You Can't Win If You're Not Playing The Right Game

Mark Minervini makes an interesting point: the market is like poker in that the most important element of success is knowing which game to sit in on.  All too often, I find that traders in a slump focus on the hold 'em versus fold 'em choices of trading when, in fact, they're sitting at the wrong table.

How can we sit at the wrong trading table?  Several variations of this challenge immediately come to mind:

*  You're a momentum trader and you're trading a slow, low volatility market;

*  You're a trend trader and you're trading a choppy, range market;

*  You're a research-oriented big picture trader and you're getting caught up in short-term price action;

*  You're a skilled short-term trader and you're locked in a longer-term directional market view;

*  You're a contrarian fader and you're getting run over in high volume directional flows;

*  You're an independent thinker, but you're distracted and influenced by the views of others;

*  You're a trader who reads others well at the table, but you're isolated from other traders;

I've seen people make money in markets two ways:  by investing and by trading.  Investing means generating a big picture view and riding out short term noise en route to seeing that view materialize.  Investors are top-down thinkers:  they're analytical and their skill lies in putting pieces of research together to form a picture that others haven't yet seen.  Traders are bottom-up thinkers:  they recognize patterns as they form and act on them quickly.  Where the investor thinks deeply about opportunity over time, the trader thinks broadly about what's happening in markets at a given time.

A great way to lose money is to not understand yourself and how you're wired cognitively.  If you're a deep thinker, you'll lose money sitting at the trading table.  If you're a fast thinker, you'll lose money dabbling with investment theses.  The route to success is to be who you are when you're functioning at your best.  Working on improving your discipline, controlling your emotions, and following your process is not helpful if you're sitting at the wrong table to begin with.

Further Reading:  Patterns of Reasoning in Markets
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A Good Way to Beat a Bad Attitude

Everyone knows what it's like to be in an attitude funk.  Perhaps it's been a long, slow drawdown; problems in your personal life; an overload of work; a lingering illness; or some combination thereof.  Nothing seems to be going right and nothing is making you particularly happy.  Thoughts and feelings shade to the negative, you're feeling grumpy, and you don't exactly feel like being around other people--especially if they're killing it in markets!

Research tells us that we perform best when we're drawing on strengths and are most vulnerable to burnout when the intensity of our work efforts crowd out the sources of our rejuvenation.  When our willpower is sapped and things aren't going well, it is difficult to access the positivity needed to emerge from an attitude funk.  An absence of positives, not just a surplus of negatives, can weigh on our mood and energy level.

One key to emerging from a bad attitude is making the transition from noun-thinking to verb-thinking.  In the noun-thinking mode, a negative attitude is something we have; we own it.  In verb mode, a negative attitude is something we're doing--we can control it.  More specifically, any attitude reflects our conversations with ourselves:  it is the direct result of our self-talk.  If we tell ourselves we're not doing well and nothing works, we will feel defeated and frustrated.  If we talk to ourselves in ways we'd never want to hear from others, we'll experience attitudes that we'd never want to be around.  

Once we switch lenses to the verb mode, we can see that our attitude is nothing more than the tone of our internal conversation.  Perfectionistic self-talk that emphasizes where we fell short leaves us feeling like we're falling short.  Worry talk about the future leaves us less than energized about pursuing the future.  Our attitude is our relationship to ourselves, made visible.  If we have a caring, supportive relationship to ourselves, we're more likely to face life with gratitude than attitude.

So, in the spirit of verb-thinking, here's a specific activity that can turn negative attitudes around:

Every time you catch yourself criticizing yourself or thinking negatively about your trading performance, write in a thought diary one or two constructive steps that you will take that day and week to make an improvement.  A great way to generate those constructive steps is to reflect on past positive experience and performance and identify what you did well at those times.  Those steps become your near-term goals and your subsequent focus.  It is important that what you write becomes what you do:  goals must turn into action plans. 

In other words, a good thought diary turns negative thinking into constructive thinking:  every self-criticism is answered with a positive change focus.  Negative thinking says, "I'm not doing good enough."  Constructive thinking says, "I'm making myself better."  

That's how we make positive experience a verb rather than a noun:  we can't always defeat a negative attitude with a positive one--sometimes things just aren't positive.  But we can always overcome a focus on what's bad with a focus on what we can improve.  Having a good attitude doesn't hinge on doing well; it is the result of appreciating the ways in which we're getting ever better.

Further Reading:  The Power of Opposites
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Resources for Traders and More to Kick Off the Market Week

*  Above is my intermediate-term measure of market strength (red) charted against the cash SPX going back to the beginning of 2014.  The strength measure takes the sum of 5, 20, and 100-day highs and subtracts the sum of 5, 20, and 100-day lows specific to the SPX stocks.  It then smooths this number with a 10-day moving average.  (Raw data via the excellent Index Indicators site.)  Note that the strength measure has been waning since late 2014 and has recently turned downward from a relatively low peak.  When strength has been above zero going back to 2012, the next 20 days in SPX have averaged a gain of +.86%.  When strength has been below zero, the next 20 days in SPX have averaged a gain of +2.34%. 

*  Here's a very important Forbes article on performance co-written by Ted Hayes, Ph.D.  It explains why the single most important thing you can do to improve trading is develop and implement a strengths-based performance framework.  Some excellent links to strengths-based tests and resources. 

*  What to look for in market bubbles and other great reads for the week from Abnormal Returns.

*  Here are some great resources for you quant types out there:  

-- A very impressive collection of market stats from Vic Scherer.

-- Great breadth data and an impressive query engine from Kora Reddy.

-- My long time source for breadth data, Index Indicators also has a query engine.

-- A new primer on quant analysis from Adam Grimes.

Have a great start to the week!

Brett
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Bayesian and Static Reasoning in Markets: Trading With an Open Mind

In a recent post, I highlighted the range trade in the ES futures over the past several months.  My point was that the market has been showing diminishing breadth at successive highs and also less weakness at successive lows during that range.  Generally, lengthier ranges lead to lengthier directional moves, as they are part of longer-term market cycles.  So the breakout from the current range should ultimately be a significant one.  Will the market break out of its range imminently, or will the range continue for another month or more?  Will the ultimate breakout be to the upside or downside?  Will we see a fakeout, false breakout prior to an eventual move to new highs or lows? 

My worst trading--and the worst trading I've observed of many traders--has been the result of what could be called static reasoning.  Static reasoning takes a variety of evidence, assembles the evidence into a conclusion, and then places trades based on that conclusion.  Risk taking is often a function of one's degree of belief in that conclusion.

Static reasoning is problematic for two reasons:  1) it is subject to overconfidence bias, as we take a firm stance on a view that we own; and 2) it is subject to confirmation bias, as we tend to process new, incoming information in the light of our convictions.  When I've seen traders take larger than desired losses, it's generally not been because they've held onto marginal views.  Rather, they have sized up their preferred views, stuck with those views in the face of contrary market information, and ultimately lost the position when drawdowns became uncomfortable.

I have found my best trading to result from what could be called Bayesian reasoning:  a thought process that reflects a Bayesian, probabilistic way of thinking.  Bayesian reasoning begins with a hypothesis, but it is a flexible hypothesis that updates with new, incoming information.  One's confidence in the hypothesis waxes and wanes with new information, and one's hypothesis can quickly change with new information.

With static reasoning, a market view is something you have and trade with.  With Bayesian reasoning, a market view is fluid and continually evolving.  

Trading leading up to and including this past Friday was a good case in point.  We traded firm for most of the week, with relative strength in small cap shares.  Volume had been coming down in recent sessions and, by April 15th, we saw new highs in the broad NYSE Composite Index not accompanied by an expansion in the number of stocks registering fresh highs.  With each observation of low volume and diminished new highs, my confidence in an upside breakout diminished.

Friday saw new information come into the market regarding China and Greece.  There was a strong selloff in pre-market hours.  Volume expanded, as did volatility.  New market participants were joining the fray, and they were joining with a downside bias.  That led me to sell an early, pre-opening bounce in the ES futures.  At that point, the evidence tilted toward continuation of the range and a short-term handoff from bullish to bearish control of the market.  I reasoned at the time that investors would not want to risk bad headlines over the weekend and so would be likely sellers in early New York trade.

That indeed materialized, but then something interesting happened in mid-to-late afternoon.  We had seen steady selling in stocks, as measured by the NYSE TICK.  When I ran a study of lopsided selling days such as the one in progress, I noticed a tendency for the market to bounce higher the next day or two.  At the same time, I noticed continued selling pressure in stocks (negative TICK values), but now the ES futures were holding above their lows for the day.  Selling was no longer able to get price higher.  I still liked the range-based view but the trade no longer looked great from a risk/reward perspective and I took profits.

Am I a bull?  Am I a bear?  Not really either, and the question presumes a degree of static reasoning.  What made Friday a good day in the market was the fluid transitioning from waning bullishness to waxing bearishness to waning bearishness.  We could indeed gap lower in the near term and take out Friday's low, but that's not where the odds were at the time.  Let's let the bulls take their turn and see what they can bring to the market.  Should we get a feeble rally and a lower high, there will be plenty of opportunity to resume a downside trade targeting the lower end of the recent range.  Should we get a more substantial rally, then we can update evidence for continued topping in the range or even upside breakout.

Bayesian reasoning means trading with an open mind and staying flexible in the face of new information.  Think of it this way:  we're in an ongoing conversation with markets.  In any conversation, if you stay locked in what you want to say, you become less sensitive to the other person.  A good conversationalist is a good listener, picking up on subtle cues and adjusting one's own tone and response accordingly.  In markets as in conversations, closed minds and strong views lead to tone-deaf interactions.

Further Reading:  The Importance of Emotional Creativity
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Breakout in the Making?

Here are the ES futures over the past several months.  Somewhat volatile and in a range.

A few interesting stats:

Stocks across all indexes making fresh 3-month highs and lows:

2/13/2015 - 510, 86
3/2/2015 - 513, 158
3/20/2015 - 708, 113
4/15/2015 - 570, 89

1/29/15 - 172, 449
3/10/15 - 137, 440
3/26/15 - 82, 213
4/17/15 - 131, 167

Fewer new highs, fewer new lows from March to April.  

Not strengthening.  Not weakening.

So far.

What I Learned By Studying My Exits

An interesting question posed on the Tradeciety site asks the one thing you wish you had known when you started your trading career--and gives the responses of a number of experienced traders.  Most of those responses focus on sound trading practices and ways of learning trading--sound universal lessons.

A worthwhile variant of that question is:  what's the one thing you wish you had known at the start of the year?  In other words, what have you been missing in the last few months of trading?

I recently conducted my own trading inventory and examined in detail what has worked and not worked.  The results were illuminating.

My exits have been bad.  In some cases, they've been really bad.  What I mean by that is that:  a) they've been less rigorously thought through than the entries; b) they've been reactive to the pain of drawdown and not the risk/reward at that moment; and c) they've been at poor locations.  A surprising proportion of my trades would have been profitable had I held the position with a wider stop.  The seemingly good risk management significantly hurt profitability.

The problem--and I see it with traders I work with--is the misalignment of goals for the upside and risk management on the downside.  At a given, reasonable, but positive Sharpe ratio, a trader seeking X% returns is going to draw down a meaningful percentage of X% at some time.  Traders--including myself--feel the desire for the X% upside, but cannot psychologically or practically tolerate the accompanying drawdown.  It is not coincidence that my hit rate on trades placed with smaller size (less risk) has been quite good.

Ultimately this is a problem of lack of diversification.  A well constructed portfolio consists of many relatively independent bets, each with positive expected return.  This smooths the equity curve while allowing the trader to place a higher proportion of capital at work.  Diversification requires ongoing research and development--and the ability to see multiple edges in the market.  It is much easier to allow trades to breathe and hit relatively wide stops when there are multiple trades working for you.  A great deal of the challenge of dealing with emotions in trading is a function of poor money management.  It's tough to trade dispassionately when all your eggs are in one basket.

Further Reading:  Diversifying Your Emotional Portfolio
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Quick Insights With Deep Meanings

*  J.C. Parets on the value of homework.

*  Mark Yusko on the power of our social environment.

*  Derek Hernquist on backtesting.

*  Brian Shannon on investing's key lesson.

*  Urban Carmel on the market's sentiment.

*  Ambrose Evans-Pritchard on deflation.

*  Steve Burns on the greatest challenge in trading.

*  Think about the meaning of this:  Since 2014, when SPY daily volume has been in its lowest quartile, the next 20 days in SPY have averaged a loss of -.06%.  When SPY daily volume has been in its highest quartile, the next 20 days in SPY have averaged a gain of +2.71%.  

Further Reading:  Evaluating Your Trading
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Sleep and Performance: The Quality of Our Nights Affects the Quality of Our Days

I find that a surprising proportion of what sets traders up for success during the day is what has happened the previous night.  We know from research that the proper quantity and quality of sleep aids concentration and learning and that disordered sleep can impair our cardiovascular health.  Sleep also has a beneficial impact on our mood and is associated with improved thought and memory.

It is fascinating that sleep disturbances are present in over half of patients with psychiatric problems--a far greater percentage than in the general public.  This has led to the observation that sleep disruptions are not only symptoms of problems such as anxiety, but active contributors to those.  One in five patients with depressive disorders are suffering from sleep apnea--disrupted sleep often associated with snoring. 

One study found that financial decision making was meaningfully impaired when subjects were sleepy due to poorer judgment about the task being undertaken.  It is when tasks are complex and challenging that we're most likely to be impaired by poor sleep.

Here is an excellent article from Maria Konnikova on how our performance is impacted by how we wake up in the morning.  Sleep inertia, she reports, significantly affects our cognitive functioning.  It appears that being process-driven in how we sleep is as important to our functioning as being process-driven in our work during the day--and indeed may set us up for either success or failure in our ability to work in disciplined and productive ways.

Further Reading:  Three Things to Improve Your Life Now
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Historic Market Strength or the Start of a Bear Market?

Jesse Felder looks at the stock market from the vantage point of historical valuation and finds us in rarefied territory.  Using other measures, Jesse Colombo arrives at a similar conclusion.  This strikes me as tremendously relevant for investors.  From a timing vantage point vis a vis shorter-term traders, I have more questions.  Prior to the large drops we saw in 1998, 2000, and 2007, for example, we saw a ramping up of volatility (VIX) and stocks making fresh new lows.  In other words, rises in volatility and weakness in leading sectors preceded those bear markets.  I'm not seeing those things at present, but the possibility that we're operating on borrowed time strikes me as a valuable one to entertain.  I'm just not sure we can expect historically normal market cycles when we have extraordinary global monetary policies. 

An extraordinary wealth of economic information and perspective is offered by Jeff Miller at Dash of Insight.  Measures he tracks suggest a healthy degree of strength in the economy.  He also raises the issue that bear markets tend to occur late in hiking cycles, not early.  Again, it may be difficult to extrapolate from past cycles to this present, extraordinary one, but Miller also notes that overvalued markets can become quite further overvalued before they run into trouble, citing data from Capital Speculator.

What we see is that intelligent market observers see the market quite differently.  My synthesis of all this is that we are historically overvalued *and* we're not yet seeing worrisome economic or market weakness.  Perhaps the best synthesis of all, however, is to go to websites such as the above and track down the original sources of data and the links from recent posts.  You are guaranteed to find intelligent perspectives that will broaden your own.  

Further Reading:  Creativity and Trading
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A Simple Strategy for Developing Yourself as a Trader

Here is a simple formula for developing yourself as a trader:

Find the people who most consistently come up with the most original and useful observations and ideas, study their thought processes (how they're generating those ideas), replicate those ways of thinking for yourself, and take the time to begin thinking like them.  Imagine doing that across many virtual mentors over time so that you begin to integrate the best thinking of the best people.  That is how imitation turns into innovation.  

Take a look at who you're following in social media.  If you're spending much time reading material from those you don't want to internalize, you'll wind up with little cumulative development.  A great exercise would be to curate the $STUDY stream of StockTwits and immerse yourself in the educational offerings of only those you'd like to emulate.  

You can't elevate your game unless you surround yourself with the best out there to challenge you, inspire you, and inform you.  You win by studying winners.

