Sunday, January 03, 2021

What You Trade Is As Important As How You Trade


Happy 2021 to colleagues and readers!

In this new year, I'll be doing something different with my blog posts and making efforts to link to the work of trading educators and mentors whose work I enjoy and respect.  The goal is to highlight valuable lessons for traders and also to introduce ideas and contributors readers might not be familiar with.

This week's lesson is "what you trade is as important as how you trade".

Here's a straightforward example from my recent coaching experience:

A trader focused day to day on "catalyst" events that would provide directional opportunity.  For instance, he might trade breaking news from a central bank meeting, a data release, or a news headline.  He worked diligently on refining his entries and exits in these trades, hoping to generate quick profits that supplemented his longer-term, thematic macro trades.  Indeed, this focus on how he traded catalysts improved the Sharpe ratio of those trades over time.

During one of our meetings, he briefly noted some frustration that some of the catalyst trades went on to become great trending moves, but only after he had exited his positions.  So, we investigated his recent successful trades and examined which ones went on to become larger opportunities.  What we found was that it wasn't just the move in a single trading instrument in response to the catalyst that made a difference; it was the move across multiple, related instruments.  

A simple example would be a stock that moves higher on an earnings beat.  If the move is idiosyncratic--limited to that stock--it tended to make for a good short-term trading opportunity.  If the relevant sector moved higher on the earnings beat, this was a sign that the news signaled a broader opportunity for an entire industry and would be more likely to be picked up by equity investors.  On those occasions, it made sense to keep a portion of the position on, as long/short investors and trend followers were likely to join the bandwagon.

Another example would be an economic release that leads to a move lower in the U.S. dollar.  If the dollar moves lower across multiple crosses, this might have very different implications than a dollar move that occurs mostly against a single currency.  If the dollar move is accompanied by correlated moves across the interest rate curve, this, too, might suggest that the macro world is interpreting the news in a way that could lead to trending behavior.

The trader I met with thus focused his energy on *what* he traded, not just on the mechanics of entries and exits.  Prioritizing opportunities that displayed a breadth of response to a catalyst, he became more selective and achieved a higher quality of returns that included both short-term opportunistic profits and the profits from the holding of longer positions.

In 2020, if you were trading stocks, the sectors that you focused on made all the difference in your returns.  The growth stocks and IPOs emphasized by Kathy Donnelly, Eve Boboch, and colleagues, for example, have performed phenomenally versus more value-oriented shares.  Once focused on the area of opportunity--the *what* to trade--it then makes sense to refine the *how* to trade.  Indeed, that was the focus of Kathy's recent podcast with Richard Moglen:  how to decide upon exits in these large opportunities.  But as Kathy relates to Richard, the initial focus of their efforts was Eve's focus on finding the next Google--figuring out *what* to be trading.

A different example of focusing on what to trade came in my own trading, as I reviewed the work of Brian Shannon at Alphatrends.  He has pioneered the application of "anchored VWAP" in trading, including the use of multiple volume-weighted average price lines anchored by key market events.  What I found, based on Brian's work, is that when anchored VWAPs at different time frames converge--and when that convergence is occurring across multiple stocks in a sector--that often provided potential breakout opportunities that had real investment implications.  Those breakouts were ones that investors would be more likely to hop on, providing the longer-term potential.  Here the *what* to trade was defined by the intersection of technical criteria and the breadth of the market opportunity.

Finally, I have noted in the past that the unusual success of many traders at SMB Capital can be attributed to a focus on what they trade and not simply on their work on how to trade the opportunities.  An important tool in this regard is "relative volume".  When a stock displays unusually high volume relative to its past, that's an indication it is "in play" and drawing unusual trader and investor interest.  Because volume correlates highly with volatility, such stocks are more likely to display meaningful moves for short-term traders.  Interestingly, many of the best opportunities are found among smaller cap stocks that don't have a large institutional or algorithmic following.  It is easier to read the tape with those stocks, allowing for better identification of when buyers or sellers dominate.  The same trading techniques applied to widely traded vehicles, such as stock index ETFs, would be far less profitable.

Focusing on what to trade means becoming more selective in our trade selection, prioritizing the quality rather than quantity of opportunities.  As for any successful entrepreneur or oil driller, where to seek opportunity makes all the difference.  You can have the greatest drilling equipment in the world, but if you're looking in the wrong spots, all you'll get are dry holes.

Further Resources:

The Three Minute Trading Coach - 30+ short videos to help traders coach themselves

Forbes Articles - A large archive of articles on methods for improving performance

Trading Psychology 2.0 - Book outlining how we can find our best practices and turn those into repeatable processes