Tracking the Psychology of the Market

Whether one is a portfolio manager or trader, success comes from generating sound market ideas and then translating those into positions that provide positive reward relative to risk.  There are many big-picture managers who develop great ideas but fail to implement them as excellent trades.  Similarly, there are many short-term traders who treat trading patterns as ideas, only to get run over by what is happening in the larger picture.  Great trading is an integration of the strategic and the tactical.  

Many of the trading patterns that I rely upon to implement bigger-picture ideas are measures of the psychology of the marketplace itself.  The NYSE TICK measure, which I have written about for a while, looks at the moment-to-moment upticks and downticks in every single NYSE stock and combines those into a single measure.  When buyers are dominant, we see more upticks than downticks; when sellers dominate, we see more downticks.  We can create a short-term moving average of the TICK, which looks like an oscillator.  By observing if the oscillator is mostly above or below the zero line and whether it is making higher or lower peaks and valleys, we can detect overall sentiment over the course of a trading day.  A cumulative measure of the TICK, constructed like an advance-decline line, can provide us with a sense for longer-term shifts in sentiment.

Recently, I have taken a more detailed look at the upticks and downticks.  Using data from the Sierra Chart platform, I have constructed TICK measures specific to the SPX 500 stocks, NYSE stocks, NASDAQ stocks, and Russell 2000 stocks.  As illustration, we see above a 20-minute moving average of upticks vs. downticks for the SPX 500 stocks only, covering the day of November 27th.  Comparing similar moving averages for the Russell 2000 TICK and the NYSE TICK can help us identify when there is stronger and weaker sentiment among the small-cap and large cap segments of the marketplace.  When we see strength and weakness across all the TICK measures, we can be alert for the possibility of trending market behavior.

Over time, we can become quite good at detecting patterns in the uptick/downtick data to identify how sentiment is actually moving the market.  For example, note how in the first half of the chart above, we get periods of net selling that fail to move SPY meaningfully lower.  In other words, the sellers are present, but are unable to move the market.  This is valuable information.  Observe how buying could not move the market higher late in the day, which was equally valuable for the astute trader.

The big takeaway here is that higher-frequency market information (the TICK measures update multiple times per minute) can capture the trading patterns of active participants, revealing the evolving psychology of the marketplace.  Longer-term shifts in this psychology can help us generate market ideas; shorter-term shifts can help us find good risk/reward spots for implementing those ideas.  Of course, it's important to use psychology to understand and master ourselves.  What is often missed, however, is that psychology is equally important in understanding the markets that we trade.

Further Reading:

How to Trade:  From Analysis to Synthesis

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Is Your Trading Purpose-Full?

What is the purpose of your trading?

For many market participants, this would seem to be a foolish question.  "Of course!", they might exclaim, "The purpose of my trading is to make money!!"

Is it that simple, however?

The purpose of a job is to make money.  But is that the purpose of a career?  Is it the purpose of a calling?

If someone were to suggest that the purpose of my being a psychologist is to make money, that would strike me as absurd.  Do I make a living from my profession?  Of course.  But is that the *purpose* of what I do?  Of course not.  Show me an artist whose aim is to make money and I'll show you a mediocre artist.  A priest, minister, or rabbi?  A physician?  The good ones aren't in it for the money, even though it is their primary source of income.

When a trader approaches his or her craft to make money, what they're really saying is that markets are their job, not a career, and most certainly not a calling.  We shouldn't be surprised, therefore, when they treat trading as an activity limited to market hours, and we shouldn't be surprised by the lack of true passion and effort that goes into their market preparation, review, and journals.

Purpose breeds passion.  Passion without purpose is mere emotion and drama.

The most recent Forbes article is based on eye-opening research that reveals the emotional, health, and productivity benefits of living with a sense of purpose.  Purpose gives us resilience--the ability to bounce back from setbacks.  Purpose also enables us to draw upon hidden reservoirs of energy.  All of these are key to success in markets.  

The trader who trades for money has nothing to energize them during inevitable periods of drawdown.  As the Forbes article makes clear, many of the greats of trading have been motivated by a sense of purpose beyond immediate P/L.  Teaching/training others; learning new modes of self-mastery; discovering new patterns and creative sources of edge--all of these are purposes associated with the process of trading, rather than the outcome.

If there isn't an overarching point to your trading process, trading will eventually feel pointless.  That is not a formula for success.

Further Reading:

The Amazing Psychological Benefits of a Purposeful Life

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The Importance of Context in Trading and Trading Psychology

Here's an interesting market display from Sierra Chart.  It is a Market Profile-style depiction of volume traded at each price in the ES futures over the past seven trading days.  The grey regions represent the value areas for each day; the magenta line represents the point of control, and the green areas represent volume traded above and below the value area.  Thus at one glance we can track the red arrow on the most recent day and see where we are currently trading relative to recent value, whether buying/selling volume can take us above/below the point of control and above/below the value area, whether volume is increasing or dying out as we move out of the value region, etc.  In short, the display places current market activity in context, helping us understand the meaning and significance of moves that are occurring.

Many trading problems occur when we lose sight of context and become so focused on short-term price action that we get run over when the larger picture predominates.  For instance, we may see the market moving lower in the short run and chase the move lower, missing the fact that the selling is on reduced volume and is unable to establish value lower.  When the market snaps back to the point of control, we get whipsawed out of that short term trade.

It's interesting that many trading psychology problems also occur when we fail to put our activities in proper context.  We can become frustrated by three losing trades in a row, failing to appreciate that, with a hit rate near 50%, this is bound to occur often to active traders.  Similarly, we can become overconfident or underconfident based upon our recent trades and thus lose sight of well-established rules for setting stop loss points.  Reminding ourselves that we are not as bad as our most recent losses might make us feel and not as good as we might feel after a win is also establishing context.

So much of trading psychology is possessing the mindfulness to process the larger context before acting on and reacting to the most recent market and trading events.

Further Reading:

Training the Brain for Mindfulness

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Peak Experience and Peak Performance

When I wrote the recent free blog book, Radical Renewal, I started with the insight that many of the problems we encounter in trading psychology are ones in which our egos become attached to short-term performance.  Once we make profit and loss a measure of our personal success and value, we introduce fear, greed, frustration, and overconfidence into our processing of markets.  To the degree that we become focused on outcomes, it becomes impossible to fully focus on sound trading process.  Too, when we are self-focused, we lose our focus on what is happening in markets.

One idea that emerged during the writing of the book is a bit different:  It's not simply the presence of negative emotional experience that interferes with good trading performance, but the absence of distinctively positive experience.

The psychologist Abraham Maslow wrote about "peak experiences", which are powerful experiences of positive emotion, meaning, and purpose.  In the book, I explore the idea that peak experiences are the positive equivalent of traumatic stresses.  Just as trauma is processed directly with the potential of reshaping personality, peak experiences exert a similar--but more constructive--reorganization of our experience.  Consider the "born again" experience of a religious person or the experience of falling in love.  These exercise an ongoing inspiration that gives us energy and positive emotional experience.

What supercharges our performance is a level of absorption in what we're doing that opens us to the flow state and peak experiences.  I question if we see ongoing peak performance without an engine of peak experience.  The trader's focus on negative emotion is the surest sign that flow states and peak experiencing are missing.  We achieve in any field when we discover something profound and meaningful that inspires ongoing effort.  That is the ultimate psychological edge of any entrepreneur.

Further Reading:

Radical Renewal

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The Two Paths Toward Winning

I recently interviewed with Seth Freudberg of the SMB Options Group, and the interview was posted to YouTube.  In the interview, I summarized research I had conducted at a number of different trading firms regarding what creates success for traders and portfolio managers.  As I suggested in a recent tweet, a major finding is that distinctive performance is based upon distinctive strengths.  The idea that all profitable traders have a particular "secret sauce" ingredient that creates their success is silly.  What we find is that success--in trading as in other fields--leverages native talent and interest, builds skill upon that base, and then channels those talents, skills, and interests in ways that exploit opportunity.  

In general, there are two paths toward winning for traders:

1)  The first path is where the trader has experienced success and is engaged in markets in ways that are interesting and fulfilling to him/her.  Very often, the approach to trading makes use of one or more strengths that show up in other areas of life.  For example, someone who demonstrates unusual intellectual curiosity outside of markets will make use of that curiosity in developing new sources of edge in markets.  Of course, markets are always changing, and so the trader who has experienced early success must work to maintain that success.  Like a talented athlete, this trader is always working on his or her game, refining and expanding skills and finding new opportunities.  Working harder and better at your game:  that is the first path to success.

2)  The second path is where the trader has not experienced success and is frequently frustrated in his or her engagement of markets.  Such a trader may work harder and harder, but the path to progress is a slow one.  Over time, the trading takes energy; it does not energize.  That is one of the best signs that this trader is playing the wrong game.  All the work on refining skills won't be helpful if you're playing the wrong game.  Getting better and better at implementing a random chart pattern that lacks edge is not going to lead to distinctive profitability.  Working harder and harder at approaches to trading that don't leverage your talents, skills, and interests will similarly lead to mediocre results.

If you look at most performance fields, you'll see that each one actually incorporates specific roles that require unique skills and interests.  On a baseball team, the role of pitcher requires very different skills from the role of outfielder or catcher.  In an orchestra, the violin player is "playing a different game" from the percussionist and keyboardist.  The medical world has space for pediatricians, psychiatrists, and surgeons:  very different "games" indeed!  A huge part of success is finding the game that is right for you, given your native abilities, your interests, and your skills.  Very, very often you have to try many paths to performance before you find the one that is right for you.  Indeed, trying out all specialties is a requirement in medical training and in many formal training programs at investment banks.

The most popular TraderFeed post of the year was one that called out many providers of "trading education" for promoting strategies that have no edge whatsoever.  That's a different way in which we can find ourselves playing the wrong game.  A huge part of the learning curve for a developing trader is trying different approaches to markets--shorter term, longer term, discretionary, quantitative--and different markets to see which "specialties" truly fit with talents and passions.  Only then can we find sound mentoring to help us play the right game the right way.  There are some excellent resources in the appendix to my blog book that point the way toward such mentoring.

That is the challenge of trading:  There is no single path toward winning.  The challenge is to find our path.

Further Resource:

The Six Characteristics of Successful Traders

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How The Market Cuts You Up

Perhaps the best trading psychology advice ever:

Move the heart, switch the pace, look for what seems out of place

Cuts You Up - Peter Murphy

I find you in the morning

After dreams of distant signs

You pour yourself over me

Like the sun through the blinds

You lift me up

And get me out

Keep me walking

But never shout

Hold the secret close

I hear you say

You know the way

It throws about

It takes you in

And spits you out

It spits you out

When you desire

To conquer it

To feel you're higher

To follow it

You must be clean

With mistakes

That you do mean

Move the heart

Switch the pace

Look for what seems out of place

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How FOMO Can Help Your Trading

I recently posted an article about how we can use our greatest weaknesses to become valuable strengths.  Here is a dramatic example from a money manager I've been working with.

The portfolio manager suffered from that common malady of FOMO:  the fear of missing out on potential market moves.  Although he had rules for entering positions that carefully circumscribed risk and reward, he would see the market moving away from his ideal entry point and, fearful of missing out on the opportunity, he would chase the short term movement.  All too often that led to paper cut losses and big distractions during the day.

Now, of course, the usual coaching strategy to help this person would be to mentally rehearse scenarios that trigger FOMO, along with the "best practices" for managing such market opportunities.  Those visualizations would be accompanied by stress management techniques to minimize the anxiety that is a typical part of FOMO.  Such an approach can be quite useful.

But suppose we view FOMO as a potential trading/investing strength!  Perhaps the FOMO is simply an unhelpful channeling of a positive drive for achievement and performance.  Rather than try to eradicate the FOMO, how could we channel it in more constructive directions?

The way we did that was by transforming FOMO into FOMOP.  FOMOP, we decided, was a fear of missing out on one's process.  It is a fear of losing the process orientation that has accounted for long-term success.  

To deal with FOMOP, the manager actively recounted, during preparation time, instances in which deviations from good process led to losses.  He specifically looked for scenarios in the upcoming day's market action that could lead to process breakdowns and prepared for them as potential landmines.  He actually cultivated his fear; he didn't try to overcome it.  He wanted to be *appropriately* fearful of losing discipline, just as, say, an alcoholic might be appropriately fearful of relapse.

As a way of gauging progress, he graded himself at the end of the day purely on process grounds:  how well he generated ideas; how well he structured trades based on the ideas; how well he managed those positions and their associated risk; etc.  The goal was to achieve consistently high process scores at the end of trading days, whether those days had positive P/L or not.

The interesting finding has been that FOMOP works!  Indeed, this portfolio manager has shown dramatic improvements in the rigor of his trading (he executes his own positions) and investing.  This has translated into a better mindframe and, most critically, into improved absolute and risk-adjusted returns.  Instead of fighting his fear of missing out, he has channeled it in a way that improves his trading.  That fear came out of a positive drive for performance; it wasn't something to be battled and eliminated.  

What if most of our weaknesses are simply strengths channeled the wrong way?  How might it help our trading, our mindset, and our relationships if we can find the positive drive behind the weakness and use it to fuel one of our strengths?

Further Reading:

Turning Weakness Into Strength

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How to Use Our Emotions as Information

Emotion is the output of the brain's fast processing system, a rapid pattern recognition system that quickly captures whether a perceived entity or event is good or bad for us, safe or dangerous, something to embrace or something to avoid.  If we had to rely on slower, analytical thought to assess if an oncoming car was a threat, we would be in a collision by the time we reached a conclusion.  Our emotional processing enables us to act quickly, facilitating fight or flight when needed.

The price we pay for sharing emotional/fast processing with the animals is that we can act quickly and not always accurately.  The salesperson who comes across as helpful and interested may or may not have your best interest in mind; the situation that you fear may actually be the very one you need to tackle in order to grow.  Emotion is necessary for navigating the world, but not sufficient.

There are traders who act impulsively--and unprofitably--on emotion and conclude that the answer to successful trading is to curb or even eliminate emotion during trading.  From this perspective, emotion is a weakness to be overcome if one is to trade rationally.  To put the matter politely, this is a limited view.  Eliminating emotion--even if it were possible--would be to remove our capacity for fast processing.  Good luck retaining a feel for markets if you're busy denying your feelings.  Imagine a parent who lashes out at a child out of anger or frustration and then concludes that he or she will solve the situation by removing all feelings from parenting.  Would they then become a good parent?

The most recent Forbes article tackles a very important topic in trading psychology:  How we can turn our weaknesses into strengths.  Rather than try to overcome or eradicate our feelings, we can channel them in a way that assists our trading.

Here's one way of doing that that:

If I feel something strongly about the market before I have conducted my usual analyses, I immediately entertain the hypothesis that if I'm feeling that way, perhaps others are as well.  In other words, before I do my preparation, I'm processing the same charts, the same headlines, and the same social media chatter as everyone else.  If what I'm perceiving frightens me or makes me think a phenomenal opportunity is at hand, I want to consider the possibility that this is a consensus perception.  In that context, my feelings are not an automatic guide to action, but rather are important information to consider when conducting my pre-market preparation.

So let's say that there is a tremendous amount of bearish chatter among market participants and I'm becoming worried about the possibility of a bear market, triggered by trade wars, political conflict, and economic weakness.  Recognizing my fear and acknowledging it enables me to see if the market data I look at actually support such a view.  In recent weeks, for example, the data have not been supportive.  Indeed, a number of formerly weak market sectors and international indexes have been displaying relative strength.  Noting the disparity between my emotional/fast processing and my analyses allows me to consider the possibility that bears will be trapped on any move higher, sustaining the upside.  In such a case, my emotions are a source of information, not a weakness to be battled.

Many traders turn to techniques such as meditation as "enlightened" ways to rid themselves of emotion.  It's not clear to me that this is the true purpose of meditation, certainly not in the Buddhist and western religious traditions I reviewed for my recent blog book.  Rather, the idea is to gain awareness of our feelings, while simultaneously acting as their observer.  The Forbes article summarizes important research that finds that embracing our vulnerabilities actually makes us stronger, more whole.  Our emotions can derail our trading or inform it.  It all depends upon our degree of mindful self-awareness.

Further Reading:

Turning Weaknesses Into Trading Strengths

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