Two Important Lessons From This Market Decline

Above we can see the ES futures covering the SPX 500 stock index as of my writing this at 4:28 AM on Friday morning.  It's been a busy week in the market, and it's been busy work with traders.  With a VIX suddenly three times as large as we had been seeing earlier this week, market volume and market volatility are much greater than anything we've seen in a long time.  Here are two important lessons passed along from my recent meetings with traders and portfolio managers:

1)  Risk management becomes crucial in volatile markets - Many traders see opportunity and want to size up, forgetting that volatility is already sizing up the movement of their positions.  The relationship between volume and realized price movement is not a linear one.  Not only do we see more volume in down markets like the current one, but the movement per unit of volume increases significantly.  If holding period stays the same, we are taking on considerably more movement in these down markets.  Many traders have been hurt by failing to take this into account.  They set stops too tight and the movement stops them out prematurely.  They size too large and then take losses much greater than they are accustomed.  It is easy to overtrade volatile markets, because so many things are moving.  That makes it easier to take a series of outsized losses.  The faster the market moves, the slower we should make ourselves to adapt to the new conditions.

2)  Not all oversold markets are ready to sustain a bounce - We were very oversold early in the day yesterday and many traders rightly entertained the notion that we could sustain an upside move.  Indeed, if you look at the chart above, you can see that we had good buying after the opening down move yesterday.  Note the green bars, showing that a high proportion of the volume traded was lifting offers, showing buying aggressiveness.  Also note, however, that all this buying only retraced a modest percentage of the prior market decline.  As impressive as the buying was at the time, in the context of the market movement, it was merely a bounce in a declining market.  Historically, yes, oversold markets do tend to rally.  When we're faced with a unique situation such as a virus outbreak, however, history is not necessarily an accurate guide to the future.

Volatile, declining markets can offer great opportunity, but also can play havoc with our psychology if we're bringing habit patterns from the prior period of low volatility bullishness.  With an uncertain U.S. election and an uncertain course of this virus, we could be seeing volatility in markets for a while.

Further Reading:

Developing Your Market Edge

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How Can We Determine When The Market Is Topping Out?

Recently we took a look at framing hypotheses for trading that suggested we could be seeing a correction following a solid run-up in prices for the major stock indexes.  This morning, as I write, we certainly seem to be correcting.  Above, I drew a chart of the ES futures, covering roughly the past month and a half, with each bar representing 350,000 contracts traded.  (Data from Sierra Chart).  As in the earlier post, the middle graphic shows the net amount of volume transacted at the market's offer price (green) minus the amount transacted at the market bid price (red).  This is a great way of tracking the psychology of the marketplace itself, a sorely neglected topic in trading psychology.    

The previous post examined this market from a cycle perspective.  Here we're asking a different question:  How can we identify when a market might be topping out?

To answer this question, we need to look at, not only the amount of volume at bid and offer, but also two other things:

• How much is volume moving price?
• How much breadth strength are we seeing with the volume?

Note where I drew the pink arrows that we have a good amount of volume lifting offers, suggesting that buyers are aggressive.  Despite that, price has stopped moving meaningfully higher.  Moreover, when we look at the breadth statistics for that period, we see something interesting.  The number of stocks across all indexes making fresh one month new highs and fresh one month new lows were as follows:

Feb. 12th:  634 highs; 313 lows

Feb. 13th:  562 highs; 389 lows

Feb. 14th:  595 highs; 408 lows

Feb. 18th:  602 highs; 580 lows

Feb. 19th:  682 highs; 402 lows

Feb. 20th:  646 highs; 476 lows

We can see that, as buyers were lifting offers, the number of stocks making new highs could not meaningfully improve.  Moreover, even though we were hovering at all time highs, the number of stocks making fresh lows was not all that different from the number registering new highs.

This pattern occurs at the tops of many market cycles.  Buyers are aggressive, sentiment is bullish, but the buying cannot move price or breadth significantly higher.  This occurs because there are many resting sell orders above the market absorbing the buying.  Large market players no longer perceive value at the elevated prices (or might be perceiving risk associated with the virus outbreak, political events, etc.) and are using the market strength to exit their positions at good prices.  This leaves a lot of bulls trapped and needing to puke positions on a market decline.

Many short-term market edges can be attributed to bulls and bears getting trapped in their positions once their activity can no longer move the market higher or lower.  This is why the psychology of the marketplace is just as important as the psychology of the trader.

Further Reading:

Posts on How to Trade

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The Hidden Cause of Trading Psychology Problems

There are two groups of traders that I see struggling:

1)  Newbies

2)  Experienced traders trying to regain a lost edge

Both experience considerable frustration and discouragement, and both often turn to trading psychology for help.

The hidden cause of their trading psychology problems, however, is what I discuss in the most recent Forbes article:  they short-circuit the learning process and never truly internalize a new edge in the markets they're trading.

The odds of trading success go way up if you do the learning process right.

This is true for all performance domains, and it's why we see coaches and mentors in fields as diverse as athletics and performing arts.  

The central skill of trading is pattern recognition.  The central element of success is drawing upon pre-existing talents and interests.  Simply trying to copy someone else's "setups" is not going to create genuine learning or performance.

Many, many of the problems that trading psychologists talk about are due to failures of learning and development processes, not failures of the psyche.  As Nate Michaud of Investors Underground recently pointed out, these problems follow from an overfocus on profitability at the expense of cultivating sound trading processes.

Further Reading:

How to Develop Your Trading Edge

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Changing From the Ground Up: The Power of Microhabits

What if you created just one microhabit? 

A microhabit is a very specific pattern of thought, feeling, and behavior that you enact at a particular time.  The key to success behind a microhabit is to make it highly circumscribed and perform it faithfully and regularly.  For example, one of the microhabits that I've developed is writing for a few minutes in a personal journal each morning.  I write whatever comes to mind and let it flow, stream of consciousness.

That's it.  Each journal entry is short and unplanned.  So it's easy to do no matter where I am or what I have scheduled later that day. 

What happens with the microhabit is that it leads to unexpected consequences.  For instance, writing the short blurb in the journal gets me in the mood to do more writing and stimulates me to work on related projects.  Ideas that crop up in the journal writing inspire me to tackle a problem in a new way.  Challenges that I've placed on the back burner come up in the journal writing and provide a fresh motivation to get them done.

In short, instead of changing from the top down by setting big goals, we can change from the ground up with small habits that reverberate across our lives.

What is a positive microhabit you might incorporate into your trading?  How might that impact other aspects of what you do in markets?  One trader I worked with made a slight change to how he enters positions, giving him slightly better reward relative to risk.  That led to spontaneous changes in other aspects of his position management that contributed further to his profitability.

Perhaps, by achieving very small changes, we internalize the sense of being able to change, inspiring us to make other changes. 

Maybe we internalize our self concepts one action, one thought pattern at a time.

Maybe who we are--and who we become--is constructed from the ground up.

This is a promising area of trading psychology that I'll be developing in coming posts.

Further Reading:

How to Break Our Worst Trading Habits

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Trading Hypotheses and Trading Ideas

As I'm writing this, it's 6:39 AM on a Sunday morning.  I've just finished an hour of market analysis and prep for the week.  Just a little example of the difference between dreaming about success versus waking up and prepping for success.  Recently I asked a trader to send me a review of his trading.  He explained that he was busy with personal things and would get that to me in a few days.  Right.  I'm still waiting for the review.  If you were to talk with this trader, he would sound convincing about his "passion" for trading.  Too bad he doesn't have a passion for working on his trading.

OK, off the soap box.  Above is an interesting chart of the ES futures, covering roughly the past month of trading.  One unique aspect of the chart is that each bar represents 300,000 contracts traded.  Below the chart, the green and red bars show whether buyers or sellers were dominant during that 300,000 contract period; e.g., whether more transactions were occurring at the current market offer vs. bid price.  The bottom oscillator captures a moving average of the volume at offer/bid data.

Ask any market participant about the stock index futures and they'll tell you that we're in a bull market of historic proportions.  And they wouldn't be wrong.  We've seen quite an upward trend recently.  Still, market cycles can occur within the context of market trends; few trends move higher with no corrections whatsoever.

A worthwhile heuristic I use in framing trading hypotheses is that the number of volume bars representing selling is roughly proportional to the number of bars of subsequent buying.  Another way of saying this is that the volume "trapped" by fading a trend is proportional to the amount of volume that ultimately has to cover their positions.  What is important in this is that we're framing a hypothesis, not jumping to a conclusion.  Before we can have a trading idea--and any "conviction" in that idea--we have to entertain a worthwhile hypothesis.  Worthwhile hypotheses come from looking at fresh market data or the usual data in fresh ways.  Creative perception precedes creative ideas: if we see the same things as other people, we'll likely trade how they trade and what they trade.  In other words, stale perception makes us part of the consensus, the herd.  It's seeing what others don't even look at that gives us hypotheses that can become promising ideas if subsequent order flow supports those hypotheses.

The chart shows the current proportionality between volume pushing the market lower and volume recently pushing us higher.  The question is whether the shorts have all been trapped and buyers exhausted, leading to a potential cyclical move to the downside.  Toward that end, I note that at the market peak this week we saw 496 stocks across the major exchanges register fresh 3-month new highs.  That compares with 751 at the January peak.  Similarly, we registered 182 new 52-week highs among NYSE stocks on Friday, with 60 stocks making new 52-week lows.  That compares with 226 new highs and 7 new lows at the January peak.  At the January peak, we saw the percentage of SPX stocks trading above their 50, 100, and 200-day moving averages at 79%, 84%, and 80%, respectively.  Most recently, those numbers are 65%, 72%, and 76%.  Small cap stocks are trading below their January peak, as are stocks outside the U.S.  In sum, as we've moved to new highs in February, the market has been losing strength relative to January, which is what we'd expect in a cyclical scenario.

To re-emphasize:  all this frames a hypothesis and the kind of unique information I look at in framing hypotheses.  If we get a fresh thrust to the upside this coming week with enhanced breadth and volume, that would clearly violate the hypothesis of a coming cyclical top.  If we see sellers dominating with weak breadth, that would support the hypothesis and could lead to an actual trade idea that I'd need to frame with sound risk/reward.  

This is a nice little example of what I do in my market preparation daily.  You may very well look at different markets in different ways.  That's great.  The idea is to have a framework for thinking about buying and selling and ways of measuring buying and selling to generate hypotheses and ideas that are more than mere subjective perceptions of chart patterns and indicator readings.  In generating ideas, I'm much more interested in understanding what markets *are* doing than in predicting what they will do.  

Oh, by the way, on the chart above, note that the point of control (the price with the greatest volume traded over the month) is 3325.  If we do see a failed upside break vis a vis the February rise, I'd expect that level to be tested, as buyers would become the ones trapped.  That's a different hypothesis...

Further Reading:

Series of Posts on How to Trade 

What I Listen to During Morning Prep

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Knowing Your Limits as a Trader

Here's a big shout out to Tom Canfield for his recent tweet on finding his limits in trading the volatile TSLA stock.  We get so many boastful tweets and self-promotions, it's refreshing to hear from a real trader who is going through a real growth process.

We talk about many trading strengths, but rarely discuss acceptance.  A top athlete in track and field may not be a top basketball player or a top weight lifter.  A great portfolio manager might make a wildly unsuccessful day trader and vice versa.  So much of success is finding what we're good at and making the most of those strengths.  But that presupposes that we can accept who we are and what we're good at--and what we're not.  

Often, we only know what we're good at by pushing our limits and finding out what works and what doesn't.  I know traders who are freakishly good at trading one kind of market and not others.  They only learn that by pushing, failing, and then coming to a reckoning--and an acceptance of the limits of their strengths.

We cannot make the most of who we are if we are always trying to be someone else.  It's great to push our boundaries, but even greater to fail fast and use the experience to double down on what makes us successful.

Further Reading:

Trading and The Path of Repentance

*This* is What Winners Do

I'll keep this relatively short and to the point.

In the previous post, I mentioned the SMB traders who reviewed every day's trades in elaborate detail, not just looking at charts but actually replaying the day.  They truly re-view their trading.  Like professional athletes, they're spending as much time in practice and workouts as in actual performance.  That gives them so many more reps than other traders, so much more material for pattern recognition, that their odds of trading success skyrocket relative to their peers.  They are doing what winners do.

This morning, I reviewed market information for the day and came across an analysis forwarded by SentimenTrader.  What they did is go back in history and create a daily ratio of the performance of growth stocks to value stocks, noting the recent distinct outperformance of growth shares.  They then looked at what that ratio had to say about, not only the direction of stocks overall, but for that ratio of growth to value.  I won't give away their intellectual property, but suffice it to say that they find something very, very few traders I know are even looking at.  That is what winners do.

If you want a good read, check out the practice habits of Michael Jordan during his NBA days.  Jordan was always a good and promising player since his days at UNC, but it was his mode of working that turned him into a superstar.  It was his practice ethic and competitive drive that made him great.  That is what makes winners.

This should be your goal in life:  To find the activities that so capture your interest, your talents, and your passions that you pursue them with more breadth, depth, and effort than the average person.  I look at many traders and they are totally "me too".  They trade the same names and ideas as others; they put in the same effort as others.  Nothing.  Stands.  Out.

C'mon!  Life is too short to be "me too"!  Is that what you want on your gravestone as an epitaph:  "Me too"???  Our challenge is to figure out that intersection of our strengths (what we're good at) and our passions (what is meaningful to us) and leverage those into something that makes us unique, more than mere "me too".  That is what winners do.

Further Reading:

TraderFeed Home Page and Index

Radical Renewal:  Tools and Techniques for Leading a Meaningful Life

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Counterfeit and Genuine Confidence in Trading

Here's an observation I've made regarding developing traders I work with on a regular basis at SMB.  Because I've worked with them from the very start of their trading in most cases, I can clearly see what has led to their success and what hasn't.

The less successful ones start with stated confidence and want to bring what they know to trading.  

The more successful ones start with an awareness of what they don't know and bring an open mind to trading.

The less successful ones are undercapitalized and feel a need to become profitable quickly.

The more successful ones try different markets, time frames, and trading styles, make lots of mistakes, and gradually figure out what they understand and do well.

The less successful ones engage in minimal reviews of their trading and set very broad goals.  They do not keep statistics on their trading to monitor whether their goals are being met.

The more successful ones review their trades daily in great detail, actually re-viewing the trades made and how those could have been done better.  They use statistics on their trading to hold themselves accountable for their goals.

The less successful ones look to psychology to help their trading, as they get frustrated when they don't make money.

The more successful ones use their best trading to help their psychology.

The less successful ones talk about confidence in terms of the "setups" they are trading.

The more successful ones ground their confidence in their learning and trading processes.

The less successful ones develop a counterfeit sense of confidence based on how they have performed recently.

The more successful ones develop genuine confidence based upon the time and effort placed in the learning process.

Perhaps I can provide an example.  One trader sent me his monthly review of his trading.  It was two pages, had no specific reviews of trades, had no detailed statistics on his trading, and finished with a general goal to be more selective in the taking of trades.  Another trader sent a review for the same month.  It ran over 200 pages.  It detailed every trade made, what was done well, and what could have been done better.  The first trader meets with me occasionally.  The second one has been meeting with me every week, focusing on the most recent lessons learned and improvements made.  The first trader is looking to make money.  The second trader is like the flower:  just blooming.

My son Macrae and I have been taking lessons in archery.  It's an interesting sport; one I've never given much thought to.  A big part of success is learning the correct form for each phase of the shooting process and then replicating that form with precision.  There are adjustments to be made when changing distance, changing targets, etc., but the key to success lies in unusual self-control.  Psychology is important to archery performance, particularly in stilling the mind and staying focused on the target.  But psychology cannot substitute for good form and continuous learning and  practice.

So it is in the trading world.

Further Reading:

The Motivations of Successful Traders

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Performance Anxiety: The Most Common Psychological Problem Traders Face

Performance anxiety is common in all fields where performers care about the outcomes of their performance.  Before a big game, baseball, football, and basketball players may experience performance anxiety.  The actor or actress before the play starts; the trader facing a volatile market--all can find that their stress levels get in the way of their performance.  Performance anxiety occurs when we become so focused on the outcomes of our performance that we no longer stay in the natural flow of performing.  It happens to golfers, it happens in the bedroom, and it happens to many traders.

When we learn trading the right way, we minimize performance pressures.  By starting with trading in simulation mode, then building consistency, then trading small, and only taking meaningful risk when we have a track record of consistent success, we give ourselves time to build the confidence that keeps performance anxiety at bay.  When I first began doing talks for groups, I became quite nervous, and that interfered with the effectiveness of my communication.  With gradual and repeated experience and learning what works and doesn't work in my public speaking, I've gotten to the point where talking with people is fun.  Some talks go better than other ones, but I know nothing catastrophic is going to occur.  

This is why losing the right way in trading is so important and why risk management is so important.  Once you trade and trade and see what works and doesn't work and see in your own experience that some trades will work better than others, the process becomes more familiar and less threatening.  If we're experiencing undue performance anxiety, we want to take risk off the table entirely, go back to simulated trading, and just focus on the process of trading well.  Traders I work with often maintain a checklist of their best practices that grounds them in what they do well in generating ideas, managing positions, managing risk, etc.  When we take risk off the table, we can get back to keeping score based on *process* and eventually letting wins and losses take care of themselves.  Gaining confidence in a learned trading process that draws upon our distinctive strengths is a major antidote to performance anxiety.

One of the most effective techniques for reducing performance anxiety is mentally rehearsing scenarios of positions going against us, staying calm and focused with deep breathing, and then imagining how we would handle those situations.  If we engage in that exercise routinely, the scenarios of loss become familiar, and we've trained ourselves to stay centered when they occur.  It's very difficult for something very familiar to be very threatening.

Below are posts and resources that discuss performance anxiety and ways of overcoming it.  Very often, the best approach is to take risk way down, refocus on consistency of process, and then only gradually put risk back on.  Once we can embrace normal, expectable losses as potential learning experiences, they become less threatening.  That allows us to simply enjoy the process of understanding markets and grounding our trading in that understanding.

Further Readings:

Performance anxiety as a trading challenge

Performance anxiety as a cause of discipline lapses

Techniques for overcoming performance anxiety

Turning trading anxiety into growth

Moving from panic to confidence in trading

Using your body to program your mind

How to use exposure methods to overcome performance pressure

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The Toughest Questions Traders Can Ask Themselves

The most recent post on trading trauma and trading addiction received the most hits from readers in quite a while.  Perhaps it's because these topics are relevant to many traders and yet so infrequently discussed.

The toughest questions we can ask ourselves are ones that challenge our most basic assumptions.  Here are questions every trader should be asking periodically to ensure that they are not only doing things right, but doing the right things:

*  Is trading genuinely adding to the well-being of my life?  Is trading providing you with true happiness, fulfillment, energy, and self-esteem?  If trading was your romantic relationship, would you want to stay in that relationship?

*  What am I giving up in life because of the time and energy I commit to trading?  Does trading truly encapsulate your greatest strengths, or is there something else you're meant to be doing with your life:  something that could better leverage who you are and what you're capable of doing?    

*  If I knew that I only had five years to live, would I be spending my time trading?  What *would* be your priorities?  If trading wouldn't be a priority, why?  If you wouldn't spend your time trading if you only had a very limited time on this earth, what does that tell you about how you're living your life today?

As noted in the earlier post, the people who make their living selling education, products, and services to traders and who make their living from the commissions and assets of traders --those people have no vested interest in your asking those questions.  If someone wants you to pay for their services as a guru, or as a trading coach, or as a mentor, or as a customer of trading products, they don't have a lot of upside asking customers, "Are you sure trading is the right thing for you?"

And let's face it.  When we've invested time and effort into trading and not received commensurate personal and financial reward, it's not so easy to contemplate those questions ourselves.

So the questions go unasked.

Here's a different perspective you may not get elsewhere:

You are important.  

The time in your life is important.  

You can do amazing things in your life.  

The goal is not to trade, and the goal is not to make money.  The goal is to have the happiest, most productive, and most purposeful life possible.

There are lots of bright, shiny objects out there that distract us from the meaning and purpose we're meant to fulfill in life.  When we ask the right questions, we ensure that we don't stay so preoccupied with feeding our egos that we ultimately lose our souls.

Further Reading:

The Spirituality of Peak Performance

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Trading Addiction and Trading Trauma: Two Trading Problems Rarely Discussed

One takeaway from the recent Forbes article is that we become better as performers (and as people) as we become free.  That means freedom from destructive habit patterns, and it means freedom from the internal chatter that can control us and divert our will.  What does it mean to plan our trade and then not follow that plan?  What does it mean to engage in the very patterns--chasing prices out of FOMO, failing to take good trades--that we know harm our results?  We do the wrong things because we are not truly free.  We are imprisoned by thoughts, feelings, and action patterns that hijack the will and harm our trading, our relationships, and ultimately our fulfillment.  Psychology and spirituality, at their best, are ways of breaking out of our prisons.

If the usual trading problems place us in prison, there are two overarching problems that can place us in solitary confinement:  trading addiction and traumatic stress.  Trading addiction occurs when we become hooked by the ups and downs of profits and losses, much as a casino player can become hooked on gambling.  Much of what we politely call overtrading is actually addictive trading.  The need for the thrill leads us to place trades when our wise minds know that there is no objective edge present.  I have seen traders so addicted to active trading that they have lost life (and family) savings.

Traumatic stress is familiar to us from accounts of people who come back from war or who undergo brutal attacks or physical/emotional abuse.  Traumatic stress is different from normal anxiety that can show up in performance situations.  The hallmark of traumatic stress is the loss of stability and security and the presence of highly stormy emotions, ranging from frustration and self-blame to fear and panic.  It is not well recognized that failure to manage risk well can create massive losses--and painful trauma.  Once traumatic stress occurs, subsequent trading ends up re-traumatizing the trader, leading to further losses and emotional damage.

If you read accounts of "trading psychology", you'll rarely encounter discussions of trading addiction or traumatic stress.  There is a reason for this.  The answer to both problems is to stop trading.  Before there can be any possible constructive return to financial markets, the addicted or traumatized trader needs to cease trading and work on their addiction and trauma.  If they ever can return to markets, it will be as very different people with very different strategies that provide them with control and consistency.    

Who in the trading world finds a vested interest in telling traders to stop trading and take care of themselves?  Not the vendors of "trading education" and trading seminars.  Not the vendors of trading software and services.  Not the proprietors of trading communities and trading firms.  Not even trading coaches.  Certainly not brokerage firms and publishers of trading materials.  Everyone who sells to the trading public (and professional traders) needs those market participants to keep trading.  There is no upside for them in telling people to back away from markets and heal their wounds, regain control of their lives, and escape the prisons created by their market involvement.

A while back I wrote an article on trading coaches as whores.  Who in the coaching world will give a trader honest feedback that they lack the skills and talents to become a successful trader?  We know from research that the vast, vast majority of people who pursue active trading will not be able to sustain an ongoing living from their efforts.  But who is willing to acknowledge that?  Who is willing to tell traders that active trading can ruin their lives, traumatize them, and leave them (and their families) scarred by addiction?  

The trading coaches, trading educators, online gurus, trading communities, trading software vendors, brokerage houses, publishers, and so many more are actually selling the same product.  They are in the business of selling hope.  There is nothing wrong with hoping, but it's important to acknowledge the damage that can be done by pursuing false hopes.  Successful trading can be a ticket to financial freedom, but many more traders may find in trading their own prisons.

Further Reading:

The Spiritual Side of Trading

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