At some point, most skilled traders achieve a degree of success and seek to maximize the economic value of their trading. This typically means taking more risk to achieve larger rewards, often by increasing the size of positions. Here are three mistakes traders typically make in growing their risk taking: 1) Increasing risk in excessive increments - We are paid in dollars, not in basis points of return on a notional portfolio size, so it's only natural for us to respond emotionally to the dollar P/L of our wins and losses. When we increase our trading size dramatically, trades suddenly *feel* different and we create a situation in which drama can lead to trauma. This is particularly common among developing traders who move from simulated trading to live trading with small accounts. The position sizing relative to the size of their accounts creates excessive price movement sensitivity, even though the absolute value of the swings may not be enormous. Very gradual but steady increases in risk taking allow us to accommodate to larger swings in P/L. It is very important to not create a situation in which you have made profits on the year taking X risk and now give it all back by taking 2X or 3X risk. No single set of expectable losses should be sufficient to impair one's subsequent decision making.
2) Increasing risk at inopportune occasions - Many traders will increase their risk-taking by scaling into trades, starting with relatively small positions and then adding to those as the trades are going their way. The problem with that approach is that, once the trades have moved in the trader's favor, the risk/reward is now different and often less. This way of growing risk taking can subtly turn a trend trader into a momentum trader: buying strength and selling weakness--especially when there is a fear of missing moves with the larger trading size. Not all trending markets are momentum markets; many times you want to buy the dips during uptrends and the bounces during downtrends. By adding risk as markets are at highs or lows, traders often ensure that they are most vulnerable to reversal when they are largest in the trades.
3) Increasing risk subjectively - An exercise I've found very useful is to study one's past profitability based on the number of trades taken per day or week and based on the amount of risk taking over time. Surprisingly often, traders perform their worst when they are trading their greatest risk. Although they tell themselves that they have confidence in their trades, the larger size (and perhaps overconfidence) leads them to be less nimble and more stubborn in their trading. This can lead to outsized losses. It is not at all clear to me that most traders are good at knowing which of their trades are going to work, so that they can size those most aggressively. Rather, if a trader's decisions have positive expected return over time, it can make sense to gradually size up each trade and not expose the account to occasional large drawdowns.
It is all too common that traders will take risk down after what are normal, expectable losses and then ramp risk up after normal, expectable runs of winning trades. If each trade has a relatively uniform edge, such decision making dramatically lowers long-term returns. Much of total trading returns comes, not just from the ideas traded, but how we pursue them. Effective money management is a powerful tool for the management of the emotions of trading.
You think the market will be going up and, sure enough, it rises sharply and you only have a small position on. Should you buy the strength and play for momentum, or should you count on mean reversion and wait for a pullback to buy? It is not at all clear that chart patterns are informative in answering this key question of entry execution, which has led me to research some technical alternatives. This is a work in progress with a relatively small data sample, so please take with appropriate caveats and grains of salt. What we have above is SPY plotted against a composite measure of daily buy vs. sell signals for several different technical trading systems: RSI, MACD, Bollinger Bands, CCI, and Parabolic SAR. (Raw data from Stock Charts). Every stock on the NYSE is tracked for each of these systems and we sum the buy signals and subtract the sell signals. The composite tends to peak ahead of price during market cycles and bottoms shortly prior to price even at seeming v-bottoms. The technical systems overlap one another to a fair degree, so I took just the ones that showed low correlation and volatility-adjusted them to equalize their signals. When we've had the greatest number of buy signals (top quartile of distribution since July), the next five days in SPY have averaged a gain of +.33%. When we've had the fewest buy signals (bottom quartile), the next five days in SPY have averaged a gain of +.42%. All other days (middle quartiles) have averaged a loss of -.12%. In other words, we have seen upside momentum when buy signals have been plentiful and we've seen mean reversion when very few stocks have been demonstrating strength. When we look at sell signals as a distinct distribution, we find that when there are many sell signals (top half of distribution), the next five days in SPY average a loss of -.21%. When there are relatively few sell signals (bottom half of distribution), the next five days in SPY average a gain of +.47%. We thus see some downside momentum following broad weakness and some upside momentum when there has been an absence of weakness. There is much more work to be done and considerably longer time frames to analyze. The work thus far suggests that the breadth of market strength and weakness is relevant to the question of whether one should be trading short-term market moves or fading them. Further Reading: Tracking Market Cycles With Pure Price Momentum
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Stocks have started the year on a particularly weak note, retracing the lion's share of rally from mid-December. This has very much fit the earlier mentioned query, in which very high levels of bullishness among ETF buyers has led to poor near-term returns. Above are three updated views on the market weakness. The top chart illustrates the high level of programmatic selling swamping the recent market. This measure, based on a basket of institutional favorite stocks and their simultaneous upticking vs. downticking, shows that selling pressure in these large cap shares has been intense. When we look at the entire market, however, it's not clear that the deep selling of the institutional favorites has translated so far into highly broad selling. The second chart tracks stocks across all exchanges making fresh three month highs vs. three month lows. Note how new lows are nowhere near the levels seen in mid-December and mid-October.
That same picture emerges from my measure of buying pressure (upticks) versus selling pressure (downticks) across all NYSE shares (bottom chart). While the balance between buying and selling has turned negative, it by no means reflects the breadth of selling that we saw in mid-October or mid-December.
Deep selling that cannot become broad selling invites the hypothesis of underlying strength in the broad stock market. I will be watching new highs and lows and sensitive momentum measures closely to see if this decline begins to gain or lose steam. If the latter, we could see a healthy rally emerging from the recent gloom.
The next best practice in our series is using imagery and visualization to change our thoughts, feelings, and actions as traders. Imagery can be a powerful method for reprogramming our minds and reframing challenging trading situations. Reader David Spengler offers this best practice from his own trading: "In German, the phrase 'to jump into cold water' refers to a situation that is new and unknown and therefore risky. Before entering a trade, I am visualizing exactly that situation to overcome fear and procrastination. I close my eyes for a few seconds and imagine it is summer. The sky is blue, it is very hot, and I am sweating. I am standing by a pool. Then I jump into the water headfirst. It is a shock, but only for a second. Then it feels unbelievably good, as I sense every cell in my body and the blood pulses through my veins, my heart pumping fast. This image reminds me that jumping into the cold water/taking risk can actually feel good. More technically speaking, I reframe the situation. Since I have made it a habit imagining this scene, problems executing my trading systems have been greatly diminished." Notice here how a situation that could be experienced as unpleasant (risk taking) is transformed into something that is refreshing (diving into cold water on a hot day). By making the visualization habitual, the exercise becomes a kind of self-hypnotic suggestion. David uses the exercise to enter trades, but a very similar exercise could be used to reframe taking losses--or any desired trading behavior that might otherwise be avoided.
I have found that visualization can also be used very effectively prior to the start of the trading day as a way to mentally rehearse one's trading plans. By walking ourselves through various scenarios via imagery, we can mentally prepare ourselves to take the right actions. What makes David's technique especially effective is that the imagery *emotionally* reframes the trading situation. If we were to prepare ourselves at the start of the day by imagining ourselves stopping out of losing trades and refreshing ourselves for the next opportunities, the act of stopping out would become far less onerous.
Replacing negative self-talk with positive imagery is a great way to retrain our thought process and channel our efforts in constructive directions. The emotional preparation to act may be as important as the trading plan itself.
* One of the things I have my eye on is cross-sector volatility within the U.S. stock market. This is a measure of realized volatility, not volatility implied by options pricing (like VIX). Generally, volatility peaks early in a market cycle and troughs ahead of price highs. We've recently come off a peak, similar to patterns we've been seeing with market breadth.
* I also note that the end of 2014 saw quite an expansion in the shares outstanding of the SPY ETF and many of the sector ETFs. (Data from State Street). That's been a pretty good sentiment gauge over the years: demand for stocks expands the supply of ETF shares and bearish sentiment leads to a contraction of shares outstanding. In the past 10 days, we've seen a rise of almost 14% in the shares outstanding for SPY. Going back to 2006, when shares outstanding for SPY have been up by 10% or more over a 10-day period, the next 20 days in SPY have averaged a loss of -2.18%. That compares to an average 20-day gain of +.77% for the rest of the sample. When ETF demand soars, that enthusiasm has not led to good returns in the past, and 2015 thus far has been consistent with that.
The next best trading practice in our series comes from reader John Hope-Robinson (@johnhr), who describes meditation as an important tool in conquering a fundamental trading flaw. John writes: "We traders can be an insecure lot. We would rather at times be seen as a mysterious genius than just a successful trader. This need, born from a false sense of reality, can lead us to confuse intuition with 'into wishing'. We only need a system with a small winning edge to be a successful trader as long as we follow the rules of the system. Herein lies the Flaw. So many traders are just not patient enough to wait. The fear of doing nothing can be so terrifying that we feel a need to act to stop the fear and gain instant relief from it. This is the core issue. Through meditation we can learn to be OK during the necessary times where we need to do nothing but wait. We learn to achieve a clarity and calmness which can allay this perceived need to act. Meditation could well be the best investment a trader may ever make!" John rightly points to three key benefits of meditation: 1) Enhanced self-control - Meditation promotes calm, and it promotes focused concentration. Both enhance our cognitive and behavioral control, so that we can become mindful observers of our emotional patterns rather than victims of those. The first step in changing our patterns is becoming aware of them and not identifying with them. 2) Enhanced access to intuition - It is when we are still that we have greatest access to what we may know, but not know that we know. Very often experienced traders possess a keen gut feel for markets, but that feel is drowned by flight or fight responses to market action. Meditation promotes a stillness that enables us to listen to ourselves. 3) Enhanced well-being - We cannot trade well if we are dominated by fear: the fear of missing moves, the fear of losing money, the fear of being wrong, the fear of inaction. Research suggests that meditation can lead to enhanced personal satisfaction and subjective well-being, which allow us to act from a position of emotional strength. A corollary of this best practice is that some of your preparation time for trading needs to occur away from trading screens. Using meditation as a midday break--as well as a morning preparation for the day--helps us step back from markets and approach them with a fresh perspective. Stepping away from markets can be a powerful way of stepping back from the reactive trading of markets. Further Reading: Trading and Mindfulness
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I thought I would update a few of the measures that I follow to help us make sense of the relative weakness that we've seen ushering in 2015. In the grand scheme of things, the weakness is not extreme; indeed, my Cumulative NYSE TICK measure has made new highs and advance-decline breadth has not been lopsided at all. Still, the weakness has exceeded my expectations; the charts above capture a worthwhile perspective. First, however, a trading psychology comment. When I'm stopped out in a trade--as happened recently with my long position in ES--I stop. My stops are placed far enough away that, if they're hit, I'm wrong. And before I resume trading I need to figure out what the hell I got wrong. One of the most destructive patterns I've observed among traders is a tendency to continue--or even accelerate--trading after stop outs. Insanity, the saying goes, is redoubling one's efforts after having lost sight of one's aim. A more sane strategy is to use losing trades as learning experiences. The charts above are part of my review and reflection process after a trade that I thought was good turned out to be a losing one. The top chart is a measure of breadth for SPX stocks. It represents the percentage of shares trading above their 3, 5, and 10-day moving averages. (Data from Index Indicators). You can see how this breadth measure reliably tops out ahead of price during market cycles; it's also done a reasonable job of bottoming ahead of price at cycle troughs. We've come off quite sharply in this measure; more so than is typical in a market cycle. This invites the hypothesis that we've already seen a momentum peak for the current cycle. The middle chart tracks all NYSE stocks closing above their upper Bollinger Bands vs. closing below their lower bands. (Data from Stock Charts). It too has shown an admirable tendency to top ahead of price at cycle peaks and ahead of cycle lows at troughs. That has not come off as sharply as the breadth measure, but also has moved steadily lower since a rapid peak off the mid-December bottom. Finally, the bottom chart tracks a basket of stocks that are institutional favorites and the upticking versus downticking in those stocks. When the majority of stocks in the basket uptick simultaneously, that is deemed to be evidence of the presence of institutional buying programs; when they downtick simultaneously, that is counted as the presence of selling programs. We can see that buying programs dominate early in a market's cycle history and give way to selling programs as markets make cyclical peaks. Note how we showed very strong buying program activity off the December lows and now have moved to a dominance of sell programs. These measures leave me open to the idea that we've hit a momentum peak for the current cycle, which will have me looking closely at any bounces from here to see if we see waning or strengthening breadth. This could have longer-term ramifications, as it invites the hypothesis that the end of year strength was not a fresh leg in a bull market but rather part of a much larger topping process that began in 2014. Further Reading: Losing Your Money Begins With Losing Your Focus
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Our next best practice in trading comes from Enis Taner (@EnisTaner) and captures the idea of keeping yourself in peak condition in all areas of life. Enis explains, "I've found that it is crucial that I am physically, emotionally, mentally, and spiritually healthy if I am to take on the challenges of trading professionally." Here's how Enis breaks it down: * Physical: 30-45 minutes of high intensity exercise, 5-6 times per week. * Emotional: Making it a habit to meet friends and/or family for social gatherings on a regular basis (not less than 3 times per week). "Good conversation is one of the best methods I've found to reduce mental stress," he observes. * Mental: I try to practice trading techniques on multiple time frames. Some weeks I will spend my learning time on reading financial statements and conference call transcripts with a focus toward long-term investments. Other weeks, I will test out correlations of short-term technical indicators. * Spiritual: I spend five minutes each morning on new things for which to be grateful. I've also found that helping others, especially young people, with positive thinking and life mentorship overall to be fruitful for my own spiritual well-being.
The key idea here is that it's not enough to reduce stress in order to be a peak performer in markets. Just as an athlete must be in superb aerobic and strength condition with continuous skill practice and work on mental sharpness, the successful trader draws upon reserves from all areas of life. It's not difficult to see how Enis' routines could be captured in a checklist, keeping him aligned with personal best practices. Creating our own peak performance processes ensures that we sustain the energy and positivity to weather the normal ups and downs of trading. Further Reading: Success and Making Your Bed
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We're kicking off 2015 with a series of posts on best practices submitted by readers. Thanks to all who shared ideas. We begin with reader Vlad, who is a discretionary trader of forex, gold, and DAX. He sets a maximum loss limit per day (1.0%); week (2.5%); and month (10%) for his trading. He explains, "That has removed a great deal of the stress from trading, knowing that no one trade or series of trades can bring me down." The best practice here is risk management: the prevention of deep drawdowns is worth many pounds of come-back cure. Readers trading for hedge funds, where capital is levered, will almost certainly set different percentages from Vlad. A loss of 10% in a month would be wholly unacceptable at many places where I have worked. Personally, I would not want three months of hitting my downside level to place me in a situation where I had to make over 40% on the remaining capital just to break even. Vlad's basic concept of setting loss limits for trading, however, is quite sound. I look at it this way: if I have a hit rate of 50%, then I will have 25% odds of two consecutive losing trades; 12.5% odds of three consecutive losing trades; 6.25% odds of four consecutive losing trades; and a little over 3% odds of five consecutive losing trades. If I place 50 trades in a year, guess what? I will almost certainly encounter strings of four and five consecutive losers. I need to be able to survive that risk of ruin. If I allow myself to lose 10% of my initial capital on each trade, I will likely get to the point where I need to double my remaining money to break even. If I allow myself to lose 1% of capital on each trade, any expectable run of losing trades is unlikely to impair my account--or my psyche. One of the practices that has served me well over the years is to enter trades with one-fourth to one-half of my maximum position size. I've found that, when I'm wrong in a trade, I'm usually wrong early in that trade. Keeping my risk exposure modest initially enables me to lose less money if I'm stopped out quickly, and it allows me to add to my position if my scenario unfolds as planned. If I'm sized maximally, moves against me become a threat. If I'm sized more moderately, moves against my position can pose further opportunity. That's a great place to be psychologically. Finally, loss prevention in trading is greatly aided by diversification. If you have two or more trading systems or trading methods that each have positive expected returns and are relatively uncorrelated in their return streams, you then create a situation where the expectable series of losing trades for any one method can be buffered by the returns from the others. Diversification can also occur in the larger picture of our money management. My trading capital is but a fraction of my total investment capital. I have many fixed income investments, for example, that throw off a reasonable yield each year. If I were to have a losing trading year, I would still harvest income from my larger portfolio. Vlad's point is an important one: risk management is the best psychological management. It is very difficult to keep our heads in the game if markets are handing our heads to us with adverse moves. Playing good defense sets us up for taking full advantage of offensive opportunities. Further Reading: Best Practice: Reading in Parallel Turning Best Practices Into Best Processes
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Wishing readers a happy, healthy, and successful New Year! TraderFeed will start the new year with a series of posts on best practices, including those submitted by readers. Perhaps one or more of those best practices will help shape goals for you in 2015. Thanks to Bella at SMB for calling attention to this excellent post re: how to make your New Year's resolutions stick. One of the key ideas from that post is to frame your resolutions in terms of habits you want to develop, rather than as long-term, pie-in-the-sky goals. That is a three-step process:
1) Frame the Objective - What is the one change you most want to make during 2015? A good place to start is to review your shortcomings during 2014 and identify the one change that would make you better.
2) Turn the Change Into a Routine - If you are going to make your change, you have to *be* that change at some time, every single day. If my goal is to be a more loving, supportive father during the new year, then I need to construct loving, supportive time each day with my children.
3) Find Triggers for the Routine - By associating our routine with a regular life activity, we can become consistent in enacting our changes. Let's say that one of my ways of being a more loving, supportive parent is to spend quality time with the children over dinner. I might take up cooking and start making fun foods that the kids would like. This would help turn dinner times into quality time. Common thinking is that we need to change how we think and feel in order to change our behaviors. The reality is that the reverse is equally true: by enacting new behaviors, we can change how we think and feel. If you can find time each day to be the person you want to be, you will begin experiencing yourself as that person--and that will start a positive momentum that will impact a variety of areas of your life. Using dinner times to be more loving and supportive might just help you be more loving and supportive of yourself during times of setback.
So what is the one change you can make in 2015 to be the person you most want to be?
Above are two perspectives on stock market breadth, focusing on the stocks within SPX. The top chart tracks the percentages of SPX shares trading above their 3, 5, 10, and 20-day moving averages. The bottom chart is a moving average of the number of SPX stocks making 5, 20, and 100-day new highs minus new lows. (All data from the excellent Index Indicators site). Note the distinct tendency of the breadth measures to top ahead of price during market cycles. The quicker breadth measures also tend to bottom ahead of price, which gives a bit of heads up on those potential V bottoms. What we're seeing from these measures presently is a healthy degree of upside breadth. We are not yet seeing the kind of decline in breadth that has preceded recent market drops. Historically, a buy dips mode has worked well in such an upside breadth environment. For example, going back to late 2006, when over 75% of SPX stocks have traded above their 100-day moving averages and fewer than 50% of those shares have closed above their 3-day moving averages, the next three days have averaged a gain of +.22%, versus an average gain of only +.03% for the remainder of the sample. Knowing where we stand with respect to breadth during a market cycle can provide a useful road map for short-term trading.
I'm not a big fan of terms like "overbought" and "oversold". Too often, those terms embed a bias--that the stretched market is likely to snap back. Similarly, one person looks at a chart and notices "consolidation"; another perceived "topping". There is a lot of room for subjectivity in how we label what we see. That's a good reason to look at many things with a fresh set of eyes. We're less likely to fall victim to confirmation biases if we view the world through multiple lenses and invite information that doesn't neatly fit into our views of the moment. Above is a chart of the ES futures. Each point on the chart represents 50,000 contracts traded. On busy days, we print more points on the chart; slow days print fewer. Similarly, the busy times of day print more points than the slow, midday hours. This normalizes, to some degree, volatility within and across days. I further take volatility out of the picture by simply recording whether the average price of each volume bar is up or down relative to the prior bar. The chart is an 80-bar moving average of this up/down count. It can be viewed as a relatively pure measure of price momentum. When the 80-period average has been in the top half of its distribution, the next 40 bars have averaged a gain of +.15%. When the average has been in the bottom half of its distribution, the next 40 bars have averaged a loss of -.01%. If you look at the chart closely, you'll see the reason for this momentum effect: early in a market cycle, we see a surge in upside momentum, which stays positive but wanes as the cycle matures. Eventually we get negative momentum, leading to a crescendo of downside price change shortly before we hit a price low. Seeing where we're at in this process gives a good read for where we stand in the present market cycle. Much of the upside movement in the market can be attributed to momentum following strong positive readings and value/reversal following strong negative readings. Tracking these helps us adapt to the phases of a market cycle. Further Reading: Finding Opportunity in Market Cycles
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* Since 2012, we can divide market days into quartiles, based upon the number of stocks in the SPX that are making fresh five-day highs vs. five-day lows. When we are in the weakest quartile--most stocks making new lows relative to new highs--the next five-day return has been +.76%. On all other occasions, the average next five-day return has been +.17%. * Since late 2006, when I first began collecting these data, when the put/call ratio across all listed stocks was in its highest quartile, the next five days in SPX have averaged a gain of .43%. On all other occasions, the average next five-day return has been +.04%.
* Since late 2006, when the number of SPX stocks making fresh five-day highs vs. lows has been in its weakest quartile, the next five-day return has averaged +.45%. Across all other occasions, the average next five-day return has been +.05%. * Since late 2006, when VIX has been in its highest quartile, the next five days in SPX have averaged a gain of +.22%. Across all other occasions, the average five-day gain has been +.11%. * Since late 2006, when the percentage of SPX stocks trading above their 5-day moving averages has been in its weakest quartile, the next five days in SPX have averaged a gain of +.46%. Across all other occasions, the average five-day gain has been +.03%. * Since late 2006, when the percentage of SPX stocks trading above their 20-day moving averages has been in its weakest quartile, the next five days in SPX have averaged a gain of +.34%. Across all other occasions, the average five-day gain has been +.07%.
One trader sees the market move higher for a few days and puts in an order to buy, fearful of missing a big market move.
One trader sees the market move lower for a few days and enters an order to sell, fearful of missing the overdue crash.
One trader sees the market move lower for a few days, fears a debilitating drawdown, and stops out of a long position.
All three traders lose money over time. Entry and exit execution predicated on fear have negative expected return.
