In past posts I've mentioned that I track a basket of institutional favorite stocks and monitor upticking and downticking across the group every minute of the trading day. The logic is that when large market participants want to buy or sell with urgency, they will lift offers or hit bids across a range of liquid stocks. This simultaneous upticking or downticking across a range of shares--the execution of buy programs and sell programs--leaves a footprint that provides a very useful view of instantaneous market sentiment.
The top chart tracks sell programs on a rolling one-day basis from October, 2014 to the present. Note the expansion of sell programs at relative market lows and the diminished level of sell programs at relative market highs. That is pretty much what we would expect to see. When we go to the second chart, tracking buy programs, we see the same pattern, however. At relative market lows, we see more buying activity. At relative highs, buying dries up. This is very important. What makes market lows is that lower prices attract longer timeframe buyers--the ones who execute in baskets. Volume ramps up at relative market lows because one group of participants is actively selling and another group is actively scooping up the shares now offered on sale. At relative market highs, nothing is on sale and longer time frame participants are not incentivized to buy. Total volume dries up.
It is the third chart, tracking the relative balance between buying and selling programs, that tells us who is winning the tug-of-war. At market lows, sell programs diminish while buy programs continue to fire. That creates a situation in which buying pressure spikes early in a market cycle. (Note that this is what has happened recently in the wake of the ECB action). As a market rise matures, sell programs begin to exceed buy programs and we see the balance between the two top out ahead of price. The recent significant expansion of program buying suggests that we should see upside momentum from recent central bank actions. I included the fourth, bottom chart to make a separate point. Notice in the third chart how we had intensive selling pressure among the institutional favorite shares prior to the recent market rise. Despite that, the cumulative NYSE TICK (the sum of upticks vs. downticks across all NYSE shares) stayed strong and now has made new highs. What that means is that we were seeing intense selling (downticking) among the liquid large cap issues, but not across the broad market. It was that discrepancy that set up the recent strength. I deeply appreciate the interest readers have shown in the work I have shared. These are proprietary measures (all data from e-Signal and all calculation and charting done in Excel), but I will update periodically to stay on top of where we stand in market cycles. I will also be sharing information about the breadth and sentiment measures I track in my upcoming book. Further Reading: A Look Back on a Previous Instance of Program Buying Surge
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Think of the successes of great sports teams or businesses. In so many cases, consistency in execution is a common feature. The great football team doesn't just block and tackle well; they do so every play, every game. A business like FedEx or UPS doesn't just deliver on time; they hit their time targets consistently. How can traders achieve high levels of consistency? The answer is by turning trading practices into trading rules. Rules are what turn best practices into habits--and habits are what give us consistency. Contrary to popular conception, discipline is not about forcing yourself to do the right thing. It's about turning right things into habit patterns. Today's best practice comes to us from reader Markham Gross (@MarkhamGross), who is the founder of Anderson Creek Trading, LLC. He explains how the use of rules and systems bring consistency to trading: "A trader or investor cannot control markets or the outside world. All that is under the trader's control is his or her reactions to what is happening in markets or what is perceived to be happening in markets. Therefore, systems should be applied. The best systems are often simple. Spreadsheets can work as an implementation tool and some light programming skills will also go a long way. Systems should be comprised of specific rules for when to enter, exit for loss, exit for profits, and size of the positions. These rules can match the trader's personality and temperament. They should be testable. Although there are limits to backtesting, performing some backtests will help the trader know what to expect so they are not surprised by normal drawdowns. To approach the market without rules on a daily or weekly basis would be a mistake." What I find in my work with traders is that many of the best work in a hybrid fashion: they make decisions on a discretionary basis *and* their decisions are guided by explicit and tested rules. For example, one trader I worked with years ago examined price breakouts that tended to continue in the direction of the breakout versus those that reversed back into the prior range. He found several factors differentiated breakouts from fakeouts, including the volume of the move, where the move stood with respect to longer time frame activity, and the time of day of the breakout. He turned these factors into a checklist, so that he only took breakout trades that scored highly on his criteria. Those rules not only helped him find winning trades, but kept him out of many losers. When that trader first generated the rules, he used the checklist everyday to guide his actions. Eventually, the criteria became solid trading habits and he implemented them routinely. Repetition is the mother of habits and habits are the backbone of discipline. Turning your successful strategies into rules is a great way to ensure that your best practices become robust processes. Further Reading: Success as a Habit
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Above are two charts from the excellent Index Indicators site that I find useful. The top chart tracks the percentage of SPX stocks making fresh five-day highs. The bottom chart tracks the percentage of SPX stocks making fresh five-day lows. Typically we see five-day highs wane and five-day lows expand as market cycles top out. We also have been seeing five-day lows crescendo ahead of cycle price lows. Yesterday, we closed modestly higher in SPX, but new lows expanded and new highs contracted. Rob Hanna of the insightful Quantifiable Edges service recently issued a query study that noticed downside tendencies when the market rises but the proportion of rising stocks falls short of 40%. Price action during the current market cycle has been somewhat distorted, but I'm viewing the current cycle as having begun with the mid-December lows, having peaked at the late December highs, and now in a down phase. If that is the case, we should see at least one further down leg to the market that would take us below those December lows. A dramatic expansion of new highs would contradict that scenario. Tracking short-term strength/weakness via new highs/lows on a daily and several day basis is a useful way of determining if markets are strengthening or weakening going forward. Further Reading: A Look at Market Cycles
