Here's an update of the multivariate trading model I keep for SPY. A number of variables go into the ensemble model, including buying pressure, selling pressure, breadth, sentiment, and volatility. Readings of +3 or greater and -3 or less have had particularly good track records in and out of sample, anticipating price change 5-10 days out. Note that we hit a -3 reading on Friday; prior to that we saw +3 readings shortly before and after the election.
Thus far, we are not seeing significant breadth deterioration in stocks. For ten consecutive sessions, we have had fewer than 200 stocks across all exchanges register fresh monthly low prices. This breadth strength generally occurs in momentum markets; weakening of breadth--particularly an expansion in the number of issues making fresh lows--tends to precede market corrections. It is not at all unusual for momentum markets to correct more in time than price. We've seen selling pressure the past two sessions, but not significant price deterioration. This dynamic allows momentum markets to stay "overbought" for a prolonged period as price consolidates and often grinds higher.
Further Reading: Previous Model Update
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The recent post emphasized pattern recognition as a core trading skill. That same skill is key to trading psychology.
One of Freud's central insights was that of the "repetition compulsion": the idea that we unconsciously repeat patterns in our lives, often with negative consequences. Change in therapy occurs when we become aware of our patterns and are able to interrupt and change those. The different approaches to helping--psychoanalytic, behavioral, cognitive, family systems, solution-focused--are simply different ways of understanding and changing the patterns we unwittingly relive.
One trader I worked with never felt fully accepted and valued by his parents. He was compared with his brothers and often found wanting. He latched onto trading as a way of making a name for himself and becoming wealthy and successful. Each time he lost money in the market, he experienced the loss as something more than the dollars and cents. The losses felt like confirmation that he really was inadequate. With his self-esteem riding on each trade, he found it difficult to make sound decisions. He took profits quickly to regain the feeling of winning and took losses very reluctantly, unwittingly repeating those mistakes.
When we track our trading mistakes--and our trading psychology--in journals, we can often detect patterns that sabotage our profitability. This is particularly the case when the same emotions crop up in trading situations, such as frustration, depression, or overconfidence. Once we become aware of those patterns, we can begin to identify triggers that set us off. That enables us to anticipate the patterns and rechannel our emotions and actions. The trader I worked with learned to take breaks after losses and process his self-talk at those times. Gradually he learned to separate his self-worth talk from his trading talk, allowing him to accept losses without experiencing himself as a loser.
It all starts with self-awareness. We can't change a pattern if we're not aware of it. When we become observers to our patterns, we are no longer immersed in those patterns. As observers we can control those patterns and ensure they don't control us. If you're experiencing repeated emotions and self-talk during your trading, the chances are great that there's a life pattern controlling you. Market mastery and self mastery go hand in hand; working on ourselves can be the best way of working on our trading.
Further Reading: How to Break Negative Trading Patterns
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A concept central to trading is that of pattern and pattern recognition. Different approaches to trading frame patterns differently, but all focus upon relationships that are deemed to be meaningful. After all, any particular configuration among market elements can occur and reoccur through random happenstance. It is when patterns happen for understandable reasons that we find them meaningful. We may or may not be able to predict when that pattern will occur next, but that is not necessary for successful trading. If we become very sensitive to meaningful patterns and their myriad expressions, we can identify their occurrence as they unfold. A psychologist, for instance, might not be able to predict when a patient will next experience a depressive episode, but can become highly attuned to occasions in which depression is starting to set in. Similarly, when couples make progress in their counseling, they can recognize patterns to their arguments and circumvent those by doing something more constructive.
Many active traders look at a very limited number of markets--often, only those that they are trading or thinking of trading--and so they miss important patterns that occur *among* markets. These intermarket relationships often reflect macroeconomic factors that are driving the participation of large market players. Recognizing when those relationships are waxing and waning can provide important clues as to whether particular market moves are likely to continue.
I've been reading a large--and excellent--book from John Netto called The Global Macro Edge. It touches upon a number of worthwhile ideas, including the importance of viewing performance (one's own and those of markets) in risk-adjusted terms. One idea I particularly liked was the ongoing tracking of correlations in the price movements among markets as a way of identifying market regimes and shifts in those regimes. The same concept is valuable in tracking correlations of moves among equity sectors. When we see dramatic changes in correlations, those patterns can alert us to the emergence of important themes that are driving market action. For example, after the recent election, we saw dramatic co-movement among equity sectors (industrials and financials versus higher yielding sectors) and markets (US dollar, rates, developed markets versus emerging ones). New flows were coming into markets, and the patterns of correlations alerted us to the drivers of those flows.
Let's combine two of Netto's ideas and imagine a situation in which your dashboard is tracking the risk-adjusted returns of different markets (a way of tracking quality of trend behavior) *and* the correlations among markets. The combination would tell you when shifting correlations are manifesting themselves as growing trends. That would be sweet for trend-following macro traders. It would also provide useful alerts as to when markets are becoming choppy and less patterned. After all, it's the pattern of patterns that ultimately defines the opportunity set for traders.
Further Reading: The Greatest Mistake Losing Traders Make
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Imagine a child diagnosed with attention deficit disorder (ADD). Unable to sustain concentration, ADD impairs school performance, but also interferes with social life. Lowered attention often brings diminished impulse control and unwanted consequences in relationships. Our child, depicted above, is connected to a biofeedback unit that measures small changes in forehead skin temperature that reflect activation of the brain's executive center, our prefrontal cortex. This hemoencephalography feedback controls a movie watched on the computer screen. When the child's emotions are engaged by the movie and the forehead temperature drops as a result, the movie stops. To continue playing the movie, the child must sustain a neutral, quiet focus. Over time, the child learns to keep the movie going, building the capacity to flexibly shift between emotional, limbic processing and frontal, executive processing.
Why is this important? As Kotler notes, heightened concentration and absorption in activity is a gateway to the flow state, the state we know as being "in the zone". He observes an interesting relationship between flow state and creativity: in flow, we have heightened focus, but diminished self-focus. In other words, we turn off our self-critical, self-conscious activities and instead lose ourselves in what we are doing. If our child became frustrated with the movie turning off, for example, and criticized himself for not being able to keep it going, the movie would remain paused. Only an absorbed, calm, neutral focus on the movie can make the movie move.
I first encountered hemoencephalography (HEG) feedback when I heard of Dr. Jeffrey Carmen's work with migraine patients. Interestingly, shifting blood flow patterns is significantly helpful in controlling migraines. That same technology was helping children with ADD and, I later learned, was helpful in helping autistic children with their executive functioning. As I wrote on this blog, this raised the possibility that HEG feedback could similarly train traders for enhanced attention and self-control, minimizing distractions and impulsive overtrading.
Kotler's observations go one step further. The zone not only brings greater self-control, but also higher levels of creativity. When we are in a state of enhanced awareness of our world, we perceive the world in new ways. Patterns and relationships in markets that we would miss when we are self-focused and frustrated with P/L jump out at us when we've quieted the self-critic and redoubled our market focus. I recently wrote on the topic of creativity as a form of play. When we witness children hard at play, we see them immersed--operating in a zone. To play deeply, we both focus and relax. It is this calm focus that appears to lie at the heart of creative synthesis.
If we can enhance the cognitive functioning of children with ADD and autism, can we take the normal cognitive functioning of professionals and turn it into an enhanced capacity to operate within the zone? Can we become more flexible in our emotional and cognitive processing, thereby performing with greater self-control and creativity? This remains truly frontier territory for trading psychology.
Further Reading: How to Cultivate Our Creativity
Note: Thanks to Dr. Jeffrey Carmen for pointing out errors in the original version of this post, which I have endeavored to correct.
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The flow state is one in which we become highly absorbed in our activities, losing a sense of time and experiencing deep pleasure. A great example of flow comes from the drumming movie mentioned in the previous post. The drumming greats are not explicitly thinking about what they are doing, what they should do, or what they should have done. The skill is flowing through them, and they are performing in a profoundly fulfilling zone.
The capacity for operating within a flow state is one that can be developed. Indeed, we can look at deliberate practice as a training ground for flow. As we tackle one challenge after another, we also extend our capacity to sustain the flow state. Flow requires an ability to operate outside our comfort zones, but our limits of willpower make it difficult to stay outside our sphere of comfort. A fascinating study by Judith Lefevre found that people experience flow more often in work than in leisure, and yet they are more motivated to seek leisure than work. She notes:
"It is possible that the higher levels of concentration and activation in flow cannot be tolerated by most people for extended periods of time. In making the choice to spend their leisure time in the low challenge, low-skill context rather than flow, the workers may be indicating their preference to rest from the demands of work, even at the cost of an overall reduction in the quality of experience." p. 317
If the research on flow is correct, then much of traditional trading psychology is wrong. The elite athlete, drummer, or chess player does not achieve flow by controlling emotions, imposing discipline, or basking in awareness of their feelings. Rather, flow is achieved by shifting to an entirely different state of consciousness, not by rearranging the components of normal consciousness. That different state requires sustained, relaxed focus and immersion in experience. That shift of state is one in which we experience ourselves and the world differently. It's also one in which we become sensitive to patterns in the world around us. A wonderful portion of the drumming movie pans to the lake surrounding the camp and the sounds of the insects and lapping water. It is impossible to not hear a poly-rhythmic drumming in the sounds of nature--something we would have never apprehended prior to watching the film.
It is in this context that Campbell's observation is profound: when we follow the bliss of operating within the zone, doors open to seeing the world in new ways. Patterns that are hidden to us in normal, distracted consciousness pop out when we in a flow state. In our normal state, we try to perform well; in the zone, performance flows through us.
Are you trying to correct your mistakes while you're trading? Are you trying to avoid poor trading practices? If so, you're trading in a flaw state, not a flow state. Flow requires a loss of self-awareness; not thinking positively or negatively about ourselves, our P/L, or our performance.
One of the greatest dilemmas we face as traders is that we benefit from following our bliss, but we are limited in our capacity to sustain bliss. It may well be the case that the greatest value of preparation for trading and review of trading is the exercise of the capacity for relaxed concentration. In building our capacity for flow, we cultivate the state of consciousness in which we're most sensitive to the flows of markets.
Further Reading:: Why It's Important to Go With the Flow State
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Thanks to an unusually creative and savvy trader for recommending the movie "A Drummer's Dream". The movie, available via Netflix, takes place at a camp for young drummers in Canada. The instructors at the camp are some of the world's most talented drummers. The movie interviews the drummers and shows them in action, both as performers and teachers.
A few fascinating takeaways from the movie:
* Many of the drumming greats started at an early age and practiced intensively, reaching a high level of talent early in life. Watching someone like Mike Mangini, it's clear, per the Seykota quote in Market Wizards, he doesn't have talent; the talent has him.
* Several of the drummers talk about being in a zone when they are performing at their best. They also talk about drumming as fun. There is an exuberance to their performance that suggests that immersing oneself in the fun of exercising a talent is essential to reaching and staying in that zone.
* The learning process for the young drummers was one of observing the greats in action, having the great drummers explain and model techniques, copying those techniques under the watchful eye of the instructors, and repeating skills until they are familiar.
* There is an unusual bond among the drumming legends based upon respect for one another and a sharing of a common passion. Many of the legends have performed with one another and value that collaboration.
Now think about the learning process for most traders:
* Do most traders begin early in life and engage in intensive deliberate practice before actually performing in real life settings?
* Do most traders find a zone of performance based upon love of what they do or does P/L emphasis and pressure make that zone difficult to find?
* Do most traders truly learn by observing and copying masters and intensively repeating techniques and skills?
* Do most traders find a collaborative bond with peers and mentors that sustains their passion and learning?
It is not surprising that there is a very high failure rate among new traders. What other field features people trying to make a living from performance before they've truly learned how to perform? How many traders, per Lionel Hampton, experience their work as a path to the divine?
Further Reading: What It Takes to Trade in the Zone
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Too often, traders take in one piece of information after another, reading emails, scanning charts, reviewing research pieces, tracking news, and talking with other traders, and never get to the point where the information is transformed into knowledge. Someone trading the stock of a company may compile all sorts of statistics and news items about that company, but those in themselves don't ensure a knowledge of the company's competitive advantages and disadvantages or its growth potential. If someone gathered pieces of information about our lives, would they truly understand us?
We often hear that the heart of trading psychology is discipline and the control of emotions. Other times, we hear that openness to and awareness of our emotions is crucial to enlightened decision making. Both perspectives have merit, yet both make the mistake of assuming that trading psychology is basically about what and how we feel.
Not so.
Every bit as important to our trading as our emotional psychology is our cognitive psychology: how we process information and turn it into knowledge. Indeed, I would argue that, as we move from beginning traders to experienced ones, emotion becomes less of a central focus for trading and information processing becomes more critical. Lo and Repin, for example, found that traders responded to heightened market volatility with emotion, with inexperienced traders far more reactive than experienced ones. Experienced, successful traders may or may not wrestle with emotional responses to a market scenario, but they will always be actively involved in processing that scenario and searching for opportunity.
Two cognitive psychology mistakes are common among traders:
1) Not making the time to assemble information into knowledge - Key to knowledge is finding meaningful patterns in data and placing those patterns into a framework for understanding. In my trading, I track statistics ranging from volume, breadth, sentiment, and buying/selling pressure, but it's the integration of the data that contributes to understanding. One form of integration is in the form of a mathematical model. Another form is a conceptual framework that is grounded in the concept of market cycles. If I get so caught up following the data that I don't engage in integration, I will fail to perceive valid trading opportunity. Equally problematic, I will tend to act on individual pieces of information that grab my attention without placing that information into proper context.
2) Not playing to our information processing strengths when we generate trading ideas - Each of us is quite different in how we make sense of the world. Some of us are quite mathematical and analytical, assembling views from the ground up. Others are conceptual and qualitative, looking for broad patterns to derive a top-down view of the world. My most native form of information processing is writing. Quite literally, writing is my way of thinking aloud and generating an internal dialogue that places information into perspective. Other traders accomplish the same thing by reading and taking notes; still others by engaging in multiple conversations. Far too often, traders fail to reach their potential because they're not accessing their cognitive potentials. They are making sense of markets in someone else's style, not their own.
I've recently begun an experiment in which I engage in very extended journaling, writing out my assessment of the most recent day's market and where it fits into the broader picture of market cycles, but also writing out every single trade that I place, why I placed it, what worked and didn't work, and what I have done well or could have done differently. The depth of the journaling is far different from the typical end of day notes on trading and markets. In practice, I keep writing and writing until I get to the point where knowledge results from the information.
It's early days, but the method so far has been helpful. One unintended consequence: I find myself feeling more confidence in trades when I've processed the opportunity in greater depth, in ways that are most productive for my sense-making.
Further Reading: The Two Brains of Trading
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We often think of a strong market as one in which many stocks are making new highs. Interestingly, a better indication of market strength has been the absence of weakness: few stocks making new lows.
One way I track this is the daily number of listed stocks making fresh one-month new highs and lows. (Data from the Barchart site). When the number of shares making monthly lows is in its lowest quartile since 2012, the next five days in SPY have averaged a gain of +.32%. When the number of shares making monthly lows has been in its highest quartile, the next five days in SPY have averaged a gain of +.53%. All other occasions have averaged a gain of only +.02%.
The absence of new lows occurs when we've had a momentum rise that has lifted the great majority of stocks. That has been the case recently. That momentum tends to continue over the near term. Conversely, when we make an important low, we see an expansion of fresh lows. That tends to bring in value participants and strength over the near term. Much of market strength can be traced to such momentum and value effects.
It's but another example of how looking at different data in a different way can yield helpful trading insights. Markets are ready to turn around when one or more sectors show weakness and we start to see an expansion of new lows, even as the index might be hovering near highs. When there is very little weakness, we have an important clue as to strength.
Further Reading: Strength and Weakness as Separate Market Dimensions
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Who is in control of the day session for stocks: buyers or sellers? A straightforward way to assess this is to track the NYSE TICK ($TICK), which continually updates the number of stocks trading on upticks versus downticks. If we see broad buying, we'll see very high (+800 or greater) TICK numbers. Broad selling gives us readings of -800 or lower.
Above we can see the five minute TICK readings for yesterday's trading session. Note that we opened with significant buying interest and stayed above the neutral zero (yellow) line for most of the trading session. Most important, we never saw selling readings of -800 or less. Quite simply, many more stocks traded on upticks than downticks over time, not so much because upticks were extremely high as because we had a relative absence of selling pressure. That absence of sellers was a great tell that prices would remain firm through the session.
By watching the distribution of TICK readings--and shifts in that distribution--through the trading day, we can become sensitive to demand/supply changes that typically occur at market turns. When the distribution is one-sided, recognition of that fact can keep us out of bad trades.
Further Reading: Tracking the Stock Market With a Broad TICK Measure
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* Every serious trader is a leader, running a trading business. Would you want to work for the business you're creating? Would you follow yourself as a leader? Would you allocate your hard-earned money to someone who manages their trading the way you do? Inspiration follows from aspiration: We are most energized when we live up to our highest ideals.
* Great weekly perspective from Jeff Miller; excellent focus on what's really important for markets. A useful way to read Jeff is to make it a point to visit the sites he links to in his posts. Enhancing your information set is essential to enhancing your ability to recognize opportunities and turn those into successful trades and investments.
* Here's a useful post from Adam Grimes on how to calculate volatility in Excel. Every weekend I work on a new research project. This weekend I took a hard look at the volatility of buying and selling activity in the stock market by tracking the volatility of upticks and downticks. There was a distinct tendency for returns in SPY to be superior when buying and selling volatility have been high; returns to be subnormal when buying and selling volatility have been low. More to come on this topic. Recently, we've had relatively high volatility readings for buying and selling, helping fuel the current rally.
* Another excellent site for perspective is Abnormal Returns. The most recent links include valuable views on the recent decline in bonds. AR is a very useful way to discover sites that enrich your thinking about markets.
* A feature I like on Stock Twits summarizes the message volume and sentiment for stocks and ETFs. Small caps have been on fire since the election, and message volume for IWM has been high. Interestingly, though, 45% of participants have been bullish on IWM and 55% bearish. We're hovering near highs for the broad indexes, but I'm not seeing frothy sentiment so far. My "pure sentiment" measure, which takes recent price change and volatility out of the equity put/call ratio, has been surprisingly bearish during this rally.
Have a great week trading!
Brett
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One of the unique ways we can look at market sentiment is to track the number of shares outstanding in market ETFs. When there is demand for the ETFs, such as SPY depicted above, we see net share creation. When supply is dominant, we see net share destruction. Notice how, for the first half of the year, we had rising prices but little net share creation. That changed off the late June lows with significant share creation accompanying the momentum move higher. When we pulled back going into the election, there was little net share destruction. Now, in the wake of the election, we've once again seen an explosion in share creation and a momentum move higher.
