Redefining the Market Game

A few market observations:

*  Going back to 2006, if you bought SPY when fewer than 50% of SPX stocks were trading above their five-day moving averages, the next five trading days averaged a gain of .44%.  If you bought SPY when more than 50% of SPX stocks were above their 5DMA, the next five trading sessions averaged a loss of -.08%.

*  If you divide market days since 2012 into quartiles based on the aggregate put/call ratios of individual equities, the top two (highest) quartiles average next five day gains in SPY of .90% and .40%.  The bottom two (lowest) quartiles have been essentially flat on a next five-day basis.

*  If you bought SPY after the highest quartile of VIX days since 2012, your next five-day gain averaged +.82%.  If you bought SPY after the lowest quartile of VIX days since 2012, your next five-day loss averaged -.18%.

*  If you bought SPY after the highest quartile of five-day volatility periods since 2012, your next five-day gain averaged .79%.  If you bought after the lowest quartile, your next five-day loss averaged -.06%.

What might account for these observations?

*  One hypothesis is that a significant proportion of market participants are over-leveraged.  This means that they formulate trade ideas on a longer time scale but have to manage risk on a shorter horizon.  The inability of market participants to take heat that is normal for a market's present level of volatility sets up short-term trading opportunities in which overstretched long and short positions need to be unwound.

Implications:

*  On the short time horizon, what matters most is not so much macroeconomic relationships or chart patterns, but the behavioral tendencies of other market participants.  A great deal of the skill of reading markets consists of reading other traders.

Further Reading:  A Remarkably Consistent Trading System
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Letting Markets Tell Their Stories

With booming momentum stocks showing signs of bust, here is some valuable perspective from David Shvartsman and the Finance Trends site.  David's makes an important point:  Nothing goes up forever.  Stocks with a great story but shaky fundamentals are particularly vulnerable to round tripping.

Few problems can be so painful as becoming anchored to a story about a company or industry--or a macro theme--and then failing to listen to the stories that markets are themselves telling.  I vividly recall the attempts to traders to buy dips all the way down in the post-2000 tech meltdown.  I equally recall the pain of those who kept selling rallies in the post 2008-2009 bull market.

One reason I like to follow the cumulative NYSE TICK on an intraday basis is that it tells me when buyers vs. sellers are taking the upper hand and when they are balanced.  On a day like yesterday, when my model forecast was pointing upward, tracking the reversal of the TICK proved invaluable.  All forecasts, stories, and themes are hypotheses:  they are maps, but they are not the territory.  It's the stories told by moving markets that are ultimately important, as they provide the tests of our hypotheses. 

Markets often tell their own stories with relative strength patterns.  Is the market rewarding growth and speculation, or is it rewarding safety and yield?  Look at the recent relative performance of XHB and QQQ versus XLU and XLP.  Clearly, growth is not what is being rewarded.  Similarly, at a global level, you can track EEM vs. SPY or, in fixed income, junk bonds (JNK) vs. investment-grade debt (LQD) or emerging market debt (EMB) vs. U.S. debt (AGG).

How do stocks trade relative to bonds?  How does EM FX trade relative to DM?  Are macro markets reflecting global growth: global slowdown; or idiosyncratic, relative movement?

Bottom line:  by spending too much time focusing on the stories we tell ourselves, we can fail to discern the stories of markets.  Permabears and permabulls are those who have so fallen in love with their narratives that they have become deaf with respect to the market's stories.

Markets are always communicating; so much of trading success begins with listening.

Further Reading:  Listening, Trading, and Emotional Intelligence

No tree grows to the sky and no stock goes up forever, especially those story stocks for which real earnings growth and sound fundamentals are lacking. - See more at: http://financetrends.blogspot.com/2014/04/round-trip-stocks-momentum-booms-and.html#sthash.EVU7PW7S.dpuf

No tree grows to the sky and no stock goes up forever, especially those story stocks for which real earnings growth and sound fundamentals are lacking. - See more at: http://financetrends.blogspot.com/2014/04/round-trip-stocks-momentum-booms-and.html#sthash.EVU7PW7S.dpuf

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The Greatest Cause of Trading Problems That No One Talks About

Sometimes good trading can fall apart and it's not because of lack of discipline and planning.  It's not because of trading the wrong information or setups.  It's not because markets have radically changed.

No, sometimes trading can fall apart because we are falling apart.  That is a reason for trading problems that very few mentors and coaches address.

Consider the facts:

*  Every year, more than 1 in 6 Americans will experience a diagnosable emotional disorder.

*  About 6% of the population experiences a severe emotional disorder during a given year.

*  According to the World Health Organization, emotional disorders are a greater cause of disability than any other medical condition, including cancer and heart disease.

*  Over 30% of the U.S. population will experience a diagnosable anxiety condition during their lifetime.

*  Over 20% of the population will experience a diagnosable mood condition during their lifetime.

Don't believe it?  Consider this:

I ran a student counseling program at a medical school for 19 years.  This was a motivated, bright, capable group of students.  Fully 15% of them made use of counseling services each year.  About a third of that group utilized the services for a significant emotional disorder.

I sincerely doubt that the universe of traders is any more immune to emotional problems than the universe of physicians in training.  If over 5% of medical students--and about 18% of people overall--experience a diagnosable emotional disorder in a given year, I suspect the same can be said for a significant number of traders.

I recall meeting with one trader who had sought prior coaching, but had not found the meetings helpful.  In our first meeting, I asked a group of questions and the answers I received led me to believe that the trader was experiencing a form of bipolar disorder (bipolar 2).  The recurring mood swings were wreaking havoc with trading.  A consultation with a psychiatrist confirmed the diagnostic impression, the trader started on a course of medication and therapy, and soon the trading problems came to an end.

Not because of any fresh discipline, and not because of any new trading methods.

Sometimes an emotional problem really is an emotional problem.

If you are going through turmoil and have a family history of anxiety, depression, or other emotional problems; if you experience those problems outside of your trading, across different areas of your life; and/or if you have a personal history of emotional upheavals, consider reaching out for help.  It could be the greatest investment in your trading career you could make.

Further Reading:  The Problem of Addictive Trading
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Taking a Hard Look at Your Life Outside of Trading

I enjoyed Bella's post on becoming a nanny trader.  Nothing quite so imparts perspective as time spent with the little ones.  When our family lived in Syracuse, I brought the kids to school and a morning ritual was going out for breakfast together.  A small thing, but it started the day on a note of connection and togetherness.

It's difficult to sustain overconfidence when you have little ones who manage to thwart your every grand parental design.  It's also difficult to go too far in the dumps when you come home to bundles of love.

The best way to weather the stresses of trading is to have a rich and full life outside of trading.  If P/L is all you have, you've set up a life that, at times, you'll need to escape from.

A sound trading process is one that also addresses how you renew yourself outside of trading.

Further Reading:  What Makes a Trader's Marriage Work
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Fallible Edges and Messy Markets

Citing Tyler Cowen's recent work, Abnormal Returns emphasized the importance of reveling in the messiness of financial markets.  Embracing uncertainty is a powerful antidote to the overconfidence biases that can plague trading.

For me, embracing uncertainty begins with market preparation.  Here's an example:

My research generally points to a higher U.S. stock market in the next few days, based on patterns that have been present over the last couple of years.  Those patterns involve sentiment, buying/selling pressure, and other measures of strength/weakness.  My chief model correlates with future market movement at a statistically significant level--and it leaves the vast majority of variance in future price action unaccounted for.

In other words, it's a fallible edge.

Fallible edge is central to how I think about markets.  Edge means that there is a reliable, repeatable, significant pattern within markets; fallible means that idiosyncratic, unique drivers of markets can always emerge and overwhelm that edge.  My model could shout "buy" from the rooftops, but that will not be helpful if military conflict erupts overseas or if a major bank announces a crisis situation.

Because edges are fallible, the outputs of any research process become hypotheses, not conclusions.  Hypotheses are meant to be tested; they are falsifiable.  Financial markets provide the test.  Based on how markets trade, I either gain or lose confidence in the forecast of the model.  If markets open and do not display net buying--or at least a drying up of selling--I then need to scan for the situational factors that might be accounting for the unexpected weakness.

A disconfirmed hypothesis is also information.

A while back, I took a car service from Connecticut, where I had been working, to LaGuardia airport for a flight back home.  The driver went past the exit that I was accustomed to taking and ended up driving around a few blocks in Queens, periodically consulting his GPS.  I finally concluded that his GPS was faulty and gave directions to the terminal.  It took quite a few minutes, however, for the driver to stop consulting the GPS and simply take the directions I offered.  I almost missed the flight.

One thing you won't find in my car is a GPS.  I study maps, internalize the main north/south, east/west roads, and then take off.  If I'm in a new place, I'll get lost.  So I'll look at a map again, figure out how I got lost, restudy the area, and then take off.

That's how I learned my way around NYC many years ago:  by getting lost often.  That's the messiness that Cowen and Abnormal Returns are talking about.  I could be the driver who relies solely on the GPS, but then I've learned nothing and I'm helpless if the GPS malfunctions.

Too many traders want a GPS for financial markets:  they look for signals and setups to tell them what to do.  But a GPS is of limited benefits if the roads keep changing.

Even the best research informs us of tendencies.  Taking tendencies for truths turns edges into liabilities.  Entertaining many hypotheses and becoming locked in few conclusions keeps traders flexible and adaptable:  ready to withdraw from markets that do not confirm expectations, and ready to pounce on those that do.

Further Reading:  Trade Like a Scientist
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Overcoming Overconfidence in Trading

One of the great challenges of trading is the fact that confidence is necessary to produce meaningful returns, and yet overconfidence can ensure catastrophic returns.  In that respect, traders and investors can be their own worst enemies, as we seem to be hardwired to perceive ourselves in unrealistically optimistic ways.  

Imagine giving a survey to traders in which they had to rate their skills on a five-point scale, where 1 = much below average; 2 = below average; 3 = average; 4 = above average; and 5 = much above average.

I strongly suspect that the average trader does not view himself or herself as average--just as few people rate their driving skills as average.  (Indeed, 82% of drivers rate themselves in the top 30%). 

One study showed that more than one third of investors who believed they had beaten the market had actually underperformed by 5% or more.  On average, investors in that study overestimated their performance by over 11%!  

How can market participants be so unrealistic in their self-assessments?  One set of experiments gave subjects tests in a variety of areas, including logic, grammar, and humor.  Those who scored in the bottom quartile averaged scores in the 12th percentile, but estimated their performance to be in the 62nd percentile.  The authors suggest this to be particularly problematic for non-experts and beginners in a field, as they lack the metacognitive ability to stand apart from themselves and objectively gauge their performance.

One characteristic I've noticed among successful traders:  they are their own hardest critics.  They avoid overconfidence by focusing on what they could be doing better.  If you read their journals, there are few excuses and emotional outpourings.  Instead, there are hard-nosed observations about what they did wrong and what they need to do better.

And how about the less successful traders?  Do they keep journals with rose-colored glasses?

No.

They don't keep journals.

Which may enable them to sustain overconfidence.

Further Reading:  Keys to Goal Setting
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Trading and Performance Anxiety: Moving From Panic to Confidence

In response to the recent post on keeping trading journals, a reader raises the following scenario:

One major problem I seem to have is a fear of being down for the month. I report to my investors monthly and it seems like every little BP loss sets me off. On my whiteboard in my office, I write out that I will shoot for 3% monthly gains with the corresponding Dollar amount, and allow myself to lose 1.5% monthly with the corresponding Dollar amount. But it doesn't seem to work. Instead, I continually compare myself to my monthly starting point, and if I get below that point, I panic. If I'm a bit above that point, I have a hard time taking risk and risking my gains. Of course, this guarantees that I will stay just about flat and potentially set myself up for a big loss. What can I do to avoid this? How can I get myself out of this mindset?

A key to this situation might be found in the first two sentences.  Reporting to investors monthly is contributing to a fear of being down on the month.  This is the essence of performance anxiety:  the fear of a negative outcome is interfering with the process of making decisions.  As the reader observes, this has the potential to paralyze risk-taking with P/L moving little on either side of zero.

The tricky element in the situation is that a personal trading problem has become a business problem.  Investors get results monthly and quite possibly are habituated to results that neither excite nor scare them.  Any meaningful bump in risk taking is apt to look to an investor as an outlier.  An advance communication to investors, explaining the current opportunity set and how the fund plans to respond, not only defuses a WTF response to greater P/L variability; it also subtly changes the performance pressure from risk-taking to risk-aversion.  It's difficult to explain to investors why you didn't take meaningful risk after sending them a notice of pending opportunity!

From that point forward, I would mentally--and actually--rehearse giving talks to investors and writing letters to investors explaining moderate losses for the month.  The one inescapable reality of anxiety is that you can't overcome a fear of something by avoiding that thing.  That, for example, is how fears turn into phobias; how performance pressure morphs into performance anxiety.

I first began teaching on a large scale by delivering lectures at an introductory psychology course of 300 students.  At first I was panicked.  Giving the lectures every Monday, Wednesday, and Friday, however, quickly led me to become accustomed to the situation.  Eventually I got the hang of it and now I enjoy addressing large crowds.   

Imagine that you had to address investors every single day on a road show and explain a 75 bps loss on the month.  Eventually, you'd become so familiar with investor questions and concerns that the talks would become routine.  More to the point, however, a future responsible losing month would lose its scariness, because you've already been through what had previously been an ordeal and come out on the other side.

To overcome anxiety, gradually face the fearful situation--first in visualization, then in the real world--until that anxiety is extinguished.  This is the essence of the exposure approach outlined in the Daily Trading Coach book.  It is difficult to panic over situations that you make routine.  

