The excellent Barchart site contains a great deal of performance information about stocks, sectors, ETFs, etc. Here is my little mashup of some of their findings:
Take a 40-day version of the Commodity Channel Index. When the oscillator moves above 100 (showing good upward price momentum), buy. When it moves back below 100, sell. Similarly, when the Index moves below -100 (showing strong selling momentum), go short. When it moves back above -100, cover shorts.
Let's see how this little system performed for the S&P 500 Index (SPY) over the past two years:
* The system made 48 trades, averaging 7 days per trade. We had 11 winning trades and 37 losers.
* Overall, the system lost a little more than 18 SPY points (the equivalent of 180 points in the futures). This, of course, occurred during a bullish period of market prices.
* The average size of the winning trades was considerably higher than the average size of the losers, but the better than 3:1 ratio of losers:winners kept the system in the red.
Ironically, this might be a great nucleus for a trading system. It's telling us that the market is trading in a countertrend mode. If you had a method to limit your losses and faded the system signals, you'd have a fighting chance to make some good money. After all, a consistently losing system *does* have a potential edge.
Now consider the following:
If we traded that exact same system in GOOG, we'd have had 33 trades averaging 11 days per trade. We'd have had 14 profitable trades and 19 losers, but the system would have made over 134 GOOG points over the last two years by catching trending moves. Almost half of that profit came from a single big trending move.
The examples show how hard it is to be a trend follower. The indices are reversing directional moves, making trend following a losing proposition. Even with good trending stocks, you have to be able to tolerate frequent losing trades. Most of all, you have to be consistent enough to stick with the system for the occasional huge winner. There *are* traders able to succeed with trend following, but shrewd stock/asset class selection and steely discipline are necessary.
Sunday, November 12, 2006
Brief Therapy Techniques: How Traders Can Become Their Own Trading Coaches - Part Three
In the second post of this series, I laid out three principles to guide traders in working on patterns of thinking, feeling, and behaving that might be interfering with sound trading decisions. The first article in the series introduced the notion of brief therapy techniques as relatively rapid and effective tools for self-change. In this final installment, I will outline a process for utilizing these tools.
Let's say we have a trader named Chris who is struggling with a problem of impulsive trading. Although Chris has a general idea of a trading plan, she finds that she takes many trades that don't meet her criteria. This is costing her money, both in added commissions and in trading losses. How could she begin to help herself with the problem?
Recall that brief methods for changing problem patterns are effective when those patterns are situational. The first question Chris should ask is whether she is impulsive and undisciplined in other areas of her life, outside of trading, and whether she is experiencing negative consequences from this broader impulsivity. If the answer is yes, that's evidence that this is not just a situational problem. Rather than try to tackle the problem on her own, she should seek a professional to help her figure it out. Perhaps it's an addictive problem; maybe it's a problem related to attention deficits and/or hyperactivity. Perhaps it's the result of a mood disorder. An objective evaluation is in order.
If, however, this is a recent problem limited to trading, the odds for success with self-help are much greater.
What Chris needs to answer is the following: "What is the problem that she is trying to solve with her impulsive trades?"
My earlier post noted that what we label as problems are actually attempted solutions to situations that bring unwanted consequences.
In Chris' case, she may be trying to manage a specific fear: one that trading coach Doug Hirschhorn refers to as the "fear of missing out". She is afraid that the market will move without her being on board.
Her real problem is in her definition of opportunity. She equates opportunity with movement in her market. Movement, however, in itself is not opportunity. Opportunity comes from anticipated movement. Behind her impulsive trades is a kind of thinking that says, "I should be able to anticipate movement. I don't want to be wrong."
In a very real sense, Chris is trading to avoid self-blame. It's her self-blaming and her faulty definition of opportunity that are the real problems. Impulsive trading is simply her way of trying to cope with these problems.
Once we frame the problem in this manner, it is not difficult to find solutions. I review Chris' trading performance with her and identify times in which she was *not* impulsive and traded well. I ask her what she did at those times that seemed to work for her. She tells me that she made a conscious effort to stick with one or two setups, wrote those down, and taped them to her monitor.
I tell Chris that self-blaming is a good thing if we're focusing on the right behavior. A person without self-blame would be a sociopath. Chris should blame herself if she doesn't trade her setups; those are her real opportunity. If a market moves without her setup, she can always research the move after the fact and see if there's opportunity in a different setup. For now, however, her opportunity is what she knows how to do best.
We perform mental rehearsals before the start of the trading day in which Chris visualizes herself trading her setups and focusing on her opportunity. I also have her visualize the "old Chris" and imagine herself correcting her errant ways. This talk of "new Chris" and "old Chris" helps cement the changes in her mind. Then, at the end of each trading day, we give her a report card based, not on P/L, but on her ability to pursue true opportunity.
In one sense the change has occurred quickly. But in another sense, no change at all has occurred. Chris is simply more consistent in doing something she already knew how to do. By focusing on solutions rather than problems, we turned self-blame and the obsession with opportunity into virtues. While, to an outsider, it appears that she's become more "disciplined", in fact she has simply redefined what it means to pursue opportunity.
Brief change occurs in four steps:
1) View the problem as a solution and ask yourself what this pattern is accomplishing. What real problem am I trying to solve by thinking, acting, and feeling the way I do?
2) Find exceptions to your problem pattern. Once you understand what your underlying fear or concern is, go back in your trading performance and identify occasions when you've successfully dealt with that fear.
3) Create a pattern out of those successful occasions that you can become part of a market routine. Do more of what you've been doing when you've been trading well.
4) Keep repeating your solution pattern until it becomes automatic. It's not enough to initiate change; you want the change to become part of you.
Additional resources are available on the Articles page of my personal site. My Psychology of Trading book goes into greater detail about solution-focused techniques for change; my latest book on Enhancing Trader Performance details cognitive and behavioral methods you can use to shift problem patterns. My hope is that these tools help you become your own trading coach. If so, you'll have developed skills to last a trading lifetime.
Let's say we have a trader named Chris who is struggling with a problem of impulsive trading. Although Chris has a general idea of a trading plan, she finds that she takes many trades that don't meet her criteria. This is costing her money, both in added commissions and in trading losses. How could she begin to help herself with the problem?
Recall that brief methods for changing problem patterns are effective when those patterns are situational. The first question Chris should ask is whether she is impulsive and undisciplined in other areas of her life, outside of trading, and whether she is experiencing negative consequences from this broader impulsivity. If the answer is yes, that's evidence that this is not just a situational problem. Rather than try to tackle the problem on her own, she should seek a professional to help her figure it out. Perhaps it's an addictive problem; maybe it's a problem related to attention deficits and/or hyperactivity. Perhaps it's the result of a mood disorder. An objective evaluation is in order.
If, however, this is a recent problem limited to trading, the odds for success with self-help are much greater.
What Chris needs to answer is the following: "What is the problem that she is trying to solve with her impulsive trades?"
My earlier post noted that what we label as problems are actually attempted solutions to situations that bring unwanted consequences.
In Chris' case, she may be trying to manage a specific fear: one that trading coach Doug Hirschhorn refers to as the "fear of missing out". She is afraid that the market will move without her being on board.
Her real problem is in her definition of opportunity. She equates opportunity with movement in her market. Movement, however, in itself is not opportunity. Opportunity comes from anticipated movement. Behind her impulsive trades is a kind of thinking that says, "I should be able to anticipate movement. I don't want to be wrong."
In a very real sense, Chris is trading to avoid self-blame. It's her self-blaming and her faulty definition of opportunity that are the real problems. Impulsive trading is simply her way of trying to cope with these problems.
Once we frame the problem in this manner, it is not difficult to find solutions. I review Chris' trading performance with her and identify times in which she was *not* impulsive and traded well. I ask her what she did at those times that seemed to work for her. She tells me that she made a conscious effort to stick with one or two setups, wrote those down, and taped them to her monitor.
I tell Chris that self-blaming is a good thing if we're focusing on the right behavior. A person without self-blame would be a sociopath. Chris should blame herself if she doesn't trade her setups; those are her real opportunity. If a market moves without her setup, she can always research the move after the fact and see if there's opportunity in a different setup. For now, however, her opportunity is what she knows how to do best.
We perform mental rehearsals before the start of the trading day in which Chris visualizes herself trading her setups and focusing on her opportunity. I also have her visualize the "old Chris" and imagine herself correcting her errant ways. This talk of "new Chris" and "old Chris" helps cement the changes in her mind. Then, at the end of each trading day, we give her a report card based, not on P/L, but on her ability to pursue true opportunity.
In one sense the change has occurred quickly. But in another sense, no change at all has occurred. Chris is simply more consistent in doing something she already knew how to do. By focusing on solutions rather than problems, we turned self-blame and the obsession with opportunity into virtues. While, to an outsider, it appears that she's become more "disciplined", in fact she has simply redefined what it means to pursue opportunity.
Brief change occurs in four steps:
1) View the problem as a solution and ask yourself what this pattern is accomplishing. What real problem am I trying to solve by thinking, acting, and feeling the way I do?
2) Find exceptions to your problem pattern. Once you understand what your underlying fear or concern is, go back in your trading performance and identify occasions when you've successfully dealt with that fear.
3) Create a pattern out of those successful occasions that you can become part of a market routine. Do more of what you've been doing when you've been trading well.
4) Keep repeating your solution pattern until it becomes automatic. It's not enough to initiate change; you want the change to become part of you.
Additional resources are available on the Articles page of my personal site. My Psychology of Trading book goes into greater detail about solution-focused techniques for change; my latest book on Enhancing Trader Performance details cognitive and behavioral methods you can use to shift problem patterns. My hope is that these tools help you become your own trading coach. If so, you'll have developed skills to last a trading lifetime.
Saturday, November 11, 2006
Weekend Reading - 11/10/06
Best of Dr. Brett's Trading Markets articles via Yahoo! Finance.
Weekend charts from Charles Kirk.
Weekend linkfest from Barry Ritholtz.
Trader Mike tracks distribution.
Big Picture on the yield curve and recession.
Weekend blog watch from James Altucher.
Hedge fund pressure to perform from Abnormal Returns.
Bill Cara's week in review, with insight on WMT.
My next Weblog post will be Sunday. Have a great weekend!
Weekend charts from Charles Kirk.
Weekend linkfest from Barry Ritholtz.
Trader Mike tracks distribution.
Big Picture on the yield curve and recession.
Weekend blog watch from James Altucher.
Hedge fund pressure to perform from Abnormal Returns.
Bill Cara's week in review, with insight on WMT.
My next Weblog post will be Sunday. Have a great weekend!
Brief Therapy Techniques: How Traders Can Become Their Own Trading Coaches - Part Two
In my first post, I introduced the idea of rapid change of patterns of thought, emotion, and behavior. This post will focus on three principles to guide traders in becoming their own coaches.
Consider a trader we'll call John. He has been successful in the markets over different market conditions and demonstrated a profitable edge in his trading. He is now at the point at which he wants to grow his size and take fuller advantage of his edge, but he is concerned about the risk and pressure of growing larger. How can he overcome his emotional reluctance?
This is a classic pattern that can be addressed with short-term behavior change techniques. It is not the result of a chronic emotional disorder, and it is not the result of poor trading practices. The best patterns to work on using brief therapy techniques are ones that are situational: ones in which you want to change how you deal with specific scenarios.
Which brings us to our first principle:
1) When you are working on yourself, carefully target the changes you wish to make. Don't try to alter your entire personality or your behavior overall. Rather, focus on a single situation that you would like to approach differently and concretely identify a goal for that situation. If you don't know what you're seeking, you almost certainly won't find it. Many times, it's helpful to conduct a review and examine occasions in which you have dealt effectively with your chosen situation. One of the first questions I'd ask John is whether there have been any times in which he has successfully raised his size, even just a little. If so, we might use that success as a foundation to build upon. Many times, we're so focused on our problems that we fail to recognize the solutions that we've stumbled upon. Start your work on yourself by trying to do just one or two things differently. Set yourself up for success and build upon that.
Our second principle is very important to setting proper goals for change:
2) Problems are something you do, not something you have. We sometimes talk about emotional or behavioral problem patterns as if they are viruses: something we've picked up and have to get rid of. The reality is that problem patterns are usually efforts at solving a problem that simply aren't working--but are the best we know to do at the time. John's reluctance to grow his size is his way of managing risk and the emotions associated with perceived risk. The "problem" serves a function and meets a need ; he won't change that pattern unless he has another way to satisfy the need. If I were working with John, I would help him measure risk in percentage terms rather than absolute dollars. I'd encourage him to grow his size very slowly, but steadily, to manage the psychological aspects of risk. I'd also help him define methods of risk management that he might not have thought of, such as using his edge to diversify across non-correlated positions. You can grow your trading size without growing the size of your individual positions: just trade more than one thing and make sure the trades are independent of each other and preserve your edge!
Our third principle is perhaps most important of all:
3) You cannot rapidly change a pattern unless you face that pattern in real time. Talking about a problem does not, in itself, resolve that problem. People learn from new experience. John will feel comfortable getting larger by actually getting larger, not by discussing his insecurities. Accordingly, I might start John on a simulator and have make some practice trades with larger size. I would teach him some basic cognitive and behavioral skills for staying calm and focused and encourage him to use those skills while placing his simulated trades. Once that goes well, we would raise his size just a small notch and have him trade live--again using the skills he's learned. Only when that's gone well do we ratchet up the size another small notch, and another, and another. John will internalize the repeated experience of success; over time, he'll think of himself as a larger trader.
These principles hold true whether you're working on trading discipline, marital arguments, or a fear of heights. Your work on yourself will be successful when you find a safe context to be the change you want to make. Changing by enacting solutions rather than discussing problems is a powerful way to develop yourself as a trader--and as a person. How to do that will be the topic of the third and final post in this series.
Consider a trader we'll call John. He has been successful in the markets over different market conditions and demonstrated a profitable edge in his trading. He is now at the point at which he wants to grow his size and take fuller advantage of his edge, but he is concerned about the risk and pressure of growing larger. How can he overcome his emotional reluctance?
This is a classic pattern that can be addressed with short-term behavior change techniques. It is not the result of a chronic emotional disorder, and it is not the result of poor trading practices. The best patterns to work on using brief therapy techniques are ones that are situational: ones in which you want to change how you deal with specific scenarios.
Which brings us to our first principle:
1) When you are working on yourself, carefully target the changes you wish to make. Don't try to alter your entire personality or your behavior overall. Rather, focus on a single situation that you would like to approach differently and concretely identify a goal for that situation. If you don't know what you're seeking, you almost certainly won't find it. Many times, it's helpful to conduct a review and examine occasions in which you have dealt effectively with your chosen situation. One of the first questions I'd ask John is whether there have been any times in which he has successfully raised his size, even just a little. If so, we might use that success as a foundation to build upon. Many times, we're so focused on our problems that we fail to recognize the solutions that we've stumbled upon. Start your work on yourself by trying to do just one or two things differently. Set yourself up for success and build upon that.
Our second principle is very important to setting proper goals for change:
2) Problems are something you do, not something you have. We sometimes talk about emotional or behavioral problem patterns as if they are viruses: something we've picked up and have to get rid of. The reality is that problem patterns are usually efforts at solving a problem that simply aren't working--but are the best we know to do at the time. John's reluctance to grow his size is his way of managing risk and the emotions associated with perceived risk. The "problem" serves a function and meets a need ; he won't change that pattern unless he has another way to satisfy the need. If I were working with John, I would help him measure risk in percentage terms rather than absolute dollars. I'd encourage him to grow his size very slowly, but steadily, to manage the psychological aspects of risk. I'd also help him define methods of risk management that he might not have thought of, such as using his edge to diversify across non-correlated positions. You can grow your trading size without growing the size of your individual positions: just trade more than one thing and make sure the trades are independent of each other and preserve your edge!
Our third principle is perhaps most important of all:
3) You cannot rapidly change a pattern unless you face that pattern in real time. Talking about a problem does not, in itself, resolve that problem. People learn from new experience. John will feel comfortable getting larger by actually getting larger, not by discussing his insecurities. Accordingly, I might start John on a simulator and have make some practice trades with larger size. I would teach him some basic cognitive and behavioral skills for staying calm and focused and encourage him to use those skills while placing his simulated trades. Once that goes well, we would raise his size just a small notch and have him trade live--again using the skills he's learned. Only when that's gone well do we ratchet up the size another small notch, and another, and another. John will internalize the repeated experience of success; over time, he'll think of himself as a larger trader.
These principles hold true whether you're working on trading discipline, marital arguments, or a fear of heights. Your work on yourself will be successful when you find a safe context to be the change you want to make. Changing by enacting solutions rather than discussing problems is a powerful way to develop yourself as a trader--and as a person. How to do that will be the topic of the third and final post in this series.
Friday, November 10, 2006
Brief Therapy Techniques: How Traders Can Become Their Own Trading Coaches - Part One
Beginning with a review article that I published in 1992, I focused my career on brief therapy: techniques for accelerating emotional, cognitive, and behavioral change. My co-edited textbook on the topic has become a standard training text for residents in psychiatry, and I've written articles for traders to teach them some brief change techniques. Most recently, my book on Enhancing Trader Performance contains two chapters with self-help manuals to help traders become their own short-term cognitive and behavioral therapists.
Many trading problems related to emotional disruptions can benefit from short-term work, but not all of them. How you trade affects your emotions just as much as emotions affect trading. This is why it is important to distinguish when frustrations are the cause of trading problems and when they are the result.
When I tried to summarize my reasons for writing my first book for traders, The Psychology of Trading, I emphasized the neurophysiology of risk and reward. Quite simply, when we encounter conditions of uncertainty and risk, the blood flow patterns in our brain facilitate our "flight or fight" response patterns. Blood flows away from the frontal cortex, our executive center, and toward motor areas and lower brain structures. That means that we are least likely to activate our judgment, planning, reasoning, and analysis when we most need it.
Brief therapy techniques help people remain grounded in their executive cognitive functions under conditions of high emotional arousal. Stated otherwise, these short-term methods help you stay calm and focused during situations that normally evoke anxiety, impulsivity, negative thinking, or greed.
This series of posts will introduce some of the basics of brief therapy in hopes that you can become your own trading coach. I often stress to traders I work with: my goal is to get fired. I want you to be your own counselor, not to become reliant on me. With practice, any trader can learn techniques for short-term change that have been validated by scores of outcome research studies. My hope is that this series of posts can begin the process for interested market participants.
Many trading problems related to emotional disruptions can benefit from short-term work, but not all of them. How you trade affects your emotions just as much as emotions affect trading. This is why it is important to distinguish when frustrations are the cause of trading problems and when they are the result.
When I tried to summarize my reasons for writing my first book for traders, The Psychology of Trading, I emphasized the neurophysiology of risk and reward. Quite simply, when we encounter conditions of uncertainty and risk, the blood flow patterns in our brain facilitate our "flight or fight" response patterns. Blood flows away from the frontal cortex, our executive center, and toward motor areas and lower brain structures. That means that we are least likely to activate our judgment, planning, reasoning, and analysis when we most need it.
Brief therapy techniques help people remain grounded in their executive cognitive functions under conditions of high emotional arousal. Stated otherwise, these short-term methods help you stay calm and focused during situations that normally evoke anxiety, impulsivity, negative thinking, or greed.
This series of posts will introduce some of the basics of brief therapy in hopes that you can become your own trading coach. I often stress to traders I work with: my goal is to get fired. I want you to be your own counselor, not to become reliant on me. With practice, any trader can learn techniques for short-term change that have been validated by scores of outcome research studies. My hope is that this series of posts can begin the process for interested market participants.
Market Update for 11/10/06
We came into the day on Thursday with a bit of a bearish bias, as noted in the recent posts, and, indeed, the sellers came out in the afternoon. Altogether, we saw 1159 stocks make fresh 20-day highs across the major exchanges and 618 register new lows. This continues to be a source of concern; it is a much higher level of new lows than we typically see near market peaks and suggests possible distribution among shares. My Demand measure, reflecting the number of stocks trading above their moving average volatility envelopes, was 44; Supply (index of stocks trading below the envelopes) was 89. This suggests continued weak momentum among stocks. If you check out the Weblog and the link to the Adjusted TICK, you'll see that the recent rise has been very unimpressive in terms of buying pressure. We're in a trading range between, roughly, 1380 and yesterday's highs. Unless we can establish greater buying interest, momentum, and strength, I will continue to view this action as part of a topping process. My next full Weblog update will be Sunday.
Thursday, November 09, 2006
Testing Out The Beach Ball Pattern In The Stock Market
We have head-and-shoulders patterns, double tops and bottoms, and flags and pennants. Why not beach ball patterns? You know how beach balls are in the water: You push them down, and they bounce right up.
Wednesday we had a beach ball day, as investors sold stocks on the election news but rallied them higher in the afternoon. What happens after such bouncy occasions?
It turns out that, since 2004 (N = 717 trading days), we've had 16 beach ball days in the S&P 500 Index (SPY), in which the market opened down by more than -.30%, but rallied to close higher than the previous day's close. The next day, the market has been down by an average -.16% (6 up, 10 down). That is notably weaker than the average one-day gain of .03% (390 up, 327 down) for the sample overall.
There's an interesting pattern within the pattern, however. When the market has a beach ball bounce following a five-day period of rising prices (N = 7), as at present, the market has been down an average of -.64% (1 up, 6 down) the next day. That is quite a weak performance.
Conversely, when the beach ball day has follwed a five-day decline (N = 9), SPY has been up by an average of .22% the next day (5 up, 4 down)--stronger than normal.
These are small samples, so must be taken with a grain of salt. Two lessons, however, follow from this little exercise:
1) Subjective impressions in the market aren't always accurate - Before doing any testing, I would have predicted that the beach ball pattern would have been bullish for next-day performance. That seems logical: the market was rejecting lower prices. In fact, if anything, the pattern has been bearish--especially when it follows a period of strength.
2) Context matters - Many chart patterns test out differently depending upon what has happened leading up to the patterns. This is restating something veteran technicians have always known: what's happening on the longer time frame really is important. The beach ball pattern tested out quite differently when it followed strength vs. weakness.
Just about any market pattern you can identify can be tested out. All of my testing is done in Excel with simple open-high-low-close data. Such tests won't always show you a significant edge, but they can be helpful in alerting you to occasions where none exists. In this case, I'm alert to the possibility that the beach ball's bounce may be more of a last gasp for air than a sign of continued buoyancy.
Wednesday we had a beach ball day, as investors sold stocks on the election news but rallied them higher in the afternoon. What happens after such bouncy occasions?
It turns out that, since 2004 (N = 717 trading days), we've had 16 beach ball days in the S&P 500 Index (SPY), in which the market opened down by more than -.30%, but rallied to close higher than the previous day's close. The next day, the market has been down by an average -.16% (6 up, 10 down). That is notably weaker than the average one-day gain of .03% (390 up, 327 down) for the sample overall.
There's an interesting pattern within the pattern, however. When the market has a beach ball bounce following a five-day period of rising prices (N = 7), as at present, the market has been down an average of -.64% (1 up, 6 down) the next day. That is quite a weak performance.
Conversely, when the beach ball day has follwed a five-day decline (N = 9), SPY has been up by an average of .22% the next day (5 up, 4 down)--stronger than normal.
These are small samples, so must be taken with a grain of salt. Two lessons, however, follow from this little exercise:
1) Subjective impressions in the market aren't always accurate - Before doing any testing, I would have predicted that the beach ball pattern would have been bullish for next-day performance. That seems logical: the market was rejecting lower prices. In fact, if anything, the pattern has been bearish--especially when it follows a period of strength.
2) Context matters - Many chart patterns test out differently depending upon what has happened leading up to the patterns. This is restating something veteran technicians have always known: what's happening on the longer time frame really is important. The beach ball pattern tested out quite differently when it followed strength vs. weakness.
Just about any market pattern you can identify can be tested out. All of my testing is done in Excel with simple open-high-low-close data. Such tests won't always show you a significant edge, but they can be helpful in alerting you to occasions where none exists. In this case, I'm alert to the possibility that the beach ball's bounce may be more of a last gasp for air than a sign of continued buoyancy.
Stock Market Sentiment Is Not Necessarily A Contrary Indicator
Sometimes the crowd gets it right.
Let's take the current market. We've been up over a three-day period in the S&P 500 Index (SPY) by over 1.5%. During those three days, the ratio of put volume to call volume among equity options has been .72. That's pretty much the average put/call ratio that we've seen since 2004 (N = 717 trading days) and slightly bearish for periods of solid three-day gain.
Since 2004, we've had 67 occasions in which SPY has been up by more than 1.5% on a three-day basis. The next day, SPY has averaged a loss of -.04% (32 up, 35 down), which is weaker than the average one-day gain of .03% (390 up, 327 down) for the sample overall.
But let's break it down by put/call ratio. When the ratio is greater than .70 over those three days (N = 33), it suggests that put buyers are more aggressive relative to call buyers. The next day, SPY averages a loss of -.22% (12 up, 21 down)--much weaker than average. When the ratio is less than .70 (N = 34) and call buyers are relatively more aggressive, SPY averages a next-day gain of .14% (20 up, 14 down).
In other words, relatively bearish sentiment from options traders during a large three-day rise has led to a correction the next day. Relative optimism among options traders during a three-day advance has carried over to greater strength the next day.
Sometimes, I guess, a true contrarian has to fade even a contrary indicator.
Let's take the current market. We've been up over a three-day period in the S&P 500 Index (SPY) by over 1.5%. During those three days, the ratio of put volume to call volume among equity options has been .72. That's pretty much the average put/call ratio that we've seen since 2004 (N = 717 trading days) and slightly bearish for periods of solid three-day gain.
Since 2004, we've had 67 occasions in which SPY has been up by more than 1.5% on a three-day basis. The next day, SPY has averaged a loss of -.04% (32 up, 35 down), which is weaker than the average one-day gain of .03% (390 up, 327 down) for the sample overall.
But let's break it down by put/call ratio. When the ratio is greater than .70 over those three days (N = 33), it suggests that put buyers are more aggressive relative to call buyers. The next day, SPY averages a loss of -.22% (12 up, 21 down)--much weaker than average. When the ratio is less than .70 (N = 34) and call buyers are relatively more aggressive, SPY averages a next-day gain of .14% (20 up, 14 down).
In other words, relatively bearish sentiment from options traders during a large three-day rise has led to a correction the next day. Relative optimism among options traders during a three-day advance has carried over to greater strength the next day.
Sometimes, I guess, a true contrarian has to fade even a contrary indicator.
Wednesday, November 08, 2006
What's Up, Doc?
I'll tell you what's up this morning in the wake of Democratic celebration and a down S&P 500 Index: some of those favorite names in alternative energy.
Ballard Power Systems (BLDP) is up over 4% as I write. Plug Power (PLUG) is up over 3%.
The alternative energy sector has long been a darling of speculators, but nothing was going to happen in a sustained way while an administration dominated by oil executives and supported by Congress was dictating policy.
With this election, that scenario is changing.
Energy independence will be the mantra of the next party in power. It will frame a response to terrorism, human rights, and the Middle East--and it will capture patriotic appeal. It will address growing concerns with global warming and the environment and will promise economic security. It will bring us closer to our allies abroad and ease some of the tensions with countries that compete with us for oil.
A few traders in that alternative energy space seem to have figured that out.
Ballard Power Systems (BLDP) is up over 4% as I write. Plug Power (PLUG) is up over 3%.
The alternative energy sector has long been a darling of speculators, but nothing was going to happen in a sustained way while an administration dominated by oil executives and supported by Congress was dictating policy.
With this election, that scenario is changing.
Energy independence will be the mantra of the next party in power. It will frame a response to terrorism, human rights, and the Middle East--and it will capture patriotic appeal. It will address growing concerns with global warming and the environment and will promise economic security. It will bring us closer to our allies abroad and ease some of the tensions with countries that compete with us for oil.
A few traders in that alternative energy space seem to have figured that out.
What Drives Investor Sentiment?
After my recent post on bullish market sentiment, a reader expressed surprise that we were seeing such protracted optimism. After all, weren't housing prices falling? Isn't the war going poorly? Aren't we reacting to geopolitical problems in North Korea, Iran, and the Middle East more widely?
My response was that, perhaps, sentiment is simply a function of price. We haven't seen a 10% correction in the Dow since the 2003 start of the bull market. Perhaps that's why sentiment has remained elevated. It's not just that bullish sentiment leads people to put their money on stocks; rising stocks also might generate bullish sentiment.
Such a conclusion would fit with the interesting research noted on the excellent CXO Advisory blog, which found that margin debt actually slightly lags stock index price: people borrow money for investment when they see rising prices.
Above we see a chart of weekly data from 2003-present. The red line is a detrended composite measure of sentiment taken from the three surveys from my prior research. The blue line represents weekly 52-week new highs minus new lows in the NYSE, adjusted as a percentage for the number of issues traded. Note that there is a strong correlation between new highs/lows and sentiment. Indeed, from July, 1987 to 2006 (N = 980 weekly periods), the correlation between new highs/lows and sentiment has been .54. When we have many stocks making new highs, sentiment tends to be more bullish; when we have many stocks making annual new lows, sentiment tends to be less bullish.
Viewed another way, we can say that the new highs/lows account for almost 30% of the variance in investor sentiment. That still leaves a chunk of variance unexplained--and room for sentiment to diverge from the new highs/lows.
Might there be trading patterns in such divergence?
When bullish sentiment across the three surveys runs 10% or more above average (N = 124), the next 20 weeks in the Dow Jones Industrials average a gain of 1.46% (70 up, 54 down). That is weaker than the average 20-week gain of 3.67% (682 up, 298 down) for the entire sample. Very bullish sentiment leads to inferior returns in the intermediate term.
But wait! Let's divide the bullish sentiment periods in half based upon the new highs/lows. When new highs are strong *and* we have high bullish sentiment, the next 20 weeks in the Dow average a gain of .28% (28 up, 36 down). When new highs are not strong and there is bullish sentiment, the next 20 weeks in the Dow average a gain of 2.63% (42 up, 22 down).
What that says is that markets yield subnormal returns when lots of stocks are making new highs and investors are very bullish. When investors are bullish in the absence of great strength in new highs, that bullishness is associated with much more normal returns going forward.
How about when sentiment is bearish? When bullish sentiment has been 10% or more below average (N = 114), the next 20 weeks in the Dow average a gain of 7.30% (94 up, 20 down), much stronger than the average 20-week Dow gain. That tells us that very bearish sentiment leads to superior returns in the intermediate term.
When we have weak bullish sentiment *and* a high level of stocks making new lows (N = 57), the next 20 weeks in the Dow average a gain of 9.1% (50 up, 7 down). That's stronger than the performance when we have weak bullish sentiment and a low level of stocks making new lows (5.49%; 44 up, 10 down).
In short, sentiment is highly but not perfectly correlated with price and market strength. It's when sentiment is highly bearish and lots of stocks are making new lows that returns are most favorable for investors.
Tuesday, November 07, 2006
This Market Is Full Of Bull!
In my recent post, I averaged the bullish stock market sentiment from three well-regarded and longstanding surveys and found unprecedented bullishness during the past two years. My latest article for Trading Markets found that the peaks and valleys of sentiment across the three surveys have tracked intermediate-term market swings quite nicely. A chart of those data can be found on the 11/7 Trading Psychology Weblog.
Going back to mid-1987 (N = 1006 weekly periods), I created a composite measure of investor sentiment by averaging the bullish percentages from the American Association of Individual Investors survey, the Investors Intelligence poll, and the survey from Market Vane. Over that period, these measures of sentiment are positively correlated with each other, but do not have huge areas of overlap. The AAII and Investors Intelligence polls are most closely related, with a correlation of .52. Those two polls correlate with the Market Vane measure by only about .26. Altogether, the polls share less than 30% of the total variance in reported sentiment. That suggests to me that the surveys may be tapping different kinds of traders: some shorter-term, some longer-term, some index traders, some traders on individual equities.
By averaging the three surveys and focusing on when they are all bullish or bearish, we can obtain a good sense for when a variety of traders are leaning the same way in the market.
What we find in doing so is that, since 1987, the 2004-2006 is unprecedented in its persistent bullishness. Specifically, the average bullish percentage from 2004-2006 has been 53%. The average bullishness from 1987-2003 has been 43%. To put that into perspective, 71% of all weekly periods since 2004 have seen bullish readings over 50%. Prior to 2004, only 20% of readings exceeded 50%.
But now the big question: Does investor sentiment have an impact upon future price changes?
When composite bullishess has exceeded 55% (N = 108), the next 10 weeks in the Dow Jones Industrial Average have averaged gains of only .57% (60 up, 48 down). That is considerably weaker than the average ten-week gain of 1.70% (640 up, 366 down) for the entire sample. Indeed, when bullishness has exceeded 60% (N = 22), the next ten weeks in the Dow average a loss of -2.51% (7 up, 15 down)--a remarkable finding, given the long-term bullish bias in the Dow over that period.
How about when bullishness has been below 40% (N = 308)? The next ten weeks in the Dow average a robust gain of 3.0% (217 up, 91 down)--much stronger than average.
It does, indeed, appear that investor sentiment possesses some contrary value. Consider the outcomes when we look 20 weeks out: When sentiment is bullish (over 55%), the average gain over the next year is a subnormal 1.44%; when there are relatively few bulls (under 40%), the average gain is a robust 5.34%.
The present market, hovering near that 60% level, has some uncomfortable company in market history, including January, 2000; April, 1998; and August,1987. Not every period of very high bullishness has led to a market crash, but only 6 of the 22 highly bullish periods were higher 20 weeks later. And that's no bull.
Going back to mid-1987 (N = 1006 weekly periods), I created a composite measure of investor sentiment by averaging the bullish percentages from the American Association of Individual Investors survey, the Investors Intelligence poll, and the survey from Market Vane. Over that period, these measures of sentiment are positively correlated with each other, but do not have huge areas of overlap. The AAII and Investors Intelligence polls are most closely related, with a correlation of .52. Those two polls correlate with the Market Vane measure by only about .26. Altogether, the polls share less than 30% of the total variance in reported sentiment. That suggests to me that the surveys may be tapping different kinds of traders: some shorter-term, some longer-term, some index traders, some traders on individual equities.
By averaging the three surveys and focusing on when they are all bullish or bearish, we can obtain a good sense for when a variety of traders are leaning the same way in the market.
