Wednesday, January 15, 2020

A Fourth Dimension of Trading

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.

Further Reading: