The Greatest Challenges of Trading Psychology - II: Ever-Changing Markets

 

The first post in this series took a look at how one of the greatest challenges to our trading psychology comes from failing to navigate the process of expertise development.  Too often, traders put their capital at risk before they have properly undergone a process of learning grounded in deliberate practice.

In many performance fields that learning process continues throughout one's career.  As soon as a surgeon masters surgical techniques, new approaches to surgery (microsurgery, robotic surgery) come along and promise better outcomes.  That means that physicians always participate in continuing education, updating and upgrading their skills.

Similarly, in business, consumer interests, needs, and demands are ever-changing.  As technology changes, what consumers wanted yesterday (high performing cars) ends up being very different from what they want today (electric motors) and tomorrow (self-driving vehicles guided by AI).  The successful business thus always reinvents itself.  

Financial markets are ever-changing, and that means that any single "edge" in trading cannot be permanent.  A stationary time series is one that is relatively stable with a constant mean and standard deviation.  Tosses of a fair coin form a stationary time series.  I recent asked ChatGPT4 whether financial time series in the stock market are stationary and the response, in part, was: 

"No, stock market time series are generally not stationary.  Stationarity refers to a time series that exhibits constant statistical properties over time, such as constant mean, constant variance and constant autocovariance structure.  In the context of the stock market, prices and returns tend to exhibit non-stationary behavior.

Stock market prices often show trends, meaning they have a tendency to increase or decrease over time.  Additionally, stock market returns typically exhibit volatility clustering, where periods of high volatility are followed by periods of low volatility, and vice versa. These characteristics violate the assumption of stationarity."

What this means in practice is that the patterns exhibited by the market at one point in time can be very different from other times.  Any trading "setup" that worked in the recent past has no guarantee of working in the future.  Volumes change as market participants change.  That alters volatility and trends.  Just like the surgeon or business person, the successful trader has to reinvent themselves to find new sources of "edge".  Failure to detect market changes and adapt to those is one of the greatest challenges to our trading psychology.  In such cases, it's not simply that our psychology undermines our trading.  Our inability to recognize market shifts creates our drawdowns--and that undermines our psychology.

Many traders ground their edge in a particular set of market conditions:  trend, momentum, bullish or bearish movement, etc.  This makes these traders inherently vulnerable.  The real edge in financial markets is the ability to detect when markets change and identify the nature of that change.  Too many traders simply label markets as "directional" or "choppy".  They make money in the directional markets and lose money in the chop.  This has recently been the case among many stock market traders.

A more promising view is that there are at least three kinds of markets:  trending, cycling, and rotating.  It is often the rotating market that appears to be choppy and impossible to trade.  If, however, we recognize the nature of the rotation, then we can trade trends and cycles in the strongest and weakest market sectors.  (Consider tech stocks and real estate shares in the recent market, for example).  In the rotational market, we have to look under the hood to see what is trading in coherent patterns.  That might point us to AI stocks; it might point us to regional banking shares.  In other macro markets (FX, rates, commodities), rotational conditions might lead us to trade in relative terms rather than outright (long West Texas Intermediate crude vs. short Brent crude, for example) or trade spreads within a given asset class (trading shapes of the yield curve in rates, for instance).  

A successful approach to trading would not first look for trends or reversals.  It would look for conditions of stationarity.  We would first identify what is trading meaningfully.  Not one in ten traders do that.  They look for *their* kinds of markets and impose their meaning onto what they're trading.  That is fertile ground for emotional upheaval. 

Because markets are ever-changing, we must be ever-flexible.  Just as a football team adjusts its offense to field conditions and the defense they're facing; just as a restaurant adjusts its menu to adapt to a new breed of young diner, we have to adjust our trading in the face of markets that sometimes trade in trends, sometimes in cycles, and sometimes rotationally.

An open and flexible mindset is best positioned to be a positive mindset.

Further Reading:

How to Adapt to Changing Markets

Why Volume is So Important to Trading

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The Greatest Challenges of Trading Psychology - I: Trauma

 

There is a common assumption among traders that if they are falling short of their performance expectations, it must be because of their mindset.  If only they can maintain a positive mind frame, the thinking goes, they will be able to succeed.  There is an element of truth of this, and there is an important sense in which it is seriously misguided.

Research suggests that, when we are in our best frames of mind--and especially when we are operating with optimal well-being--we will be more productive and also more creative.  We will engage in our best trading when we are trading consciously, with what I have called a high mental Sharpe ratio.  The right kind of trading interests us, gives us energy, and doesn't deplete us.  The positive mind frame is both a contributor to good trading, and it is also the result of good trading.  Importantly, the proven change methods of psychology can help us find, not only positive emotional experience, but a deep spiritual fulfillment.  That can help make trading personally as well as financially rewarding.  In that sense, trading is not simply about making money.  It is one among many paths toward becoming the greatest person we can be.

It's a logical fallacy, however, to assume that because positive mindset is necessary for optimal trading, then trading success will necessarily follow from improving our mindset.  Negativity can interfere with the performance of an elite athlete, but reaching that elite status requires far more than a positive mind frame.  Mastery is a complex combination of inborn talents, available opportunities, and skills acquired through deliberate practice.  No amount of positivity can substitute for the experience required to gain mastery in any performance domain.  Trading the right way is just as likely to generate positive emotional experience as positivity will help our trading.  

Notice that, in any performance field, the process of gaining mastery is separate from the process of professional performance.  That is, a basketball team will practice offense and defense during the week before playing a weekend game; a singer will practice with a coach before performing in a concert; military troops will practice maneuvers before entering the battlefield.  One of the greatest challenges of trading psychology is that market participants spend relatively little time in pure practice mode and instead hope to gain their experience by putting their capital at risk.  They even justify this by claiming that practice modes cannot duplicate the pressure and stresses of live trading.  Can you imagine battlefield commanders or professional golfers foregoing practice because the stresses are not the same as in actual performance?  It is precisely by cultivating skills through deliberate practice under increasingly realistic conditions that we develop our mastery.

What happens psychologically is that traders who put their capital at risk too quickly encounter losses and P/L volatility that they are not prepared for.  These are experienced as dangers and threats to one's trading successes.  When we take risk too quickly and when we take too much risk in search of high returns on capital, we create emotional upheaval.  This turmoil does not just go away because we tell ourselves to be disciplined and to have a positive mindset.  It is the nature of trauma to stay with us and to be triggered by future experiences similar to those past losses.  I've described this as the dark side of trading:  with unrealistic expectations of profit and premature risk-taking, traders expose themselves to significant emotional turmoil that ultimately unhinges their future performance.

Because market conditions change frequently, even experienced traders need to revisit their learning curves and gain fresh mastery.  If they continue to trade aggressively and with large size based upon past success, they will be vulnerable to significant drawdowns when market themes, trends, and volatility change.  The most successful traders maintain their high mental Sharpe ratios by quickly detecting market changes, avoiding losses, and returning to a mode of observation and practice to gain mastery in the new regime.  If our overriding need is to get bigger and bigger and make more and more money, it's only a matter of time before we traumatize ourselves.  

The best way to learn is to fail fast.  The best way to fail fast is to fail small.

Further Reading:

Trading Addiction and Trading Trauma

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Greatness as a Mission-Driven Life

 

A heroic life is one driven by a noble purpose, an all-absorbing sense of mission.  Past posts have asked the question, "What is the Path to Your Greatness?" and explored what makes for greatness in life and trading.  When we think of life's heroines and heroes, we inevitably focus on people whose lives have been devoted to a noble purpose and who have persisted in the face of challenge to accomplish things that make the world better.  Not all obsessions are paths to greatness--plenty of traders become obsessed with the ups and downs of markets but never invest in the skills, tools, and processes that would build their mastery.  It is difficult to imagine a great life, however, that does not have an overarching sense of mission that becomes a singular focus and theme.  A great life cannot be lived randomly or comfortably.  It has to be mission-driven, in which activity is organized around constructive purposes and challenges.

As Ayn Rand pointed out, we can forgive many people and their shortcomings, but "not those who lack the courage of their own greatness".  It is difficult to imagine a betrayal greater than avoiding who we are and what we can become.  For many of us, greatness seems to be a bridge too far.  The solution-focus in psychology offers a very different perspective.  It tells us that the answer to our challenges is not simply to fix our problems.  Rather, we need to identify what we are currently doing--even in small measure--to be the person we seek to become.  Greatness consists of doing more and more of what we are already doing when we are at our best.  In the talents and passions we experience in the present, we can identify our future:  our missions and our paths to greatness.  

The first step toward a mission-driven life is to live an hour and then a morning, and then a day absorbed in a purpose that speaks to us and gives us energy.  We know we are on the path of our mission when we achieve the peak states described by Maslow in which we are fully absorbed in what we're doing.  Those flow states are ones in which we find our greatest creativity and productivity.  For many of us, those moments of flow are all too few and fleeting--but they *do* occur.  Our challenge is to identify what we're doing when we're most passionate and turn those peak moments into an enduring sense of mission.  Once we recognize that greatness is not an end point, but rather a process for living life, our mission becomes clear:  to live each day meaningfully, purposefully, and creatively in pursuit of a quest worthy of our greatest efforts.

Further Reading:

Blueprint for an Uncompromised Life:  Part One, Part Two, Part Three

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Revisiting the Momentum Curve: Anticipating Market Turns

 

Back in 2014, I wrote about the Momentum Curve and how it is useful in visualizing market breadth and strength/weakness across different time frames.  It's almost nine years later and I have maintained the Momentum Curve database.  The dataset goes back to 2006 and captures the percentage of stocks in the SPX universe that are above their 3, 5, 10, 20, 50, 100, and 200-day moving averages.  I then look at what the market did going forward, from 1 to 50 days, following various configurations of the curve.

In June, I will be participating in my first webinar in quite a while, as part of the TraderLion conference.  The session will be a group coaching session, in which attendees can bring in their questions and challenges and I will respond with best practices in evidence-based psychology and among successful portfolio managers.  Preceding the coaching session, I will review the Momentum Curve and its application to the present market.  This will offer a nice illustration of how quantitative analyses can great aid our discretionary trading judgement.

As it happens, we recently (on Thursday) hit a point at which fewer than 40% of stocks were trading above their 3, 5, 10, and 20-day averages.  Out of over 4200 days in the database, this has occurred 621 times.  Over every forward time frame, from 1 to 20 days out, the market has--on average--displayed superior returns.  For example, the average next twenty-day return following the oversold occasions has been +1.42% vs. +.55% for the remainder of the sample.  Indeed, we did see a nice trend day higher on Friday.

As the initial article indicates, these analyses provide hypotheses, not firm conclusions.  If we observe a strong historical tendency for a move and then current market behavior follows that tendency, we have the possibility for a trade with the proverbial wind at our back.  I'll offer other examples and applications in the webinar; stay tuned!

Quick update (5/11/23; 9:27 AM ET) - The bounce in the market since the historical study posted above has been choppy at best with very mixed breadth.  If a historical tendency doesn't play out, it's important to ask whether something is making the current situation different or unique.  I'm struck by how few market participants I speak with are taking the prospect of U.S. debt default seriously...by and large, it's not on their radar.  With only two percentage points standing between the former and current U.S. Presidents; the former President speaking favorably about default; and a Speaker who owes his position to supporters of the former President, could we be in for a constitutional crisis?  I find it important to ask questions and use what-if scenarios for trading and financial planning.

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Further Reading:

The Psychology of Quant Analysis

Using Breadth to Track Market Cycles

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