Familiarity breeds content. 

Further Reading:  Brief Therapy Methods for Self-Coaching
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Can Day Traders Be Successful?

Is it stupid to pursue day trading?

Back in 2008, I wrote about a research study that suggested that the great majority of day traders lose money, but it is "not entirely a fool's game", as the largest participants demonstrated skill and success. 

An update of that study finds that there is evidence of cross-sectional variation in day trading skill:  those who make money in one year are more likely to be profitable in the following year and vice versa.  Altogether, about 15% of traders studied earned meaningful returns (enough to overcome trading expenses) over the course of a year.

I'm not sure pursuing day trading is any more stupid than pursuing a Hollywood career or a calling to become a WWE wrestler.  Many are called, few are chosen in most performance fields.

What *is* stupid is thinking that you can be in the elite group of performers without substantial deliberate practice and experience.  I know of several day traders who have enjoyed very long careers of consistent success.  Every one spends significant screen time absorbing market patterns and working on their craft.  

Barber and team also cite evidence that day traders not only learn from their trading experience, but also show signs of failing to learn from experience.  In their study, for example, 24% of all traders had histories of prior losses and they accounted for over half of all day trading volume!

In short, day trading is like American Idol tryouts.  A few contestants are really good and a few of those become true stars.  Many are fair to middling and never go anywhere.  And a few are so head-scratchingly awful--and unaware of their awfulness--that you wonder how they can persist in their talent delusion.

Is it stupid to pursue a dream?  Not if you wake up and are willing to do what's necessary to make it a reality.

Further Reading:  Why It's So Easy to Lose Money in Markets
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When Strengths Become Derailers

The tricky thing about playing to our strengths is that it is often our strengths, applied across situations uncritically, that can hold us back.  The dark side of strengths are sometimes called derailers, because of their potential for interfering with progress and derailing success.

Consider the following examples:

1)  The diligent hard worker who periodically burns out and fails to maintain valuable friendships and personal relationships;

2)  The process-oriented trader who develops good trading habits, but fails to innovate and expand those habits;

3)  The trader who processes information very well through teamwork and social interaction, but who falls prey to consensus thinking;

4)  The caring manager who has great relationships with employees, but avoids conflict and does not effectively uphold work standards;

5)  The trader who is passionate about markets and learning about trading and who loses money by overtrading.

In each case, a strength carries the seed of its own undoing:  what powers us down the track can also derail us.

It's a good exercise:  list your top three strengths as a trader and then clearly identify a dark side to each that has, at times, derailed you.  You'll wind up with a pretty good list of best and worst practices that can feed your self-awareness and guide your trading process.

Further Reading:  Building  Strengths and Correcting Weaknesses
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The Power of Trading Journals

I recently suggested one way of taking journals to the next level, by making them more interactive.  It can be easier to sustain a journal if it becomes a group process that brings you feedback and ideas--and that contributes your own observations to others.

There are two kinds of journals that I encounter:  1) personal journals that track performance, goals, trading process, and best practices; and 2) idea journals that synthesize thoughts about markets, macroeconomics, research, etc.  

The first kind of journal acts as a springboard for learning and development:  it is your way of studying you.  The second journal is a springboard for idea generation and creativity.  It is your way of making sense of markets and finding opportunity.

The first journal looks inward; the second outward.

I recently came across a quote that I like:  "A friend is someone who knows the song in your heart and can sing it back to you when you've forgotten the words."  

Journals can be friends in that way:  they remind us of what we're meant to be doing.  They are a way of focusing on process, rather than anchoring our moods and self-esteem to the ups and downs of P/L.

Trading without review is like playing a football game without huddles; like preparing for a baseball or basketball game without practices or review of game film.

If you spend more time trading than preparing and learning, you'll quickly find yourself underprepared and behind the learning curve.  A performance principle you can take to the bank:  Elite performers--in music, theater, professional sports, chess--spend more time practicing and preparing than actually performing in competition.  By turning journals into the friends who know what's in your heart, you transform trading into a true performance activity.

Further Reading:  What Kind of Journal is Right for Me?
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A Quick Guide to PREP Tweets From @steenbab

Generally before the market open, I will send out tweets that are labeled PREP.  (You can follow the stream at StockTwits:  @steenbab).  PREP tweets capture some of the information I rely upon to prepare for the trading day.  Below is a guide to some of the abbreviations and the terminology used in those tweets:

Price Targets - These are generally for the overall market ($SPY) and represent price levels that I am targeting during the day session.  Please see this post for details.  We have a 73% probability of hitting either the R1 upside level or the S1 downside level.  The probabilities of hitting R2/S2 and R3/S3 are 54% and 37%, respectively.  Earlier targets are the overnight high/low and the previous day's high/low.  The odds of hitting more distant targets are increased if volumes are coming in higher than average.

