The quest for self-esteem is the surest sign of its absence, as Ayn Rand once observed. The motivation of unsuccessful traders is to become a success. As the recent Forbes article points out, that ego-based motivation makes us vulnerable when we face inevitable losses. This is the problem with what Maslow called deficit motivation. When we seek something to fill a perceived void within us, any disruption thrusts us back into that void. For example, if I feel unlovable and unworthy, I may desperately seek companionship in relationships, but how much will I have to give to those relationships? How well will I be able to navigate challenges in those relationships? If what two people bring to relationships are gifts, they naturally support each other and benefit from their interactions. If two people merely bring needs to relationships, they are always taking from one another and cannot tolerate situations where the other cannot give. All traders have relationships with the markets they trade. How well would *your* romantic relationships and friendships go if you interacted with your partner and friends the way you interact with markets? Great relationships bring strengths to interactions. Barren relationships bring needs. When we bring our needs to our trading, those color our decisions, and our relationships with markets become barren. A great way to identify beginning traders with promise is to focus on the promise they have fulfilled in other areas of their lives. Such traders bring developed strengths to their learning curves. Less promising traders are looking to become successful. They are not looking for self-esteem; they're not seeking to leverage existing successes and strengths. When I hear a trader talk about their "passion" for trading, I ask about the other passions they are currently fulfilling in their lives. If I can't get a concrete answer, I know that passion comes from a void desperately needing to be filled. Trading cannot repair our damaged, bruised, or underdeveloped egos. Just as relationships cannot provide us with the love and esteem we are unable to provide to ourselves, market cannot make us successful. Rather, we leverage the strengths and successes that we already possess to find ways of maximizing opportunities we perceive in markets. Many of those strengths, the recent article notes, are spiritual ones: they come from the soul, not the ego. What that concretely means is that there are certain ways of viewing the world, certain abilities we possess, and certain ways of acting that make us who we are and define us at our best. The developing trader should not be trying to get rich; the developing trader should figure out ways in which he or she is already wealthy in terms of what they do well and who they are and then figure out how to express that in an approach to markets. What motivates a successful trader is what motivates success throughout life. Success follows from consistently being the person we already are when we're at our best.
I notice that the excellent SentimenTrader site observes that the Hindenburg Omen market pattern was triggered yesterday in the U.S. stock market. Basically, that pattern occurs when we've had a strong market, but register a high number of stocks making fresh 52-week lows. As a rule, I'm more than skeptical about technical analysis patterns and especially ones with dramatic titles. The logic behind the Hindenburg notion, however, makes sense to me. If we have many stocks making new lows when the overall index is high, that suggests weakness beneath the surface. A trending market, like a rising tide, should lift all boats. In the Hindenburg situation, many boats are not lifting and indeed are sinking. I decided to test out a different version of this pattern. I collect data on all listed stocks making fresh 3-month new highs and lows on a daily basis. (Data from Barchart.com). Going back to the start of my database, late 2010, I examined all occasions in which the SPX was up more than 5% over a prior 3-month basis, but we register more than 500 stocks making fresh 3-month lows. Out of over 2200 days in the database, only 46 displayed this pattern. Interestingly, over the next three trading sessions, we had 18 occasions up, 28 down for an average loss of -.49%. That compares to an average three-day gain of +.15% for the remainder of the sample. Even 20 days out, we had 23 up and 23 down for an average loss of -.12%, compared to an average gain of +.92% for the remainder of the sample. The takeaway here is that context matters. One of the better predictors of momentum that I've found is not the presence of lots of stocks making new highs, but the absence of new lows. If no individual segment of the market is weak, it's tough to get overall market weakness going forward. If, however, a market has been strong, but many of its components have been rolling over, that weakness can spread to the broad indexes. As I recently wrote, we're currently dealing with a unique situation in China that is likely to dominate price action going forward. When we have unique events of this nature, historical models are of limited relevance. That is why I'm always open to considering historical evidence as hypotheses, but reluctant to embrace it as conclusions.
Panic is a strange emotion. We can have extreme reactions to minor events if our minds blow those up into catastrophes. We can also go into denial about genuine threats. Panicky markets create opportunity, as good assets are dumped alongside the not-so-good ones. What we don't know is whether panic is justified. As the saying goes, if you can keep your head about you when everyone else is losing theirs, perhaps you're not aware of the situation! The current situation with the coronavirus in China is a great example of a fear-filled scenario, as uncertainty is built into the situation and the possibility of a horrendous outcome is present. Here are a few observations that may be helpful for traders adjusting to markets quite different from what we've seen so far this year: * Volatility and Correlation - This is a different market regime. Volume and volatility are greatly increased and correlations among markets will be higher than recently has been the case. When markets are more volatile, the price movement is sizing up positions for you: risk and reward are much higher for a given position. Adjusting sizing of positions to account for this change is essential. Adjusting existing hedges to positions may also be important, given shifts in correlations. For investors, portfolios that looked invincible a week or so ago (think stocks and high-yield bonds) may suddenly seem quite vulnerable. * Following the Story Closely - I'm watching to see if the virus story gains significant traction in the media outside Asia. I have concerns. One data point: if you go online and try to order surgical respirator masks, you'll see a lot of sites and retailers that are sold out. Another data point: China is treating this as a genuine emergency. You don't lock down tens of millions of people and build a new, large hospital for nothing. Still another data point: Wuhan, the epicenter of the viral outbreak, is also the location for China's only bio-lab designed to study BSL-4 level pathogens. Concerns about the safety of the lab were voiced as early as 2017. And I'm not sure we'll ever know whether that lab has been involved in the design and manufacturing of bio-weapons. Bottom line: when the country closest to the situation is reacting the strongest, that situation has to be taken seriously, especially given the mathematics of viral contagions. * Thinking Through Broad Market Impacts - Increases in volatility measures; flight to safe assets; and a new reason for central banks to stick with low rate policies are some expectable impacts. To the degree that this hampers growth in China, we can also expect some re-rating of global growth estimates. If we thought tariffs could slow China, this could have a far greater impact on the economic activity of Chinese citizens and companies doing business in China. Recall how Asian crises impacted the equity markets in the late 1990s. That didn't stop markets from rising to major highs by early 2000, but that rise was punctuated by sharp declines and increased volatility. I'm watching equity prices in China especially closely. Note that we broke out to new highs earlier in the year and now have returned to the prior trading range in FXI. Tough to imagine a roaring global bull market and China not participating. Even tougher to imagine should contagion meaningfully spread beyond China. * Timing is Everything - Money managers who are paid on annual performance had started 2020 nicely in the green with the bull market in stocks and handsome returns from risk parity strategies. Are they really going to want to go red on the year and face investors already wondering why they don't just invest passively in low-cost ETFs? Just as we saw quite an unwind in January, 2018 following great strength, a similar dynamic may be at work at present. Everyone goes for exits at the same time when payouts are at risk. That created opportunity later in 2018, but it was not a one and done day or two of weakness either. * Sometimes This Time Really *Is* Different - I recently wrote about the value of historical market analyses and how those can illuminate current market scenarios. I also noted how, historically, very strong equity markets tend to be followed by strength in the bigger picture. Market history is probably the best guide we have to an uncertain future, but idiosyncratic influences can make the present quite different from the past. Blindly following the past can be dangerous for traders when they face unique situations such as the September, 2001 attack. If history plays out, the current situation could lead to a great investment opportunity, such as those corrections in the late 1990s, but could also last longer--and can be deeper--than investors can tolerate in the short run. The one thing we know is that we are facing a more uncertain global landscape, and that will likely be reflected in volatility and increased herd behavior.
All of us go through changes. The role of psychology is to direct those changes, so that we are continually growing. There has been an explosion of outcome research documenting the effectiveness of techniques that help us change in positive ways. Some of this research is about methods that help us change negative patterns, so that they no longer dominate our lives. Some of this research concerns methods that help us achieve new, positive states in our lives. The average person (and, sadly, the average coach or therapist) has limited access to this research and ends up pursuing change in inefficient and often ineffective ways. What the research tells us is that it is relatively easy to make initial changes in our lives. More difficult is sustaining these changes and building upon those. That's what growth is all about. My work places me at the center of evidence-based methods of psychological change. I coordinate a medical school course for mental health professionals in research-backed short-term approaches to therapy. I have also reviewed the major approaches to brief therapies and co-authored a standard textbook in the field. Much of that work reflects my practical experience coordinating student counseling programs and delivering performance coaching help to traders and portfolio managers. Over that time, I have focused my efforts on "therapies for the mentally well": ways of helping normal people achieve supernormal lives and careers. Psychology is a perennial topic in the trading world, but rarely is it possible to find solid, evidence-based, how-to methods for achieving lasting growth. Much of what is written is well-intended advice that falls well short of helping people navigate the growth process. It was because of this vacuum that I wrote the Daily Trading Coach book/audiobook to help traders help themselves. But a book is not a course. Increasingly, I've felt the desire to directly teach traders how to act as their own performance psychologists. It's for that reason that, starting the new decade, I will be teaming up with videographer Eli Francoeur to produce a video-based course on the how-to's of trading psychology. Accompanying the videos will be a workbook that walks traders through various exercises and activities. The stark truth is that many traders live in areas where they do not have access to trading psychologists. Also, many cannot afford those services. Having taught brief therapy methods for years at the medical school in Syracuse, I am convinced that it is possible to help people help themselves with state-of-the-art psychological methods. The video series and workbook will be posted online, available free of charge anywhere in the world for traders with online connections. There will be no promotions or sales pitches, but lots of how-to's. My hope is to have this available by mid-year. I look forward to working with video whiz Francoeur in creating a resource that can help us become our best selves--in markets, and in all of life. Brett
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The recent Forbes article is one of the better ones I've written, describing how we can best deal with major setbacks in life. There are few better arenas for learning to deal with loss than trading, because trading is by its very nature a probabilistic game. Losses are normal and expectable, even for the best traders. Your win percentage can be 60% and you will still have better than 6% odds of three consecutive losses. That may not seem very high until you calculate how many trades active traders might place in a year's time. For that active trader, losing streaks are guaranteed. Of course, the issue is more complicated than that because market conditions change and our win rate itself has a degree of variability. That 60% trader may go for stretches of time winning 75% of the time and stretches of 45%. This further ensures the presence of winning and losing streaks that are guaranteed even with the best processes and psychology. So a major challenge in trading is learning to lose the right way. If we change how we trade after every random loss, we will become incoherent in our approach to markets. If we fail to recognize when we are trading poorly, we can turn expectable setbacks into prolonged slumps. If we become overconfident after every random winning streak and underconfident after every normal losing period, we'll be sized largest when things turn for the worse and smallest when we're ready to rebound. So what is the right way to lose in trading? The right way means that we make a hard distinction between making money and trading well. Trading well means that we understand what we do when we're successful and that we follow those best practices, including the best practices that allow us to adapt to changing market conditions. The goal is to be consistent in trading well, not focused on the random ups and downs of daily P/L. If we lose money and trade well, there may be a message in that about a changing market. If we lose money and trade poorly, there is probably a message in that to take actions that align us with our best selves. But, like the surgeon and like the baseball pitcher, we focus on doing the right things and let the probabilities play themselves out. It's when we lose for the wrong reasons that losses can become fuel for making us better. All of this highlights the importance of detailed and intellectually honest review practices. The trader that does not review and learn from performance is not a trader who is growing. I consistently find that the traders who show the most longevity in the business are the ones who are always learning, always losing for the right reasons. Anything less is a deathblow to our potential. And that's the greatest loss of all.
I've been hearing a lot from people who loudly assert that a strong stock market such as we've recently witnessed is "due for a correction". Those making the assertion have several things in common: 1) a strong conviction that a bearish move is on the horizon; 2) a total absence of any statistical evidence supporting their view; and 3) dramatic underperformance during the recent market period. So let's look at a little bit of evidence. (Eye-opening evidence, by the way, was published overnight by Market Tells, SentimenTrader, and Quantifiable Edges). We'll go back to 2005 and identify occasions in which more than 80% of stocks in the SPX have been trading above their 3, 5, and 10-day moving averages and in which more than 80% have been trading above their 100-day moving averages. (Data from the excellent Index Indicators site). So we're looking at short-term strength in a longer-term strong market. There have been only 39 such daily occasions out of over 3300 trading days. That alone tells you that such broad strength is rare, even in a market that has risen over the lookback period. Out of the 39 occasions, 22 occurred in 2009 and early 2010. Note that this was a new bull market period following an important bear market. During such periods, as I noted back in March, we tend to see momentum conditions. It's easier to see that we have emerged from a bear market when we look at weekly price charts for small caps and overseas stocks, both of which declined from early 2018 through well into 2019. After the strength noted above, in 33 of the 39 occasions we posted a lower daily close within the next three trading days. So, yes, a pause in the rise after unusual strength has been normal. However, if we look 20 days out, the average market gain has been +1.43% versus an average gain of +.61% for the rest of the sample. Over that next 20-day period, 27 occasions were up and 12 down. History is not guaranteed to repeat itself, but formulating strong views in the absence of any knowledge of history is not trading: It is malpractice. History provides a rich source of hypotheses and an understanding of market flows can tell us if history is, indeed, playing out. Markets dance to the rhythms of momentum and value; edges occur because so many participants can't hear the music.
The recent post tackled the topic of trading based on understanding what markets are doing, rather than trading based upon isolated patterns of variables. For me, such understanding has always been a function of three variables: who is in the market, what they are doing, and where they are doing it. (See the "How to Trade" posts from October to see how I track these variables). Where solid quantitative studies can be useful is in identifying occasions in history when these variables have behaved similarly to the present and seeing whether there has been any significant directional edge going forward. It is by reaching a point of understanding and determining if there is an objective edge associated with current market conditions that we can generate genuine confidence in trading. Conviction without understanding is mere dogma. One thing you can count on in markets is that your dogma is always likely to get run over by your karma. A fourth dimension that I have found valuable is how broadly a market behavior is occurring. In other words, do we see the same behavior across different segments of the market (small caps, large caps); different market indexes (Asian, European, U.S., etc.); and different sectors within the market (technology, energy, consumer, etc.)? The breadth of market behavior is key to identifying trending markets (ones in which the majority of indexes are behaving similarly) and rotational markets (ones which are dominated by sector and market reallocation). For instance, suppose we see that the SPX is moving to a new high for the day. Whether that move is likely to continue depends not only on who is in the market (volume) and where volume is transacting, but also on whether the movement is narrowly or broadly based. It helps to think of a trend, not only as a directional move in one index, but as a directional move shared by the majority of market components. I have found the various TICK indexes (NYSE TICK, TICK measures specific to the SPX stocks, TICK for the Russell stocks, etc.) to be useful in identifying the breadth of market buying and selling. To go back to the previous example of a market trading within a range and moving to a new high, the uptick/downtick (TICK) readings on that move will be an important measure of the sustainability of that breakout. It is when we break out to a new distribution of the upticks/downticks that we can more confidently count on a new distribution of forward prices. An index may move to a new high in a rotational environment because of the impact of one or two sectors. That is very different from a scenario in which broad-based buying lifts all sectors. An important takeaway is that the right trading psychology comes from looking at the right market information, assembling it the right way, and generating the right understandings. As Mike Bellafiore emphasizes, we produce one great trade when we begin with a valid thesis, see that thesis set up in a way that we have studied (play booked) in the past, and then fight for the best price to execute the trade based on our idea. We don't trade well because we have a good psychology; we cultivate a confident psychology when we learn to trade well.
I've been teaching myself new approaches to trading and have learned many valuable lessons in the process. One of the most significant changes I've made is trading from a place of understanding rather than a place of knowledge. As the quote suggests, knowing something and understanding it are quite different things. I know a number of people, but I would not be so presumptuous as to pretend that I understand all of them. Similarly, I might know a Bible passage or a poem, but that doesn't necessarily mean I understand them. Much of what is taught in trader education is knowledge. It might be knowledge about fundamental factors that influence the stock market, such as interest rates. It might be knowledge about chart patterns, trends, and indicators. It might be knowledge about potential catalyst events, such as shifts in monetary or fiscal policies. From their knowledge, traders typically attempt to make predictions, such as whether the market will go up or down. Sometimes the predictions made from the pieces of knowledge are quantified through backtests. This is common among many of the services that I recently highlighted. This knowledge-prediction paradigm of trading is what I have found to be limited. "X is occurring; therefore the market should do Y" does not necessarily reflect any understanding of why that relationship might hold. When we look for X-Y patterns in markets, it becomes easy to reach for so many patterns that the relationships we trade are spurious and not meaningful. That is how overfitting occurs in backtests, for example. We test so many combinations of variables that eventually we find the 1 in 20 that is significant at the p<.05 level! In science, we first observe nature and develop theories about what is occurring and why. Theory building is the hallmark of understanding: a theory represents causal thinking, not just correlational thought. "The market is going higher because we've formed a certain candlestick pattern on a chart" does not capture anything of a causal nature. Conversely, if we look at the expansion of the Federal Reserve's balance sheet and their stance on rates and hypothesize that excess funds in a low rate environment will spur speculative activity, that could represent part of understanding of why we're in a bull market. Or if I break down volume that is transacted at market bid and offer prices and notice that institutions are predominantly lifting offers across different time frames, this could represent an understanding of market participant behavior and a theory of why we're seeing a market trend. To be sure, once the scientist has a promising theory, it's important to put the ideas to the test--and that is where prediction comes in. Ideally, a trade is a test of a market hypothesis derived from a trader's understanding. When well-constructed trades are working out, they add confidence to our theory. When they don't work out, they may lead us to revise our theory. Ideally, our trading is our way of testing our understanding of the market. Too often, however, traders assemble knowledge and immediately want to create trades out of what they have learned. Bypassing the process of understanding leads to a shallow perspective on market behavior--one that does not merit true conviction. Genuine conviction comes from deep understanding, not simple correlations and patterns. "There is nothing so practical as a good theory," psychologist Kurt Lewin observed. What traders need are frameworks for understanding how markets behave and why, not mere "setups" for the next trade.
There is a number of very good research services and platforms that allow traders to identify occasions when there is a directional trading edge in markets. The common thread among these is that they identify a set of conditions that are present in today's market that are distinctive and meaningful. They then examine past occasions when these conditions have occurred and determine whether the market has moved a particular way in the next time period with statistically significant odds. This is known broadly as event research. For example, if the SPX makes a new 12 month high for the first time in two years, we could explore whether, in the past, this has reliably led to future gains. Or, if we have a Fed meeting on Day 1 and close that day weak, we can identify the odds of continued weakness over subsequent days. Or, if the NYSE TICK hits a very strong level of +1000 during the opening 15 minutes of the trading, we can assess the odds of this being a trend day to the upside. In all these cases, we're using historical research to see if there is a directional edge during the upcoming period in the market. Seven providers of such research that I have found to be reliable and useful are (in alphabetical order):
We can also conduct our own event research, as my recent post illustrates. Such studies do not require advanced mathematical or programming methods as one might need for a fully developed trading system. The goal here is not to become a systematic trader, but rather to identify promising hypotheses for the coming trading period. When experienced discretionary traders possess one or more valuable historical hypotheses for the coming day or week, they can then track news flow, price action, and overall market behavior to assess whether the hypothesized move projected from market history is actually playing out right now. In other words, you look in real time to see when there is a reliable "setup" or catalyst that allows you to trade a historical edge with well-structured risk/reward. History doesn't always repeat itself, but knowledge of history generally beats ignorance. Understanding how markets have moved in the past under the conditions we see at present can keep us out of bad trades and help us focus on promising ones. It's an important way that discretionary traders can make use of quantitative strategies without having to do the data collection and coding from scratch. And it can become an important part of our market preparation.
The fatal mistake traders make is that they define themselves narrowly, and this artificially constrains their opportunity set. For instance, a trader might define himself or herself as a "breakout trader", a "trend trader", or a "bear market trader". All ensure that the trader will underperform when markets are not breaking out, trending, or moving lower. The frequent justification for such limitation is that the trader is adapting trading to his or her personality. But would that work in other performance fields? Would a quarterback in football last long if he defined himself only as a running QB? Would a baseball pitcher succeed if he declared himself to be a fastball pitcher? How about an actress who only played one kind of character? In every performance field, ongoing and elite levels of success require the ability to adapt to the opportunity set, not expect the game to adapt to the performer. The trader who does one thing consistently in all situations is not a disciplined trader. He is a one-trick pony. Let's take a practical example: During 2019, the SPY ETF moved a total of nearly 73 points. During the NYSE day session, total movement up and down was about 303 points. Total movement overnight was about 272 points. During all the day sessions, SPY gained about 39 points. During all overnight sessions, SPY gained about 34 points. In short, declaring oneself to be a daytrader effectively cut the opportunity set in half. Many daytraders work hard at improving their trading. Less often do they work at broadening their trading. As I mentioned in a recent post, there are many markets in which a demonstrated edge *is* present, but not on the day time frame. Similarly, there are markets in which a demonstrated edge is present, but not directionally. (For example, volatility may be in a very tradeable declining trend, but the market may not move a lot directionally during that period. One part of the market may be moving higher, such as large caps, while another is moving lower, such as small caps. A good long/short trade is present, but perhaps not an overall market trade.) I consistently find that traders who develop multiple ways to win show the greatest career longevity. As in the business world, long term success requires flexibility and innovation, not a stubborn insistence that the market adapt to our preferred edge. In a coming post, I will share how I have been expanding my trading through the integration of quantified models and discretionary pattern recognition.
Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), The Art and Science of Brief Psychotherapies (APPI, 2018) and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. Currently writing a book on performance psychology and spirituality. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014.
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