader extends to more of a swing time frame, the correlation between today's price change and tomorrow's since 2012 has been -.02. In other words, overall, what happens in the market during one short-term period offers no information about what will happen in the next period. We like to think directionally, in terms of trends, but--overall--what we can extrapolate from current markets to future ones is quite modest. I have tested many patterns in markets and can attest that a correlation between market predictors and future price change that exceeds .20 is something quite special. Yet even that correlation implies that the predictors account for only 4% of future price movement. Our error variance is very high relative to what we can predict, even for statistically significant research. That, of course, leads some to create models of sufficient complexity that they will promise far higher levels of predictive accuracy. As Derman notes, such complexity comes at the cost of fragility: modeling the financial world is fundamentally different from the modeling of the physical world. The laws of physics don't change readily. The behavior of market participants does. One of the better predictors of market bottoms in recent times was elevated volatility, particularly the "pure volatility" measure I have written about. During this most recent market decline, volatility blew out: what had been significant levels of volatility for calling market bottoms no longer applied to the new regime. We can calculate the odds of a given backtest being overfit, and it doesn't take much in the way of complexity to get to that point. So where does that leave us? Simple patterns do not provide reliable profitability, breathless claims such as the above graphic notwithstanding. Complex patterns are all too likely to be overfit, producing great backtests but failing in real time performance. No, the answer is not to be simple or complex; the answer is to be different. Of the traders I worked with a decade ago, fewer than 5% are currently trading and experiencing success. In each case, they are doing something very different from what the standard trading books describe. They have found sources of "edge" in markets that they have made their own, and they have been consistent in exploiting those edges. One trader, for example, came up with an ingenious method for identifying when trading in a particular asset was becoming highly crowded. He then looked for indications of loss of price momentum and took the other side of the crowded trade, benefiting from the herd running for the doors. A big part of his edge was that, if he didn't find the right patterns of crowding, he did not trade. He only played the game when the odds were on his side. A very different trader at a financial institution obtained information from satellites that provided information about weather and crop planting patterns and used those data to predict yields for agricultural commodities. When markets were mispriced relative to the new data, trades with an edge could be placed. Still another trader found that market moves at certain times of day had more likelihood of reversing than at other times of day, as different participants impacted the market throughout the day. By tracking the level of participation and movement and segmenting time differently from other traders, he was able to identify profitable trading patterns.
In the trading world as in the business world, "me too" is not a formula for success. The successful entrepreneur is the one who operates with a vision, doing something differently--and better--than rivals. It's not enough to plan your trade and trade your plan. Those plans have to be grounded in insight and unique information if they are to lead to ongoing success. Further Reading: Keys to Day Trading Success
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The previous post looked at three market measures that assess strength vs. weakness from the bottom up; that is, by looking at all the components of a stock index, rather than the time series for the index itself. Above we see three additional bottom up measures that I update daily and below I will describe how I utilize these. The top chart displays what I call the Momentum Curve (data obtained from the excellent Index Indicators site). This enables us to see the percentages of stocks in the SPX average that are trading above moving averages of varying lengths across the past five trading sessions. What we can see most recently is that the percentages of stocks trading above their 3, 5, and 10-day moving averages bottomed out ahead of the recent market low and now have moved smartly higher, even as we remain oversold vis a vis the longer-term averages. We typically see the reverse pattern at cyclical market peaks, where the percentages of stocks above their shorter-term moving averages head downward in advance of an ultimate price high. The middle chart, also drawn from data available from Index Indicators, is a multiperiod measure of breadth specific to the stocks in the SPX average. Specifically, we're looking at the sum of new highs minus new lows over a 5, 20, and 100-day basis. The composite new lows bottomed most recently on October 13th, a few days prior to the recent price lows. The composite new highs topped well before the most recent price peak in September. The bottom chart, drawn from data available on the very useful Barchart site, is a running total of the number of stocks crossing above their 20-day moving averages minus the number crossing below those averages. This covers all common shares across the major exchanges, which makes it a broader breadth-related measure. Most recently, the cumulative number of crossovers bottomed on October 1 and based for a while, as other breadth measures continued lower. The cumulative number of crossovers very commonly peaks well ahead of price during cyclical topping periods, as occurred prior to the September high. New traders often look to indicators such as these for specific buy and sell signals. My experience is that analyzing any single indicator for such guidance is less helpful than synthesizing the information across multiple measures. Across a series of well-constructed measures that examine different portions of the market across differing time frames, common themes will emerge that tell a story. It's that story that ultimately provides the basis for useful trade ideas. The story is less about what markets *should* be doing based upon share earnings, economic fundamentals, or esoteric numerological schemes and more about concretely assessing whether the individual components of indexes, on balance, are trading stronger or weaker over time. The best way to use these indicators, I find, is to take the time to create a narrative that makes sense of all the observations--and then generate an alternative narrative suggested by data that don't fit into the original story. Having that "Plan B" narrative is very useful in staying flexible and avoiding confirmation biases regarding your primary view.
As with the other measures, I will be updating these periodically to keep up with evolving market conditions.
Typically, if we want to use a technical indicator to gauge the strength or weakness of a given market index, we will simply apply that indicator to the price series for that index. Suppose, however, we took a different approach, from the bottom up, rather than the top down. Suppose we applied the indicator to every single stock within the index and gauged strength and weakness via the breadth of individual buy and sell signals. Above are three charts that take a bottom up view of the recent market. (Data obtained via the excellent Stock Charts site). The top chart will be familiar to readers; it's the balance of NYSE stocks trading above their upper Bollinger Bands vs. below their lower Bands. The middle chart utilizes the Parabolic Stop and Reverse (SAR) indicator developed by Welles Wilder and takes the number of NYSE stocks at the close each day giving buy vs. sell signals. The bottom chart shows the number of buy vs. sell signals for each NYSE stock for the Commodity Channel Index (CCI). Note that there is a family resemblance among the charts, but differences also. Each indicator operates with different parameters on different time frames. The links in the paragraph above explain how each indicator is constructed and how buy and sell signals are derived. I think of each of the indicators as a prism through which we can see the breadth of strength and weakness across the entire market. No one prism provides a perfect signal all the time, but when you see common patterns among the prisms, it's generally worthy of attention.
As a rule, we see peaks in the numbers of stocks giving buy signals ahead of cyclical peaks in the broad market (SPY) and we see peaks in the numbers of shares giving sell signals ahead of cyclical troughs. You can see how the indicators peaked--but stayed positive--prior to the recent September market top and how they have troughed ahead of yesterday's rally in stocks and have now turned positive.
We have many ideas about whether markets *should* trade higher or lower, but bottom-up measures like this show whether they are actually strengthening or weakening. I will feature regular updates of the indicators for those interested in following the signals.
Here are two updated views of stock market breadth. Recall that it was waning breadth that gave us a heads up on the recent market weakness. What we're now seeing is the reverse. The top chart monitors all common stocks traded on the major exchanges making three-month new highs vs. three-month new lows. We can see from the chart that this decline has been much broader than ones previous. New lows hit their maximum level so far on October 10th and then held slightly above that level at the market low on October 15th. With yesterday's buying interest--my Buying Power measure hit its highest level since 2012 yesterday--new lows dried up and so far in premarket today we're seeing continued buying interest. This suggests a momentum low has been put in place. The second chart tracks the number of NYSE issues closing above vs. below their upper/lower Bollinger Bands, which I refer to as the Bollinger Balance. Note again the recent persistent weakness, the failure to expand the number of shares closing below their bands at the recent lows, and now the drying up of that weakness. As I've stressed in the past, it helps to think of topping and bottoming as processes, not as fixed points on a chart. Markets make bottoms when they hit a momentum low, bounce, and then subsequent weakness occurs with less downside momentum and volatility and fewer shares making new lows. It would surprise me if this bottoming process is over--a general rule is that more extensive declines undergo more protracted bottoming--but a continued drying up of weak breadth is something I'll be on the lookout for to find opportunities to scoop up some value.
How big was the volume during yesterday's decline? Apparently large enough for even the dark pools to turn away customers! I show about 380 million shares traded for SPY, compared with an average of 84 million from June through August of this year. What that means is that entirely new sets of participants have been active in the marketplace, creating a complete change in market movement. We can see that in the chart of pure volatility from late 2013 to the present. I introduced the idea of pure volatility in an earlier post and have since refined it. It is a measure of the amount of price movement we get for a given amount of volume traded in the ES futures contract. What is evident from the chart is that pure volatility has gone through the roof. We are not just getting a lot more volume; that volume is moving markets more than twice as much as they did at our market highs. The reason for this is that the added market participation is directional in nature, so that moves find more buyers and sellers. Think of e-Bay auctions for a very hot item whose popularity has gone viral. The price movement would be much greater than for items that are not popular. I will be watching volume and pure volatility closely from here, as we will need to see normalization of those numbers as part of any bottoming process.
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Ah, if it were only that easy! I took a look at the average true range for the past five trading sessions in SPY. It was almost 2.1%. By contrast, at the July peak, the five day average true range was almost .53%. So basically, in terms of realized price movement, we have quadrupled volatility in a span of about two months. What does that mean for trader psychology? Imagine quadrupling your trading size over the span of a couple of months. How might that impact your trading? By placing a magnifying glass on the dollar size of your P/L moves, it accentuates the potential psychological impact of wins and losses. A random streak of four losing trades on quadruple size could wipe out a substantial portion of prior profitability. Conversely, random large winning trades could convince a trader of his hot hand and lead to overconfidence and overtrading. When volatility increases by several orders of magnitude, not only are the moves in the direction of the trend accentuated, but also the moves against the trend. That means it's very easy to have a trade move 1% against you in minutes, where it would have taken a few days for such a move to materialize in the slower, low volatility market. If your trading size is the same in a high volatility market as a low volatility one, you have effectively magnified your size by several times. That does not mesh well with many people's risk tolerance. The reason this is important is that spikes in volatility associated with intermediate-term market pullbacks are more common than recent experience would suggest. Check out this very helpful blog post from Philosophical Economics. Since World War II, we have seen 10% market corrections about 20% of the time and 15% corrections over 12% of the time. This ensures that buy and hold investors will have meaningful drawdowns, and it also guarantees that career short-term traders will experience spikes in volatility. Such spikes can represent meaningful opportunity, but only if one's emotional volatility is not tied to that of the market. Further Reading: Volume and Volatility
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A while back, I noted that the bull market was over for the majority of stocks, observing the relative weakness of small cap and midcap shares. After quite a bout of weakness, I'm now seeing the emergence of the opposite situation: the number of small cap and midcap shares making fresh 20-day lows has not been expanding, even though we've seen recent price weakness and a new low for the large cap Dow average. (Credit to Index Indicators for the charts). Meanwhile, the equity put-call ratio over the past 20 days has exceeded 1.0, levels seen during the May-June, 2010 correction; the August-September, 2011 break; and the decline of May-June, 2012. All were good intermediate times to be buying stocks; all were also choppy, stairstep declines with extended periods of basing that included sharp rallies as well as price erosion. While my Selling Pressure measure has been seeing new lows lately, that pressure is not translating into more stocks trading below their 20-day moving averages, either among large caps, small caps, or midcaps. That is very much on my radar near term.
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Between following markets, engaging in chat with fellow traders, and keeping up with news sources and social media flow, it is difficult to maintain a high quality of concentration during the day. When we are distracted, we are more likely to make decisions on a reactive basis, without the mindful planning that comes from being in a zone and activating our brain's executive capacities. Here are some resources designed to improve your focus: * Lift is an app that helps you track your goals, participate in structured plans for everything from diet to meditation and yoga, and connect with people with similar goals. * Check out these online apps for improving focus curated by Lifehack. These include tools for blocking unwanted online content when you're wanting to concentrate; create to-do lists that can be accessed from all your devices; and engage in brain games that train your concentration. * Lifelogger is a wearable video device that enables you to capture life events as they are occurring. With 8 hours of video storage and wi-fi capability, it allows you to stream whatever you are seeing to others. It is promoted as a tool for augmented memory, as anything--from market reactions to news to how we traded the recent breakout pattern--can be captured forever. * Here are 10 more apps for sustaining a calm and focused mind, including a mind-mapping tool for capturing your ideas visually and apps for brain training, meditation, mindfulness, and stress management. * Focus @ will is an interesting app that creates the right musical environment to enable people to concentrate on their work. Here's an explanation of the science behind the tool. Further Reading: Proven Methods for Building Happiness
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There are many ways of measuring investor and trader sentiment about the stock market: put-call ratios, surveys, measures of breadth, etc. One interesting measure is to see how actively people conduct searches on a topic via Google. It turns out that a measure of worry about market related topics can be an effective predictor of prices. Above, we see the chart for searches conducted on the topic of "bear market", as captured via Google Trends. Notice the spikes in searches beginning in January, 2008, before the worst of the bear market had taken hold. We also see smaller spikes in August through October of 2011 and still smaller ones in April-June of 2013, and this month so far. As the stock market has become less volatile since the GFC, we see lower volatility in the time series of searches for "bear market". Note Google's extrapolation to forecast search activity for 2015: it also remains tame. While we have a blip higher in bear market searches, those are so far nowhere near as high as the searches in 2011 and certainly not as pervasive as in 2008. Investors are not exactly complacent: October's search level is 24--higher than any other month of 2014--and the month is only half over. Still, the level of bearishness by this measure is consistent thus far with what would be seen in a bull market correction, not an outright bear market. Further Reading: Equity Put-Call Ratio
