Wishing readers a happy, healthy, and successful New Year!
TraderFeed will start the new year with a series of posts on best practices, including those submitted by readers. Perhaps one or more of those best practices will help shape goals for you in 2015.
Thanks to Bella at SMB for calling attention to this excellent post re: how to make your New Year's resolutions stick.
One of the key ideas from that post is to frame your resolutions in terms of habits you want to develop, rather than as long-term, pie-in-the-sky goals. That is a three-step process:
1) Frame the Objective - What is the one change you most want to make during 2015? A good place to start is to review your shortcomings during 2014 and identify the one change that would make you better.
2) Turn the Change Into a Routine - If you are going to make your change, you have to *be* that change at some time, every single day. If my goal is to be a more loving, supportive father during the new year, then I need to construct loving, supportive time each day with my children.
3) Find Triggers for the Routine - By associating our routine with a regular life activity, we can become consistent in enacting our changes. Let's say that one of my ways of being a more loving, supportive parent is to spend quality time with the children over dinner. I might take up cooking and start making fun foods that the kids would like. This would help turn dinner times into quality time.
Common thinking is that we need to change how we think and feel in order to change our behaviors. The reality is that the reverse is equally true: by enacting new behaviors, we can change how we think and feel. If you can find time each day to be the person you want to be, you will begin experiencing yourself as that person--and that will start a positive momentum that will impact a variety of areas of your life. Using dinner times to be more loving and supportive might just help you be more loving and supportive of yourself during times of setback.
So what is the one change you can make in 2015 to be the person you most want to be?
Here are a few posts you might find helpful with respect to developing new habit patterns:
Turning Goals Into Consistent Habit Patterns
Turning Success Into a Habit
Cultivating Winning Habits
.
Above are two perspectives on stock market breadth, focusing on the stocks within SPX. The top chart tracks the percentages of SPX shares trading above their 3, 5, 10, and 20-day moving averages. The bottom chart is a moving average of the number of SPX stocks making 5, 20, and 100-day new highs minus new lows. (All data from the excellent Index Indicators site).
Note the distinct tendency of the breadth measures to top ahead of price during market cycles. The quicker breadth measures also tend to bottom ahead of price, which gives a bit of heads up on those potential V bottoms. What we're seeing from these measures presently is a healthy degree of upside breadth. We are not yet seeing the kind of decline in breadth that has preceded recent market drops. Historically, a buy dips mode has worked well in such an upside breadth environment.
For example, going back to late 2006, when over 75% of SPX stocks have traded above their 100-day moving averages and fewer than 50% of those shares have closed above their 3-day moving averages, the next three days have averaged a gain of +.22%, versus an average gain of only +.03% for the remainder of the sample. Knowing where we stand with respect to breadth during a market cycle can provide a useful road map for short-term trading.
Further Reading: Breadth Volatility
.
I'm not a big fan of terms like "overbought" and "oversold". Too often, those terms embed a bias--that the stretched market is likely to snap back. Similarly, one person looks at a chart and notices "consolidation"; another perceived "topping". There is a lot of room for subjectivity in how we label what we see. That's a good reason to look at many things with a fresh set of eyes. We're less likely to fall victim to confirmation biases if we view the world through multiple lenses and invite information that doesn't neatly fit into our views of the moment.
Above is a chart of the ES futures. Each point on the chart represents 50,000 contracts traded. On busy days, we print more points on the chart; slow days print fewer. Similarly, the busy times of day print more points than the slow, midday hours. This normalizes, to some degree, volatility within and across days. I further take volatility out of the picture by simply recording whether the average price of each volume bar is up or down relative to the prior bar. The chart is an 80-bar moving average of this up/down count. It can be viewed as a relatively pure measure of price momentum.
When the 80-period average has been in the top half of its distribution, the next 40 bars have averaged a gain of +.15%. When the average has been in the bottom half of its distribution, the next 40 bars have averaged a loss of -.01%. If you look at the chart closely, you'll see the reason for this momentum effect: early in a market cycle, we see a surge in upside momentum, which stays positive but wanes as the cycle matures. Eventually we get negative momentum, leading to a crescendo of downside price change shortly before we hit a price low.
Seeing where we're at in this process gives a good read for where we stand in the present market cycle. Much of the upside movement in the market can be attributed to momentum following strong positive readings and value/reversal following strong negative readings. Tracking these helps us adapt to the phases of a market cycle.
Further Reading: Finding Opportunity in Market Cycles
.
* Since 2012, we can divide market days into quartiles, based upon the number of stocks in the SPX that are making fresh five-day highs vs. five-day lows. When we are in the weakest quartile--most stocks making new lows relative to new highs--the next five-day return has been +.76%. On all other occasions, the average next five-day return has been +.17%.
* Since late 2006, when I first began collecting these data, when the put/call ratio across all listed stocks was in its highest quartile, the next five days in SPX have averaged a gain of .43%. On all other occasions, the average next five-day return has been +.04%.
* Since late 2006, when the number of SPX stocks making fresh five-day highs vs. lows has been in its weakest quartile, the next five-day return has averaged +.45%. Across all other occasions, the average next five-day return has been +.05%.
* Since late 2006, when VIX has been in its highest quartile, the next five days in SPX have averaged a gain of +.22%. Across all other occasions, the average five-day gain has been +.11%.
* Since late 2006, when the percentage of SPX stocks trading above their 5-day moving averages has been in its weakest quartile, the next five days in SPX have averaged a gain of +.46%. Across all other occasions, the average five-day gain has been +.03%.
* Since late 2006, when the percentage of SPX stocks trading above their 20-day moving averages has been in its weakest quartile, the next five days in SPX have averaged a gain of +.34%. Across all other occasions, the average five-day gain has been +.07%.
One trader sees the market move higher for a few days and puts in an order to buy, fearful of missing a big market move.
One trader sees the market move lower for a few days and enters an order to sell, fearful of missing the overdue crash.
One trader sees the market move lower for a few days, fears a debilitating drawdown, and stops out of a long position.
All three traders lose money over time. Entry and exit execution predicated on fear have negative expected return.
Indeed, the results of acting on fear are so poor that they're promising.
Trading success lies on the other side of fear.
Further Reading: Making Fear Your Friend
.
In yesterday's post, I described a process of reading in parallel: reading many books at a time and gaining insight into a topic by juxtaposing the views of many authors. Parallel thinking is central to pattern recognition: in simultaneously processing multiple events, we are able to discern meaningful patterns connecting those events.
Take a look at Rob Smith from T3 describing his eight screen trading station layout. There are many charts on each screen, grouped by sector, stock type, etc. He then can refresh all the screens at once to view many other stock groups based upon screening criteria. Each stock can be viewed across multiple time frames. As Rob points out, he monitors all of these screens throughout the day to get a sense for when opportunities are "lining up". Then Rob will go "around the horn", looking at every stock in the SPX to detect emerging trends or moves out of the ordinary.
What is noteworthy in the video is that Rob is processing much more information much more rapidly than the average trader. He is reading the market much like I am reading books: finding themes by processing multiple sources in parallel. Instead of examining one stock in detail, consulting myriad indicators and chart perspectives, Rob considers many stocks and finds patterns that cut across them.
If you jump over to SMB, you'll notice that their traders are utilizing tools that filter stocks based on liquidity and volume and then track promising candidates tick by tick to detect unusual volume or order flow patterns. The technology acts as an extension of the traders' parallel processing, reducing an impossibly large array of intraday data across stocks to a manageable universe of "in play" opportunities.
Serial processing is common among investors: digging deeply into particular subject areas to arrive at unique analyses that become trading opportunities. An example would be scouring the wording of Fed statements and speeches of Fed officials to discern shifts in policy. Parallel processing is less about deep analysis and more about rapid synthesis. It is more common among high speed traders: finding patterns in market action that reveal shifts in supply and demand.
Most of us possess thinking styles that are our unique blend of parallel and serial processing. An important source of failure for traders is attempting to adopt trading styles that do not make optimal use of our cognitive strengths. An important source of failure for trading firms is failing to assess cognitive strengths as part of the hiring process. The myth continues that trading success is a function of personality, while evidence strongly suggests that personality can accomplish little in markets if the right brain wiring isn't in place.
Emotions are a problem in trading only insofar as they may nudge us from our cognitive strengths. When trading becomes challenging, higher frequency traders should push themselves to look at more things and feed their pattern recognition; lower frequency investors should push themselves to think more deeply about what they're doing and why. Bad things happen when active daytraders respond to challenge by slowing their thinking and when investors become more speedy.
But of course, we don't hear about any of that from would-be trading mentors and coaches. They tell us to "trade our plan".
Whatever.
Oil was weak most the day on Friday. High yield bonds underperformed stocks and then saw decent selling late in the session, as sell programs took stocks off their highs. That was a piece of pattern recognition from yesterday's trading. When all that began to unfold, my long ES position came off the table. Not all patterns are meaningful, but that was a movie we've seen before and I wasn't in the mood to replay. If you're only looking at the chart of what you're trading, it's tough to see those intermarket patterns in real time. Markets are always talking to each other; it can be very helpful to join their conversation.
Further Reading: Data Rich, Information Poor
.
With today's post, I'll begin a series on best practices in trading. Those will include some of my own, as well as those submitted by generous readers. My hope is that at least several of those best practices can inform your trading processes for 2015.
Above is a live 5 AM snapshot of my home office. There are 16 books on the floor in various phases of being read and 41 books on the window box that have either been read or are on tap for next reading. The books cover three topics: happiness and well-being; the mastery of change; and creativity. These are the themes that are central to the book I'm writing.
When I'm not writing a book, there are fewer books tossed about the office, but there are always a few. What I'm doing is reading in parallel: reading one book and then going to the other books to see what they say about the topic. That is why I read the actual print books rather than the electronic versions: it is easier for me to bookmark the texts and read them side by side if they are right in front of me.
Reading in parallel means that I rarely finish a book from start to finish. I quickly scan the books and find an anchor text: one that seems unusually well researched and well written. The anchor text guides the selection of topics. I read about the topic I find most interesting and relevant in the anchor text and then move to the other books to read whatever they say about the topic. This creates a virtual conversation among the authors, as I view the topic through each of their lenses.
When I stop reading new and interesting material on the topic, I move to the next topic. The reading never is boring for that reason. As soon as I start to lose interest, I take a short break and switch topics, usually returning to the anchor book. The most interesting and relevant ideas that I encounter are bookmarked and written down, often in Evernote.
The inventor Thomas Edison filed over 1000 patents during his career. He held himself to a discipline in which he and his assistants were required to generate one minor invention every ten days and one major invention every six months. By churning out more inventions, he raised the odds of achieving at least a few significant inventions. Similarly, by reading material from a number of books in a dedicated time period each day, we expose ourselves to more ideas--and then have more ideas to draw upon in generating our own.
Having worked this way for years, I've become unusually good at skimming books, identifying their main ideas, and deciding if they are worth reading in detail. The same process applies to research papers or online articles on a particular topic. This efficiency means that you can cover more high quality material than the average person--and that you become better over time at identifying high quality material.
Reading a book is like having an expert visit your home for a conversation. Reading in parallel is like inviting a group of experts to your home and participating in their conversation. The acid test for reading in parallel is whether you come away from the exercise with perspectives that are contained in none of the individual texts. That is when reading becomes a truly creative exercise.
Further Reading: Best Practices During Trading Slumps
.
I generally find that traditional ways of viewing traditional market indicators and charts are not the most informative. Years ago, a developer of trading software lamented in a conversation that he wanted to educate customers in the use of his product, but he found that the vast majority of users never even tried to vary the software's preset levels. Traders wanted answers from the software, not new information that could lead to new questions and answers.
In the spirit of looking at old things in new ways and extracting information that others miss, here are a few variations I've found helpful during 2014:
* Change the Charts - Who says that arraying price on the y-axis and time on the x-axis is the best or most informative way of gleaning information about markets? When we create bars based on volume rather than time and generate indicators from the volume bars, intraday and multi-day changes in volatility are greatly attenuated and patterns become more stable. Market Delta charts include, within the bar, important information about the distribution of volume at the bid vs. offer, revealing short-term shifts in demand and supply. WindoTrader charts display bars within bars so that you can visualize price action across time frames in a single view. Charts from e-Signal display the percentage of stocks trading at new highs vs. new lows for the day session, capturing short-term shifts in breadth.
* Change the Indicators - Tracking net upticks vs. downticks in the market (NYSE TICK) is useful, but my greatest advance in 2014 came from separating upticks (buying pressure) from downticks (selling pressure) and treating those as separate variables, tracking the behavior of separate market participants. (See above). Strong or weak buying can occur within the context of strong or weak selling--it's a difference that makes a difference. We commonly look at market indicators for the stock or index we're trading. StockCharts displays the number of stocks giving buy vs. sell signals for a variety of indicators, turning traditional indicators such as Wilder's Parabolic SAR into sensitive breadth measures. Everyone asks about the trend, but sometimes the world is not linear. StockSpotter has built an impressive track record by basing buy and sell signals on the cycle-based behavior of stocks.
* Change the Interpretation - I've been tracking the number of stocks giving buy and sell signals via Bollinger Bands and found something interesting. The best predictor of market strength in the short run has been the number of sell signals. Since May, when the number of sell signals has been high (top half of distribution), the next five days in SPY have averaged a loss of -.06%. When the number of sell signals has been low, the next five days in SPY have averaged a gain of +.70%. This has led me to identify the absence of weakness--not just the presence of strength--as a predictor of upside momentum. The Pure Volatility measure that I recently shared takes volume out of volatility and displays informative dynamics at market turns. David Aronson has published a worthwhile paper on the purification of the VIX measure. It turns out a number of indicators can be improved through purification: eliminating their overlap with other measures. Aronson and Masters offer a book and software for traders interested in looking at purer versions of market measures.
Show me what a trader looks at during the day and I'll show you how successful he or she is. If we process old information in traditional ways, we're not likely to achieve unique, standout returns. The best traders I know display a passion for understanding markets, not simply trading them.
Further Reading: Turning Innovation Into a Habit
.
Successful traders get more rational when they get more uncomfortable. That feeling of discomfort is not a call to act; it's a call to plan a course of action.
In the past five trading sessions, we've moved from a situation in which fewer than 20% of SPX have been trading above their 20-day moving averages to one in which over 80% have exceeded that benchmark. That is quite a shift in breadth in a short period of time. I found myself feeling uncomfortable with my long position; it seemed as though anything that's moved that far, that fast is due for a pullback.
So I decided to become more rational. I went back to 2006, when I first began collecting breadth data, and looked all occasions in which the above criteria were met in a sub-20 VIX market and what happened in SPX going forward. There was only one problem: it had never occurred over that time span. This was a greater five-day breadth thrust than we had ever seen in a sub-20 VIX market.
I then decided to take a second tack. I looked at five-day breadth thrusts exceeding the level of 50 under sub-20 VIX conditions. That is, the percentage of stocks trading above their 20-day moving averages had to move over 50% in a five day period. Still, I only found 9 non-overlapping occasions. Over the next three trading sessions, 8 occasions were up, 1 down for an average gain of .65%. It's too small a sample to make for a statistically significant analysis, but it certainly did not support the source of my discomfort. It did encourage me to look further into breadth thrusts and the price paths of the market when breadth moves higher, sharply.
My observations? Not all strong markets are "overbought". How we reach strong breadth readings is as important as the absolute level of those readings themselves.
Further Reading: Perspectives on Breadth
.
One of the central themes of my new book is the importance of creativity in generating trading ideas with an edge. What I call Trading Psychology 2.0 emphasizes flexible adaptation to changing markets, not rigid adherence to static trading methods. From this perspective, creativity is the new discipline: poor discipline shows up not only in emotional decision-making, but in consensus thinking.
You know that saying "Garbage In, Garbage Out"? Poor quality inputs will lead to faulty outputs even if you employ the best of programming. In trading we might say "Consensus In, Consensus Out". If you look at the same things as everyone else, you'll pretty much wind up thinking--and trading--like everyone else. That's not a good recipe for superior risk-adjusted returns.
To enhance our creativity, our discipline needs to be an improvement in our information diet. We need to take in fresh information, better information, and information organized in new and useful ways. I've long enjoyed the Finviz website as a source of novel perspective. If you click on the heatmap above, you'll see major ETFs and the relative volume of their trading yesterday. Light blue indicates much above average volume; dark indicates significantly below average volume. At a single glance, we can see where money was flowing. That's not a bad starting point for identifying rotational markets and sector/asset class based market themes.
How have the SPX stocks behaved on recent earnings days? This heatmap gives a useful view, a quick visual take on whether the market is tending to be pleased or disappointed with company performance. That's not a bad starting point for thinking about long/short themes.
Want a visual on the relative performance of various commodities? Or how about a visual on the relative strength of various currencies? Looking across asset classes, you can begin to detect emerging global themes.
But not all creativity comes from visualization. Here is a well curated summary of breaking news and blog posts that can feed the head.
A great goal for 2015's trading is to enrich your capacity for market insight. If you look at what others are not, you begin to ask questions they don't ask. And that can lead to fresh answers.
Further Reading: The Sobering Odds of Daytrading Success
.
One of the most interesting aspects of working as a trading coach is the ability to see, first hand, what contributes to the success of traders. So often the factors that lead to success are not those emphasized in mainstream articles and books. Here are two unappreciated virtues I see among successful portfolio managers and traders:
1) The ability to tolerate uncertainty - Suppose you take any particular configuration of price in a market; say, trading x% above or below a Y period moving average. Then look at what that market does on average over the next Y period. The odds are great that for any value of x and Y, the market's directional tendency will be swamped by the variability of price within that next Y period. What that means is that, on average, the signal to noise ratio for a directional trader is low. Whatever directional tendency is present is generally not statistically significant and not readily tradeable. Given such a situation, the modal opinion of any trader should be "I don't know". Uncertainty is itself a view and, in fact, should be one's base case. When a trader cannot tolerate uncertainty and needs to manufacture conviction, the result inevitably is overtrading the objective opportunity set. It is impossible to properly manage risk if you are intolerant of uncertainty.
2) The productivity of time spent away from trading - I consistently find that successful traders spend more time identifying good trading opportunities than actually putting on and managing trades. Csikszentmihalyi conducted a fascinating study with artists in which they were shown 27 objects and asked to arrange a small group of them into a composition and generate a sketch. They had one hour for the task. The artists fell into two categories. One group quickly identified the objects for the composition and spent the better part of the hour refining their sketches. The second group spent most the hour figuring out what to draw. They selected objects, started sketches, changed the objects, sketched some more, rearranged objects, etc. By the time they found the composition they liked, they spent only a few minutes on the final sketch. The drawings of the second group were rated as significantly more creative by a group of art critics than those of the first group and, after a five year period, the second group demonstrated significantly greater success as artists. The less successful artists spent most their time sketching. The successful artists spent most their time finding compositions worthy of sketching. It's a great analogy for trading.
Good things happen when these two strengths come together. The ability to accept uncertainty frees the mind to maximize time away from trading and creatively generate sound trade ideas. For the successful trader, uncertainty provides the opportunity to get away from screens and look at markets through new lenses. Overtrading exists when the need to trade exceeds the need to understand.
Further Reading: How to Deal With the Uncertainty of Trading
.
* The above chart tracks buying vs. selling programs executing in the stock market every minute of the day. The underlying logic is that I take a basket of stocks and identify when they are upticking and downticking at the same moment. This basket execution is only undertaken by institutional players, so tracking buying vs. selling baskets is a great way to gauge how institutional participants are leaning. As you can see most recently, when we were making lows this past week, buying programs were already exceeding selling ones. The rally since then has seen very strong buying interest from institutions, exceeding that in early October. Note also how at the market highs in late November/early December sell programs began to outnumber buying ones. This is an unusually valuable indicator, and I will be updating periodically.
* Very useful end-of-year perspective from Barry Ritholtz on 10 basic principles for investors.
* Great brain science links from Abnormal Returns, including redefining discipline in our childrearing.
* One of the things I'm looking at is the relationship between message volume on Stock Twits, trading volume on the NYSE, and volatility in stock prices. Here are the recent data on SPY. I would expect superior returns during periods when message volume is highest.
* Always excellent perspective from Howard Marks, this time on the oil drop and failure of imagination among investors.
Have a great start to the week--
Brett
.
One of the hallmarks of trading this year has been the underperformance of small caps relative to large caps. As you can see from the top chart, the Russell 2000 Index (IWM) has pretty well underperformed SPY for most the year. Recently, however, that relationship appears to have turned around. At the recent market lows, we did not see relative lows for IWM to SPY and, indeed, IWM is trading very near its highs for the year. Similarly, microcaps (IWC) are trading at multi-month highs. This is relevant, because it suggests that the recent market strength has been broadening in its breadth, not narrowing like recent rallies.
In the middle chart, you can see that the cumulative NYSE TICK has bounced from recent lows, but remains below its highs for the year. When we take the cumulative TICK for all U.S. stocks, however--which captures the buying and selling of the broadest market--we can see in the bottom chart that that has moved to new highs and never corrected significantly during the recent weakness.
I will be watching breadth measures carefully here. Given the expanding relative strength from the smaller caps, this does not appear to be a weakening market--which suggests that the rally should have legs.
Further Reading: More About the U.S. TICK
.
Two of the questions most important to understanding market behavior are: 1) Who is in the market? and 2) What are they doing? We need the broad participation of buyers and sellers to move markets, and we want to see if there is a skew in the participation of buyers and sellers. So, in a sense, we can characterize any given market as being quiet, average, or busy with respect to volume and selling, neutral, or buying with respect to the relative dominance of buyers vs. sellers.
Above we can see the tracking of buyers vs. sellers over the past several months. The top chart tracks buying pressure and is a measure of total upticking among all NYSE stocks. The zero line means that we have average buying interest; positive values suggest strong buying and negative values indicate weak buying.
The general pattern during market cycles is that we come out of a market low by attracting longer timeframe participants, who respond to the lower prices as value. This creates a surge of buying pressure out of market lows, as we saw early in October and as we have been seeing recently. It is this sharp turn from diminished buying (levels below zero) to strong buying (highly positive values) that tells us that the skew of market participation has shifted.
The bottom chart tracks selling pressure and is a measure of total downticking across all NYSE shares. The zero line represents average selling pressure; positive values represent below average selling and negative values indicate above average selling pressure.
As we move to market lows, selling pressure expands to a crescendo and typically hits its most extreme level shortly before we get a price bottom. When those low prices attract longer timeframe participants, we see selling pressure reduce significantly, as the balance between buyers and sellers quickly inverts.
During the early phase of a market's topping process, we typically see above average buying pressure and below average selling pressure. As the market cycle matures, we characteristically see buying interest wane and actually go below average, while selling pressure also remains low. In the later stages of a market upturn, selling pressure picks up, while buying remains restrained, eventually pulling prices lower.
By tracking buying and selling pressure separately, we can more clearly identify where we're at in an intermediate-term market cycle and gauge the odds of reversals vs. continuation of recent moves. In my next post, I will take a look at how overall levels of market participation vary across phases of intermediate-term cycles.
Further Reading: Who Has the Upper Hand in the Market?
.
Well, here we go again: another V bottom! Stocks rallied sharply yesterday and are up substantially in overnight hours to add to gains. But perhaps V bottoms are only V bottoms if we focus on price. Might there be changes in momentum patterns that precede the price reversal?
Above are a few things I've been focusing upon. The top chart is what I call the momentum curve: it depicts the percentages of stocks in the SPX universe that are above their 3, 5, 10, 20, 50, 100, and 200-day moving averages over the past several days. (Data from the Index Indicators site). What we can see is that the percentage of stocks trading below their shortest moving averages (3 and 5-day) actually bottomed ahead of price. (They actually hit their lows on 12/10). There was no V in short-term momentum.
In the middle chart, we track the number of NYSE stocks closing above their upper Bollinger Bands vs. those closing below their lower bands. (Data from the Stock Charts site). The number of stocks closing below their bands peaked on 12/12 and did not confirm the actual price lows.
In the bottom chart, we track the number of buy vs. sell signals across all NYSE stocks for the Commodity Channel Index (CCI). (Data from the Stock Charts site). It, too, hit its lowest downside point on 12/12, prior to the price lows.
What I'm seeing is that, recently, tops have been distinguished by price divergences; bottoms have been characterized by momentum divergences. It's an observation and hypothesis only at this point, but one that warrants further investigation and testing.
Further Reading: Bollinger Balance
.
Suppose we could ask all participants in the U.S. stock market whether they are bullish, bearish, or neutral on the market's direction and get a fresh reading every minute? That might be useful information, as it would show when bullish or bearish sentiment is turning; when it is becoming extreme; when it is staying bullish or bearish over time, etc.
When market participants pay up to buy a stock by accepting the best offer price ("lifting the offer"), they display urgency getting into their positions. Similarly, when they sell a stock at the best bid price ("hitting the bid"), they show their urgency getting out of positions. If a participant has no particular urgency, they will leave orders in the market to achieve better execution by buying at bid prices and selling at offers.
Urgency reveals sentiment on a moment-to-moment basis.
Above we see a chart for yesterday's price action in SPY (blue line) and a measure of bid/offer sentiment. (Raw data from e-Signal). This measure looks at where each trade in each stock occurs relative to the best bid/best offer at that moment and tells us how many stocks in the NYSE universe are executing at offer prices minus those executing at bids. Savvy readers will recognize that this is similar to the logic behind the Market Delta measure and is similar (but not identical) to the NYSE TICK measure I've covered in the past.
Notice the dramatic shift in sentiment near the day's high price and how later periods of bullish sentiment occurred at successively lower price levels. In short, the bulls were lifting offers, but their sentiment was not able to lift price higher. That's a nice tell for a weak market.
Further Reading: Upticks vs. Downticks for All Stocks Across All Exchanges
.
Central to sound trading is taking trades that offer favorable reward relative to the risk taken. This assumes, however, that we can accurately estimate both risk and reward--and the likelihood of achieving those. That may sound easier than it proves to be in practice.
We know that volatility in the stock market is intimately connected with the volume of shares traded. As the VIX has recently climbed from low double digits to over 20, volume in SPY has moved from less than 100 million shares per day in late November to close to 200 million shares in recent sessions. Average daily true range has gone from about .50% in late November to over 1.5% in recent sessions.
Complicating the picture is that the relationship between volume and volatility itself changes over time. The measure of pure volatility charted above shows the average amount of movement that we get for a given unit of market volume. As markets peak, volume contracts, but a given unit of volume gives us less movement. As markets fall, volume expands, and a given unit of volume gives us increasing volatility.
The bottom line is that markets move much less near market tops and much more near market bottoms than we typically expect. Both volume and the relationship of volume to volatility change frequently, so that traders who anchor expectations to the recent past are going to become poor estimators of movement going forward. That will result in poor placement of stops and targets and poor decisions regarding when moves are likely to reverse vs. extend.
When traders leave too much on the table or overstay their welcome in trades, it's not necessarily emotions and poor discipline doing them in. Rather, they are shooting at targets that are proving to be more fast moving than stationary.
Further Reading: Pure Volatility and Market Efficiency
.
The recent post outlined a way of setting goals for the new year based upon a breakdown of key elements of trading process. Two mistakes that traders can make in such a review are 1) the comfortable inaction of casually reviewing without taking the next steps of setting concrete goals and steps toward reaching those and 2) the tackling of too many goals at one time, diluting efforts to fully work on any of them. My experience is that selecting a very limited set of highest yield goals--no more than three--and working on those intensively produces the best outcomes over time.
So if you are limited to a couple of trading goals for the new year, what might they be? Here are some areas where I find traders need the most work:
* Generating better ideas - Looking at 2014, most traders can find plenty of missed opportunities. Many times the opportunities are missed simply because we were not focusing on the right markets or the right stocks in the right time frames. Improving our data set--looking at more things in different ways--is an important step in feeding our pattern recognition. Reading fresh perspectives from knowledgeable writers and speaking with insightful traders similarly can fuel our creative thinking. One of my goals for 2015? I've chosen the Abnormal Returns site as a source of readings and podcasts and will hold myself to keeping a daily Evernote journal of market-relevant ideas. Indexing those ideas over time should produce a valuable database for future reference.
* Better risk management--and opportunity management - It helps to look at the tails of your P/L distribution. Do fat tails on the left side--outsized losses--hold your overall returns down? That is a challenge for risk management: sizing positions appropriately, utilizing reasonable stops, ensuring that multiple positions are sufficiently uncorrelated, using options rather than cash where prudent, etc. On the other hand, are you missing fat returns on the right side of that P/L distribution? Cutting opportunity short can significantly weigh upon overall returns. Plotting your P/L for each trade and looking at the shape of the distribution will tell you a great deal about your management of risk and opportunity.
* Better entry and exit execution - It doesn't show up in the P/L stats directly, but looking at how your trades performed after you entered and after you exited will give you some idea as to whether your execution is adding value. Too often traders will chase market moves and enter at bad levels and/or puke out of trades on noise and exit prematurely. A review of market paths following recent entries and exits can identify those problems. No one should hold themselves to buying the low tick and selling the high one. Overall, however, you should be aware of the heat you take on trades once you enter and the amount you leave on the table when you exit. My goal for 2015 is to be quicker at entering good ideas with at least a small position. Too often I've become perfectionistic about entry levels, missing good portions of good trades.
Everyone likes to identify the next big trade, the can't fail setup. It's like throwing the long pass for a touchdown. In reality, however, the game is more often won by the unsexy blocking and tackling: gathering information to generate better ideas, managing positions better, and having clear and useful entry and exit criteria. Work on trading process is the best way to achieve better trading outcomes.
Further Reading: What Works in Goal Setting
.
Ah, yes: more wisdom from those purveyors of Despair! A positive attitude may be necessary if we're to learn from experience, but it's not sufficient. Change only happens when we turn observations into goals and goals into corrective actions.
As we get to year's end, I find a look back on the year's trading to be very helpful in identifying goals for the coming year. One way of accomplishing that is to break trading down into component processes and map out what you've done well in each area and what you need to improve. Goals can be all about extending strengths and becoming more consistent with what you do well as well as shoring up weaknesses and correcting mistakes.
So here's a starting point for a report card for your year's trading. Give yourself an A, B, C, D, or F grade in each category, followed by a strength or weakness-related goal for each:
- INFORMATION COLLECTION - Consistently gathering useful information that is relevant to your trading
- IDEA GENERATION - Engaging in creative thought to turn information into unique and promising ideas
- TRADE STRUCTURING - Expressing ideas as trades that possess promising risk/reward
- EXECUTION - Entering trades at levels that provide promising risk/reward; exiting trades at planned targets
- POSITION/RISK MANAGEMENT - Sizing positions appropriately for risk control and targeted reward; using hedging and scaling in and out of positions to dynamically manage risk/reward
- PORTFOLIO MANAGEMENT - Assembling ideas and trades into a coherent whole where each trade provides potential unique returns; monitoring correlations and managing risk and reward effectively across the portfolio
- SELF-MANAGEMENT - Keeping yourself in optimal mental, physical, emotional, and spiritual condition to make sound decisions and sustain a high energy level
Your own trading may include fewer or more categories; these are ones I find particularly relevant across traders. The idea is to approach your trading the way a physician approaches diagnosis: assessing the health of every facet of your functioning. By turning your performance review into a process review, you are more likely to pinpoint areas of work that can make a meaningful difference to the bottom line in 2015.
Further Reading: Goal-Setting and Performance
.
I propose that there are two primary ways in which traders engage markets: via the intellectual functions of the brain and via the social functions of the brain. This distinction underlies the differences we see between traders who are primarily quantitative and systematic versus those who are more qualitative and discretionary.
When a trader engages markets intellectually, decisions about buying and selling are made empirically based upon observed relationships. Growing revenues and promising new product development at a company may lead to higher expectations for earnings and a higher price multiple, leading an equity manager to place the company on the buy list. The decision is governed by a model that links inputs (revenues, profit margins, expenses, contributions of new product areas) to outputs (price-earnings multiples, target prices). When operating in the intellectual mode, the trader is looking at current pricing relative to historical norms, finding a discrepancy, and placing trades that exploit this discrepancy (mispricing). The intellectual mode thus involves considerable analysis and research.
When a trader engages markets socially, decisions about buying and selling are made qualitatively, based upon the perceived intentions and anticipated behaviors of other market participants. For example, if I see--going into year end--that positioning is stretched in a number of markets and I know that traders will be reluctant to lose too much money in December because of year-end bonus conventions, I might anticipate greater than normal volatility in the stretched markets. That could lead to a profitable options trade. The trade is predicated on a situational theory of the behavior of market participants, not a historically generalizable theory about market volatility. The social mode thus involves considerable synthesis of information about markets and market participants.
The social brain hypothesis suggests that the brain has evolved in size and function as our social networks have expanded. From this perspective, the brain is as much a social organ as an intellectual one, with distinct brain centers coordinating knowledge of our own minds and knowledge of those of others. In his excellent book A User's Guide to the Brain, John Ratey explains, "...traditional psychologists and neurologists have been slow to acknowledge that social behavior is, at least in part, a brain function just like memory or language...Neurologists and neuroscientists have shown that damage to the cortex can affect one's ability to be empathetic, that problems in the cerebellum can cause autism and its social ineptness, and that deficits in the right hemisphere can make it difficult to understand life's overall picture. Together, these parts and others make up the social brain" (p. 296).
Having worked with many traders and portfolio managers, my observation is that the very skilled ones have either: a) very developed intellectual capacities; b) very developed social capacities; or c) a very developed integration of the two. The first we see among world-class systems traders and those with keen analytical frameworks; the second we see among short-term traders who can read order flow and sentiment and anticipate the behavior of "the herd"; and the third we see among skilled portfolio managers who factor logical and psychological factors into their idea generation.
A great example of the latter recently showed up in a meeting I had with a manager who explained the anticipated action of the Fed in coming months based upon an analysis of incoming data. He then referenced the internal dynamics of the Fed and the relationships among the members and explained how the group was likely to process the incoming data. It was apparent that he displayed a level of expertise regarding the central bank in terms of the logical and psychological factors at work in its decisions.
This perspective suggests that brain function--and cognitive strengths--may be more important than personality in determining trading success. It also suggests that understanding and playing to our cognitive strengths may be particularly important in guiding our own trading success. I suspect many traders fail at the kind of trading they're doing, not because they lack emotional control or discipline, but because they are not wired for the cognitive demands of that particular approach to markets.
Further Reading: Inside the Trader's Brain
.
If we look at the same things in the same way, the odds are good that we'll keep doing the same things. That's great if we have a formula for success; not so good if we're repeating mistakes. Different perspectives can bring fresh perception, and that can spark insights and new action patterns.
One way I've found useful to gain flexibility of viewpoint is to track measures across different time frames. Above is a chart of my intermediate-term market strength measure, which is a moving average of the number of stocks in the SPX universe making fresh 5, 20, and 100-day highs vs. lows. It is much less noisy than shorter-term measures and has done a good job of cresting ahead of price during market cycles. It is also helpful to see where we stand on the intermediate-term measure when we're short-term oversold. As you can see, we're not yet at levels that have corresponded to recent market lows.
Still another aid to flexibility of perception is to look, not only at the stock or index you're trading, but an array of related shares and sectors. It is not unusual to find weakness or strength seeping into leading stocks or sectors that can serve as heads up for more general weakness or strength. The expansion of stocks making new short-term lows--even when SPX was trading at or near its recent highs--was a great tell for weakness that spread to the general market.
A third way to gain flexibility in perception is to examine markets across asset classes, not just within the asset class you're trading. A key to understanding recent market weakness has been seeing the rising correlations among a number of macro assets, including oil, high yield bonds, currencies, and stocks. Those macro correlations are an excellent indication that the drivers of market prices are becoming larger than the dynamics within your particular stock or index. Earnings for a company may look good, for example, but if global deflationary fears are driving stocks lower, it could be a big mistake to assume that nice earnings will translate into strong upward price performance.
In general, we can generate new views by either looking deeper into what we're trading or by looking broader. By switching our levels of breadth and depth, we can develop a more complete view of the big picture and spark those "aha!" experiences that lead to great trade ideas.
Further Reading: Perception and Motivation
.
The weakness that has been showing up in stocks picked up yesterday, with SPY (top chart) breaking to multi-day lows. The middle chart shows breadth specific to stocks in the SPX universe: it is a composite of the percentages of stocks trading above their 3, 5, 10, and 20-day moving averages (data via Index Indicators). Note how it tends to top ahead of price and often troughs ahead of market bottoms as well. For the first time in a while, we've hit an oversold level similar to levels that preceded market lows in early August and mid-October.
Once we expand our look beyond the SPX universe, the picture becomes interesting. My data show 891 stocks across all exchanges posting fresh monthly lows yesterday. That compares with 1180 lows the day before and 1007 lows the day before that. As the bottom chart (IWM) shows, smaller cap shares have not posted multiday lows in the same way that the large caps have. That is noteworthy, because the smaller caps have been performance laggards since early in the year.
A nice intraday tell for yesterday's weakness was the high correlation across multiple asset classes. Stocks, the U.S. dollar, oil, and high yield bonds all moved lower in relative concert. I will be watching closely to see whether those rising macro correlations swamp the divergences that are showing up among stock indexes. Good trading means sustaining flexibility when evidence is mixed and conviction when evidence lines up.
Further Reading: Keeping an Open Mind in Roiling Markets
.
Many observers of markets note the tendency toward "group think": good ideas (and some not so good ones) catch on, eventually become consensus, and then become oversubscribed. Here's an illuminating exercise regarding stock market sentiment:
I went back to 2006 and looked at the daily equity put/call ratio: the ratio of puts to calls traded for every stock with listed options. (Index options were excluded). I then divided the observation into halves, based on high vs. low put/call readings. When the ratio was in the upper half (more puts traded relative to calls), the next 10 days in SPY averaged a gain of +.50%. When the ratio was in the lower half (more calls traded relative to puts), the next 10 days in SPY averaged a gain of only +.03%. It's been when traders and investors have been relatively bearish that we've seen the lion's share of broad market gains.
But suppose we look at how sentiment is related to recent, past price action. When the put/call ratio has been in its highest quartile (most bearish), only 45% of stocks have traded above their five-day moving averages. When the put/call ratio has been in its lowest quartile (most bullish), a little over 59% of stocks have traded above their most recent five-day moving averages.
In other words, sentiment is sensitive to recent price action. Traders and investors are susceptible to recency biases: how markets have behaved over the last few days has impacted how bullish or bearish they are going forward. (BTW, the correlation between equity put/call ratio and the proportion of stocks above their five-day moving averages is a statistically significant -.38). The human tendency is to project the recent past into the immediate future--and that leads to substantially poorer near term returns.
How can we extract ourselves from short-term information processing biases? One way is to make sure our thought processes are operating at a time frame greater than the one we are observing on screens. Yesterday was a classic example for short-term traders: we started the day with significant weakness, but small cap stocks notably could not trade to fresh multiday lows. Indeed, my measure of monthly new lows showed that we had fewer new lows yesterday than during the prior decline early in the month. As yesterday's post noted, when we see large groups of shares not participate in a market move, we have to question whether the move truly represents a sustainable trend. It often reflects rotation within a range market.
But we can't know that if we can't stand back from the time frame we're trading and see the larger picture.
Feeding the brain with big picture thinking is a great way of freeing ourselves from becoming slaves to the short term. This is why I like reading well-assembled collections of links from astute market observers:
* Charles Kirk posts "quotes for the day" in his service that are uniquely insightful. I don't agree with all the perspectives offered, but almost all of those views are plausible and well reasoned--which helps me question my own thinking and not become locked in a single mindset.
* Every day, Abnormal Returns is curating best content from the financial web. A good example are his links from yesterday: several reads ended up providing me with fresh perspectives.
* Barry Ritholtz shares his daily reads, with a useful slant toward economics and markets. Great to get inside the head of an experienced market observer.
* Reformed Broker Josh Brown shares what he's reading in the morning as his "hot links" of the day. He finds great articles and research pieces as well, such as this one regarding income inequality during economic recovery periods.
If we're not operating at least one time frame above the one we're observing, our trading is likely to be more reactive than proactive. Feeding the brain is a great way to avoid starving our trading accounts.
Further Reading: Trading and Cognitive Bias
.
