Tuesday, August 11, 2009

Changing Our Lenses and Finding New Opportunity

Cognitive psychologists stress that our schemas--our mental maps of the world--are like lenses through which we perceive events around us. Those lenses can clarify or they can distort. Many times, they limit what we perceive. We assume that we are seeing reality, when in fact our perceptions are as much a function of our lenses as the world around us.

Traders often identify trading range environments as ones of poor opportunity. Volatility tends to go down in range environments; there are no big trends and breakouts to ride.

Let's change lenses, however.

Suppose we view trading range environments as sector rotation environments. During trending markets, the majority of shares and sectors reset levels of value. During range environments, shares and sectors re-establish value relative to one another. In other words, range environments offer *relative* movement, not absolute movement.

Review the sector updates from recent weeks. (Each post has a link to the prior week). You'll see meaningful shifts among the sectors, even as markets have stayed in multiday ranges for much of the time. The entire market may be range bound, but one sector might be trending relative to another (or relative to the entire average), offering good opportunity.

Might this suggest that we could perform better as traders if we focused on outright trades in trending environments and relative/pairs trades in range markets? Might we see evidence of promising trading patterns and could we identify day structures and volume patterns if we chart relative prices (i.e., one sector plotted as a function of another) as well as absolute ones?

What would Market Delta charts look like for sector pairs and what might we infer from them? Could we use sophisticated screening tools such as Trade Ideas to track relative sector performance intraday?

I find this a promising line of inquiry. Many good answers start as good questions. And many good questions come from changing the prescriptions on our lenses.