What we find in doing so is that, since 1987, the 2004-2006 is unprecedented in its persistent bullishness. Specifically, the average bullish percentage from 2004-2006 has been 53%. The average bullishness from 1987-2003 has been 43%. To put that into perspective, 71% of all weekly periods since 2004 have seen bullish readings over 50%. Prior to 2004, only 20% of readings exceeded 50%.
But now the big question: Does investor sentiment have an impact upon future price changes?
When composite bullishess has exceeded 55% (N = 108), the next 10 weeks in the Dow Jones Industrial Average have averaged gains of only .57% (60 up, 48 down). That is considerably weaker than the average ten-week gain of 1.70% (640 up, 366 down) for the entire sample. Indeed, when bullishness has exceeded 60% (N = 22), the next ten weeks in the Dow average a loss of -2.51% (7 up, 15 down)--a remarkable finding, given the long-term bullish bias in the Dow over that period.
How about when bullishness has been below 40% (N = 308)? The next ten weeks in the Dow average a robust gain of 3.0% (217 up, 91 down)--much stronger than average.
It does, indeed, appear that investor sentiment possesses some contrary value. Consider the outcomes when we look 20 weeks out: When sentiment is bullish (over 55%), the average gain over the next year is a subnormal 1.44%; when there are relatively few bulls (under 40%), the average gain is a robust 5.34%.
The present market, hovering near that 60% level, has some uncomfortable company in market history, including January, 2000; April, 1998; and August,1987. Not every period of very high bullishness has led to a market crash, but only 6 of the 22 highly bullish periods were higher 20 weeks later. And that's no bull.
Monday, November 06, 2006
The Most Promising Application of Psychology to Trading
If trading firms managed money as scientifically as they conduct their hiring, most would be out of business quickly.
The problem is prevalent in the business world. We have sophisticated tools for accounting, process control, and marketing, but hiring practices remain mired in the subjectivity of personal interviews and reviews of resumes.
Hiring new traders poses special challenges. Without an established track record of success, how can firms determine if candidates have the skills and talents needed to succeed?
Few people are aware that research in psychology has led to the creation of highly realistic simulations that allow firms to directly measure the competencies needed for success. The studies of Drs. Siegfried Streufert and Usha Satish are particularly noteworthy in this regard. Their Strategic Management Simulations put candidates through a series of scenarios that require decision making. The decisions made and rationales for these are used to create a web-like diagram of the candidate's cognitive functioning. What the diagram actually measures, the researchers note, are aspects of frontal activity in the brain.
The brain's frontal cortex is called by cognitive neuroscientist Elkhonon Goldberg our executive center. It is responsible for much of our reasoning, planning, judgment, analysis, and problem-solving. By creating standardized tasks for a variety of professions--from CEOs to physicians--Streufert and Satish in essence have designed a methodology to match people's brains to the work they will be doing.
The implications for trading are immense.
It is not difficult to create highly realistic trading simulations utilizing actual historical market data. By asking traders to trade a standardized set of markets and track news and market events as they occur, we can analyze their reasons for decisions. This analysis will generate cognitive maps that display how candidate traders think and behave under varying conditions of challenge, complexity, and stress. We can directly observe how people handle risk, how their emotions aid or hinder their objectivity, and how they manage change and new information.
If simulations on a computer can accurately predict the performance of surgeons, perhaps they can unlock some of the factors that account for trading success. Perhaps, too, they can help identify future superstar performers.
The most promising application of psychology to trading--and many other fields--comes, not from the therapy couch, but from cognitive neuroscience. Quietly, in a variety of fields, matching brains to tasks is revolutionizing hiring practice.
The problem is prevalent in the business world. We have sophisticated tools for accounting, process control, and marketing, but hiring practices remain mired in the subjectivity of personal interviews and reviews of resumes.
Hiring new traders poses special challenges. Without an established track record of success, how can firms determine if candidates have the skills and talents needed to succeed?
Few people are aware that research in psychology has led to the creation of highly realistic simulations that allow firms to directly measure the competencies needed for success. The studies of Drs. Siegfried Streufert and Usha Satish are particularly noteworthy in this regard. Their Strategic Management Simulations put candidates through a series of scenarios that require decision making. The decisions made and rationales for these are used to create a web-like diagram of the candidate's cognitive functioning. What the diagram actually measures, the researchers note, are aspects of frontal activity in the brain.
The brain's frontal cortex is called by cognitive neuroscientist Elkhonon Goldberg our executive center. It is responsible for much of our reasoning, planning, judgment, analysis, and problem-solving. By creating standardized tasks for a variety of professions--from CEOs to physicians--Streufert and Satish in essence have designed a methodology to match people's brains to the work they will be doing.
The implications for trading are immense.
It is not difficult to create highly realistic trading simulations utilizing actual historical market data. By asking traders to trade a standardized set of markets and track news and market events as they occur, we can analyze their reasons for decisions. This analysis will generate cognitive maps that display how candidate traders think and behave under varying conditions of challenge, complexity, and stress. We can directly observe how people handle risk, how their emotions aid or hinder their objectivity, and how they manage change and new information.
If simulations on a computer can accurately predict the performance of surgeons, perhaps they can unlock some of the factors that account for trading success. Perhaps, too, they can help identify future superstar performers.
The most promising application of psychology to trading--and many other fields--comes, not from the therapy couch, but from cognitive neuroscience. Quietly, in a variety of fields, matching brains to tasks is revolutionizing hiring practice.
Are The Bulls Stampeding?
I know that sounds like a crazy question, but I like to listen to the data.
Let's take three measures of investor sentiment: the polls of the American Association of Individual Investors, Investors Intelligence, and Market Vane. What we find across all three is that more than 50% of survey participants are bullish on the stock market.
Going back to 1987 in all of those polls (N = 1006 weeks; the extent of my data set), we only find 86 weekly periods in which this has been the case.
Three clusters of those occasions fell during August, 1987; April, 1998; and January, 2000. Not exactly great times to be owning stocks.
But here's the really unusual thing: 64 of the 86 weekly periods of unanimous bullishness since 1987 have occurred during this bull market: since June, 2003.
We have never had such a protracted period of bullishness in the surveys in recent history.
Tonight I'll break it down and post my analyses tomorrow AM. Odd that this isn't on the radar for more traders and investors.
Let's take three measures of investor sentiment: the polls of the American Association of Individual Investors, Investors Intelligence, and Market Vane. What we find across all three is that more than 50% of survey participants are bullish on the stock market.
Going back to 1987 in all of those polls (N = 1006 weeks; the extent of my data set), we only find 86 weekly periods in which this has been the case.
Three clusters of those occasions fell during August, 1987; April, 1998; and January, 2000. Not exactly great times to be owning stocks.
But here's the really unusual thing: 64 of the 86 weekly periods of unanimous bullishness since 1987 have occurred during this bull market: since June, 2003.
We have never had such a protracted period of bullishness in the surveys in recent history.
Tonight I'll break it down and post my analyses tomorrow AM. Odd that this isn't on the radar for more traders and investors.
Testing The Market's Winds
Much of my morning routine consists of looking at a few core measures of market sentiment, participation, momentum, and strength and seeing what stands out in the recent market. Once I find something that stands out, I go back in time and see what happened following similar episodes. This gives me an initial idea of whether this historical pattern might be associated with a directional trading edge.
The historical pattern is just that. Such patterns do not last forever, and--at best--they can put probability on your side, not certainty.
I treat these patterns like a scientist treats a hypothesis: an idea that will have to be supported by further investigation before it is accepted. Each day in the market, in that sense, is a kind of laboratory experiment, either supporting or failing to support history's hypothesis.
This morning, one pattern that I'm looking at is four consecutive days of negative daily readings in the Adjusted NYSE TICK. The Adjusted TICK is quoted daily in the Weblog and reflects whether more stocks were trading at their offer prices or at their bids. This is an excellent short-term measure of sentiment, because it captures the willingness of buyers to pay up to acquire stocks and the willingness of sellers to bail out at market prices.
The first thing we see in the data is that four consecutive days of negative TICK (bearish sentiment) is relatively unusual. We've only seen 45 such occasions since the beginning of 2004 (N = 709). The next day in the S&P 500 Index (SPY), the market was up by an average of .29% (31 up, 14 down), much stronger than the average one-day gain of .03% (382 up, 327 down). Stated otherwise, the odds of an up day following a four-day period of persistent bearish sentiment have been better than 2:1.
Sometimes we'll see more than one historical pattern point toward the same general conclusion. That provides us with a bit more confidence in our hypothesis. Still, it is just a hypothesis. If today is going to be an up day from open to close, we need to see a net positive TICK. That means an abundance of high readings (above +500) and very few weak ones (below -500). If we see selling in the ES futures--traders hitting bids--but TICK staying relatively strong, I'll conclude that the selling is not spilling over into the broad market, and I'll be willing to go with my hypothesis on the long side.
Should selling in ES spill over to the broad market, I will entertain the notion that this market is not living up to its historical norms. That, too, is valuable information.
The good scientist is open minded. Carl Swenlin of the Decision Point service makes a fine point when he says that indicators are windsocks, not crystal balls. They tell you which way the market wind is blowing. All history can do is prepare you just a bit for those winds.
The historical pattern is just that. Such patterns do not last forever, and--at best--they can put probability on your side, not certainty.
I treat these patterns like a scientist treats a hypothesis: an idea that will have to be supported by further investigation before it is accepted. Each day in the market, in that sense, is a kind of laboratory experiment, either supporting or failing to support history's hypothesis.
This morning, one pattern that I'm looking at is four consecutive days of negative daily readings in the Adjusted NYSE TICK. The Adjusted TICK is quoted daily in the Weblog and reflects whether more stocks were trading at their offer prices or at their bids. This is an excellent short-term measure of sentiment, because it captures the willingness of buyers to pay up to acquire stocks and the willingness of sellers to bail out at market prices.
The first thing we see in the data is that four consecutive days of negative TICK (bearish sentiment) is relatively unusual. We've only seen 45 such occasions since the beginning of 2004 (N = 709). The next day in the S&P 500 Index (SPY), the market was up by an average of .29% (31 up, 14 down), much stronger than the average one-day gain of .03% (382 up, 327 down). Stated otherwise, the odds of an up day following a four-day period of persistent bearish sentiment have been better than 2:1.
Sometimes we'll see more than one historical pattern point toward the same general conclusion. That provides us with a bit more confidence in our hypothesis. Still, it is just a hypothesis. If today is going to be an up day from open to close, we need to see a net positive TICK. That means an abundance of high readings (above +500) and very few weak ones (below -500). If we see selling in the ES futures--traders hitting bids--but TICK staying relatively strong, I'll conclude that the selling is not spilling over into the broad market, and I'll be willing to go with my hypothesis on the long side.
Should selling in ES spill over to the broad market, I will entertain the notion that this market is not living up to its historical norms. That, too, is valuable information.
The good scientist is open minded. Carl Swenlin of the Decision Point service makes a fine point when he says that indicators are windsocks, not crystal balls. They tell you which way the market wind is blowing. All history can do is prepare you just a bit for those winds.
Sunday, November 05, 2006
Tracking Market Psychology With NYSE Margin Debt
In my recent post, I tracked margin debt on the NYSE back to 1970 and found a consistent pattern across bull and bear markets. During cyclical declines, we tend to see year-over-year declines in margin debt. During bull market peaks, we tend to see substantial annual gains in margin debt. It is this tendency to borrow money to buy stocks when markets are already high and refrain from borrowing when markets are weak that makes margin debt a worthy contrary indicator.
From the vantage point of market psychology, margin debt is one of the purest measures of fear and greed. When investors are greedy, they will go beyond their cash balances to buy stocks. When they are fearful, they will refrain from leveraged positions. The big question, however, is whether future market returns are impacted by the fear and greed of margined investors.
Going back to 1970 (1818 weekly periods) in the Dow Jones Industrial Average, we find that, when annual changes in margin debt exceed 30% (N = 445), the next 52 weeks in the Dow average a gain of only 1.39% (209 up, 236 down). That is much weaker than the average 52-week gain of 9.05% (1285 up, 533 down) for the entire sample. In short, periods of greed lead to subnormal market performance.
How about fear? When the annual rate of change in margin debt has been -25% or less (N = 128), the next 52 weeks in the Dow average a gain of only 1.14% (57 up, 71 down). Again, that is much weaker than the average yearly gain for the Dow since 1970.
Indeed, when we have neither fear nor greed--when the annual rate of change in margin debt is less than +10% but greater than -10% (N = 427), the next year in the Dow brings an average gain of 13.91% (357 up, 7o down)--considerably stronger than average. Given that we are neither seeing extreme fear or greed at present in margin debt, we'd have to say that there are no immediate bearish indications.
In short, extremes of investor fear or greed have led to subnormal returns in stock prices. It is when sentiment has been moderate that returns have been best.
Let's however, consider the trajectory of margin debt at recent market peaks. The annual rate of margin debt peaked in March/April, 2000, near the peak in the NASDAQ but prior to the Dow peaks later that year and in May of 2001. The annual increase in margin debt peaked in May/June, 1998, a month or two ahead of the sharp decline. The peak in August, 1989 preceded the price peak of 1990 by nearly 11 months. The margin debt rate peak of December, 1986 preceded the price peak of 1987 by about 9 months. The annual peak in November, 1983 preceded the price peak of 1984 by about 2 months. The late April peak in 1981 was only about 2 months ahead of the price peak.
What is clear from this little excursion is that annual rates of change in margin debt are not precise market timing tools, but there is a tendency for these rates of change to top out ahead of the Dow stocks. In other words, investors reduce the growth in their margin accounts as markets are topping. This is relevant because we saw our maximum annual rate of change in margin debt all the way back in April, 2004. The most recently reported rate is well below that recorded in May of 2006. The slowing of growth in margin debt following a multi-year rise is a yellow--not a red--light for stocks going forward.
From the vantage point of market psychology, margin debt is one of the purest measures of fear and greed. When investors are greedy, they will go beyond their cash balances to buy stocks. When they are fearful, they will refrain from leveraged positions. The big question, however, is whether future market returns are impacted by the fear and greed of margined investors.
Going back to 1970 (1818 weekly periods) in the Dow Jones Industrial Average, we find that, when annual changes in margin debt exceed 30% (N = 445), the next 52 weeks in the Dow average a gain of only 1.39% (209 up, 236 down). That is much weaker than the average 52-week gain of 9.05% (1285 up, 533 down) for the entire sample. In short, periods of greed lead to subnormal market performance.
How about fear? When the annual rate of change in margin debt has been -25% or less (N = 128), the next 52 weeks in the Dow average a gain of only 1.14% (57 up, 71 down). Again, that is much weaker than the average yearly gain for the Dow since 1970.
Indeed, when we have neither fear nor greed--when the annual rate of change in margin debt is less than +10% but greater than -10% (N = 427), the next year in the Dow brings an average gain of 13.91% (357 up, 7o down)--considerably stronger than average. Given that we are neither seeing extreme fear or greed at present in margin debt, we'd have to say that there are no immediate bearish indications.
In short, extremes of investor fear or greed have led to subnormal returns in stock prices. It is when sentiment has been moderate that returns have been best.
Let's however, consider the trajectory of margin debt at recent market peaks. The annual rate of margin debt peaked in March/April, 2000, near the peak in the NASDAQ but prior to the Dow peaks later that year and in May of 2001. The annual increase in margin debt peaked in May/June, 1998, a month or two ahead of the sharp decline. The peak in August, 1989 preceded the price peak of 1990 by nearly 11 months. The margin debt rate peak of December, 1986 preceded the price peak of 1987 by about 9 months. The annual peak in November, 1983 preceded the price peak of 1984 by about 2 months. The late April peak in 1981 was only about 2 months ahead of the price peak.
What is clear from this little excursion is that annual rates of change in margin debt are not precise market timing tools, but there is a tendency for these rates of change to top out ahead of the Dow stocks. In other words, investors reduce the growth in their margin accounts as markets are topping. This is relevant because we saw our maximum annual rate of change in margin debt all the way back in April, 2004. The most recently reported rate is well below that recorded in May of 2006. The slowing of growth in margin debt following a multi-year rise is a yellow--not a red--light for stocks going forward.
Solution Focused Trading
What is the one thing we see among successful traders, artists, athletes, executives, researchers, and companies?
They build upon their strengths and don't become bogged down trying to invent new ones or attempting to improve their weaknesses. In so doing, they become learning machines.
Consider a simple example. When I first began this blog not quite a year ago, I averaged about 7500 visits per month. This continued for the first few months.
I then began to study the daily statistics of how many people were accessing the site, which pages they went to, and where they were referred from. What I found was that certain topics interested readers and other bloggers quite a bit. Other topics fell flat and generated little interest.
Did I spend time trying to make the unpopular topics more palatable or trying to convince other bloggers to link to my less desired work? No, I took what brief therapists call a solution focus instead. The readership was telling me what their needs and interests were. I needed to do more of what was already working, not fiddle with topics that weren't relevant for readers.
With a shift in emphasis toward highly practical research findings and psychology themes, I found that readership had tripled by May. Feedback from reader comments and emails led me to build further on strengths, adding the morning market updates to help readers apply information from the blog in real time. With that, readership has undergone a doubling from May levels.
By gathering information every day on how the blog was performing and using the data to identify and build upon strengths, I've been able to make the site more useful for readers. Every post, popular and unpopular, became a learning experience. The trajectory of growth in readership, which had been flat prior to my studying the statistics, took a significant upward turn.
This is the process by which all elite levels of success are achieved: identify core competencies and build upon them, constantly assessing what is working and what is not. Figure out what you're doing right--and then become very intentional in doing it more often, more consistently. Don't invest your limited time and effort in areas that don't represent what you do best.
This is why it is vital to study your best trades, not just write in a journal about your worst ones. Find the trades where you had an excellent plan or read of the market and where you were able to execute the idea well. What patterns did you pick up on? How did you act upon the pattern? Were the patterns more apt to appear in certain stocks or at particular times of day? Such questions will lead you to what works best for you.
You may find that just one or two patterns in one or two markets at one or two time frames account for a large part of your success. Don't try to tweak what isn't working: figure out ways to capitalize on your core success in related markets, with steadily increased size. Build upon what you do well; don't try to remake yourself based on preconceived notions.
The solution focus is evolution in real time. We are selecting the strongest of our behavior patterns and allowing the weakest to become extinct. Over time, our own guided natural selection enables us to become learning machines, capable of superior adaptation.
Think about how a solution focus could guide your trading development, your career development, and your relationships. Think of yourself as an engine of continuous evolution. How far we could go if we provided every facet of life with an emotional P/L statement and just focused on doing more of what makes us happy, fulfilled, and successful!
They build upon their strengths and don't become bogged down trying to invent new ones or attempting to improve their weaknesses. In so doing, they become learning machines.
Consider a simple example. When I first began this blog not quite a year ago, I averaged about 7500 visits per month. This continued for the first few months.
I then began to study the daily statistics of how many people were accessing the site, which pages they went to, and where they were referred from. What I found was that certain topics interested readers and other bloggers quite a bit. Other topics fell flat and generated little interest.
Did I spend time trying to make the unpopular topics more palatable or trying to convince other bloggers to link to my less desired work? No, I took what brief therapists call a solution focus instead. The readership was telling me what their needs and interests were. I needed to do more of what was already working, not fiddle with topics that weren't relevant for readers.
With a shift in emphasis toward highly practical research findings and psychology themes, I found that readership had tripled by May. Feedback from reader comments and emails led me to build further on strengths, adding the morning market updates to help readers apply information from the blog in real time. With that, readership has undergone a doubling from May levels.
By gathering information every day on how the blog was performing and using the data to identify and build upon strengths, I've been able to make the site more useful for readers. Every post, popular and unpopular, became a learning experience. The trajectory of growth in readership, which had been flat prior to my studying the statistics, took a significant upward turn.
This is the process by which all elite levels of success are achieved: identify core competencies and build upon them, constantly assessing what is working and what is not. Figure out what you're doing right--and then become very intentional in doing it more often, more consistently. Don't invest your limited time and effort in areas that don't represent what you do best.
This is why it is vital to study your best trades, not just write in a journal about your worst ones. Find the trades where you had an excellent plan or read of the market and where you were able to execute the idea well. What patterns did you pick up on? How did you act upon the pattern? Were the patterns more apt to appear in certain stocks or at particular times of day? Such questions will lead you to what works best for you.
You may find that just one or two patterns in one or two markets at one or two time frames account for a large part of your success. Don't try to tweak what isn't working: figure out ways to capitalize on your core success in related markets, with steadily increased size. Build upon what you do well; don't try to remake yourself based on preconceived notions.
The solution focus is evolution in real time. We are selecting the strongest of our behavior patterns and allowing the weakest to become extinct. Over time, our own guided natural selection enables us to become learning machines, capable of superior adaptation.
Think about how a solution focus could guide your trading development, your career development, and your relationships. Think of yourself as an engine of continuous evolution. How far we could go if we provided every facet of life with an emotional P/L statement and just focused on doing more of what makes us happy, fulfilled, and successful!
Saturday, November 04, 2006
Stock Market Margin Debt: An Indicator That Hasn't Lost Its Value for Investors
One of the best indicators of speculative sentiment among investors is margin debt. This doesn't measure what participants think will happen in the market; it assesses their actual commitments to the market. A sharp rise in margin debt means that investors are eager to get into stocks. A sharp contraction in debt suggests that investors are loathe to commit funds. When all the speculative money has piled into stocks--or has pulled out--what will sustain future rises or declines? It's for this reason that margin debt is a consummate contrary indicator.
Let's check the historical track record:
* During the large market drop in 1970, margin debt plunged year over year by over 35%
* With the market recovery in 1972, debt had risen by over 50%.
* During the large market drop in 1974, margin debt fell by 30%.
* By the market's recovery early in 1977, margin debt rose by over 50%.
* During the 1982 market decline, debt fell by over 22%.
* By the market peak in 1987, market debt had risen over 30%.
* With the 1987 crash, debt dropped by over 25% in 1988.
* Margin debt was slow to recover after that crash and rose only 8% by 1989.
* With the 1990 drop, debt dropped by nearly 20%.
* By early 1994, speculators were back and margin debt was up by 40%.
* Speculators were reluctant to leave the market and, by late 1994, margin debt was down only about 4%.
* With the market's speculative binge in 2000, margin debt had risen by 90%.
* The ensuing crash in tech stocks took margin debt down over 40% by 2001 and cut total margin debt in half from 2000 peaks by 2002.
* Since that drop, we saw a year-over-year peak in margin debt change of over 30% in early 2004 and over 20% in 2006, although we are not yet at the 2000 level of margin debt.
In my next post, I'll see if some guidance for long-term investment can be gained from the margin debt figures.
In the interim, several conclusions stand out:
1) Spikes in annual changes in margin debt have been associated with market tops.
2) Large declines in annual changes of margin debt have been associated with most major market bottoms.
3) Speculators have been relatively slow to jump on board the stock market following the drop of 2000-2002. In that sense, the response to the decline has been similar to the response following the drop of 1987 and, to a lesser degree, 1970 and 1974. Large bear markets appear to affect the behavior of speculators over the next business cycle.
Interestingly, margin debt is below the levels recorded in May, despite the market's recent rise. Year over year, we're up about 9% in margin debt, down from the 2006 peak of over 24%. It is hard to believe this bull swing will have legs if it continues to fail to attract speculative interest. If history is a guide, it will take a significant year-over-year drop in margin debt to usher in a cyclical market bottom.
Friday, November 03, 2006
How Can I Join A Trading Firm?
There are many disadvantages to trading independently. Many independent traders cannot command the same low commissions received by exchange members and member firms. Trading on your own may also be isolating. At a firm, you have dedicated support teams handling equipment, software and hardware upgrades, and developing/acquiring new trading tools. That is beyond the budget of many independent traders.
It is natural, therefore, that many independent traders consider joining a trading firm. Having coordinated a training/hiring program for a Chicago-based proprietary trading firm, I have some familiarity with the challenges and issues involved in making such a move. Here are a few items for your consideration:
1) Many of the best career opportunities for traders are at large institutions, such as investment banks and hedge funds. These are often very well capitalized and able to invest in training and development of traders. The catch? These organizations like to hire graduates of finance and financial engineering programs. Quantitative and programming skills are in demand. If you're looking to build a long-term career in the financial world, I'd strongly encourage you to consider an MBA program with a finance concentration or a Master's program in financial engineering to provide yourself with the competencies and skill sets that are increasingly in demand. In such firms, you'll be an employee with benefits and a salary.
2) Can you afford to start out by trading your own capital? If so, this opens several doors. There are trading "arcades" that provide you with office space, tech support, equipment, and trading platforms and pass along economies of scale to you. These shops generally can command low commission rates and may or may not pass along some of their own commissions to you on top of monthly fees for the service, rent, and equipment. Note that in this structure, you are a customer of the firm, not an employee. That means no salary and, in all likelihood, no draw against future earnings. The upside is that you keep the lion's share of your trading profits. One nice variation on the arcade is the trader's co-op, in which a few experienced traders go in together to share equipment, office space, and other overhead, but trade their own accounts.
3) Do you need capital to get yourself started? Then you might be looking at a proprietary trading firm, in which you trade the firm's capital. The firm provides you with all equipment, space, tech support, software, and platforms. At some of these firms, you may be charged a commission on top of monthly fees. The firm, because it takes 100% of risk, will also take a good chunk of profits. You may qualify as an employee of the prop firm, which means that you would be eligible for normal employee benefits. A monthly draw against future profits may provide you with some stable income; straight salaries are not the norm.
You'll be more competitive to join a bank or hedge fund if you have the education and internship placement experience. You'll be more competitive to join a prop firm if you already have an independent track record of trading success. The education departments at the major exchanges, such as the Chicago Mercantile Exchange and the Chicago Board of Trade, publish lists of member firms and often are aware of training programs and hiring among these. Googling "Master's of Science in Financial Engineering" and looking into MBA programs with strong finance components (see who is publishing in the Journal of Finance!) will give you leads for training for institutional positions.
The bottom line is that few organizations will take you off the street and put capital into your hands to trade. If you're not an experienced trader with your own capital, my advice is to find a graduate program or a training program within a proprietary firm and learn the business from the ground up. Think about building a career, not just getting a job.
It is natural, therefore, that many independent traders consider joining a trading firm. Having coordinated a training/hiring program for a Chicago-based proprietary trading firm, I have some familiarity with the challenges and issues involved in making such a move. Here are a few items for your consideration:
1) Many of the best career opportunities for traders are at large institutions, such as investment banks and hedge funds. These are often very well capitalized and able to invest in training and development of traders. The catch? These organizations like to hire graduates of finance and financial engineering programs. Quantitative and programming skills are in demand. If you're looking to build a long-term career in the financial world, I'd strongly encourage you to consider an MBA program with a finance concentration or a Master's program in financial engineering to provide yourself with the competencies and skill sets that are increasingly in demand. In such firms, you'll be an employee with benefits and a salary.
2) Can you afford to start out by trading your own capital? If so, this opens several doors. There are trading "arcades" that provide you with office space, tech support, equipment, and trading platforms and pass along economies of scale to you. These shops generally can command low commission rates and may or may not pass along some of their own commissions to you on top of monthly fees for the service, rent, and equipment. Note that in this structure, you are a customer of the firm, not an employee. That means no salary and, in all likelihood, no draw against future earnings. The upside is that you keep the lion's share of your trading profits. One nice variation on the arcade is the trader's co-op, in which a few experienced traders go in together to share equipment, office space, and other overhead, but trade their own accounts.
3) Do you need capital to get yourself started? Then you might be looking at a proprietary trading firm, in which you trade the firm's capital. The firm provides you with all equipment, space, tech support, software, and platforms. At some of these firms, you may be charged a commission on top of monthly fees. The firm, because it takes 100% of risk, will also take a good chunk of profits. You may qualify as an employee of the prop firm, which means that you would be eligible for normal employee benefits. A monthly draw against future profits may provide you with some stable income; straight salaries are not the norm.
You'll be more competitive to join a bank or hedge fund if you have the education and internship placement experience. You'll be more competitive to join a prop firm if you already have an independent track record of trading success. The education departments at the major exchanges, such as the Chicago Mercantile Exchange and the Chicago Board of Trade, publish lists of member firms and often are aware of training programs and hiring among these. Googling "Master's of Science in Financial Engineering" and looking into MBA programs with strong finance components (see who is publishing in the Journal of Finance!) will give you leads for training for institutional positions.
The bottom line is that few organizations will take you off the street and put capital into your hands to trade. If you're not an experienced trader with your own capital, my advice is to find a graduate program or a training program within a proprietary firm and learn the business from the ground up. Think about building a career, not just getting a job.
Sell Stocks After A Week of Weakness?
Two measures of buying and selling activity tracked on the Trading Psychology Weblog each day are the Adjusted NYSE TICK (a daily summed measure of number of stocks on NYSE trading at offer minus those traded at bid, adjusted for a zero mean) and the Institutional Composite (the same measure, but with the Dow Jones Industrial Average stocks). During the past five trading sessions, we've had four net selling days in the TICK and all five showing net selling in the Composite. I decided to investigate what happens after we get similar periods of significant weakness in both measures (average daily Adjusted TICK < -300; average daily Composite < -200).
It turns out that we've had 20 such occasions since 2004 (N = 708). Three days later in the S&P 500 Index (SPY), we've seen an average gain of .44% (15 up, 5 down). That is a meaningful bullish edge compared to the average three-day gain of .10% (397 up, 311 down) for the sample overall.
The market, of course, is on edge this AM awaiting the big jobs numbers. Keep an eye on the interest rate and currency markets to see if the news pushes us to new levels of valuation in those markets. If so, the news really is economic news and the adjustments of macro traders could lead to a sustained downward revaluation of equities as well. If the news doesn't really change the outlook for rates or the dollar, I'm going to question whether we'll sustain a major revaluation of stocks. In that scenario, the odds tell us that, as a whole, selling into a week of weakness is not a good bet.
It turns out that we've had 20 such occasions since 2004 (N = 708). Three days later in the S&P 500 Index (SPY), we've seen an average gain of .44% (15 up, 5 down). That is a meaningful bullish edge compared to the average three-day gain of .10% (397 up, 311 down) for the sample overall.
The market, of course, is on edge this AM awaiting the big jobs numbers. Keep an eye on the interest rate and currency markets to see if the news pushes us to new levels of valuation in those markets. If so, the news really is economic news and the adjustments of macro traders could lead to a sustained downward revaluation of equities as well. If the news doesn't really change the outlook for rates or the dollar, I'm going to question whether we'll sustain a major revaluation of stocks. In that scenario, the odds tell us that, as a whole, selling into a week of weakness is not a good bet.
Thursday, November 02, 2006
Addictive Trading: Getting Your Life Back
My recent post on out-of-control trading brought many email inquiries and insightful comments on the blog. One of the common questions voiced was: How can you tell when a trader is passionate about trading vs. addicted to it?
The first step in dealing with any addictive pattern is identifying it--and identifying it as a problem. Here are a few questions that you might ask yourself:
* Have there been times when I told myself to stop trading, but still found myself placing trades any way?
* Do I find myself overtrading by putting on positions with too large size or by trading during periods when nothing is happening?
* Have my trading losses created problems for me in my relationship(s), or have they caused financial problems for me?
* Have people close to me told me that I need to stop trading?
* Is the pain from losing more extreme than the satisfaction from winning?
* Do I find my moods fluctuating with my P/L?
* Do I trade simply out of boredom sometimes?
* Do I find myself preoccupied with trading outside of market hours at the cost of other work and relationships?
Notice that, for many of these questions, you could substitute the word "drinking" or "gambling" for "trading". The dynamics of addictions are the same across the board. If you answered yes to three or more of these questions, I would suggest that trading has become a problem for you.
How does one deal with addictive trading? The first step is to identify it, but the second--and harder--step is to acknowledge that you need help for it. It's pride that tells us we can handle it on our own through will power, but addictions wouldn't occur in the first place if will power were sufficient to prevent consequences.
Telling yourself you can manage your own addiction is itself a form of denial.
That is why a key step in Alcoholics Anonymous is acknowledging that you are powerless against alcohol.
That is why AA substitutes mutual support for drinking and advocates abstinence as a goal.
Through books, self-help groups, and counseling, you learn to identify the thought and behavior patterns that drive your addictive behaviors. You also learn to identify cravings in advance and channel these in productive directions.
Most of all, you regain a measure of control over your life and end the negative consequences of the addiction.
If you find yourself unable to control your trading and you find the emotional, financial, and social consequences mounting, that's not a passion for trading. It's an addiction.
Do the right things:
1) Close your account.
2) Get help.
I do not provide private counseling myself, but will be happy to assist with a referral in your region. If these posts help just one person turn his or her life around, that will be one of the best returns on investment I've ever achieved.
The first step in dealing with any addictive pattern is identifying it--and identifying it as a problem. Here are a few questions that you might ask yourself:
* Have there been times when I told myself to stop trading, but still found myself placing trades any way?
* Do I find myself overtrading by putting on positions with too large size or by trading during periods when nothing is happening?
* Have my trading losses created problems for me in my relationship(s), or have they caused financial problems for me?
* Have people close to me told me that I need to stop trading?
* Is the pain from losing more extreme than the satisfaction from winning?
* Do I find my moods fluctuating with my P/L?
* Do I trade simply out of boredom sometimes?
* Do I find myself preoccupied with trading outside of market hours at the cost of other work and relationships?
Notice that, for many of these questions, you could substitute the word "drinking" or "gambling" for "trading". The dynamics of addictions are the same across the board. If you answered yes to three or more of these questions, I would suggest that trading has become a problem for you.
How does one deal with addictive trading? The first step is to identify it, but the second--and harder--step is to acknowledge that you need help for it. It's pride that tells us we can handle it on our own through will power, but addictions wouldn't occur in the first place if will power were sufficient to prevent consequences.
Telling yourself you can manage your own addiction is itself a form of denial.
That is why a key step in Alcoholics Anonymous is acknowledging that you are powerless against alcohol.
That is why AA substitutes mutual support for drinking and advocates abstinence as a goal.
Through books, self-help groups, and counseling, you learn to identify the thought and behavior patterns that drive your addictive behaviors. You also learn to identify cravings in advance and channel these in productive directions.
Most of all, you regain a measure of control over your life and end the negative consequences of the addiction.
If you find yourself unable to control your trading and you find the emotional, financial, and social consequences mounting, that's not a passion for trading. It's an addiction.
Do the right things:
1) Close your account.
2) Get help.
I do not provide private counseling myself, but will be happy to assist with a referral in your region. If these posts help just one person turn his or her life around, that will be one of the best returns on investment I've ever achieved.
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