Friday, October 31, 2014

Does Greater Wealth Make Us Happier?

Traders work hard to make money, but is Franklin correct?  Will increasing wealth bring increasing happiness?  It turns out that the evidence is somewhat mixed and in some surprising ways.

The research of Diener and colleagues suggests that satisfaction with one's country is a strong positive predictor of individual life satisfaction, particularly among impoverished people.  As people gain wealth, their life conditions are more likely to be predictive of their level of satisfaction.  Across countries, high income, individualism, human rights, and social equality are significantly and positively correlated with one another and all of them are predictive of overall personal well-being.  

A research review from Compton and Hoffman finds that living in a wealthier country and having greater wealth within that country are positively predictive of happiness.  There is some evidence that this relationship is curvilinear:  money matters more to people who have little of it than to people who already possess a high income.  Kahneman and Deaton found that, once annual incomes exceed about $75,000 in 2010 USD, additional income did not contribute greatly to additional happiness.  Interestingly, however, additional income did contribute to greater overall life satisfaction.  Happiness in terms of emotional state was more impacted by factors such as health status and relationship quality.       

More recent work by Stevenson and Wolfers finds no income level at which increased wealth stops contributing to greater happiness.  As Susan Adams points out, however, this finding also may depend on how happiness is measured.  When happiness is viewed as life satisfaction, increased wealth is more likely to contribute to higher happiness across income levels than if happiness is viewed purely as an emotional state.

A curve ball in all these findings is that the research tends to look at correlations, not necessarily causal relationships.  Diener and Biswas-Diener suggest the counter hypothesis that happier people are more likely to be successful and hence wealthy!  Given what we know about subjective well-being and productivity, that is not a far-fetched hypothesis.  People who are satisfied with their lives are more likely to invest themselves in their life's endeavors; they are also more likely to be physically healthy

In short, it may well be the case that there is a mutually reinforcing relationship between happiness-as-life-satisfaction and wealth.  To the degree that wealth accompanies advancement within a profession or society, it can be expected to contribute to well-being.  To the degree that well-being energizes work efforts, it can be expected to contribute to the success of our labors and increased economic success.  A happy and satisfying life can be expected to contribute to investment and trading success as much as the reverse.

Further Reading:  Success Starts With Making Your Bed

Thursday, October 30, 2014

Two of the Biggest Mistakes Traders Make

As I look across the good trading and not-so-good trading that I've observed over the years--my own, as well as that of others--there are two big mistakes that stand out as key differentiators:

1)  Putting Prediction Ahead of Understanding - In a sense, this boils down to acting before we truly understand the rationale for action.  At first blush this makes no sense at all.  Still, the fear of missing moves and the need to make money sometimes lead us to anticipate market behavior before we've fully done the work of understanding why markets should move in such a fashion.  Traders often speak about the importance of having confidence in their views.  Genuine conviction, I find, is a function of deep understanding.  If we perceive that we have a grasp of what is driving markets, we are more likely to stick with the trade ideas emanating from that understanding.  Nothing guarantees, of course, that our explanations of market behavior are correct.  It's a pretty good guarantee, however, that if we anticipate market movement and put on positions before we achieve a grasp of why that movement should occur, we'll be easily shaken from our ungrounded convictions.

In the chart above, I track what I call "Demand" for stocks.  It is a running five-day average of upticks vs. downticks among NYSE shares.  There is some predictive value to those data, but particularly important from my vantage point is putting the data into context to understand what is happening in markets.  When markets move quickly from a point of negative Demand--net selling pressure--to a point of high Demand (net buying pressure), that momentum reflects an important shift in market participation that tends to persist over the near term.  Conversely, when markets bounce higher but net Demand remains negative, that suggests a lack of upside participation and, ultimately, a vulnerability to the rise.  Note how that was the case during the market topping in September.  One important component of understanding is simply identifying whether buyers or sellers are in control of the market and which way that balance is moving.  Identical chart patterns can follow from very different configurations of net Demand.

2)  Mismatch of Time Horizons - This is the result of conceptualizing trade ideas on one time horizon and managing the risk on a very different time frame.  A classic example would be a "macro" trader who develops a fundamental thesis about how stocks should move over the next 3-6 months, but then is forced to stop out of positions on retracements that, ultimately, are expectable over such a time period.  In other words, the psychological tolerance for loss is poorly matched with the trader's conceptual framework.  This occurs at trading firms where risk is managed tightly, but where traders still feel a need to stick with ideas and maintain their convictions.  I recall working with a rookie daytrader whose hit rate on trades was startlingly abysmal.  It seemed as though the results were not random, but represented a significant negative alpha.  What that trader would do is set stops insanely close to the point of entry, pride himself on a "good risk-reward trade" and then get stopped out 80% of the time on a putative 3:1 good bet. 

