Monday, June 27, 2022

Three Causes of Trading Stress--And What to Do About Them

Indeed, being stressed is no treat!  Stress typically occurs when we perceive threat.  That places our bodies in the classic flight-or-fight response, mobilizing for coping with the threat.  That mobilization draws blood flow away from our brain's frontal cortex, leaving us least grounded in our center of planning and reasoning just when we most need our rationality.  This becomes a particular problem when stress turns into distress:  anger, frustration, anxiety, etc.  As I emphasized in an earlier post, our first response to stress should be to identify where it is coming from.  In general, there are three sources of trading stress:

1)  Markets have changed, no longer behaving in ways that match our expectations.  In such an event, our stress represents information.  Just as we might feel uncomfortable if we should walk from a safe place to a high crime area, our stress in the new market environment alerts us to potential danger.  The proper response to this stress is to pull back from trading, reassess our environment, and revise our plans.  We need to adapt to the new environment.  The best trades come to us; that requires an open, focused mind.  The best trade ideas are of limited value if we trade them in a distracted mind state.

2)  Our stress is self-generated, reflecting pressure we're putting on ourselves.  It is easy to be our own worst critics.  When our self-talk focuses on everything we've done wrong or should have done differently, that negativity creates anger, frustration, and discouragement.  Perfectionism is a great example of such negative self-talk:  good is no longer good enough.  Cognitive techniques can be extremely effective in changing our self-talk, as described in The Daily Trading Coach; see also this series of three articles.           

3)  Our risk exposure exceeds our psychological tolerance.  Many times traders feel a need to make money and convince themselves that a huge opportunity is at hand.  They oversize their positions, creating volatility of P/L.  When the market itself becomes more volatile, the moves in the trading account can be difficult to tolerate.  The perception of threat that creates the stress is a function of the risk being taken.  Each of us has a different tolerance level for risk; the key is trading with a sizing that is not emotionally disruptive.  To be sure, we can have the opposite problem and not take enough risk in our trading.  That creates a different kind of frustration and distraction.  Good risk management is essential to good self-management.     

The most important point is that stress can impact our trading for many reasons.  By clearly identifying the source of our stress, we can best figure out how to move forward constructively.  A surgeon would not want to be stressed out during a procedure; peak performance requires peak focus.

Further Reading:


Sunday, June 19, 2022

Finding Success By Diversifying Your Trading

A lot of trading wisdom repeated by traders is surprisingly unintelligent.  A good example is the mantra that it is important to "have a process" for your trading and follow that process religiously.  Sounds great--until markets change and the process that worked in one kind of market no longer works.  If a business repeated a process endlessly, it would never adapt to changes in consumer tastes, new opportunities, etc.  Similarly, a singular focus on "discipline" is shorthand for a failure to innovate.

Which brings us to yet another piece of common wisdom that masquerades as wisdom:  Be patient and only put on your very best trade ideas.  Sounds great!  Don't overtrade and wait for the really good "A+" opportunities.

Not so.

In the most recent post, I outlined my approach to trading, highlighting finding opportunities in which detecting market cycles allows for good risk/reward entries in established trends.  What is interesting about this approach is that it applies across a very wide range of time frames.  Thus, one could look at long-term data and trade dominant cycles within broad trends, or one could implement the approach intraday.  As a rule, variability of price action increases as time frames increase, so it's unlikely that one would obtain the same risk-adjusted returns trading long-term vs. intraday.  By the logic of the idea of "be patient and only put on your very best trade ideas", we should only trade the time frame that yields the best results.

The problem with that view is that opportunities differ across time frames, as well as across instruments.  While it could make sense to trade a short-term pattern from the long side, this might be a mere blip for a good longer-term short trade.  When we trade multiple patterns that are relatively uncorrelated (or perhaps even negatively correlated), we as traders achieve the diversification normally associated with investing.

We can think of it this way:  an investor diversifies holdings at a given point in time.  The investor might hold in a portfolio relatively uncorrelated positions in currencies, rates, stocks, etc.  That diversification allows trades with a decent Sharpe ration to create a portfolio with a truly superior Sharpe.  If you put enough different edges together in a portfolio, the portfolio will show relatively smooth positive returns, because some ideas are always working when others aren't.  That's the beauty of diversification.

The active trader tends to participate in fewer opportunities at any given point in time, but over time will trade multiple cycles and trends, some shorter-term, some longer-term, some in one instrument, some in another.  Note:  A flexible trader might put on multiple long and short trades during the day, achieving over time what the investor structures all at once:  diversification!  

The successful active trader will have multiple, promising patterns ("setups") to trade, creating multiple, independent edges.  That is the beauty of Mike Bellafiore's idea of "playbooking".  Like a football or basketball team, the trader practices many different "plays" and thus can adapt to any environment.  Can you imagine a basketball team consisting of players that won't take shots because they don't have the wide-open look at the basket?  Any team--and any trader--is competitive only if they can find multiple ways to win.

Sitting passively and not trading until the perfect trade presents itself is not discipline; it's the essence of being a one-trick pony.  And when the market changes, the one-trick pony becomes a lame horse.  Many different edges of different quality and different instruments and different time frames creates what we might call a "trader's portfolio".  It's a lot harder to lose when we have many ways to win.  

Good traders have an edge.  Great ones constantly find new ones.


Further Resources:

The Daily Trading Coach - Trading psychology self-help methods

The Three Minute Trading Coach - Short videos on trading psychology

Sunday, June 12, 2022

A Framework for Trading and Trading Psychology

If you were to listen into the conversation of a basketball coach with a player, you would hear quite a bit about how to play the game.  The coach might talk about getting back on defense or working harder to get position on rebounds or taking the high percentage shot, but the conversation would be about playing better.  Whatever needed to be addressed in terms of psychology would be embedded within the coaching regarding the playing.  

For example, if the player is not taking the high percentage shot at the top of the key (a failing for which I vividly recall being taken to task), the coach will address the psychology by making it abundantly clear that he believes in you and that you will never be blamed for missing a high percentage shot.  The coach might also include a ridiculous number of top of the key jumpers in the next round of shooting practice.  Such coaching *very* much addresses psychology, but in the context of actual playing.

Oddly, trading psychology is rarely approached in such a fashion.  I find it refreshing (and unfortunately rare) to hear a trading coach talk about actual trading.  It is as if the game inside the trader's head is completely separate from the game of trading and somehow, magically, the two are supposed to converge.  I can't think of any other performance field where psychology is so completely decontextualized.

In coming weeks, I will be returning to regular trading and, yes, I will be reviewing my performance and coaching myself.  You can be sure that I will not be exhorting myself to perform positive affirmations; nor will I be telling myself--in generic fashion--to follow my process and trade with discipline.  I will review each trade like a basketball coach reviews game film with a team.  In so doing, I'll address my psychology within the context of what was done well and what needs improvement.  That is what deliberate practice is all about.

I look forward to sharing what I'm learning, in markets and in psychology!

So let's start with trading.

My framework for trading is to break the market down into three components:

*  Trend
*  Longer-term Cycles
*  Shorter-term Cycles

Trades are placed based upon the assumption that the trend and cyclical components that characterize the most recent market action will continue into the immediate future.  That assumption of what is called stationarity is based upon an assessment of the stability of market participation from one time period to the next.  It is for that reason that I trade at certain times (which, historically, tend to be stationary/uniform) and avoid trading at other times.

The charts of market action that I track are based on events, not time.  When we look at bars on a chart that are denominated by volume, trades, ticks, etc., we create more stationary data series.  That enables us to find more uniform cyclical behavior within markets.

Trends and cycles are two primary dimensions of market behavior.  A third dimension is rotation.  Most markets display a rotational component where certain sectors and industries within the market are relatively strong; others relatively weak.  Trend determines the direction of the trade; cycles determine when to trade.  Rotation is crucial in identifying what to trade.  A significant portion of overall profitability comes from trading the right instruments.  

Note that trades in a very strong rotational market can be structured in relative terms--long the strongest market segments, short the weakest--to create trend trades.  There are also situations in which volatility is priced cheaply in a market that has the potential for a meaningful directional move.  Structuring the trade idea with options can provide particularly favorable reward relative to risk.  Trade structuring is a fourth dimension of trading.  A significant portion of profitability comes from optimal structuring of a market idea.     

At the end of the day, I am looking to buy troughs of cycles in rising markets and sell peaks of cycles in falling markets.  An important way I identify those potential troughs and peaks is by determining regions of market activity where bears have been dominant and cannot push the market lower and where bulls have been dominant and can no longer lift the market.

In posts later this summer, I will illustrate my trading--and my trading psychology.  The focus in these posts will be the integration of psychology with the actual trading.  

Key lesson:  We develop psychologically by doing things differently.  There is no meaningful psychological development apart from doing.

Further Reading: