Social Cognition and Trading: Part Two

The first post in this two-part series made the case that much of thinking is a social process; isolated from the back-and-forth testing and revising of ideas, traders lapse into internal feedback loops that magnify perceptual biases and action tendencies. In other words, many problems of discipline may boil down to problems of isolation--in lesser measure to be sure, but perhaps similar to the cognitive distortions and disordered behavior that occur during prolonged exposure to sensory deprivation.

What brought this to my attention was an experience with a large trader a little while ago. He had been losing significant money, much of which could be attributed to poor money management under conditions of frustration. My work with him, like much of my work in prop environments, took place while he was trading and was highly interactive. This is useful in two respects: it offers immediate feedback as to whether the coaching is helpful or not (P/L is a merciless judge!) and it offers windows into the processes that make the coaching more or less helpful.

With this particular trader, the results were notable. Significant losses, in a short period of time, became significant gains. Because this trader was placing dozens of trades per day and we worked together over many days, it was highly unlikely that the difference in performance was due to chance. Something about the coaching made a meaningful difference, but it was certainly not any grand market insights that I provided. In fact, I limited my discussion with the trader to observations of the trader's trading and occasional observations of the behavior of volume, indicators, sectors, etc.

Nor did I provide what I thought were grand psychological insights; the coaching was not psychotherapy. The discussions simply focused on what the trader was doing that was working and what wasn't effective, interspersed with normal social banter. One trader who observed us shook his head in disbelief. "I've been trying to tell him the same thing for months now!"

I think that was an astute observation. It wasn't so much the content of the communications that was effective as the process: what had been a damaging internal dialogue of losing money, blaming self, becoming frustrated, and wanting to make the money back changed into a constructive social dialogue that was performance and market focused. Under conditions of positive social dialogue, the trader could access his skills at reading markets and executing good trades. Under conditions of negative internal feedback loops, the subtle felt cues of pattern recognition were overwhelmed by emotional upheaval.

The takeaway here is that what we know is at least in part a function of how we interact. In one mode of cognition--isolated from self-correcting feedback from interactions--we lose access to information and lose the ability to recruit skills. In another mode--grounded in constructive dialogue--we suddenly become exemplary performers.

Does this work for all traders? Not at all. There are plenty of traders who have benefited far less dramatically--and sometimes not benefited at all--from work with me. It may well be that traders who are most attuned to the social processing of information (the trader in my example is an extremely social, extroverted individual) will benefit most from interactive coaching. A different trader, one who is more analytical, might gain more benefit from interactions with a statistician or market analyst.

In either case, social interaction can augment traders' cognitive processing styles, enhancing native strengths. This may not require formal coaching; rather, it may simply call for participation in the kind of peer dialogues that bring out the best in oneself. In talking to others, we inevitably hear ourselves and hear reactions to what we say. This, in turn, shifts how we view and respond to situations. It's difficult to have a meltdown when you are sustaining constructive dialogue with a valued colleague.
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Twitter and Decision Support for Traders

A while back I posted my ideas regarding Twitter as a kind of daytrading analyst: a tool of decision support for traders. This fits with the recent ideas on the blog regarding social cognition; it is also almost singlehandedly responsible for the recent growth in traffic on the blog, as I've linked intraday market tweets to real-time charts and posts concerning market action.

A majority of the intraday tweets and posts are written while I am working with prop traders, so that I am able to share many perspectives from this real time experience. (The multitasking can be challenging at times!). The tweets and posts synthesize what I am seeing on the screen, what I'm observing among the traders, and what I'm hearing from colleagues who talk with me through the day.

Let's take an example from Friday's trade. We started the day trading higher, and the market looked strong, with over 1700 more advancing issues than decliners. Take a look at my tweets beginning just minutes after the open:

8:40 AM CT - Mixed sector performance so far; range trade from open; XLY, NQ strong; financials weak. Bk l8r

8:47 AM CT - 23 stks up, 17 dn from open; my basket more mixed than one would think; NQ rel strong. VWAP near 920

8:49 AM CT - TICK quite strong so far this AM; but volume at offer and bid pretty even so far in ES; broad mkt stronger than big caps

9:16 AM CT - That disparity between ES and small caps & between TICK and Delta has been informative; selling has entered mkt, now belo vwap

You can see that as the first hour of trading unfolded, it became clear that this was not a trending market: all sectors were not moving in unison. Traders who recognized this dynamic were not fooled by the market's subsequent retracement of strength in the afternoon.