When the press for opportunity greatly exceeds the tolerance for loss, it's a sure bet that good trades will be managed poorly.  We can have superior market understanding, derive excellent trade ideas from that understanding, and still fail to make money simply because we our psychological misalignment between risk and reward leads to poorly aligned position management.  Far better to stay in good trades with modest size than continually stop oneself out on noise and fail to capitalize on solid understanding.

Further Reading:  Five Distinguishing Features of Great Traders

Wednesday, October 29, 2014

A Fresh Look at Stock Market Breadth

A pattern that has played out across most recent market cycles is that breadth peaks ahead of price.  So what are we seeing with breadth now, given the recent strong move higher in stocks?

Notice that yesterday's gains came on a breadth surge.  The top chart shows us expanding the number of common stocks across the NYSE that are making fresh three-month highs vs. those making new three-month lows.  Indeed, that number now exceeds the new high strength we saw at the September market peak--not something you'd expect if the stock market were weakening and setting up a head-and-shoulders top.

Similarly, the bottom chart shows the number of NYSE shares closing above their upper Bollinger Bands vs. those closing below their lower bands.  This, too, has marched to new high ground, eclipsing September levels.  New highs are around levels that have marked recent momentum peaks going back to the second half of 2013, so it would not be unusual to see some give-back in the near term.  Perhaps the more important takeaway is that the stock market is displaying expanded breadth relative to September, not a continuation of the weakening we saw from July through September.

Tuesday, October 28, 2014

Cultivating Emotional Creativity

We often think of creativity in cognitive terms:  as coming up with new thoughts and ideas.  Creativity also manifests itself in art, which is a bit different.  The truly creative artist feels something strongly and gives that experience a distinctive form.  In that transformation, there is emotional creativity:  feeling things in new ways.

A fascinating study by Averill and Thomas-Knowles examines emotional creativity and how it overlaps--and yet is distinct from--cognitive creativity.  One of their observations is that emotionally creative people find challenge where others see threat.  I would amend that slightly and suggest that emotionally creative people experience challenge *and* threat in particular uncertain situations.  Theirs is a more emotionally nuanced response to a situation, aware of both risk and reward and able to fashion adaptive responses that integrate both.  For example, when a trader perceives good reward but also meaningful tail risk in a trade, he or she might structure the trade through options that limit risk and preserve a good amount of upside.  As the trade works out, the simultaneous awareness of risk and reward does not vanish, and the trader might continue to manage the situation through delta hedging.

Consider an alternative:  the emotionally uncreative trader who treats risk and reward as polar opposites, becomes enamored of reward, and piles into a cash position in the name of "conviction".  Or the reverse:  the emotionally uncreative trader who identifies solely with risk and either puts on a ludicrously small position or freezes and misses opportunity altogether.  The emotionally uncreative person locks onto particular emotions to the exclusion of others and thus ends up responding in extreme and stereotyped ways.  Racial and cultural prejudice are examples of low emotional creativity.  Many psychological problems are the result of processing feelings in rigid ways, keeping us locked into patterned--and ultimately unfulfilling--behaviors.

From this perspective, successful coaching and counseling is an exercise in emotional creativity.  In cognitive therapy, for example, what happens is that people access fresh--and more constructive--feelings toward themselves and turn that emotional expression into a more positive internal dialogue.  Many times in counseling, it is internalizing the new emotional experience with a caring therapist that catalyzes the change in self-perception.  Behavior change starts with a change in emotional experience.  Expanding emotional experience is a gateway to changing behavior.

This is the problem with rote attempts at change such as routinely filling out a journal or checklist.  Yes, those can help us be more mindful of things to-do, but rarely do such cognitive devices shift our emotional experience.  One of the reason imagery techniques can be so useful in change is that they enable us to generate our own fresh experience and hence expand our emotional repertoire.  An example would be helping an angry spouse visualize a partner as being in pain and recruiting caring and empathy along with the feelings of frustration.  This could lead to empathic ways of communicating frustration--far more creative and productive than mere venting of negativity.

As Averill notes, emotions both generate creative activity and are the results of processing the world creatively.  Once we view emotions as experiences we can cultivate, not just ones that occur to us, it opens the door to fresh ways of generating new patterns of feeling and action.  A richer internal life ultimately contributes to a richer set of behaviors in challenging situations.

Further Reading:  Conflict and Creativity in Trading

Monday, October 27, 2014

What We Can Learn From the Relative Performance of Stock Market Sectors

In a little while, I will be rolling out a feature that examines the relative performance of various segments of markets as a bottom-up way of understanding and anticipating macro themes that are important to the longer-term trajectories of markets.  An example of such bottom-up analysis is reflected in the relative performance of sectors within the stock market.

Is tech leading market performance, while defensive sectors lag?  That is one kind of market.  Are we seeing outperformance from consumer cyclical companies relative to consumer discretionary ones?  That is a different kind of market.  All tell us something about economic and growth expectations of market participants.  To the extent that markets are forward-looking, such information can be valuable, reflecting the implicit forecasts of many agents.


So what is sector performance telling us right now?

The top chart, from the excellent Finviz site, shows us that sector performance has been highly variable over the past month.   Utilities have dramatically outperformed Basic Materials shares and many sectors have gone nowhere over that period, despite the meaningful uptick in market volatility.  I would argue that the relative outperformance of Utilities, traditionally viewed as market defensiveness, is nothing of the sort here and now.  Rather, the market is pricing in a disinflationary environment, in which rates will be staying low for long.  In such an environment, a factor that will drive returns is carry, the yield on any particular asset.  With disinflation and low rates, the yield of utility shares is attractive and there is little attraction to inflation-sensitive commodity-related shares.

If this is correct, we should see carry continue to attract capital across asset classes, from currencies and rates to stocks.  We've already seen a reach for yield in rates markets, as investors have gone further out in duration and further out on the low-quality spectrum to achieve carry returns.  At some point that will end badly, but the market is not telling us that point is now.

The middle chart is my tracking of rolling 20-day correlations among stock market sectors and the bottom chart reflects rolling 20-day volatility among sectors.  Typically in a market cycle, volatility and correlation expand into market lows and continue high as the market rebounds.  As a cycle matures, volatility wanes and correlations come down, as we see reduced volumes and more divergent day-to-day performance among sectors.  One of the things I find interesting now is that sector performance, per the top chart, is divergent, but we're still seeing high day-to-day correlations of sector movement.  In other words, sectors are moving in relative lockstep, but some are moving with more strength than others.

The continued high levels of correlation and volatility suggests to me that the current market cycle, coming out of the mid-October lows, is still relatively early in its development.  If precedent holds, we should see a momentum peak in breadth, followed by declining volume, volatility, breadth, and correlation, as stocks top out.  The resilience of stocks itself reflects a forecast that continued low rates and the recent decline in energy prices will not be negatives for corporate earnings growth.

Further Reading:  The Importance of Sector Correlations

Sunday, October 26, 2014

Starting the Week Looking Through Fresh Eyes

Here are some fresh eyes for seeing the world to start the new week:

*  Interesting habits manifesto from The Happiness Project.  I like the idea of writing out your personal manifesto to capture personal best practices;

Great post and links re: trend following from Meb Faber; 

*  What brain science tells us about risk taking and other good Sunday links from Abnormal Returns;

Excellent critical look at smart beta from Alpha Architect; by the way, check out the Alpha Architect interview from Abnormal Returns;

Insightful look at how high frequency trading relies on a volume clock and what low frequency traders can do about it;

*  Boosting growth post QE and other good Sunday perspectives from Barry Ritholtz; 

Perspectives on teamwork and trading; taking collaboration beyond mere chat.

Creating a Training Program for Happiness

Ah, yes, too often traders put the key to happiness in the market's pocket, ensuring that their mood will fluctuate with prices.  That is a vulnerable state, and not one conducive to peak performance.

When we refer to happiness, we're not talking about living life with a perpetual grin.  Happiness embraces positive mood, but also implies a high degree of contentment with one's life and inner fulfillment.  Not everything that provides pleasure contributes to our happiness, as we can observe in the case of addictions.  Indeed, the problem of willpower is that we often act short-term to achieve pleasure and thwart our longer-term happiness.  

The psychologist Michael Fordyce developed a happiness training program in the 1980s that demonstrated statistically significant gains in people's overall level of positive emotional experience.  The program drew upon five components  to achieve these results:

Changing Your Activities - Making a conscious effort to be more active and engage in productive, meaningful work.  Getting more organized and prioritizing your activities.

Changing Your Thinking - Making conscious efforts to be more optimistic in outlook and more present-centered.  Shifting expectations to make sure they are achievable and not frustrating.

Nurturing Relationships - Spending more time meeting people and engaging in quality time with friends and romantic partners.

Valuing Personal Growth - Spending time on activities that expand who we are, such as physical exercise, spirituality, and education.

Decreasing Negative Emotions - Making conscious efforts to interrupt worry, self-criticism, and pessimism and channel frustrated energy toward constructive activity.

Interestingly, Smith, Compton, and West found that adding meditation to the five program components further increased the happiness of subjects.  By increasing mindfulness, we are most likely to be consistent in enacting the other portions of the training program.

Imagine creating a daily to-do list in which you make concerted efforts in each of the five categories above for the period of a month.  Over time, you would begin to build happiness habits that would take on a life of their own.  

Why is this important?  Happiness has been linked to improved health.  Enjoying life is a significant contributor to physical well being as we age and can reduce the negative effects of aging.  Happiness also boosts our productivity, and it brings greater creativity and quality of effort to our work.

Happiness is not just a positive mood that comes upon us.  It is a way of life that can be cultivated over time. 

Now think about your trading and the five happiness ingredients above.  Does your participation in markets add to your happiness or detract?  If the latter, there are few better investments you could make in your trading than reorganizing your business plan and ensuring that your trading process is also a happiness process.  

My own formula for such a personal business plan is simple:  take the ratio of daily activities that give energy to those that drain energy.  If that ratio is well above one, you will most likely lead a happy life.

Further Reading:  Happiness and Success:  Which Brings Which?

Saturday, October 25, 2014

Three Things You Can Do Right Now to Improve Your Life

One of my favorite quotes is from Nietzsche:  "Under peaceful conditions, a warlike man sets upon himself."  In other words, when life becomes comfortable, that's when it's time to think about pushing boundaries and taking on worthy challenges.  Not all of those boundary pushings need to be market related.  Here are three things the research literature tells us we can do to make meaningful life improvements right now:

1)  Engage in Physical Exercise - Important research shows that aerobic exercise has tremendous brain benefits, particularly as we age.  These include improvement of memory and overall health.  Physical exercise also helps to moderate stress and reduces susceptibility to depression and anxiety.  Interestingly, there may be different brain benefits associated with resistance vs. aerobic training, suggesting that an exercise regimen of both is ideal.  Exercise benefits children as well as young and older adults, and it brings particular benefits to our executive brain functions, so key to real-time decision making.

2)  Build Positive Relationships - Building positive relationships brings a variety of benefits to life, including better health and overall emotional well-being.  People in significant relationships are happier than people who are not and produce fewer stress hormones.  In fact, being in a relationship with a healthy person tends to promote one's own health!  Physical affection, from hugs to sex, also brings meaningful health benefits

3)  Improve Your Sleep - It is easy to take sleep for granted, but both the quantity and quality of sleep bring meaningful life benefits.  These include improvement in memory, longevity and quality of life, lower disease levels, enhanced creativity, and improved physical performance among athletes.  Over time, a consistent loss of 60-90 minutes of sleep per night creates a "sleep debt" that adversely impacts our emotional well-being, cognitive functioning, and overall health.   

In short, there are important links between how we manage our lives and how we manage our trading accounts and investments.  Olympic athletes know that they have to be in flawless condition to achieve peak performance.  Rarely, however, do we think of ourselves as performance professionals and train accordingly, creating lifestyle habits that enhance all facets of life.

Further Reading:  Making Peak Performance a Lifestyle

Friday, October 24, 2014

When Stop Losses Stop You From Winning

More than a few traders were stopped out at inopportune moments during recent volatile trading.  There are few things as frustrating as getting stopped out of what, ultimately, turns out to be a good trade.

I generally find that traders are much less detailed in their planning for exits than their entries.  They will select support/resistance levels as potential stops, but as often as not these represent pain thresholds and not sober assessments of a market's likely movement over a holding period.  Not a few traders lately were stopped out simply because their position sizing was not matched to the market's higher volatility, causing pain thresholds to become exceeded prematurely.

Suppose a trader exits a long position after several days of losses.  That seems prudent.  When we go back to 2006 in SPY, we find that five days of weakness (fewer than 50% of SPX shares trading above their five-day moving averages) has brought a next five-day return of +.43%.  Five days of strength have brought a next five-day return of -.08%.  In other words, if you bought on strength (prudent waiting for price confirmation) and bailed out on weakness (prudent stopping out), you were the very embodiment of negative timing alpha.  Stopping out in such a manner stops profitability.

So what is a trader to do?  One possibility arose recently when I was building a short-term trading system for the ES futures.  The system was modestly profitable after a one day holding period; better after two days; and considerably better after three days.  When I examined next day returns, there were many points where, had I been trading intraday, I would have stopped out.  Those trades went on to become nicely profitable over the next two trading sessions.

After tweaking possible stops and no doubt overfitting some of them, I said to myself, "This isn't working!"  So I eliminated price-based stops altogether and set a catastrophic stop level that I could live with, but that had never been hit during my in- or out-of-sample periods.  So once the signal occurred, I was to hold for three trading sessions and stick with the trade as long as the catastrophic stop did not trigger.  I sized in a manner that allowed me to weather expectable drawdowns without undue trauma to the portfolio and sat back to let trades breathe.

I stopped price-based stops and let time and position size define my risk/reward.  Early days, but so far it's been easier on the psyche and better for the bottom line.

Further Reading:  Why Traders Keep Losing Money

What is Different About This Market?

An observation I've heard from quite a few traders about the stock market is, "Something is different about this tape."  Because these are traders with good instincts and considerable market experience, I take their observations seriously.  That led me to delve into some of the unique aspects of the present market.

The first difference was referenced in a recent blog post:  We have seen unusually strong levels of buying off the recent market lows.  Specifically, we had seven consecutive trading sessions in which my measure of Buying Pressure was a full standard deviation or more above the daily average going back to 2012.  Interestingly, the last two trading sessions have shown reduced buying interest; that's something I'm tracking closely.

