Is There a Formula for Trading Success?

This afternoon's webinar hosted by SMB's Option Tribe featured excellent questions from participants.  Two in particular have me thinking, and I hope to share thoughts soon:

1)  How does the developmental phase of the trader (age, marital status, kids/no kids, other career activities) affect how the trader approaches markets?  Might there be different best practices for traders in middle and later years compared with those in early years?  Are the motivations of older traders different from those of younger ones?

2)  How do the best practices of longer time-frame traders differ from those of shorter-term ones?  Is the learning process for longer-term traders different from that of shorter-term ones?  How can longer-term traders achieve the deliberate practice needed for the development of expertise, given that they place far fewer trades than daytraders (and hence have fewer learning trials)?

There are many paths to success.  Traders vs. investors; younger participants vs. older ones; intuitive pattern traders vs. research-oriented ones--all may have very different best practices and work processes.  Trying to mimic the practices of traders unlike oneself might be a formula for frustration.

Further Reading:  A Solution Focus to Trading

Creating Change Through Corrective Emotional Experience

There are two very important principles of psychological development that are relevant for traders.

The first is the use/disuse principle:  Use it or lose it.  We grow in the capacities that we challenge and exercise.  What we don't challenge and exercise, we lose.  There is no stasis over time, only development and decay.

The use/disuse principle forces us to examine our daily and weekly activities and ask ourselves which life functions we are using and which we are losing.  Are we growing and developing physically?  Emotionally?  Intellectually?  Spiritually?  Socially?  Professionally?  

When we are in a use spiral, the energy we gain from growing in one or two of those areas catalyzes efforts to develop the others.  

When we are in a disuse spiral, the energy lost from neglecting one or two of those areas gives us less fuel for growth in the others.

Much of performance is creating processes that ensure use spirals.  Much of aging is living out disuse spirals.

The second principle is the mirroring principle:  We are what we eat, and we are always consuming life experience.  Everything we engage in life--the people we deal with, the activities we undertake--acts as a mirror, reflecting something about ourselves.  

Over time, we internalize what is mirrored to us:  if we have successful experiences, happy experiences, loving experiences, and affirming experiences, those emotions are what we internalize.  If we are mired in unfulfilling work, hurtful relationships, and frustrating activities, the sense of self that we internalize becomes much more negative.

Much of life success comes from creating and maintaining the right mirrors.

And, of course, the very best life experiences are ones that push us to "use it" and, in so doing, create positive mirroring experiences--or what therapists call "corrective emotional experiences."

We don't change via motivation.  We change by reshaping life experience.

Further Reading:  Creating Change With Corrective Experiences

PREP: Bottoming Stock Market or Gain Before Eventual Pain?

I've received quite a few questions from traders about stocks and whether we're putting in a bottom here.  The question is understandable.  If you look at a chart of the NYSE Composite Index ($NYA), for instance, you'll see that we've bounced off a support area.  Too, you can see from the number of fresh three-month highs minus lows among all common stocks (charted above), that we are at levels consistent with pullbacks during the past year or so.

What the chart doesn't show is that pullbacks in 2012 (early June, mid-November) occurred with well over 1000 issues making three-month lows over three-month highs.  While we did bounce off lows today, that occurred after new three-month lows had expanded from their April 11 levels:  782 vs. 621.  

Perhaps even more interestingly, new three-month lows (at 782) are getting close to the level we saw early in February (968), even though SPY is well above its early February price.

All of this suggests deterioration from my perspective.  Small cap and growth-oriented NASDAQ shares are underperforming, contributing to the new low heaviness.  In a bottoming market, you'd like to see fewer shares participating on the downside, as stronger, pro-risk sectors begin to assume leadership.  So far, that is not happening.  It's the defensive names and sectors that are near their year's highs.

My models weigh the 2013-2014 experience strongly and so have been bullish lately.  And, yes, we have gotten some bounce.  I am mindful, however, that we may be breaking recent regimes--hence the close watch on breadth and downside participation.  Those measures suggest we're not getting stronger.

Further Reading:  An Earlier Read on Market Strength

Succeeding by Failing: The Art of Messing Up

If you haven't read the latest Howard Marks memo on the topic of daring to be great, I heartily recommend it.  

In it, the Chairman of Oaktree Capital makes the case for the importance of being different--and the importance of daring to look wrong.  The memo makes a strong case for creative thought being crucial in the generation of superior financial returns.

The recent post on signature strengths suggested that sustained trading success is an expression of our distinctive abilities and our application of those to markets. By definition, this means that there is an idiosyncratic component to success: it is a function of what makes us unique and distinctive. 

To a person, when I think of highly successful traders, I can identify something quirky and original in how they approach markets.  They are the antitheses of those who purchase trading software, stick with the preset values, and expect to make money.  How they view and trade markets is closely aligned with who they are.

Howard Marks makes the excellent point:  Everyone is willing to dare to be great.  Few people, however, have the fortitude to stand out and dare to do the things necessary to be great.  "You can't take the same actions as everyone else and expect to outperform," Marks observes.

Creativity--the generation of unique and distinctive ideas--springs from what is unique and distinctive in us.  It pushes us to innovate:  try new things, find new ways of doing old things.  Creativity ensures that we will make mistakes and fall flat on our faces.  Creativity sounds noble and beautiful, but in reality it is a messy process, filled with dead ends and new things that don't work.  What we don't typically see is the many prototypes of the inventor that don't work; the drafts of a book manuscript that have to be deleted by the author; the canvasses of the painter that never see the light of day.

Can't lose goes hand-in-hand with can't win, Marks points out.  Nothing expands without a push of boundaries--and a willingness to look wrong and be wrong.  A great way to assess your trading process is to ask yourself, "How often am I conducting failed experiments?  How often am I innovating and finding truly fresh ways to be wrong?"  

It's much easier to trade fearlessly when you embrace failure as your teacher.

Further Reading:  Creativity and Trading Success 

Treating the Mind by Minding the Body

A growing body of research suggests that physical activity brings both health and emotional benefits.  Indeed, exercise may help emotional health by increasing neurochemicals in the brain that help to buffer stress.  By reorganizing the brain, physical activity can help us become more effective in dealing with a variety of life demands, including those in financial markets.

Psychotherapy research suggests that change is most likely to occur when people undergo shifts in their states of awareness.  Staying our habitual frames of mind helps support our habitual behaviors.

What if one of the best ways to make those state shifts is shifting the body?

That can occur through meditation, through yoga movements, through Crossfit workouts, etc.

The idea is that giving your body fresh energy may fuel the mind's awareness by adding to emotional well-being.  

We can fill out trading journals, talk with coaches, and try the latest hot trading setups.  If we're sitting in a chair, hunched over a computer, however, we may be placing our bodies in the absolute worst position to energize the changes we're trying to make.

Further Reading:  Shifting Emotional Gears as a Trader

Signature Strengths and Trading Success

Humility spurs practice; confidence spurs performance.  To have the confidence that you have what it takes to sustain good risk-adjusted returns *and* to retain the humility to know that you always need to practice to retain and renew your edge:  that's a rare and challenging combination.

But how do you practice if you don't know your best practices?  

Every very successful trader I've known has at least one signature strength:  some skill or talent distinctive to them.  That strength is not something specific to trading: it is something that defines who the person is across domains.  Super-disciplined people become super-disciplined traders; uniquely creative people approach markets in unique, creative ways:  success in markets comes from leveraging the best of who we are.

When you identify and enact your best practices in markets, you train yourself to become more of who you already are when you're at your best.

I am at my best as a parent when I'm emotionally intelligent, attuned to the communications of my children.  That is also when I'm best in markets and best as a psychologist.  No market research or chart study can help me if I'm so out of tune that I'm no longer attuned.

So some of my best practices are actions that I take that keep me open, responsive, and attuned.  Those will be different from your best practices.  Once you know your signature strengths, you have an opportunity to leverage them and consistently draw upon them.  That's what best practices accomplish for us.

Those best performances are guideposts, pointing you to who you are at your best.  Learn from your worst trades, but absorb the lessons of your best ones.  Inside those best trades is the best within you:  the signature strengths that will anchor your trading success.

--------------------

This Wednesday at 5 PM, I'll be doing a free webinar session hosted by SMB:  the topic will be best practices.  I look forward to building on this important topic.

--------------------

Further Reading:  Best Practices Submitted by TraderFeed Readers 

Preparing to Win in Markets

I have been spending significant time each day for the past six months preparing for a return to active trading.  During that time, I've developed a method for identifying and analyzing aperiodic (non-time based) cycles in markets.  I've also refined a multivariate method for modeling stock index futures based upon a core set of technical drivers of price action and standardized my methodology for conducting historical market queries to greatly reduce bias and the odds of overfitting market data.  Finally, I've culled my intraday indicators to focus on the few that best track whether or not current market action is falling in line with the forecasts from the cycles, models, and studies.

It's a lot of work.  But that's how you build a business:  you spend days and months crafting your products before you ever make your first sale.  And the crafting never stops, because the marketplace never remains static.

In coming days, I will begin sharing a whole new set of posts.  These will be labeled "Preparation".  Some will be sent out as tweets from @steenbab via StockTwits; others will be included as short blog posts, depending on the content.  Preparation posts will be sent out only if I see distinctive potential opportunity in markets or have special observations that could be useful for traders.  All will be sent out prior to the U.S. stock market open.

Meanwhile, here are a few preparation resources I'll be relying upon to start my market day.  A more complete list will be the topic for a separate post:

*  Financial blog and journalism summary:  Abnormal Returns - Take a look at the links for the day.  There are posts pertaining to markets, trading strategy, the economy, you name it.  You would have to spend hours to replicate the curation accomplished by Tadas.  Combine with your favorite news feed and you have a great resource for staying on top of current market thought.

*  Stock picking:  StockTwits - Punch up a stock or ETF and you get a chart.  Click on the tabs above the chart and you see the number of messages posted about the issue and the social sentiment for those shares.  Click on "heat map" on the top menu bar and you'll see social sentiment across sectors over varying time periods.  There is a lot of information here, folks--even apart from the content of the people you like to follow.

*  Charting:  FinViz - News, insider trading info, charts, stock screening, creative heat maps that track stocks and sectors, performance tracking by stock groups, tracking of futures and forex--and that's just their free information!  This is one of the best (and underappreciated) financial sites around.     

*  Indicators:  Index Indicators - This is where I get my breadth data, but there is a lot more information on the site, including put/call data the ability to run basic queries.  Mo has done an excellent job of including technical perspectives on international indexes as well as U.S. ones.

*  Analysis:  Stock Spotter - John Ehlers and Ric Way track cycles and more on this site and include real time stock picks and a full track record of past picks.  The Swami charts take a bit of getting used to but incorporate quite a bit of useful information in a single view.   

Life is a team sport.  One key to success is selecting the right teammates and resources.  There is too much going on in the world--and in markets--to stay on top of it all by yourself.  Preparation is easier when you can also rely on the quality work of others.  I hope to be able to contribute quality work to your trading efforts.

Further Reading:  Three Myths of Trading Psychology

Dealing With Market Insanity

In The Psychology of Trading, I told the story of the psychiatric patient who repeated over and over that he was a department store.  One junior therapist after another tried asking questions of the man and he only repeated, "I'm Woolworth store!  I'm TG&Y store!"  Needless to say, the trainees thought the man was completely crazy and could not be a candidate for talk therapy.  Medications would be needed to bring him into contact with reality.

A senior trainee, however, sat patiently with the man.  When he proclaimed that he was a retail outlet, she calmly asked, "What's for sale?"  The man looked at her intently and said that nothing was for sale.  When she asked him why, he explained that the shelves were bare.  She then asked why he had no products and, lo and behold, a discussion about feeling empty ensued.  The man made perfect sense if you accepted him on his terms.

So it is with markets.

A trader recently told me that trading the markets was "insanity".  Nothing made sense, he explained.  None of the moves could be explained by fundamentals.  The economy was firming; rates remain low:  why are stocks selling off?  If the Fed is tapering and readying markets for a rate rise, why is fixed income rallying?  It's insane.

I thought of Woolworth Man.  So often, what doesn't make logical sense makes good psycho-logical sense.

When traders had the Fed at their backs, money flowed into speculative issues.  From the end of last year to late February alone, TSLA practically doubled.  It was up roughly 5x in the past year before moving down about 20% from that February peak.  The biotechnology ETF IBB rose over 50% in the past year, also hitting a peak in late February--and since is down over 20%.  But utility shares (XLU) and consumer staples stocks (XLP)?  They're not far off their highs at all.

Investors are acting as if the Fed no longer has their backs.  They are sticking with stability and selling momentum.  They started the year with the perception of tailwinds and now are behaving as if they're facing headwinds.  That makes them take risk off the table.

So the market falls, the growth companies drop, assets that were held for their strength move lower, and it doesn't make sense.  Insanity.

Except to the seasoned traders who calmly enter the room and ask the crazy market, "What's for sale?"

Further Reading:  Life Insights From Great Inventors

How to Deal With the Uncertainty of Trading

Reader Eldad Nahmany asks the excellent question, "What if I can eliminate uncertainty by accepting the true range of results that can arise from each trade?  I guess everybody said it before: accept the loss before you even enter the same way you accept the winner, then I can become a true observer of information.  The question now is how do I accept the loss before i get involved? I need to believe in the trade, no?"

It's a dilemma on the surface:  how do you maintain confidence and conviction in a trade and, at the same time, embrace the trade's uncertainty by planning its failure?

If you were a retailer and you had perfect knowledge of demand, you would always order the right amount of product in each category and never maintain excess inventory.

Once we accept that we cannot have perfect foreknowledge, then we accept the necessity of inventory.  We order extra product, because we don't know if customer interest will expand or contract; if a particular offering will fly off the shelves or languish there.

Of course, you could ask the retailer, "How could you believe in your product and yet still plan for inventory?  Aren't you preparing for your own failure?"

The answer, of course, is that any specific product might succeed or fail.  If you are a good buyer and merchandiser, you succeed across a variety of products.  You carry enough different products and price them well enough to ensure that you'll have some hits as well as some duds.  The duds will lose you a limited amount of money; the hits will be restocked again and again and will make up for the duds--and then some.

So it is with trades.  You don't need blind confidence in each position.  You need enough confidence in your overall trading ability to put on a variety of trades.  Some will be duds, and you'll catch those quickly and minimize their losses.  Others will be hits and you'll add to those as they prove themselves.  Any particular trade can be a failure; it's the edge across trades that makes you successful.

When people wax poetic about their conviction in trades, my emotional reaction is:  Whatever.  A trade is a bet at the poker table.  Some bets will work, some won't; some you'll size up, some you'll fold.  Whatever.  Over time, if you play the odds, you'll do OK.  Beyond that, it doesn't make a lot of sense to beat the chest and invite overconfidence bias to replace normal confidence.

Every forecast of a statistical model can be wrong.  Every trading judgment is fallible.  If you have a 50% hit rate on your trades and you trade once a day, on average you're going to have an occasion in which you lose every day for a week during a trading year.  That doesn't mean you're in a slump; it doesn't mean you should change what you do.  It's going to happen and you can mentally prepare yourself--and size yourself in such a way that five consecutive losing days won't take you out of the game.

The goal is not to eliminate losses--that would require omniscience.  Rather, the goal is to  anticipate losses so that you're never surprised, never overwhelmed, never thrown onto the back foot.  True confidence comes, not from believing that you must be right, but from knowing that you can survive and even thrive if you're dead wrong.

Further Reading:  The Power of Uncertainty   

Three Best Practices for Turning Trading Stress Into Performance

In the recent post on trading stress and distress, I suggested the former was necessary for our development as traders; the latter was a potential impediment to our evolution.  Stress is the result of challenge; distress is the breakdown that occurs when we are overwhelmed by challenges.

So how can we keep the normal, inevitable, and ultimately constructive stresses of trading from becoming sources of distress?  Three best practices that I'll be touching upon in my upcoming webinar presentation are key:

1)  RISK MANAGEMENT - Trading losses should be planned and anticipated.  By limiting risk per trade and limiting drawdowns across trades, you ensure that any single period of poor performance will not impair your emotional or financial capital.  This means that proper trade construction, portfolio construction, and reduction of risk-taking during periods of poor performance are as important to success as generating the next great trade ideas.  One of the most common trading problems I see among less experienced traders is that they size positions and predicate their risk taking based upon how much money they want (need) to earn, not on how much they can afford to lose.  They take so much risk that they ensure an eventual emotional upheaval.  

2)  PERFORMANCE FOCUS - The ever-changing nature of markets ensures that they will test you.  They will test your research and understanding; they will also test you emotionally.  Turning the stress of challenge into fuel for growth is a great way of staying positive, constructive, and free of distress.  Look at it this way:  the market is your gym and it's going to give you a workout.  What trading muscles are you going to build this week?  This month?  Turning setbacks into learning lessons and goals for future trading ensures that you will use losses and drawdowns to make yourself better.  A positive performance focus starts with constructive self-talk:  how you process market challenges will very much impact your emotional responses to those challenges.

3)  LIFE BALANCE - There will be times when markets will not sustain you emotionally--and quite possibly not financially.  What will get you through the lean periods?  Having activities and relationships that nourish you emotionally, physically, and spiritually can make all the difference in sustaining the mindset needed for optimal performance during difficult times.  Having diversified income streams takes a great deal of pressure off P/L and makes it much easier to have the patience to wait for good trades.  We know that emotional well-being contributes to creativity, productivity, and positive performance.  The best way to avoid distress is to build a life buffer of well-being.

So, as I'm writing this, I'm not a happy camper.  My models gave useful buy signals in stocks late in March and sell signals in the first few days of April.  They also were premature in giving buy signals the last few days and were completely leaning the wrong way yesterday.  Intellectually I know that the best of predictive models in markets only reduce uncertainty, but when I get false signals, I go back to work and see what I can learn from them.  It is not fun to get something wrong when you've put days and weeks of long effort into crafting something.  But I know that's the only way the craft will get better.

(Note to self: you get different results when you model realized vs. implied market volatilities). 

"If it ain't broke, don't fix it," is the wrong approach.  In fixing breaks, we build our selves.  And that ensures we benefit from the stress of operating in uncertain, risky environments.   

Further Reading:  The Well-Being Hypothesis   

Navigating Trading Stress and Distress

Well, not too many traders getting desserts from the markets lately, but quite a few reverse desserts!

A developing trader wrote to me recently:

I have a question that I would like to ask you. It has to due with the recent turn in the markets. My question is how to cope and manage the stress that comes with trading. I have been able to cope with the stress for awhile now, but in times of market volatility I have more trouble with dealing with stress and it spilling over into my personal life.

It's a great question; let's tackle it first by clarifying our terms.

Stress is the result of challenge.  When I lift 10 pounds more than my normal workout weight in the gym, I create stress for my body.  Distress is a breakdown resulting from a poorly managed stress.  If I try to lift twice my normal weight, I can damage muscles: that is distress.

Or, to take another example, Margie and I are taking a vacation in May.  We could go to a familiar Florida beach and have a relaxing week.  That would be stress free.  Or we could go to northern Alaska, navigate fjords and glaciers, and see things we've never encountered before.  That would have its stressful moments.  (Of course, we're going to Alaska).  There is no growth and development without stress.  Stress is the natural result of testing our boundaries and moving out of our comfort zones.

When you are developing as a trader (and hopefully all of us are), you always want markets to challenge and stress you--just like you always want workouts in the gym to challenge and stress you.  Show me a stress-free workout and I'll show you one that did not result in further aerobic fitness or strength.  We grow by taking the challenging path to Alaska, not the well-worn path on the beach.

So when our developing trader laments recent stress in markets, he's really saying that market action is overwhelming him, not just challenging him.  He isn't simply going to Alaska; he's alone with a dogsled miles outside of Nome.  What he is experiencing is distress--a kind of breakdown when we can no longer manage a challenge.

Distress can provide painful and ultimately valuable learning experiences, but no one performs at their peak while in a state of distress.  We want markets to test us and make us elevate our game, but we don't want markets to traumatize and impair us.  When stress morphs into distress, we are on the path to trauma. 

All of this means that we have a twofold mandate:  maximizing the value of stress and minimizing the likelihood of distress.  We want to learn and grow in the face of trading challenges, but we don't want those challenges to cripple us.  How we navigate that twofold mandate meaningfully shapes our learning curves--and our P/L curves.  The next post will take a concrete look at how we can meet that mandate.

Further Reading:  Overcoming Trauma

The Power of Cognitive Flexibility in Trading

In response to the recent post on the risks as well as rewards of selective attention, reader Igor Marinkovic raises an excellent point:  If you entertain outcomes at odds with your trade expectations, might you not create a situation in which you overweight non-confirmatory information and prematurely abandon your position?

Igor is absolutely correct.  Indeed, we can think of worry and anxiety as selective *negative* attention.  In becoming too focused on what can go wrong, we can overreact to the first bit of random variance from our expectations and fail to allow trades to go to their targets.

Clearly there is an alternative to blind overconfidence and skittish lack of staying power in ideas.  That alternative, I believe, is flexible commitment.  We can be committed to a course of action at the same time that we're open to modifying it.  Military leaders know this well:  you create a strategy, but few strategies survive the fog of war.  You are always ready to modify the strategy based upon conditions on the ground. 

Cognitive flexibility requires emotional flexibility:  the ability to anticipate being right, but also prepare for being wrong.  We recently moved sharply lower in stocks and my regression models, as well as a breadth query that I ran, suggested the probability of a bounce over a 3-5 day horizon.  Indeed, we got some bounce in today's session.  But I know that models and queries based on historical data rely on a crucial assumption: that the immediate future will mirror the recent past.  

As we look at the tense situation within Ukraine and Russian concerns there, we have to entertain the possibility of a new element entering into markets.  Too, we see fresh tensions between an expanding China and its rivals, including recent concerns over disputed islands.  Can historical models adequately account for unique geopolitical events?  Not without meaningful modification.

Cognitive flexibility means building plans around your research, models, experience, and expectations--all the while creating alternate plans should this time truly be different.  I might expect a bounce in stocks, but I also know that nasty headlines emerging from Ukraine or the East China Sea could severely test nearby support in the ES futures.  I don't just want a trading plan; I also want a Plan B.  The best-constructed quant models are severely challenged when idiosyncratic factors drive price action. 

Hope for the best, plan for the worst: not a bad approach to life and trading.  Flexible commitment is not an oxymoron: it lies at the heart of performance in fast-changing, uncertain domains.

Further Reading:  Why Controlling Emotions is Not the Goal of Trading Psychology 

Selective Attention and Trading Blindness

Selective attention can be a blessing and a curse in performance activities.

Before you go any further with this post, please take this short selective attention test from the research of Chabris and Simons.  You'll see students in white and dark shirts passing balls.  Your goal is to count the number of passes tossed by the people in white shirts.  That requires a good degree of concentration, as you have to filter out the activities of the black-shirted participants.  Give it a try and see how many you count.

The advantage of focused attention is that allows us to process information within our focus quite efficiently and effectively.  Chabris and Simons note that chess experts recall board positions better than non-experts, but only when the board depicts realistic game situations.  If the boards are laid out randomly, the experts show little if any advantage in memory.  Their focus and memory are quite selective, based on the positions they've studied and played.  

With selective attention, however, we can become so focused on what we expect to see that we fail to notice the unexpected.  That is the big takeaway from the test in the video linked above.  If we expect that markets will move a certain way based on our research or experience, we're apt to miss the information in front of our faces that tells us that the market is doing something unexpected.  This is called inattentional blindness:  the inability to see things that we don't expect to see.

Have you ever traded during a day, lost money, reviewed your trades, and then asked yourself how you could have possibly made those decisions?  The chances are good that you're noticing something in your review that you were not prepared to see during the trade.

Inattentional blindness is a natural outcome of confirmation bias.  We look for information to support our expectations and disregard what does not fit into our ideas about the world.  As traders, we can be very calm and focused--and completely biased and blind.  One cure for inattentional blindness is to actively mentally rehearse a variety of scenarios and outcomes, so that you're truly open-minded when events do unfold.  

