Every year you start with a zero P/L balance. At any time, a rogue event could turn your portfolio and your account upside down. If you don't kill, you don't eat: you're only as good as your latest performance. When you're very good, you'll still lose on roughly half of everything you do. That means you'll have strings of losers and periods of drawdown. Markets will sometimes change faster than you can adapt. You'll question whether your edge in the marketplace is gone. You'll see others whose edges truly have eroded and you'll wonder if you can ever hope to compete with the machines. Little wonder that those who do succeed in the money management world display a good amount of mental toughness. There are tremendous rewards to those who succeed and precious little job security for those who don't. The entire profession is based upon the ability to act in the face of uncertainty and take meaningful risks. How many fields--even in sports--require such daily endurance? An excellent overview article identifies several components to mental toughness: 1) Hope - A strong degree of self-belief; 2) Optimism - A general expectation of favorable outcomes; 3) Perseverance - Consistent pursuit of one's aims in the face of adversity; 4) Resilience - The ability to adapt to challenging situations Mental toughness thus requires the grit described by Angela Duckworth--that ability to keep going when the going keeps getting difficult. Learning to handle smaller pressures and challenges builds the toughness needed to handle the larger ones. Dealing with day to day, week to week setbacks in trading is training for dealing with the inevitable larger setbacks. This can only happen, however, if the elite performer maintains what Emilia Lahti describes as an "action mindset". The Finnish concept of Sisu describes the ability to tap into hidden wellsprings of resources during times of extreme challenge; Lahti describes it as a kind of second wind, in which environmental demands bring out more than we thought we had. It is not enough to endure; fueled by Sisu and in an action mindset, we can find and pursue the opportunity in challenges. I have spoken with many traders who go on winning streaks and then become complacent. They cut back on their rigorous preparation and take more marginal trades. It's as if, instead of a second wind, they lose their wind--or at least their willpower. What if winning is as challenging for the competitor as losing? What if it's not just adversity that challenges us, but any cognitive/emotional state that greatly differs from our norm? Ironically, the trader who experiences win after win after win may be as challenged as the one who experiences a series of losses. That would explain my observation that the best traders double down on their discipline and planning after they have made money. In Lahti's terms, they sustain the action mindset. Their Sisu kicks in, not because they experience extremes of pain, but because they experience extremes of positivity. It is any shift outside our normal experience that taxes us--even shifts that we desire. Most traders have a plan for dealing with drawdowns. How many have a plan for dealing with draw-ups? Maybe, just maybe, sustaining performance after consistent winning requires as much mental toughness as sustaining performance after consistent loss. Perhaps success brings its own adversity. Further Reading: Emotional Resilience in Trading
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When you take a look at a trader's journal, what do you typically see? Many traders use journals to document the mistakes they make, often venting about the problems they are having. In such cases the journals are little more than listings of problems that the trader has encountered. It's the rare journal that takes the next step and turns the identification of problems into the creation of concrete, practical goals. The greatest psychological mistake a trader can make is to stay problem focused. By devoting attention to problems only, traders reinforce the notion that they are beset with problems. It is important to address shortcomings in trading, to be sure, but if all you do is focus on problems, you miss out on the most important part of your development--all the things that you do right! Elite performance is not simply a function of minimizing our weaknesses. It is an outgrowth of our strengths. We become successful by leveraging our talents and skills, not just by making fewer mistakes.
A little while ago, I conducted a review of my winning and losing trades. The best predictor of whether one of my trades was successful surprised me: it was the length of time since I had placed my previous trade. When more time had elapsed between trades, it meant that I had waited for everything in my research to line up. Those tended to be the most profitable occasions. When I carried a pre-existing view to the next trade and did not wait for the view to emerge from the research, the trade was much more likely to fail. Patience was a key, but it was more than patience at work: I trade best when I truly understand what markets are doing. My strength, as both trader and psychologist, is the capacity to understand. I recently began a new blog for Forbes which will focus on specific psychological techniques for identifying and maximizing our strengths. A wealth of research in the field of positive psychology provides us with tools and techniques for leveraging what we do best. Addressing our mistakes and problems is great. We can equally learn from what we do well in markets. Who are we when we are trading well? What are the best practices that lead to our best trades?
When we reverse engineer our wins, we discover a blueprint for ongoing success. I think you'll find the new blog to be a useful toolkit for self-coaching.
* Great podcast insights from Abnormal Returns, including an interview with Howard Lindzon and a look at multidisciplinary thinking with Michael Mauboussin.
When psychologists listen to people in counseling, they not only process what is being said, but also the connections among the various topics. Themes connect the issues we face in life, cutting across relationships, work, and our emotional experience. To an untrained observer, it might seem as though a person is jumping all over the place when he talks about drawdowns in markets, arguments at home, and an ankle injury from running. The psychologist, however, finds common threads linking these. All represent frustrations, all represent real and feared losses, and all impact self esteem, motivation, and mood similarly. Instead of working on three different issues, a person in counseling learns to identify the theme connecting all of these and develops skills for dealing with that theme. Markets also reflect themes, as geopolitical, macroeconomic, and sentiment-related factors drive buying and selling decisions. Just as a therapist listens for shifts in themes in a client's talk, a savvy trader is sensitive to market themes and their waxing and waning. Friday was an interesting day in the market from that vantage point. We had strong economic data and interest rates rose significantly (top chart). The sector that had been leading market strength, utilities, sold off in sympathy with the rate rise. Stocks overall, which had been seeing strong buying interest on my measure of upticks vs. downticks (middle chart), saw significant downticking for the day, as large market participants persistently hit bids. Meanwhile, the market's larger picture of weakening breadth (bottom chart) remained intact. A random blip or a meaningful shift in theme? Expectations of economic strength and the pricing in of Fed hikes sooner rather than later strengthened the U.S. dollar on Friday, but did not benefit stocks. Should stocks and bonds move lower in concert, that would be quite an unwind of the risk parity trade that has worked for a while: the volatility-adjusted position of long bonds and long stocks. One day doesn't make a trend and one thematic shift doesn't necessarily reflect a significant change in a person's life. But when a psychologist perceives a dramatic shift, the ears perk up. Reading markets is not so different from reading people. Further Reading: Social Intelligence and Trading Skill .
We put thought into what we need to get done, but often don't reflect upon the ordering and organization of what we do. Relatively simple changes in our workflow can yield profound benefits in the effectiveness and efficiency of what we do. I recently spoke with a trader who conducted the lion's share of his market review immediately prior to the New York open after a lengthy commute into the city and after numerous conversations on the trading floor upon his arrival. By the time he got around to figuring out what he was doing for the day, he felt a mixture of distraction, fatigue, and time pressure--none of which helped him focus on market opportunity. His reduced concentration early in the day led to silly trading mistakes, which in turn built frustration. Quite simply, his workflow was not setting him up for success. Today's best practice is from reader Rahul Rijhwani who describes the organization of his trading workflow. Here is what he has observed:
"I analyze my stocks only after market hours. During market hours, the focus is only on execution. This way there is a lot of clarity since there is only one task at hand at any given point. Also, there is a sense of calm and clear thought process when analyzing and executing.
To explain the process briefly, when the markets are closed, I open charts in my watchlist, then analyze them and set alerts at important price points based on the trading strategy. Then I calculate the position size and note it in a diary. When the market is open the next day, when price comes close to the point where I have set an alert, there is a beep. I then open the chart, calculate risk/reward, and punch the order if the risk/reward is favorable."
The key takeaway here is that Rahul is using his workflow to separate the process of generating ideas from the process of following markets and executing trades. By preparing his trades in advance, down to the details of price level and sizing, he helps ensure that his trading is controlled and planned and not reactive to the situation of the moment. This enables him to stay clear headed without the need to resort to psychological techniques during the trading session.
Very often the organization of our time helps us stay mentally organized. If I need to be open-minded and creative at one point in the trading day, I will make sure that the preceding activities are not ones that are taxing and stressful. If I need to tackle stressful and detailed work, I will make sure that I do so at times when my concentration and willpower are at high levels. A good workflow can create a rhythm during the day between activities that require energy and those that give energy. Most of all, setting our workflow means that we control our work and it doesn't control us. That is a great psychological benefit. Further Reading: Managing Your Energy Level
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You know, sometimes I hear things and shake my head. Then I hear them again and roll my eyes. Finally, I keep hearing them and make a valiant effort to not throw up in my mouth. I mean, really, you don't want to be rude to people, but there's only so much one can endure when platitudes pose as wisdom. Take the virtuous advice that trading success hinges on "following your process." Please. WTF does that mean? Here's a process for you: I drink Turkish coffee every morning and then examine the coffee grounds at the bottom of the cup. If the grounds mostly settle at the top of the cup, it will be a bullish day in stocks and I buy at the open and sell the close. If the grounds settle at the bottom of the cup, it will be a bearish day in the market and I sell the open and cover at the close. If the grounds settle at the left side of the cup, it will be a quiet day and I'll sell volatility. If the grounds settle on the right side of the cup, volatility will expand and I will be a vol buyer. And if the grounds are evenly settled at the bottom of the cup, there's no edge for the day and I'll drink a second cup. Now that *is* a process. But does my trading success hinge on fidelity to my process? Of course not! That's because, in the language of psychometrics, the process is reliable but not valid. It is repeatable but random. Being process driven is necessary, but not sufficient. Before one waxes poetic about following a process, it helps to define a process worth following. Or let's take the platitude that one shouldn't try to predict markets but instead should listen to markets and follow their lead. I don't know what that means. Does it mean that you are supposed to naively extrapolate the last X bars on a chart and blindly assume that they will continue their pattern? Does it mean that you impose expectations of momentum and trend on every market regime? Does it mean that you utterly lack backtesting skills and are bravely turning that into a horse-whispering virtue? Whatever. So here's a great experiment that anyone can conduct. Define a trading system that takes the last X bars and extrapolates from them to the next X bars, buying the X+1 bar open when the extrapolation is positively skewed; selling the X+1 bar open when the extrapolation is negatively skewed; and standing aside when the extrapolation displays no directional bias. That way you'll always have a replicable process *and* you'll be following what the market is telling you. Just as a lark, I tried the experiment with historical data, buying SPX when the percentage of stocks above their five-day moving average was above 50% and selling SPX when the percentage of stocks above their five-day moving average was below 50%. The data were for SPX stocks specifically, going back to 2006, and the holding period was for the next five trading days. Buying strength gave an average five-day return of -.07%--a small loss. Selling weakness gave an average five-day return of -.44%, a considerable loss. The average five-day return over this period was a gain of +.15%. In other words, having a robust process and following the market's lead has ensured losses in both rising and falling market environments. Interesting: the track record of the received wisdom is so poor that it's promising. Further Reading:
Abnormal Returns recently posted a number of thought-provoking links regarding startups and entrepreneurship. One of the articles posted summarized the lessons learned by a Shark Tank winner. She noted something that I have also observed among friends who have started businesses: "Being an entrepreneur is a grind." The failure rate among startups is high. During the early phase of the business, the entrepreneur necessarily fills a number of roles, from research and development to production to sales. It takes an unusual dedication and conviction to pour oneself into an enterprise where success is far from assured. Many times we hear about trading as a business. Not so often do we consider trading as a startup. Each trader is an entrepreneur, seeking superior returns in a crowded business world. Every startup begins with three basics: 1) An idea - A new product or service that has the potential to deliver unique value and profitability;
2) A vision - A way of turning the idea into a living, breathing business; 3) A plan - A blueprint for pursuing the business, bringing on partners, and making the venture successful. It is the power of the vision and deep belief in the idea that fuels the effort needed to get a venture off the ground. It is the power of the plan that grounds the vision and attracts the right human and financial capital to the growing enterprise. So let's look at your trading as a business startup. Here are some questions you might expect from would-be venture capitalist investors: 1) What is the core idea behind your trading business? What makes you unique and distinctive? What will provide your edge in the marketplace? What evidence do you have that you truly offer value? 2) What vision animates your trading business? How are you turning your core ideas into sustainable and scalable processes? How are you making your vision sufficiently compelling that others would want to join your venture or invest in it? 3) What is your business plan? How are you acquiring the resources--information, teamwork, finances--needed to make the business a success? How are you ensuring that you are succeeding at each phase of the business, from researching new opportunities to managing risks to expanding your opportunity sets? Most important of all: Do you work like an entrepreneur? Do you find yourself consumed with the power of an idea and vision? Or is trading your hope for avoiding a life of work? There are those who fill jobs and those who pursue careers. Then there are those who follow a calling. Jobs and careers belong to us, but we belong to our callings. Further Reading: Proactive Personality and Entrepreneurial Success
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Still, I find divergences to be useful observations as a kind of heads up, a yellow caution light. If the broad market indexes are making new highs or new lows and a substantial proportion of shares are not participating, I want to be open to the hypothesis that the move reflects a handful of highly weighted shares within the indexes, not the broad market. This keeps me open to the possibility of reversal, combating any overconfidence bias I may have with respect to the recent market move.
Yesterday gave us a perfect example of the cautionary value of divergences. When we made fresh lows in SPX in the morning, my measure of selling programs showed considerable hitting of bids in my basket of highly liquid large cap names (top chart). These stocks were not only downticking, but doing so at the same moment, revealing an elevated level of basket executions of sell orders.
Despite this selling activity, the broad list of stocks (all listed U.S. shares) was showing reduced selling pressure (middle chart) as we made new lows. My measure of upticks vs. downticks across all stocks was showing considerably less selling pressure at yesterday's lows relative to the prior recent downturns. That was an indication that intense selling pressure was occurring in a smaller group of large cap names, but not across the broad market. Indeed, my cumulative measure of upticks vs. downticks among all listed shares was hitting new highs yesterday! (All data above from e-Signal). On the bottom chart (data from Barchart), we can see how this divergence played out with respect to stocks making fresh three-month lows. Although we touched price lows intraday yesterday, the number of shares listed on all exchanges did not expand the number of new lows made from the last few days. Again, there was intense selling pressure in the visible large cap group, but a lack of selling impact across the broad market. Keeping tabs on market strength and divergences, I find, helps keep me cognitively flexible. For someone like myself who was short the market going into the day, that flexibility proved to be quite useful. It is very easy to get caught up in the stock market and lose sight that it's actually a market of stocks. Looking at what the components are doing can be very useful in anticipating the movement of the broader market. Further Reading: Views on Breadth
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If markets were perfectly ordered and static, we could discover a trading edge and exploit it for all time by doing the same thing. Because markets are not static, doing the same thing ensures that we will eventually become dinosaurs. Adaptation--the ability to change in response to market environments--is essential to longevity in markets. Traders typically recognize the importance of learning and growing in their work. The need to focus on markets and the wealth of market-relevant information often means that we spend far more time managing positions than managing ourselves. Like a business that is executing well in the present but not preparing for the future, many traders convince themselves that following a routine makes them "process focused." Sadly, they lack a process for innovation and adaptation. So how can traders become better change agents? Here are three processes that can enhance fresh, creative thinking: 1) Process Old Information in New Ways: Write out your thinking in stream of consciousness fashion, not censoring or editing any of your thoughts. Let yourself jump from idea to idea without worrying about whether the connections make sense. If you aren't comfortable with writing, you can talk your stream of consciousness aloud into a recorder. Very often you'll discover new connections and associations that will lead to fresh ideas. Many times talking aloud or committing thoughts to writing helps us become aware of things we know but don't know that we know. It's a great way to bring intuitions to the surface, so that we can act upon them. 2) Process New Information: It is easy to fall victim to tunnel vision. Look at markets other than the ones you're trading: what story are they telling? Look at sectors within the stock market; look across different commodities and currency pairs. Very often we can pick up patterns once we survey the broad range of financial markets. The same principle applies by looking at time frames other than the ones we trade: what looks like a trend at one level of resolution could look quite different when we zoom out and examine the bigger picture. 3) Turn Learning Into a Social Process: I am continually impressed with the bright, creative, and talented traders I meet through the blog and across trading firms in my coaching. There are many, many people we can learn from and many who can benefit from interaction with us. Social media has made interactive learning more readily available than ever. By observing what others do well, we can create models for our future development. We can become better traders by becoming more creative traders, more able to spot opportunities. Many problems of trading psychology occur when our rate of change is slower than that of markets. The answer isn't simply to control our emotions; it's to expand the scope and flexibility of our thinking. Further Reading: Cultivating Emotional Creativity
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So let's take stock of the markets after the first month of the new year, making use of several worthwhile visualizations from the excellent FinViz site. Here are a few themes that pop out: 1) Increase in uncertainty - The rise in VIX has been outstanding. Volumes in stocks have picked up significantly, leading to much greater volatility. SPY daily volume averaged about 109 million shares in 2014. Thus far in 2015, we're averaging about 159 million shares. That rise represents the increased presence of longer time-frame participants acting on global macroeconomic shifts. The rise in gold also reflects investor uncertainty. With rates going to zero and lower around the world, the lack of yield from owning gold goes away as a reason to not be an owner. 2) U.S. dollar strength - With the exception of the Swiss currency (CHF), just about every major currency has been significantly weak with respect to the U.S. dollar. The top chart shows USD as one of the few winning groups on the month. The central bank moves toward easing--in Japan, China, Europe, Canada, and more--combined with talk of a normalization of U.S. rates and an end to QE have created a situation in which the dollar has been king for seven consecutive months. 3) U.S. fixed income strength - With rates around the world going to zero--and even negative--the seemingly paltry returns in the U.S. bond market suddenly become attractive. The uncertainty in stocks also contributes to a safe haven play in rates. Some of the best relative performers among stocks for a period of months have been higher yielding shares, such as utilities and consumer staples shares. In a world where safe guaranteed returns are going away, yield and carry become attractive. 4) General commodity weakness - It's not just crude oil; commodities have been weak across the board, from ags to base metals (copper) to a variety of energy products. The deflation concerns globally have not abated despite central bank actions; weak demand spawns weak commodity prices. The inability of many global stock markets to make new highs when SPX hit its peak this past December speaks to concerns regarding global recession. 5) U.S. stock weakness - This perhaps has been the greatest surprise. The U.S. was supposed to be an island of economic strength amidst the global weakness. With a strong dollar and good relative yield, why wouldn't international investors flock to U.S. equities? A look at the middle and bottom charts shows that growth stocks--consumer discretionary shares and technology names--have been beaten up lately. International companies that depend upon exports are doubly hurt by global recession and the surging dollar. The weakest sector for the month? It's financial shares, not the beaten up energy names. Check out banking names in Canada; a weakening economy combined with increasingly shaky energy loans has created real turmoil in that sector. The dynamics may not be so different in the U.S., as the headwinds from a rising dollar may be more than offsetting any benefits of low gasoline prices to consumers. Bottom line is that we're seeing substantial risk-off dynamics across markets and regions of the world. Stock market breadth has been weakening; volatility has been on the rise. Should stocks weaken significantly and energy sector related weakness and dollar headwinds threaten U.S. growth, we could hear a very different tune from the Fed than has been anticipated of late. Further Reading: The Weak Breadth in Stocks
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Here's a worthwhile exercise I recently discussed with a trader. Select a measure of market trending, such as a X-period Sharpe ratio for the market. Divide the last couple of years into bullish trending, non-trending, and bearish trending periods. Select a measure of market volatility, such as VIX. Divide the last couple of years into low, medium, and high volatility. Compute your cumulative profit/loss during the bull, non-trending, and bearish periods. Compute your cumulative profit/loss during the low, medium, and high volatility periods. Where are your sweet spots? Where do you lose money? When should you be stepping up your game? When should you be stepping back from markets? Where is your happy zone? Further Reading: Finding Your Trading Strike Zone
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Interesting research from Daniel Goleman and others suggests that emotional intelligence and social intelligence are important to business leadership. As the graphic above suggests, successful business managers combine self-awareness and self-management with social awareness and relationship management. In other words, effective leaders know themselves and use this awareness to be more effective. They also can read others well and utilize that sensitivity to be more effective with peers. Thanks to a savvy money manager for pointing out this article detailing how social intelligence is much more important in team-based success than IQ. Interestingly, people who are more skilled at reading emotions from the eyes of others are also significantly more effective in teamwork. Women also tend to be more capable at reading the emotions of others than men. One telling predictor of team-based success is the tendency to take turns in talking: effective people speak *and* listen. What are markets but the outcomes of the collective decisions of others? We frequently make reference to market sentiment and changes in market character much as we would speak of another person. Is it such a far stretch to imagine that emotional intelligence helps traders know and manage themselves and social intelligence helps them read and respond to the actions of others? Some of the most successful portfolio managers I know do not engage in copious quantities of original macroeconomic or market research but are quite talented in picking out the best ideas from researchers and other traders. They are like the skilled poker players, who are classically intelligent (they know the odds of each hand); emotionally intelligent (they know their emotions and manage their risk taking); and socially intelligent (they can read the players around the table). All of us have known traders who become so locked in their views they stop seeing and responding to what markets are actually doing. This may masquerade as "conviction", but it is actually socially unintelligent--not unlike harping on a topic in a conversation and alienating listeners. Research finds that social intelligence operates just as effectively in online environments as direct, interpersonal ones. Perhaps one of the boons of social media is the opportunity for traders--including female traders!--to leverage their skills at reading and interacting with others in generating new and better trading ideas.
Two kinds of traders fail to find success: those who cannot change and adapt and those who cannot focus and exploit their edges in markets. Very often traders become frustrated with losses and abandon what they are doing, seeking ever better ideas and methods. This makes it very difficult to ever master any particular opportunity or skill set in markets. Today's best practice submission comes from David Blair (@crosshairtrader). Readers will recognize him from the CrosshairsTrader site and blog. David's best practice is all about focus: eliminating what is non-essential in markets and developing a very specific market edge and expertise:
"When I first started trading I decided to be a sponge, soaking up all the stock market information I could, free or otherwise. After sponging it for a few years I realized I created a monster devoid of creativity; replaced by anxiety, confusion, fear, and impatience, all of which were a result of a lack of focus. I traveled in a black hole with a flashlight and didn't know it.
During these years I was trading with a partner: a friend who introduced me to the business. Each day he would have a new topic for us to study. As a result, our trading room began to look like a war room. 8 monitors, two big screen TVs, 2 color printers for printing charts, cases of books, CDs, seminar manuals, etc. The problem was, the more we added, the worse our performance, the worse our performance, the more we added, creating a vicious cycle of spoiled intentions. As my partner continued to add, I began to subtract. I began practicing minimalism by getting rid of all the things I thought were so important, realizing that stock prices cannot be predicted no matter how much I learned or added to my charts.
My process now involves a very simple, easy to understand price pattern wherein I look for stocks breaking from price boxes to either 1) continue the previous trend or 2) reverse the previous trend. I have a well defined method for locating these trades when they trigger on two time frames, the weekly and daily. I have prepared a watch list of stocks and have developed indicators specifically designed to alert me when there is a potential trade opportunity. In other words, I have become a 'process specialist'. I have developed a specific process that helps me manage the uncertainty of future stock prices. I no longer feel the need to study everything or watch anything other than the stocks on my watch list."
David's methodology makes sense: stocks trading in a box are ones that have consolidated. Both directionality and volatility have gone to reduced levels. He is identifying opportunities in which breakouts place him on the right side of both direction and volatility. This not only means that the market moves his way, but moves his way with impulsivity. Psychologically, having a specific methodology like this reduces distraction and enables a trader to become a true specialist, building skills in a particular kind of trading. Perhaps most important of all, specializing in a type of trading enables David to make trades truly his own, so that he will have the confidence to act--and also has the perspective to quickly recognize when setups are not working.
Many successful physicians are not only specialists but sub-specialists. They find their "edge" by knowing one area in great depth. This can be a very helpful approach for traders as well.
There are several classes of indicators I routinely follow to track market strength and weakness. These include measures of sentiment, breadth, momentum, volatility, correlation, and market participation (behavior of large market participants). Among these measures, there is often considerable statistical overlap. Because they are correlated, they are not truly measuring different things. In an upcoming post, I will address this issue by discussing purified indicators--ones in which overlap has been removed, so that we are looking at purer forms of sentiment, breadth, etc. For an inspiring example of purification, check out this paper from David Aronson highlighting his construction of a purified VIX measure. Above we see three current measures of market breadth. The top chart tracks the sum of 5, 20, and 100-day new highs minus new lows among all shares in the Standard and Poor's 500 Index. The middle chart looks at the average of the percentages of stocks in that index that are trading above their 3, 5, 10, and 20-day moving averages. The raw data for both these measures come from Index Indicators. The bottom chart displays the sum of stocks across all exchanges that are making fresh three-month new highs minus new lows. Note that the three measures tell a similar story: Peaks in breadth tend to precede price peaks for intermediate-term market cycles. Until recently, successive breadth peaks were occurring at fresh price highs for the broad market. During this most recent cycle, we've seen lower peaks in breadth and a failure of breadth strength to generate fresh price highs. All of this is suggestive of a weakening/topping market, as recent buyers have not been able to sustain the market uptrend. Further Reading: Tracking Breadth Across Cycles
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I recently took a look at changes in the number of shares outstanding of the SPY ETF as a sentiment measure. When traders are bullish, shares are created in the ETF; when they are bearish, shares are redeemed. This is a useful sentiment gauge, because it reflects what traders are actually doing in the market, not just their stated sentiment.
What is interesting is that we have seen considerable share redemption in SPY since the end of the year. Indeed, shares outstanding are down on a 5, 10, and 20-day basis. Since 2012, we've had 23 non-overlapping periods of such share redemption. Ten days later, SPY was up 18 times, down 5 for an average gain of 1.18%, compared with an average 10-day gain of .43% for all other occasions during that period.
Although we are not so far from all-time highs in SPY and have bounced well off recent lows, bearishness on this measure continues. Interestingly, the put/call ratio for all listed U.S. equities has been above .90 for the last two trading sessions, also above average. As noted yesterday, I have concerns about the longer-term pattern of breadth among U.S. stocks. One reason for tracking different market measures is that we can avoid confirmation bias by observing when things are not lining up. Right now, sentiment is not lining up with a picture of a topping market. There are times when flexibility is as important as conviction: a big edge in markets is retaining the option of not trading and waiting for clarity before placing bets. Further Reading: Options-Based Sentiment
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Suppose we think of technical indicators as measures of strength and weakness, with each giving buy and sell signals based upon different time frames and definitions of strength. One way to assess the overall strength of the stock market would be to track, over time, how many shares are giving buy and sell signals across different indicators. The above data track the cumulative buy vs. sell signals for every stock in the NYSE universe based upon the CCI, Parabolic SAR, and Bollinger Bands indicators (raw data and signals via the Stock Charts site). I find it interesting that the cumulative measures have largely lagged price gains since the October lows. This is what I would expect in an environment of weakening stock market breadth. In the wake of dramatic central bank actions this past week, I am watching breadth measures closely to see if the expansion of global QE breathes fresh life into stocks. Further Reading: Tracking Strength With the Bollinger Balance
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One of the greatest psychological challenges of trading is a cognitive, not an emotional, one. It is the challenge of bandwidth: our limitations in processing large amounts of information at any given time. Many portfolio managers I've worked with have developed ways of expanding their bandwidth, including building out teams to help with research and execution; connecting with savvy peers to discuss market ideas; and staying in touch with colleagues on the trading floor. Turning trading into a team sport increases the number of eyes and ears on markets and is valuable in spotting emerging trading ideas. How many times have I observed traders so focused on their particular trades that they miss what is happening in the broader market? Tunnel vision is a great way to get blindsided in markets.
What social media is accomplishing is a leveling of the bandwidth playing field for individual traders. Most independent traders do not have a trading floor to turn to for market color and cannot afford to build out teams of analysts. Through social media, however, they can turn their trading into a virtual team sport. Cultivating a focused network of insightful peers adds to the eyes and ears on markets and sparks thinking about fresh sources of opportunity. This is why building a social learning network is a best practice in trading. This is a network of peer traders who value your input and provide you with valuable observations and insights into markets. The key to creating an effective social learning network is selectivity. A great deal of the commentary via tweets, blog posts, and chat is high on noise, low on signal. You want a network that provides very high signal value. A great place to start a learning network is Stock Twits. The Stock Twits feed is a curated stream of tweets with high information value. Via the feed, you'll notice certain contributors come up again and again. These are often high value sources of information you will want in your network. Of particular value are the Saturday $STUDY sessions from the Stock Twits feed that select specific tweets and links for their valuable content. In general, the $STUDY postings offer a broad range of observations, analyses, and information. You'll find particular good links via founder Howard Lindzon and head of community development Sean McLaughlin. Yet another place to build your learning network is through sites that comb through content on the financial web and curate selections. Abnormal Returns offers a broad range of links daily and each week selects top podcasts and highlights the most popular links of the week. This also is a great way to discover valuable sources of information that can become your regular listening and reading. On the podcast side, there are the offerings from Michael Covel and Barry Ritholtz that feature interviews with top professionals in finance. Other excellent sources of links are Josh Brown via The Reformed Broker blog and Barry Ritholtz's The Big Picture site. The acid test for any addition to your learning network is that what you read or listen to actually does contribute fresh and useful perspectives to your understanding and trading of markets. There is much to be said for entertainment and it's easy to get into surface readings of many sources, but what is ultimately valuable is what feeds your head. You can't solve fresh puzzles unless you have the right pieces. And you won't get all the pieces if you're locked inside your head. Through social media, you can move from research to building a virtual research team. It doesn't matter how emotionally controlled and disciplined you are: you can't trade the opportunities you never see.
The body's flight or fight response that we know as stress is often a reaction to perceived threat. When we care about an outcome that is uncertain--and especially when we perceive a threat to that outcome--our bodies mobilize for action, with adrenaline pumping, muscles tensing, and heart rate accelerating. That is an adaptive response for dealing with physical threats, such as avoiding an oncoming car, but often gets in the way of careful, deliberate action when the threats we perceive are coming from the trading screen. It is ironic that, just as we most need to be grounded in the rational activities of our frontal cortices, we typically activate our motor areas and risk acting before thinking. How we react to perceived plays an important role in determining whether stress brings distress. Today's best practice comes from Daniel Hunter, who outlines his use of biofeedback in dealing with trading stress. Readers will recognize biofeedback as a tool that I have emphasized both on the blog and in books, as it's a great way for us to become aware of our stress responses and deal with them proactively rather than reactively. Here's what Daniel has to say: "I am a scalper in the forex markets, so anxiety, excitement, and apprehension can creep into the trading day. I combat this with a device that measures heart rate variability. The device I use is the Emwave2. It has an earlobe attachment that I use during trading. I use it along with the computer program provided and have a visual, real time status of my current state. If my emotions start to waver and my breathing starts to change, it alerts me, often before I realize my state. With breathing exercises, I can bring my emotions back under control and focus on what is actually happening in the market. It is also a fantastic practice before bedtime, as you fall asleep faster and your quality of sleep is much improved. It is basically an objective meditation monitor."
Daniel also mentions that considerable research supports the use of heart rate variability feedback in controlling stress and enhancing well-being. Because the monitor gives us real time feedback about whether we are in or out of our performance zone, it serves as a tool for mindfulness. Once we are aware of our stress responses, we can channel them in constructive ways and prevent them from driving our next trading decisions. If we choose to trade, we choose to operate in an environment where there is risk and uncertainty. That ensures that we will experience stress. Our challenge is to turn stress into a stimulus for self-mastery: to control our responses rather than allow them to control us.