In yesterday's post, I described a process of reading in parallel: reading many books at a time and gaining insight into a topic by juxtaposing the views of many authors. Parallel thinking is central to pattern recognition: in simultaneously processing multiple events, we are able to discern meaningful patterns connecting those events. Take a look at Rob Smith from T3 describing his eight screen trading station layout. There are many charts on each screen, grouped by sector, stock type, etc. He then can refresh all the screens at once to view many other stock groups based upon screening criteria. Each stock can be viewed across multiple time frames. As Rob points out, he monitors all of these screens throughout the day to get a sense for when opportunities are "lining up". Then Rob will go "around the horn", looking at every stock in the SPX to detect emerging trends or moves out of the ordinary. What is noteworthy in the video is that Rob is processing much more information much more rapidly than the average trader. He is reading the market much like I am reading books: finding themes by processing multiple sources in parallel. Instead of examining one stock in detail, consulting myriad indicators and chart perspectives, Rob considers many stocks and finds patterns that cut across them. If you jump over to SMB, you'll notice that their traders are utilizing tools that filter stocks based on liquidity and volume and then track promising candidates tick by tick to detect unusual volume or order flow patterns. The technology acts as an extension of the traders' parallel processing, reducing an impossibly large array of intraday data across stocks to a manageable universe of "in play" opportunities. Serial processing is common among investors: digging deeply into particular subject areas to arrive at unique analyses that become trading opportunities. An example would be scouring the wording of Fed statements and speeches of Fed officials to discern shifts in policy. Parallel processing is less about deep analysis and more about rapid synthesis. It is more common among high speed traders: finding patterns in market action that reveal shifts in supply and demand. Most of us possess thinking styles that are our unique blend of parallel and serial processing. An important source of failure for traders is attempting to adopt trading styles that do not make optimal use of our cognitive strengths. An important source of failure for trading firms is failing to assess cognitive strengths as part of the hiring process. The myth continues that trading success is a function of personality, while evidence strongly suggests that personality can accomplish little in markets if the right brain wiring isn't in place.
Emotions are a problem in trading only insofar as they may nudge us from our cognitive strengths. When trading becomes challenging, higher frequency traders should push themselves to look at more things and feed their pattern recognition; lower frequency investors should push themselves to think more deeply about what they're doing and why. Bad things happen when active daytraders respond to challenge by slowing their thinking and when investors become more speedy.
But of course, we don't hear about any of that from would-be trading mentors and coaches. They tell us to "trade our plan".
Whatever. Oil was weak most the day on Friday. High yield bonds underperformed stocks and then saw decent selling late in the session, as sell programs took stocks off their highs. That was a piece of pattern recognition from yesterday's trading. When all that began to unfold, my long ES position came off the table. Not all patterns are meaningful, but that was a movie we've seen before and I wasn't in the mood to replay. If you're only looking at the chart of what you're trading, it's tough to see those intermarket patterns in real time. Markets are always talking to each other; it can be very helpful to join their conversation. Further Reading: Data Rich, Information Poor
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With today's post, I'll begin a series on best practices in trading. Those will include some of my own, as well as those submitted by generous readers. My hope is that at least several of those best practices can inform your trading processes for 2015.
Above is a live 5 AM snapshot of my home office. There are 16 books on the floor in various phases of being read and 41 books on the window box that have either been read or are on tap for next reading. The books cover three topics: happiness and well-being; the mastery of change; and creativity. These are the themes that are central to the book I'm writing. When I'm not writing a book, there are fewer books tossed about the office, but there are always a few. What I'm doing is reading in parallel: reading one book and then going to the other books to see what they say about the topic. That is why I read the actual print books rather than the electronic versions: it is easier for me to bookmark the texts and read them side by side if they are right in front of me. Reading in parallel means that I rarely finish a book from start to finish. I quickly scan the books and find an anchor text: one that seems unusually well researched and well written. The anchor text guides the selection of topics. I read about the topic I find most interesting and relevant in the anchor text and then move to the other books to read whatever they say about the topic. This creates a virtual conversation among the authors, as I view the topic through each of their lenses. When I stop reading new and interesting material on the topic, I move to the next topic. The reading never is boring for that reason. As soon as I start to lose interest, I take a short break and switch topics, usually returning to the anchor book. The most interesting and relevant ideas that I encounter are bookmarked and written down, often in Evernote. The inventor Thomas Edison filed over 1000 patents during his career. He held himself to a discipline in which he and his assistants were required to generate one minor invention every ten days and one major invention every six months. By churning out more inventions, he raised the odds of achieving at least a few significant inventions. Similarly, by reading material from a number of books in a dedicated time period each day, we expose ourselves to more ideas--and then have more ideas to draw upon in generating our own. Having worked this way for years, I've become unusually good at skimming books, identifying their main ideas, and deciding if they are worth reading in detail. The same process applies to research papers or online articles on a particular topic. This efficiency means that you can cover more high quality material than the average person--and that you become better over time at identifying high quality material. Reading a book is like having an expert visit your home for a conversation. Reading in parallel is like inviting a group of experts to your home and participating in their conversation. The acid test for reading in parallel is whether you come away from the exercise with perspectives that are contained in none of the individual texts. That is when reading becomes a truly creative exercise. Further Reading: Best Practices During Trading Slumps
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I generally find that traditional ways of viewing traditional market indicators and charts are not the most informative. Years ago, a developer of trading software lamented in a conversation that he wanted to educate customers in the use of his product, but he found that the vast majority of users never even tried to vary the software's preset levels. Traders wanted answers from the software, not new information that could lead to new questions and answers.
In the spirit of looking at old things in new ways and extracting information that others miss, here are a few variations I've found helpful during 2014:
* Change the Charts - Who says that arraying price on the y-axis and time on the x-axis is the best or most informative way of gleaning information about markets? When we create bars based on volume rather than time and generate indicators from the volume bars, intraday and multi-day changes in volatility are greatly attenuated and patterns become more stable. Market Delta charts include, within the bar, important information about the distribution of volume at the bid vs. offer, revealing short-term shifts in demand and supply. WindoTrader charts display bars within bars so that you can visualize price action across time frames in a single view. Charts from e-Signal display the percentage of stocks trading at new highs vs. new lows for the day session, capturing short-term shifts in breadth.
* Change the Indicators - Tracking net upticks vs. downticks in the market (NYSE TICK) is useful, but my greatest advance in 2014 came from separating upticks (buying pressure) from downticks (selling pressure) and treating those as separate variables, tracking the behavior of separate market participants. (See above). Strong or weak buying can occur within the context of strong or weak selling--it's a difference that makes a difference. We commonly look at market indicators for the stock or index we're trading. StockCharts displays the number of stocks giving buy vs. sell signals for a variety of indicators, turning traditional indicators such as Wilder's Parabolic SAR into sensitive breadth measures. Everyone asks about the trend, but sometimes the world is not linear. StockSpotter has built an impressive track record by basing buy and sell signals on the cycle-based behavior of stocks. * Change the Interpretation - I've been tracking the number of stocks giving buy and sell signals via Bollinger Bands and found something interesting. The best predictor of market strength in the short run has been the number of sell signals. Since May, when the number of sell signals has been high (top half of distribution), the next five days in SPY have averaged a loss of -.06%. When the number of sell signals has been low, the next five days in SPY have averaged a gain of +.70%. This has led me to identify the absence of weakness--not just the presence of strength--as a predictor of upside momentum. The Pure Volatility measure that I recently shared takes volume out of volatility and displays informative dynamics at market turns. David Aronson has published a worthwhile paper on the purification of the VIX measure. It turns out a number of indicators can be improved through purification: eliminating their overlap with other measures. Aronson and Masters offer a book and software for traders interested in looking at purer versions of market measures. Show me what a trader looks at during the day and I'll show you how successful he or she is. If we process old information in traditional ways, we're not likely to achieve unique, standout returns. The best traders I know display a passion for understanding markets, not simply trading them. Further Reading: Turning Innovation Into a Habit
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Successful traders get more rational when they get more uncomfortable. That feeling of discomfort is not a call to act; it's a call to plan a course of action. In the past five trading sessions, we've moved from a situation in which fewer than 20% of SPX have been trading above their 20-day moving averages to one in which over 80% have exceeded that benchmark. That is quite a shift in breadth in a short period of time. I found myself feeling uncomfortable with my long position; it seemed as though anything that's moved that far, that fast is due for a pullback. So I decided to become more rational. I went back to 2006, when I first began collecting breadth data, and looked all occasions in which the above criteria were met in a sub-20 VIX market and what happened in SPX going forward. There was only one problem: it had never occurred over that time span. This was a greater five-day breadth thrust than we had ever seen in a sub-20 VIX market. I then decided to take a second tack. I looked at five-day breadth thrusts exceeding the level of 50 under sub-20 VIX conditions. That is, the percentage of stocks trading above their 20-day moving averages had to move over 50% in a five day period. Still, I only found 9 non-overlapping occasions. Over the next three trading sessions, 8 occasions were up, 1 down for an average gain of .65%. It's too small a sample to make for a statistically significant analysis, but it certainly did not support the source of my discomfort. It did encourage me to look further into breadth thrusts and the price paths of the market when breadth moves higher, sharply. My observations? Not all strong markets are "overbought". How we reach strong breadth readings is as important as the absolute level of those readings themselves. Further Reading: Perspectives on Breadth
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One of the central themes of my new book is the importance of creativity in generating trading ideas with an edge. What I call Trading Psychology 2.0 emphasizes flexible adaptation to changing markets, not rigid adherence to static trading methods. From this perspective, creativity is the new discipline: poor discipline shows up not only in emotional decision-making, but in consensus thinking. You know that saying "Garbage In, Garbage Out"? Poor quality inputs will lead to faulty outputs even if you employ the best of programming. In trading we might say "Consensus In, Consensus Out". If you look at the same things as everyone else, you'll pretty much wind up thinking--and trading--like everyone else. That's not a good recipe for superior risk-adjusted returns. To enhance our creativity, our discipline needs to be an improvement in our information diet. We need to take in fresh information, better information, and information organized in new and useful ways. I've long enjoyed the Finviz website as a source of novel perspective. If you click on the heatmap above, you'll see major ETFs and the relative volume of their trading yesterday. Light blue indicates much above average volume; dark indicates significantly below average volume. At a single glance, we can see where money was flowing. That's not a bad starting point for identifying rotational markets and sector/asset class based market themes. How have the SPX stocks behaved on recent earnings days? This heatmap gives a useful view, a quick visual take on whether the market is tending to be pleased or disappointed with company performance. That's not a bad starting point for thinking about long/short themes.
A great goal for 2015's trading is to enrich your capacity for market insight. If you look at what others are not, you begin to ask questions they don't ask. And that can lead to fresh answers. Further Reading: The Sobering Odds of Daytrading Success
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One of the most interesting aspects of working as a trading coach is the ability to see, first hand, what contributes to the success of traders. So often the factors that lead to success are not those emphasized in mainstream articles and books. Here are two unappreciated virtues I see among successful portfolio managers and traders: 1) The ability to tolerate uncertainty - Suppose you take any particular configuration of price in a market; say, trading x% above or below a Y period moving average. Then look at what that market does on average over the next Y period. The odds are great that for any value of x and Y, the market's directional tendency will be swamped by the variability of price within that next Y period. What that means is that, on average, the signal to noise ratio for a directional trader is low. Whatever directional tendency is present is generally not statistically significant and not readily tradeable. Given such a situation, the modal opinion of any trader should be "I don't know". Uncertainty is itself a view and, in fact, should be one's base case. When a trader cannot tolerate uncertainty and needs to manufacture conviction, the result inevitably is overtrading the objective opportunity set. It is impossible to properly manage risk if you are intolerant of uncertainty. 2) The productivity of time spent away from trading - I consistently find that successful traders spend more time identifying good trading opportunities than actually putting on and managing trades. Csikszentmihalyi conducted a fascinating study with artists in which they were shown 27 objects and asked to arrange a small group of them into a composition and generate a sketch. They had one hour for the task. The artists fell into two categories. One group quickly identified the objects for the composition and spent the better part of the hour refining their sketches. The second group spent most the hour figuring out what to draw. They selected objects, started sketches, changed the objects, sketched some more, rearranged objects, etc. By the time they found the composition they liked, they spent only a few minutes on the final sketch. The drawings of the second group were rated as significantly more creative by a group of art critics than those of the first group and, after a five year period, the second group demonstrated significantly greater success as artists. The less successful artists spent most their time sketching. The successful artists spent most their time finding compositions worthy of sketching. It's a great analogy for trading.
Good things happen when these two strengths come together. The ability to accept uncertainty frees the mind to maximize time away from trading and creatively generate sound trade ideas. For the successful trader, uncertainty provides the opportunity to get away from screens and look at markets through new lenses. Overtrading exists when the need to trade exceeds the need to understand. Further Reading: How to Deal With the Uncertainty of Trading
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* The above chart tracks buying vs. selling programs executing in the stock market every minute of the day. The underlying logic is that I take a basket of stocks and identify when they are upticking and downticking at the same moment. This basket execution is only undertaken by institutional players, so tracking buying vs. selling baskets is a great way to gauge how institutional participants are leaning. As you can see most recently, when we were making lows this past week, buying programs were already exceeding selling ones. The rally since then has seen very strong buying interest from institutions, exceeding that in early October. Note also how at the market highs in late November/early December sell programs began to outnumber buying ones. This is an unusually valuable indicator, and I will be updating periodically. * Very useful end-of-year perspective from Barry Ritholtz on 10 basic principles for investors.
* Great brain science links from Abnormal Returns, including redefining discipline in our childrearing. * One of the things I'm looking at is the relationship between message volume on Stock Twits, trading volume on the NYSE, and volatility in stock prices. Here are the recent data on SPY. I would expect superior returns during periods when message volume is highest.
Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), The Daily Trading Coach (Wiley, 2009), Trading Psychology 2.0 (Wiley, 2015), The Art and Science of Brief Psychotherapies (APPI, 2018) and Radical Renewal (2019) with an interest in using historical patterns in markets to find a trading edge. Currently writing a book on performance psychology and spirituality. As a performance coach for portfolio managers and traders at financial organizations, I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014.
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