We often hear that risk-taking should be predicated on one's conviction in their market views.  It is when our conviction is highest, however, that we are most at risk for blindness.  It is the explicit and active consideration of multiple views--not just confidence in a single perspective--that enables us to best see what is there in markets, and not what we expect to be there.

Further Reading:  Countering Information Processing Biases

Trading and Losses: When to Stop the Pain

In a recent blog comment and in a past post on his site, Bruce Berger asks the question about when to use stop losses as a value investor.  After all, if you believe an asset is a good buy at one price, surely isn't it a better buy 10% lower, 20% lower, 30% lower...??

The topic is relevant for those who have been long the stock market and now see weeks of gains evaporate in a couple of trading sessions.

When do you add to positions and achieve greater value?  When do you stop out of positions and preserve capital?

My approach to this issue is different from some, as I try to approach it both logically and psychologically.  Unlimited losses pose risk of financial ruin, but also risk of emotional ruin.  Losses--for a competitive trader--will always be annoying and upsetting.  They may even be painful at times.  But they should not be traumatizing.  

If you lose 50% of your capital, you need to double your money to get back up to high water mark.  Game pretty close to being over, because the risk you'd need to take to double the remaining capital would expose you to meaningful percentage drawdowns.  But if you lose 50% of your capital, you don't just return to markets cheerily swinging for fences to make the money back.  Losses of that magnitude have the same psychological impact as other significant losses:  they set us back emotionally as well as financially.

To protect your mind as well as your money, each trade has to be sized as a bet and each bet has to be expressed to keep you in the game.  You can limit risk through hedging, through the use of options, or through the use of stops.  Think of it this way:  Every trade expresses a hypothesis based upon an idea.  In essence, when you enter the market, you're saying, "Because of X fundamental/technical/statistical reasons, I believe we are going higher/lower and I am willing to risk A in order to make B."  The hypothesis is that you'll achieve the profit B before hitting the loss A.  

Those who stay in trades on an unlimited basis look only at the idea, not the hypothesis.  They are betting on being right, not betting on a specific market outcome.  When ideas are not expressed as risk-limited trades, the only stopout remaining is pain.  And that's not an outcome good for emotional or financial capital.

Further Reading:  Emotional Trauma and the Dark Side of Trading

Preparation and Opportunity to Start the Week

"Chance favors the prepared mind," Louis Pasteur observed.  Here's some worthy preparation to start the week and place yourself in a position to benefit from chance:

*  Great post from Abnormal Returns on avoiding the monsters in the financial industry;

*  Here's an excellent article on the dark side of backtested trading strategies; see also this post on testing the predictions of market gurus.

*  Worthy effort from VIX and More on tracking emerging market volatility and its implications for trading;

*  Valuable post from Derek Hernquist on using breadth data to define the market opportunity set and become more systematic with discretionary trading;

*  Good article on why rising interest rates aren't necessarily bad for bonds;

*  Interesting "gap up" trading pattern from Quantified Strategies;

*  Trend following has not performed so well of late.

*  Why selectivity is so important to trading performance.

Three Best Practices During Trading Slumps

A respected friend and trading colleague had his first big trading day in a while on Friday.  He noted the market's weakness early and pressed his advantage.  Not long before, he had noted that he was on a cold streak and expressed frustration with the pace of his progress.

Traders will often write in their journals when they are experiencing such frustration.  The really important times to be journaling are after the big successes.  It is difficult to leverage our strengths if we're not aware of them.

While it's tempting to look first at the good trading on Friday, it's what came before that set him up for that day's success.  Here's a list of best practices during trading slumps:

*  Keeping risk-taking down until you see markets clearly - Losing small and gaining big is what makes for excellent risk-adjusted returns.  Accepting that you're not seeing things well is half the battle.  By continuing to actively engage markets in small size, you give yourself an opportunity to regain perspective.  Trading larger or more often out of the frustration of losing is a recipe for disaster.

*  Focusing on yourself - Very often, losses occur because market patterns have changed.  Slumps occur because your mindset has changed.  By working on yourself before you go hard at markets, you place yourself in an optimal mindset to press your advantage when things line up.  Stepping back from trading, renewing your energy, getting back to core strengths--all can help create the mindset to see markets freshly.

*  Searching and re-searching - Stepping back from trading doesn't mean you step back from markets.  When times are tough, great traders double down on research and idea generation.  It's that pipeline of ideas that will produce the next winning trades.  Research and development is what ultimately keeps your trading business alive; turning the search for trades into trading re-search turns a losing period into an opportunity for advancement.

Drawdowns are inevitable.  Slumps are not.  Your job in coaching yourself is to learn from the drawdowns and use them as opportunities to make yourself better.  A drawdown only becomes a slump when it gets inside our heads and takes us away from our core strengths.  Drawdowns become business opportunities when they focus us on those strengths and prod us to expand them.

Further Reading:  The Key to Breaking Trading Slumps

Building Your Trading Culture

Recent posts have focused on running your trading business, especially by keeping score and innovating.  Toffler's quote is a reminder that the world is constantly changing, requiring not just learning, but relearning.  I increasingly find that traders fail to succeed, not because they cannot learn markets and not because they are beset with psychological problems, but because of the inherent challenges of actively trading markets and simultaneously running an adaptive trading business.

Early in a trader's development, a great deal of time is spent learning new skills, studying different market relationships and patterns, and trying out different trading strategies.  Once the trader is established, how much time is spent in learning/growing mode?  Understandably, the demands of keeping up with markets push innovation to the back burner: it's hard to work on tomorrow's trading when you're pushing to make money today.

If you look at a successful company like Apple or Toyota, you'll find that they are doing fresh things from one time period to another.  They innovate.  They improve their processes.  They stay close to customers and anticipate shifting tastes and needs.  They don't stay still.  They don't just motivate; they inspire.

That is rare in the business world (which is why those companies are frequent objects of study in business schools); it is equally rare in the trading world.  

Look at how most traders run their businesses:  how they understand, structure, and assess their processes; how they pursue innovations in trading; how they evaluate what they do and how well they do it and feed that information forward for continuous improvement.  Would you want to work for such a business?  Would you invest in those businesses?

The WindoTrader site makes a great point about "trading culture".  Successful businesses have a distinctive culture:  they have core values, unique areas of expertise, and signature strengths.  Market knowledge and self-understanding are necessary for trading success, the site points out, but the culture created by a trader is what brings those two together.  Culture is "the process of knowing the why, what, when, where, who, and how of your trading."  It is what defines what your trading business is all about.

One can be passionate about trading and yet completely neglect running a trading business, just as one can be passionate about cooking and baking and fail to run a successful restaurant.  Terry at WindoTrader points to Bridgewater as an example of a trading enterprise that is grounded in culture.  One's own culture may differ from Bridgewater's, but it will serve the same purpose: it aligns who you are with what you do.  When you are aligned, you become visible--and the right people find their way to you.

How do you define *your* trading culture?  Here are a few questions to get you started:

*  Write out a mission statement for your trading business.  Make sure that statement captures the values, principles, and goals of your trading business.

*  What are you doing, specifically, to ensure that you're following your mission?

*  What truly distinguishes your trading business from the many others in the marketplace?  What is your distinctive knowledge?  Skill sets?  Experience? 

*  What processes set you apart from other market participants?  How are you generating ideas and trades that differ from consensus?

*  What is your vision for the future of markets--the opportunities and the threats--and what are you doing now to prepare for that future?  

*  How do you detail your trading results and use them to make yourself more knowledgeable and skilled?

Interestingly, those are some of the same questions savvy investors would be asking if they were looking to place money with you.  They realize they are investing in a business, not just a track record. 

Further Reading:  Self Leadership and Trading

Deep Learning and Trading Edge

Recent posts have focused on trading "edge", the advantages of successful traders in the marketplace, and what that might mean as a broader approach to life.

Some of these "edge" factors can be found in a post from Charles Kirk, which passes along insights from George Fontanills.  Among the key ingredients of "a winning trader's edge", the list includes:

*  Humility - Never thinking you're smarter than the market.
*  Learning Curve - Acquire and test your knowledge to build confidence before taking risk.
*  Flexibility - Adapt your strategies to market conditions.
*  Planning - Know what you want to do next to avoid impulsivity in the heat of battle.
*  Specialize - Develop an area of expertise and master one thing at a time.
*  Continuous Learning - Never stop growing and innovating

Another post by Kirk highlights a very important part of developing an edge:  knowing your probabilities.  Read the part where Kirk talks about how he tracked the success of technical patterns.  This captures the essence of deliberate practice and the development of elite performance.  There is an important difference between traversing a learning curve and immersing yourself in a deep learning curve.  Learning curves help you become knowledgeable; deep learning curves cultivate expertise.

This is why I like the "anchor trade" concept.  Instead of trying to learn many kinds of trading and developing expertise in none, it makes sense to master one facet of the craft before extending the expertise to related areas.  I strongly suspect that mastery-based learning is more effective in exploiting brain plasticity than more diffuse, generalized learning.  In other words, the right kind of learning process is more likely to rewire us for further learning.  Not all experience brings expertise: deep learning is transformative.

Further Reading:  The Brain's Role in Trading Performance

Examining the Edge of the Discretionary Trader

Traders commonly speak of having an edge in financial markets--a strategic advantage over other market participants.  When trading systematically, or when using systematized ideas as a backbone for decision-making, that edge is captured through an empirical process:  testing over a market period, applying the test to a fresh period in the market, and validating in real time.  One risk in such a strategy is testing so many ideas over so many periods that eventually some will provide good results merely by chance.  Such "overfitting" can be difficult to detect--and is more common than generally realized. 

On the discretionary side of trading, it is especially difficult to recognize those with an edge, as audited track records and detailed performance metrics are rarely available to the trading public.  Over the past couple of months, however, I have played market sociologist and used posts to Stock Twits, as well as material published on websites, to identify what active and experienced market participants are doing.  Several of these discretionary participants are actively involved in the training of traders:  these include AlphaTrends, Crosshairs Trader, and SMB Training. 

(Note:  none of these enterprises are aware that I am writing about them; none solicited my post and I have not accepted--nor would accept--any compensation or promotional consideration for mentioning them in the blog.  I've focused on them because I have interacted with each of them in the past and found them to be serious about what they do.  They have been doing this for a while, have an extensive history of posting ideas to StockTwits, and have gained a substantial number of followers.  All put significant work into their market activity, creating and posting videos and offering specific trading ideas in real time.  I know some traders look askance upon those who charge fees for educational services--"those who can't do, teach"--and Lord knows there are some sketchy providers out there.  One advantage of a platform like StockTwits is that it provides a track record of idea-related productivity and the value of such ideas to a trading community.)

So what are common elements in the strategic edge sought by these discretionary stock traders?  I observe several:

1)  A discipline of pre-market preparation:  All emphasize the importance of process and preparation: sticking to what you do best and being prepared for fresh opportunity--and threat--each market day.

2)  Selectivity:  All have some methods for screening stocks and focusing on a core group that offer opportunity.  Often, these screens focus on stocks that are trading actively, that show good movement, and that are setting up for directional price moves because of earnings reports, breakout patterns, etc.

3)  Patience:  This follows from the first two.  The experienced traders emphasize risk management and waiting for high quality trades, rather than overtrading.  All stress understanding the current market environment and adapting to it.

4)  Diversification:  These traders don't focus on one or two opportunities, but look at a range of promising shares and setups and trade more than one thing at a time.  All the proverbial eggs are not in one basket.  

5)  Simplicity:  My sense is that the traders are focused on understanding what is happening now, not predicting what will happen in the future.  If I had to guess, I'd say that they are talented in detecting the flow of activity in and out of shares and are riding moves as they are getting under way.  They don't appear to be researching deep value and holding for long periods to wait for that value to be realized.

So much of this kind of market edge boils down to pattern recognition, and so much of pattern recognition boils down to practice and immersion in markets.  This may be why the traders I selected all make extensive use of videos in their training:  they are attempting to hasten learning curves by providing more practice time in pattern recognition.

Having observed the tweets and posts of these and other traders in the StockTwits community, I'm left with the question of testing and systematizing some of the elements that they are using for decision-making.  Would adding a backtested component to the discretionary pattern recognition aid selectivity and trading results or would it interfere with a process that is largely implicit and intuitive?  There are considerable promises--and pitfalls--associated with such hybrid trading, but it is a direction I see many skilled traders taking in the money management world.

Further Reading:  Implicit Learning and Trading Performance

From Henry Carstens and Brett Steenbarger: Markets and Life Philosophy

I've been honored to know Henry Carstens for many years--probably more than either of us care to count.  His Vertical Solutions site has a number of gems on the topic of system development, including quite a few worthwhile papers.  (The backstory is that Henry and I met through our mutual interest in the writings and insights of Victor Niederhoffer).

Today's post began as a short email from Henry to me yesterday.  I quickly expanded on Henry's idea, he expanded on mine, and pretty soon we had developed some interesting insights on markets and life.

Below is the sequence; a subsequent post will provide reflection:

HENRY:

Stress is the inability to find or execute an edge in life.

BRETT:

Stress results from challenges in finding/executing an edge in life.

Distress results from the inability to find or execute an edge in life.

Well-being results from fresh opportunities to find/execute an edge in life.

Edges in life are ever-changing.

This guarantees stress.

The inability to change/evolve guarantees distress.

Flexibility/adaptability guarantees well-being.

HENRY:

 Success results from finding an edge

Ever-changing edges guarantee unlimited opportunities for success

With implications for

Goal setting

Focus

What’s my edge?

Why do/don’t I have an edge

[How do I find an edge]

And from far out in left field

In relationships, work or personal, the disproportionate sharing or appreciation of edges results in stress

Having an edge means

Reducing life, or aspects of life, to non-random processes

Continuous improvement and practice can be applied to non-random processes

BRETT:

The most well-worn paths in life possess the least edge;

Ergo, traveling well-worn paths ensures stress and distress;

And paths that lack stress probably lack edge.

HENRY:

Implementing/Preserving/Maximizing

Automate or delegate an edge implementation so you can work on new edges

Combine w/ other edges to build new derivative or evolutionary edges

Automate edge creation and build an edge factory

Estimate when and how fast an edge will degrade

 ***

So here's one takeaway question from yesterday's email exchange:

How would you be leading your life differently if you were looking to maximize your edge as a person?  As a trader?

Further Reading:  What Trading Teaches Us About Life