The same is true for stock picking.  How many people truly study the best performers during any given period and reverse engineer that performance?  There are common features of best and worst performers among stocks and markets, just as there are common features of best and worst traders.  You learn to select the best trades and investments by studying the best trades and investments.

Kudos to @ivanhoff and @howardlindzon for their recent offering on identifying the next Apple among market performers.  The greatest investments don't start as the most optically appealing choices in many cases.  Similarly, great trades to the long side often start as scarily weak markets--October, 2014 being a recent case in point.  If you study one winning idea after another, however, you begin to see common threads.  You immerse yourself in winning trades and, after a while, you recognize patterns as they emerge.

It's great to focus on our mistakes and correct our errors.  Reducing the negatives of performance, however, will never in itself generate elite positives.  If you want to perform at high levels, you have to study--and internalize--high level performance.

Further Reading:  The Success Pyramid
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Opening the Week With New Ideas

*  Here are three charts that I use to track demand and supply in the broad stock market.  I decompose the time series for the NYSE TICK (number of stocks upticking vs. downticking at each moment of the trading day) into a measure of Buying Pressure (top chart; a measure of upticks); Selling Pressure (middle chart; a measure of downticks); and Balance (bottom chart; the daily net of upticks vs. downticks).  In recent sessions, we've seen relatively restrained buying interest and also relatively restrained selling.  This is typical of low volume, low volatility markets.  On a net basis, we've generally seen more buying than selling pressure and stocks have drifted toward their highs over this period.  This is as much due to a relative absence of sellers as the positive presence of buyers.  Institutional players--those that drive volume as buyers or sellers of baskets of stocks--have been quiet of late, creating few surges of either buying or selling activity.

*  When academic reviewers took a look at the profitability of traders, they were shocked by how poor the results looked.  Here's my psychological look at what separates the winners from the losers.

*  More evidence that active fund managers as a group fail to outperform their benchmark indexes.  In fact, managers in every category fail to outperform.  You would think that half would outperform by sheer chance.  As the article emphasizes, however, the odds of such across-the-board underperformance occurring by chance are ridiculously small.  It's not that managers lack a positive edge.  They actually seem to have a significantly negative one.

*  It's very difficult to not find good posts on the Quantocracy site.   

*  It's also very difficult to not find something good in the weekly top clicks at Abnormal Returns, including an unusually good study of moving average rules--what works and doesn't work.

*  The $STUDY stream from Stock Twits invariably contains some gems.

*  Here are some coming resources from Adam Grimes, including a primer on how to study markets with quant tools.

 *  Great post from SMB on what golf teaches us about trading.

Have a great start to the week!

Brett

The Three Paths to Success in Financial Markets

I propose that there are, at root, three basic paths to success in financial markets that correspond to three kinds of market participants.  These are very different approaches to markets and require quite different skills, knowledge, and talents.

The first path to success in markets is the path of the statistician.  The statistician is one who identifies the probabilities of outcomes as a function of current and past conditions.  A statistician, for example, might notice that two currencies are trading out of line with each other because of temporary flows attributable to mergers and acquisitions and place a bet that these will return to their historical relationship.  The idea for the statistician is to construct a portfolio that consists of many distributed bets, each of which has a favorable probability of paying off.  

The second path to market success is the path of the theorist.  The theorist is a big picture thinker who identifies an antecedent set of conditions that, over time, should drive the price movements of financial assets.  Macro money managers, those who look at geopolitical events and macroeconomic developments such as central bank policy shifts, are classic examples of theorists.  Their approach to markets is top down:  understand the big picture and then define a diversified set of bets from that understanding.  For instance, the theorist will notice that central bank policies are notably more dovish--providing more liquidity--in some countries than others and will buy stocks in those countries and sell stocks in the more hawkish regions.

The third path to success in financial markets is the path of the trader.  The trader is a pattern recognizer who exploits quick-developing shifts in sentiment, supply/demand, and relative movement.  A trader, for example, might notice that episodes of selling pressure in a a few, visible large capitalization stocks are not accompanied by significant selling pressure across the broad market.  When the selling slows down in the large caps and the broad market begins to catch a bid, the trader quickly joins that reversal for a move higher in the broad index.  Diversification is achieved, not necessarily by making many independent, simultaneous bets, but by making many independent short-term bets over time.

These three paths are extremely different.  Whereas the theorist is deductive in thinking, moving from big picture understanding to individual trades, the trader is inductive, noticing relatively minute patterns in order flow or price movement and generating trade ideas from those.  The statistician is highly analytical in a quantitative way, emphasizing prediction.  The theorist is more interested in a synthesis of information to achieve understanding.  The trader is more likely to be adept at intuitive pattern recognition--in Kahneman's terms relying on fast, rather than slow thinking.

These differences call on very different skill sets, knowledge bases, and personality strengths.  The action orientation of the trader is quite different from the analytical, cerebral orientation of the statistician.  The theorist needs confidence in his or her big picture understanding of the world.  The statistician relies on objective odds to take subjective appraisal entirely out of the trading process.  Statisticians gain expertise from intensive quantitative research; theorists gain expertise from the qualitative assembly of many different facts and trends; traders gain expertise from immersion in market patterns.

While it is popular to speak of "hybrid" traders that combine elements of these different paths, my experience is that a successful combination of approaches is much less common than is typically recognized.  Indeed, it is much more common for trading problems to emerge:  a) when market participants don't clearly identify their path to success and hence meander among different approaches; and b) when they attempt to blend paths and ultimately don't play to their strengths.

A classic example of this is when big picture macro traders become overly concerned with limiting their risk and end up behaving like short-term traders.  Similarly, statistical, quantitative traders can allow their priors to bias their research processes, skewing their results over time.  Traders with a good feel for markets can suddenly trade in tone deaf ways when they become locked into big picture views.  What generates success for one path can undermine success in the others.

Many market participants fail over time because they lack a consistent path to success and because they lack the self-understanding to chart the path that is right for them.  In markets as in relationships, success often requires a commitment to one path and a willingness to leave other ones behind.

Further Reading:  Three Winning Trading Practices
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The Market Is Not Getting Stronger, But Is It Getting Weaker?

The recent post tracked the diminished strength of the stock market, with fewer stocks making new highs over time.  But is a market with reduced strength necessarily one with increasing weakness?  This is a very important question, as it gets at the heart of when breadth is and isn't a problem for the market.

Above we see a chart of SPY from the start of 2014 to the present.  In red, we see the number of stocks across all exchanges that registered fresh one-month lows each day.  (Raw data from the Barchart site.)  Notice that we're only looking at new lows--a measure of weakness.  We are not combining the new highs and lows, which can muddle the views of strength vs. weakness.

What we see are sharp elevations of new lows around important cyclical bottoms.  What we also see is that new lows begin creeping higher before markets top out during these cycles.  This was dramatically the case during the second half of 2014 but also occurred leading up to the March top of this year.  While new highs have been waning per the recent posts, notice that we are seeing *very* few new lows most recently.  The market has not been getting stronger in terms of breadth, but neither has it been weakening.

On Friday, we saw 168 shares post new monthly lows across all exchanges.  That is well below the median value of 350.  When we have had fewer than 200 stocks post new monthly lows since the start of 2014 (N=58), the next five days in SPY have averaged a gain of +.34% vs. an average gain of +.13 for the remainder of the sample.  While a market without weakness might appear "overbought", in fact it is healthy in the short run.  In order for the broad stock market to roll over, we have to see some leading stocks and sectors display weakness.  At the moment, we are indeed "overbought", but not weak.

Further Reading:  Breadth and Market Cycles
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Three Views of the Breadth of Stock Market Strength

Here are updated charts for what we might call the breadth of market strength and weakness.  (Raw data from the excellent Stock Charts site.)  Any individual stock can give a buy or sell signal according to rules from a technical trading system.  The top chart reflects Wilder's Parabolic Stop-and-Reverse (SAR) system; the middle chart tracks a system based on Bollinger Bands; and the bottom chart follows a system derived from Lambert's Commodity Channel Index.  The charts reflect the balance between buy signals and sell signals for all NYSE stocks on a daily basis.  They thus capture the breadth of strength and weakness for the general market.

As a whole, the signals tend to top out ahead of price during intermediate-term market cycles and bottom shortly ahead of price.  Of the three systems, the SAR tends to be the fastest moving (greatest lead times); the CCI the slowest.  When all are in sync, turning lower or turning higher, we generally find ourselves in the relatively early phase of a trending move.  I find the interplay among the signals to be helpful in identifying where we're at in those intermediate-term cycles. 

Note that SAR has recently turned negative, despite the recent price strength.  The Bollinger Band measure is coming off a high reading but remains positive.  The CCI system recently gave a high reading, which has preceded the most recent market strength.  It has fallen off that high but remains neutral.  As a whole, the signals are showing reduced breadth of market strength, but not net weakness--consistent with the waning breadth readings noted in yesterday's post.    

Further Reading:  Tracking the Breadth of Market Strength
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Weakening Breadth and Rising Volatility in the Stock Market

Here are the reasons I am cautious about the stock market at this juncture:

1)  We are seeing good buying activity in stocks, as gauged by the NYSE TICK which has been making new highs on a cumulative basis.  Among the large caps (top chart), that buying activity is no longer able to give us fresh price highs.  (Credit for the top three charts to Index Indicators).  Note that breadth in the large caps has continued to dwindle throughout 2015, with fewer 100-day new highs vs. lows.

2)  We have seen greater recent price strength among mid-caps (second chart from top) and small caps (second chart from bottom), as we're hovering near price highs.  Despite this, the breadth specific to mid-caps and small-caps has also been waning, with fewer shares making new highs vs. lows in April than March.

3)  If you look at the cash VIX, it seems as though volatility remains crushed, as VIX is sub-15.  Actual volatility, however, as measured by average true range over a rolling 100-day period, has been higher during 2015 than during the vast majority of the prior two trading years.  Rising volatility in stocks historically has been associated with weakening markets, not strengthening ones.  Indeed, volatility picked up at market highs in 2000 and 2007 well before the subsequent bear markets.  While I don't expect that kind of bear market activity currently, any downside break from here would likely see greater volatility than recent corrections.

I also note that the volatility of realized volatility (vol of vol) has been higher recently than at any time since 2013.  The recent rise in realized volatility and vol of vol helps to explain why short-term traders have had difficulty trading U.S. stocks:  We've had movement, but not trend.  It's been a choppy, volatile range trade.  Buying strength or selling weakness--trading with a fear of missing out--has been a consistent way to lose money.  Viewed on a longer time scale, however, this market appears to be one of narrowing breadth--even among those smaller cap sectors that have been strongest.  That keeps me cautious.

Further Reading:  Macro Themes Impacting Stocks
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The Importance of Understanding WTF We're Doing as Traders

I noticed that Bruce Bower, via SMB, has posted on the topic of what a winning trading methodology looks like and has released an e-book on the topic.  Bruce emphasizes that a methodology must be grounded in a replicable process and that this process must fit well with the personality and skill sets of the trader.  A very important observation from Jack Schwager in his Market Wizards series is that successful money managers have quite different skills, personalities, and workstyles.  These result in very different trading styles.  What creates success is not adherence to a particular style, but the ability to exploit market inefficiencies in a manner consistent with one's own abilities.

Replicability as a process and fit with a trader's skills and personality are necessary for a successful trading methodology, but not sufficient.  Bruce points out that the method must also manage risk effectively and filter the many possible decisions into ones that offer a reward that is superior to the risk incurred.  In short, a successful method must possess an "edge":  positive expected returns over time that justify the risks incurred.

But there is one other ingredient in a successful methodology that tends to be overlooked:  understanding.  

If you think of a trading methodology as a core aspect of a business plan, the element of understanding becomes clear.  A good business plan doesn't just describe a business with a process and a fit with the owner.  Nor does it simply limit risks and pursue greater rewards.  The good business plan starts with an understanding of the consumer and the drivers of demand in the marketplace.  A startup business meets an identified need.  Entrepreneurs must understand their markets.

Too often I see trading plans/methods that describe "setups" that are devoid of market understanding:  a shape on a chart, a reading on an indicator, a news development, a data release, etc.  Missing from such an approach is a clear identification of what drives prices and how one's methodology will uniquely exploit such drivers.

A very worthwhile text is this regard is Expected Returns from Antti Ilmanen.  Ilmanen identifies specific factors that uniquely impact the pricing of markets, such as value, momentum/trend, carry/roll, volatility, seasonality, liquidity, and the like.  Bender and colleagues break down factors into value, size, volatility, yield, quality, and momentum.  If we think of trading methodologies as business plans and factors as defining opportunity sets, then the solid methodology should be grounded in an explicit understanding of the factors  being targeted and the ways in which the trading approach uniquely exploits those factors.

A simple example would be a breakout trading style that defines periods of market balance and pursues directional moves that emerge from this balance.  That would be a strategy for exploiting momentum and possibly trend.  That would be quite different from a value-oriented long/short strategy that buys undervalued companies and sells stocks of similar companies that are more richly valued.

Three simple tests for a sound trading methodology would be:

1)  Can you clearly identify the factors that your methods/plans will be exploiting?
2)  Can you clearly explain why your methods uniquely exploit these factors?
3)  Can you demonstrate with research or trading evidence that the methods you're trading indeed do uniquely exploit the factors targeted?

If you were investing in a business as a potential venture capitalist, you'd ask those questions of anyone pitching their business to you:  Can you identify the business opportunity?  Can you clearly explain how your proposed business exploits that opportunity?  Can you produce evidence that your business indeed does exploit that opportunity?

If you wouldn't invest in a business plan that lacked clear answers to these questions, why would you invest in a trading plan similarly devoid of understanding?

Traders are entrepreneurs:  We're most likely to trade with confidence and conviction when we possess a deep understanding and belief in what we're doing.

Further Reading:  The Proactive Personality of the Trader
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Reinventing Yourself: The Key to Long-Term Success

I noticed a couple of good articles on Duke coach Mike Krzyzewski in the wake of Duke's win for the 2015 NCAA championship.  The first article outlined how he adapted to different times in recruitment by going after players who weren't committed to four years of college.  The second article pointed out Coach K's time with USA basketball and how coaching pros helped him change the way he coached his new players.  When you put the articles together, you realize that the coach who won his fifth national championship was quite different from the one who won his first.

The winning team at Duke was dominated by freshmen, many of whom will almost certainly jump to the pros after this year.  The opposing coach, no doubt unhappy in defeat, mentioned that his team doesn't do "rent-a-player"--a clear swipe at how professionalized the game has become.  Gone is the idea that these are student athletes.  They are athletes who are students for a while.

That is what makes adapting to the future and making changes so difficult--and so rare.  When you deeply believe in what you do and then have to adapt to a new future, it feels like self-betrayal.  It seems as though you're going against everything you believed in.  And in a sense you are.

I was trained in longer-term psychodynamic therapy during my graduate internship.  It was great training and informs my work to this day.  When I began working in student counseling at Cornell, however, I realized that my training in mental illness had left me poorly prepared to work with mental health.  Out of that, I researched and learned brief therapies to help healthy people make changes in their lives.  The psychodynamic model stressed building a relationship and working with people over months and even years.  The brief model assumed that the first session could well be the last one and emphasized rapid change over long-term insight.

I was accused of being superficial and betraying my training.  At times I felt that way.  The only way to work with a new group, however, was to work in new ways.  No one adapts to the future without leaving parts of the past behind.

A trader I'm currently working with--he'll know I'm talking about him!--has made extraordinary strides in remaking himself.  He used to trade remarkably short-term for a big trader, but he found that the short-term drivers of price in a QE world no longer held up.  Extending his holding periods, he has changed his way of generating trade ideas and managing the resulting positions.  He reminds me of Coach K.; he is so invested in winning that he's been willing to lose the past.  That ability--not to stick to a process, but reinvent one--is what is also returning him to the winner's circle.

Further Reading:  Performance and Creativity
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New Tools and New Views for a New Week

*  This time is different?  Money flow into the SPY index ETF has notably dwindled during 2015 after having tracked price pretty well for most of 2014.  Money flow reflects price times the number of ETF shares outstanding.  My figures show significant flow differences from sector to sector.  I will be posting those numbers this week.  In general I've found money flows to be a good (contrary) sentiment measure that is independent of options-related sentiment indicators.

*  Thanks to a savvy trader for pointing out this portable biofeedback unit measuring brain waves.  The idea is to directly measure brain activity related to concentration/focus, stress, relaxation, etc.  What's unusual about the unit is that it allows measurement even when the wearer is moving around.  I'll look into this further, particularly for validation studies that show a high correlation between the readings of the portable unit and those of standard EEG machines.  

*  Here's another new tool on the market that looks quite interesting:  The Edgewonk electronic journal is integrated into Excel and integrates your trading observations (mood/psychology; thoughts about markets) with your P/L.  The journal also tracks performance metrics, so that you can see where your trading has been strongest and weakest.  Over time, this could form a great database for learning and performance improvement.

*  Podcasts have been gaining in popularity, and a number of worthwhile sites are out there.  Abnormal Returns curates excellent podcasts each week, including the recent selection that includes discussions on creativity and technical analysis.  A wide ranging collection of podcasts related to positive psychology can be found here.

*  Here is the collection of Forbes blog posts related to positive psychology, with a particularly look at the factors that contribute to success in performance-related fields such as trading.

Have a great start to the week!

Brett
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Winning Through Defeat: The Secret to Resilience

Thanks to a savvy trader for pointing out this Lewis Howes podcast with Eric Greitens on the topic of resiliency and falling in love with pain.  A former Navy SEAL, Greitens learned about resilience first-hand during his training.  In his book, he points out, "If we are trapped in a life where everything is provided for us, our minds fail to grow, our relationships atrophy, and our spirits deteriorate."  We grow through challenges, including those that are hardships.  Greitens points out that we never bounce back from adversity; rather, we find healthy ways to integrate those experiences into our lives.  When we do what we are afraid to do, we don't return to the person we were.  We find ourselves just a bit more fearless.

When Angela Duckworth researched the phenomenon of grit, she found that it wasn't the highly successful children who were most able to sustain effort in the service of long-term goals.  Those who knew little other than success and were frequently praised by parents had very little experience with adversity.  That made it difficult to persevere.  When children experienced setbacks and challenges, they were more likely to develop the internal resources needed to sustain efforts.  Grit is resilience sustained over time.  As Duckworth explains, "grit...entails having and working assiduously toward a single challenging superordinate goal through thick and thin, on a timescale of years or even decades." 

Trading financial markets is unique in that it regularly forces us to experience loss and setback.  The uncertainty built into markets ensures that we will go through drawdowns.  The ever-changing nature of markets ensures that what worked today may not work tomorrow.  There can be no successful trading without resilience, and there can be no successful trading career without grit.

When we approach life as a gymnasium, even the most routine activities can be approached as workouts that challenge and develop us.  Every item in our daily planner--even those connected to recreation--can be pursued in a conscious, effortful way or in a routine manner of going through the motions.  It makes sense for us to undertake routine activities as routines, as this saves energy for more demanding situations.  But if all of life becomes a series of routine activities, we become less capable of responding to demands.  No one builds strength and endurance in life's gym by tackling the equivalent of ten-pound weights.

What's the key to becoming a resilient, gritty person?  I strongly suspect it's the ability to tap into hidden reserves of energy--that mental, emotional, physical, and spiritual second wind--that become available to us under conditions of high challenge.  Emilia Lahti refers to this by the Finnish term sisu:  "the second wind of mental toughness."  The paradox here is that challenges drain us of energy.  Extraordinary challenges--especially those that inspire us--help us tap into new and greater sources of energy.  When we tackle normal efforts, our willpower powers down.  When we reach for greater things, we find our willpower renewed.

In the long run, we don't sustain perspiration without sustaining inspiration.  Goals challenge us, but eventually wear us down unless they uplift us and pull from us the kinds of efforts that yield that second wind of sisu.  If you're cold and exhausted after long days of workouts and little sleep and that's all that's on your mind, you're going to drop on request and ring that bell to get yourself out of the SEAL program and into a hot shower.  The only thing that can move you past that place of pain is a commitment to your team, a commitment to your future, and a commitment to serving a larger cause.

Resilience begins with purpose.  We tackle life as a gym when workouts become the path to a greater future.

Further Reading:  From Setbacks to Success
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Why Do Disciplined Traders Make Bad Decisions?

We've all known traders who lack self-control.  They react rather than act, making decisions impulsively, often based on those twin fears of missing out and losing money.  It's no surprise when such traders draw down.  In a very real sense, they trade their hopes and fears, not the markets in front of them.

But how about traders with excellent self-control?  I know many: experienced money managers with long histories of success.  Once in a while they make mistakes that they describe as rookie errors.  They don't seem fearful or reactive, yet they will chase bad prices or stick with losing trades too long.  What's going on in such cases?  Aren't discipline and self-control supposed to produce good trading outcomes?

An interesting window of insight into the bad decisions of good traders comes from research conducted by Maria Konnikova that identifies the limits of self-control.  Konnikova finds that people high in self-control tend to be more overconfident than others in situations where control over outcomes is limited, but perceived control is high.  In other words, those with high self-control can also fall victim to an illusory sense of control.  That leads to poor decisions.

What is particularly fascinating in Konnikova's work is that people with high self-control are most likely to overestimate their actual control in situations when they are experiencing positive emotions.  Konnikova notes, "...the positive affect that usually accompanies both the illusion of control and high self-control can be an Achilles heel of high self-control in certain environments with limited actual control, creating a feeling of overconfidence that translates into suboptimal decision making."  It's when traders are winning and feeling good that their confidence is most likely to morph into overconfidence.  That leads them to overestimate their control over market outcomes and make decisions based upon illusory--not actual--control.

What is the solution to this dilemma?  Konnikova explains that the self-awareness of those high in self-control can help them recognize that positive emotions are a threat to their control, thus cooling them down when their confidence is running hot.  This fits very well with observations I have made in the course of working with traders: often the worst decisions are made when the trader has just made money, not when he or she has drawn down.  We don't normally think of positive emotion as a risk factor, but in fact any experience that takes our attention from markets and leads us to focus on outcomes rather than process is likely to interfere with performance.

We commonly hear that traders should take the most risk when they have the highest conviction in their ideas.  That can work as long as conviction doesn't come at the expense of self-awareness.

Further Reading:  The Lack of Profits From Market Prophets
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Three Things We Can Do To Boost Our Trading Performance

Hurdles seem small when we're on top of our game, and they can feel insurmountable when we're not.  The best traders I've known are those that work on their performance when they're on top of their game and they work on it when they're not.  Their competition is not just with markets, but with themselves.  By focusing on getting better, they end up staying profitable.

So when we're at those valley periods, the great things we see can be overwhelming obstacles or inspiring goals.  Here are three things traders can do to turn discourage into courage:

1)  Renew, re-energize - No one can deliver peak performance when they're mentally, physically, and spiritually exhausted.  As the recent post points out, we are most likely to sustain the discipline to reach our goals if we renew our resources.  There is no sustained work quality without life quality.

2)  Reach beyond yourself - The best way to clear your head is to get out of your head and engage in something outside yourself.  By finding a positive motivation far greater than the frustration you may be feeling, you tap into new sources of inspiration.  Frustrated with your work?  Double down on the parts of your life that mean even more to you than your work.

3)  Set yourself up for success - What do basketball coaches do when a player goes into a shooting slump?  They call a play that allows the player to take a high percentage shot.  Make an easy basket or two and suddenly the rhythm and confidence come back.  An important path to success is always having goals, always making sure they're challenging and meaningful, and always ensuring they're attainable.

It boils down to this:  Winners take care of themselves when they're down.  Losers kick themselves when they're down.  You are always coaching yourself, in how you approach success and in how you approach defeat.  Peak performance requires peak self-coaching.

Further Reading:  Finding Your Zone
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What We Can Learn From Options Skew

Above is a chart of CBOE options skew for the S&P 500 Index from 2014 to the present.  The skew index measures the degree to which index options traders are bidding up out of the money puts relative to calls.  The index moves between 100 and 150, with 100 meaning that traders are not pricing in negative tail risk and 150 reflects a high degree of negative tail risk pricing.  This can be viewed as a sentiment index, as it reflects the degree to which traders are hedging against market risk.

Interestingly, we've tended to see low skew numbers near intermediate term lows in SPY and high skew number near intermediate-term tops.  This is different from what we see with put/call ratios.  Here we see a higher degree of tail risk hedging following strength rather than weakness, perhaps as a strategy to lock in gains.

I divided the sample into quartiles.  When the skew has been in its highest quartile, the next ten days in SPY have averaged a loss of -.76%.  When skew has been in its lowest quartile, the next ten days in SPY have averaged a gain of +1.14%.  The most current skew reading is in the lowest quartile.

I will be refining this measure and looking at a longer history in the near future.  It appears to be a worthwhile complement to other sentiment measures.

Further Reading:  Equity Put-Call Ratio
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The U.S. Stock Market is Hostage to Macro Themes

Has the U.S. stock market been strong or weak so far in 2015?  As the above three charts from the excellent FinViz site indicate, the answer very much depends on the segment of the market you've been following and trading.

With respect to stock sectors, consumer discretionary and healthcare shares have performed well.  Note the strength in housing stocks (XHB) and retail shares (XRT), for example.  Commodity-related shares have been consistent underperformers.  Global economic weakness has contributed to commodity weakness, particularly in oil, which has been perceived as a boost for consumers.  Concerns over a normalization of interest rates by the Fed has hurt interest-rate sensitive shares such as utilities. 

Small and midcap stocks have performed well so far in 2015, but large cap stocks are relatively flat and mega cap shares are actually down on the year.  The idea here is that a strong U.S. dollar hurts large companies that depend on overseas sales, but a strong consumer economy can benefit small and medium sized domestic firms.  If you've equated the stock market with capitalization-weighted indexes, you've had a distorted picture of performance.

Finally, on the bottom chart, take a look at U.S. listed shares as a function of their country of origin.  Shares from Greece and Brazil have been hurt greatly; shares from much of Europe and Japan have performed well; and U.S. shares are relatively flat.  Stocks in countries that have been implementing quantitative easing programs (Europe, Japan) have been stronger than those exiting those programs (U.S.).

All this means that stocks, to a fair degree, have been hostage to macro themes.  Two visions of the future collide:  1)  The pace of economic growth in the U.S. slows and strong consumer and smaller cap shares roll over with the commodity shares and large caps; or 2) Global growth picks up and lifts the weaker segments of the market as part of a reflation trade.  I'm watching the stock market leaders and laggards closely to handicap those scenarios.

Further Reading:  Five Macro Themes Influencing the Market
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