As you might expect, net share creation has exploded in the financials ETF (XLF) and industrials ETF (XLI), rising over 30% since the beginning of November. Over that same period, we've seen net share destruction in the utilities ETF (XLU), reflecting the move out of higher yielding stocks in the face of the bond market decline and higher rates. (All numbers from the State Street site). What I find interesting is that the share creation in SPY--the market overall--more closely resembles the pattern of the strongest sectors, not the weakest ones. That suggests that it's not just sector rotation impacting the market, but actual net dollars being put to work in stocks.
Further Reading: Fresh Perspectives From New Data
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After a number of days in moderately bullish territory, the ensemble trading model has fallen back to a reading of -1. This is very modestly bearish over a several day horizon, and I take it more as an indication of a maturing trend than as an outright bearish signal. Indeed, as we saw in the rallies off the February and late June lows, the model will often pull back as a trend matures, with the upside continuing but moderating. There has been sufficient upward thrust to the present move--note the expansion in the number of stocks registering fresh annual highs--that such a moderating scenario is my base case. With VIX back to low levels and volume tailing off as we approach holiday season, I anticipate narrower trading ranges going forward--a change from the volatile action we saw after the election.
The election has been a game-changer in at least one important respect for US stocks: there is a sense that policy is going to shift from the monetary realm (ever lower interest rates as a function of further central bank buying of bonds) to the fiscal one (increased spending/stimulus). That has changed the market's psychology from disinflationary to inflationary, resulting in lower bond prices (higher yields), a stronger US dollar, and a boost in stocks--particularly industrial and financial shares. With considerable cash on the sidelines, we could see a move out of bonds and into stocks, which would be supportive of continued market strength. Interestingly, my model of sentiment, which looks at a "pure" put/call ratio with recent price movement and volatility stripped out, has remained above average in bearishness. It is not clear to me that, despite the vigorous stock rally, that sentiment has become over-the-top bullish.
Longer term, I harbor doubts that doubling down on debt will yield hoped-for growth. I felt that way when Democrats were proposing further spending, and I feel that way now that a Republican package is likely to come early in the year. That invites the possibility of stagflation and could return attention to (lofty) stock valuations. For now, however, we are responding to an anticipated fiscal boost and that has kept selling pressure quite modest, even when we've had short-term pullbacks.
Further Reading: Quant Models and Discretionary Trading
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A little while ago, a trader who has been quite successful this year sent me a draft of his trading plan for the new year. Shortly after, he had his best day of the year. I have little doubt that he'll use information from the winning day to help him build on his strengths and hone his goals for 2017.
That's what winners do. They learn from what they do wrong, they learn from their successes, and they translate their lessons into plans and actions. A big winning day is a double win if you can figure out what you did well and replicate that success going forward. Maybe the big day was a function of a particular type of market action that you recognized early on. Maybe the big day was a function of researching great trade ideas. Maybe the big day was a function of sizing up a position you had prepared well and saw clearly.
Suppose you catalogued your top 10 trades of the year, where you fired on all cylinders, making the most of your trading process. What patterns of success would you discover? What best practices could you identify that you could bring into the new year?
Good traders celebrate after a win. Great traders treat wins like losses and learn from both.
Further Reading: How to Become a More Confident Trader
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Character reflects who we are as people: our deepest values, priorities, and strengths. Talent and skill leads people to do things right. Character is about standing up for and doing the right things. I am struck by how long-term success in financial markets often reflects character. Doing the right things leads people to not blow up; it leads them to attract the right people; it inspires loyalty. When I was doing recruitment interviewing at a hedge fund, I recall candidates talking about themselves, pounding on what made them special. They wanted to display confidence. Instead, in their exclusive me, me, me focus, they displayed a questionable character.
Character shows up when trading the money of others. It shows up in one's dealings with peer traders. The truly great basketball players make their teammates better; true leaders act on principle even when that is not the most immediately popular or expedient course. Character means we stand up for what we believe and act in a way that is consistent with our highest values.
We can train skill, but character is built upon role modeling. The character of those we're closest to is likely to reflect our own character. It's one thing to journal about whether you traded well or poorly, whether your psychology is positive or not. A different focus would be to consider your character and whether it's truly being expressed in your market-related dealings. We don't have to discipline ourselves to do the right things if those right things are intrinsic to who we are as people.
Further Reading: Why Character Matters
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I recently had the opportunity to answer five questions for the Trading Technologies' Trade Talk blog. The questions were good ones, and ones worth reflecting upon, each trader for him- or herself. One of the questions in particular dealt with who have been our greatest influences.
Yesterday I pointed out that our passions reflect our values, interests, and strengths. So it can be said for our positive influences. They are influences precisely because they speak to something deep within us, crucial aspects of who we are.
The people influencing us right here, right now are the experiences we will be absorbing, shaping our future selves. Who are our positive influences right here, right now? How can we maximize the quality of our time with them?
The people who have influenced us in the past, making us who we are now: How can we reacquaint ourselves with them and cement their positive influence? Perhaps with a visit, perhaps by rereading the books that have meant most to us...
We internalize our experiences, and we internalize the influences of those around us. Most of the time, we take our environments for granted. But we can play an important role in shaping our environment and choosing the influences that will mold us going forward. When we surround ourselves with the best, we bring out the best in ourselves.
Further Reading: Dr. Brett's Five Questions
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A great Morgan Housel quote cited by Abnormal Returns points out that passion is not just what we feel, but is expressed in what we do. I wrote my first trading psychology book with no contract in hand from a publisher. It was something I had to write for myself, and I was confident that if I stayed true to my ideas, someone would find the text worthy of publication.
Our greatest trading passions reveal themselves when markets are closed. That's when it's clearest that we're engaging in markets for the love of the work, not for the thrill or profit of the trade. When something is a passion, it becomes an intrinsic part of who you are. Like being an artist or an animal lover, you can't turn it on and off between the hours of 9 and 5. It's what you do despite the fact that nothing makes you do it.
We find our greatest passions at the intersection of our strengths and interests. Expressing our values and exercising our strengths is intrinsically rewarding; it's what we naturally do without the need for extrinsic motivation. Indeed, if we need to motivate ourselves to get something done, there's a strong likelihood that we're operating outside our values and strengths.
An important implication is that we're most likely to succeed in trading if how we trade becomes an expression of who we are. A great example is a trader I worked with who, on his own, was not especially disciplined or diligent. He often did not do the deep dives he knew he needed to do to be successful. When he built a team with junior traders to do the basic research work, he absolutely thrived. He loved managing people and benefited greatly from talking ideas aloud. Once his trading process played to his values of helping others and his strengths of processing information interactively, he became highly engaged and his success expanded exponentially.
Your greatest passions have been expressing themselves long before you took up trading. Two of my greatest passions are writing and helping people. There's a reason I've written multiple books, book chapters, journal articles, and blog posts, and there's a reason I became a psychologist--and started helping activities while in high school and college. I love research. As a young child, I used to collect statistics on baseball players and figure out who was best in different categories. Now I collect statistics on markets and figure out opportunity sets.
Your path to trading success is to figure out the path you've already been on, the one that you gravitate to naturally. Your trading strengths and passions have existed long before you knew anything about financial markets. The best approach to trading psychology is to figure out who you are and how to harness that in markets--not trying to change yourself to fit a preconceived notion of trading success. You'll find your greatest success when your passion is your paycheck.
Further Reading: Finding Yourself as a Trader
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Above is a real time screenshot of the ES futures, with 15-minute bars. It's a nice chart, because it illustrates an important trading principle: that of the efficiency and inefficiency of the market's price behavior.
In an efficient market, a given amount of buying or selling activity yields a significant degree of price change. In an inefficient market, a given amount of buying or selling activity leads to relatively little price change.
Think of an idealized market cycle. At the peaks and troughs, we have topping and bottoming activity. Notice, for instance, the bottoming of the ES market at the left hand side of the chart and the topping on the right. At market turning points, we have selling and buying activity, but now that selling and buying finds interest on the other side. That leads to back-and-forth movement that comprises the bottoming or topping of the cycle.
Between these bottoming and topping processes, we see rather efficient market behavior. The buying in the middle of the chart moves prices relatively steadily higher. These cycle dynamics occur across multiple time frames, including intraday as noted above. For an example over a long time horizon, think about the SPX market during 2007 and early 2008 (topping) and late 2008 to early 2009 (bottoming), with efficient selling between the two and efficient buying afterward.
These cycle dynamics help to explain why trading is so challenging. During those transitional times of topping and bottoming (inefficient markets), fading strength and weakness will work as a strategy. During the efficient periods, we want to ride trends. If we understand cycle dynamics and can assess the transitions between greater and lesser efficiency, we're in a stronger position to adapt our trading to the supply/demand situation of the marketplace.
It's when we're locked into a single mode of trading, whether it's "mean reversion" or "trending", that we court frustration, as we're ill-prepared to trade with market cycles. As I've noted in the past, if we're going to dance with the market, we have to let it lead; otherwise, we'll find ourselves in a ballroom waltz when the music turns hip-hop.
Further Reading: The Dynamics of Stock Market Cycles
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It's all too easy to see things through the lenses of our own preferences, positions, and emotions. This is particularly the case in the wake of the recent election. Few people have neutral reactions to the outcome, and few have neutral views as to the implications for the economy and financial markets.
There is a fair amount of talk about a big economic stimulus package to be launched by the new administration. There is also observation that many of the people on the transition team are of a conservative leaning that normally tends to avoid government debt and spending. How this might play out could have important implications for the economy and for monetary policy. My base case is that we get a large stimulus packaged as a jobs-and-infrastructure-building initiative that could pay for itself with increased growth. I'm skeptical of that latter part, which means that we could see not only rising inflation from fiscal stimulus, but also stagflation.
The important point is that we don't really know at this moment and the best we can do is make ourselves aware of various potential outcomes and continually update the odds of those occurring. This is why I'll be watching interest rates, the U.S. dollar, commodities, and stocks very closely. I'll be viewing those in relative terms--as they compare with rates, currencies, and equities globally. I want to view the world through multiple lenses to best handicap the likelihood of growth versus stagnation, disinflation versus inflation. Those outcomes will depend upon policies and developments overseas, not just in the U.S. After all, despite our hyperfocus on the recent election, perhaps 2017 will not about the U.S.; perhaps it will be more about China or geopolitical turmoil in the Middle East. Perhaps it won't be about bull or bear markets, but volatile ones.
It takes an open mind and flexible perception to not become too locked into one way of viewing the world. Looking at multiple markets in multiple regions, in relative as well as outright terms, helps us change our lenses and perceive fresh opportunity--and threat. I encourage readers to check out my latest post on how we can approach the world more creatively. There is a three-step process that we can actually practice and cultivate that enables us to see opportunities and threats that others miss. Adapting to changing markets starts with asking the right questions and making ourselves open to a variety of possible answers.
Ultimately, the best way to see the right thing in markets is to begin by seeing many things.
Further Reading: How to Cultivate Our Creativity
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Above is an update of my ensemble trading model, which combines individual predictive models for SPY over a 10 day horizon. The individual models include measures of buying and selling pressure, institutional participation, volatility, breadth, sentiment, and cycle status. The best signals occur at +3 and above and -3 and below; we currently stand at +2, with a mildly bullish bias. We had +3 readings on 11/1 and 11/2 and, despite considerable election-related volatility since then, we stand meaningfully higher at this point.
At present, breadth has been expanding, in no small part due to the strength of small cap stocks since the election. We have also seen selective strength among sectors, most notably the financial and industrial sectors deemed to benefit from the new administration. Stocks making fresh three-month highs have expanded to their greatest level in many months. It's exceedingly rare for such expanding breadth to suddenly reverse and morph into a bear market. Rather, these momentum phases of a cycle tend to fade away, with decreasing volume and volatility and divergences of new highs, as value investors no longer perceive value and pull back from segments of the market. I would expect the model to turn bearish should volume and volatility pull back and should we see diminishing institutional participation on any further strength.
Meanwhile, the model components contributing to the modestly bullish current reading include sentiment, institutional participation, and buying pressure. In a nutshell, sentiment (adjusted for volatility and recent price movement) has been unusually bearish; participation has been quite high; and a growing proportion of that participation has been channeled toward buying. Those dynamics have had me in the mode of buying dips. Equally important, the model readings have prevented me from fading strength, which I've seen a number of traders doing, perhaps caught up in a bearish bias related to the election result. The psychological value of a well-constructed trading model is that it imposes the discipline of patience. Instead of assuming that I have an edge in trading, the model tells me when the market is affording edge. That's an important distinction that takes a lot of ego out of trading. Once we realize that edge is a function of opportunity set in the market, we can flexibly adapt to changing market conditions.
Further Reading: Quant Models and Trading Psychology
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When traders think of regimes, they often think in terms of bullish, bearish, or rangebound. That is, they think directionally. Within directional frameworks, two regime variables are particularly important: volatility and correlation. I have posted often about volatility, including a measure of pure volatility that assesses the amount of movement we're seeing for each unit of volume traded. The waxing and waning of volatility often gives us clues as to where we stand in market cycles.
Like volatility, correlation can be assessed in two ways: realized and implied. One way I look at realized correlation is by taking the major sector ETFs for the SPX, such as XLY, XLV, etc., and take a moving average of their pairwise correlations. Right now, that measure of realized correlation is quite low--about .56. That is about two standard deviations below the median correlation among sectors that we've seen since 2005. The effect of this low correlation can be seen in the bottom graphic from the excellent FinViz site, which tracks trailing one-month performance for major stock sectors. Notice the considerable variability of returns. Whether you've made money, stayed flat, or lost money over the past month has very much depended upon the sectors you've been in.
Implied correlation tracks the correlation among stocks implied by their options pricing relative to the pricing of options on stock indexes. The top chart shows the CBOE Index of implied correlation ($JCJ). Note the recent roller coaster ride and especially the recent plunge in correlation. Options are pricing in very different paths for individual stocks relative to the index, and this has been recent--a reflection of different appraisals of the industries that might be winners and losers in the aftermath of the Presidential election.
Notice how a long/short trading strategy--one that is relatively market neutral and buys strong sectors and sells weak ones--can work well in a lower correlation regime. High correlation regimes are more likely to be ones favoring directional trades implemented with index products. Correlation can tell us when we're in a stock picking environment and when we're not.
The interplay of volatility and correlation tells us a good amount about where we stand in market cycles, with low volatility and low correlation at market tops and high volatility and high correlation around market lows. When we see mixed readings in volatility and correlation, we're often transitioning from one cycle phase to another.
Right now we're in an unusually low correlation regime, with returns driven by sector-related bets. That sector rotation tells us that investors are not withdrawing money from stocks overall, but are reallocating their exposure.
Further Reading: Returns from Volatility and Correlation
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Steve Burns recently offered a worthwhile post on the topic of ten things to do instead of overtrading. Many of the ideas pertain to curiosity: looking into new trades, new ideas, new sources of edge, new information. Successful traders I've known flow naturally from trading mode to idea generation mode. When they're not managing positions, they're working on ways of managing and developing themselves. Part of the day is spent trading, part of the day is spent reviewing trading and setting plans and goals for the next day, and part of the day is spent gathering the information that will lead to the next day's trades. That rhythm ensures that boredom is not a major part of the trading day, even when markets are relatively slow.
Without intellectual curiosity and the competitive drive for self-improvement, trading becomes little more than sitting in the casino and pulling the levers on slot machines. A trading edge does not consist of a particular setup or indicator; the edge of a trader is like the edge of an athlete, reflecting ongoing training, review, practice, and performance. Perhaps the most important element in that edge is the ability to channel curiosity in the direction of opportunity: to develop ideas of what truly moves markets and find new and better ways of assessing those factors. Reverse engineering the dynamics of the Brexit trade in June and the Trump trade recently is a good start for exercising curiosity.
Boredom is the surest sign of an absence of performance process. If you're not engaged in self-improvement and creative generation of trade ideas, you'll engage in trading without the benefit of self-improvement and creative research. We can trade for profits or we can trade for stimulation and excitement; rarely both.
Further Reading: A Creative Cure for Overtrading
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Here are a few topics and resources on this post-election morning:
* I think it's fair to say that most people--myself included--did not expect the election outcome. One result of the surprise is that realized volatility has gone through the roof during overnight trade in the ES futures. I use a measure of "event volatility", which is the price movement of bars that are based upon either volume or price movement. This is a "pure" measure of volatility, which tells us the volatility per unit of volume or price change. Note in the chart above that we've spiked on the event volatility measure. We're now at levels last seen at the January/February and Brexit lows. In general, high event volatility has been associated with intermediate-term market bottoms, not tops.
* The resulting huge rise in realized volatility means that not only are we seeing above average volume, but each unit of volume is moving the market twice as much as just a few days ago. That's a double barreled effect, and it's extremely relevant for sizing positions. Easy to underestimate the amount of risk you're actually taking.
* Here is a link to a recording of the webinar I gave for the SMB Options Tribe re: best trading practices of successful traders. I've been impressed by the work of the Tribe...they emphasize ways of trading options that don't involve being glued to screens daily.
* Here is a link to a recording and podcast of the webinar I gave for the LockeInYourSuccess group re: the best psychological practices of successful traders. John Locke has developed a number of options trading models that might be of interest to traders. He recently announced an interesting affirmation challenge for traders.
* The best way to use these webinar recordings is to pick out one idea from each that is worth working on as a goal, so that you're not just listening passively to a presentation, but actively learning and moving yourself forward.
Further Reading: Volume and Volatility and What They Mean for Trading
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One of the most damaging psychological patterns in trading is seeing markets through the lenses of hopes and fears--what you want to happen or what you fear could happen. Both are quite different from seeing the world in terms of what typically happens and estimates of variability around that. It's when we view markets through lenses of drama that we create frustration, and sometimes trauma.
Many traders trade patterns that reflect momentum and/or trend. They look for stories and catalysts that would justify the kinds of moves they want to see. A great example of this is provided by Jeff Miller, who notes the frequent calls for recession that never come to fruition. People look for dramatic outcomes because they want to benefit from the moves that would be created. Along the same line, I'm surprised by the amount of conversation I hear from traders about the huge downmoves that would be created if we get a Republican presidency in today's election. Yes, it could happen, but if you look state by state at the electoral count, wouldn't you want to plan equally rigorously for a different outcome?
The tendency to look for big events that could create big (and presumably profitable) moves leads us to underestimate the odds of modest outcomes. It reflects a long volatility bias, so that when volatility is decreasing, frustration inevitably rises. I attribute the recent challenge to money management returns in large part to the crushing of volatility across markets in the wake of zero interest rate policy among central banks. When you look for themes and trends and breakouts in low and declining volatility markets, you'll inevitably be subject to reversals.
The really valuable trading and investment sites, like Jeff's, take a sober look at what is expectable. That may not provide the click bait of Dow 5000 forecasts, but it enables traders to understand and take what markets give them. The idea is not to trade viewing markets through the lenses of optimism or pessimism, but with the clear-eyed perspective of realism.
Further Reading: The Importance of Psychological Risk Management
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