The recent post noted the underperformance of high yield corporate bonds relative to high quality bonds over the last few months. In general, a preference for riskier, high yield fixed income has suggested a general risk appetite among investors, whereas periods of underperformance have been associated with a broader risk aversion.
The chart above extends the look at the relationship between high yield (JNK) and high quality (LQD) bonds back to the beginning of 2008. What you can see is that relative interest in high yield returned early in 2009 and fell off significantly during the summer 2011 risk-off period. Notice, however, that as stocks (SPY) have since moved steadily to new highs, the relative relationship between JNK and LQD has remained below that 2011 peak. Moreover, the volatility of the JNK:LQD relationship has declined significantly during the same period that stock volatility has been crushed.
Since five-week realized volatility in JNK bottomed early in June of this year, we've seen a notable uptick in high-yield volatility. Not surprisingly, that has been accompanied by a selloff in stocks. Given the underperformance of high-yield bonds generally and now their uptick in volatility, I will be watching the sector closely for signs of risk aversion that could affect markets more broadly.
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A useful measure of risk appetite vs. risk aversion in US fixed income markets is the relative performance of high yield bonds (JNK) to liquid, highly rated bonds (LQD). Note how this ratio topped in late 2013/early 2014 and has been making fresh lows in recent days.
The ratio is not a precise market timing tool, but does give an indication of when investors feel comfortable reaching for yield and when they feel comfortable sticking with safety. Even as stocks have been making new highs this year, investors have been less willing to touch the junk.
There was a major episode of JNK:LQD risk aversion at the 2009 stock market low and we've seen bouts of fixed income risk aversion recently during market corrections at mid- and late 2012; April, 2013; February, 2014; and April, 2014. When markets least want you to touch their junk, the opportunity antennae should perk up.
Could we, however, be rolling over on a longer-term basis in terms of willingness to reach for yield? The next post will take a look at that possibility.
Further Reading: Letting Markets Tell Their Stories
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It's difficult to imagine achieving uniquely positive results in trading by looking at the same information in the same way as everyone else. Distinctive returns require distinctiveness of information processing: either seeing old things in new ways or seeing entirely new things.
Can you name specific old things that you process in new ways to generate trading ideas?
Can you identify new things that you process that others don't look at?
If you were applying for a trading job and I was the recruiter, those are questions you could expect to be asked. If you were running your own fund, those are questions you could expect seasoned investors to ask.
So it's worth asking yourself: When it comes to idea generation, what makes you unique?
I recently downloaded intraday information on the number of NYSE stocks making new highs for the day session vs. those making new lows. The new highs and lows are for the current trading session only and the numbers are cumulated for every stock, every minute of the session.
Suppose I choose a time of the morning--say, 10 AM EST. The stock market has been open for 30 minutes. What does it mean if many stocks are making fresh daily highs or lows precisely at 10 AM? For one thing, it means that many stocks have broken out of their opening ranges.
With that recognition, now we can ask new questions:
If many stocks break out of their opening ranges, is the day more likely to be a trend day? Does opening range breakout breadth (the number of stocks breaking out of their opening ranges) predict trend better than opening range breakouts of a single broad market index?
What is the earliest time of day that we can detect broad opening range breakouts that is predictive of trend? If we see few opening range breakouts by a certain time of the morning, can we validly conclude that we're likely to see a range bound session?
This is but one research project I'm working on. There are several others, all just as out of the box, but all similarly built on old, familiar market concepts.
90% of these ideas will not bear significant fruit. If I generate one new idea to research every week, however, that will leave me at the end of the year with five new, significant ideas. Over the course of a career, that adds up.
Simonton has it right: It's all about natural selection and sustaining the originality to generate plenty of mutations.
Further Reading: Creativity and Greatness in Trading
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There have been some reports of very weak NYSE TICK statistics and the possibility those could foreshadow a stock market crash. I've received several requests to update my Cumulative TICK Line for readers. This consists of the summed total of five-minute high-low-close values for NYSE TICK (upticks minus downticks for all NYSE shares). As you can see, the cumulative line has been making new highs--not diverging from large cap indexes.
I realize Mr. Cook looks at a proprietary version of this indicator, but the standard version has been unusually strong. (My data come from e-Signal).
As a check, I constructed a similar indicator, but now using upticks and downticks for every single US stock. That includes NASDAQ and microcap issues as well as NYSE shares. My thought was that this might show greater weakness, given the small cap underperformance of late. It, too, however, has been hitting new highs in recent days.
My historical research suggests that market volatility bottoms out well in advance of bull market price peaks. That was the case in the run up to the peaks in the late 1990s, 2000, and 2007-8. It was also the case in the run ups to the big peaks in the late 1920s, 1968, and 1972. With a VIX not far off its bull lows and realized volatility near bull market lows as well, this suggests that we may need to see more animal spirits before we encounter any crash.
Further Reading: Bubbles, Booms, and Busts
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At the broadest level, trading consists of analyzing, synthesizing, and doing.
Analyzing is extracting information from markets, immersing ourselves in data. It is our look through the microscope.
Synthesizing is assembling those data into a coherent picture, extracting pattern and meaning from the reams of market information. It is our telescopic view.
Doing is taking action on the meaning we have extracted from studying markets. It includes everything from determining the best expression of a view to managing risk and reward once the view has become a position.
In trading, the microscope and telescope of viewing are transformed into real world doing.
At the end of a trading day, week, or month, we repeat the process--only we turn the lens inward.
We analyze our performance, immersing ourselves in the data that tell us how well we executed and managed our trades; how well we discerned genuine opportunity in markets.
We synthesize our performance observations into goals that move us forward, capturing what we've done well and what we need to improve.
Then we return to doing, feeding those goals forward into future market analysis, synthesis, and doing.
Deliberate practice is a cycle of stepping back to observe and stepping forward to act. It's also a cycle in which we first act in the world and then act upon our performance.
Analyzing, synthesizing, and doing, in markets and with ourselves: that is what a trading process is all about.
Further Reading: Trading as a Performance Activity
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Successful traders share a number of qualities with successful entrepreneurs. This is not surprising, as trading is all about defining, discovering, and realizing value in a marketplace. Both successful traders and entrepreneurs have a proactive side to their personalities: they possess a vision of what they want and work in a directed way to achieve it. As Lori Greiner astutely observes, it is this drive that leads entrepreneurs to work long hours to avoid working the standard work week.
While broad personality traits have been associated with entrepreneurial success, research suggests that very specific personality characteristics are the best predictors of entrepreneurial pursuit. Specifically, four traits are common among successful entrepreneurs:
* Proactivity - the ability to spot opportunities
* Creativity - the ability to generate innovative ideas
* Opportunism - the tendency to pursue opportunities as they arise
* Vision - the desire to make a difference in the world
What stands out is that successful entrepreneurs are thinkers, dreamers, and doers. This is very similar to successful investment success, which combines research and idea generation with the management of positions and portfolios. The vision dimension is particularly interesting. Having unique ideas might not be sufficient to motivate the entrepreneur to get through inevitable roadblocks and setbacks. It's the vision of creating something worthwhile--something that makes a difference--that provides the extra motivational push. Interestingly, many of the Market Wizards interviewed by Jack Schwager are known for their involvement in charitable causes. Those activities are one way that market success becomes a way of making a difference in the world.
The proactive personality that distinguishes entrepreneurs is seen among people who are not especially constrained by situational forces. They tend to take action and persevere in challenging situations, particularly when they perceive opportunity. This capacity to sustain intentional action in the face of potential distractions and obstacles speaks to a high degree of focus and motivation. In short, the successful entrepreneur is good at locating opportunity and then pursuing it relentlessly. This sounds very much like a domain-specific version of the "rage to master" noted in the recent blog post. Indeed, it would not be far wrong to suggest that entrepreneurs have a rage to create.
This may be the key to why some traders succeed over time, adapting to ever-changing markets, while others do not. If a trader's primary motivation is proactive creation, then he or she will sustain innovation. When we think of the great business leaders, they are not just entrepreneurs--they are serial entrepreneurs. The rage to create ensures that great traders will remain creative, continually searching for fresh opportunity. It's what traders do when they make money that reveals their capacity for long-term success: do they become comfortable and complacent, or do they chafe at the status quo and look for continued ways to innovate?
Further Reading: Trading, Entrepreneurship, and Gambling
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A grateful shout out to Abnormal Returns for linking Adam Grimes' post on the "rage to master". As Adam points out in his blog:
"People who have the rage to master are completely obsessed beyond any
sense of balance, beyond any reason, with mastering their chosen craft.
For these people, hard work usually doesn’t seem like work. They are
motivated by the end goal, yes, but perhaps even more so by the process
of learning and the process of getting better."
Ellen Winner, who coined the term "rage to master", makes the argument that innate talents have a motivational component and that the mastery drive is often present from an early age. She points out:
"No one disputes the biological basis of retardation (with the exception of that due to extremely impoverished environment); and yet some do assert that high ability, the flip side of retardation, is entirely due to hard work. But if biological retardation exists, why not biological acceleration?"
Citing evidence from children who display early talents in the visual arts, Winner observes that young people with precocious talent are intrinsically driven to pursue their domains, accelerating their learning and development via supercharged deliberate practice. The rage to master occurs at the intersection of natural talents and immersive practice.
An important implication of Winner's view is that one of the best predictors of performance in a domain is an early and rapid learning curve. This is the notion of "niche" that I emphasized in the trading performance book. Exercising our talents is intrinsically rewarding, which leads us to immerse ourselves in the activities that provide deliberate practice. Greatness, from this perspective, is a function of how we approach life; the rage to master is, as Adam points out, a form of obsession.
Per the Michelangelo quote above, if you're working ordinary hours in an ordinary manner, you're probably not operating within your mastery niche.
The work we're meant to do is not what we push ourselves to do; it's what no one can keep us from doing.
Further Reading: Greatness and Creativity in Trading
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One of the more interesting findings in the positive psychology research literature is that happiness is more related to the frequency of positive feelings than their intensity. Occasional feelings of intense joy are less important to our overall happiness than frequent positive experience.
Related to this finding is the important observation that positive and negative emotion--while negatively correlated in the short run--are largely independent of one another over longer time frames. This is due, in part, to the intensity dimension. People can have frequent positive experiences amidst occasional intense negative experiences and vice versa. During highly emotional periods, positive and negative emotion are strongly negatively correlated. Over longer periods and ones of more modest intensity, positive feelings are recalled relatively independent of negative ones.
Indeed, if we think of positive and negative emotion as independent, we can define four temperaments: 1) happy (high positive/low negative); 2) distressed (low positive/high negative); 3) volatile (high positive/high negative); and 4) stable (low positive/low negative). An interesting hypothesis is that these temperaments impact how people view markets and trading. We commonly think that successful trading is a function of controlling one's emotions, as in the fourth category above. Might it be the case, however, that successful traders find constructive ways to engage markets within their particular temperaments?
A good example would be the distressed category above. Traders who worry about their positions and focus on what could go wrong in their trades might be successful by tightly managing risk and achieving superior risk-adjusted returns. That would be different from more volatile, risk-taking traders, who sacrifice Sharpe ratio to achieve superior absolute returns.
Even on shorter time scales, might traders experience varying mixtures of positive and negative emotions throughout the day and week? Once we adopt the scientific temperament described above and treat positive and negative emotions as separate, independent experiences, then we can ask interesting questions about the types of events that lead us to feel positively or negatively. We can also track performance as a function of the two states and examine whether, say, increases in market or P/L volatility correlate with increases in the volatility of both positive and negative emotions.
Given that temperament impacts emotion, attention, and activity, it is surprising that we know so little about how temperament is related to performance success. We would think, for example, that very outgoing people with loads of positive emotion would make good salespeople. In fact, the opposite appears to be the case: those with moderate temperament tend to do the best at sales. Interestingly, something similar appears to be at work among traders: a study I conducted with Andrew Lo and Dmitry Repin with traders studying with Linda Raschke found that high levels of emotional reactivity were associated with worse trading performance. Personality traits did not predict performance, but the intensity of emotionality during trading did--in a negative way. It didn't matter whether the emotion was positive or negative: intensity of experience was disruptive of performance.
Still, the research of Lo and Repin suggests that emotions do play an important role in trading decisions. Even experienced traders, hooked up to biofeedback units while trading, display patterns of emotional arousal in the context of their trading. That research also found, however, that experienced traders displayed less intense emotional reactivity than inexperienced traders. Once again, we see an important distinction between emotional intensity and frequency. Perhaps one valuable aspect of training and experience is that they enable us to dampen the intensity of our emotional reactions within whatever temperament we might have. Once we've been there, done that, it's easier to not overreact to situations.
We gravitate toward particular trading approaches for many reasons: our cognitive strengths, personality traits, and emotional temperament all likely play a role in determining whether we seek success as systems traders, investors, daytraders, or active portfolio managers. Ultimately, our trading reflects who we are and either generates emotional experiences that suit or frustrate our temperaments. That fit of trading experience and personal temperament may well be an important mediator of sustained trading success.
Further Reading: Peyton Manning and the Heart of Peak Performance
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Recent posts have emphasized the role of emotional well-being in creativity, health, and productivity. Well-being is also likely to moderate the frustrations that can lead to lapses in trading discipline. When we maximize positive experience, we broaden our thinking and build new competencies.
But what is well-being? We commonly equate well-being with happiness, but that is only one dimension of positive experience. Our physical and emotional energy are also crucial to well-being, helping us turn goals into achievements. Well-being also stems from experiences of affection and the development of close, meaningful relationships. Finally, our positive experience depends upon our level of life satisfaction. It is difficult to pour ourselves into trading, for example, if we are dissatisfied with trading.
A 2013 Pew Research poll found that 81% of Americans say they are satisfied with their lives. Interestingly, however, only 50% rate their relationship with their partner/spouse as "excellent"; only 38% describe an "excellent" spiritual life; 28% rate their employment situation as "excellent"; 27% rate their health as "excellent"; and only 13% describe an "excellent" personal financial situation.
A tempting inference from these findings is that most people are satisfied with less than excellence. There is, however, a different possibility.
A very interesting study found that personality changes over the lifespan--and those personality shifts are more responsible for changes in our life satisfaction than our changes in income or employment. Indeed, changes in personality accounted for 35% of changes in life satisfaction, compared to only 4% for income and employment and less than 4% for marital status.
What this suggests is that life satisfaction may be more about who we are than what we do. Subjects in the research study who rated themselves as less agreeable over the years also reported lower levels of life satisfaction. Conversely, those that reported becoming more open to experience also described higher life satisfaction.
This leads to an important question: How has involvement in financial markets affected your character? Has trading made you a better person or a worse one?
I strongly suspect the answers to those questions are meaningfully connected to traders' life satisfaction and, ultimately, the ability to sustain a successful career in markets. Profits from markets can make us happy, but what might be more important to long term well-being is the perception that we are personally profiting from our trading experience.
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There's a very important distinction between activities and people that give us energy and those that sap our energy. Imagine spending time adjusting the thermostats in your house and installing sophisticated heating and cooling systems while leaving all the windows wide open. That's what we commonly do: we manage our time, but allow energy to leak through the windows of our lives. By spending time in low energy activities, by surrounding ourselves with low energy people, by failing to engage in the sleeping, eating, and exercising activities that could energize us, we live life in less than an energized mode.
How many of our trading lapses, whether in concentration or discipline, occur because we are operating at a low level of willpower, our concentration fatigued, our focus lost?
Imagine if the overriding priority in your life was to keep yourself at a maximum level of mental, physical, and emotional energy. What would you be doing to maintain that state? What would you eliminate from your life to stay at your peak?
The answer to a leaking gas tank is not to fill up your car every few hours.
Goals without energy are simply good intentions.
The car takes us much further when we repair the gas tank.
Further Reading: Top Ten Reasons Traders Lose Their Discipline
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The recent post describing the single best predictor of sustained trading success emphasized the difference between being drawn to markets because of personal strengths vs. pursuing markets to mask personal deficiencies. The psychologist Abraham Maslow distinguished between basic--or deficit--needs and being--or growth--needs. Among the deficit needs are physiological needs, needs for safety, social needs, and esteem needs. A cardinal principle of Maslow's thinking was that deficit needs grow stronger when they are unfulfilled. They need to be fulfilled, he observed, in order for people to focus on being, or self-actualization, needs.
In other words, gifted people fail to open their packages when more basic (unmet) needs trump the pursuit of their (self-actualization) gifts. Can we really build and sustain career success if our more basic physical, social, and self-esteem needs are not being met? Can we truly expect to succeed if we burden our work with the demand that it compensate for all our unmet basic needs?
If our self-worth and social status hinge upon our trading success, how can we remain objective and dispassionate during times of drawdown?
When we overtrade or bail out of positions at the worst possible times, violating our planned exits, is it really that we lack discipline, or could it be that our trading is carrying too great an emotional burden?
When basic needs are met, you can feel good about yourself, good about your connections to others, and secure in your finances even during periods of market loss. Drawdowns in our trading accounts don't have to become emotional drawdowns.
To pursue markets in the drive to actualize skills and interests and not to fill deficit needs: that is the ultimate market edge.
Further Reading: Greatness in Life and Trading
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It's true of all great performance fields: they can bring the best--and the worst--out in people.
Trading can bring out our worst fears, our greediest ambitions, and our innermost self doubts.
Trading can also reveal our greatest character strengths: perseverance, creativity, and self mastery.
What is the difference? What determines whether financial markets bring out our greatest efforts or our worst biases?
A wealth of research on character strengths suggests that when we draw upon those strengths, we achieve higher levels of emotional well-being. Indeed, people who more consistently draw upon their strengths report lower levels of stress, higher levels of positive emotion, and higher levels of self-esteem over three and six month horizons. A study of college students found that those who are best at making use of their strengths also are most successful at making use of social supports and most likely to build on successes by applying their strengths to new situations.
Optimism fuels performance; successful performance fuels confidence and self-efficacy; confidence fuels broadened social networks and resources and builds further competencies. In other words, exercising our greatest strengths with the greatest consistency sets up virtuous cycles that, over time, expand our horizons and abilities.
At the risk of oversimplification, I would like to suggest a straightforward hypothesis: Some traders are attracted to markets as a way to exercise their strengths and some are attracted to markets to compensate for their weaknesses. This is why trading, like football in the Marv Levy quote, reveals character. Some traders don't want to work for a living; they don't see themselves as successful in the world. They view markets as a way to strike it rich and provide them with the esteem they lack.
Other traders find in markets the performance challenges that engage their greatest cognitive and emotional strengths. Trading, for them, is an affirmation, not a compensation.
What brings you to markets determines what markets bring out in you. I strongly suspect that is the single greatest determinant of sustained trading success.
Further Reading: The Power of Teamwork
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Thanks to a savvy trader for pointing out this excellent post from James Clear on the role of selective attention in the development of expertise. His observations regarding repetition as the source of skill development is spot on. So much of expert performance is a function of knowing what to tune out--and then intensifying concentration on the essentials that remain.
While you're at it, check out James' post on quantity vs. quality and how that impacts our work output. Expertise is all about learning-by-doing, not seeking an abstract standard of perfection. As he puts it, "start with repetitions, not goals."
The reason this is powerful is that frequent, positive experience--those small wins--have a powerful mirroring impact. When we are doing things better and better, we begin to experience ourselves as being better and better. Our self-concept is an internalization of what we do, not something we can merely talk ourselves into. Viewing changes with doing: repetitions created repeated positive experiences and repeated reinforcement of a new experience of self.
Further Reading: How to Change Your Self
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Milton Erickson, M.D. was a pioneer of brief approaches to psychotherapy, making use of hypnosis techniques to accelerate change. "You use hypnosis not as a cure," he observed, "but as a favorable climate in which to learn." His work stood traditional therapy on its head. Instead of using insight as a means to promote change, he employed hypnosis to directly instill new behavior patterns. "Change will lead to insight," he insisted, "more often that insight will lead to change."
Recent neuroscience research into hypnosis suggests that it represents a distinctive state of consciousness. Specifically, hypnosis is associated with activation of attention and deactivation of "default mode" functions such as self-awareness and semantic thought. It is as if the person in a hypnotic induction intensifies their focus at the same time that they shut off their active reasoning. This has made hypnosis particularly useful as a treatment for pain, as it enables us to process the experience differently, where we no longer identify with the discomfort.
One of Erickson's most provocative ideas is that hypnosis is a naturally occurring state of consciousness and does not require formal induction processes. Indeed, in his therapy, Erickson commonly told stories, often of a complex and even confusing nature, that held listeners' attention and helped them think differently about their problems. His goal was to allow change to occur naturally and indirectly by changing people's views of their problems, including the language they used to describe their experience.
A classic Ericksonian therapy described by Jay Haley was his single session treatment of a patient's insomnia. He encouraged the insomniac to get out of bed when he couldn't sleep and meticulously scrub his apartment floor with a toothbrush to get the floor perfectly clean. When the patient had tried to make himself sleep, of course, his efforts only heightened his awareness of his problem. When he scrubbed the floor, however, he became so bored with the task--and so focused away from his problem--that his natural tiredness took over.
When we become absorbed in a task, we enter a state very similar to hypnotic trance. It appears that the flow state associated with creativity--the state of being "in the zone" familiar to traders--is actually a form of trance. Just as cancer patients can disconnect from their pain through the focused attention of hypnosis, it may be possible for any of us to disconnect from unwanted behavior patterns by shifting our conscious state. Similarly, we may best acquire desired patterns--including the patterns of markets--when we are in a flow state of enhanced cognitive processing.
Traditional therapies and coaching interventions have tended to emphasize verbal communication and conscious reflection on one's problems. It may well be the case, however, that change occurs most efficiently when we are in an alternative mode of processing that facilitates the internalization of new patterns. Staying in a single state of consciousness keeps us locked in our routine modes of viewing and doing. What Erickson realized is that it takes a gear shift of consciousness to help people process experience in new ways. Trance formation may be the hidden key to transformation: first we change, then we achieve insight.
Further Reading: Why Controlling Emotions Should Not Be a Goal of Trading Psychology
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Many traders I've spoken with have expressed the feeling that they are very close to breaking out and taking their trading to an entirely new level. Often, their unspoken assumption is that once they reach that new level, the problems of mastering markets will be behind them. As the all-too-spot-on quote suggests, however, new levels bring new devils. With fresh success come the demons of overconfidence, envious colleagues, and the renewed humbling challenges of changing markets.
Not infrequently, getting to the next level of trading requires getting to the next level in your personal development. That can be difficult when a big part of you might be committed to old ways of doing things. It is easy to do something well, but far harder to turn best practices into established habits. I find that getting to that next level generally is more a matter of doing many small things consistently well than making any single explosive breakthrough. You can't have a successful year without having a successful month, and you need successful days to make a successful month. It's great to have great goals for the indeterminate future, but what is the energizing vision and specific, concrete actions that will transform your work today? There is no greatness without individual acts performed greatly in the present.
A vivid example of doing small things well is Rory McIlroy, the young golfer who recently won the British Open. He revealed, before the competition, that he had two secret words that were his cues for success. He invited the media to guess the words, but no one was successful. The words were "process" and "spot". His entire focus was on the process of taking the right swing with his long shots and hitting desired spots on the green with his putting. No thoughts of where he stood in the competition; no thoughts of how he performed on the previous hole. Rory was entirely present-centered, absorbed in the mechanics of doing the right things and letting the score take care of itself.
There is no great trading without making individual great trades. And there can be no individual great trades without great ideas, great entry execution, great position management, great planning. Process, spot. That's the focus Bella talks about at SMB when he emphasizes making "one good trade".
It would be nice to have a trading coach spurring your development, much as personal trainers work with people in the gym. For most traders, however, that is neither a practical nor available option. Recognizing this, Terry Liberman of WindoTrader approached me with the idea of offering a webinar on the topic of getting to the next performance level in trading. Unlike traditional webinars, however, this will not be a didactic session. Rather, it will be a free group coaching session, where the content is brought to the event by traders in the form of questions, challenges, and keen observations. My role will be to help traders think about old problems in new ways, both to address trading flaws and build existing strengths.
The event will be held this Wednesday, July 23rd at 4:30 PM EST; check the WindoTrader site for details and registration. My hope is to provide a unique, interactive learning experience for traders--look forward to seeing you there!
Brett
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Hope your weekend has been a good one. Here are a few topics that might get us started for the week to come:
* I've heard from several traders who have taken position sizes well outside their comfort zones, lost money, and shaken their confidence. As we learned from Naomi (above), recovering from a traumatic event is not something you can just talk yourself into. My experience is that the traumatic responses of traders--while not on the scale of extreme anxiety-producing events that occur in military combat--have some similarities to what soldiers go through in wartime. This is partly because the stress symptoms often precede the specific traumatic event and because second guessing, anger, and grief are common after the event. This is why prudent risk management is so crucial to trading psychology: it is the best preventive measure we can take to avoid overloading ourselves emotionally. Otherwise, it becomes all too easy for drama to turn into trauma.
* I'm not sure if it's great minds thinking alike, but I see that David Blair and SMB Training posted some perspectives on hidden biases in trading that I hadn't seen prior to my recent post on bias blind spots. David, on his Crosshairs Trader blog, describes how developing a stock trading process can improve decision making. As Tadas Viskanta of Abnormal Returns emphasizes, putting market activity into the context of one's life--and not the reverse--is an important way of avoiding emotional overreactions and biases: "there is much more to life than investing". One way to reduce bias is to operate with sound trading rules. Here are some of the rules emphasized by Barry Ritholtz; here is his second group--very relevant to investors and traders alike.
* Here is a very interesting post on the financial literacy of investors from David Bailey and research group. That group has also posted quite pointedly on the dangers of overfitting when backtesting trading strategies (see this recent article from Jason Zweig on the topic, as well). The area where I find traders most lacking in financial literacy is risk management, per the trauma observations above. Here is an informative post on using the 2% rule as a risk management guideline. Evaluating your trading like a trading system is evaluated is a good way to get a handle on risk management; here are valuable perspectives archived by Henry Carstens. As one wise researcher once told me, "Every successful trader is a system, whether they realize it or not." It makes sense to study the system behind your own trading; hence the importance of studying one's trading metrics.
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As a rule, good entry execution in stocks means waiting for pullbacks if you're going long; bounces if you're looking to be short. The exception to this rule are is the trend day, in which the market moves consistently in one direction for the entire day session. For traders on short time frames particularly, good entry execution on a trend day--such as we saw yesterday--means entering early in the day and benefiting from the day's directional tendency.
Please review this post from May; it summarizes key ingredients of an upside trend day. All of these were present in yesterday's session. This earlier post also provides a number of trend day signposts; see also this 2009 post.
In the chart above, I track yesterday's ES futures versus the number of stocks trading across all exchanges that are making fresh day session highs minus those making fresh day session lows. (Data were obtained via e-Signal). This is an interesting measure, as it begins tracking new highs/lows from the market open. For that reason, values tend to be elevated during the early minutes of trading relative to later in the day. During uptrend days, we see two things:
* The difference between new intraday highs and lows stays positive throughout the trading session;
* We get spikes in new highs well into the trading session, as a large proportion of stocks are trending.
Conversely, during rotational days, we'll see some stocks making fresh highs for the day session and some making fresh lows. As the market oscillates, the difference between intraday new highs and lows will cycle from positive to negative and back again.
Along with the indicators outlined in the above posts, the intraday new highs/lows give a good sense for whether there is a directional bias to the day's trade. With a bit of testing, relatively early in the session, we can identify the probability that we are operating in a trend environment or a rangebound one. This not only benefits daytraders, but also aids the entry and exit execution of longer timeframe participants.
Further Reading: Catching Trend Days in the Stock Market
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Surveying the literature on the behavioral biases of investors, it does indeed seem as though the model of infinite stupidity is closer to the truth than the model of rational market participants! The list of such biases is impressively long: Barry Ritholtz offers this list; see also this overview from Morgan Housel and this particularly thorough list from the Psy-Fi Blog. Abnormal Returns highlights the problems associated with positive thinking; Stammers focuses on 3 biases that impact investments; and Above the Market offers this summary of biases.
A very interesting study from the University of Pennsylvania finds that neither investor sophistication nor investor experience, by themselves, is sufficient to overcome the behavioral bias known as the disposition effect. This is a bias to sell winning investments and hold onto losing ones. Investors who are both sophisticated (knowledgeable) and experienced are able to sell losing investments appropriately, but they still display a tendency to prematurely sell winners.
This phenomenon, known as the bias blind spot, reflects the fact that knowing about biases does not prevent people from falling prey to them. Indeed, we typically perceive biases in others more readily than in ourselves, as this Stanford study finds. This happens, in part, because we tend to focus more on our introspections than on our behavior, leading us to assume that we are not biased because, subjectively, our thoughts do not seem biased!
Here is a telling anecdote: I have worked as a performance coach for traders for a number of years. People have sought me out for a variety of concerns, ranging from emotional interference with trading decisions to challenges in learning new markets. How many--of the many hundreds of people I've interacted with in a coaching capacity--have expressly sought help for their cognitive and behavioral biases?
None.
Traders are much more likely to attribute trading problems to emotional, psychological sources, external distractions, or evil market manipulations than they are to illusion, bias, and statistical artifact.
What does that mean?
A staple of trading psychology wisdom is that one should trust their "processes" and remain grounded in them at all times. But what if those processes involve subjective impressions from second-hand sources of unknown accuracy, poorly constructed statistical tests, or conclusions based upon limited, recent samples of experience? The advice to stay process-driven presumes that traders operate in a bias-free manner--which is itself a beautiful example of the bias blind spot!
Suppose a trader's base case was that his/her own thinking could very well be biased. In such an event, the trader's process would be replete with routines that test assumptions, validate sources, and explicitly entertain counterfactual scenarios and alternate explanations. The trader seeking to minimize bias blind spots would be vigilant, questioning and even doubting all trade ideas. How many of us do that in a structured manner and on a routine basis? (Hat tip to the hyperrational colleague who inspired this question).
So who is more likely to be hired at the average trading firm: the bold, confident trader who expresses great conviction in his ideas or the cautious, questioning trader who makes special efforts to avoid bias blind spots? The answer to that question goes a long way toward explaining why average trading firms rarely sustain above average trading results.
Further Reading: Hindsight Bias and Regret in Trading
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The recent post on improving your cognitive environment suggested that performance is not only a function of talent, skill, and effort, but also one's surroundings. Those surroundings include at least three elements:
1) Our physical environment - How our space is laid out; the resources available in that space; the degree to which the environment is comfortable, quiet, stimulating, distracting, etc.
2) Our social environment - Who we are surrounded by and who we choose to surround ourselves with; the interactions we have with others, virtual and actual; the degree to which we benefit or are hindered by our interactions.
3) Our cognitive environment - The information we process; the degree to which we filter vs. seek information; the ways in which information we format and process our information; the sources we seek for our information.
Rarely are our environments optimized for the work we undertake. Partly this is because we tend attribute performance outcomes to internal factors: our decisions, our psychological states, our research, etc. Because we don't systematically vary our environments or focus on the impacts of naturally occurring environmental changes, we generally don't appreciate the ways in which the world around us impacts our decision-making and performance.
A simple example is the quality and quantity of sleep we get each night. We know from research that getting the right kind of sleep, as well as the right amount of sleep, is important to mood regulation, concentration, learning, and performance. We also know that sleep is affected by what and when we eat and drink, our exercise level, and our nighttime routines. Keeping a phone at the bedside to check on nighttime quotes is a common environmental choice for many money managers--and it's one that can rob us of the deep restorative sleep that aids next day performance.
One challenge traders have in structuring the environment optimally is that trading consists of multiple activities, each of which typically requires a different environment. For many traders, quiet periods of deep analysis--whether by reviewing charts, reading research articles, or analyzing data--are an important part of their understanding of markets. Such work is best undertaken in distraction-free environments that promote sustained focus--not on the desk with multiple distracting screens and phones.
