Saturday, September 05, 2015

The Single Most Important Trait of Successful Traders

Great to see that the new book will be coming out on the 28th of this month.  I titled it Trading Psychology 2.0, because I wanted to update the standard version of trading psychology, which I find increasingly limited.

Traditional trading psychology has begun with an important set of premises:  Human beings process information emotionally and often non-rationally in the face of risk, reward, and uncertainty.  These information processing biases lead to poor trading decisions.  The natural conclusion that follows from these assumptions is that successful trading requires emotional control, self-discipline, and adherence to a grounded process.

I don't dispute the above at all.  My problem is that, over the years, I have met with a number of very emotionally controlled, disciplined, and process-focused traders who have not been able to make money.  Mastering cognitive biases is necessary for success in markets, but I found it's not sufficient.

What I'm calling the 2.0 version of trading psychology begins with a different set of premises:  markets are ever-changing, such that patterns and relationships that yield profits in one time period (regime) may be spectacularly unsuccessful in another.  A good example from recent financial history has been the impact of quantitative easing on the trading of stocks.  QE resulted in a crushing of volatility in stocks and a transfer of flows from lower-yielding bonds to stocks that possess both yield and the prospect of higher returns.  When the end of QE and possibility of interest rate normalization comes to the fore (think taper tantrum and the recent prospect of a Fed hike), stocks have traded with far greater volatility and risk-off bias.

What has made recent trading challenging is that the stock market is not behaving in anything like the way it behaved for much of the past two years.  We see higher volatility and strong selling flows.  For all intents and purposes, the trader who trades stocks now and in the first half of 2015 might as well be trading different asset classes.  

As long-time readers are aware, I build non-linear regression models of short-term returns in SPX.  Typically these models predict returns over a 3-5 day horizon.  The recent model I built covers market periods displaying a medium level of volatility; the prior model covered market periods with low volatility.  The variables in the models are entirely different, and they have different predictive power.  One important difference is that short-term strength and weakness is more likely to reverse in the higher vol regime; more likely to show near-term continuation in the low vol, QE period.

Now if a trader starts with the traditional set of assumptions and strictly adheres to a particular process, that trader will get torched when markets change from choppy, low volatility range movement to high volatility decline.  If discipline is defined as sticking to a particular set of rules and practices, then discipline eventually sows the seeds for a failure of adaptation.  The trader who used to make consistent money and now cannot succeed has not suddenly morphed into an emotional basket case or a massively biased thinker.  Rather, that trader has failed to adapt to a changing set of market conditions.  It is often a trader's virtues--consistency and discipline--and not vices that create losses during periods of market flux.

This is why the single most important trait of traders who achieve career success is adaptability.  Adaptability does require discipline and self-control, but importantly it also requires self-awareness, market awareness, creativity, and flexibility.  Companies continued to churn out personal computers when laptops gained traction.  Companies continued to emphasize laptops when tablets became popular.  There will be companies pushing tablets when wearable computing devices become the rage.  All of those companies had fine processes and disciplined execution.  They simply failed to adapt to changing markets.

Do stocks trade with higher or lower correlation to one another?  Is that correlation waxing or waning?  Are we trading with higher or lower volume and volatility?  Is volume and volatility waxing or waning?  Do we show evidence of trending/momentum or reversal on short time frames?  Longer time frames?  Do we see signs of weakening breadth or strengthening breadth as we make successive price highs or lows?  Which sectors of the market are leading performance?  Lagging?  Is leadership stable or changing?  How are stocks correlated with other asset classes?  Is that correlation changing recently?  What do those cross-asset correlations and patterns of leadership tell us about the U.S. economy?  The global economy?  How are we responding to economic data releases and market movements overseas?  Is that pattern of response changing?  What are those patterns of response telling us?

When you ask those questions, you take the first step toward developing meta-processes:  processes for adapting your best practices to changing market conditions.  Trading is *not* like poker, chess, or athletics: the rules in typical games of skill do not change from one competition to another.  Trading is like business.  The business marketplace never stays still.  Success is not about finding a magic formula and slavishly adhering to it.  It's about staying flexible and finding new formulas under evolving conditions.  The faster the pace of change, the more creativity becomes the essence of discipline.

Further Reading:  Why You Should Keep A Journal