More Ways Of Finding Edges With Momentum And Value

 

In the recent post, we took at look at short-term breadth strength and how that can help us identify opportunities associated with momentum and value.  Now let's extend that view by exploring breadth strength at longer time horizons.

Using the same database with SPX, what we find is that when the percentage of stocks closing above their 20-day moving averages is in the highest quartile of the sample, the next five days average a gain of +.51%.  When the percentage of stocks closing above their 20-day moving averages is in the lowest quartile of the sample, the next five days average a gain of +.33%.  All other occasions actually average a loss of -.17%.  In other words, in the rising market since 2014, essentially all short-term gains were achieved when the market was broadly strong and broadly weak.  If we look at next 20-day returns, we find out that when stocks were most broadly strong, returns averaged +1.76%.  When stocks were most broadly weak, returns averaged +.98%.  All other occasions averaged a gain of only +.17%.  

Now let's zoom out to the percentage of stocks closing above their 100-day moving averages.  When we have had the greatest longer-term breadth strength, the next 20 days have averaged a whopping gain of +2.36%.  When we have had the lowest level of breadth strength, the market has actually averaged a loss of -.33%.  In other words, breadth strength at the longer time frame has brought considerable momentum, but low breadth strength has also shown a level of downside momentum--not value!

We're starting to see that edges are complex:  the result of interplays among short, medium, and longer timeframes.  That cannot be captured by a single chart pattern or indicator reading.

But let's take another look:  We will divide the sample into quartiles based upon VIX readings.  When VIX has been in its highest quartile, the next 20 days in SPX have averaged a large gain of +2.40%.  The remainder of the sample has averaged a gain of only +.28%.  So here we see a large value effect (weak and volatile markets leading to reversals) and relatively modest evidence of momentum.  When we look at edges in the market, breadth strength matters but may show very different forward returns in low and high volatility regimes.

What I have found is that it's when short-term patterns of supply and demand, such as the ones described here and here and here, line up with the multi-day patterns of breadth strength and volatility that the best trading opportunities occur.  There is a huge edge in clearly knowing where your edge lies.

Added 9/1/20:

Notice how we closed 8/31 with fewer than 50% of SPX stocks above their 3- and 5-day moving averages, according to the Index Indicators site.  That triggered the breadth signal from this post.  We can see from the chart below that we were getting a good amount of volume hitting bids in the ES futures, taking us to a short-term oversold point at a higher price low.  That is how price and volume behavior can confirm a signal from breadth.  Note how we have since bounced in premarket trading.

Trading psychology cannot substitute for understanding the psychology of the market you're trading.  Per Ms. Parker, when you hear someone say that your mindset is your edge, don't toss their advice aside lightly.  Hurl it with great force.  

The Three Minute Trading Coach Video Series

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Actively Trading Momentum and Value In The Stock Market

 

This post will begin a short series on finding edges in the broad stock market related to momentum (directional persistence) and value (directional reversal).  A good place to start would be to review the recent post on how to trade a trending market.  Notice how the signal described in that post captured the most recent upside opportunity quite well.  Not all movement in the market is meaningful and it's easy to get so caught up in short-term ups and downs that we end up trading randomness.  If we can backtest patterns of momentum and value, we can begin to ground our trading is what is meaningful.

So let's begin simply.  We're interested in the percentage of stocks in the SPX universe that close each day above their respective five-day moving averages.  (Data can be found via the Index Indicators site).  That provides an indication of what I call breadth strength:  the degree to which there is broad strength or weakness in the market.

My database goes back to August of 2014, so let's see what happens in the market after five days of broad strength and weakness.  To accomplish that, I first divide the dataset into quartiles and examine average forward returns.  When we have seen the broadest strength in the market (top quartile of readings above five-day moving averages), the next twenty days in the market have averaged a gain of +1.31%.  When we have seen the weakest readings on our indicator, the market has averaged a 20-day gain of +.97%.  All other occasions in the market have averaged a 20-day return of only +.48%.  

In other words, we have achieved superior returns by buying the market when we've had unusually strong breadth and when we've had unusually weak breadth.  The unusually strong breadth has provided upside momentum; the unusually weak breadth has provided value.  During the overall upward market from 2014 to present, that has been a way of capturing a good chunk of returns in the market trend, as the recent post observed.  This simple indicator has done a pretty good job of tracking the psychology of the market.

Are there ways of improving on this indicator and refining our ability to trade value and momentum?  That is what we'll explore in the next post.

Using Breadth, Strength, and Momentum to Capture Market Cycles

What Does A Professional Trader Work On In His Trading?

 

I jumped at the opportunity to participate in the upcoming Festival of Learning hosted by RealVision.  (Here is where you can sign up for the sessions that run from September 2nd - 4th).  My eagerness came from the chance to speak with Mark Ritchie, Jr., an experienced trader and fund manager.  I wanted to hear his take on trading psychology and the challenges he faces running his own fund.

So what was one of the very first things that Mark discussed in our pre-recorded session?  Was it managing his losses or staying in emotional control of his trading?  No.  It was letting his profits run.  He wisely pointed out that a trader can be great at limiting losses and getting stopped out, but still not make the most of his or her trades.

Mark questioned the wisdom of the old saying that you can't go broke taking a profit.  Because much of a trader's total return comes from a handful of top opportunities, taking profits prematurely can cap success.  This is why, in my work with traders at SMB, we focus on monthly statistics and pay particular attention to whether the average size of winning trades is greater than the average size of losers.  Many times that ratio needs improvement, not because the trader is letting losing positions go or adding to them, but because they stop out of winners before the positions have hit their targets.

Here's a big psychological point:

The traits and strengths that we need to limit our losses are different from the ones we need to maximize our gains.  We need to consider these as separate skill sets and work on them independently.

Limiting our losses is all about prudence and conscientiousness:  the ability to be careful.

Maximizing our gains is all about willpower: the ability to sustain a goal in the face of uncertainty. 

Mark's insight was that, for experienced traders, the prudence comes naturally.  If it didn't, they would never get to the point of being experienced!  But tolerating uncertainty is different.  When we watch our positions tick by tick, it's easy to see something concerning and use it as an excuse to bail.

There's an old saying:  failure to plan is tantamount to planning to fail.  If tangible targets for our positions aren't firmly set in our minds and mentally rehearsed, we will have no goals to focus on to get us through the uncertainty of price paths.  The real problem is not just getting out of trades too early.  The problem is failing to set vivid goals for our trades that energize us and feed our willpower.  Come to think of it, that's a problem many of us face in life as well as markets!

RealVision Festival of Learning

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A Different Look At The Market's Weak Breadth

 

Above, with big kudos to the excellent Index Indicators site, we can see a chart of the SPX (black line) over the past six months.  Overlaid in the green line is the percentage of SPX stocks trading above their 20-day moving averages.  Note how this percentage has tailed off in recent days, falling slightly below 50%.  It is one further indication of weak breadth in the current stock market.  (Please check out the recent Forbes article for a detailed discussion of current market breadth and what that has meant for stocks over the past 20 years).  Indeed, I went back to my database which starts in 2006 and examined all market occasions in which SPX was up over 5% in a month, but the majority of its stocks were trading below their 20-day moving averages.  Surprisingly, there was only one occasion, on July 25, 2011.  That preceded a double-digit percentage decline in stocks over the next 10, 20, and 50 days.

When I divided the sample of strong monthly returns in quartiles based upon the percentage of SPX stocks trading above their 20-day moving averages, I found that the quartile with the weakest breadth returned an average of -.77% over the next 50 trading sessions.  All other occasions averaged a 50-day return of +3.05%.  The results suggest that, when we have strong upside momentum, the rising tide lifts all boats and forward returns are favorable.  When the tide is not lifting all boats, there is reason for caution.

The current market is interesting because there are differences among stock sectors regarding relative strength, with technology (XLK), consumer discretionary (XLY), and communication services (XLC) sectors quite strong in the relative performance ratings of StockCharts and the energy (XLE), financial (XLF), utilities (XLU), and real estate (XLRE) sectors notably weak.  Even within each of these sectors, there are relatively strong and weak industries.  For example, in the weak energy sector, renewable energy equipment shares are very strong.  In the strong technology sector, telecommunications equipment companies are weak.  

As we move forward, shifts in the market's advance-decline numbers will tell us a great deal as to whether the rally can broaden out and sustain itself or if it falls into a topping mode with continued industry and sector weakness.  I note that, even with the recent market strength, we're seeing subpar performance from banking stocks, real estate REITs, integrated oil and gas shares, airlines, and marine transportation companies.  If the economy is to turn around, these areas should display growing strength.  For that reason, they are among the parts of the market on my radar.

Further Reading:  Runaway Bull Market and Weak Breadth

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What We Do Shapes How We Feel

 

The Rabbi makes a profound point:  Our joy supports our thinking.  When we are downhearted, can we really focus on opportunity?  When we are joyful, will we really become wrapped up in short-term P/L and missed trades?  We tend to think that trading well will make us happy.  But what if happiness helps us trade well?

A fascinating study finds that even just simulating the act of smiling leads us to feel happier.  What our muscles do, our minds process.  "When your muscles say you're happy, you're more likely to see the world around you in a positive way," the study author reports.  There are houses of worship where prayer is interwoven with dancing, singing, and clapping of hands.  We see the same thing during weddings.  Could it be that the physical acts of celebration help us internalize a celebratory frame of mind?

We know from psychological research that positive emotional experience helps us process information more broadly and more effectively.  Research also finds that positive experience also helps us be more productive and is associated with enhanced physical health.  What if active expressions of joy, fulfillment, love, and energy actually contribute to our positivity?

This has important implications for trading psychology.  What we express with our bodies may shape the quality of our mindsets and experience.  Think of what you're expressing during your trading, during your meetings with peers, and during your reviews.  Perhaps you're not expressing very much at all in your body language, your tone of voice, etc.  How might such a lack of expression impact your experience?  Perhaps it's not a coincidence that the interns I see learning so well at SMB are so physically expressive in their enthusiasm.

What our bodies do may shape what we experience--and that can either strengthen our common sense or disrupt it.  Cognitive psychology emphasizes that our viewing impacts our doing:  how we process events shapes how we experience and respond to them.  But perhaps it's equally true that our doing shapes our viewing:  what our bodies do shapes our feelings and thoughts.  Could a restricted range of physical activity and expression create limitations in our states of awareness?  

Think about team meetings in most workplaces.  Think about the environment on most trading floors.  Think about how much energy, joy, and satisfaction you give visible expression to during your trading.  Too often, our image of behavior that is "professional" does not permit such expressions.  Could it be, that in our pursuit of the professional, we never find the common sense that is strengthened by joy?

Further Reading:  Radical Renewal

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How You Learn Shapes How You'll Earn

 

There's a trader I'm working with who I believe will be a star in the not-too-distant future.  He reviews his trading extensively each day and week, keeps a wealth of statistics about his trading, and often sends his reviews to me and others for suggestions. What I find unique about this trader is that his sole focus has been on improving the consistency of his trading, not the P/L.  He is like a Toyota manufacturing plant, closely examining quality in every part of the process and then pouncing on opportunities for quality improvement.  He derives pleasure from getting better and better and that drives increases in his sizing and risk-taking.

I recently did a video on how to avoid trading on tilt.  It's a big question for so many traders: How do we make sure that emotional disruptions don't color our decision-making and hijack our trading?  It was only after making the video that I realized that I had never seen this trader on tilt.  Yes, he had losing days, and in the past he had some slumps.  But I never saw emotional, reactive trading.  That's when it hit me:  The entire way he had set up his learning process has kept him level-headed.  He is always looking for what he could do better, so missing trades and placing losing trades aren't threats or frustrations.  They are simply fuel for quality improvement.  

When we focus on learning and quality of trading, we take P/L out of the equation, which helps us take our egos out of trading.  Some journals I read are like, "I did this and then I did that. I lost money and next time I need to take my time." It's all about them!  The trader I'm working with spends much more time examining how his stocks moved and how he could better recognize that movement.  He's like a diamond cutter looking at his work, finding small flaws, and then working on reducing those.  It's a focused, intentional process, without much drama at all.

Little wonder, then, that his trading has this same quality.  How we learn shapes how we earn.  Our learning processes shape our mindsets and our priorities.  What we do and how we do it becomes what we internalize.  Without a disciplined, focused learning process, can we truly expect to trade in disciplined, focused ways?

The Three Minute Trading Coach Video Series

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Trading A Trending Market

 

I had an interesting conversation with a frustrated trader recently.  He lamented that it is impossible, as an active trader, to trade a market that "goes up every day".  Out of this frustration, he had broken rules, placed trades outside his "playbook", and lost money.

It's a great example of how a negative trading psychology can create poor trading, but also follows from poor market understanding.

With a big shoutout to the Index Indicators site, above we see a chart of the SPX 500 (black line) over the past three months.  The green line represents the percentage of stocks in the index that close above their three-day moving averages.

Now here's the important principle:  In any market, there is always a trend component and a cyclic component.  In other words, we can best describe any time series as a linear, directional function plus a dominant cycle.  It is the ways in which the linear (trend) component combines with the cyclical component that creates the charts we see.

In a market with a strong trend, the linear component will dominate and corrections (from the overlying cycles) will be short-lived.  In a range market, the cyclical component will dominate and there will be only a small directional aspect to movement.  If we can estimate cycle frequency by locating trends and ranges within longer time-frame cycles (cycle amplitude is in part a function of volatility), then we can use cycle extremes to more actively trade directional movement.  

The chart above illustrates this concept.  We have had good buying opportunities when the percentage of stocks trading above their three-day moving averages has dipped below 50.  In an uptrend, such pull backs occur at successively higher price lows.  By waiting for the cycle trough, we can participate in the trend with good risk/reward.

So, for instance, buying those 11 occasions in the past three months when fewer than 50% of SPX stocks were above their respective short-term moving averages led to a a 91% win rate with an average holding time of a little more than two days.  Such an active trading strategy did not capture all the gains of buy-and-hold, but the active trader participated in half of those gains while keeping the maximum downside to under half a percent.

The important point here is that many trading psychology problems come from fighting trends.  If we perceive a trend, a promising strategy for active traders is to buy dips at successively higher lows (or sell bounces at successively lower highs).  Trending markets are impossible to trade only if you have no tools for identifying the cycles within trends.

Trading Psychology Resources

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Avoiding Burnout: Every Goal Needs A Vision

 

One mistake traders make is reviewing their trading and stating an intention to do things better next time, but then never actually turning that review into specific goals and plans that would guide the improvement process.  This is very common when traders begin keeping a journal.  

A second mistake traders make is setting very specific goals--and often multiple goals--but never connecting those goals to a broader vision that provides energy and inspiration.  Without the vision, work on goals easily becomes drudgery:  an endless task list.  Perhaps that is why I'm hearing from so many burned out traders during this COVID period.  Goals can push and guide our efforts, but it's the pull that comes from vision that truly moves us forward.

In the previous blog post, we looked at handling adversity as a key element in trading success.  It is when we are supremely challenged that we dig deep and access fresh sources of energy.  Many times, this rising to a challenge occurs in a team context, where members of the team draw from each other in a positive role modeling.  When we have an individual or shared vision, we can tap into the meaning and significance of that ideal to forge ahead with our goals even in the face of setback.  

The vision may need to be something larger--more meaningful to you--than P/L alone.  It may be a vision of the kind of person you wish to become; the kind of business you ultimately want to build; the ways in which you want to make use of the returns from your trading.  Perhaps trading is a means to a vision that you pursue in the non-market hours of your life.

In any of these cases, what moves us forward is a purpose that is larger than us.  Yes, it helps to work on our execution, our idea generation, our risk management, etc.  But we will pour ourselves into those efforts if they speak to what is important to us in life.  To use an analogy, no amount of working on problems will restore love and commitment to a troubled relationship.  A fulfilling relationship is so much more than something we work on.  We have a relationship with markets as well.  Working on trading is necessary, but it can't be all that we do.  We also need to nurture the positives to keep the vision alive.

Trading Psychology Resources

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How Do You Handle Adversity?

 

It is said that adversity doesn't build character; it reveals it.  When the sh*t hits the fan and everything is going against us, we learn a lot about ourselves.  

When power went down in our region and we were left without telephone, internet, or cable service, I wondered how I would work with traders.  Everyone was working from home, which meant that my only ways of connecting with them had been taken away.  A fleeting thought went through my mind that I could cancel all my meetings.  As soon as the thought entered, I rejected it.  I was not going to give up.  I drove my car to various towns in the area until I found a spot with a solid internet connection.  I kept my phone charged with the car battery and downloaded an app that allowed me to do face-to-face meetings with minimal bandwidth demands.  Instead of working from home, I discovered work-from-car!

Similarly, when everything went down in the recent storm, I received encouragement from Margie and together we figured out how to use a portable generator and connect it to major portions of our house.  I have minimal mechanical skills--I actually tested as learning disabled with respect to performance tasks as a child--but I was not going to be a victim of the storm, and I was not going to let Margie down.  

In both cases, adversity brought out a latent strength, a quality I have, but do not always draw upon:  persistence in the face of challenge.  I refuse to let circumstances control me.  That refusal gives energy and leads to creative solutions I would have not pursued otherwise.

Recently, I've noticed significant differences in how traders handle adversity, whether it's a losing trade, a missed opportunity, a drawdown, etc.  The really good traders refuse to let the setback control them.  They view and re-view their trading and they make sure they drill the learning lessons in their head.  They miss an entry, but they don't give up on the idea.  They don't simply place a revenge trade; they become even more focused as a result of the missed trade--and that allows them to find another way to participate.

That's really it:  adversity can disrupt us, or it can focus us.  It can lead us to withdraw and seek comfort, or it can push us to dig deep and draw upon our latent strengths.  The concept of sisu suggests that each of us possesses a second wind of energy that we can access during periods of challenge.  Might it be the case that the winners in life's race are those with the greatest capacity to draw upon that second wind?  Perhaps by continually placing ourselves in challenging circumstances, we can cultivate the sisu--the access to hidden strengths--needed to perform at our best when we most need to perform.

Further Reading:

The Profound Psychological Benefits of a Purposeful Life

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Why Virtual Internships Are The Future Of Trader Education

In a recent Forbes article and in this Bloomberg interview, I explained how the current work-from-home phenomenon is likely to reshape workplaces in an ongoing way.  The same is happening in the world of education, where work-from-home has become study-from-home, leading to an explosion of online education that creates unique opportunities for students.  Consider the following:

*  I recently delivered a talk to students enrolled in the Greenwood Project, which is introducing women and minority students to the world of finance.  This week I will be conducting mock job interviews with Greenwood students, helping prepare them for the workplace.  In the pre-COVID world, there is no way I would have enjoyed this opportunity.  Now, the Greenwood students benefit from many contacts in the industry who can help them navigate the career world beyond internship.  The net result will be a highly significant broadening of the hiring base for financial firms.

*  In my work with SMB Capital, I am for the first time able to offer coaching and education to college student interns interested in finance and the trading business.  Because the internship is a virtual one, I can read the performance reviews of each intern and help them with their learning in real time.  Prior to that, I only met with interns if they were hired by hedge funds and even then we weren't connected on a regular basis.  The virtual medium has allowed college students to sit in on trading teams led by experienced, expert traders and participate in ongoing instruction, mentoring, and coaching.  The old model of trader education with unconnected webinars, conferences, and talks given by traders pales in comparison:  the virtual internship is a complete disruption of the education business not only for trading firms, but also for banks.

*  I've recently been working with Connect-123, a provider of virtual internships for college students seeking work and learning experiences in unique cultures.  A student working from home connects with organizations in such places as Cape Town, South Africa; Barcelona, Spain; and Dublin, Ireland and works with teams in those locations to complete a project.  The experience provides an amazingly affordable and engaging way of gaining the career competencies emphasized by organizations like the National Association of Colleges and Employers (NACE), including teamwork, leadership, and intercultural communication.  The online classes that I teach help prepare students for their work experience and then support them in bringing their updated skills to the new workplace.       

What makes these virtual internships work is that they are much more real than the usual classroom.  They allow for a learning-by-doing, with real-time instruction and support.  Amazingly, it's now possible to learn globally and learn directly from and with experts.  Education, including in the trading world, will never be the same.

Further Reading:

Positive Career Development:  Bringing Positive Psychology to the Internship

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