Conversely, most traders need to stay on top of breaking developments during the trading day and so stay closely connected to news, chats, and interactions with colleagues. The quiet, distraction-free environment, so helpful to deep thinking, is not so useful for the fast thinking of keeping up with and understanding the implications of news releases and the dynamics of real-time market movement.
And how about those activities in which traders piece together the elements of market puzzles, integrating the results of both deep analysis and fast market pattern recognition? Such synthesis--quite different from the deep dives of market analysis--benefits from processing information in multiple ways. We can write journals, carry on conversations with valued colleagues, or simply remove ourselves from the work environment and ponder the world while on a hike. The creative process of synthesis benefits from fresh interactions, fresh settings, and fresh ways of piecing together our observations--and those of others.
What is unlikely is that sitting at a desk, in front of a trading screen, will optimize all our efforts at analysis, observation, and synthesis. Each is a different process, and each of us engages in those processes in different ways. If you find yourself distracted, inefficient, a step behind in understanding markets, frustrated with performance, and/or undisciplined in your work routines, consider the possibility that there might be a suboptimal fit between you and your work environment. Tracking shifts in your environment and their impact upon your performance is a worthwhile first step in discovering what works best for you.
It's amazing how much we can pick up when we process the right information the right ways in the right settings.
Further Reading: Where to Find a Trading Career
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The recent post distinguished between financial bubbles and manias, suggesting that blowoff tops and eventual crashes occur when overpriced assets--instead of returning to fair value--become the object of frenzied speculation. The above graphic from Jean-Paul Rodrigue captures this dynamic quite nicely, suggesting that the phases of blowoff and crash are accompanied by participation from different segments of investors. Enthusiasm, he suggests, turns to greed and eventually to the delusion that we are living in a new paradigm.
This dynamic has caught the attention of researchers, as it is so completely at odds with the common view of efficient markets and rational investors. Indeed, Rodrigue refers to bubbles as "misallocation engines", as lax credit provides the fuel for the paradoxical situation in which higher asset prices lead to greater investor demand. Hence the phenomenon of rising volatility and volumes even as prices move higher, noted in the previous post.
In 2007, I cited the momentum life cycle work of Lee and Swaminathan, which suggested that there are common patterns linking share prices and volumes. Specifically, stocks go through phases of rising volume, which correspond to short-term momentum effects (strength leading to further strength) and longer-term reversals (strength leading to correction). Following such corrections, stocks typically show low volume characteristics and behave in a value (mean-reversion) manner, rather than a momentum one. These momentum life cycles help to explain why value and momentum strategies work--and why each does not work uniformly.
From this perspective, the bubbles researched by Kindleberger might represent exaggerations of the normal cyclical behavior of assets. The role of lax credit in these exaggerations would help to explain why, in the wake of low interest rates policies across the globe, Colombo finds current evidence of bubbles across multiple markets and regions.
Recent research suggests that the dynamics underlying the transition from normal, cyclical behavior to bubble creation may lie in the brain. Participants in a simulated trading market underwent brain scans via fMRI while trading that market. Overall, participants displayed activity in the pleasure centers of the brain as prices rose. Successful participants, however, received a warning signal from the brain when a market was in its manic phase, leading them to exit before boom led to bust. Less successful participants did not receive such a signal and continued to act on their pleasure signals well after the market had turned.
Colin Camerer, researcher behind the study, noted that subjects were able to control the prices of the simulated assets through their decisions. "The first thing we saw," he noted, "was that even in an environment where you don't have squawking heads and all kinds of other information being fed to people, you can get bubbles just through pricing dynamics that occur naturally." Interestingly, the lowest earning group of traders in the study were momentum participants who consistently acted on their brains' pleasure signals. The best performing group bought early and sold while prices were still on the rise.
To return to the above graphic from Rodrigue, successful traders behaved more like the "smart money", while unsuccessful traders acted like the uninformed public, valuing the market more as its valuation rose. It is in this context that the advice of Abnormal Returns, to stand aside from bubble prediction and participation, makes good sense. What gratifies our pleasure centers is not necessarily what makes us profitable.
Still, as Tadas notes, citing Daniel Gross, there can be an upside to bubbles in the broader scheme of things: boom and bust in the short run--from gold rush frenzies to dot-com speculation--provide funding for frontier efforts that eventually lead to real development. Not all infatuations lead to lasting romance and not all speculations end in long-term, profitable investments. Without animal spirits, however, perhaps many frontiers would remain unexplored and undeveloped.
Further Reading: Why Emotions Are Key to Trading Performance
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