Friday, September 09, 2016

How Fear Keeps Us From Trading Success

Two versions of fear impair traders:  the fear of losing money and the fear of missing opportunity.

Out of fear of losing money, traders will avoid buying weak markets or selling strong ones; they will stop out of long trades on weakness and exit short trades on strength.

Out of fear of missing opportunity, traders will buy markets when they're up and sell them when they're down.

Both forms of fear have negative expected return, particularly in low volatility market conditions, when moves are least likely to extend.  Of course, it's these same low volatility conditions that lead traders to lament that there are no market moves and no way to make money.

Maybe, however, low volatility conditions lead traders to want to catch breakouts and thus act on fear.  When we make new highs or lows, they're afraid of missing the (finally!!) big move.  It's the same fear of a big move that leads those traders to exit long positions on weakness and short positions on strength.

With one trader I coached a while back, we took at look at what his P/L would have looked like had he added a unit of risk every time he stopped out of a trade.  Sure enough, he would have been very profitable.  His ideas were fine.  But he managed his positions on fear, not opportunity.

As a little demonstration, I went back to the start of 2015 and constructed a measure of relative breadth.  I created an index of the percentage of SPX shares trading above their three and five-day moving averages (raw data from the excellent Index Indicators site).  I compared the index value to its average value over a lookback period and expressed the result in standard deviation units.  Thus, I could see when short-term breadth was significantly strong or weak in relative terms.  

Simply dividing the data in half based on a median split, we find that when relative breadth is strong, the next five days in SPX have averaged a loss of -.13%.  When relative breadth has been weak, the next five days in SPX have averaged a gain of +.33%.  Two people could have the same exact idea; how they execute their entries--on fear or not--makes the difference between loss and profitability.

Even under high VIX conditions for the sample, five-day returns are much better following periods of breadth weakness (+.80%) than breadth strength (+.25%).  Interestingly, high volatility and high breadth weakness represents the kind of market most people are fearful to buy.  When we've had low volatility and strong breadth, the next five days in SPX have averaged a loss of -.40%.

It's a nice illustration of how success lies at the intersection of trading psychology and market understanding.

Further Reading:  How Success Can Be Found on the Other Side of Fear