Sunday, January 18, 2015

Best Practices in Trading: Training Yourself in Pattern Recognition

One of the themes of my upcoming book, Trading Psychology 2.0, is that creativity is the new trading discipline.  Success in markets is not so much a function as rigidly adhering to a single, unchanging edge as continually finding fresh sources of edge in ever-changing markets.  But how do you come up with fresh trading ideas and sources of edge?

Reader, author, and blogger Ivaylo Ivanov (@ivanhoff) offers a best practice that can feed our creativity.  Here's what he suggests:

Studying your own past trades is a must, but it provides a limited perspective of opportunity cost--it only helps to analyze the trades you took; it tells you nothing about the trades you did not take.  One of the most practical habits that has helped me as a trader is going through the daily charts of the best performing stocks on a daily, monthly, quarterly, and 6-month time frame.

Here are some of the benefits of this daily exercise:

*  It has substantially improved my setup recognition skills;

*  It has given me ideas for new ways to approach the market;

*  It provides an unbiased view of what is currently working in the market; which industries are under accumulation.  Recognizing industry momentum is of utmost importance for swing traders as it helps to focus on setups that don't only have higher probability to break out or break down, but are also likely to deliver bigger gains;

*  The mere going through the screens provides me with a constant flow of great anticipation swing setups--stocks that are setting up for a potential breakout.

Readers will recognize this as a structured exercise in pattern recognition.  In his book, Ivaylo outlines his "perfect setup" for swing trades.  His best practice above, additionally enables him to learn new setups.  It also allows him to identify sectors that are most likely to yield good setup candidates.  Indeed, the patterns that emerge from such review could lend themselves to backtesting and possible systematic inputs into discretionary trading.

I also suspect that Ivaylo's best practice helps him identify market themes early--for instance, the breakdown in energy stocks in the wake of oil weakness or the rise in utility shares resulting from declining global rates.  It's not such a leap to go from his exercise to a review of patterns across global markets to identify the macro themes that might be attracting the interest of institutional investors.

Interested readers can check out Ivaylo's website, as well as his book and Twitter feed linked above.  He's a great example of savvy traders sharing worthwhile ideas via StockTwits.

Further Reading:  Parallel Processing and Pattern Recognition