Tracking The Market's Strength

Above we see a helpful chart from the excellent Index Indicators site.  Note that we're hovering near all time highs in SPX, but the number of stocks trading above their 20-day moving averages has been tailing off and now stands a bit above 57%  This waning of strength is also reflected in the intermediate-term new high/new low data, as tracked at Barchart.com.  Yesterday, we saw 578 stocks across all exchanges register fresh monthly highs and 605 make new monthly lows.  Even on a three-month basis we had 330 new highs and 316 new lows.  Not exactly resounding strength for an index at its highs.  The average 14-day RSI for the 500 SPX stocks is currently about 54, down from the 60s earlier this month.  

Meanwhile, a number of sectors of the market are trading below their highs, including financial shares (XLF); energy stocks (XLE); industrials (XLI); raw materials shares (XLB); healthcare (XLV); midcap stocks (MDY); and small caps (SLY).  Internationally, we're seeing notable failures to approach new highs among emerging market stocks (EEM) and European stocks (VGK).  Indeed, stocks outside the U.S. as a whole (EFA) have been underperforming.

Volume in SPY has been extraordinarily low, telling us that we neither have bearish catalysts to bring institutions to divest their holdings nor bullish catalysts to justify richer valuations.  For July, we've averaged about 49 million shares traded daily.  Compare that to an average volume of almost 84 million shares this past May.  It may well be the case that it will take a distinct catalyst to bring market participants off the sidelines and generate the next significant market leg.

It's been helpful to stay open minded and flexible on a day-to-day trading basis, but I am completely on the sidelines in my investment account.  I need to see evidence of breadth strength to justify a longer-term bullish position and so far that evidence is missing.

Further Reading:

What We Can Learn From Unique Breadth Data

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Wiring Our Brains For Trading Success

A major theme of this blog and the Trading Psychology 2.0 book is that success in trading is just as much a function of cognitive strengths as personality ones.  How we learn very much impacts our ability to pick up patterns in markets and trade them successfully.  Yes, emotional factors can derail our trading, but it is our capacity to process market information efficiently and effectively that ultimately determines our ability to trade well.

An interesting study at CalTech looked at people's brain activity during a trading exercise.  What researchers found is that the capacity to read the intentions of other people was key to understanding what was going on in markets.  In other words, reading the market was not so unlike reading people.  As I reviewed the study, I was reminded of a recent conversation I had with a skilled trader.  He was using a program called Bookmap to identify buy and sell orders in the market, including a historical view of where buys and sells were placed at each point in the market day.  This allowed him to see which orders were being continually placed and pulled in the market (fake buyers and sellers) and which ones represented genuine supply and demand at particular price levels.  It was as if he were at a poker table reading the bluffing and bidding of the various participants.

The above study, interestingly, did not find any correlation between short-term skill in reading markets and skill at solving mathematical and logical problems.  Recognizing patterns in order flow is a different cognitive skill from analyzing markets and finding longer-term opportunity.  Another provocative finding from the study was that participants became better at reading order flow when it was displayed with graphics and not just presented as numbers on a ladder.  How information is organized can help or hinder our processing of that information.

A variety of cognitive skills are important to the performance of athletes, including attention, visual processing, and memory.  Tools are available to assist in the perceptual-cognitive training of these skills.  Research is under way to identify the neurophysiological factors associated with peak performance and ways of training for those.  Traders typically focus on patterns to trade and secondarily on keeping themselves calm and in a good mindframe.  Might it be the case that wiring our brains for trading success is less about finding "setups" and patterns to trade and more about cultivating our degree of focus (concentration); our breadth of focus (flexibility of perception); our strength of focus (ability to sustain effortful information processing); and our depth of focus (ability to take in more information at one time)?  

This is an area of tremendous promise.  If we were trying out for a sports team, no doubt we'd work out in a gym.  If we're trying out for trading success, perhaps a mind gym is what we need.

Further Reading:

Exercising Our Brains For Trading Success

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How Do We Make Changes In Our Trading?

There are many different approaches to change in the world of psychology.  A fascinating body of research suggests that these work surprisingly similarly, with similar results.  Although the theories underlying these approaches (psychodynamic, behavioral, cognitive, systems, humanistic, etc.) are quite different, their common effective ingredients account for much of their success.  When I reviewed short-term approaches to change, one fascinating common ingredient stood out:  all the successful therapies begin by shifting the cognitive, physical, and emotional states that we are in.

As I emphasize in my new book, which will be out in August, in our usual states of mind and body, we think and do usual things.  If we want to make meaningful changes in our lives, we have to exit our routines and experience our lives in fresh ways.  This is why newlywed couples go to new, inspiring places for their honeymoons; it's also why we find value in meditation, arts, travel, and celebration.  When we want our lives to feel special, we seek special experiences, not everyday routine.

So often, it is the pull of habit that keeps us from making changes.  Yes, we all need trading routines, but if all our trading is nothing more than routine, we'll achieve routine results.  It is important to follow robust, proven processes, and it is equally important to exit those routines when we want to make meaningful changes in our trading.  That's the tricky thing: we need habit to stick to what we do well, but we need to break habits when what we're doing no longer works.

So how do we break out of our routines and make changes in our trading?

In the most recent Forbes article, I explore a most unlikely topic:  forgiveness and repentance.  What do we mean when we say we repent for something?  It means we recognize that we've done something wrong and want to make amends for it.  It's no coincidence that every major religion embraces formal services for the purpose of forgiveness and repentance.  It's when we stand outside ourselves, look at our selves from a fresh perspective, and feel really crappy about what we see, that we can become filled with a desire to change.  Many life changes occur because we can no longer tolerate the status quo.  At that point, change feels like a need--an imperative--not merely a desire.  That's what happens when an alcoholic hits bottom.  Looking at the consequences of his drinking, he feels tremendous remorse.  In that new state of consciousness, he cannot go back to his old ways.

The article explains how this is relevant to trading.  When we make mistakes in trading--when we overtrade, when we fail to act on our ideas, when we take imprudent risks--we end up betraying the best within us.  We are most likely to make real changes in our trading if we own up to what we have done wrong, feel the pain of that betrayal, and find the courage and motivation to be better than we've been.  It's a kind of hitting bottom, and it's a great purpose for a trading journal.

No pain, no gain is a common slogan.  This is true emotionally as well as physically.  Great things were never achieved inside comfort zones.  It's the trader who can tap into the pain of f***ing up and find a way to forgive--but never forget--that finds the energy to make lasting changes.  Our successes and our failures are there to teach us something, in trading and in life.  Sometimes it's the pain of the failures that brings us back to what we're meant to be doing and to what brings us that success.

Further Reading:  Repentance, Forgiveness, and Performance

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What Is Your Trading Gift?

Here is a question I recently posed to the developing traders at SMB:  What trading do you do that is gifted?

Per Picasso's quote above, our life's goal should be to find where our gifts lie and then make the most of those strengths and passions.  If you have a gift for something, whether it be artwork, sports, or trading, you can point to very specific things that you do that express that giftedness.

The idea is that we shouldn't make a career out of anything we're not gifted in.  Why settle for being OK?  Our gifts are what can make us extraordinary.

When we receive a gift, we are grateful.  We treat it with specialness.  Back in 2006, I needed a new car and, to my surprise, my Mom and Dad wrote Margie and me quite a nice check for a car I very much liked.  Their act was special precisely because I didn't need the gift.  They wrote the check solely out of wanting to contribute to our happiness and success.  You can believe their gift meant a lot to me.  I drive that car to this very day and treat it like my baby.  Even more, that gift inspired Margie and me to always be giving to our children and grandchildren, through gifting, but also by giving of ourselves.  Not out of need, but out of caring.  When we are overflowing with gifts in life, it's easy to share with others.  That is the true meaning of wealth.  

If that car is special to me, how much more so should I treat my life's gifts!  A gift is something we value and treasure and treat with honor.  If you are gifted in your trading, that is the only trading you need to be doing.  Everything else waters down what you've been given and cheapens it.  If you have a trading gift, your only priority as a developing trader should be to nurture and develop that gift.  And if your gifts lie in areas other than trading, that's important to know.  You shouldn't dilute those special gifts by settling for mediocre returns in markets.

So what is your trading gift?  

Only a review of what you do well and a careful analysis of how you do it will reveal what makes you special.  I recently interviewed a trader interested in joining SMB.  He developed three strategies for trading stocks and sophisticated ways of identifying the stocks that could be traded in each of those strategies.  This has given him multiple ways to win each day.  I have no doubt that this individual is gifted in his trading.  His gift is to define unique opportunity and trade it rigorously.  Like so many gifted traders, it's not that he plays the game better than others.  He has found a different game to play and win, based upon his analytical and creative strengths.

When we view our best trading as a gift we've been given, we don't want to be doing anything else.  It isn't discipline that keeps us doing the right things; it's pride and gratitude.  Does the trader I met with feel tempted to play every breakout and trending move?  Of course not.  Do I feel a need to get a new car each year?  Not a thought.  When we truly value what we do--and we truly feel grateful for our gifts--that grounds our actions.  To do anything else would be an unbearable self-betrayal.

In some areas of life, you are gifted.  Somehow, some way, you are meant to unwrap those gifts, hold onto them, and turn them into something special.  Life is way too short to do anything other than what we're meant to be doing.

Further Reading:

Awakening Your Talent

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Finding Edges In Markets

A few things I've been thinking about regarding trading edges:

1)  I went back to 1994 and tested monthly data for SPY, looking at short-term momentum as measured by a two-period RSI.  Interestingly, a median split of the data found returns over the next 10 months that were over twice as high following market strength as following market weakness.  That is, over the longer time frame, we have seen momentum effects.  Over none of the quartiles, on average, did we see anything close to negative returns.  

2)  What if the rise of algorithms (which often draw upon large data samples to learn patterns) has combined with the risk aversion of portfolio managers and the needs of day traders to create markets that are most efficient on short time frames?  What if the greatest edges are to be found over time frames that traders either cannot trade or do not want to trade?  What if opportunity is more a function of holding period than short term "setups", breakouts, and catalyst-driven events?

3)  A number of daytraders are finding opportunity trading small stocks that are not traded by institutions.  These display a more orderly order flow and clearer trading patterns.  Could it be the case that even greater edges could be found by identifying the time frames no one wants to trade/is able to trade and exploiting patterns within those?  Might there be a significant edge in the ability to hold positions and not stop out when others must?  If one were to optimize that edge, what would the process of trading look like?  How would trading psychology differ?

Might the greatest impediment to trading success be the *need* to trade?  

Might the greatest opportunities exist at time frames no one looks at?

Further Reading:

Where Does Market Edge Come From?

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Looking at the Market Through Different Lenses - 4: Momentum

A great way to lose money in financial markets is to play the same game as everyone else.  Yes, copying the masters is an essential phase of the learning process, as for artists.  At some point, however, you copy Master #1, Master #2, etc. and out of that learning find your own style, your own voice.  For the greats, the synthesis is something wholly new.  They don't just play the game better; they play a different game.  Impressionist painting is not a better form of realism; trading risk parity is not a better way of trading market direction.  Innovation is essential to elite success in markets, as in business and the arts.

Very often, the right question is not, "Why am I not making money in trading?" but rather, "Why *should* I make money with the kind of trading I'm doing?"  If you're looking at the same charts, the same stocks/instruments, the same data as others, why *should* your results be distinctive?

Lack of innovation is a hallmark of mediocrity.  It doesn't matter how much "passion" you profess for trading.  High levels of success never came from being a "me too" performer.

Above is a chart of the recent market, where each data point represents a large number of price changes in the ES futures.  That is, we draw a fresh bar every time ES makes X number of price changes.  As I've indicated in the past, this normalizes market behavior over the course of slower and busier market periods, making it easier to identify market cycles.  The red line is what I call the "Power Measure", calculated over a moving 40-bar window.  It is a rolling correlation of absolute price movement (price range) and net directional price movement (price change).  A simple way to think of the Power Measure is to consider whether the green (up) bars on a chart are larger or smaller than the red (down) bars over a given lookback period.  That is, are we seeing more upside or downside momentum?

Interestingly, the Power of a market is relatively uncorrelated with its rate of change.  Some deep thinking about high and low momentum up and down markets bears fruit.

Note how negative Power readings (downside momentum) occurring at higher price lows offer good buying opportunities; positive Power readings (upside momentum) at lower price highs become candidates for selling.  If upside and downside momentum cannot generate fresh price highs and lows, we have a situation in which buyers and sellers become trapped in their positions.

The goal of this post and the three others in this series (see links below) is not to get you to think about markets the way I do.  Rather, it's to illustrate the importance and value of viewing markets through fresh lenses.  It doesn't matter how much emotional control you exercise in your trading if you're part of the herd in your idea generation.

Previous Posts in This Series:

A Fresh Look at Volatility

A Fresh Look at Buying/Selling Pressure

A Fresh Look at Breadth

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Looking at the Market Through Different Lenses - 3: Volatility

When I model the market, I typically include three variables:  1) a measure of short-term performance; 2) a measure of longer-term performance; and 3) volatility.  I think of volatility as a regime measure, so that--for a given vol regime--I want to see what happens when the market has been short-term and longer-term overbought or oversold.  The most common measure for volatility is VIX, which captures the movement anticipated in the options market (implied volatility).  Another measure would be "realized" volatility, which I measure by a moving average of the average daily true range.

I find value, however, in tracking unique volatility measures.  One, for instance, looks at volume bars in the ES futures and tracks *their* realized volatility.  That measure, which I dub "pure volatility", represents the amount of movement we get per unit of trading volume.  That has been quite helpful as a regime measure, but also helps in terms of sizing positions, as it captures the degree of movement one can expect for a given trading volume.

Yet another measure was one that I created in 2012, a regression equation designed to predict the VIX from two variables:  the net directional movement over a several week period and the realized volatility of the daily bars during that period.  These two variables were very significantly predictive of VIX.  When I looked at the residuals, however, I noticed additional value.  The "excess" VIX--the amount that VIX exceeds or falls short of what it "should" be given the regression formula--tells something about the psychology of the market.  It is the degree to which options participants are anticipating unusually high or low movement.

The excess VIX is plotted against SPY (blue line) above.  Note that spikes in excess VIX have been associated with intermediate-term market bottoms.  When I performed a quartile split on the daily data, an interesting pattern emerged.  Returns have been significantly better than average when excess VIX has been in its lowest and highest quartiles.  Specifically, over the next 20 trading sessions, SPY has averaged a gain of almost +1.2% when excess VIX has been in the extreme quartiles and only +.23% in the middle quartiles.  

What that suggests is that there is a momentum effect when options players price in very low volatility relative to what would be expected and a value effect when they price in too much volatility.  Much of the market's uptrend over this period came from occasions when VIX was priced "too low" or "too high" relative to its norm.  This is an interesting finding, given that the results are entirely out of sample.

This is a good example of the value of assessing the psychology of the market, not just our own psychology.  It's also a good example of the value of going beyond traditional measures to create unique indicators that capture what others miss.  (Note:  the recent Excess VIX has been in its third quartile, where VIX is relatively fairly priced.  There has been less upside edge in the market over the next 20 trading sessions at such times.)

Further Reading:

Volume and Pure Volatility

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Why Trading Psychology Matters

The recent Forbes article poses a key question:  Does your career actualize your self?  In other words, does the work you perform--whether as a trader or something else--serve as a pathway for your development as a person?  

Trading psychology matters because why we pursue profits in financial market matters.  To paraphrase Ayn Rand, the search for self-esteem is the surest evidence of its absence.  If we need profits from markets to feel good about ourselves--if it's all about the calls we make in markets and the moves we "catch"--then we will always be frustrated when the probabilities don't pay off for us.  

Here is an important trading psychology principle:

If you're trading for the right reasons, your market participation will bring out the best in you.
  

If you're trading for the wrong reasons, your market participation will bring out the worst in you.

Does trading expand you and make you a better human being--one who is more aware and more self-aware; one who is capable of acting decisively on unique insights--or does trading so narrow and frustrate you that you never develop?

We always exist in a relationship with the work we perform, just as we exist in romantic relationships.  The best relationships bring out the best in us.  They inspire us to be more than we are.  The worst relationships are focused on, "What can I get out of this?"  Markets can challenge and inspire us, or they can drown us in narrow self-interest.

Trading psychology matters, because if we have the wrong trading psychology, the odds are good we're pursuing markets the wrong way.  When I work with the traders at SMB, I have the privilege of reading their trading journals.  Some are entirely focused on how much money was made and how much was left on the table.  Other journals make minimal reference to P/L and instead focus on process and self-refinement.  Over time, that difference makes a difference.  

In the Forbes article, I summarize the qualities of self-actualization that have appeared in recent research.  A great self-assessment is to ask yourself how often you experience those things in your trading.  The challenging thing about trading is that it can be a powerful platform for building your strengths--or a certain path to losing your soul.

Does Your Career Actualize Your Self?

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