New Year's Eve Readings

HAPPY NEW YEAR!!

Thanks to readers for a great 2009;

Let's do big things in 2010!

* Managing risk and maximizing trading opportunity;

* Managing the psychological risks of trading;

* Could a flight from bonds spark a stock market boom?

* Nice results from the stock screening machine;

* What municipalities need to do to cut expenses;

* The challenge of an asymmetrical recovery in Europe;

* Wooing companies from India in search of jobs;

* Good 2009 wrap-up readings;

* More protectionism on the way?

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The Most Important Trading Goal for the New Year

As we come to the end of 2009 and a holiday weekend, it's a great time to reflect on trading performance for the past year and goals for 2010.

Without ways of tracking and reviewing performance in real time, however, trading goals for the year aren't much more likely to have force than other well-intended (but quickly forgotten) new year's resolutions.

Where are you making money? What is causing you to lose money? What are the market ideas and conditions where you should be taking more risk? What are the situations in which you should be containing risk, or perhaps standing aside altogether? How much heat do you typically take on trades, and how can you execute your ideas better to reduce drawdowns within the trade? How do your winning and losing trades clump together over time, and how much of the clumping is due to psychological influences? How much is due to market conditions?

You can't get the answers if you don't ask the questions, and you can't get the answers if you don't have ways of tracking what you're doing.

I see where StockTickr is offering a basic version of their journaling and performance software free of charge. They're also offering a free trial for their pro version that tracks risk and performance metrics and that links to Trade Ideas and the Trade Ideas odds maker module. This latter functionality creates a very nice suite of tools for generating, executing, and tracking the outcomes of your ideas.

Performance improvement starts with measurement, whether you're performing in track and field events, racecar driving, or weightlifting. To know what you are doing well so that you can do more of it; to know what you're doing poorly, so that you can avoid it: that's not such a bad goal for the new year.

More:

Focusing on Trading Solutions

Generating a Culture of Learning

The Performance-Based Life

Learning and Developing as a Trader

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Attributional Style and Trading Performance

When positive or negative things happen in life, we tend to attribute them to causes. This helps us make sense of the world. A robust line of research over the last two decades suggests that how we attribute causes--our attributional style--plays an important role in our moods and behavior.

The Attributional Style Questionnaire (ASQ) developed by Peterson et al (1982) has been used in a wide range of research to assess three dimensions of attributions:

1) Internal vs. External: Are events attributed to factors within our control or outside our control?

2) Stable vs. Unstable: Are events attributed to factors that are enduring or that are transient?

3) Global vs. Specific: Are events attributed to general circumstances or highly circumscribed causes?

It turns out that the mix of these dimensions defines a person's attributional style, and that style is predictive of the onset of symptoms of depression.

Let's take an example:

Suppose a trader loses money several weeks in a row. We are more likely to see a depressed mood if the trader attributes the poor performance to something about himself (internal), something not likely to change (stable), and something likely to occur across a variety of situations (global): "I keep losing money because I lack the discipline to be prepared each morning."

We're also more likely to see depressed mood among traders who attribute positive outcomes to external, unstable, and specific factors: "I make money when volatility is high and markets are trending."

Why is that important? Emotions can be thought of as motivational states; depressed mood reflects a kind of motivational suppression. We lose the will to change events if we perceive those events to be outside our control. Conversely, if we view important events as within our control, we are likely to experience optimism and motivational enhancement.

Take the example of those notorious high-frequency trading programs that affect short-term market movement. A pessimistic attributional style would attribute losses to those programs and view the "manipulations" of those programs as outside the trader's control.

An optimistic attributional style would attribute losses to the failure to adapt to the algorithms and would view such adaptation as within the trader's control.

In the first case, the pesssimistic trader loses motivation and fails to take specific steps to adapt to the market. In the second case, the optimistic trader gains motivation to beat the bots and takes a number of steps to change how he executes and manages trades.

So it is that attributional style can become a self-fulfilling prophecy: Our viewing inevitably shapes our doing--and our lack of doing. Ultimately, however, research sides with the optimists: attributional style itself is within our sphere of control: We can learn to be more optimistic. More on that in the next post on this topic.

More:

Attributional Biases Among Traders

Taking Control of Perception and Motivation

Denial as a Trading Motivation

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Mental Flexibility vs. Sticking to Trading Plans: Which is Correct?

Reader George raises excellent questions concerning my recent post on mental flexibility and trade planning. Citing Henry Carstens' ideas in the article "The Axiom of the Small Edge", George asks how one resolves the seeming discrepancy behind the notion of sticking to trade plans that have an edge and staying mentally flexible and adjusting plans as needed. Isn't being mentally flexible, he asks, just a nice way of describing getting scared out of a trade?

(By the way, do check out the huge collection of worthwhile articles on Henry's site. There's a lot of good and thoughtful reading there.)

I would argue that Henry is correct and that my post on mental flexibility is also correct. That is a key difference between mechanical systems trading and discretionary trading.

When one has a properly backtested system for trading, meddling with the parameters is usually going to degrade performance. The system is designed to exploit a relatively small edge over a large number of trades. Failing to take signals, taking extra signals, and sizing trades differently than in test conditions all invite a reduction in that small edge, as they introduce untested elements into the system.

A discretionary trader, on the other hand, is relying upon pattern recognition skills, research, and a feel for markets to make buying and selling decisions in real time. The performance of a discretionary trader is no different than that of a trading system: both can be analyzed for profitability, risk, and other performance parameters. If a discretionary trader maintains positive risk-adjusted returns across a range of market conditions over time, that trader has a demonstrated edge.

Getting scared out of a trade implies that a trader is reacting to emotional factors and not to objective characteristics of the real-time market. To be sure, that can be a major hindrance to performance. When one gets scared out of a trade idea, that emotional reactivity is substituting for informed discretion, eroding the discretionary trader's edge just as changing parameters can degrade the performance of a system.

There are times, however, where a discretionary trader will start with a plan or framework for a trade and then adjust the plan, not based on emotional upheaval, but upon the unfolding action of the markets themselves. This is part of a skilled discretionary trader's edge.

We see similar dynamics in other discretionary performance fields. A poker player may begin with a plan based upon the draw of cards, but will adjust betting and strategy with each new card drawn. A football quarterback will come to the line of scrimmage after calling a play in the huddle, but may call an audible to adjust the play based on the real-time read of the defense. A boxer will have a fight strategy, but will adjust that strategy round by round based upon the strengths and vulnerabilities of the opponent.

George touches on a very important point: it is all too easy for a trader to rationalize an emotional, reactive trade as an informed discretionary decision. The key difference is in the reasoning behind the decision. Let's take an example:

This morning I bought the S&P 500 Index early in the day when I saw that there wasn't enough selling interest to take out the overnight low. My plan was to hold the trade for as long as needed to test the bull highs, making this a swing trade idea. The Chicago PMI numbers came out and stocks popped nicely higher...and then sat there. I waited and saw a lack of follow-through buying interest, so I took my profit and told myself I'd get back into the trade at a better price. That did happen later in the day on a market pullback.

Had my swing trade idea come from a backtested system, Henry (and George) would be correct in chiding me for meddling with the system. In this case, however, the discretionary decision to take a quick profit and re-enter the longer-term trade at a better price added value to the original plan. Could I have been wrong and missed my move? Quite possibly. Over the years, however, I've found that my ability to read short-term shifts in sentiment, momentum, and strength generally serve me well. That's quite different from getting scared out of an idea, and it's quite different from meddling with a proven formula.

At least in my case, I can state without reservation that my greatest losses have come when I have lacked mental flexibility, not when I've modified existing trading plans based upon a reading of supply and demand. To be fair, however, I also have to say that my greatest growth as a trader has come from sticking with trade ideas after opportunistically trading around them (as in today's trading). It's easier to see losses in an account statement than lost opportunities: being mentally flexible is no advantage if it ultimately takes you out of sound longer-timeframe ideas.

More:

Trading and Mental Flexibility

Keeping an Open Mind When Markets Are Moving

Attribution and Bias in Trading

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How Volume Determines Intraday Volatility and Opportunity

How much movement can you expect during a trading day? As I've stressed in past posts, this is very much related to the volume of business being transacted in the market (which, in turn, is a reflection of institutional participation).

Here is a nice graphic that illustrates the relationship: Note how volume in the S&P 500 Index (SPY) is quite correlated to the average daily high/low range. During holiday periods such as the present one, we can expect daily ranges of under 1%, whereas ranges of 2% are much more common once we do more than 250 million shares worth of business.

More:

Relative Volume and Volatility

Is There Intraday Opportunity in the Market?

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The Trading Process: Day Structure

In the first post from this series that describes how I trade, I emphasized the importance of understanding the market's context: whether current action is situated within strengthening, weakening, or stable conditions. The second post stressed the importance of identifying price levels as potential price targets for trade ideas.

The concept that unites these two ideas for me as a short-term trader is day structure. Each day has a particular structure to its price action and strength/weakness. Identifying the likely structure for the day as early as possible is perhaps the most important skill demanded of the intraday trader. I say this because you can be skilled at recognizing chart patterns or reading immediate supply or demand in the order book, but if you get day structure wrong, you can easily find yourself selling in a market that is ready to breakout to the upside or buying at the wrong time in a falling market.

Day structure, for me as an intraday trader, trumps longer timeframe trend considerations, though the latter are hardly irrelevant. If you look at my recent post where I reviewed one of my trades, you'll see that early in the morning I was selling the S&P 500 Index even though all of my contextual indicators said that we were in a rising market. The reason for this was that, at the day time frame, I was making the call that we were not seeing enough buying interest to sustain a move to the overnight high and would likely move back toward the prior day's pivot level. In other words, I was identifying a potential range day early in the session and keying my trade off of that information.

In my market preparation, I think about seven day structure possibilities:

1) Range Day - The market will oscillate around an average price value with relatively low volatility through the day, likely ending the day not far from its opening price level and/or its volume-weighted average price (VWAP);

2) Upside Trend Day - The market will open near its low price for the day session and build its way higher through the day, closing near its high price. The market will tend to stay above its VWAP for most of the day;

3) Downside Trend Day - The market will open near its high price for the day session and work its way lower through the day, closing near its low price. The market will tend to stay below its VWAP for most of the day;

4) Upside Breakout Day - The market will open within a range, but will build volume and attract participation at the upper end of that range, leading to a price break above the range, and further acceptance of price above the range with solid volume. An upside breakout represents a transition from range to upside trending conditions.

5) Downside Breakout Day - The market will open within a range, but will build volume and attract participation at the lower end of that range, leading to a price break below the range, and further acceptance of price below the range with solid volume. A downside breakout represents a transition from range to downside trending conditions.

6) False Upside Breakout Day - The market opens within a range and moves above the range, usually with limited participation and volume that wanes with higher prices, only to fall back into the range and return toward VWAP. A false upside breakout represents an extension of range trading conditions.

7) False Downside Breakout Day - The market opens within a range and moves below the range, usually with limited participation and volume that wanes with lower prices, only to bounce back into the range and return toward VWAP. A false downside breakout represents an extension of range trading conditions.

Why are these important structures?

In range markets and on false breakouts, you'll be trading for moves *toward* VWAP and often the prior day's pivot level. In trending and breakout markets, you'll be trading for moves *away* from VWAP and toward the R1/R2/R3 or S1/S2/S3 price levels. In other words, you'll be fading price strength and weakness in range and false breakout markets and trading with strength and weakness during trending and breakout conditions.

Without a proper understanding of market context and key price levels, it is very difficult to get a handle on day structure early in the session. You'll find yourself looking at very short-term "setups", only to miss the more basic question of whether price will move toward or away from its most recent estimates of value (VWAP, value areas). That's not to say that trading very short-term setups cannot be successful. Rather, you want to situate those setups within a broader framework and consideration of day structure, so that larger time frame market direction works for you, rather than against you.

Key to a trader's trading is recognizing these various types of days. The links below should help get you started; further posts that build on these ideas will follow.

More:

Three Basic Trade Setups

Historical Observations on Day Structure

VWAP and Day Strucutre

Links to Posts That Illustrate Different Structures

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Tuesday Evening Reading

* Here's a very interesting site that tracks the odds of market indexes hitting particular price levels during the day;

* Becoming the best you can be as a trader;

* Junk bond funds continue to attract money and more good reading;

* A different way of looking at price targets: Fib projections;

* Best 2009 posts from Quantifiable Edges: some good market patterns here;

* Investing in India and a broad look at ETF strength and weakness;

* Sign of the times: Amazon sells more Kindle books than physical books.
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Nice Way of Organizing Price and Technical Signal Data

I notice that the beta version of Barchart.com (for subscribers) has a new "Trader's Cheat Sheet" feature that plots prices for any stock, ETF, or futures contract on a vertical ladder, along with pivot-point based support and resistance levels; 4, 13, and 52 week high and low prices; and the prices at which particular technical indicators would provide signals.

It's a nice way of organizing price level information; I'll be playing with it in the days ahead and reporting on any findings. Above is part of the cheat sheet for the S&P 500 Index (SPY).
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More On Planning Trades and Mental Flexibility

My previous post outlined how I use price levels to set targets for trade ideas. Note how, in the opening minutes of trade, we could not muster any significant buying interest, as we had already come off pre-market highs. At the time, I noticed deterioration in several sectors, in the intraday advance/decline line, and among the euro and Aussie dollar vs. the USD. All of that suggested that, like yesterday, the bullish context was breaking down.

As a result, my trade idea was to sell the S&P 500 Index (above) for a move back to yesterday's pivot level of 1123.50, which was also a high volume area for yesterday's trade. I sold during the 8:34 AM CT minute at 1126.25 and then watched the market move promptly in my direction by about a point and a half. Volume was light on the move, however, and the NYSE TICK never went significantly negative.

I actively considered taking a profit at that point, convinced already that we were facing a slow, pre-holiday market. After a moment, I decided to hold for the original target but not add to the trade.

Almost immediately after, we bounced in stocks, and the U.S. dollar bounced firmly against the Aussie dollar. We also got a nice bounce in gold and oil. NYSE TICK also hit a morning high, although it was not a very high level. At that point, I changed my plan and decided to exit on the next market pullback and take whatever profit the market afforded me. My usual criterion for such a "next pullback" is the next move in TICK back to zero.

We got that pullback in TICK at the 8:49 AM CT minute; I waited to see if we would get any follow-through selling. That didn't happen and I worked a bid and exited at 1125 at the 8:50 AM CT minute.

It was very similar to yesterday's posted trade: quickly changing a plan on the fly when market conditions didn't stay in favor of the idea. We did, later, pull back to almost hit that pivot target, but both volume and the restrained range of NYSE TICK told me that this was not going to be a morning market that would sustain significant movement. That diminished the risk/reward benefit of holding the trade to the target.

Once again, we see that short-term trading involves a high degree of preparation and planning, but also the ability to adjust plans on the fly. In that sense, the trader is not unlike the battlefield commander or the football quarterback: it's important to have a battle plan or a game plan, but it's also important to know when to scrap that plan or call an audible at the line of scrimmage.
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The Trading Process: Key Price Levels and Targets

In this series of posts, I am outlining my trading process to help traders think through what they are doing in markets and why. The first post in the series dealt with market context: evaluating what has been happening in related markets and across related time frames. In subsequent posts, I illustrated how context was evaluated real-time in market preparation and how context is integrated into real-time price action in formulating and managing a trade.

The second phase of my trading process is the identification of key price levels as potential targets for market moves. This is where my process differs from that of many traders. Rather than beginning a trade idea with a setup, I start with potential targets that I think are likely to be hit. It is only once I have a target in mind that I will look for a possible entry point that provides a favorable reward level relative to risk.

Among the key price levels that I most commonly rely upon are:

* The overnight high and overnight low from Globex stock index futures trading. The odds are very, very high that we will take out either the overnight high or low during the regular trading hours. When stocks open inside their overnight range, I will use early market action to handicap the odds of breaking out of that range. That is often my first trade of the day.

* The volume weighted average price (VWAP) for the stock index futures market, calculated from the start of the overnight session. If we open near the highs or lows of the overnight range but cannot sustain those highs or lows (i.e., we see buying or selling interest dry up), I will look for stocks to move back into their overnight range and return to VWAP. That is another trade that can set up early in the day.

* The previous day's high and low price. My research suggests that the S&P 500 Index trades either above its prior day's high or below its previous day's low over 85% of the time. Relatively few days are inside days, particularly when volume is running average or higher. If we open inside yesterday's range, I will use price and indicator action to handicap the odds of taking out the previous day's high or low. That is a trade that can set up early in the day, especially during trending days.

* The evolving day's volume weighted average price (VWAP). If we see buying or selling drying up as we attempt to hold prices above or below the prior day's high or low, we can anticipate a move back into the previous day's range. That sets up the current day's VWAP and the prior day's pivot level (see below) as potential targets.

* The previous day's pivot level. I calculate the pivot level for a day's trade as an estimate of the average trading price. My historical calculations find that we touch the previous day's pivot in the current day's trading about 75% of the time. This makes the pivot level a target worth considering when markets cannot sustain moves outside yesterday's trading range.

* The current day's projected support (S1, S2, S3) and resistance (R1, R2, R3) levels. I calculate these by a proprietary, volatility-weighted formula and publish them daily before the market open via Twitter. (You can follow or subscribe to the Twitter stream free of charge by going to my Twitter page.) My historical work going back to the year 2000 finds that we hit either R1 or S1 about 70% of the time; we hit R2 or S2 about 50% of the time; and hit R3 or S3 about 33% of the time. These levels give good targets for consideration if we are able to sustain moves outside the prior day's trading range.

* Price levels that have attracted high levels of volume. Many times during a day, we will see stocks trade in a range, with significant volume transacted within those prices. When we are unable to sustain moves above or below that range, very often we'll get a move back to that high volume area. That can set up nice reversal trades on a short-term basis. We can also see price move back to high volume areas from the previous day (or days) of action on longer timeframe reversals.

* Support/resistance levels from prior trading days. Here we look further out to identify price levels where trade has shut off in recent days. Many times these levels are helpful in gauging possible breakout trades and trades that fail to break out and that will return to average price levels. I generally like to look one, two, three, and more days back to identify trading ranges, their average price levels, and the range extremes. It can be very useful to place the current day's trade within the context of such ranges, so that we can anticipate those breakouts and reversals.

A large part of preparation for the trading day is identifying these levels and either writing them down or marking them on charts. Your task as a trader is to integrate your understanding of market context (whether we're trading in a trending or bracketing market; whether the market is gaining or losing strength/weakness) with your identification of potential price targets so that you can anticipate a move to a target before that move occurs.

I will be illustrating this integration in an upcoming post.

More:

Six Questions That Help You Prepare for the Market Day

More on My Trading Process

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Adapting to High-Frequency Trading Algorithms

Hats off to Mike Bellafiore of SMB Capital who has written one of the few insightful articles I've read on how traders can adapt to the high-frequency trading of algorithmic programs. Mike's firm trades individual stocks and ETFs, using strategies that rely on both technical setups and a reading of order flow. They are active in training traders in those strategies and have seen first hand how the computerized trade has posed challenges for short-term traders.

The key word in Mike's article is "adapt". Setups that might have worked very well in the past become marginal when trade is dominated by the algorithms. Conversely, variations on those setups can become quite successful once one adapts to the high-frequency trade.

If, for example, we know that programs are buying new lows in stocks, we can wait for those bounces before going short, rather than aggressively selling weakness. In other words, you wait for the algorithms to do their thing and then act on opportunity.

As one savvy trader (who has adapted well to changes in the market wrought by high-frequency trading) told me recently: "Programs change the path, not the destination."

It's an important lesson for short-term traders.

More:

Thoughts on High Frequency Trading

Reading Tape and Adapting to Algos From SMB's GMan

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Lessons From a Recent Trade

In my recent post, I walked readers through a short-term trade, explaining how I used an understanding of market context to help frame an idea. Here are a few takeaways from that post:

* Short-term trading takes considerable focus and concentration. I was completely immersed in the market through the time of that trade, watching multiple sectors, markets, and indicators and synthesizing the real-time action into updated ideas about whether the trade was working or not working;

* Short-term trading takes considerable mental flexibility. At 8:45 AM CT, I'm in the trade; at 8:47 AM CT, I'm liking the trade; at 8:49 AM CT, I'm not liking it and getting out. I don't wait to get stopped out; if the market is not doing what it's supposed to be doing, I get out proactively;

* Short-term trading means fighting for ticks. That adds up over time. I'm buying bids and selling offers, not lifting offers and hitting bids. When I decide to get out, I battle to get an extra tick from the trade; I don't just bail out. Had the market picked up volume and volatility, however, I would have been more likely to bail. Tactics are relative to market conditions;

* Short-term trading means learning from trades and moving on. The inability of the market to hit R2 told me that we were having trouble sustaining the upside and could move back into the overnight range. That's a good piece of information. I don't spend time frustrated about the trade that didn't work out or frustrated with the market's lack of volume and movement. The mindset is to learn from the last trade and factor that information into the next one;

* Short-term trading means deciding when to not play. I didn't see a good risk/reward trade after exiting my trade and I saw volume drying up. As a result, I decided to not put on any further trades in the morning. Holding onto capital in slow times is as important as making capital when conditions are favorable.

More:

Being Right vs. Making Money

Patience and Not Trading

Quiet Markets Reveal Good Traders

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A Window on a Short-Term Trade: Integrating Context and Real-Time Market Action

So here is an example of a good trade idea gone wrong. Please note that in this example I am trading a very short-term time frame, not looking for market swings.

I noted in my post on market context that we were in a short-term uptrend. That put me in the mindset of buying weakness.

My discipline is to wait for the opening minutes of trade and get a feel for market strength/weakness and intraday sentiment. We popped up at the open in the ES futures, sold down to 1124, and then moved to new highs at 1126. The NASDAQ 100 futures (NQ) were relatively strong; the Russell 2000 Index was relatively weak (a concern); intraday advances were handily ahead of declines (but not by a phenomenal margin); and NYSE TICK was consistently positive (but not registering values > +800). All told, strength, but not great strength.

My discipline is also to wait for weakness to buy an uptrending market. I want to take advantage of weak longs and unprepared bears, rather than chase highs and have the market put me in the hole on normal countertrend movement.

So in the 8:39 AM CT minute, we come down to 1125 and then bounce higher; TICK stays positive. 8:42 and 8:43 minutes see us come down to 1125 again and hold. NQ is still strong; TICK is still positive; Russell is holding above its morning low. I bid for one unit (a quarter sized position) at 1125 and get filled in the 8:45 minute.

I immediately work a sell order at 1127.25. Why? That is my R2 level: my trade idea is that we're showing strength, we've taken out R1, and as long as TICK stays positive, we'll hit R2. (Note: my profit target levels for SPY are published every AM before the market open via Twitter; if you multiply the SPY targets by the ESf number, you'll get profit targets for the ES futures contract, front month).

My stop is at 1124, since that's where morning selling dried up at that point. Basically I'm risking a point to make two. Not my most heroic idea, but it's what I saw at the time. If the market suddenly picked up strength, I'd cancel my sell and consider riding to R3. If the market dried up, I'd also cancel that 1127.25 sell and consider getting out altogether.

That's the planning going through my head.

By the 8:47 minute, I see the Russell jump higher. We also hit 1125.50 in ES and move to a new high in NQ. I'm feeling good about the trade and the execution. In my head, I'm already thinking of moving my stop to breakeven. No sense losing money to start the week.

Lo and behold, the Russell hits selling immediately thereafter and ES goes into a low-volume stall for several minutes. The intraday advance-decline line is deteriorating and I see dollar strength and commodity weakness. My context is breaking down, short-term.

In a hurry I move my sell to 1125.50, because I want out and want the best price I can get. My stop is now 1125. I no longer like the trade. At all. Volume has petered out; the A/D line is no longer in trending mode; and too many sectors are weak from their opening price.

I get filled quickly and am out with a two-tick profit. Basically it was a scratch that I happened to execute well, which tells you something, over time, about the importance of execution.

The next thought in my head is that maybe I'll stop trading for the day; volume is dwindling. The following idea is that we've possibly seen the high for the day. I'm thinking about the next trade idea, which is selling the market for a move back toward the pivot level, which is a little north of 1120.

(Note: as of this posting, I did not take that second trade idea. I just didn't like the low relative volume; in a more active market, I would have taken the trade. The better idea was for a move back toward the day's VWAP, but I didn't like the risk/reward and passed).

That's what my early morning looked like; a psychological window on the short-term trading process, integrating morning preparation and understanding of context with real-time market dynamics.
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Evaluating the Market's Trading Context

The previous post took a look at how I assess market context as an initial step in framing, executing, and managing trades. Let's take a look at how the context ideas apply to this morning's stock market:

* First, we go to the longer-term market indicators, which are highlighted in this post. Notice that we're seeing more S&P 500 sectors in uptrends than downtrends; that new 65-day highs are expanding and outnumbering new 65-day lows; that Demand is expanding and exceeding Supply; and that we have broken to bull market highs in the advance/decline line specific to the common stocks listed on the NYSE. All those indicators place us in a short-term uptrend.

* Second, we take a look at the indicator tweet this morning from my Twitter stream and compare that to the prior indicator tweet. We see that 20-day highs are handily outnumbering new lows; that Demand exceeds Supply; that above 50% (and an expanding) number of stocks are trading above their 20-day moving averages; and that a majority (and expanding number) of stocks in my basket are trading in short-term uptrends. All those indicators place us in a short-term uptrend.

* Third, we notice in overnight Globex futures trade that we opened the post-holiday session weak, touching the 1117 area that had been support from 12/24. From that point forward, selling pressure diminished and we've traded higher. That tells us that, above the 1117 area, we're in a short-term uptrend.

* Fourth, we take a look at overseas stock markets and commodities (gold, oil) and see firm prices, suggesting that traders are buying risk assets. We're also seeing further yield curve steepening from Treasuries. Those are supportive of a short-term uptrend.

As I emphasized in the earlier post, none of these things constitute trade ideas; they are only market background. As a trader, I take it to the next step by thinking ahead about the price and indicator action that would tell me that we're ending the short-term uptrend, and the price and indicator action that would tell me the uptrend is intact.

But that gets us into an analysis of price levels, volume at price levels, historical trading patterns, and intraday sentiment: all topics for future posts in this series.

More:

Avoiding Getting Chopped Up in Range Markets

Trends Not Always Your Friends

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The Trading Process: Context

In this series of posts, I will outline the steps I go through in the trading process. I want to stress that there are other ways of trading, and what I describe is not at all necessarily best for all traders. My hope is that this explication of process will help traders reflect on their own processes and tighten those up. I also hope that, in absorbing examples of trading from many writers, traders can more readily find their own synthesis and style.

The first step in trading for me is identifying what we might call context. Context refers to all the factors surrounding the upcoming day's trade. That includes whether the prior day was stronger or weaker than the day(s) before, whether we're trading in a short-term range or trending, whether markets correlated to stocks are in a trending or range mode, and whether volatility is expanding, contracting, or remaining relatively constant. Context also includes news items and economic releases and how markets have responded to those in recent days and in pre-opening trade. Finally, context also includes intermarket themes and leading sectors that have impacted the stock market and whether those correlations have been waxing or waning.

I recently posted a collection of posts illustrating the market indicators that I follow; each week, I also post an update of some of the indicators that are most important to my assessment of context. Through morning Twitter posts (follow here), I keep current on several of those important indicators. By assessing the number of stocks making fresh 20-day highs and lows; the number of stocks trading above their 20-day moving averages; and the number of stocks closing above and below the volatility envelopes surrounding their short-term moving averages, I can generally get a sense for whether the market is in trend or range mode.

Unless news items and/or economic releases greatly change the financial landscape, I'll use the most recent market context to frame my early hypotheses about markets. If we're showing increasing strength, I'll expect this week's trade to take out the prior week's high and today's trade to take out the prior day's high. If the market is stalling out across the indicators, I'll expect moves away from the recent value area to fail and return back toward the middle of the range. Note that these are just tentative ideas at this point, not firm trading plans.

A great deal of context can be picked up from Asian and European markets and their trading prior to the U.S. open. Overseas trade gives us clues as to risk appetite or risk aversion of global investors. It also reveals how markets correlated to stocks--currencies, commodities, and interest rates--are trading prior to the market open.

A good deal of my morning preparation is spent gathering information about the most recent market context. To frame a promising trade idea, much more data are needed. The next post in this series will take a look at that.

More:

Key Post on My Trading Process

Preparation and Reasoning

How Preparation Affects the Perception of Time

Preparation and Execution of Trade Ideas

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Indicator Update for December 27th

This past week, we broke to bull market highs across most of the major U.S. stock market indexes. Let's see how our major indicators behaved:

TOP CHART: S&P 500 Sector Technical Strength - We saw significant improvement in Technical Strength ( a proprietary measure of short-term trending) across the eight sectors that I track weekly, with particularly notable gains among Materials, Health Care, and Technology shares. Interestingly, we still see neutral readings for three of the sectors. I will be watching closely to see if we broaden the rally; note that trend data for the basket of stocks that I follow are posted each morning prior to the market close via Twitter (follow here).

SECOND CHART FROM TOP: Cumulative Demand/Supply Index - We've broken to a multi-week high in the cumulative DSI, which tracks the number of stocks closing above their volatility envelopes relative to those closing below. Note, however, that we are not at all at levels that have recently corresponded to overbought; note, too, that we tend to get those overbought readings prior to price peaks. This suggests that we could have significantly more room to go to the upside early in 2010;

THIRD CHART FROM TOP: Here we see the number of NYSE, NASDAQ, and ASE stocks trading at 65-day highs minus those closing at 65-day lows. This, too, has broken out to a multiweek high, but is not at levels that have recently corresponded to market tops. As long as we see new highs expanding and exceeding new lows, I consider the intermediate-term trend to be intact to the upside.

BOTTOM CHART: Here we see one of my favorite charts from Decision Point: it tracks the advance-decline line for NYSE common stocks only. Observe that it, too, has broken to a new bull market high, reflecting strength across smaller cap stocks as well as large caps. We need to stay above the advance/decline line levels from the past several months to sustain the uptrend.

In sum, we're seeing both higher prices and stronger indicator readings, suggesting that the upside break from the recent intermediate-term trading range is legit. As long as we stay above last week's lows, I'll be viewing this uptrend as intact.
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Market Awareness, Self Awareness, and Trading Expertise

A very perceptive reader recently asked a question regarding the post on sustaining self-awareness during trading. If traders are self-aware during trading, how can they also be immersed in market action and maintaining their feel for trading patterns?

Ultimately, there is no contradiction: one can be immersed in, say, a fantastic concert and also aware of one's own pleasure in hearing the music. I can be totally focused on the road when I'm driving and yet be aware of my own comfort level with traffic patterns. Indeed, it wouldn't be wrong to say that my focus on the road is filtered through my driving experience, just as my market focus is filtered through my gut feel for moment to moment market action.

When I'm absorbed in a conversation, I'm aware of bodily and emotional cues that tell me how that conversation is going. That awareness is the result of absorption; it doesn't compete with it. For instance, a person will tell me about their view of the market. I will be focused on what they're saying and how they're saying it. I notice that they are rushed in their speech, that they speak of the market with increased volume, that their tone has an argumentative quality despite the fact that no one is arguing with them, and that their assertions are not accompanied by any underlying reasoning. I am very aware of what the person is saying, aware of how they're saying it (and how I'm responding to the message), and aware of how I want to frame my reply (given the person's defensiveness).

In trading, a large part of expertise is learning to filter market action through our own immediate experience, much as a race car driver or a psychologist might. It is this absorption that allows self-awareness to coexist with market awareness.

Note in the prior post how the wrestling coach taught self-awareness to developing athletes during practice time. At first, young wrestlers are completely wrapped up in their match, just as young drivers are totally consumed with the tasks of pressing pedals, watching out for traffic, and steering the wheel. Early in the developmental process, the coach (or driving instructor) provides the self-awareness piece through real-time commentary. Over time, the coach's voice becomes internalized, coexisting with the focus on the tasks at hand.

This is why much of the best performance coaching occurs in real time or very close to real time. The developing performer's self-awareness begins as the internalization of a coach's voice and actions, just as a child's self-awareness begins as internalized dialogue and experience with parents and other significant figures. That "slow down, slow down" message from the driving instructor becomes the young driver's self-talk early in the learning process; eventually it becomes a routine part of the experienced driver's performance.

When developing traders are coaching themselves, they provide their own commentary through what they mentally rehearse before trading and what they write in journals. Many traders keep these messages as post-it notes attached to trading screens, so that those "slow down, slow down" messages are sustained during periods of market absorption. Over time, the messages are repeated enough times, in enough ways, that they become part of a trader's self-talk and a natural part of performance.

At that point, absorption in markets and self-awareness become one: we experience, not ourselves and markets, but markets through our selves.

More:

Becoming Your Own Coach

Key Self-Coaching Posts

Three Steps Toward Self-Coaching

The Most Important Self-Coaching Step

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Posts on Trading Techniques and Stock Market Indicators

As many readers are aware, I use the Become Your Own Trading Coach blog as an archive for TraderFeed posts across a variety of topics. Most recently, I've pulled out 2009 posts dealing with stock market indicators and trading methods, hoping that these posts can help traders focus on useful patterns that set up in trending, breakout, and range markets. I'll be posting more shortly on the topic of my trading process and how I use these indicators and methods.

Indicator and Trading Patterns Posts:

* Volume One

* Volume Two

* Volume Three

* Volume Four

More Archived How-To Trading Posts:

* Market Lessons

* Trading Patterns That Set Up During the Day

* Trading Techniques Linkfest

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Tracking Trading Results for 2009: A Worthwhile Trading Review

Some of the best traders I'm working with are not only reviewing their 2009 returns, but breaking those down by the strategy/setup/market traded. That way, they learn what has been working for them and what hasn't. From The Daily Trading Coach:

"In your trading business, diversification provides you with multiple profit centers. You can make money from intraday stock index trades and longer-term moves in the bond market, for example. If you divide your capital among different ideas and strategies, you smooth out your equity curve, much as the presence of many departments keeps traffic flowing to the department store. When any one or two strategies fail to produce good returns, others contribute to the bottom line.

But how do you know your trading business is truly diversified? Just because you are trading different setups or markets doesn't mean that you necessarily possess a diversified portfolio. The only way you can ensure true diversification is by tracking the correlations among the returns of your different strategies." (p. 244).

Interestingly, people see this more clearly with their retirement portfolios (and with professional portfolio managers) than they do with their trading. Even the daytrader can trade multiple patterns and track returns across setups. That tracking provides useful information about performance--and also provides us with important insights into recent market conditions.

Much of performance boils down to allocating resources toward strengths and away from weaknesses. You can't do that if you don't know where your strengths lie.

More:

Emotional Diversification

Reviewing Trading

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What I See Among Many of the Best Traders

Here are four qualities I observe among winning traders and portfolio managers. These can be great areas for self-development in the coming year:

1) A creative way of looking at markets, and a way of creatively resolving conflicting market views;

2) The emotional resilience to re-enter a trade idea after being stopped out, when subsequent action confirms the initial view;

3) The courage to bet large when there is high conviction in an idea; the prudence to control risk when that conviction is lacking;

4) An insatiable desire for self-improvement that builds a deep, internal sense of confidence.

More:

Ten Characteristics of Winning Traders

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Happy Holiday Readings

* Stress and performance in trading; see also posts on handling the stress of trading;

* Very interesting project at Market Rewind to track asset class rotation in real time;

* Quantifiable Edges has developed a promising swing trading system, for sale to traders with fully disclosed parameters. Sweet!

* Worthwhile thoughts on Greece, California, and shaky sovereign debt;

* Many thanks to Richard and the Stock Market Psychology site for the kind book review; see this post on how emotions can sabotage trading success;

* Interesting interview on training the brain;

* Thanks to sharp reader Adam for this article on states in the U.S. with the highest level of happiness and what might account for the findings;

* Why banks aren't lending;

* Continued rising GDP in China;

* Record yield curve steepening in U.S.;

* Who will and won't be affected by the emerging health care plan.
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Human Performance as a Lifestyle

The best performers in any field of endeavor approach their work from a performance vantage point: they are mindful of their development and direct efforts to learn from experience and take charge of their growth. The boxer who conditions in the gym and spars between bouts under the watchful eye of a trainer; the actress who rehearses lines and works with a director to perfect a script; the artist who sketches and refines a vision before committing it to canvas: all have transformed ordinary work into a platform for self-development.

Why, however, limit such development to career activity? If we think of performance as a lifestyle, then almost any activity can become a platform for growth. If we're developing ourselves physically, how we eat, how we exercise--even how we rest--become performance activities. If we are approaching trading or parenting or a recreational sport as a performance activity, then we are reflecting on our actions in each of these areas, refining what we do and how we do it, and making ourselves ever better as a result.

This is not a new idea: prayer for the truly religious is a vehicle for transforming consciousness; tea ceremonies and martial arts training are vehicles for developing self-control; the very act of breathing can be a performance activity if it cultivates mindfulness. We can prepare and eat a meal in haste, or we can create a gourmet experience that captures all the senses. I can interact with people casually, or I can use my interactions to ever improve myself as a psychologist.

When performance becomes a lifestyle, we create massive synergies, as the progress in one domain fuels growth in others. What I do to achieve self-control and forethought as a trader helps me in managing risk and reward in a career. My physical development provides the energy to spark extra efforts at work and home. Working at becoming a better parent and spouse has made me more sensitive to the challenges of others as a psychologist--and vice versa.

Life is too fleeting and precious to be lived on autopilot. In refining ourselves, we inevitably extract the most from our experience, enriching others and the world. I can think of no nobler way to live a life.

More:

Trading as a Performance Activity

The Value of Trading

Achieving Greatness

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Looking at the Correlation of Trend and Volatility

Note how volatility (average daily high/low range for SPY over a moving five-day period; red line above) has been coming down during the lead up to the holiday, as prices have been breaking out to the upside. Eventually, particularly with the holidays behind us, we will see a mean reversion in volatility and a pickup in market movement. I will be tracking the correlation between volatility and directionality moving forward, as this will provide us with insight as to whether we move back into the multiweek trading range vs. melt up to significant bull highs.
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Why Quiet Markets Reveal the Best Traders

Following my recent post highlighting a few difficult realities for traders, several readers questioned the following generalization:

Quiet markets reveal the best traders

Let's take a look at why that's the case:

1) Flexibility - When traders first get off the ground, their natural tendency is to follow what the market is doing. That leads them to follow perceived trend and momentum. Under certain market conditions, one can make significant money buying strength and selling weakness. Over time, however, traders making their living this way wind up being one-trick ponies. We saw that in the late 1990s and then again when traders had slam-bang years in 2008, only to wither in 2009. Quiet markets demand that successful traders either execute trend ideas in a countertrend fashion (buy dips, sell bounces) or outright trade in a countertrend manner (fade both strength and weakness). When a trader can make money in a quiet market, it generally reveals an ability to adapt to shifting market conditions.

2) Patience - Quiet markets don't move around as much and, for long stretches of time may not move much at all. The best traders are patient at those times and either don't trade or trade very selectively. The ability to not overtrade during quiet markets generally reveals a discipline that will serve a trader well in any market environment. The best traders keep their money in quiet times and then make money when things pick up.

3) Adaptability - When the market goes quiet, there are often sectors and individual stocks that are moving well. The best traders will find the spheres of opportunity and concentrate their efforts on those. They realize that what you're trading is as important as how you're trading. Similarly, even in quiet markets, morning hours will offer much more opportunity than later hours. The best traders will find the times of best opportunity and make the most of those.

Consider an analogy: a hotel located in a college town can make money with ease during periods when the school is hosting its homecoming games or holding its graduation ceremonies. It's in the dead of winter, when no events are scheduled and family travel is light, that the best hotels hold their own. They adopt unique tactics (advertising to locals for getaways; creating package deals that combine dining, lodging, and entertainment) and contain their overhead so that they can stay profitable in the leanest periods.

Traders face similar fat and lean periods in their businesses. It's the ones who adapt their tactics to market conditions that survive over the long haul.

More:

Losing Money the Right Way

Thoughts on Winning and Losing

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The Psychological Importance of Paths of Returns

In my post on risk and return, I showed how shifts in volatility and the size of a trader's edge greatly affect the path of returns over time.

Above, we can see with the aid of Henry Carstens' forecaster different possible paths of annual returns for a high frequency trader who trades a portfolio of $100,000, nets an average of $100 per trade, and has a 2% standard deviation for daily returns (i.e., two-thirds of all daily returns fall between -$1900 and +$2100).

In the four scenarios above, the annual profits for the trader fall between 10.88% and 14.5%. Note, however, that paths differ greatly simply based upon the random arrangement of the winning and losing trades.

For instance, in the third scenario down, we see a drawdown of about 17% before the trader ends up with a 14.5% profit. The fourth scenario at bottom sees a drawdown of only a little more than 3%, but quickly makes and then loses a 20% return before ending the year up 10.88%. We see a similar harrowing drawdown in the first scenario, but a rather steady and gradual move to year end returns in the second scenario.

Observe that this is a profitable trader with an objective edge, trading that edge aggressively. Depending on the path of returns, however--something outside the trader's control--it may be easier or harder to stick to the winning method. The odds are good that, during a harrowing drawdown or extended, choppy period, the trader might abandon the formula and unwittingly erode his or her edge.

The point here is that the random distribution of winning and losing trades ensures that we can have runs of winning and losing periods that we will experience as hot and cold hands. Few traders recognize the importance of the path of returns on a trader's psyche.

How many successful traders never saw their success to fruition simply because they confused a normal run of losing trades for their method not working? How many successful traders have blown up because they became too aggressive after an extended run of winning trades?

Expertise can ensure a positive destination for our trading, but cannot ensure the path we take along the way.

More:

The Psychology of Decision Making and Risk

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Musical Interlude: Visual Kei

When I begin new projects, I generally immerse myself in new reading and fresh music. These days, the music is coming from bands influenced by the ヴィジュアル系 (visual kei) movement in Japan. The style is known for its use of bright colors, bold costumes, and androgynous looks derived from manga. Many of the bands fuse musical styles, from metal to jazz to pop. You're unlikely to hear any of this music via mainstream U.S. media; enjoy!

* The GazettE: Cassis

* SID: Natsukoi

* Zoro: Kitsune

* An Cafe: Snow Scene

* Cinema Bizarre: Lovesongs (English language)

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The Power of Uncertainty

Losing confidence in your trading is not necessarily a bad thing. Many times, we lose confidence when we sense that our edge in markets might be eroding. All good traders cycle between periods of high conviction--seeing markets well--and low conviction. The diminished belief in trade ideas can itself be a useful indicator; someone with continuously high confidence is in danger of overconfidence.

Over the years of working with very good traders, I've found that all of them go through periods in which they're out of sync with markets. The really good traders--those who sustain long-term careers--don't fight those dry periods. They use the time to research markets, wait for good ideas, and hang onto their capital.

They realize that the goal is not to trade, but to make money. For them, uncertainty is a powerful motivator, not a performance problem.

More:

* What to do When You Lose Confidence: Gaining Perspective

* What to do When You Lose Confidence: Changing Self-Talk

* What to do When You Lose Confidence: Restructuring Experience

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Sustaining Self-Awareness During Trading

One important element of working on trading performance is sustaining self-awareness during trading, so that you know which strategies (setups) and tactics (execution) you're using at the times you're trading. After all, if you're not fully aware of what you're doing when you're doing it, can you hold that in memory to reflect upon it later and learn from it?

Many traders think that more days, weeks, and years of trading will give them better skills. But that's not necessarily so. It's the awareness of performance that enables us to internalize it, adjust it, and learn from it. Performing on autopilot is a recipe for repeating a day's worth of experience 250 times, not achieving 250 days' worth of experience.

Consider this perspective from wrestling coach Nick Cipriano:

"The strategy and tactics that wrestlers employ in competition are conceived in the practice environment, but they are often perfected in competition under stressful conditions. Through experience, wrestlers learn to better track match developments, and they slowly learn to adjust strategy and tactics accordingly. In my experience, I have found that highly accomplished wrestlers (as compared with novice wrestlers) can recall explicit details of their matches. I believe their recall ability is directly linked to their ability to process and interpret match developments, not only more readily, but also much more accurately. In my judgment, the coach facilitates development of this important psychological skill by integrating technical training with psychological training and by constantly reminding the wrestler during sparring sessions to monitor developments and adjust tactics accordingly. One specific strategy I use involves encouraging wrestlers to maintain a broad focus of attention during sparring and to visualize the actions of their opponent from a third-person perspective (as if watching the sparring from the sidelines). Being able to assess match developments from an external perspective allows a more accurate interpretation of strategic and tactical adjustments that must be made."

Expert Performance in Sports
Starkes and Ericsson (Eds.)
p. 165

More:

Cultivating Self Awareness

Implications of Sports Psychology for Trading

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