Monday, August 28, 2023

The Wellness Grid: A Framework For Optimizing Your Trading Psychology


Note:  Written aboard a ship on the Danube River, traveling to Prague, Czech Republic:

Imagine a 3x3 Wellness Grid:

On the X axis, we have three dimensions of psychological wellness:  

1)  Happiness - How much joy we experience;

2)  Fulfillment - How much satisfaction and pride we experience;

3)  Energy - How much inspiration and excitement we experience;

On the Y axis, we have three dimensions of wellness in life:

1)  Personal Life - What we are doing to develop ourselves as individuals;

2)  Interpersonal Life - What we are doing to maintain, expand, and deepen our relationships;

3)  Work Life - What we are doing to grow and succeed in the work we undertake.

With this Wellness Grid, we have a handy weekly report card that enables us to track over time how well we are maximizing the quality of our lives.  We also have a framework for tracking the synergies in our lives:  the degree to which improving one area of life creates benefits for other areas.  And, of course, we can track how setbacks in one sphere of life might be impacting others.

If we are consciously working on the nine boxes of the Wellness Grid, what we're really working on is intentionality:  the expansion of our free will.  The idea is to live life in a state in which we're fully awake, not functioning on auto-pilot.  We maximize our trading psychology when we maximize our capacities for living intentionally.  The big enemy of mindset is not stress; it's the absence of well-being.  We all need routines to live life efficiently, but when all of life becomes a set of routines, we are no longer fully alive--and we fail to grow.  Ideally, each week, we push ourselves beyond our comfort levels in all nine areas of the Wellness Grid.

Further Reading:

Tacking Your Problems Will Never Optimize Your Life

Gurdjieff, Turtles, and Trading


Sunday, August 20, 2023

Weak Market: What Comes Next?

We've seen a stock market that has been rather weak over the last couple of weeks.  Higher interest rates at the long end have particularly impacted rate-sensitive sectors, such as utilities and real estate, and have provided support for the U.S. dollar and dollar-related carry trades.  Speculation has shifted from imminent recession to an environment of "sticky" inflation and rates that are likely to be "higher for longer".  So is the recent pullback in stocks an opportunity to participate in the longer-term uptrend, or is it a warning to preserve capital?

Let's step back a minute.

I observe two problems among market participants.  The first is to construct trades without underlying robust ideas.  Traders who look to charts for "setups" are particularly guilty of this mistake.  The second problem is to generate big picture, top-down narratives based on fundamental data, but not anchor these themes in well-analyzed trades that provide favorable reward relative to risk in a shorter-term time frame.  My experience with successful market participants is that they are both investors and traders.  They generate robust bigger picture ideas through unique, rigorous analyses and they then translate those ideas into good trades by rigorously assessing shorter-term risk-reward.

In the terms of Daniel Kahneman, success in markets requires both deeper, slower thinking and faster, flexible thinking.  In practice, this means having consistent strategies but flexibly adapting the implementation of those frameworks based upon current conditions.

So now let's look at the current market:

I notice that, across the NYSE universe, we have seen over 1500 stocks making fresh monthly lows and fewer than 1000 registering new three-month lows.  That is what we would expect during a correction in a rising market.  When one-month lows *and* three-month lows are high (bear market), next ten-day returns since 2010 have been negative.  When one-month lows have been high and three-month lows have not been significantly elevated, next ten-day returns have been distinctively bullish--significantly above average.

In short, context matters.

When analyzing market returns, it's not enough to examine one time frame.  We want to see how the shorter time frame fits into the market's larger picture.

Let's take a second example.  This past week, looking across the NYSE universe, we have seen very few stocks giving buy signals on two technical trading systems, the Wells Wilder Parabolic SAR and the Bollinger Bands.  These systems assess strength and weakness across shorter (SAR) and medium (Bollinger) time frames.  When the number of stocks providing buy signals on the SAR has been weak but the number of stocks giving buy signals on the Bollinger measure has been relatively strong, next ten-day returns since 2019 have been flat to negative.  When we have had few buy signals on both technical systems simultaneously, next ten-day returns have been solidly bullish.

Again, context matters.

Across a number of these kinds of analyses, we see favorable average near term returns after selloffs in rising markets.  That's the perspective from the slower, deeper analyses.  Now, going forward, if we see selling pressure that cannot result in lower prices, we can speculate that bears are trapped, will need to cover, and we could bet on higher prices going forward.  Conversely, if we see that buying pressure is limited and/or cannot drive price meaningfully higher, we can entertain the idea that this time, indeed, may be different and follow that up with further analyses and possibly very different bets.

The most successful traders I work with look at new and different things and they look at things in new and different ways.  Over time, unique returns cannot come from consensus thinking.  

Further Reading:

The Momentum Curve


Monday, August 14, 2023

Your Flaw Is Your Strength

While writing my next book, I came across a thought-provoking essay from a well-known Jewish Rabbi, Zalman Schachter-Shalomi.  His topic was the opal stone that we see in jewelry.

The opal gem consists of small silica spheres and gaps between the spheres, which in one context could be considered flaws.  However, the very gaps that occur on the opal's surface are what create the opal's beauty when light is shined.  The light rays are diffracted by the spheres and gaps, which break the light into a fiery array of component colors.  The Rabbi's point is that we are like opals:  what are our flaws when viewed one way become our greatest sources of beauty in a different light.  

Our flaws, in the right light, are our strengths.

For example, in one light, our ambition and achievement orientation are flaws, leading us to become so wrapped up in our work that we neglect our health and relationships.  Those flaws lead us to trade from the egooverreact to gains and losses, and chop ourselves up when big moves aren't realized.

In a different light, our ambition and achievement orientation lead us to define and seek goals and ideals and realize our vision for being the best possible version of ourselves. 

There are so many ways in which our flaws and strengths mirror one another.  Think about how our sensitivity in relationships can lead to caring, but also hurt and disagreements.  Think about how our desire for self-development can result in personal growth--and in an insensitivity to others.  Think about how our commitment to not losing money can stand in the way of making significant money.

We are like opals, and our challenge is to find the light that enables us to shine.

Here's a simple exercise to help with that challenge:  Each week, identify the one most fulfilling, meaningful event that occurred to you during the past seven days.  Then identify the one most frustrating, negative event over that same period.  Then reflect on how the two are related and what made the positive experience so special and what made the negative experience so disappointing.  What is the light in which you are simply a stone with spheres and gaps, and what is the light in which you shine?  Over time, keeping this simple journal, you'll discover the contexts in which you display your fire.   

The goal is not to eliminate your flaws, but to turn those into sources of beauty.

Further Reading:

Greatness in Life and Trading


Sunday, August 06, 2023

Why Do I Get Chopped Up In My Trading?


The most recent post took a look at why we can perform well in markets, only to suddenly make poor decisions and blow up.  Now we'll examine a second common complaint of traders, especially in recent markets:  how we can develop good ideas for trades but then get chopped up in actually trading those ideas.  Most often this occurs when we are counting on momentum or trend--shorter or longer-term extensions of directional moves--only to experience reversals.  

Getting chopped up can cause considerable psychological frustration, but I'm not sure it's a purely psychological problem.  Let's look at the last 10 years of data from the stock market to illustrate the point:

For the first investigation, I broke down the daily closing cash VIX level into quartiles and examined the forward returns in the SPX.  When VIX has been in the lowest half of its distribution over the past ten years (below 16.66), the next five days in SPX have averaged a gain of only +.06%.  When VIX has been in the highest half of its distribution, the next five days in SPX have averaged a gain of +.36%.  The results widen out over time, so that the next twenty-day return in SPX for the two VIX conditions have been +.32% vs. +1.39%.  We know that VIX tends to fall in a rising market and rise in a falling market.  Indeed, there is a very significant correlation between VIX and most recent 50, 100, and 200-day returns.  What the data are telling us is that we are most likely to get a meaningful five-day bounce in a weak, volatile market.

For the second investigation, I examined the daily 5-day RSI for every stock in the SPX and the overall average level of those 5-day RSIs.  I then broke those daily average RSIs into quartiles over the past ten years.  Sure enough, when the RSIs have been in their weakest quartile, the next five days in SPX averaged +.49% vs. +.11% for the remainder of the sample.  When the market sells off over a five-day period, the next five day returns are superior to all other market occasions.  

For the third investigation, I examined the percentage of stocks in the SPX closing each day above their five-day moving averages over the past ten years.  When that percentage has been in its highest quartile, next five-day returns have averaged only .06%.  When the percentage has been in its lowest quartile, net five day returns have averaged a respectable +.51%. 

Historically, strong markets have led to more modest forward returns and weak markets have led to superior returns.  This occurs over multiple time frames.  Indeed, by creating a momentum curve across various time periods, we can develop reasonable forecasts for future market moves.

We get chopped up when we expect momentum and trends to extend.  Our expectations set us up for frustration.  This becomes a particular problem if we wait for "price confirmation" to enter a rising or falling market.  By the time that confirmation occurs, the anticipated forward returns are diminished.  One way of overcoming this problem is to investigate the presence of cycles in the market data and use short-term cycles to trade trending markets.  I have consistently found that how we trade a market idea is just as important to profitability as the idea itself.  If we can find short-term cycles within the market moves we're trading, we can become much better at finding superior risk/reward, both on entries and on take-profit levels.

Not all problems that impact our psychology are psychological in origin.  Our tendency to think in straight lines and ignore cycles breeds considerable frustration.

Trading well is the best formula for a winning psychology.