BP/SP - This refers to buying pressure and selling pressure and is a measure of whether buyers or sellers were aggressive during the prior trading session.  BP and SP are two variables I utilize in market queries (studies of historical patterns in the market).

%DMA - This refers to the percentage of S&P 500 shares trading above a given moving average.  So, for instance %20DMA refers to the percentage of stocks in the S&P 500 universe trading above their 20-day moving averages.  It's another variable I rely upon in market queries.

Model - This refers to regression-based forecasts that I use to gauge $SPY over a 3-5 day time horizon.

Cycle - This refers to cycle-based forecasts that I use to gauge $SPY over a period of weeks to months.  Very experimental work.

New Highs/Lows - Unless otherwise specified, this refers to the number of common stocks across all exchanges trading at fresh 3-month highs/lows.  I look at this number to identify potential divergences.

CumTICK - This is a cumulative total of intraday NYSE TICK levels.  It basically takes 5-minute readings of $TICK and sums them like an advance-decline line.  A good overall indication of buying/selling dominance--bigger picture than BP/SP.

PC - Unless otherwise specified, this refers to the ratio of put options to call options traded across all individual equities, not including index options.  Useful sentiment gauge.

RelVol - How much volume is being traded at a given time of day compared with the average volume traded at that time of day.  Useful in gauging potential volatility.

%VWAP - Percentage of NYSE stocks trading above their day's volume-weighted average prices.  Useful in identifying trend vs. range days.

Delta - A measure of volume traded at the market bid vs. offer, pioneered by Market Delta.

Divergence - When an index makes a new high or low, but many sectors/stocks do not participate in the strength/weakness.  Helpful in identifying potential turning points.

I'll add to the list as we go along.  If you share your market preparation via Twitter or StockTwits, feel free to pass along your info as a comment to this post.  Thanks for the interest--

Brett

Three Perspectives on Stock Market Strength

The cumulative line of NYSE TICK has once again hit all-time highs, as large cap indexes now stand close to their own high water marks.  Overall, I am not seeing a change in the bull market dynamics, though there has certainly been a high degree of sector rotation.

The results of the rotation can be seen in the bottom two charts.  Fewer shares across the common stock universe are registering fresh three-month highs as we approach the highs in SPX (middle chart); we're also seeing fewer new highs vs. lows among the S&P 500 stocks (bottom chart).  

All of this is consistent with mature bull market cycle behavior, but it is not clear to me that we are on the cusp of any bear market.  The absence of broad strength does not necessarily imply the presence of broad weakness.

Further Reading:  Countertrend trade execution in a trending market
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The Power of Repetition

The recent post focused on breaking bad trading habits. 

We can think of best practices as good trading habits.

We can think of creativity as breaking habits.

What we do repetitively gives us repeated experience of ourselves, for better or for worse.  

Experience provides our mirrors; we internalize repeated experience.

Fresh experience provides fresh mirrors:  it's not that we change psychologically and then change our actions.  It's shifted doing that leads to fresh construing.
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Breaking Bad Trading Habits Through Self-Coaching

A reader asks the question of how to break bad habits in trading.  His example was failing to endure the pain of gain:  taking trades off before they have reached their intended targets.

This post will provide some perspective on the problem.  The key idea is that problem patterns often represent ways of meeting needs that unfortunately bring their own consequences.  If you can identify the need that lies underneath the problem and find a better way to meet that need, the problem suddenly yields way to a solution.

In the case of taking profits prematurely, that need might be a need for psychological victory and a fear that such victory will be lost should the market reverse.  This often occurs when traders measure their progress and success solely in outcome terms (by their P/L), rather than in process terms (by how well they engage in the right trading behaviors).  One of the advantages I've observed by having traders keep best-practice checklists is that those become a kind of report card, enabling the traders to identify their good trading.  When success is experienced in process terms, the insecurity that leads to premature profit grabbing no longer drives behavior.

Once you accept that problems shouldn't be eradicated--that every problem represents a suboptimal strategy for meeting a legitimate need--fresh paths to solution appear.  

When I wrote The Daily Trading Coach, I intended it as a resource to help traders coach themselves.  Below are a couple of posts to get interested readers started.  Many of the research-validated techniques of brief therapy are not difficult to pick up and apply--and once you have those skills, you have them for a lifetime.  

Further Reading:

Therapy for the Mentally Well

Becoming Your Own Brief Therapy Coach

Self-Coaching Ideas for Traders

On Growing One's Thoughts in a Garden

A walk through a plant exhibit at the very impressive New York Botanical Gardens with the Spec List group and friend/mentor Victor Niederhoffer led to reflections, fresh market research, and this post to Daily Speculations. 

It was thinking about plant-based folk medicine, the difference between pre-scientific thought and anti-scientific thought, and ways in which early technical analysis was similar to pre-scientific investigation that led to renewed efforts to find strict, mathematical expressions for support and resistance.  After hours of work, I arrived at a beta formulation that adds value to the historical studies I run.

The key was looking at support and resistance as verbs, not things:  processes, not static levels.

In seeking stimulating settings and surrounding ourselves with the right people, we can find new sources for combinatory play and fresh market thinking.  Routine is great for efficiency, but it is breaking routine that can make us more effective.

Further Reading:  Core Trading Psychology Ideas
   

Readings and Resources for the Market Week

Many thanks to readers who offered their best practices resources as comments to this post.  If you scan those comments, you'll see quite a few worthwhile sources of information and perspective.  It only takes one or two, added to your routine, to make a meaningful difference in your generation of ideas.  Per the quote above, fresh information sources create fresh internal conversations.  Exposure to divergent views is a great way to build cognitive flexibility and creative insight.

In the spirit of facilitating fresh internal conversations, here are several additional fine reads:

*  Excellent proverbs from Tom Wiswell, courtesy of Daily Spec.

*  Really excellent example of a structured method for finding trade setups from Trader Hacks.

*  Thanks to an inspirational portfolio manager for this piece on Einstein's thought process.

*  Worthwhile crowdsourced favorites from Abnormal Returns.

*   Excellent macro blog takes a look at selling EURUSD.

*  Mathematicians take a hard look at a commonly cited seasonal tendency of the stock market.

Have a great start to the week.  I'll be posting market preparation via StockTwits:  @steenbab.
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Yoga for the Mind

Suppose you spent dedicated time each day searching your failures for success lessons; reflecting on your anger to identify your vulnerabilities; dwelling on your prejudices to reach a point of empathy; eating only when you are hungry; observing your impulses before you acted; tying seemingly unrelated thoughts together; changing your daily routines; etc.

In doing what doesn't come naturally, we build mindfulness and create a kind of mental yoga. 

Might it be possible to train ourselves for cognitive and emotional flexibility the way we can train our bodies?

And might it be possible that a significant portion of the effects of aging come from failing to retain flexibility: physically, emotionally, cognitively?

Flexibility workouts for the mind could be great training for the cognitive and emotional flexibility needed to respond to ever-changing markets.

Further Reading:  Cognitive Flexibility and Trading

StockSpotter as a Trading Tool

John Ehlers and Ric Way are far too professional to pump me for a recommendation of their StockSpotter service, which is always something I look for in a market service with integrity.  I was first impressed with John's longtime work on market cycles and then discovered that he and Ric had assembled the StockSpotter site.  

Above is an algorithmic, cycle-based forecast for Boeing stock ($BA) that Ric had shared recently on StockTwits (@StockSpotter).  In addition to the forecasts, StockSpotter tracks where individual stocks and ETFs stand in their dominant cycles and identify both trade setups (stocks poised to give buy or sell signals within a few days) and actual trade signals.  

Particularly impressive is the fact that John and Ric track the accuracy of their signals in real time and report the P/L of each of their recommendations.  Because they track the broad universe of U.S. shares, they can make far more recommendations than an individual trader is likely to implement.  A Monte Carlo simulation feature shows how their forecasts performed if one were to take one or several random recommendations from their lists.  The Sharpe Ratio of 1.3 for the strategy is quite good; a separate Monte Carlo drawdown analysis helps identify the risks of the strategy.

There are many ways to use the information.  You could create a long/short strategy of the names that give buy and sell signals or you could trade a basket of shares with signals against a sector or index ETF that does not give a signal.  You could also use the cycle-based research as a second opinion for your own trade ideas.  I've found, for example, that when the StockSpotter forecasts and my own model signals point in a particular direction at the same time, that's a high probability entry signal.

As I've emphasized many times, trading is a team sport.  Finding the people who do good work and making them part of your team is a great success strategy.

Further Reading:  Visualizing Market Sentiment

Turning Learning Into a Learning Culture

One of the occupational hazards of trading can be isolation.  Even within trading firms, portfolio managers and traders can operate in silo mode.

As this post notes, there is much to be said from building your own learning culture.  That means, not only learning from your successes and failures, but also leveraging learning by reaching out to likeminded traders and benefiting from their experience.

The goal is to accelerate the learning curve and fuel creativity.  Fresh inputs from the right colleagues can turn your efforts at improvement into a shared learning culture.

Identify who is already sharing their work:  when someone is continuously innovating, they are not threatened by the idea of sharing innovations. Those are potential teammates.  Just one fresh conversation a week with the right people over the course of a year can get the idea factory working at full capacity.  That sounds like a best practice worth turning into a best process.

Further Reading:  Become Your Own Trading Coach

Trading, Creativity, and Becoming an Idea Factory

As I've mentioned in the past, discipline in trade execution and risk management is one part of the success equation in trading. Another part of that success equation is generating new ideas and fresh perspectives on markets.  Discipline and process orientation keeps us doing the right things.  Creativity enables us to discover those right things.

There are many ways of becoming an idea factory.  In a recent post, I described a method I use for establishing the price targets for trades.  Quantifying targets helps with the discipline and process orientation because it keeps me grounded in an updated appraisal of risk/reward.  But I find that quantification also helps with idea generation.

Here's an example:  A staple of my market analysis is to identify stable regimes in a market and a core group of drivers that account for a significant portion of variance in forward price movement during those regimes.  The models so derived did a nice job of anticipating the recent market strength, but did not do a great job of anticipating the prior market weakness.  This led me to investigate the current market and look for drivers of market action that I hadn't accounted for in the models.  Sure enough, it turns out that intermarket behavior was an important factor that I had neglected in the earlier modeling.  This led to new investigations and insights.  

One need not be quantitatively oriented to become an idea factory.  A hard-nosed review of losing trades will often identify where you have either misread markets or traded them suboptimally.  Either is fertile ground for learning and adaptation.

Henry Carstens is someone who I've cited as an example of an idea factory.  Take a look at the very creative idea he posted as a comment to the recent post.  This is a great example of the power of priming.  By posting to his computer screen the various elements of problems he wishes to solve, Henry stimulates the creation of new combinations and associations.  These are the foundation of fresh ideas.

Discipline and process orientation are necessary for success, but they are not sufficient.  As any business in a fast-changing market knows, it is not enough to execute stale ideas faithfully.  When you are an idea factory, you continuously renew your sources of edge in markets.

Further Reading:  Success and Failure Quotes

Personality and Character in Trading

Our personality is revealed in our trading.  If we are successful, how we engage markets is an expression of who we are:  our skills, our interests, our traits.

Our character is revealed when markets are closed.  It's when we can't put on trades and follow markets that we find out who really works on their game, who actually reviews their performance, who truly sets goal and pushes themselves further and higher.

Lots of market participants love trading.  It's the love of what it takes to sustain trading success that makes all the performance difference.

Further Reading:  Assessing Trader Personality

Determining Price Targets for Trades

I find that many traders are better at setting their entry points in markets than their exits.  In that sense, they are like archers who take great care to position the bow properly on their shoulders and pull the arrows with just the right amount of tension, only to lack proper targets.

There are many ways of defining price targets.  One might rely upon charts and define range extremes or price levels based upon wave relationships.  One might be fundamentally grounded and establish targets based upon a researched notion of fair value.  If every trade is to have a favorable relationship of reward to risk, it is important to have a target clearly in mind.  

My method of establishing targets in the stock market is statistical/mathematical.  Two things we can know from tests:  past volatility is positively and significantly correlated with future volatility and volume is positively and significantly correlated with volatility.  Volatility tells us how far we are likely to move in either direction over a given time period.  

So what I do is estimate today's volatility from recent volatility and identify the percentage probabilities of hitting particular upside and downside targets given that volatility level.  The key is estimating upside *and* downside targets.  These estimates have nothing to do with any directional view of markets I may hold.

Let's take an example.  If we were to open trade in SPY at 186.39 on Monday, my volatility model suggests a 78% likelihood that we would touch either the 187.13 level or the 185.65 level in that day's trade.  The odds of touching either 187.99 or 184.79 are a little under 25%.  So basically, think of a chart and next to each price level above and below where we're at, there's a probability estimate of hitting that level.

Again, this has nothing to do with my opinion about markets or my subjective reading of chart patterns, sentiment, the nation's politics, astrological formations, etc.  

Now, let's add an element to the estimation:

As the day's trade proceeds, we can identify if the current volume coming into the market equals, exceeds, or falls short of the volume that is typical for that time period.  So, for example, Thursday's first half-hour volume did not differ significantly from Wednesday's, but was lower than the average volume during preceding days.  Because volume and volatility are correlated, the updating of volume in real time allows me to adjust my estimates of reaching nearer and more distant price targets.  I identified quite early on Thursday (especially with it being the day before a holiday!) that we were unlikely to hit a distant, lower probability target.

This ability to adjust targets in real time is exceedingly useful, as participation during the day may greatly expand or contract based upon situational developments, such as an upcoming Fed announcement or a next day holiday.

There are many trading psychology lessons in all of this, and I'll address some of them in my next post.  From a trading perspective, let me simply mention that defining target probabilities is also very relevant to the setting of price stops and that this approach is scalable with respect to time.  Estimating the probability of hitting a particular target in the coming week or month draws upon the same process as estimating targets for the current trading day--and can provide a rational basis for holding vs. folding positions.

And, yes, this method can be used to estimate price targets for individual equities as well as indexes.  Indeed, it is relevant to any market in which volume and past volatility information provide a statistically valid basis for estimating future price movement.

My trading goal is to identify occasions in which my models provide a high probability directional view on the market and then to implement this view in a sound risk/reward structure with a) the calculation of price targets; b) the real-time (Bayesian) updating of the likelihood of reaching particular objectives; and c) continuously updated, real-time market indications of a directional bias to the day's trade by tracking the relative dominance of buying and selling pressure.

For those interested in the initial price targets, I will post a first approximation for SPY early in the trading day via StockTwits (@steenbab) as part of my market PREP posts.  Please note: my current method for determining targets is a refinement of my prior process, which is linked below.

CORRECTION TO THE POST:  Thanks to David Ayer for his helpful comment and correction to this post.  I identified the source of my error and the fifth paragraph above should read that, if we open at 186.39, we have a 72% probability of hitting either 187.38 or 185.40.  On the other hand, we have a 23% likelihood of touching either 188.37 or 184.41.  I am using something a bit different from 5-day ATR, so my numbers may differ from David's, but they should be in the same ball park.  I hereby amend the quote at the top of the post to read, "The odds of hitting your target go up dramatically when you calculate it properly."  :)

Further Reading:  My Previous Method for Calculating Targets

On the Dangers of Chasing Trades and Losing Yourself

That's a great quote from Will Smith.  Substitute "ideas" for people and you have a pretty good recipe for success in markets.

When we doubt ourselves, it's easy to chase other people's ideas.  After drawdowns, it's not at all easy to do your own thing and sustain hard work.

Drawing down by chasing trades or other people's ideas is a double loss:  the loss of capital and the erosion of self-confidence that comes from placing the judgment of others ahead of one's own.

To pursue your best work and lose money is frustrating.  To fail to pursue your best work and lose money is self-betrayal.

When trading becomes difficult, you want to double down on who you are and what you do best.  It's amazing how ideas come to you--and stay--when you do your own thing:  the things that brought you success in the first place.

Further Reading: The Reason I Don't Partner With Your Firm

Best Trading Practices Through Crowdsourcing

Thanks once again to SMB Options Tribe for hosting yesterday's webinar on best practices in trading.  For those who could not attend live, here is the recording of the session. 

In that session, I suggested that a review of one's performance can be a great way to identify trading strengths and best practices.

But suppose we make that review a social process and ask a number of experienced traders to share a best practice.  While not every idea will resonate with every one of us, the crowdsourced list of worthwhile practices would provide fertile ground for expanding one's own processes.

So let's try a little crowdsourcing:

There is a tremendous amount of information on the financial web.  None of us could possibly read it all.  If, however, a number of informed traders suggested their favorite expert sites on particular topics, the result would be a nicely vetted set of information sources that could feed one's market intelligence.

I'll start with an example:

I mentioned a little while back that the website Abnormal Returns is part of my daily market preparation.  I have found that Tadas is both thorough and discerning in his selection of daily links across the landscape of financial journalism.  It doesn't make sense for me to review everything out there when someone with an informational edge is already doing a good job of curating content.  Yes, there are things I look at independently, but if I'm looking for fresh perspectives, an efficient solution is to start with the pieces selected daily by Abnormal Returns.

My best practice is to go with an assumption:  Somewhere in the collection of daily links, there is something I should know to help with my idea generation.  My job is to scan the array of links and articles and find the one, two, three items that provide me with a fresh perspective.  I don't leave the site until I have found content that can feed my brain.  So, for instance, this morning, I was checking out articles on housing starts, inflation, and the distribution of returns across market sectors.  I am very interested in the expectations of traders vs. what markets are actually telling us and pricing in.

Now suppose each of us that has a go-to site that feeds the head offers their favorite site in the comments section for this blog entry, along with a short summary of how they find the site useful.  Across the readership crowd, we should be able to source good information that can prove useful to understanding markets and trading.  So please feel free to share your favorite sites as a comment below and I will follow up with a post that pulls together the ideas.  

Thanks!

Brett

Further Reading:  Five Virtues and Best Practices