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A while ago, I wrote about what works in goal setting, according to the research of Locke and Latham. One of their more interesting findings is that there is a positive, linear relationship between goal specificity and difficulty and performance. When goals are specific, they direct and energize behavior far more effectively than when they are vague. Difficult, challenging goals inspire greater efforts--and hence greater attainment--than easy goals. If we think of goals as representing visions of the future, it is the most concrete and stirring vision that will bring out the best in us. Key to the achievement of goals, according to the researchers, is self-efficacy. People are much more likely to buy into and pursue goals if they believe themselves to be competent to reach those goals. This is why the best goals embrace our strengths: they represent ways in which we can leverage the best of who we are. Sometimes, people have gone through so many setbacks that they lack the sense of self-efficacy. They come to believe that they can never reach their goals. In that case, setting distant, difficult goals will not be helpful; the focus has to be on achieving small wins. A series of small goals that are achieved provides multiple experiences of efficacy. When you win, win, and win--even with relatively small goals--the boost to self-efficacy can inspire larger goals, which energize even further. It may seem too daunting to lose 30 pounds for a heavy person, for example. By focusing on losing one pound per week by eating smarter, it is much easier to create experiences of goal achievement, which then fuel the larger goal. Where traders often fall short is not in goal setting, but in the feedback process following the pursuit of goals. If a goal is not reached, something went wrong. It is important to figure that out and make corrective efforts to pursue the goal in a new way. Goal setting with feedback provides deliberate practice, because the feedback hones our efforts to reach goals. It is very common in my experience that, when traders keep a journal, they write about their problems, but do not take the next steps of translating problems into challenging, specific goals. Even when they do outline such goals, it is rare that the goals are revisited with concrete feedback that is used to guide future efforts. Too much of life occurs in auto-pilot mode. We take life--and markets--day to day, without an overarching plan and with no deadlines. We act as if experience itself will teach us all we need to know, when it is guided experience--experience informed by goals and feedback--that gets us where we want to go. One of the most important functions of a trading journal is as a chronicle of our goals, feedback, learning, and achievement. We deliver our best efforts when we're on the path to becoming our very best.
Here are three charts from the excellent Finviz site that provide a bit of perspective to the recent market weakness. The top heatmap shows overseas shares listed on US exchanges and organized by their countries of origin. What we can see is that stocks have been declining across the world. The current weakness is telling us something about anticipated global slowdown. If you look at stocks outside the U.S. (EFA is a good example), you'll see that they have been in retreat since mid-June, well ahead of the U.S. large cap market peak in September. Indeed, just as small caps have underperformed large caps within the U.S. universe, the broad range of international shares have been underperforming U.S. shares. The middle chart shows year-to-date performance among U.S. sectors. Note the wide disparity: how you performed this year as an equities money manager has been quite dependent upon your sector bets. Utilities and Consumer Goods have been among the best performers, not only because they are defensive, but because many of those shares offer relatively strong yield. We can see this outperformance during the past week (bottom chart) as well. I believe this is important. Economic growth globally is poor and the major forms of stimulus will involve weakening of currencies and maintenance of low rates. In such an environment, the U.S. dollar has performed well and shares with good dividends have benefited from the reach for yield, given that government bills offer no return. In a world where rates will be "lower for longer", especially outside the U.S., I like high quality U.S. dividend ETFs as a core holding in an investment portfolio. They are not sexy in the least, but should we see an accelerated reach for yield among international and domestic investors, the total returns on those could continue to be attractive. A good example is VYM, which combines a yield near 3.0% with a low expense ratio. Further Reading: What I Was Writing in June, 2008
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Traders have been experiencing an understandable case of whiplash the last few days. More than one person contacting me has commented on the confusing nature of the market action. To try and make sense of what has been going on, I included two charts above, both of which I find helpful in gauging underlying market trend. The top chart is the Cumulative NYSE TICK and represents the number of upticks vs. downticks across all NYSE shares each minute of the day. By cumulating that time series, in the manner of an advance-decline line, we can gain of sense for accumulation or distribution across the broad stock universe. (Data obtained from e-Signal). We can see that, throughout the year, the cumulative TICK followed price closely, confirming new price highs with new highs in the cumulative line. That suddenly stopped after early September, as the later September price peak occurred on a falling cumulative TICK line. My read at the time was that the broad market had ceased to function in a bull market, due to weakness across small caps and midcaps. We can see that the decline in Cumulative TICK has continued with the recent market decline, as we're now seeing the weakness among small and midcaps extend to the larger caps. Of particular note, the Cumulative line has breached its early August lows. The bottom chart is a bit more sensitive and is based on upside and downside strength. What we're looking at is also a cumulative line, but this is a net total of the number of stocks each day closing above and below their upper and lower Bollinger Bands, across all NYSE shares. (Data obtained via Stock Charts). Here we can see that the cumulative Bollinger Balance line peaked early in July, dramatically underperformed at the August and September peaks and now has fallen off the face of the earth as few shares are trading with strength. By cumulating breadth data--I find these measures much more sensitive than the standard advance-decline line gauges--we can see what is happening over time across all stocks, not just the large names that dominate the cap-weighted stock indexes. It's because of the weakness in these measures that I have not been inclined to buy the market simply because it's oversold.
Adam Grimes' blog recently posted a worthwhile article from David Blair on the importance of decision-making in trading success. A key point made by David was that success is less a function of "static" tools used to make decisions, such as charts or indicator patterns, and more a function of the quality of active decision-making. Readers will recognize the difference drawn earlier between crystallized and fluid intelligence. It is not so much what traders know as what they do with what they know that makes the difference. A good example came up in a question I was asked during my Benzinga interview yesterday about the NYSE TICK. The interviewer asked if high and low levels could be interpreted as overbought and oversold levels that could be faded. I cautioned against this, noting that, coming out of an overbought or oversold market, very low or very high TICK readings are often suggestive of a change in the tide of short-term sentiment and can lead to downside or upside momentum.
Little did I know at the time that this is exactly what would happen in the wake of the Fed minutes release. Up to that point, we saw a feeble bounce from an oversold condition and it appeared likely that we could eventually test the early August lows in the ES contract. With the release of the dovish minutes, however, buying exploded and we saw NYSE TICK levels multiple standard deviations above average. Indeed, multiple one-minute readings exceeded +1000. Instead of being a level to fade, the high readings suggested that entirely new participants were jumping aboard the market, creating upside momentum that carried through to the end of the day. Static reasoning tells us to fade the "overbought" TICK readings. Fluid reasoning recognizes the context in which the extreme readings are occurring: this is a short-term game-changer. The ability to change gears and recognize new information and fresh upside participation in the marketplace is key to trading success. Success is not so much a matter of making right decisions, as making decisions the right way: fluidly, placing current observations into broader context. Further Reading: Honing Your Trading Process
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Credit to the excellent Index Indicators site for these charts. What we're looking at is the percentages of stocks trading above their 200-day moving averages for four different indexes: the SPX and NASDAQ large caps; the midcaps; and the small caps. My earlier post observed that the majority of stocks across the averages were no longer in a bull market. Small caps and midcaps were notably underperforming the SPX and NASDAQ large caps. What we're seeing now is that small caps and midcaps have decisively moved below their early August lows. Less than 24% of small cap shares and less than 29% of midcap stocks are trading above their 200-day moving averages. The SPX and NASDAQ large caps have held above their August lows, but note the deterioration in their breadth. Only about 54% of NASDAQ shares and less than 52% of SPX stocks are now above their 200-day averages. In other words, close to half the large caps are now in bull market mode, levels we haven't seen since late 2012. Meanwhile, we had 101 more new 100-day lows than highs among SPX stocks, which was an expansion of lows from the recent market bottom. New lows also expanded relative to last week for the NDX large caps. My base case has been for a stock market correction, followed by year end rally. So far, however, the breadth data suggest that weakness has been broadening from the smaller caps to the large caps. That has me alert to the possibility that any expectable rally from these oversold conditions could lead to a lower price high for stocks as part of a larger market correction.
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Consider your values now and what you believe your values will be ten years from now. How much change do you think there will be? Consider your personality traits. How much change do you think you'll see in your personality over the next ten years? And how about your interests? How will those change in ten years? As Dan Gilbert points out in his TED Talk, people systematically underestimate the changes they go through over time. We inevitably change far more than we think we will change.
I see this very often in the trading world, where preparing for the coming day and week takes precedence over preparing for a long-term horizon. When I examine how much time traders spend to prepare for the future by developing new sources of edge, I'm floored. It's as if markets will never change; the future will bring no new demands and challenges. We assume that edges will last forever and, by default, we will trade in our accustomed way indefinitely. At the recent Traders4ACause conference, I made an observation. The greatest threat for new and early career traders is a loss of emotional self-control. The greatest challenge for experienced traders is the threat of obsolescence. New traders have to make themselves, and a big part of that is rewiring themselves emotionally to not act on the first natural, human impulses. Experienced traders have made themselves, but periodically have to remake themselves. The setups and trading patterns we expect over time will undergo change and we will be challenged to keep up with them--and hopefully anticipate them.
If we underestimate the degree to which we will change, it suggests that change will happen to us; it won't be planned by us. This is why I like some portion of a trader's process devoted to innovation: looking at new potential sources of edge. If innovation is embedded in what you do each week, you create an evolution and won't be forced into revolutionary changes after markets have already shifted and drawdowns have occurred. "Anyone who fights for the future," Ayn Rand observed, "lives in it today." Gilbert's observations suggest the reverse, as well: living in the future is the best way of fighting for it now. Further Reading: The Heroic Dimensions of Trading
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If you're looking for fresh sources of edge in financial markets, you either have to look at fresh data or look at old data in fresh ways. Often it's the data that get overlooked that hold particular promise. Each week I make it a habit to examine new data series. Some are not promising at all. Some look quite promising, only to find out that they are highly correlated with other, familiar data and so don't offer any unique edge. Once in a while, however, new data can lead to new insights. That's an important way to grow a trading business. When we trade ETFs, we focus of course on their price and perhaps on the volume traded. What we don't focus on so much is the number of shares outstanding in the particular fund. Every day fund shares are created and redeemed by authorized participants. This helps keep the ETF price in line with the underlying shares. If the fund is pricey relative to the underlying shares, you can sell the ETF and buy the shares and vice versa. If we look at the most popular ETF, SPY, we find out that daily increases in shares outstanding correlate with daily price change in the fund by a miniscule .034 going back to 2012. That, in itself, I found interesting. After all, if changes in shares outstanding perfectly mirrored price change, then there would be no reason to track the outstanding shares of the fund. (Data available through State Street). Going back to 2012, if we track 20-day changes in shares outstanding for SPY, we find something interesting. When the number of shares outstanding is in its highest quartile over the past 20 days, the next 20 days in SPY average a gain of only .29%. When the number of shares outstanding is in its lowest quartile over the past 20 days, the next 20 days in SPY average a meaningful gain of 2.02%. One possible explanation for this is that the creation and redemption of fund shares is capturing something about sentiment with respect to the ETF and its shares. In the arbitrage process, it is when stocks are priciest in a relative sense that ETFs will be created and stocks sold and vice versa. Bursts of ETF redemption appear to be correlated with superior returns, at least for SPY. Since the early August lows in stocks, we've seen a burst of share creation in SPY. Despite the recent downdraft, 20-day change in shares outstanding is currently +4.77%. (Although it's worth noting that the past six trading sessions have brought a pullback in shares outstanding; I'll be tracking this). Interestingly, we've been seeing great share creation at a time when we've also seen waning market breadth. That hasn't been a bullish combination for stocks. Further Reading: Innovation and Trading Success
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* Above you can see the Momentum Curve, described in this earlier post. What we're doing is tracking the percentage of SPX stocks trading above their various moving averages, plotted against SPX. You can see the dynamics of the recent drop and bounce, as we double-bottomed in downside momentum and now have shifted sharply higher in the shorter-term measures. The alignment of the various portions of the curve is a nice way of capturing markets that are overbought or oversold on various time horizons. * Kudos to Traders4ACause for an excellent conference. There were excellent speakers and great opportunities for networking. It was interesting speaking with Michail Shadkin, who has won numerous poker, gambling, and trading tournaments. Check out some of his trading insights; clearly he's leveraged his skills at gambling into valuable trading practices. * The challenges of shorting GPRO and other great views from Abnormal Returns.
Above are three charts that provide current perspective on the U.S. stock market. The first two chart are my measures of "Buying Power" and "Selling Power", as described in the August post. By separating out upticks from downticks among all NYSE stocks, we can gain a perspective of demand and supply in the marketplace. The third chart is a measure of composite breadth across all 500 stocks in the SPX average. It tracks the proportion of SPX shares trading above their 3, 5, 10, and 20-day moving averages. What we can see from the first two charts is that there has been a dramatic shift in buying pressure over the course of 2014. Fewer stocks overall are upticking. Interestingly, we can see that buying power completely stalled out at the recent market peak and has actually picked up during the recent decline, although it still remains below the zero, average line. Selling pressure, on the other hand, has behaved in a much more uniform fashion through the year. It tends to peak (lightest selling) ahead of price during intermediate market cycles and tends to bottom (heaviest selling) around cycle price lows. Note how the recent decline has occurred at levels of selling very similar to the levels reached at recent cycle bottoms. With the breadth measure, we can see that breadth tends to top ahead of price peaks and bottom either ahead of or coincident with price lows for intermediate-term cycles. Once again, we can see that breadth completely petered out at the recent price cycle high and has bottomed very close to levels seen at recent cycle bottoms. The bottom line here is that stocks have suffered during the latter half of the year from an absence of buying, not from unusual levels of selling. This has been particularly evident in the smaller capitalization portion of the market. Are we preparing for a fresh bull leg higher? Is the stock market finally topping out after a historic run? I strongly suspect we'll get the answer in the behavior of the buyers and their ability to generate Buying Power.
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Thanks to @cambro320 for pointing out this worthwhile Ted talk from Kelly McGonigal on making stress your friend. When dealing with risk and uncertainty, as traders naturally do in markets, stress is inevitable. The question is whether stress generates distress--or whether we can channel stress in more constructive directions. The quote from William James suggests that an important aspect of that channeling is how we think about sources of stress. "One thing we know for certain," McGonigal explains, "is that chasing meaning is better for your health than trying to avoid discomfort." People who experienced stressful life outcomes but who reached out to help others were significantly less likely to suffer health consequences of stress than those who did not reach out. In other words, when stress is buffered with experiences of positive emotion, the stress is less likely to manifest as distress. This brings to mind a several decade old study that examined the physiological arousal of people who experienced test anxiety (performance pressure in academic testing situations) and those who did not. The hypothesis was that test-anxious subjects would experience far greater physiological signs of stress--elevated heart rate, etc.--relative to those who did not report performance pressure. These signs of arousal would then be expected to result in interference with recall of the information being tested. As it turned out, both groups showed high physiological arousal. The group that did not report test anxiety was every bit as keyed up as the group that reported high stress. When the subjects were asked what they were thinking going into the test, the low anxiety group reported thoughts about "being pumped" and excited for the challenge of the test. The high anxiety group reported fears over not performing well. In other words, both groups were stressed, but one group channeled the stress as a performance challenge; the other group as a performance threat. It wasn't the stress of a difficult test that caused distress--everyone felt that. It was how subjects interpreted their stress. Think about two traders in the exact same position based on a sound, well-researched idea with a solid edge. The position moves against them. One is on heightened alert, sees greater opportunity, and has a plan to add at better levels. The other is on heightened alert, sees threat, and pukes the position. Who will make money over time?
Perhaps it's not our emotions that do us in as traders. It's what we do with them.
Josh Brown asks some pointed questions about the time we have left and how we want to use it. Building on Josh's post, Abnormal Returns raises an important point: our trading and investment returns are meant to be funding the things important to our lives. They should not stand in the way of our life's fulfillment. I was struck by Charles Kirk's recent decision to step back from day to day trading, move to the location of his dreams, and devote more time to his mentorship of traders. Years of sitting, staring at screens, and clicking the mouse had taken a toll on his health. His decision was to make his market-related activities serve his life and not the reverse.
Check out this very well-done video on the one thing you can do to improve your life and health. I'll give a hint: it doesn't involve sitting in front of a screen all day. To be sure, trading can be challenging and it can be personally and financially rewarding. The question worth asking is, "What would you be doing if you weren't trading actively?" After all, that's the opportunity cost of an active trading career. Do the rewards you receive from your trading justify that opportunity cost?
Many years ago, I stepped down from a full-time position as a psychologist to pursue full-time trading. I enjoyed the challenge and made reasonable money from it. But after a short while, I could not sustain the trading as a full-time endeavor. I desperately missed my interactions with people and my work as a psychologist. I knew I was on the wrong path when I found myself chatting online with people about markets--and missing trades as a result! Quite simply, the opportunity cost of ongoing market involvement was too high for me.
I think Josh is right: We should start with the assumption that we have, say, 10 years left to live. Given that constraint, how do we want to be spending our time? How much of that time do would we want to be spending on markets? Who would we want to spend that time with? What would we want to accomplish? Experience?
It's great to climb the ladder of success. We just need to make sure that ladder is propped against the right building. Further Reading: What It Means to be Free
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Check out a great piece from Daniel Coyle on a mental trick utilized by the New Zealand All Blacks rugby squad. As Coyle points out, we tend to think of our temperament as a fixed part of ourselves. Some of us are laid back, some of us are driven and competitive, etc. The All Blacks view temperament as a skill to be trained. They conduct workouts specifically designed to keep them in the right mindset during games. The trick described by Coyle makes the distinction between being in Red Head mode--filled with hot emotions--vs. Blue Head mode, which is cool, calm, and collected. The players learn to identify physical, emotional, and cognitive signs that tell them when they're getting in Red Head mode and then use a cue to shift them into a more Blue Headed state. The cue could be a gesture, bringing an image to mind--each player comes up with and rehearses their own cues.
This is very akin to the self-hypnosis methods I described in an earlier post. In a self-hypnotic routine, you enter a very calm, very focused state and associate a particular cue with a specific outcome. So, in my example, I hold my hands in front of me, palms facing each other, and tell myself that there's a magnet slowly bringing my hands together. As they get closer and closer, I feel more and more calm, more and more focused. When the hands finally touch, I will be in a complete focused zone.
What makes the use of such gestures or triggers effective is that, with practice, they become associated with the state of mind that you want to cultivate. A simple use of the gesture (such as putting one's hands together) can invoke the state that has been rehearsed in the self-hypnotic routine. This is extremely helpful in the heat of battle--whether on the rugby field or on the trading floor.
We tend to think of emotions and states of mind as things that happen to us. Once we see them as skills that can be trained, we open the door to a degree of self-mastery that otherwise would be closed.
Traders are known to complain that they formulate sound and detailed trading plans and then fail to follow through on those plans once markets are moving. Typically, this problem is attributed to emotional interference and/or a lack of discipline. It is quite possible, however, that the problem of following trading plans is simply a function of a trader's limitations of working memory. It may be asking too much to keep in mind detailed plans, plus keep in mind what is happening in the market now--not to mention what could be happening in the news, in correlated markets, and in other stocks/instruments. Similarly, failures of working memory could lead traders to forget their rules when they are completely focused on markets, leading to overtrading and/or poor trade execution.
If this is the case, then enhancement of working memory should be very valuable to traders who have had difficulty following through on their best intentions. Cognitive training through brain strengthening games could be one way of enhancing working memory. Another way could be through the creation of effective memory aids, such as writing down key plans and keeping them in front of us for easy reference. Still another way of enhancing working memory is by working within a team. While plans or rules may slip by a single person trading in isolation, they are less likely to go unheeded with extra sets of eyes on the trading.
The broader point of this post and the one previous is that traditional trading psychology might overplay the role of emotion in trading difficulties and underestimate cognitive skills and limitations. It may well be that strengthening ourselves cognitively could be the best thing we could do for mastering the emotions of trading. Further Reading: Important Psychological Skills for Traders
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Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab). I teach brief therapy as Teaching Professor at SUNY Upstate in Syracuse, with a particular emphasis of solution-focused "therapies for the mentally well". Co-editor of The Art and Science of Brief Psychotherapies (American Psychiatric Press, 2018). I don't offer coaching for individual traders, but welcome questions and comments at steenbab at aol dot com.
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