One trader put it this way to me: He is looking for facts, not opinions. The key to the Twitter postings is providing timely, relevant facts that might otherwise escape the attention of the trader. The trader can then use his/her experience to incorporate or discount those facts, depending upon circumstances.

Over 5000 traders now subscribe to the "Twitter Trader" posts. During the past month or so, it has become what is probably the only free, real-time posting of trading-relevant information that reflects the thinking--and observations--at professional trading firms. You can subscribe to the tweets via RSS or follow on my Twitter page; alternatively, you can check out the latest five tweets on the blog page under "Twitter Trader". Either way, you'll find links to trading-relevant blog posts and articles from the mainstream media; indicator updates and profit targets prior to the market open; heads up notices on pending economic releases-- as well as those intraday analyses.

And I hope to be pushing the envelope still further in the months to come. Thanks for the interest and support; I benefit from your feedback (and from links to interesting posts and articles that you email me!) and appreciate the communication.
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Social Cognition and Trading: Part One

Social cognition has been a prominent topic of study within psychology for many years, as psychologists have attempted to understand how we make sense of our social worlds. Related to social cognition is the study of how we process information within social contexts: thinking as a social, not just individual, process.

We are accustomed to viewing thought as occurring wholly within our heads. Even casual observation, however, suggests that much of how we process information transpires within social interactions. Physicians consult one another over problem cases; teens sort out problems together; and children learn to make sense of the world through transactions with parents and peers.

I would argue that much of the value of counseling and therapy is that they provide a social context for processing self-relevant information and experiences. Many times, an individual in isolation cannot understand why he behaves in a particular manner and seems incapable of changing his patterns. Through the social medium of counseling, he gains a fresh understanding of self, which opens the door to new ways of acting and interacting. Indeed, many times the changes rendered by successful therapy first appear within the counselor-client relationship, only later generalizing to wider social networks.

In the business world, we commonly find work teams tackling difficult problems; group processes--rituals and ceremonies--also provide fresh perspectives within religions. Executives hire consultants; alcoholics seek peer groups through AA. It is difficult to find spheres of life in which people do not turn to social networks for fresh guidance. Indeed, the entire phenomenon of online social networking--from Twitter and Facebook to virtual communities--reflects a recognition that how we think overlaps how we interact. To a surprising measure, thinking is a team sport.

There are interesting corollaries to this view. For example, intelligence may not simply be a function of how well one can solve problems in a test, but also a function of how well one can marshal the interactions needed to arrive at such solutions. When I interact with others, I experience my own ideas in a new context. That can either strengthen my convictions or lead me to modify them. You would be surprised at how much time hedge fund portfolio managers spend on the phone with peers, analysts, and brokers: they think by interacting, catching patterns in others' thoughts that cannot be viewed in market data. To a large degree, they are not trading the markets; they're trading the biases and consensus views of others.

With this as backdrop, allow me to advance an important idea: Much of the emotional disruption experienced by traders is a function of cognitive isolation. Facing only a screen, largely cut off from social processing, traders become--in a manner of speaking--less intelligent. They lose access to normal ways of talking out and testing out ideas. Without the perspectives of others, isolated traders lose perspective: small moves take on disproportionate significance; small pieces of market data are blown into biased views.

The decisions we make in a group/social context are not the same as those we would make in isolation. To be sure, group processes can dampen creativity and divergent thought; there is more to truth than popular perception. But group processes can also serve as a check on our cognitive and behavioral biases. Many a spouse serves as a grounding influence on their partner; many a business partner has reined in a colleague's impulsive tendencies. When we place a person in situations of heightened risk, reward, and uncertainty and *then* isolate that person from normal social regulatory interactions, the results are predictably dire.

Could it be that many struggling traders could succeed if placed within the right social contexts? The next post in this series will demonstrate that this can, indeed, be the case.

RELEVANT POSTS:

Virtual Trading Groups

Fighting the Isolation of Trading

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Excellent Reading to Start the Weekend

* "Some of your greatest successes are going to be the children of failure." - Paul Tudor Jones

* Many thanks to Denis Popov for this Russian translation of an important TraderFeed post on the importance of spouses to trading careers. Check out the worthwhile blogroll for My Ideal Trade.

* Overcoming procrastination; thanks to Gustavo that key post is now available in Portuguese. Here's an English language post of a pattern Gustavo traded today.

* After the deepest recession, the weakest recovery.

* Housing to rebound by 2012?

* Thanks to an alert blogger for this link to a fascinating post on DNDN.

* Here's a tutorial from that blogger on using Level 2 data.
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Gauging Market Strength and Weakness With a Basket of Stocks

As I'm writing, there are 369 more stocks advancing on the day than declining, off from a difference of over 1700 in the morning. If you look at the quote board for my basket of stocks, however (click for detail), you'll see nothing but red. That is because the quote board measures advancing and declining stocks from the market open, not from the prior day's close. Even when the S&P 500 Index was up nicely for the morning, we were showing a number of sectors--and highly weighted stocks within those sectors--trading below their opening prices.

When we see mixed sector performance and a trading range, as we did early this morning, I like to look at the strongest and weakest sectors. Very often a turn in one of those will be a good tell for a market break from a trading range. Once small caps started to weaken, it became clear that the large caps would win the market battle and we'd trade back into the meat of yesterday's range. A look solely at the advance-decline statistic, measured from yesterday's close, would have likely missed the important dynamics behind the morning trade.

Having done the 4 AM - 8 PM work schedule for two weeks running now, it's time to get away from it all and find a place where no cars go. Have a great weekend.
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Pre-Opening Briefing: Accepting Value Higher

After yesterday's session in the S&P 500 e-mini (ES) index (bottom chart) held above the prior day's low, we saw strong buying on the morning economic news and then proceeded to accept value higher at the 914 area of resistance. That level then became the base and springboard for trade higher overnight, as we now are accepting value (side histogram) in the 919 to 921 region. The day's trend stays bullish as long as selling cannot take us back into yesterday's high volume area; that resistance should now act as support.

9:27 AM CT - Here (top chart) we see why it is helpful to track sentiment via volume at bid vs. offer (Market Delta; bottom histogram) as well as via NYSE TICK. TICK was strong early this morning, reflecting relative strength among small cap stocks. We saw more selling pressure than buying pressure in Delta, however, providing a nice alert for the downside market break. If the market is to sustain trend mode, we should see Market Delta and TICK moving in unison; if not, we're probably in a rotational environment.
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Tracking a Summer Trade

Above we see the five-day average volume (top chart) for the S&P 500 Index (SPY) and the five-day average trading range (bottom chart). One theme stressed on this blog is the importance of trading volume, largely because of its correlation with volatility.

As stocks have moved higher since the March lows, volume has steadily declined and so has the average high-low trading range. Stocks now provide almost 1/3 the expectable range as earlier in the year.

This is why I find it crucial to adjust profit targets for volatility. (Note: SPY profit targets are posted every morning before the market open via Twitter; follow here or check the last five tweets on the blog page). Without such adjustment, we inevitably expect too much out of a trade when volatility comes out of the market, leaving us open to frequent and frustrating reversals.
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Latest Videos From Dr. Brett

Thanks to MoneyShow for posting the following videos from my Expo visit to Los Angeles:

Emotions and Trading

Be Your Own Coach

When to Change Your Trading Methods

Setting Realistic Trading Expectations


Conference Podcast: Coaching Yourself for Trading Success

My next seminar will be in July in downtown Chicago; details and registration info will be posted shortly.
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Pre-Opening Briefing: Continuing the Trend

Here's how we look (bottom chart) in the S&P 500 e-mini (ES) contract going into the 7:30 AM CT jobless claim numbers. Note the resistance between 912 and 914, as we continue in a short-term downtrend mode. If the 7:30 AM number cannot move us above that resistance level, I'll be looking for a test of Wednesday's lows below 900. Note that we'll have a few opportunities to move this morning, with Treasury Secretary Geithner talking at 8:30 AM CT and Leading Economic Indicators and Philadelphia Fed reports at 9 AM CT.

I find it worth tracking interest rates and the dollar in response to these releases and events and correlating those moves to stocks to pick up on emerging and continuing intermarket themes. In general, if the numbers cannot move us out of a value range that was established up to that point, I assume that the trend that has been in place will remain intact. Once again, I'll be tracking all of this intraday via Twitter (follow the tweets here).

8:15 AM CT - Update: We traded higher on the jobless claim numbers, but have stayed firmly within the overnight range. Note in the middle Market Delta chart that we're now trading above the day's volume-weighted average price (VWAP; red line), as the dollar has weakened versus the euro and 10-year rates have bumped higher. I'll be watching to see how we trade around VWAP to handicap the odds of taking out Wednesday's lows in early morning trade vs stay within the overnight range trade.

10:24 AM CT - I've added a fresh Market Delta chart (top) to show how we've been accepting value above the VWAP (red line) and around the 914/915 ES resistance. This raises the odds that, rather than trap bulls, we'll flush out bears by taking the market above that resistance. I'm watching TICK and intermarket themes (weak dollar, strong 10-year rates) to see if that scenario unfolds.
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A Quick Look at Taxable and Tax-Free Yields

Ten-year Treasury yields ($TNX, above) have pulled back at the same time that stocks have corrected, as concerns about economic weakness resurface. Note, however, that those yields remain in an uptrend and are significantly above the lows registered in March when quantitative easing led to greatly reduced rate expectations.

Meanwhile, I notice that yields among AAA insured, general obligation municipal bonds have backed up over the past month. Two-year yields moved from .92% to 1.05%; five-year yields from 1.84% to 2.32%; seven-years from 2.37% to 2.87%; and ten-years from 3.13% to 3.59%. While those ten-year muni rates are meaningfully down from 4.4% in December, they are once again close to overtaking the rates on equivalent but taxable Treasuries, as concerns about municipal financing continue. At least one savvy investor, however, thinks that the markets have overreacted to muni risk.
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Mid-Week Resources for Traders

* The Wall St. Cheat Sheet site offers an interesting inside look at trader and entrepreneur Howard Lindzon. Howard is the guiding force behind Stock Twits, which brings together tweets from across the trading world.

* I often receive inquiries regarding simulation platforms for those getting their feet wet in the markets. Apex Futures in Chicago offers its platform in simulation mode, with a nice feature that treats fills for limit orders conservatively, rather than assuming that you'll be filled as soon as the market touches your price. Craig Ross at Apex tells me that TraderFeed readers trading the S&P 500 e-mini market will be given a discounted, all-inclusive $4.25/rt price per contract that includes phone support; you may want to check them out.

* Henry Carstens offers a free e-book on Testing Trading Ideas, as well as numerous papers on trading topics. Great resource. I'll be interviewing Henry for the blog shortly.

* Many thanks to Charles Kirk for including The Daily Trading Coach in this site's listing of favorite investment books. Check out The Kirk Report's regular linkfests; the selection of articles and posts provides an excellent overview of economic and market themes.

* NewsFlashr offers an excellent way to stay on top of recent postings for a number of market-related blogs; also check out Corey Rosenbloom's Editor's Picks each week.
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The Bleeding Edge of the Market Downturn

Two of the sectors that failed to make highs along with the major indexes in June are now trading below their May highs: banks ($BKX, top chart) and homebuilders (XHB, bottom chart). It is difficult to imagine a sustained, vigorous bull market when the financial system and housing are not inspiring investor confidence.
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Pre-Opening Briefing: Shift to a Downtrend

Here we see the S&P 500 e-mini (ES) futures prior to the 7:30 AM CT release of consumer inflation numbers (bottom chart). What you can see is that we broke below the early June range (purple horizontal line); note how that range support turned into upside resistance early yesterday as we moved further into May's trading range. This transition from a range trade to a short-term downtrend was anticipated by the non-confirmations among the indicators I track and has also been reflected in recent indicator readings, which I put out via Twitter (follow here) prior to each market open: more new 20-day lows than highs; Supply exceeding Demand; less than 50% of stocks trading above their 20-day moving averages, etc.

We should stay below the early June range to sustain the downtrend. I'll be tracking intraday sentiment and intermarket themes (strong dollar, weak commodities) via the tweets to see if we can sustain the downside.

8:23 AM CT - In the top Market Delta chart, we see that we're building value at the low end of yesterday's trading range, as in-line inflation numbers at 7:30 AM CT could not sustain a move to the upper end of the overnight range. With acceptance of lower value, we keep the short-term downtrend intact, with short-term resistance at 908/909.
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Two Days Down, Ten Day Low: What Next?

Tuesday made it two days down in a row, as the S&P 500 Index (SPY) registered yet another 10-day low.

Since 1989, there have been 478 occasions in which we've had two days down in a row, culminating in a 10-day low. There is a bullish bias from one to five days out: a tendency to bounce following weakness. For example, the next day in SPY averages a gain of .20% (293 up, 185 down) vs. a gain of .01% for the remainder of the sample (2399 up, 2275 down). Five days out, SPY averages a gain of .62% (295 up, 183 down) vs. an average gain for the rest of the sample of .10% (2567 up, 2107 down).

It's easy to get bearish after breaking out of a multiday range to the downside. Historical investigations are helpful checks on our biases, encouraging us to examine all possibilities, rather than get locked into easy assumptions.
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Sentiment Holding Up Well: A Look at Cumulative TICK

Interestingly, though we've moved back into May's trading range in the S&P e-mini (ES) contract (pink line above), the Cumulative NYSE TICK has stayed well above May levels. Continued strength in Cumulative TICK would suggest to me that we're experiencing a correction in a bull market, not the start of a renewed bear.
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From Range Trade to Breakout: Making the Identification

One of the topics I'd like to cover in the summer seminar in Chicago is recognizing range vs. breakout trading conditions. The Market Delta chart above (click for detail) shows how we broke below the volume bulge mentioned in the intraday tweet (921-924) and found increased volume/participation as we broke the overnight lows and then broke below Monday's low. It is the acceptance of price at lower levels that creates a shift in the market's estimate of value. That acceptance, demonstrated by increased volume-at-price, is our best indication that the institutional traders/investors that move markets are participating in--indeed, leading--the weakness.

If we can get conference room space during market hours, perhaps we'll be able to track some of these ideas in real time. More on the seminar to come...
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Pre-Opening Briefing: How Do We Trade After Good News?

Here's a look at my Market Delta screen shortly after release of the PPI and housing numbers (bottom chart), both of which were better than expected. We have held above Monday's lows in the overnight trade, with commodity weakness and dollar strength reversing. Note the volume at offer exceeding volume at bid (bottom histogram) so far; I'm now watching to see if we can move back into the June trading range vs. establish value lower, into May's range. A bounce following a high momentum decline is not unusual; returns thereafter tend to be dicey. A move below the level from which we rallied with the 7:30 AM CT numbers would suggest difficulty moving higher on good news; that would hit my radar.

9:03 AM CT - Here's an update of ES trading (top chart); note how we're building value between 921 and 924 in a range trade so far this morning. I'm watching closely to see if moves toward the edges of this range attract volume (institutional participation). Should volume slow significantly, we could set up some extended range trade.
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Ten Day High Followed By Ten Day Low

We had a 10-day closing high on Friday in the S&P 500 Index (SPY) followed by a 10-day closing low on Monday. It turns out that this is an unusual reversal. Since 1990 (N = 4895 trading days), there have only been six occasions in which this has occurred.

While six occasions is hardly a sample from which we can build a robust analysis, it's worth noting that the market was down subsequently on a five and ten day basis on four of the six occasions by averages of -.22% and -.76% respectively.

Although there are often occasions when buying stocks following weakness is indicated, there is nothing to suggest a positive edge following a reversal such as we saw on Monday. This fits with my earlier analysis of what happens following strong downside momentum days.
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Indicator Update for June 16th

Last week's indicator review concluded that "Friday's price highs in the major indexes were not confirmed by fresh highs in the 65-day high/low measure, an indication that the rally may be in for a period of consolidation. As long as we stay above the May highs in the S&P 500 Index, however, one has to respect the sustained buying displayed by this market." During the subsequent week, we did indeed see range trade and consolidation, followed by Monday's weakness. That weakness took us below May's highs, raising the possibility that much of the June strength was a head to May's shoulder.

Even before Monday's decline, we saw a drop in trend strength among the S&P 500 sectors, as well as poor relative performance from three key sectors. Although Friday closed at a bull market high, we saw non-confirmations from the number of stocks making fresh 65-day highs vs. lows (middle chart) as well as reduced upside momentum (top chart). While the advance-decline line for NYSE common stocks did register a fresh bull peak early in June, it did not for the S&P 600 small caps (bottom chart, much credit to Decision Point). This once again highlights the distribution occurring at the June highs.

So where do we go from here? On Monday we registered 391 new 20-day highs among NYSE, NASDAQ, and ASE stocks, against 768 new lows. As long as new lows exceed new highs, we have to look at this as a potential trend shift that could take us well into May's trading range. The key is holding below those May trading highs: if June's trade amounts to a false breakout, we should stay within May's range and trap the June bulls. A move back into June's prior range and above May's highs would set up a fresh set of range bound conditions.

As always, I will be following the indicators each day before the market open so that readers can gauge market strength and weakness. Those indicators are posted via Twitter; subscription via RSS is free, or you can check out the five most recent tweets on the blog page.
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Summer Trading Seminar in Chicago: Quick Update

Thanks to readers who have expressed interest in a summer trading seminar in Chicago. Trevor at Market Delta has kindly offered to use his tenancy at the Chicago Board of Trade building to find a large and affordable room for the session; I hope to have details on this later in the week. Based on the availability of the space, I believe we'll be looking at a weekday afternoon some time in the first half of July. I'm also talking with Trevor about doing a webinar for those who cannot attend the live session in Chicago.

Topics will range from reading market psychology to mastering our own psychology as traders. I will devote a portion of the time for open Q&A in a group coaching session. I look forward to meeting and having a good time. Details to come!
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