Sunday, May 28, 2023

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: