Creativity in Analyzing Market Information

 

In a recent video shared by SMB Capital, I discuss why creativity is necessary for trading success.  Quite simply, in order to achieve unique returns, we have to be able to perceive and act upon unique opportunity.  What we see in markets is a function of where we look.  If we're drilling for oil and look in the same places as everyone else, we'll come up with a lot of dry holes.  Half the battle is knowing where to look for the opportunities that others are missing.  

An important topic in the Trading Psychology 2.0 book is how to develop our creativity by asking questions that others don't ask and studying information that others don't gather.  Here's a nice example of creative processing from my trading many years ago.  My point in that article was that "creativity is the new discipline".  It's not enough to find an edge and stick to it in a disciplined manner.  Now the discipline has to extend to finding fresh edges.

Here's an example of a creative edge emerging from unique data sets.  For a number of years, I have tracked, each day, the number of stocks across all indexes that make fresh one-month new highs and fresh one-month new lows.  Normally, we look at the data reported by the NYSE regarding 52-week new highs and lows.  I have found value in the shorter-term measures.  Over the past three years, all of the market's gains (SPY) over a next 10-day basis can be attributed to low levels in the monthly new highs.  In other words, it's the relative absence of new highs that predicts positive returns over the next 20 days.  Similarly, a relative absence of new monthly lows is significantly associated with positive returns over the next ten trading days.  What is meaningful, interestingly, is the absence of new highs and new lows.  I would have never anticipated this had I not collected and investigated the data set.

(A good exercise is to develop an explanation for why this edge exists and how you might use the underlying logic to create edges at other time frames or in other markets.  That's how the creative process works).

Here's another unique finding over that same period.  Essentially all the market's (SPY) upside on a next 3-5 day basis has occurred when few stocks close above their upper Bollinger Bands.  Similarly, we see superior returns over a next five-day basis when few stocks close below their lower Bollinger Bands.  

In short, there is information in the absence of strength and weakness.

When you look at new and different data, you open the door to seeing new and different patterns in markets.  And that means your drilling is more likely to strike oil.

Further Reading:

How Rare It Actually Is For Daytraders to Consistently Make Money

What is the Purpose of Your Trading--And Why That's Important

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The Key to a Successful Trading Psychology

 

In recent posts, I have shared my framework for thinking about trading and trading psychology.  I've also explained a few core concepts central to this approach, including how active traders can diversify their risk-taking; how to deal with stress in trading; and why volume is key to understanding trading opportunity.  In this post, I will explain the single most important psychological factor in active trading and why it is crucial to performance:  open-mindedness.

Pattern recognition is the core cognitive skill involved in active trading.  One mistake many beginning traders make is that they equate patterns in markets with chart patterns.  For the rational, evidence-based trader, patterns are only meaningful if they have explanatory value.  

When trading short time frames, the patterns in markets that are meaningful are ones that track actual supply and demand among market participants.  From the sequencing of trades in a market, we can observe increasing or decreasing volume and whether the volume has a directional bias.  Across many trades, we can detect trends and cycles.  When there is relatively stable participation in markets, we can expect the patterns of trending and cycling that we've observed in the recent past to continue in the immediate future.  That sets up potential opportunity.

One of the challenges of financial markets is their complexity.  Patterns show up across differing time frames, with trends and cycles nested within one another.  Thus, at one time frame, we may observe a trend, but at a longer time frame we can see that this trend is simply a directional move within a larger cycle.  A true understanding of market patterns requires the ability to place price behavior in proper context.  Successful pattern recognition is not merely seeing a trend or cycle on one time frame; it is the understanding of price behavior across multiple time frames.

In practice, that means our tracking of markets needs to be dynamic, not static.  We need to be tracking what is happening across shorter, medium, and longer time frames in order to detect the opportunity in their alignment.  Meaningful market patterns do not "set up" at any single period, but rather derive their meaning in how they are nested within one another.  I recently noticed the ES market cycling on a higher time frame (using charts where each bar represents 20,000 contracts traded) and making a clear higher oversold low on a shorter time frame (each bar was 5000 contracts traded).  That led to a profitable trade buying the oversold low and holding until we tested the high of the longer-term range.

At other times, those kinds of patterns will set up in the nesting of much longer time frames and even shorter ones.  Only if I am dynamically scanning the market across multiple time horizons can I begin to detect how the longer-term and shorter-term movement are meaningfully related.  During that dynamic scanning, I am not looking for trades and I am not at all focused on what I think the market will do or should do.  Rather, I am watching across the time horizons with a completely open mind, much as I (as a psychologist) might start a first meeting with person by listening, listening, listening.  Eventually, if I observe and listen long enough, a pattern--something meaningful--will jump out at me.

This is why maintaining an open mind is the key to a successful trading psychology.  Great trade ideas can't come to us if we are not open to them.  Pattern recognition, whether in a therapy office or in trading, means that we see relationships unfold.  This is why intuition is central to successful active trading.  The goal is not to have an optimistic mindset or a mindset filled with "conviction".  The goal is to be have a quiet and open mind, dynamically observing the interplay of markets and time frames.

The truly great trades are the ones that come to us.

Further Reading:

A Radical Method for Quieting the Mind

How to Develop Creativity, Best Practices, and Best Processes

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The Most Important Piece of Information for Active Traders

 

Just about everyone looks at volume, but do they actually *see* volume?

Volume tells us who is in the market.  Who is in the market determines how the market will move.  

Since 2019, yesterday's volume in SPY correlates with today's volume by over .80.

Since 2019, today's volume correlates with today's high-low range in SPY by a little under .60.

When volume expands, it's a sign that institutional participants are active in the market.  Because many of them trade directionally, their involvement/non-involvement contributes to volatility and the ways in which moves continue or reverse.

Since 2019, daily SPY volume correlates with VIX by over .80.

When we look at relative volume (how today's volume at a given intraday period compares to average volume for that time of day) and track its evolution through the day, we can clearly see--in real time--who is playing at the poker table and who isn't.  That helps us handicap the odds of moves continuing or not.

When we note the price levels at which relative volume expands or contracts, we gain a window into the intentions of other traders.  This is where Market Profile can be quite useful.

If you're an active trader, track your P/L as a function of time of day.  Odds are good that your profitability is related to the volume patterns for that time of day.

When we have stable volume trading day over day, the odds are increased that the cyclical behavior of recent markets will continue in the near future.  There can be a tremendous trading edge in this information.

The market magician has us looking at the hand that waves price in front of us.  But the magic is being done with the other hand, the volume hand that few people truly see.

Further Reading:

How Active Traders Achieve Diversification

Where Trading Stress Comes From

My Trading Framework

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