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Success in trading requires the ability to act decisively in the midst of uncertainty. Even when a trader possesses a durable edge in markets, the random variation around that edge makes for a meaningful proportion of losing trades. Risk management begins with the acknowledgment that we could very well be wrong. Today's best practice, submitted by Jonathan Frank, a 20-year old college student and trader, is the conscious acceptance of uncertainty. Jonathan writes: "The market goes up and down (crazy, I know) and I have been a successful trader because I know that shit happens that you cannot always prepare for, as happens in life. You live, you learn, and you move forward. Once you become okay with this uncertainty, you are ready to hit that buy button. Until then, you might want to start searching for another Albert Einstein" to come up with the perfect theory and prediction of the future. "I assess market uncertainty by educating myself on consumer outlooks, job reports, and international events that have direct and indirect effects on the U.S. markets. I then decide if we are in a state of composure or panic...Market uncertainty is like the weather in that there will always be people speculating about whether stocks are going to go up or down in the future, but unless there is a drastic occurrence you have to be optimistic and know that rainy days are followed by sunshine. Always." Jonathan has not been trading for long, but he has come to an important and mature insight: How we trade depends upon how we assess the environment. Are we experiencing a normal market environment or an abnormal one? If we hear a weather forecast predicting a rain storm, we do not freeze and refuse to go outdoors. We dress appropriately and go about our business, understanding that there is some small possibility that the storm could become something truly ugly and dangerous. If, however, we notice very ominous clouds and very low air pressure and hear a weather alert, we may very well decide to take precautionary measures and batten down the hatches. Jonathan mentions data releases and international events as indicators of uncertainty in the world. In markets, we can also gauge uncertainty by looking at realized and implied volatilities--how much markets are moving and how much volatility is priced into markets via options. I find that historical analyses of markets also provide a useful gauge of uncertainty. When we look at where the market stands today and then go back in time and examine all similar occasions, we can get a sense for the variability of forward outcomes. Sometimes those prospective outcomes contain a directional edge; sometimes they are random. Sometimes those outcomes are highly variable; other times they are more constrained. By examining the uncertainty of past outcomes, we can sensitize ourselves to the uncertainty of the immediate future. Further Reading: Dealing With the Uncertainty of Trading .
* My recent projects have included developing better measures of price momentum and volatility. With respect to momentum, I am working on a measure that cuts across multiple time frames and that measures momentum in vol-adjusted terms. With respect to volatility, I'm working on a measure that cuts across realized and implied vol. Above is a fast measure of multiperiod momentum that has tended to top and bottom ahead of price during intermediate market cycles. Instead of using backtests to predict (and trade) forward price movement, I use the tests as gauges for the average expectable movement from any given configuration of momentum and volatility. That provides a useful framework for determining whether the current market, going forward, is behaving stronger or weaker than average. Sustainable trends, early in their life, perform stronger than average. So far the current market is behaving weaker than average. * Worthwhile perspectives on bond price strength (falling yields) and more from the top links of the week via Abnormal Returns. It's a great way to discover insightful blogs you may have missed. * Does early January performance in the stock market predict full year returns? * A look at market sentiment and what it might mean. * Interesting market observations from Nautilus Research. * A look at returns from trading absolute momentum.
One of the themes of my upcoming book, Trading Psychology 2.0, is that creativity is the new trading discipline. Success in markets is not so much a function as rigidly adhering to a single, unchanging edge as continually finding fresh sources of edge in ever-changing markets. But how do you come up with fresh trading ideas and sources of edge?
Reader, author, and blogger Ivaylo Ivanov (@ivanhoff) offers a best practice that can feed our creativity. Here's what he suggests: Studying your own past trades is a must, but it provides a limited perspective of opportunity cost--it only helps to analyze the trades you took; it tells you nothing about the trades you did not take. One of the most practical habits that has helped me as a trader is going through the daily charts of the best performing stocks on a daily, monthly, quarterly, and 6-month time frame. Here are some of the benefits of this daily exercise: * It has substantially improved my setup recognition skills;
* It has given me ideas for new ways to approach the market;
* It provides an unbiased view of what is currently working in the market; which industries are under accumulation. Recognizing industry momentum is of utmost importance for swing traders as it helps to focus on setups that don't only have higher probability to break out or break down, but are also likely to deliver bigger gains;
* The mere going through the screens provides me with a constant flow of great anticipation swing setups--stocks that are setting up for a potential breakout.
Readers will recognize this as a structured exercise in pattern recognition. In his book, Ivaylo outlines his "perfect setup" for swing trades. His best practice above, additionally enables him to learn new setups. It also allows him to identify sectors that are most likely to yield good setup candidates. Indeed, the patterns that emerge from such review could lend themselves to backtesting and possible systematic inputs into discretionary trading.
I also suspect that Ivaylo's best practice helps him identify market themes early--for instance, the breakdown in energy stocks in the wake of oil weakness or the rise in utility shares resulting from declining global rates. It's not such a leap to go from his exercise to a review of patterns across global markets to identify the macro themes that might be attracting the interest of institutional investors.
Interested readers can check out Ivaylo's website, as well as his book and Twitter feed linked above. He's a great example of savvy traders sharing worthwhile ideas via StockTwits.
The recent post talked about the importance of being mindful of evidence for the other side of your trade and the bounce probability following short-term oversold conditions played out on Friday. Above are three perspectives on the U.S. stock market at week's end. The top chart depicts a ten-day moving average of all stocks across exchanges making three-month new highs vs. lows. That breadth has been deteriorating since late October, but notice also that this week's price lows saw fewer shares making fresh net new lows than at the mid-December bottom. For that reason, I'm viewing the market as a range one defined by the December highs and lows. The middle chart takes a look at the balance between buying pressure (upticks) versus selling pressure (downticks) across all NYSE shares. Note the recent intensity of selling pressure ahead of price lows, followed by Friday's buying surge. This is a pattern that has been common at intermediate market lows and is consistent with the range perspective noted above. Finally, in the bottom chart we see the 10-day average of changes in shares outstanding for the SPY ETF. This has been an excellent sentiment gauge, as we have tended to see expansions in shares outstanding when traders have been bullish and contractions in shares outstanding when traders and investors have been bearish. We finished 2014 with considerable bullishness and recently have swung to the opposite extreme, again consistent with the range notion. The follow through to Friday's rally should tell us a great deal about the vigor of this market. It would be understandable for traders to respond to strength with further buying, given the recent concerns regarding V bottoms. A weak follow through would suggest that recent macro considerations (deflation, global economic weakness) pose ongoing headwinds. I will be tracking that in days ahead. Further Reading: Gaining Fresh Perspectives
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Consider the talented weather forecaster, the skilled CIA analyst, and the successful sports gambler. What they share is an appreciation of probabilities. It's not that they have a crystal ball into the future. Rather, they are intelligent about the range of possible outcomes and the likelihood of each occurring. In David Apgar's terms, these individuals display risk intelligence. The risk intelligent person is one who quickly learns about risks and rewards and adapts to changes in those. Dylan Evans makes the case that risk intelligence is indeed a distinctive form of intelligence, not correlated with overall IQ. As we sometimes see in markets, very bright people can make very stupid decisions about risk. (See the Projection Point site for an example of a risk intelligence test). Let's take two traders. Both are long a market that has been trending upward. The trend has lasted long enough that the trade has gained popularity and the position is widely held. The first trader cites "price confirmation" and the possibility of a "parabolic" move and increases his position size in the trade. The second trader experiences the same enthusiasm, but looks at positioning, reassesses risk/reward, and buys some inexpensive downside protection with options. When the market stalls and traders run for the exits in the crowded position, the first trader draws down meaningfully. The second trader holds onto the vast majority of gains. *That* is risk intelligence. The first trader is carried away by the market move and becomes risk-stupid. The second trader draws upon risk intelligence to reformulate odds and shift exposure. A great deal of trading success occurs when emotional intelligence--our awareness of our experience and ability to adapt to that--triggers risk intelligence. It's not that successful traders control or eliminate emotions; it's that they use emotions as information in assessing and reassessing risk. The traders I know who have been quite successful sometimes take higher levels of risk, sometimes lower. They are distinguished not by their level of risk taking but by the intelligence of their risk taking process.
In the wake of the decision of the Swiss National Bank (SNB) to end its peg to the euro, we have seen massive volatility in CHF, Swiss stocks, and stocks and currencies globally. Like a flash crash or an unexpected news item or earnings release from a company, such event risk has the potential to inflict significant damage to trading accounts and portfolios.
With the overnight action in the ES futures, my measure of pure volatility--the amount of movement generated by a fixed amount of volume; see chart above--has risen to its highest level since the October lows. The same amount of stock index volume is now generating more than twice as much movement as late in December. What pure volatility tells us is that we don't need specific event risk to see dramatic increases in market movement. During recent market selloffs we've seen both more volume and more volatility per unit of volume.
This is why stress-testing your positions and portfolios is a best practice in trading. Consider the position(s) you currently hold and your intended holding period for that position or positions. Now look back over the past two years of trading and identify the worst drawdowns that could have occurred to that position or portfolio over the course of that holding period. Because financial returns are not normally distributed, the odds of outsized losses are greater than we would expect from usual statistical analyses. Looking back over a period of years and identifying worst possible drawdowns is at least a beginning heuristic to let you know if you could survive a significant event risk or adverse move.
If the loss you would incur from worst case gap/event risks or drawdowns would impair your trading account and impair your trading, you know that your risk-taking amounts to a kind of Russian roulette. It is only a matter of time before an active trader encounters a two-plus standard deviation adverse move. Sizing positions to survive stress tests is immensely important to longevity in a trading career.
Sizing is not a total solution, however. Even reasonable sizing wouldn't have protected you from the kind of multi-multi standard deviation move we just saw in the Swiss franc. This is why diversification in a portfolio is essential. When one position blows out, other positions have the opportunity to work in your favor. Spreading risks that are sized properly helps protect traders and investors from those rogue moves that are associated with fat tails of financial returns. You can't win the game if you can't stay in the game. The trading literature is filled with admonitions to size up trades and portfolios when you have confidence in your views. Flash crashes happen. Downside gaps on negative earnings surprises happen. Spikes in volatility happen. Confidence not tempered with prudence is an accident waiting to happen. Further Reading: Mistakes in Risk Taking
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The recent look at the market suggested weakening breadth in a market dominated by deflation concerns. Interestingly, stocks have traded lower and we're starting to get into negative territory on the intermediate-term strength measure (above). That measure takes the number of SPX stocks making fresh 5, 20, and 100-day highs vs. lows and smooths those with a ten-day moving average. The indicator has room to go on the downside to be sure, but I do make note that we're hitting levels similar to those seen in December even though prices remain higher. When weak breadth cannot produce fresh price lows, I become more vigilant for the possibility of a bounce higher. On a related note, I have mentioned in the past the Stock Spotter site of John Ehlers and Ric Way. They make use of cycle analysis to generate buy and sell signals for individual stocks and ETFs. Notably, they publish their track record of signals and have done well overall. I note that, as of yesterday's close, they had 138 buy signals on stocks. Since late 2013, when I began tracking the service, there have only been five occasions in which we've had 100 or more buy signals. It's a small sample, to be sure, but all five occasions were higher in SPY five trading sessions later, by an average of 1.59%. Indeed, when we divide the buy signals by quartiles and look at the highest quartile (most buy signals), we see an average next three-day gain in SPY of +.33%. The lowest quartile (least buy signals) yields an average next three-day gain in SPY of +.06%. This is clearly not how John and Ric designed the service to be used, but I do find it interesting that the broad market has tended to perform best when individual stocks are giving the greatest number of buy signals.
The key point is that, even when you have a strong directional view on a market--especially when you have a strong directional view on a market--it is valuable to avoid confirmation bias and seek out information that runs counter to your conviction.
Perhaps this is the most important performance principle of all: We internalize what we do repeatedly. When we engage in behaviors again and again, those behaviors become a habitual part of us. That can work for better or for worse. It's an expression of the idea of "use it or lose it". Our capacities never stay constant. We either develop them or let them atrophy. What we develop defines who we are. This is why negative thinking is so damaging: over time we internalize a negative sense of self. It's also why it's important to develop ourselves cognitively, physically, emotionally, and spiritually. Each day, each week, we either exercise those capacities or we lose just a bit of life fitness. What are the success behaviors you repeat day in and day out? What are you exercising regularly and what has been going undeveloped? Can we really expect to internalize a sense of success when we're not succeeding at the daily challenges we define for ourselves? Here's an excellent resource from James Clear on building positive habit patterns.
Who we are is an internalization of what we do. Life is one big gym and each day is a potential workout. What will you develop today?
I have consistently found that success comes from asking better and deeper questions. It's the out of the box questions that can lead to fresh insights and answers. I recently came across a 2014 review of performance from a trader that outlined all the mistakes he had made during the year and the things he wanted to improve. I asked a question he did not anticipate: "What did you do well in 2014 and what if you *only* did those things in the new year?" Asking a fresh question will not always generate new and better answers, but asking the same, stale questions almost certainly will not yield creative insights. In my current research, I'm looking at overbought and oversold indicators. How much of an edge do they actually provide? Do some measures offer significantly greater edges than others? Over what time frames? Do overbought and oversold measures offer different levels of edge in different types of markets? Are there times to utilize these indicators and times we should not be giving them weight? Notice that such an approach is very different than simply looking at a standard measure such as RSI or Stochastics and pronouncing a given level as overbought or oversold. It's the tougher, more detailed questions that can yield nuggets of insight. For example, suppose we track the number of stocks in the SPX index that are making fresh five-day highs vs. five-day lows. If we go back to 2006 and divide the market into quartiles based upon volatility (VIX), we find that an oversold level in the lowest VIX quartile (1 SD below average) is -62. An oversold level in the next VIX quartile is -138. In the third VIX quartile, the same oversold level is -199. And at the highest VIX quartile, the oversold level is -265. In other words, what constitutes overbought and oversold is relative to the volatility regime of the market. Looking at static levels of overbought and oversold across all markets gives us very distorted results. Does a regime-specific measure of overbought vs oversold breadth offer a greater trading edge than an absolute level? It's all very testable, but only if we gather the data and ask the question. Further Reading: Institutional Participation and Momentum
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* The recent post illustrated the deflation theme impacting global stock markets. My concern is that the overseas weakness may be more subtly impacting U.S. stocks. The top chart tracks stocks across all exchanges and the number making fresh three month new highs vs. lows. Note that the balance of new highs vs. lows has been waning since the very end of October. The bottom chart tracks all NYSE shares closing above their upper Bollinger Bands vs. those closing below their lower bands. This measure also has been showing waning upside strength. This invites the hypothesis that the recent market action represents a topping process and that we could see a meaningful leg lower as the result of any oil/commodity-led capitulation. * Interesting post on why the Fed may be concerned about overseas economic weakness. See also why deflation may be relevant to China and why "lowflation" is a challenge for Europe. * Some excellent links from the past week via Abnormal Returns, including the asset that best diversifies a stock portfolio. * Thanks to Steve at SMB for pointing out this well researched book and resource on momentum investing. Have a great start to the week! Brett
The broad U.S. stock market (New York Stock Exchange Composite Index; top chart) has been making lower highs, but other equity markets have been in significant decline since mid-year, including EuroStoxx (FEZ; second chart from top); non-U.S. shares (EFA; third chart from top); and emerging markets (EEM; third chart from bottom). At the same time, we've been seeing a precipitous decline in oil prices (USO; second chart from bottom) and dramatically declining yields at the long end (TLT; bottom chart). A common theme among these markets is deflation. My concern is that a capitulation leg down in oil from here would lead to a similar risk-off leg among stock markets, including the U.S., reflecting concerns regarding possible global recession. An update on the breadth and other indicators will expand upon this idea. Further Reading: The Challenges of Disinflation
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Deliberate practice is a process in which we continually evaluate performance and use those evaluations to make targeted efforts at improvement. Research from Anders Ericsson and others suggests that deliberate practice is essential in developing performance expertise. Today's best practice comes from reader Norbert Beckstrom and consists of a daily review of trading performance. The power of such a review comes from the fact that it can anchor a process of continuous learning and performance improvement. Here are the questions Norbert puts to himself after a day's trading: 1) Did I put on high probability (A+) trades that I wouldn't be easily scared out of? 2) Did I trade to win or did I trade not to lose? 3) Did I have enough size in my conviction trades? 4) Did I break any of my rules? Why? 5) Was I mindful of what I was doing? 6) How many of today's trades would I make again under the same circumstances? 7) How many of my trades did I bail on before the stop or profit target? How did that work out? 8) How many of my trades today were placed out of fear of missing a move? 9) How many trades did I miss today because I wasn't paying attention or was working on something else? 10) How many doubles were there that I didn't have an edge for? 11) How do I feel about my trading at the end of the day? 12) What can I do to improve these answers? Norbert adds that if he conducts this review in the morning before the market open rather than in the evening at the end of the trading day, the answers are more likely to be fresh in his mind and he's more likely to avoid making trading mistakes. In that sense, his review process is a mindfulness process. Clearly, Norbert's review is geared to a discretionary day trader. Traders with different trading styles and traders working on different trading issues will have very different review lists. My review, for example, is much more about markets and much less about making emotional errors. Because my trades are based upon backtested rules and relationships, my first hypothesis is that a losing trade means I may well have missed something important and idiosyncratic in the market. This prods me toward further market analysis. Should the trading loss result from not following my rules, that would prod me toward further self analysis. Ultimately, the most important question is Norbert's final one. Answering the questions is only useful to future performance if the answers anchor specific plans and actions toward improvement. Review is necessary for deliberate practice, but not sufficient. It is what we *do* with the answers to our review questions that determines whether our experience turns into learning and development. Further Reading: The Rage to Master
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At some point, most skilled traders achieve a degree of success and seek to maximize the economic value of their trading. This typically means taking more risk to achieve larger rewards, often by increasing the size of positions. Here are three mistakes traders typically make in growing their risk taking: 1) Increasing risk in excessive increments - We are paid in dollars, not in basis points of return on a notional portfolio size, so it's only natural for us to respond emotionally to the dollar P/L of our wins and losses. When we increase our trading size dramatically, trades suddenly *feel* different and we create a situation in which drama can lead to trauma. This is particularly common among developing traders who move from simulated trading to live trading with small accounts. The position sizing relative to the size of their accounts creates excessive price movement sensitivity, even though the absolute value of the swings may not be enormous. Very gradual but steady increases in risk taking allow us to accommodate to larger swings in P/L. It is very important to not create a situation in which you have made profits on the year taking X risk and now give it all back by taking 2X or 3X risk. No single set of expectable losses should be sufficient to impair one's subsequent decision making.
2) Increasing risk at inopportune occasions - Many traders will increase their risk-taking by scaling into trades, starting with relatively small positions and then adding to those as the trades are going their way. The problem with that approach is that, once the trades have moved in the trader's favor, the risk/reward is now different and often less. This way of growing risk taking can subtly turn a trend trader into a momentum trader: buying strength and selling weakness--especially when there is a fear of missing moves with the larger trading size. Not all trending markets are momentum markets; many times you want to buy the dips during uptrends and the bounces during downtrends. By adding risk as markets are at highs or lows, traders often ensure that they are most vulnerable to reversal when they are largest in the trades.
3) Increasing risk subjectively - An exercise I've found very useful is to study one's past profitability based on the number of trades taken per day or week and based on the amount of risk taking over time. Surprisingly often, traders perform their worst when they are trading their greatest risk. Although they tell themselves that they have confidence in their trades, the larger size (and perhaps overconfidence) leads them to be less nimble and more stubborn in their trading. This can lead to outsized losses. It is not at all clear to me that most traders are good at knowing which of their trades are going to work, so that they can size those most aggressively. Rather, if a trader's decisions have positive expected return over time, it can make sense to gradually size up each trade and not expose the account to occasional large drawdowns.
It is all too common that traders will take risk down after what are normal, expectable losses and then ramp risk up after normal, expectable runs of winning trades. If each trade has a relatively uniform edge, such decision making dramatically lowers long-term returns. Much of total trading returns comes, not just from the ideas traded, but how we pursue them. Effective money management is a powerful tool for the management of the emotions of trading.
You think the market will be going up and, sure enough, it rises sharply and you only have a small position on. Should you buy the strength and play for momentum, or should you count on mean reversion and wait for a pullback to buy? It is not at all clear that chart patterns are informative in answering this key question of entry execution, which has led me to research some technical alternatives. This is a work in progress with a relatively small data sample, so please take with appropriate caveats and grains of salt. What we have above is SPY plotted against a composite measure of daily buy vs. sell signals for several different technical trading systems: RSI, MACD, Bollinger Bands, CCI, and Parabolic SAR. (Raw data from Stock Charts). Every stock on the NYSE is tracked for each of these systems and we sum the buy signals and subtract the sell signals. The composite tends to peak ahead of price during market cycles and bottoms shortly prior to price even at seeming v-bottoms. The technical systems overlap one another to a fair degree, so I took just the ones that showed low correlation and volatility-adjusted them to equalize their signals. When we've had the greatest number of buy signals (top quartile of distribution since July), the next five days in SPY have averaged a gain of +.33%. When we've had the fewest buy signals (bottom quartile), the next five days in SPY have averaged a gain of +.42%. All other days (middle quartiles) have averaged a loss of -.12%. In other words, we have seen upside momentum when buy signals have been plentiful and we've seen mean reversion when very few stocks have been demonstrating strength. When we look at sell signals as a distinct distribution, we find that when there are many sell signals (top half of distribution), the next five days in SPY average a loss of -.21%. When there are relatively few sell signals (bottom half of distribution), the next five days in SPY average a gain of +.47%. We thus see some downside momentum following broad weakness and some upside momentum when there has been an absence of weakness. There is much more work to be done and considerably longer time frames to analyze. The work thus far suggests that the breadth of market strength and weakness is relevant to the question of whether one should be trading short-term market moves or fading them. Further Reading: Tracking Market Cycles With Pure Price Momentum
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Stocks have started the year on a particularly weak note, retracing the lion's share of rally from mid-December. This has very much fit the earlier mentioned query, in which very high levels of bullishness among ETF buyers has led to poor near-term returns. Above are three updated views on the market weakness. The top chart illustrates the high level of programmatic selling swamping the recent market. This measure, based on a basket of institutional favorite stocks and their simultaneous upticking vs. downticking, shows that selling pressure in these large cap shares has been intense. When we look at the entire market, however, it's not clear that the deep selling of the institutional favorites has translated so far into highly broad selling. The second chart tracks stocks across all exchanges making fresh three month highs vs. three month lows. Note how new lows are nowhere near the levels seen in mid-December and mid-October.
That same picture emerges from my measure of buying pressure (upticks) versus selling pressure (downticks) across all NYSE shares (bottom chart). While the balance between buying and selling has turned negative, it by no means reflects the breadth of selling that we saw in mid-October or mid-December.
Deep selling that cannot become broad selling invites the hypothesis of underlying strength in the broad stock market. I will be watching new highs and lows and sensitive momentum measures closely to see if this decline begins to gain or lose steam. If the latter, we could see a healthy rally emerging from the recent gloom.
The next best practice in our series is using imagery and visualization to change our thoughts, feelings, and actions as traders. Imagery can be a powerful method for reprogramming our minds and reframing challenging trading situations. Reader David Spengler offers this best practice from his own trading: "In German, the phrase 'to jump into cold water' refers to a situation that is new and unknown and therefore risky. Before entering a trade, I am visualizing exactly that situation to overcome fear and procrastination. I close my eyes for a few seconds and imagine it is summer. The sky is blue, it is very hot, and I am sweating. I am standing by a pool. Then I jump into the water headfirst. It is a shock, but only for a second. Then it feels unbelievably good, as I sense every cell in my body and the blood pulses through my veins, my heart pumping fast. This image reminds me that jumping into the cold water/taking risk can actually feel good. More technically speaking, I reframe the situation. Since I have made it a habit imagining this scene, problems executing my trading systems have been greatly diminished." Notice here how a situation that could be experienced as unpleasant (risk taking) is transformed into something that is refreshing (diving into cold water on a hot day). By making the visualization habitual, the exercise becomes a kind of self-hypnotic suggestion. David uses the exercise to enter trades, but a very similar exercise could be used to reframe taking losses--or any desired trading behavior that might otherwise be avoided.
