Three Views of the Breadth of Stock Market Strength

Here are updated charts for what we might call the breadth of market strength and weakness.  (Raw data from the excellent Stock Charts site.)  Any individual stock can give a buy or sell signal according to rules from a technical trading system.  The top chart reflects Wilder's Parabolic Stop-and-Reverse (SAR) system; the middle chart tracks a system based on Bollinger Bands; and the bottom chart follows a system derived from Lambert's Commodity Channel Index.  The charts reflect the balance between buy signals and sell signals for all NYSE stocks on a daily basis.  They thus capture the breadth of strength and weakness for the general market.

As a whole, the signals tend to top out ahead of price during intermediate-term market cycles and bottom shortly ahead of price.  Of the three systems, the SAR tends to be the fastest moving (greatest lead times); the CCI the slowest.  When all are in sync, turning lower or turning higher, we generally find ourselves in the relatively early phase of a trending move.  I find the interplay among the signals to be helpful in identifying where we're at in those intermediate-term cycles. 

Note that SAR has recently turned negative, despite the recent price strength.  The Bollinger Band measure is coming off a high reading but remains positive.  The CCI system recently gave a high reading, which has preceded the most recent market strength.  It has fallen off that high but remains neutral.  As a whole, the signals are showing reduced breadth of market strength, but not net weakness--consistent with the waning breadth readings noted in yesterday's post.    

Further Reading:  Tracking the Breadth of Market Strength
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Weakening Breadth and Rising Volatility in the Stock Market

Here are the reasons I am cautious about the stock market at this juncture:

1)  We are seeing good buying activity in stocks, as gauged by the NYSE TICK which has been making new highs on a cumulative basis.  Among the large caps (top chart), that buying activity is no longer able to give us fresh price highs.  (Credit for the top three charts to Index Indicators).  Note that breadth in the large caps has continued to dwindle throughout 2015, with fewer 100-day new highs vs. lows.

2)  We have seen greater recent price strength among mid-caps (second chart from top) and small caps (second chart from bottom), as we're hovering near price highs.  Despite this, the breadth specific to mid-caps and small-caps has also been waning, with fewer shares making new highs vs. lows in April than March.

3)  If you look at the cash VIX, it seems as though volatility remains crushed, as VIX is sub-15.  Actual volatility, however, as measured by average true range over a rolling 100-day period, has been higher during 2015 than during the vast majority of the prior two trading years.  Rising volatility in stocks historically has been associated with weakening markets, not strengthening ones.  Indeed, volatility picked up at market highs in 2000 and 2007 well before the subsequent bear markets.  While I don't expect that kind of bear market activity currently, any downside break from here would likely see greater volatility than recent corrections.

I also note that the volatility of realized volatility (vol of vol) has been higher recently than at any time since 2013.  The recent rise in realized volatility and vol of vol helps to explain why short-term traders have had difficulty trading U.S. stocks:  We've had movement, but not trend.  It's been a choppy, volatile range trade.  Buying strength or selling weakness--trading with a fear of missing out--has been a consistent way to lose money.  Viewed on a longer time scale, however, this market appears to be one of narrowing breadth--even among those smaller cap sectors that have been strongest.  That keeps me cautious.

Further Reading:  Macro Themes Impacting Stocks
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The Importance of Understanding WTF We're Doing as Traders

I noticed that Bruce Bower, via SMB, has posted on the topic of what a winning trading methodology looks like and has released an e-book on the topic.  Bruce emphasizes that a methodology must be grounded in a replicable process and that this process must fit well with the personality and skill sets of the trader.  A very important observation from Jack Schwager in his Market Wizards series is that successful money managers have quite different skills, personalities, and workstyles.  These result in very different trading styles.  What creates success is not adherence to a particular style, but the ability to exploit market inefficiencies in a manner consistent with one's own abilities.

Replicability as a process and fit with a trader's skills and personality are necessary for a successful trading methodology, but not sufficient.  Bruce points out that the method must also manage risk effectively and filter the many possible decisions into ones that offer a reward that is superior to the risk incurred.  In short, a successful method must possess an "edge":  positive expected returns over time that justify the risks incurred.

But there is one other ingredient in a successful methodology that tends to be overlooked:  understanding.  

If you think of a trading methodology as a core aspect of a business plan, the element of understanding becomes clear.  A good business plan doesn't just describe a business with a process and a fit with the owner.  Nor does it simply limit risks and pursue greater rewards.  The good business plan starts with an understanding of the consumer and the drivers of demand in the marketplace.  A startup business meets an identified need.  Entrepreneurs must understand their markets.

Too often I see trading plans/methods that describe "setups" that are devoid of market understanding:  a shape on a chart, a reading on an indicator, a news development, a data release, etc.  Missing from such an approach is a clear identification of what drives prices and how one's methodology will uniquely exploit such drivers.

A very worthwhile text is this regard is Expected Returns from Antti Ilmanen.  Ilmanen identifies specific factors that uniquely impact the pricing of markets, such as value, momentum/trend, carry/roll, volatility, seasonality, liquidity, and the like.  Bender and colleagues break down factors into value, size, volatility, yield, quality, and momentum.  If we think of trading methodologies as business plans and factors as defining opportunity sets, then the solid methodology should be grounded in an explicit understanding of the factors  being targeted and the ways in which the trading approach uniquely exploits those factors.

A simple example would be a breakout trading style that defines periods of market balance and pursues directional moves that emerge from this balance.  That would be a strategy for exploiting momentum and possibly trend.  That would be quite different from a value-oriented long/short strategy that buys undervalued companies and sells stocks of similar companies that are more richly valued.

Three simple tests for a sound trading methodology would be:

1)  Can you clearly identify the factors that your methods/plans will be exploiting?
2)  Can you clearly explain why your methods uniquely exploit these factors?
3)  Can you demonstrate with research or trading evidence that the methods you're trading indeed do uniquely exploit the factors targeted?

If you were investing in a business as a potential venture capitalist, you'd ask those questions of anyone pitching their business to you:  Can you identify the business opportunity?  Can you clearly explain how your proposed business exploits that opportunity?  Can you produce evidence that your business indeed does exploit that opportunity?

If you wouldn't invest in a business plan that lacked clear answers to these questions, why would you invest in a trading plan similarly devoid of understanding?

Traders are entrepreneurs:  We're most likely to trade with confidence and conviction when we possess a deep understanding and belief in what we're doing.

Further Reading:  The Proactive Personality of the Trader
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Reinventing Yourself: The Key to Long-Term Success

I noticed a couple of good articles on Duke coach Mike Krzyzewski in the wake of Duke's win for the 2015 NCAA championship.  The first article outlined how he adapted to different times in recruitment by going after players who weren't committed to four years of college.  The second article pointed out Coach K's time with USA basketball and how coaching pros helped him change the way he coached his new players.  When you put the articles together, you realize that the coach who won his fifth national championship was quite different from the one who won his first.

The winning team at Duke was dominated by freshmen, many of whom will almost certainly jump to the pros after this year.  The opposing coach, no doubt unhappy in defeat, mentioned that his team doesn't do "rent-a-player"--a clear swipe at how professionalized the game has become.  Gone is the idea that these are student athletes.  They are athletes who are students for a while.

That is what makes adapting to the future and making changes so difficult--and so rare.  When you deeply believe in what you do and then have to adapt to a new future, it feels like self-betrayal.  It seems as though you're going against everything you believed in.  And in a sense you are.

I was trained in longer-term psychodynamic therapy during my graduate internship.  It was great training and informs my work to this day.  When I began working in student counseling at Cornell, however, I realized that my training in mental illness had left me poorly prepared to work with mental health.  Out of that, I researched and learned brief therapies to help healthy people make changes in their lives.  The psychodynamic model stressed building a relationship and working with people over months and even years.  The brief model assumed that the first session could well be the last one and emphasized rapid change over long-term insight.

I was accused of being superficial and betraying my training.  At times I felt that way.  The only way to work with a new group, however, was to work in new ways.  No one adapts to the future without leaving parts of the past behind.

A trader I'm currently working with--he'll know I'm talking about him!--has made extraordinary strides in remaking himself.  He used to trade remarkably short-term for a big trader, but he found that the short-term drivers of price in a QE world no longer held up.  Extending his holding periods, he has changed his way of generating trade ideas and managing the resulting positions.  He reminds me of Coach K.; he is so invested in winning that he's been willing to lose the past.  That ability--not to stick to a process, but reinvent one--is what is also returning him to the winner's circle.

Further Reading:  Performance and Creativity
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New Tools and New Views for a New Week

*  This time is different?  Money flow into the SPY index ETF has notably dwindled during 2015 after having tracked price pretty well for most of 2014.  Money flow reflects price times the number of ETF shares outstanding.  My figures show significant flow differences from sector to sector.  I will be posting those numbers this week.  In general I've found money flows to be a good (contrary) sentiment measure that is independent of options-related sentiment indicators.

*  Thanks to a savvy trader for pointing out this portable biofeedback unit measuring brain waves.  The idea is to directly measure brain activity related to concentration/focus, stress, relaxation, etc.  What's unusual about the unit is that it allows measurement even when the wearer is moving around.  I'll look into this further, particularly for validation studies that show a high correlation between the readings of the portable unit and those of standard EEG machines.  

*  Here's another new tool on the market that looks quite interesting:  The Edgewonk electronic journal is integrated into Excel and integrates your trading observations (mood/psychology; thoughts about markets) with your P/L.  The journal also tracks performance metrics, so that you can see where your trading has been strongest and weakest.  Over time, this could form a great database for learning and performance improvement.

