Friday, August 14th * For me, the standout observation for today's trade is that the yuan stabilized at the overnight fix, we got a small pop in stocks, and then there has been no follow through and, as I write, that small pop has been entirely reversed. Meanwhile oil and copper continue to languish near their recent lows. The need for devaluation in China is a response to economic weakness and perhaps the best real-time gauge of that weakness is in commodities pricing. I have trouble seeing any sustained bull move in stocks until the deflationary pressures reflected by commodities weakness abate.
*
* My various breadth measures have been peaking and, recently, bounces in stock market breadth have not been sufficient to lift the index to new highs (see chart of Intermediate Strength above). I'm content, given the dynamics above, to have a small swing position for a move to oversold levels. The models are neutral, and it would not take a huge amount of weakness to turn them bullish, so at this juncture I'm not anticipating a full-on bear market move. Too, as the above chart shows, we've seen a drying up of the number of stocks making fresh lows. Should we get near-term price weakness and fewer stocks making new lows, I will use that as a tactical opportunity to take profits. If the weakness hypothesis is correct, we should not take out the overnight highs in today's trading session. With models not lined up, I'm happy to have a relatively short leash for position trades. * The breadth volatility measure referenced yesterday is at the lowest levels seen since late February/early March. Such low levels have been associated with weak returns over a next five-day basis. Pure volatility has also moved below median levels, also associated with weak forward returns over a swing basis.
Thursday, August 13th * Yesterday's note about caution chasing oversold levels when pure volatility is high turned out to be more right than I expected, as we reversed the recent weakness and rallied strongly in SPX. We dropped all the way below 2050 in the ES futures early in the day, a two-week low. Interestingly, we only saw 1058 stocks across all exchanges make fresh monthly lows vs. 1078 on 8/6 and 1862 on 7/27. Note a number of sectors that held up with relative strength, including the yield-sensitive utilities and consumer staples shares. The commodity-related stocks have also held up. This told us that the early drop was more about sector rotation than full-on risk-off--a valuable tell. Market breadth has not been weakening with the recent China related selloff.
* Pure volatility remains unusually elevated even with yesterday's rebound; when this occurs, there is usually more upside left in the move, as the combination of volatility and strength leads to near-term momentum. * The 3-5 day models are mixed: one is neutral, the other mildly bearish. The next day model is neutral. These are the kinds of signals you get in the middle of trading ranges. I could be persuaded to buy intraday weakness that holds above the overnight lows for a short-term trade higher based on the strong pure volatility, but otherwise don't perceive a strong edge. * My breadth volatility measure is hitting multi-week lows. That's a measure of the volatility of day to day breadth and it's been a helpful measure. When breadth volatility has been in the lowest half of its distribution since 2014, the next five days in SPY have averaged a loss of -.01%. When in the highest half of its distribution, the next five days in SPY have averaged a gain of +.34%. If we were to get other volatility readings dropping, the models would likely turn bearish.
Wednesday, August 12th
*
China devaluation continues as major driver of stocks globally. While
developed market equities have traded in a range over the past several
months, emerging market stocks have been in a consistent downtrend (see
EEM chart above). This suggests that a major engine of recent global
economic growth is no longer a contributing factor. It is this weakness
and not the stimulus value of the weaker Asian currencies that is
driving stock and commodity markets lower and stimulating a flight to
the safety of quality yield.
*
The 3-5 day models for SPX are neutral; the next day model ended
Tuesday very modestly bullish. The models cannot factor in
idiosyncratic market factors such as the devaluation, so I am not
relying upon them for signals at this time. Sometimes this time really
is different.
* My measure of "pure volatility"--the average price movement per unit of trading volume--has become elevated, which means that we could see outsized moves (including countertrend ones) as volume picks up. This has important implications for the setting of stops and targets on trades and makes it particularly dangerous to chase overbought or oversold price levels.
*
General game plan is to continue to sell bounces in SPX that terminate
at lower highs. If the devaluation truly is contributing to an ongoing
risk-off trade, we should not trade above the levels seen just prior to
the most recent yuan fix. I continue to harbor doubts about any kind of
sustained Fed hiking in the face of what is increasingly looking like a
currency war of competitive devaluations.
Tuesday, August 11th * China devaluation key piece of overnight news; USD rises vs. Asia; stocks give back a chunk of Monday's gains. China devaluation affirms government concern over economic weakness. Difficult to see much in the way of Fed hiking with Asian goods becoming cheaper in U.S. and dampening inflation. Also difficult to see Fed hiking in any sustained way in the face of what is increasingly looking like a currency war. All in all, this is consistent with the macro themes recently outlined and should be supportive of U.S. stocks offering yield. Economic benefits of lower inflation/lower prices are tempered by headwinds from higher USD. * My 3-5 day models for SPX turned modestly bearish at end of day on Monday, but reaction to the China news swamps model effects. Next day model for SPX turned from modestly bullish to neutral. * General game plan is to sell bounces in SPX that fail to take out Monday highs. Commodity markets have been a good proxy for the Asia weakness theme, and it is difficult to see stocks sustaining a rally if that theme is dominant.
* While the overall SPX index has traded within a multi-month range (blue line above), the cumulative number of stocks in the NYSE universe trading above their upper Bollinger Bands vs. below their lower Bands has been steadily declining. That tells us that we're seeing more significant weakness than strength among individual stocks, no doubt aided by the relative weakness in commodity-related shares. I am seeing the same underlying weakness in the cumulative NYSE TICK, suggesting that we're seeing more hitting of bids than lifting of offers among the broad range of NYSE shares (Raw data via Stock Charts). * We can accelerate our growth as traders by mastering change processes and becoming our own psychologists. It takes a vision and a plan to make changes and sustain them.
* This week I will begin a new blog feature where I maintain a page of "trading notes" documenting observations from the most recent day's trading. The notes will update relevant market measures and findings from some of the forecasting models that I've described recently, as well as interesting links. Readers can feel free to add their own notes to mine via the comment feature of the blog. The goal is not to pitch trade ideas, but rather to expand the information set that can help traders make better trading decisions. * Yet another way to expand your opportunity set is to find one new valuable information source each month that can become a regular part of your research/decision process. Over the course of 12 months, you can greatly widen your scope and sustain your development as a trader. When you peruse posts curated by such sites as Abnormal Returns and Quantocracy, focus on the sites offering the posts and not just the posts themselves. Many times you'll discover great resources that way. * Looking forward to the speakers and networking time at the Traders4ACause conference next month. My program off the program will be that I will bring a one-page write up of an original, valuable trading method and will exchange with all participants who are similarly willing to share their writeups. It's not just broader networking, but smarter networking, that helps us adapt to changing markets. Have a great start to the week! Brett
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Every so often, I'll post on topics relevant to my own trading, in hopes of inspiring fresh directions for active traders. This weekend I undertook an exercise to develop a predictive model for the next day's returns in SPY.
Above are the results for the simple model. The data are divided into quartiles, with the top quartile representing the most bullish predictions and the bottom quartile representing the most bearish predictions. The model consists of only three variables, which I would describe as: 1) the amount of buying and selling pressure for the previous trading session; 2) the number of stocks in the SPX universe showing price weakness over a multiday period; and 3) the number of stocks in the SPX universe showing price strength over a multiday period. The model lookback period was January, 2014 - present. Here are a few takeaways from the exercise: 1) As in other models I've built, the predictive value tends to be at the extremes of the distributions of the predictor variables. This is a way of saying that the relationship between predictors and forward price change is not a simple linear one. Being able to model those nonlinearities results in superior price forecasts. 2) The model is statistically significant, but accounts for a modest proportion of overall variance in next day outcomes. The model provides an edge, but significant uncertainty and randomness are present. Even the best models require sound money/risk management. 3) None of the three predictor variables is a traditional measure from technical analysis. When I add traditional technical indicators to a stepwise regression process, the technical measures are generally not significant predictors in their own right and never add predictive value to the three model variables. Parsing market data in unique ways promises unique forecasting power. Measures most commonly followed by traders possess little forecasting power. 4) Lookback period matters. The model that is robust in 2015 does not perform well on 2008 data. Before searching for predictive relationships, it's necessary to identify a stable lookback period that captures strong, flat, and weak markets. All models assume that the stable regime of the recent past will persist into the immediate future--an assumption that will be incorrect at times. 5) The hit rate for the top and bottom quartiles is around 60/40. Again, it's an edge, but it leaves plenty of room for error. The hit rate for the middle quartiles is closer to 50/50.
6) I have other models that forecast SPY price change over 3-5 day horizons. There is value in lining up the daily forecast with the swing forecasts. For me, the sweet spot of trading is seeing those occasions in which the action of the tape lines up with the anticipation of the market forecast. The tape comes first: I want to see expanding buying interest in order to go long and selling interest if I'm to be a seller. When the forecast lines up with the tape, those tend to be occasions when it's useful to bump up the risk taking and extend holding periods for potential trend days. An additional value of these models is that they keep me out of bad trades: I do not fade the market when forecasts are in the top and bottom quadrants. For those who might be interested, Monday's forecast is the first positive one in several sessions, with a forecasted gain of +.11%. That is in the second quartile; similar readings have been up 17 times, down 12 times for an average gain of +.12%. My swing forecasts are neutral. In all, Monday is not a day with a strong edge from the models. Further Reading: Integrating What We Know and What We Feel as Traders
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I have met many people who work hard from day to day, but never define and realize a dream. Too, I have met many people who espouse their visions and dreams, but never seem to wake up and actually sustain directed effort toward those. When dreams are expressed with purpose, we no longer simply have a job or even a career. We live a calling. Are you living your calling? Few questions are more important. To find our dream and live it with purpose on a daily basis requires that we make and sustain positive changes. But how do we become change agents in our own lives, as well as the lives of those that matter to us? Important clues come from this recent Forbes article: we change from both top-down and bottom-up. From top-down, we adopt a different perspective; redefine who we are and what we're meant to do. From bottom-up, we turn that fresh perspective into a guide for daily actions. We change the viewing, and we change the doing. By turning new directions into consistent actions, we internalize an expanded identity. Look at your daily planner; look at your trading journal: do you see clear expression of a fresh perspective implemented via consistent actions? All too often, the planner moves from task to task in unfocused fashion; the journal chronicles one trade and challenge after another with little cumulative relevance or impact. Living your calling means becoming your own change agent. Greatness is not to be found in grand visions or in daily actions, but in the ability to express positive directions through consistent, cumulative action. Further Reading: Becoming Your Own Psychologist
Every so often, it is worthwhile to step back and canvas the macroeconomic picture from a global perspective. Above are three charts that tell a distinctive macro story:
1) Deflationary pressures - In a world of expanding global economic growth, we would expect to see greater utilization of raw materials, driving the prices of commodities higher. What we've been seeing instead (top chart) is a collapse of commodity prices, particularly in the wake of concerns regarding growth in China. Over the past year, emerging market stocks have notably underperformed those of developed markets, just as periphery equity markets in Europe have underperformed core markets in response to concerns regarding Greece. One would like to see the emerging markets of the world as engines of growth, but instead the commodities markets suggest that those regions have become burdened by deflationary pressures, even as debt burdens have mounted. 2) Flight to safety and USD strength - Given the QE dynamics abroad and greater economic growth in the U.S., the U.S. dollar has soared as commodities have fallen (middle chart). Among equities, SPY is not far from its highs, despite the weakness among commodity-related shares, while emerging market equities (EEM) are flirting with multi-year lows. USD strength has set up an interesting dynamic among stocks, whereby companies that import raw materials have benefited and companies that depend upon export sales for growth have been hurt. The interplay between the boost to the U.S. economy from falling raw material prices and the drag on export sales from the strong dollar, as well as the global economic weakness, have contributed to an abundance of caution from the Fed regarding interest rate hikes.
3) The challenge to rising interest rates - Most of 2014 saw falling long-term interest rates in the U.S. (rising prices; bottom chart), whereas most of 2015 has seen a rise in rates in anticipation of Fed rate hikes. Most recently, we've seen a bounce in bond prices (lower yields), in response to weaker domestic data (Friday's ECI a case in point) and continued commodity weakness and concerns over global growth. To the extent that a debt/deflation dynamic abroad keeps a lid on global economic growth and incentivizes greater central bank activism abroad than domestically, it is difficult to imagine a Fed wanting to raise rates in any meaningful way, as higher rates would encourage further flows into the dollar and add to export-related headwinds.
One of the great challenges of trading is reconciling--and integrating--two modes of knowing: the explicit and the implicit. Explicit knowledge is what we readily verbalize as part of reasoning processes. Implicit knowledge is what we feel and sense as part of intuitive processes. We navigate life through a complex interplay of these modes of processing.
I recently fielded a phone call from one of my daughters who described stomach pains she was feeling. I walked her through a few questions to try to establish the possible cause of her pain. My first hypothesis was that she might be experiencing a gastroenteritis due to food poisoning, so I asked questions relevant to sharp pains, nausea, what she had recently eaten, etc. That is explicit reasoning at work: I am drawing on a database to establish a cause-effect relationship. While going through the questioning, however, I heard real distress in her voice. She had called me in the past about not feeling well, but the tone of her voice was different this time. My immediate sense was that this was a serious problem and that *she* was sensing it was not a normal stomach pain. That is implicit reasoning at work: I am drawing upon a database of experience with my daughter to recognize a pattern. Because of the intuition regarding distress, I began asking questions about the *location* of her pain. Sure enough, it was a bit more painful on the right side. It was also tender there. Right away, I told her of my concern regarding possible appendicitis and the importance of going to the ER for evaluation. She took prompt action and, within a few hours, was in surgery: explicit and implicit reasoning led to a helpful plan of action. All of life inevitably involves our two information processing modes. We hear people talk, and we read their non-verbal communications. We research the car we want to buy, and we get a feel for the car when we test drive it. We think, we feel, and at the end we integrate. Insight lies at the intersection of what we know and what we feel. Different forms of trading make different use of these cognitive modes. At one extreme, algorithmic trading makes use of formal analyses with no subjective evaluations of markets. At the other extreme, the pattern recognition of rapid daytraders makes little or no use of formal analyses. Both can make money, because both can reflect genuine knowing. Both can also be vulnerable, because markets are not static entities. We become vulnerable when we are so grounded in formal models of past markets that we have no feel for shifting market conditions. We also become vulnerable when our feel for recent market action is blind to fundamental developments that radically alter the flows of supply and demand. Do you formulate a plan and trade your plan? Do you trust your gut and trade what you see? It's easy to find gurus whose advice falls on either side of the explicit/implicit divide. Perhaps trader problems occur, not so much because of lapsed discipline, as because of difficulties finding an optimal integration of explicit and implicit knowing. Caught between their brains and hearts, traders struggle in markets for the same reasons most of us have struggled in romance. When we feel strongly, we can make decisions that are relatively brainless. When we make decisions strictly from our brains, we can end up with practical choices, but not inspiring ones.
If you've traded for a while, you no doubt have experienced occasions in which what you know and what you feel come together and you have an unusually profitable opportunity. It's like the situation in which my pattern recognition of my daughter's distress and my knowledge of appendicitis line up and immediately result in a useful course of action. Our best decisions in life speak volumes as to the ways in which *we* ideally integrate explicit and implicit knowing. Deconstructing our best trades points the way toward how we uniquely harness the power of dual information processing.
The goal is to place these modes in harmony, not in mutual opposition. But we cannot achieve harmony unless we spend enough time to assemble a knowledge base for explicit reasoning and an experiential base for pattern recognition. Beginners at trading fail for the same reason that beginners would fail in a chess or golf tournament: they simply lack the database of understanding and experience to make sound decisions from head or heart. Further Reading: Making the Right Decisions in Life and Trading
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When we have difficulty arriving at solutions, many times it's because we haven't spent sufficient time defining the relevant problem. Trading major U.S. stock indexes the past several months has been quite interesting, as we've traded within a range throughout that time. Several sectors--most notably commodity-related shares--have been unusually weak; several sectors (consumer discretionary, healthcare) have been relatively strong. Altogether the major indexes have gone nowhere, though they've traveled a considerable distance within their range. That's the very definition of a low-Sharpe asset. It's not unusual to hear traders lament such "choppy" markets. What they're really saying is that the market isn't sustaining directional movement over intended holding periods. The trader wants to profit from a move from X to Y in Z time period, but the market will move from X to X' and reverse to X or beyond before it ever gets to Y in the Z period. For the trader hoping to plan a trade with good risk/reward--a price target twice as far away as their stop-out level (or more)--such choppiness leads to frustration. An intended 2:1 reward-to-risk trade isn't so favorable when you're stopped out three times as often as you hit the target!
Hence the lament: choppy markets just aren't tradeable.
Been there, done that: this week alone I had several intraday trades in ES that moved 4-5 points in my favor before retracing and moving against me. Frustrating.
That led me to spend more time defining the problem.
Suppose we model any market time series as the sum of a linear (trend) component and one or more cyclical components. (John Ehlers' work is a good example of this kind of thinking). To the extent that there is little cyclical component and a dominant linear component, we have a consistently trending market where buy/sell and hold would be an ideal strategy. To the extent that there is little linear component and a dominant cyclical component, we have a consistently oscillating, mean-reverting market, where fading overbought and oversold levels would be an ideal strategy.
Of course, the financial world is a bit more complex than that, as linear components can vary in their slope and cyclical components can vary in both frequency and amplitude. The relative balance between linear and cyclical components changes over time, as do slope, frequency, and amplitude. This means that any single approach to trading markets--trend following, counter-trend trading--will go through winning and losing periods simply as a function of changing cycles. So let us define choppy markets as ones with low linear component and cyclical components with high frequency and low amplitude. That would define a low VIX market (low amplitude) with minimal persistence of directional movement. Such a market is untradeable only if you need to trade directional trends of a certain size and duration. Consider: within each cycle, there are linear/directional components; these simply last for less time and travel less distance when the cycles are higher in frequency and lower in amplitude. If you were to model those cycles, however, you would find that, for any stable market period, directional moves of X can be expected for holding periods of half the dominant cycle frequency. Traders frustrated by choppy markets might turn to psychoanalysis, but cycle analysis is probably more relevant and helpful. I modeled the recent market linear and cyclical components after my frustrating trades (hint: cycles are clearer when you don't use time as your X-axis) and, sure enough, I found that the odds of hitting my price targets given the current regime were actually quite low. A move of 4 ES points was expectable in my intended holding period; a move of 8 points was unlikely.
A common piece of market wisdom is that traders must trade in a way that is consistent with their personalities. There is truth to that--a quantitative investor probably will not do well as a discretionary day trader--but all too often that principle is used to justify sticking with trading methods that simply do not fit market conditions. No one would tell an owner of commercial radio stations to program the airwaves to fit his or her personality. Rather, programming would need to fit the marketplace of targeted listeners. Similarly, traders need to adapt to *their* marketplace--and then re-adapt as that marketplace evolves.
Perhaps the problem is not choppy markets, but static traders. When all we have is a hammer, Maslow noted, we inevitably treat everything as nails.
* We continue to see massive divergences among stock sectors, as nicely tracked by the Finviz site. This has created weakening breadth for stocks overall, as interest rate sensitive, US dollar strength sensitive, and commodity sensitive shares have significantly underperformed healthcare and growth-related sectors. It is difficult to imagine a resumed bull market with China/Asia/commodity weakness; it is also difficult to imagine a true bear market unless concerns over global growth start to hit U.S. growth-related shares. That has me watching the strongest and weakest sectors and their relative price performance going forward.
* If we truly treat our trading as a business, then it makes sense to look at ourselves not just as traders, but also as managers and leaders of our enterprise. Surprisingly, there's been little attention paid in trading psychology to this aspect of performance and success. My latest Forbes article covers a very important theme in the management literature: we best lead by creating standards of excellence and managing toward those. Many trading failures boil down to failures of leadership, and those boil down to shortcomings in managing ourselves, our resources, and our work processes.
* Two excellent conferences coming up this fall that I'll be participating in: 1) Traders4ACause in Las Vegas and 2) Stocktoberfest in Coronado, CA. Both promise a great lineup of speakers and plenty of opportunities for networking. * One topic that recurs in my conversations with traders is refining the quality of their information networks. It's not at all common to read lots of things and come away with very little. Just as important as taking in information is synthesizing it into meaningful views. But those views will only be as good as the information we synthesize. For those with a bent toward numbers, good information via Twitter can be found by following @sentimentrader, @paststat, and @RyanDetrick. Broad perspectives can be found by following @dashofinsight, @abnormalreturns, and @Quantocracy. Trading perspectives can be found by following @crosshairtrader, the Stock Twits STUDY stream, @NewTraderU, @seeitmarket, and @ivanhoff. A good source for trading psychology ideas is #tradingpsychology. I'll have many more good links and follows to suggest shortly!
A reader recently asked the question of why we so often don't trade our plans after we've gone to the trouble of planning our trades. The usual answer to this question is that emotion gets in the way, which naturally leads to strategies for yet more planning, "discipline", and the dampening of emotion. As an interesting article on motor sport makes clear, however, it may well be that we lose our plans when we lose our concentration. Instead of working to control emotions, it makes sense to cultivate expanded levels of focus. After all, an athlete can be fired up emotionally *and* wholly focused on the game: emotion can facilitate performance. Indeed, it's the football or basketball team that comes to the game "flat" that is apt to fall short in performance. Quite literally, their heads are just not in the game. In the aforementioned article, the author speaks of "concentration styles". This is a very useful concept. Not all people focus in the same ways. For example, I work with extroverted traders who are very skilled at processing information interpersonally. When they are at the trading desk, sharing ideas with others, they are in their zone. Alternatively, I also work with more introverted traders who are very skilled at analyzing situations in markets. They concentrate best when they tune out chatter from others and place themselves in a quiet environment. Concentration benefits from a distraction-free environment, but sources of distraction vary as a function of concentration style. If internal cues (stray thoughts and feelings) are distracting, staying socially focused can facilitate good decision-making. If external stimuli (sights, sounds) are distracting, staying in a neutral environment can be most helpful to performance. For a visually oriented trader, focusing on charts and other visual displays could yield superior information processing. That would not be the case for many quantitative traders. In short, we fail to trade our plans when we lapse in our concentration, and we lapse in our concentration when we stray from our information processing strengths. When we exercise those strengths, we strengthen them further. In that sense, focused trading can become excellent training for our concentration. Conversely, when we approach trading in a haphazard manner, we fail to cultivate our ability to focus and become easily swayed emotionally. I've never known a trader operating "in the zone" who has complained about emotional disruption. Show me an Olympic champion and I'll show you someone emotionally charged *and* performance focused. Further Reading: The Key to Making Changes: Training the Brain for Performance
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Back in May, I wrote about an experiment I was conducting in my trading. Since that time, I've made mistakes and learned valuable lessons. Out of those has emerged a promising consistency in my profitability. I am quite confident that I have many more lessons to learn and mistakes to make. So far, however, those lessons have been constructive ones, so I thought I'd share the most important ones: 1) Since May, I have returned to my daytrading roots. In that May post, I outlined three patterns that anchored my trading. My trading consistency (hit rate) and profitability increased dramatically when my trading of those patterns was intraday. When I focused on the larger picture--patterns and price projections from those patterns--I lost my feel for the market and became ill-prepared for variations in price paths. When I used the patterns as context but focused on the moment to moment flow of market behavior, I could actually feel whether or not patterns were playing out. This has become important, not only in terms of managing risk proactively (exiting trades when the flow of volume is diminishing in my direction; not when prices have reversed and hit my stop), but also in terms of opportunity management (sizing up trades in which flows line up with the patterns). Fast pattern-recognition is my greatest cognitive strength as a trader. By focusing on longer-term market behavior and patterns, I was neglecting this strength and that led to trading that was not consistently profitable. It's been a great reminder for the psychologist: success comes from leveraging who we are at our best. 2) Since May, I have refined quantitative models that forecast ES prices 3-5 days forward. The greatest refinement has been to model non-linearities in the data: situations in which the relationships among predictors and outcomes are different at extremes of the distributions. For instance, it's not too unusual for average values of an indicator to be unrelated to future price action, but extreme values to have predictive significance. Modeling those non-linearities has led to better models. (They actually are quantifications of the patterns mentioned in the May post). Per the first point above, however, my trading has been best when these model forecasts act as background and context. The successful trading comes from seeing order/trade flow line up with the forecasts. Even the best forecasts predict only a modest fraction of total variation in forward prices; trading only when flows line up with forecasts has greatly improved the hit rate. 3) I review every trade and what I've done right and wrong. It is no exaggeration to say that I spend much more time reviewing trade results, reverse-engineering success and failure, and researching the lessons from those than actually trading. The intensity of this deliberate practice has greatly accelerated my learning curve. Increasing the selectivity of the trades I take (per the two points above) and maximizing my review process has been much more successful than spending a lot of time in front of the screen and less time in review. 4) The number one psychological predictor of the success of my trades is my cognitive state while putting the trades on. If I am highly focused and have a clear sense of both larger picture and moment-to-moment flows, the trade is much more likely to be successful than if I lack that quiet sense of understanding and mastery. A great example of a trade lacking that sense would be one where I am entering because I'm concerned about missing a move. Almost invariably, the timing on such a trade will be poor. It's in the quiet, focused state that the pattern recognition will kick in and I will have a much better feel for when flows are turning in the expected direction. Eliminating distractions while trading has been crucial for me. 5) Where I have the greatest progress to make from here is in proper trade sizing and position management. What I'm finding is that it is much better to limit the number of trades taken based upon the above four criteria and sizing those trades up, rather than taking more trades and sizing them moderately. I'm also finding it helpful to use this increased sizing to facilitate a scaling out of positions, so that the portfolio can benefit from both short-term price reversals and ongoing trend behavior. Because I only trade one instrument, my diversification comes from differentiating time frames. This requires separate planning and review for the short and longer trades, and that is a work in progress for me. The challenge is to ensure that the longer-term planning and trading process does not bleed over into the flexible management of the shorter-term positions mentioned above. My hope is that this self-reflection can serve as a kind of model for your own trading. Your lessons will be different from mine, because you are different from me and your trading is different from mine. The overlap will be in the process sense: by treating your trading as a performance activity, learning from mistakes and successes, and feeding those lessons forward into your future trading, you can evolve dramatically. If you write a blog and thoughtfully review your lessons learned, by all means let me know and I will be happy to link in the spirit of mutual learning!
* Above we see the daily average of 5, 20, and 100-day new highs versus new lows for all SPX stocks. (Raw data from the ever-helpful Index Indicators site). When this multiperiod breadth measure has been in its weakest quartile going back to 2014, the next five days in SPX have averaged a gain of +.64%. All other occasions have averaged a gain of only +.05%. Interestingly, when we look just two days out, the strongest breadth periods have led to an average gain of +.15% and the weakest periods have yielded an average gain of +.40%. All other occasions have averaged a two-day loss of -.02%. On short time horizons, returns have been a function of either strong upside momentum or mean reversion following broad weakness. When trading price patterns, it helps to know the context in which they're occurring.
* Management and leadership concepts don't just pertain to corporations; they are vital to the running of any trading business. If there's no vision to running your business, you're running blind. And if you're not running your trading like a business, do you really have any business trading?
Promiscuity and trading: admittedly not the most common of topics in trading psychology, but I think it's quite relevant. Alvarez makes a good point: on important matters in which we feel commitment, there is no promiscuity. If you're committed to physical health and being in peak conditioning, you won't be promiscuous in what you eat. If you're committed to a marriage, you won't be sexually promiscuous. If you're committed to career or a religious faith, you will necessarily be selective in what you pursue. The problem with promiscuity is that the pursuit of breadth allows for no cultivation of depth. If I roam from one job to another each year, I never build a career--and never accumulate a career's worth of achievements. If I flit from one romantic relationship to another each week, I will never experience the depth of relationship that comes from a lifelong commitment. Once we make a commitment to something, we opt for selectivity. The pursuit of all things reflects a lack of commitment to anything. It is common to attribute the breaking of trading rules to a lapse in discipline. Perhaps, however, those undisciplined occasions reflect an absence of commitment. Look at it this way: if you developed your own approach to trading; tested it well, historically and in your own experience; and knew deep down that it possessed unique value, you would feel a degree of commitment to that approach. You would trade it consistently, not because you impose a discipline upon yourself, but because you believe in it deeply. An artist doesn't flit from style to style, one painting to the next. Why? Because underneath that style is a vision--and that artistic vision expresses an emotional commitment.
When traders flit from one type of trade to another, their promiscuity reflects an absence of such artistry and commitment. They have not found their trading vision. Often, their ideas are borrowed from others and not tested and made their own. One more journal entry or checklist will no more help such traders than they would help the bored overeater. If you want to eat healthy, you must be committed to an ideal of physical conditioning. If you want to trade healthy, your trading must be connected to a greater purpose and commitment.
I will make a bet:
If we were to cut the types of trades that we take by two-thirds and focus solely on the one or two that reflect our greatest edge in markets and our greatest trading strengths--and if we were to meaningfully increase the size/risk taken for each of those trades--our overall profitability and risk-adjusted returns would rise significantly.
In other words, if trading becomes an expression of a commitment to a particular approach that is ours, many of the problems of trading psychology melt away. In trading, as in any career, dedication is the most durable source of discipline.
Here are some good self-assessment questions: * How purposeful are you in getting the sleep you need to function at your best? * How purposeful are you in getting the exercise you need to function with maximum energy? * How purposeful are you in eating the right foods to sustain your health and well-being? * How purposeful are you in organizing your time so that you're spending your highest quality time on your most important priorities? * How purposeful are you in cultivating the quality of time with the people who matter most in your life? * How purposeful are you in ensuring that, each day, you are accomplishing something meaningful in your life? Can we really expect to achieve our life's purposes if we are not living our days purposefully? Can we trade with intention and discipline if we don't live the rest of our lives intentionally? Everything in life can be approached with intention and purpose or it can be approached mindlessly and routinely. In carrying out daily activities with self-direction, we strengthen our ability to stay mindful and purposeful for life's greater goals.
* Above we can see that we're coming off an unusually oversold level on the composite indicator that I've created from two technical measures. What we're looking at is a ten-day moving average of daily buy signals versus sell signals for every NYSE stock for two indicators: Bollinger Bands and Parabolic SAR. (Raw data from the excellent Stock Charts site). Going back to June, 2014, when I began collecting these data, if we divide the signals into quartiles, we find that the strongest composite indicator readings have led to a next 10-day return of +.32%. The weakest composite indicator readings have led to a next 10-day return of +.42%. All other readings have averaged a next 10-day return of only +.08%. In other words, most of the recent price action is attributable to short-term momentum and mean reversion. There has not been much of an edge trading middle-level market strength.
* Excellent perspective from Barry Ritholtz: We've had large intra-year corrections on average, but the great majority of the last 35 years have finished with positive performance in stocks.
Shoutout to @BrianTracy for the graphic and message. It speaks to what I call a mission-based mindset. Think of the Special Forces team embarking on a mission to rescue their colleagues from enemy capture. Every one of those soldiers will be mission-focused. They will have drilled and prepared; their goals--and the actions they will take to reach those goals--are front and center.
When people live with a mission-based mindset, they are like those elite troops. Their thoughts, feelings, and actions are directed toward what they should be doing in life. Most of all, they immerse themselves in worthy missions, and those make life a challenge and adventure.
Here are three follow up questions pertaining to the personal sense of mission: * How many people do you know--and regularly interact with--that convey the sense that they are on earth to do something special with their lives? If you're not regularly interacting with people who have a mission-based mindset, what is mirrored to you, and what will you internalize over time? * If you continue doing precisely what you've been doing in your life, what goals will you reach? What mission will you have accomplished? What special thing will you have done with your life? * How many people have you recently inspired with your mission? If you're not routinely inspiring others, is it reasonable to assume that you will sustain inspiration?
We lose a mission-based mindset when we become so immersed in life's immediate demands that our priority becomes coping rather than achieving. If we move from one crisis to another--one to-do item on a list to the next one--then events control us. When there is no mission, there is only getting by.
And how about trading? Is your pursuit of financial markets part of an overarching life mission, or is trading your escape from the responsibility of crafting a life purpose? The answer to that question lies in what you pursue outside of normal market hours. From the Special Forces team to the religious missionary to the startup entrepreneur, there are no life missions that operate on abbreviated work schedules.
But then again, when in a mission-based mindset, work does not feel like work. It feels like service: service devoted to a noble cause. Further Reading: Changing Our Lives
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* There are many ways to achieve, but I know of none that does not involve a willingness to tolerate discomfort. Our boundaries are what make us feel comfortable; pushing our boundaries is what achievement requires. In life as in the gym, if you're not breaking a sweat, you're not building your fitness. If you want to develop a part of yourself, that development requires regular workouts. * I'm not sure people can make positive changes in their lives without first changing their internal dialogues. Can we really sustain new patterns of behavior if we're sustaining the same old thought patterns? As noted in the recent article, keeping a journal can be a structured method for changing our self-talk. Not many traders actually use journals that way. But we really can reprogram ourselves. We eat well, sleep well, exercise--do a lot of things to maintain our hardware. That won't get us where we want, however, if we're running faulty software. * Keep trading simple and don't overthink things. I've worked with many successful traders and portfolio managers. None has ever held that view. Seriously. None. * What traders mean when they say a market is choppy is that it is not following a linear price path. They assume, therefore, that price action is random and untradeable. Suppose, however, that choppy markets are simply ones in which non-linear (cyclical) price influences dominate linear (trending) ones. A choppy market could be a very tradeable one if there is a stable pattern of cyclical behavior. If one has no method for testing for non-linear regularities, however, trading success would be limited to trading straight lines. Not all trading failures can be attributed to psychology. * If you desire success in markets and have developed no unique, concrete way of achieving it, you aren't pursuing your dream; you're pursuing a fantasy. Successful traders talk about markets and trading. Wannabees talk about themselves and their "passion" for trading. Is there any more powerful confession of incompetence than a longstanding passion devoid of achievement? * The hardest lesson I have learned as a trader is to understand and accept what I do best in markets. There are traders and there are investors: fast thinkers good at pattern recognition and slow, deep thinkers good at analysis. There are aggressive risk takers who achieve absolute returns and there are balanced risk takers who achieve superior risk-adjusted returns. These are fundamental differences of cognitive and personality style. Great traders are rarely, rarely great at all styles. We find our success by leveraging our distinctive strengths. But that means we must truly understand and embrace our strengths. * The people I know who are really good at networking with trading colleagues are those who have something of value to share, not those who are focused on their need to learn from others. There's something to be said for being a sponge when you're learning, but there's nothing quite so deadly as a room full of sponges. That's why I put out my challenge for the September T4AC conference event. Further Reading: Trading Psychology Articles
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In my recent post, I talked about some of the common ingredients of successful traders. It turns out that many of those traders will be attending September's Traders4ACause event in Las Vegas. In addition, the charity event will include such noteworthy speakers as Jack Schwager, Peter Brandt, Jim Dalton, Terry Liberman, and Mark Minervini. Two of the traders featured in the upcoming book I mentioned in my post will also present: Bao Nguyen (@Modern_Rock) and Nate Michaud (@InvestorsLive). My presentation for the Traders4ACause event will focus on solid research in psychology and what it teaches us about best trading practices. I will be sharing specific best practices that I have observed among successful traders over the years and ways you can adapt those practices to your trading. The theme of the presentation is that there is much more to successful trading processes than simply controlling emotions and staying disciplined. Those are necessary for success, but not sufficient. Perhaps most important of all, such a charity event is a way of giving back--and a way of giving to one another. It's great to connect with other traders online, but nothing beats face to face interaction, sharing ideas and experiences, and building an active, helpful, and supportive network.
In the spirit of networking and mutual learning, I will be bringing to the September event a one-page writeup of a specific trading practice (not psychology; an actual trading method) that I have found to be a best practice in my own trading. I will give that handout to anyone who also brings their own trading-oriented one-pager describing their best trading method. Nothing in the handouts should be stupid or generic; rather, each will describe something unique in trading practice that has had value for you. Bottom line: I give you my insight; you give me yours.
Now suppose--just suppose--all the participants at the conference bring their one-pagers and everyone shares with everyone else. You'll go to the meeting and receive literally hundreds of promising ideas. Even if only 10% of them have specific promise for you, that's a great return on your attendance and sharing. Giving to charity is great; we can also make giving to one another part of our cause.
* After a considerable period of tepid new highs vs. lows among NYSE shares (data from the excellent Index Indicators site), we've recently seen an expansion of the number of stocks registering fresh three-month lows. I will be tracking this closely to see if what is already oversold breadth exhibits further deterioration in the wake of problems in Europe and China. * Why do smart people do dumb things in markets? This post takes a fresh look at a perplexing problem for traders--and how it can be overcome.
We often hear that traders, to be successful, should "follow their process." But what really goes into trading processes? The recent post described a few common elements of successful trading. One of those was selectivity. Faced with an infinite number of possible trades and times to trade, even the active trader must find some way of filtering out the majority of possibilities and focusing on the smaller number that offer distinctive opportunity.
How does such selectivity work? I would argue that every successful trader and portfolio manager filters trades by three criteria: 1) An Idea - The trading idea expresses the underlying logic of the trade. It is what gives the trade a potential positive expected return. The idea could be that risk assets will rise when the rate of change among a host of macroeconomic indicators is positive; the idea could also be that a company's shares will fall if they experience a parabolic rise because of promotion not grounded in fundamentals. The trading idea defines the field of opportunity.
2) An Expression - Any trading idea can be expressed in a variety of ways, and those expressions ultimately determine the risk/reward of the trade. For example, daytraders might run several scans of stocks in the premarket to identify promising "pump and dump" candidates. Portfolio managers might express a view in currencies, equities, and/or rates, depending upon the positioning in those assets and how they might fit together in a portfolio. An expression could be in options, in a relative value trade, or in an outright long or short cash position. Each brings different risks, different rewards. 3) An Implementation - To a surprising degree, the way in which a trade expression is implemented impacts its ultimate profitability. Two traders could have the same trading idea and decide to express it with a long stocks trade. One trader predicates entry execution on strength, buying when there is upside price confirmation and then adding to the position on strength. Another predicates entry execution on weakness, buying pullbacks in price and scaling out on strength. The profitability curves for the two traders over time will look radically different. Indeed, for the ES futures, the former implementation strategy could have easily led to flat to negative returns even in the recent bull market! Placement of stops, sizing of trades--all of these greatly impact trading outcomes. I would propose that a truly process-driven trader has studied each of the three areas above, so that all three contribute to an overall trading edge. The process-driven trader should be able to justify the trade on all three criteria, and the process-driven trader should be able to review performance across the criteria to determine where improvements can be made. There is much more to profitable trading than arriving at good ideas, and there is much trading of randomness in the place of good ideas. Not all who follow routines are process-driven. There are also psychological processes underlying success across performance domains. Further Reading: Feeding Your Head And Developing Your Self
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I recently wrote a foreword for a very interesting book of interviews with successful daytraders that will be coming out shortly. Among the excellent contributors were @modernrock, @OzarkTrades, @InvestorsLive, @lx21, @offshorehunters, @elkwood66, @kroyrunner89, @DerrickJLeon, @johnwelshtrades, and @TomKellyLV, Although my trading is different from theirs--and theirs is quite different from that of portfolio managers I work with--I notice three broad areas of overlap. These seem to be common elements of what makes traders successful: 1) Resilience - Successful traders take risk. Successful traders are sometimes wrong. Successful traders take hits. Successful traders learn from the hits, get up, and move on. They are resilient. They succeed, as Churchill observes, by moving from failure to failure with enthusiasm. 2) Selectivity - Successful traders have clear criteria for what makes good trade ideas. They also have separate criteria for what turns good ideas into good trades. They don't watch everything, and they certainly don't trade everything. They wait for good ideas to become good trades. 3) Calling - Successful traders have an uncanny sense that this is what they're meant to be doing. It's not a job, and it's not a career for them. It's a calling. That's the only thing that can keep people searching and re-searching, banging away for good ideas and good trades. And it's the only thing that enables them to gain the immersive pattern recognition experience that separates them from average traders.
To be sure, there are other success ingredients, from discipline to creativity. What I see among the traders listed above, as well as those I work with, is an unusual combination of these three factors. It's a pleasure and a true education to study successful people. There is much more to success than avoiding failure.
It's good advice: the right foods can be the right medicine. I recently met with someone who was experiencing feelings of depression and a loss of energy. Those, in turn, affected his concentration and that interfered with his trading. It turned out that he had gained significant weight. His weight gain influenced his sleep quality, as he began snoring and experiencing interruptions of sleep (apnea). The disrupted sleep prevented him from entering the deeper, restorative stages of sleep, which left him tired and run down by the morning. On the advice of his physician, he changed his diet, lost weight, stopped snoring, slept better, and regained his energy and concentration. Had he resorted to sleeping pills and antidepressant medications instead of diet, he could have compounded his problems. In the recent Forbes article, I make the case for a different kind of diet. Our daily experience is what we process each day, and that is what we internalize--for better or for worse. The work we perform, the people we interact with, the activities we engage in: that provides our psychological diet. What we do in life and who we do it with shapes our experience--and our experience shapes how we view ourselves. I recently spoke with a young trader who aspired to doing great things in markets. My first questions asked about the great things he was doing each day. Can we really expect extraordinary results from a series of ordinary days? Ask yourself to define the ideal you: how you would like to be as a person, as a romantic partner, as a trader. Then identify those specific things in your daily diet of experience that will lead you to move consistently toward those ideals. If you're not progressing toward your goals and find yourself dreaming of ideals but not achieving them, perhaps it's time for a diet. Further Reading: Role Modeling and Mirrors
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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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