I have found that visualization can also be used very effectively prior to the start of the trading day as a way to mentally rehearse one's trading plans. By walking ourselves through various scenarios via imagery, we can mentally prepare ourselves to take the right actions. What makes David's technique especially effective is that the imagery *emotionally* reframes the trading situation. If we were to prepare ourselves at the start of the day by imagining ourselves stopping out of losing trades and refreshing ourselves for the next opportunities, the act of stopping out would become far less onerous.
Replacing negative self-talk with positive imagery is a great way to retrain our thought process and channel our efforts in constructive directions. The emotional preparation to act may be as important as the trading plan itself.
* One of the things I have my eye on is cross-sector volatility within the U.S. stock market. This is a measure of realized volatility, not volatility implied by options pricing (like VIX). Generally, volatility peaks early in a market cycle and troughs ahead of price highs. We've recently come off a peak, similar to patterns we've been seeing with market breadth.
* I also note that the end of 2014 saw quite an expansion in the shares outstanding of the SPY ETF and many of the sector ETFs. (Data from State Street). That's been a pretty good sentiment gauge over the years: demand for stocks expands the supply of ETF shares and bearish sentiment leads to a contraction of shares outstanding. In the past 10 days, we've seen a rise of almost 14% in the shares outstanding for SPY. Going back to 2006, when shares outstanding for SPY have been up by 10% or more over a 10-day period, the next 20 days in SPY have averaged a loss of -2.18%. That compares to an average 20-day gain of +.77% for the rest of the sample. When ETF demand soars, that enthusiasm has not led to good returns in the past, and 2015 thus far has been consistent with that.
The next best trading practice in our series comes from reader John Hope-Robinson (@johnhr), who describes meditation as an important tool in conquering a fundamental trading flaw. John writes: "We traders can be an insecure lot. We would rather at times be seen as a mysterious genius than just a successful trader. This need, born from a false sense of reality, can lead us to confuse intuition with 'into wishing'. We only need a system with a small winning edge to be a successful trader as long as we follow the rules of the system. Herein lies the Flaw. So many traders are just not patient enough to wait. The fear of doing nothing can be so terrifying that we feel a need to act to stop the fear and gain instant relief from it. This is the core issue. Through meditation we can learn to be OK during the necessary times where we need to do nothing but wait. We learn to achieve a clarity and calmness which can allay this perceived need to act. Meditation could well be the best investment a trader may ever make!" John rightly points to three key benefits of meditation: 1) Enhanced self-control - Meditation promotes calm, and it promotes focused concentration. Both enhance our cognitive and behavioral control, so that we can become mindful observers of our emotional patterns rather than victims of those. The first step in changing our patterns is becoming aware of them and not identifying with them. 2) Enhanced access to intuition - It is when we are still that we have greatest access to what we may know, but not know that we know. Very often experienced traders possess a keen gut feel for markets, but that feel is drowned by flight or fight responses to market action. Meditation promotes a stillness that enables us to listen to ourselves. 3) Enhanced well-being - We cannot trade well if we are dominated by fear: the fear of missing moves, the fear of losing money, the fear of being wrong, the fear of inaction. Research suggests that meditation can lead to enhanced personal satisfaction and subjective well-being, which allow us to act from a position of emotional strength. A corollary of this best practice is that some of your preparation time for trading needs to occur away from trading screens. Using meditation as a midday break--as well as a morning preparation for the day--helps us step back from markets and approach them with a fresh perspective. Stepping away from markets can be a powerful way of stepping back from the reactive trading of markets. Further Reading: Trading and Mindfulness
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I thought I would update a few of the measures that I follow to help us make sense of the relative weakness that we've seen ushering in 2015. In the grand scheme of things, the weakness is not extreme; indeed, my Cumulative NYSE TICK measure has made new highs and advance-decline breadth has not been lopsided at all. Still, the weakness has exceeded my expectations; the charts above capture a worthwhile perspective. First, however, a trading psychology comment. When I'm stopped out in a trade--as happened recently with my long position in ES--I stop. My stops are placed far enough away that, if they're hit, I'm wrong. And before I resume trading I need to figure out what the hell I got wrong. One of the most destructive patterns I've observed among traders is a tendency to continue--or even accelerate--trading after stop outs. Insanity, the saying goes, is redoubling one's efforts after having lost sight of one's aim. A more sane strategy is to use losing trades as learning experiences. The charts above are part of my review and reflection process after a trade that I thought was good turned out to be a losing one. The top chart is a measure of breadth for SPX stocks. It represents the percentage of shares trading above their 3, 5, and 10-day moving averages. (Data from Index Indicators). You can see how this breadth measure reliably tops out ahead of price during market cycles; it's also done a reasonable job of bottoming ahead of price at cycle troughs. We've come off quite sharply in this measure; more so than is typical in a market cycle. This invites the hypothesis that we've already seen a momentum peak for the current cycle. The middle chart tracks all NYSE stocks closing above their upper Bollinger Bands vs. closing below their lower bands. (Data from Stock Charts). It too has shown an admirable tendency to top ahead of price at cycle peaks and ahead of cycle lows at troughs. That has not come off as sharply as the breadth measure, but also has moved steadily lower since a rapid peak off the mid-December