In past posts I've mentioned that I track a basket of institutional favorite stocks and monitor upticking and downticking across the group every minute of the trading day. The logic is that when large market participants want to buy or sell with urgency, they will lift offers or hit bids across a range of liquid stocks. This simultaneous upticking or downticking across a range of shares--the execution of buy programs and sell programs--leaves a footprint that provides a very useful view of instantaneous market sentiment.
The top chart tracks sell programs on a rolling one-day basis from October, 2014 to the present. Note the expansion of sell programs at relative market lows and the diminished level of sell programs at relative market highs. That is pretty much what we would expect to see. When we go to the second chart, tracking buy programs, we see the same pattern, however. At relative market lows, we see more buying activity. At relative highs, buying dries up. This is very important. What makes market lows is that lower prices attract longer timeframe buyers--the ones who execute in baskets. Volume ramps up at relative market lows because one group of participants is actively selling and another group is actively scooping up the shares now offered on sale. At relative market highs, nothing is on sale and longer time frame participants are not incentivized to buy. Total volume dries up.
It is the third chart, tracking the relative balance between buying and selling programs, that tells us who is winning the tug-of-war. At market lows, sell programs diminish while buy programs continue to fire. That creates a situation in which buying pressure spikes early in a market cycle. (Note that this is what has happened recently in the wake of the ECB action). As a market rise matures, sell programs begin to exceed buy programs and we see the balance between the two top out ahead of price. The recent significant expansion of program buying suggests that we should see upside momentum from recent central bank actions. I included the fourth, bottom chart to make a separate point. Notice in the third chart how we had intensive selling pressure among the institutional favorite shares prior to the recent market rise. Despite that, the cumulative NYSE TICK (the sum of upticks vs. downticks across all NYSE shares) stayed strong and now has made new highs. What that means is that we were seeing intense selling (downticking) among the liquid large cap issues, but not across the broad market. It was that discrepancy that set up the recent strength. I deeply appreciate the interest readers have shown in the work I have shared. These are proprietary measures (all data from e-Signal and all calculation and charting done in Excel), but I will update periodically to stay on top of where we stand in market cycles. I will also be sharing information about the breadth and sentiment measures I track in my upcoming book. Further Reading: A Look Back on a Previous Instance of Program Buying Surge
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Think of the successes of great sports teams or businesses. In so many cases, consistency in execution is a common feature. The great football team doesn't just block and tackle well; they do so every play, every game. A business like FedEx or UPS doesn't just deliver on time; they hit their time targets consistently. How can traders achieve high levels of consistency? The answer is by turning trading practices into trading rules. Rules are what turn best practices into habits--and habits are what give us consistency. Contrary to popular conception, discipline is not about forcing yourself to do the right thing. It's about turning right things into habit patterns. Today's best practice comes to us from reader Markham Gross (@MarkhamGross), who is the founder of Anderson Creek Trading, LLC. He explains how the use of rules and systems bring consistency to trading: "A trader or investor cannot control markets or the outside world. All that is under the trader's control is his or her reactions to what is happening in markets or what is perceived to be happening in markets. Therefore, systems should be applied. The best systems are often simple. Spreadsheets can work as an implementation tool and some light programming skills will also go a long way. Systems should be comprised of specific rules for when to enter, exit for loss, exit for profits, and size of the positions. These rules can match the trader's personality and temperament. They should be testable. Although there are limits to backtesting, performing some backtests will help the trader know what to expect so they are not surprised by normal drawdowns. To approach the market without rules on a daily or weekly basis would be a mistake." What I find in my work with traders is that many of the best work in a hybrid fashion: they make decisions on a discretionary basis *and* their decisions are guided by explicit and tested rules. For example, one trader I worked with years ago examined price breakouts that tended to continue in the direction of the breakout versus those that reversed back into the prior range. He found several factors differentiated breakouts from fakeouts, including the volume of the move, where the move stood with respect to longer time frame activity, and the time of day of the breakout. He turned these factors into a checklist, so that he only took breakout trades that scored highly on his criteria. Those rules not only helped him find winning trades, but kept him out of many losers. When that trader first generated the rules, he used the checklist everyday to guide his actions. Eventually, the criteria became solid trading habits and he implemented them routinely. Repetition is the mother of habits and habits are the backbone of discipline. Turning your successful strategies into rules is a great way to ensure that your best practices become robust processes. Further Reading: Success as a Habit
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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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