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.
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