Sunday, April 06, 2008

What Are You Doing Between Trades?

I want to thank readers for excellent comments and perspectives on my recent post that addressed the question of why trading is so difficult. In particular, I thought that Charles and Ziad identified a most important issue: the trader's engagement with markets *between* trades.

To take a step back, if I were asked the question, "What makes trading so difficult?", my response would echo Victor Niederhoffer: "Trading is difficult because of the ever-changing nature of market patterns".

In statistical terms, this is called nonstationarity; in my previous writings I described it as playing blackjack when the number of decks in the "shoe" periodically changes. You the card counter are keeping track of the number of picture cards dealt, not knowing that the supply of picture cards has just increased multi-fold.

Similarly, from one time period to the next, market patterns can change: we can see altered patterns of trending and altered patterns of volatility. This occurs within the day--the market's behavior is different in morning than midday--and across days, weeks, months, and years. (We currently are experiencing far more volatility than a couple of years ago).

A nice example of Niederhoffer's "ever-changing cycles" is the recent shift in one-sided days that I wrote about. When we get such shifts, traders who internalized the previous patterns (and, in this case, fade opening strength or weakness) become caught in the new patterns and lose money. This is a major cause of frustration in trading, and it is a major reason that successful traders can rather quickly become unsuccessful ones.

It is because of these changing cycles that traders need to stay actively engaged with markets *between* trades. At any time, trends can reverse, breakouts can occur, markets can become quiet, etc. Only by following the market's emerging patterns can traders hope to adapt to them and eventually profit. Charles provided an excellent example in his comment to the post: because he is actively figuring out what the market is doing, he avoids what I called the "fireman" syndrome among traders, in which periods of boredom oscillate with periods of intense emotion and action.

Ziad makes the valuable point that one does not need to approach the markets quantitatively to stay actively engaged. In my own trading, for example, I stay engaged by watching unfolding sentiment (NYSE TICK, Market Delta), seeing how price and volume behave at the edges of market ranges, and by seeing how markets correlated to my own are behaving. The time between trades is never boring, because my interest is captured by reading the emerging market patterns.

Herein lies the problem beneath the fireman syndrome: If the trader is more interested in trading than in understanding markets, the period between trades will not be productive. That period will either be boring (which will incite overtrading), or it will be dominated by negative thinking about recent performance (which will color future decision making).

This is why structuring one's time between trades with processes to examine markets--and to examine oneself, when needed--is very helpful for trading. The mind, like nature, abhors a vacuum. If we aren't prepared with constructive activities between trades, the mind will latch onto non-constructive ones.

I strongly suspect that a reliable way to identify a good trader is to observe what he or she is doing *between* trades.