bottom. Finally, the bottom chart tracks a basket of stocks that are institutional favorites and the upticking versus downticking in those stocks. When the majority of stocks in the basket uptick simultaneously, that is deemed to be evidence of the presence of institutional buying programs; when they downtick simultaneously, that is counted as the presence of selling programs. We can see that buying programs dominate early in a market's cycle history and give way to selling programs as markets make cyclical peaks. Note how we showed very strong buying program activity off the December lows and now have moved to a dominance of sell programs. These measures leave me open to the idea that we've hit a momentum peak for the current cycle, which will have me looking closely at any bounces from here to see if we see waning or strengthening breadth. This could have longer-term ramifications, as it invites the hypothesis that the end of year strength was not a fresh leg in a bull market but rather part of a much larger topping process that began in 2014. Further Reading: Losing Your Money Begins With Losing Your Focus
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Our next best practice in trading comes from Enis Taner (@EnisTaner) and captures the idea of keeping yourself in peak condition in all areas of life. Enis explains, "I've found that it is crucial that I am physically, emotionally, mentally, and spiritually healthy if I am to take on the challenges of trading professionally." Here's how Enis breaks it down: * Physical: 30-45 minutes of high intensity exercise, 5-6 times per week. * Emotional: Making it a habit to meet friends and/or family for social gatherings on a regular basis (not less than 3 times per week). "Good conversation is one of the best methods I've found to reduce mental stress," he observes. * Mental: I try to practice trading techniques on multiple time frames. Some weeks I will spend my learning time on reading financial statements and conference call transcripts with a focus toward long-term investments. Other weeks, I will test out correlations of short-term technical indicators. * Spiritual: I spend five minutes each morning on new things for which to be grateful. I've also found that helping others, especially young people, with positive thinking and life mentorship overall to be fruitful for my own spiritual well-being.
The key idea here is that it's not enough to reduce stress in order to be a peak performer in markets. Just as an athlete must be in superb aerobic and strength condition with continuous skill practice and work on mental sharpness, the successful trader draws upon reserves from all areas of life. It's not difficult to see how Enis' routines could be captured in a checklist, keeping him aligned with personal best practices. Creating our own peak performance processes ensures that we sustain the energy and positivity to weather the normal ups and downs of trading. Further Reading: Success and Making Your Bed
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We're kicking off 2015 with a series of posts on best practices submitted by readers. Thanks to all who shared ideas. We begin with reader Vlad, who is a discretionary trader of forex, gold, and DAX. He sets a maximum loss limit per day (1.0%); week (2.5%); and month (10%) for his trading. He explains, "That has removed a great deal of the stress from trading, knowing that no one trade or series of trades can bring me down." The best practice here is risk management: the prevention of deep drawdowns is worth many pounds of come-back cure. Readers trading for hedge funds, where capital is levered, will almost certainly set different percentages from Vlad. A loss of 10% in a month would be wholly unacceptable at many places where I have worked. Personally, I would not want three months of hitting my downside level to place me in a situation where I had to make over 40% on the remaining capital just to break even. Vlad's basic concept of setting loss limits for trading, however, is quite sound. I look at it this way: if I have a hit rate of 50%, then I will have 25% odds of two consecutive losing trades; 12.5% odds of three consecutive losing trades; 6.25% odds of four consecutive losing trades; and a little over 3% odds of five consecutive losing trades. If I place 50 trades in a year, guess what? I will almost certainly encounter strings of four and five consecutive losers. I need to be able to survive that risk of ruin. If I allow myself to lose 10% of my initial capital on each trade, I will likely get to the point where I need to double my remaining money to break even. If I allow myself to lose 1% of capital on each trade, any expectable run of losing trades is unlikely to impair my account--or my psyche. One of the practices that has served me well over the years is to enter trades with one-fourth to one-half of my maximum position size. I've found that, when I'm wrong in a trade, I'm usually wrong early in that trade. Keeping my risk exposure modest initially enables me to lose less money if I'm stopped out quickly, and it allows me to add to my position if my scenario unfolds as planned. If I'm sized maximally, moves against me become a threat. If I'm sized more moderately, moves against my position can pose further opportunity. That's a great place to be psychologically. Finally, loss prevention in trading is greatly aided by diversification. If you have two or more trading systems or trading methods that each have positive expected returns and are relatively uncorrelated in their return streams, you then create a situation where the expectable series of losing trades for any one method can be buffered by the returns from the others. Diversification can also occur in the larger picture of our money management. My trading capital is but a fraction of my total investment capital. I have many fixed income investments, for example, that throw off a reasonable yield each year. If I were to have a losing trading year, I would still harvest income from my larger portfolio. Vlad's point is an important one: risk management is the best psychological management. It is very difficult to keep our heads in the game if markets are handing our heads to us with adverse moves. Playing good defense sets us up for taking full advantage of offensive opportunities. Further Reading: Best Practice: Reading in Parallel Turning Best Practices Into Best Processes
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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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