The second difference is volatility, as documented in the top chart above.  When we look at 10-day realized volatility (the ten-day average of daily average true range in SPY), we can see that this market is wholly unlike what we've seen during 2014.  This has real implications for the sizing of positions and risk-taking, as stocks are likely to move more than we're accustomed to seeing.  If we look solely at implied volatility, such as VIX (the volatility implied in the options market), we are currently at levels that we saw during early 2014, around the February lows.  Realized volatility, however, is much higher.  In other words, we're seeing more market movement than even the VIX would lead us to expect.

The third difference is reflected in the bottom chart, which depicts something I call the "Power Measure".  Basically, the Power Measure is a running correlation between volatility and price change.  We're looking to see if big volatility moves are tending to occur to the upside or downside.  It is not unusual for the Power Measure to bottom ahead of intermediate-term market lows, reflecting the trajectory of downside momentum, and it is not at all unusual for it to peak ahead of price during intermediate-term bull cycles.  I use it less as a timing tool than as a general gauge to tell me if markets are moving more impulsively to the upside (Power > 0) or downside (Power < 0).  I expect us to crest in coming days, but the shorter-term version of the indicator is already peaking at a lower price high relative to September.  This makes me sensitive to the possibility that, despite the buying pressure, we could put in a lower high and correct further.  The drop we saw overnight with the NYC Ebola scare reminds us that volatility can still work both ways in this market.

The big takeaway for me is that there are limits to how much you can assume that present markets will mirror past ones.  When we see unusual price movement and wholly different volatility regimes, we are wise to not extrapolate from recent--but dissimilar--markets.

Further Reading:  Putting Direction and Volatility on Your Side Intraday

Thursday, October 23, 2014

Putting Gratitude in Your Attitude

A while back my daughter was involved in a single-car accident.  She acknowledged that it was the result of careless driving.  The repair estimate was a few thousand dollars.  My immediate reaction on hearing the news was relief that she was not injured.  Yes, we spoke about driving carefully and learning from the incident, but I was not stressed or angry.  I was relieved:  grateful, because I knew the outcome could have been much worse.

It turns out that gratitude is an underappreciated component of emotional well-being.  Robert Emmons, Ph.D. and his colleagues have done interesting work in this area.  The research tells us that gratitude contributes significantly to positive relationships, physical health, and general happiness.  These, in turn, are known contributors to performance:  productivity and creativity.

It also turns out that gratitude, like any attitude, is one that can be cultivated through mindful practice.  Indeed, many spiritual disciplines and religious practices promote gratitude.  Journaling can be an effective means for generating gratitude as a pattern of thinking and feeling.

In one study of gratitude, half of the subjects were asked to write a few sentences per week on things that they were grateful for.  The other half was asked to write about their daily irritations.  By the end of the ten week study, the group expressing gratitude expressed more optimism and happiness than the group venting irritation.  Intriguingly, those who wrote about gratitude were also less likely to need visits to physicians.  The benefits of gratitude are so dramatic that there is a grant-funded project to promote gratitude as a public health initiative. 

The idea is that every day can be Thanksgiving.  When we are steeped in frustration about market moves that we missed, trades we got wrong, or drawdowns we incurred, we place ourselves in an emotional and physical frame that is not conducive to future performance.  A worthwhile trading practice is to extract at least one piece of personal and professional progress from each day that you are grateful for.  We will always experience drawdowns--in trading and in life.  Gratitude helps us focus on the riches we can never lose.

Further Reading:  Gorillas in the Middle of the Market

Wednesday, October 22, 2014

A Look at the Recent Buying Surge

The recent post noted the drying up of downside breadth in the stock market, even as we were posting fresh price lows.  I said at that time that I would be surprised if the bottoming process were over, but that I'd be on the lookout for continued signs of strengthening breadth.  Well, I was surprised, and we certainly have had the strengthening breadth!

The charts above document the recent surge in buying interest.  The Buying Power measure, which is derived from a measure of the number of upticks among NYSE shares, has hit its highest level since I began collecting those data in early 2012.  Over that same period, short-term breadth among SPX stocks has moved from deeply oversold to strongly overbought (middle chart), which is reflected in the radical shift in the shape of the Momentum Curve (bottom chart; the percentages of SPX shares trading above their various moving averages).

As we can see from the middle chart, surges in breadth from oversold levels tend to show momentum:  further price gains even as breadth wanes.  Many investors and traders have missed this "V-bottom", and that provides powerful incentives to buy the first dips.  

Further Reading:  Institutional Participation and Momentum

Tuesday, October 21, 2014

How Moods and Motivations Impact Trading Performance

A very interesting summary of research on mood and creativity finds that people are most creative when they are in particular states.  First, when mood is positive, people solve problems more easily and are more likely to think broadly and perceive fresh alternatives.  We are most cognitively flexible when we experience positive vs. negative moods.

Second, when people are moderately energized, they are most likely to engage in complex and creative thinking.  When at low levels of arousal, we don't fully engage the world cognitively; high levels of arousal interfere with reflective thinking.  It is when we are energized in positive ways that we display superior processing speed, focused attention, flexible thinking, and creative response.  

Finally, when we are in "promotion states"--states in which we seek positive outcomes--we are most likely to respond creatively.  In "prevention states", we tend to narrow our cognitive focus and fail to see alternate courses of action.  It is when we seek positive outcomes that our attention broadens and we become most flexible in our response patterns.

If we put together these three conclusions, it is not difficult to see how negative emotional experience adversely impacts trading performance.  When markets are behaving against our expectations and positions are moving against us, that is when we want to be most open, flexible, and creative in our thinking.  Under the influence of negative mood, very high arousal, and prevention-oriented thinking, we become unable to clearly perceive all our alternatives and recruit our most flexible responses.

From this perspective, one of the most important psychological things we can do to improve trading performance is to sustain positive mood, high energy, and clear, constructive goals.  We cannot eliminate the uncertainty of markets or the stresses of drawdowns.  What we can do, however, is balance those pressures with our own positive internal environment, so that stress never turns into distress.  

In an important sense, bad trading results from a failure of creativity:  the inability to think and respond in divergent ways when markets are behaving counter to our expectations.  Maintaining an emotional and cognitive state conducive to broad information processing and flexible thinking helps ensure that we truly respond to markets, and not to our own fears and frustrations.

Further Reading:  Creativity and Finding Your Trading Zone

Monday, October 20, 2014

The Real Source of Trading Success

Thought you might enjoy this graphic I picked up from the web.  Admittedly, it's a bit extreme, but it captures something we all see in the trading world:  the allure of getting rich quick and the willingness of some to exploit that allure.  Nowhere is that more prevalent than in the world of day trading.

We know from research that persistent success at day trading does exist, and we also know that it is rare.  In a sense, that should not surprise us:  by definition, elite talent is rare.  What makes trading difficult is that, in many fields, we can make a living from our work even if we are not operating at elite talent levels.  In day trading, as well as other forms of trading, making a consistent living from trading *is* elite talent.

To illustrate some of trading's challenges, I ran a few numbers using SPY as my proxy trading instrument.  From 2012 to the present, SPY has gained a little over 60 points.  About half of those points were gained during overnight hours; half during U.S. day hours.  The traditional day trader has limited himself/herself to about half the directional opportunity by trading only during U.S. hours.

Should traders seek greater directional opportunity by extending the time frame, they will find that the correlation between overnight changes and day session changes in the stock market since 2012 has been -.01.  They might as well be totally different markets.  If the trader extends to more of a swing time frame, the correlation between today's price change and tomorrow's since 2012 has been -.02.  In other words, overall, what happens in the market during one short-term period offers no information about what will happen in the next period.  We like to think directionally, in terms of trends, but--overall--what we can extrapolate from current markets to future ones is quite modest.

I have tested many patterns in markets and can attest that a correlation between market predictors and future price change that exceeds .20 is something quite special.  Yet even that correlation implies that the predictors account for only 4% of future price movement.  Our error variance is very high relative to what we can predict, even for statistically significant research.

That, of course, leads some to create models of sufficient complexity that they will promise far higher levels of predictive accuracy.  As Derman notes, such complexity comes at the cost of fragility:  modeling the financial world is fundamentally different from the modeling of the physical world.  The laws of physics don't change readily.  The behavior of market participants does.  One of the better predictors of market bottoms in recent times was elevated volatility, particularly the "pure volatility" measure I have written about.  During this most recent market decline, volatility blew out:  what had been significant levels of volatility for calling market bottoms no longer applied to the new regime.  We can calculate the odds of a given backtest being overfit, and it doesn't take much in the way of complexity to get to that point.

So where does that leave us?  Simple patterns do not provide reliable profitability, breathless claims such as the above graphic notwithstanding.  Complex patterns are all too likely to be overfit, producing great backtests but failing in real time performance.  No, the answer is not to be simple or complex; the answer is to be different.  Of the traders I worked with a decade ago, fewer than 5% are currently trading and experiencing success.  In each case, they are doing something very different from what the standard trading books describe.  They have found sources of "edge" in markets that they have made their own, and they have been consistent in exploiting those edges.  

One trader, for example, came up with an ingenious method for identifying when trading in a particular asset was becoming highly crowded.  He then looked for indications of loss of price momentum and took the other side of the crowded trade, benefiting from the herd running for the doors.  A big part of his edge was that, if he didn't find the right patterns of crowding, he did not trade.  He only played the game when the odds were on his side.  

A very different trader at a financial institution obtained information from satellites that provided information about weather and crop planting patterns and used those data to predict yields for agricultural commodities.  When markets were mispriced relative to the new data, trades with an edge could be placed.

Still another trader found that market moves at certain times of day had more likelihood of reversing than at other times of day, as different participants impacted the market throughout the day.  By tracking the level of participation and movement and segmenting time differently from other traders, he was able to identify profitable trading patterns.

In the trading world as in the business world, "me too" is not a formula for success.  The successful entrepreneur is the one who operates with a vision, doing something differently--and better--than rivals.  It's not enough to plan your trade and trade your plan.  Those plans have to be grounded in insight and unique information if they are to lead to ongoing success.

Further Reading:  Keys to Day Trading Success

Sunday, October 19, 2014

New Views to Start the Market Week

*  Here's a really excellent look at the week ahead and the week just passed from Dash of Insight.  Very thoughtful presentation.  Also check out the "best of" from Jeff's site.

*  Why stock markets crash and other excellent links from the week past from Abnormal Returns.

*  If small caps come back, these might provide particular opportunity.

*  Thanks to a savvy trader from SMB for pointing out this article on why women are better decision makers than men, particularly under stress.

*  This looks like a particularly promising book on momentum trading/investing. Also check out this research paper on profitable momentum strategies for individual investors.

*  Interesting case for making fixed income part of a portfolio strategy.

*  While much of the trading world focuses on the epidemic in West Africa, the situation in Greece looks particularly problematic.

Have a great start to the week!


More Bottom Up Stock Market Indicators and How to Use Them

The previous post looked at three market measures that assess strength vs. weakness from the bottom up; that is, by looking at all the components of a stock index, rather than the time series for the index itself.  Above we see three additional bottom up measures that I update daily and below I will describe how I utilize these.

The top chart displays what I call the Momentum Curve (data obtained from the excellent Index Indicators site).  This enables us to see the percentages of stocks in the SPX average that are trading above moving averages of varying lengths across the past five trading sessions.  What we can see most recently is that the percentages of stocks trading above their 3, 5, and 10-day moving averages bottomed out ahead of the recent market low and now have moved smartly higher, even as we remain oversold vis a vis the longer-term averages.  We typically see the reverse pattern at cyclical market peaks, where the percentages of stocks above their shorter-term moving averages head downward in advance of an ultimate price high.

The middle chart, also drawn from data available from Index Indicators, is a multiperiod measure of breadth specific to the stocks in the SPX average.  Specifically, we're looking at the sum of new highs minus new lows over a 5, 20, and 100-day basis.  The composite new lows bottomed most recently on October 13th, a few days prior to the recent price lows.  The composite new highs topped well before the most recent price peak in September.

The bottom chart, drawn from data available on the very useful Barchart site, is a running total of the number of stocks crossing above their 20-day moving averages minus the number crossing below those averages.  This covers all common shares across the major exchanges, which makes it a broader breadth-related measure.  Most recently, the cumulative number of crossovers bottomed on October 1 and based for a while, as other breadth measures continued lower.  The cumulative number of crossovers very commonly peaks well ahead of price during cyclical topping periods, as occurred prior to the September high.

New traders often look to indicators such as these for specific buy and sell signals.  My experience is that analyzing any single indicator for such guidance is less helpful than synthesizing the information across multiple measures.  Across a series of well-constructed measures that examine different portions of the market across differing time frames, common themes will emerge that tell a story.  It's that story that ultimately provides the basis for useful trade ideas.  The story is less about what markets *should* be doing based upon share earnings, economic fundamentals, or esoteric numerological schemes and more about concretely assessing whether the individual components of indexes, on balance, are trading stronger or weaker over time.  The best way to use these indicators, I find, is to take the time to create a narrative that makes sense of all the observations--and then generate an alternative narrative suggested by data that don't fit into the original story.  Having that "Plan B" narrative is very useful in staying flexible and avoiding confirmation biases regarding your primary view.

As with the other measures, I will be updating these periodically to keep up with evolving market conditions.

Further Reading:  More Posts on Indicators and Patterns

Saturday, October 18, 2014

Looking at Technical Indicators From the Bottom Up

Typically, if we want to use a technical indicator to gauge the strength or weakness of a given market index, we will simply apply that indicator to the price series for that index.  Suppose, however, we took a different approach, from the bottom up, rather than the top down.  Suppose we applied the indicator to every single stock within the index and gauged strength and weakness via the breadth of individual buy and sell signals.

Above are three charts that take a bottom up view of the recent market.  (Data obtained via the excellent Stock Charts site).  The top chart will be familiar to readers; it's the balance of NYSE stocks trading above their upper Bollinger Bands vs. below their lower Bands.  The middle chart utilizes the Parabolic Stop and Reverse (SAR) indicator developed by Welles Wilder and takes the number of NYSE stocks at the close each day giving buy vs. sell signals.  The bottom chart shows the number of buy vs. sell signals for each NYSE stock for the Commodity Channel Index (CCI)

Note that there is a family resemblance among the charts, but differences also.  Each indicator operates with different parameters on different time frames.  The links in the paragraph above explain how each indicator is constructed and how buy and sell signals are derived.  I think of each of the indicators as a prism through which we can see the breadth of strength and weakness across the entire market.  No one prism provides a perfect signal all the time, but when you see common patterns among the prisms, it's generally worthy of attention.

As a rule, we see peaks in the numbers of stocks giving buy signals ahead of cyclical peaks in the broad market (SPY) and we see peaks in the numbers of shares giving sell signals ahead of cyclical troughs.  You can see how the indicators peaked--but stayed positive--prior to the recent September market top and how they have troughed ahead of yesterday's rally in stocks and have now turned positive.

We have many ideas about whether markets *should* trade higher or lower, but bottom-up measures like this show whether they are actually strengthening or weakening.  I will feature regular updates of the indicators for those interested in following the signals.

Further Reading:  Breadth Volatility and Market Cycles

Friday, October 17, 2014

What Market Breadth Has Been Telling Us Lately

Here are two updated views of stock market breadth.  Recall that it was waning breadth that gave us a heads up on the recent market weakness.  What we're now seeing is the reverse.

The top chart monitors all common stocks traded on the major exchanges making three-month new highs vs. three-month new lows.  We can see from the chart that this decline has been much broader than ones previous.  New lows hit their maximum level so far on October 10th and then held slightly above that level at the market low on October 15th.  With yesterday's buying interest--my Buying Power measure hit its highest level since 2012 yesterday--new lows dried up and so far in premarket today we're seeing continued buying interest.  This suggests a momentum low has been put in place.

The second chart tracks the number of NYSE issues closing above vs. below their upper/lower Bollinger Bands, which I refer to as the Bollinger Balance.  Note again the recent persistent weakness, the failure to expand the number of shares closing below their bands at the recent lows, and now the drying up of that weakness.

As I've stressed in the past, it helps to think of topping and bottoming as processes, not as fixed points on a chart.  Markets make bottoms when they hit a momentum low, bounce, and then subsequent weakness occurs with less downside momentum and volatility and fewer shares making new lows.  It would surprise me if this bottoming process is over--a general rule is that more extensive declines undergo more protracted bottoming--but a continued drying up of weak breadth is something I'll be on the lookout for to find opportunities to scoop up some value.

Further Reading:  Finding Opportunity in Stock Market Cycles

Thursday, October 16, 2014

Why This Market is Moving So Fast and Far: The Explosion of Pure Volatility

How big was the volume during yesterday's decline?  Apparently large enough for even the dark pools to turn away customers!  I show about 380 million shares traded for SPY, compared with an average of 84 million from June through August of this year.  What that means is that entirely new sets of participants have been active in the marketplace, creating a complete change in market movement.

We can see that in the chart of pure volatility from late 2013 to the present.  I introduced the idea of pure volatility in an earlier post and have since refined it.  It is a measure of the amount of price movement we get for a given amount of volume traded in the ES futures contract.

What is evident from the chart is that pure volatility has gone through the roof.  We are not just getting a lot more volume; that volume is moving markets more than twice as much as they did at our market highs.  The reason for this is that the added market participation is directional in nature, so that moves find more buyers and sellers.  Think of e-Bay auctions for a very hot item whose popularity has gone viral.  The price movement would be much greater than for items that are not popular.

I will be watching volume and pure volatility closely from here, as we will need to see normalization of those numbers as part of any bottoming process.

What Volatility Means for Your Trading Psychology

Ah, if it were only that easy!  I took a look at the average true range for the past five trading sessions in SPY.  It was almost 2.1%.  By contrast, at the July peak, the five day average true range was almost .53%.  So basically, in terms of realized price movement, we have quadrupled volatility in a span of about two months.

What does that mean for trader psychology?  Imagine quadrupling your trading size over the span of a couple of months.  How might that impact your trading?  By placing a magnifying glass on the dollar size of your P/L moves, it accentuates the potential psychological impact of wins and losses.  A random streak of four losing trades on quadruple size could wipe out a substantial portion of prior profitability.  Conversely, random large winning trades could convince a trader of his hot hand and lead to overconfidence and overtrading.

When volatility increases by several orders of magnitude, not only are the moves in the direction of the trend accentuated, but also the moves against the trend.  That means it's very easy to have a trade move 1% against you in minutes, where it would have taken a few days for such a move to materialize in the slower, low volatility market.  If your trading size is the same in a high volatility market as a low volatility one, you have effectively magnified your size by several times.  That does not mesh well with many people's risk tolerance.

The reason this is important is that spikes in volatility associated with intermediate-term market pullbacks are more common than recent experience would suggest.  Check out this very helpful blog post from Philosophical Economics.  Since World War II, we have seen 10% market corrections about 20% of the time and 15% corrections over 12% of the time.  This ensures that buy and hold investors will have meaningful drawdowns, and it also guarantees that career short-term traders will experience spikes in volatility.  Such spikes can represent meaningful opportunity, but only if one's emotional volatility is not tied to that of the market.

Further Reading:  Volume and Volatility