*  Podcasts have been gaining in popularity, and a number of worthwhile sites are out there.  Abnormal Returns curates excellent podcasts each week, including the recent selection that includes discussions on creativity and technical analysis.  A wide ranging collection of podcasts related to positive psychology can be found here.

*  Here is the collection of Forbes blog posts related to positive psychology, with a particularly look at the factors that contribute to success in performance-related fields such as trading.

Have a great start to the week!

Brett
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Winning Through Defeat: The Secret to Resilience

Thanks to a savvy trader for pointing out this Lewis Howes podcast with Eric Greitens on the topic of resiliency and falling in love with pain.  A former Navy SEAL, Greitens learned about resilience first-hand during his training.  In his book, he points out, "If we are trapped in a life where everything is provided for us, our minds fail to grow, our relationships atrophy, and our spirits deteriorate."  We grow through challenges, including those that are hardships.  Greitens points out that we never bounce back from adversity; rather, we find healthy ways to integrate those experiences into our lives.  When we do what we are afraid to do, we don't return to the person we were.  We find ourselves just a bit more fearless.

When Angela Duckworth researched the phenomenon of grit, she found that it wasn't the highly successful children who were most able to sustain effort in the service of long-term goals.  Those who knew little other than success and were frequently praised by parents had very little experience with adversity.  That made it difficult to persevere.  When children experienced setbacks and challenges, they were more likely to develop the internal resources needed to sustain efforts.  Grit is resilience sustained over time.  As Duckworth explains, "grit...entails having and working assiduously toward a single challenging superordinate goal through thick and thin, on a timescale of years or even decades." 

Trading financial markets is unique in that it regularly forces us to experience loss and setback.  The uncertainty built into markets ensures that we will go through drawdowns.  The ever-changing nature of markets ensures that what worked today may not work tomorrow.  There can be no successful trading without resilience, and there can be no successful trading career without grit.

When we approach life as a gymnasium, even the most routine activities can be approached as workouts that challenge and develop us.  Every item in our daily planner--even those connected to recreation--can be pursued in a conscious, effortful way or in a routine manner of going through the motions.  It makes sense for us to undertake routine activities as routines, as this saves energy for more demanding situations.  But if all of life becomes a series of routine activities, we become less capable of responding to demands.  No one builds strength and endurance in life's gym by tackling the equivalent of ten-pound weights.

What's the key to becoming a resilient, gritty person?  I strongly suspect it's the ability to tap into hidden reserves of energy--that mental, emotional, physical, and spiritual second wind--that become available to us under conditions of high challenge.  Emilia Lahti refers to this by the Finnish term sisu:  "the second wind of mental toughness."  The paradox here is that challenges drain us of energy.  Extraordinary challenges--especially those that inspire us--help us tap into new and greater sources of energy.  When we tackle normal efforts, our willpower powers down.  When we reach for greater things, we find our willpower renewed.

In the long run, we don't sustain perspiration without sustaining inspiration.  Goals challenge us, but eventually wear us down unless they uplift us and pull from us the kinds of efforts that yield that second wind of sisu.  If you're cold and exhausted after long days of workouts and little sleep and that's all that's on your mind, you're going to drop on request and ring that bell to get yourself out of the SEAL program and into a hot shower.  The only thing that can move you past that place of pain is a commitment to your team, a commitment to your future, and a commitment to serving a larger cause.

Resilience begins with purpose.  We tackle life as a gym when workouts become the path to a greater future.

Further Reading:  From Setbacks to Success
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Why Do Disciplined Traders Make Bad Decisions?

We've all known traders who lack self-control.  They react rather than act, making decisions impulsively, often based on those twin fears of missing out and losing money.  It's no surprise when such traders draw down.  In a very real sense, they trade their hopes and fears, not the markets in front of them.

But how about traders with excellent self-control?  I know many: experienced money managers with long histories of success.  Once in a while they make mistakes that they describe as rookie errors.  They don't seem fearful or reactive, yet they will chase bad prices or stick with losing trades too long.  What's going on in such cases?  Aren't discipline and self-control supposed to produce good trading outcomes?

An interesting window of insight into the bad decisions of good traders comes from research conducted by Maria Konnikova that identifies the limits of self-control.  Konnikova finds that people high in self-control tend to be more overconfident than others in situations where control over outcomes is limited, but perceived control is high.  In other words, those with high self-control can also fall victim to an illusory sense of control.  That leads to poor decisions.

What is particularly fascinating in Konnikova's work is that people with high self-control are most likely to overestimate their actual control in situations when they are experiencing positive emotions.  Konnikova notes, "...the positive affect that usually accompanies both the illusion of control and high self-control can be an Achilles heel of high self-control in certain environments with limited actual control, creating a feeling of overconfidence that translates into suboptimal decision making."  It's when traders are winning and feeling good that their confidence is most likely to morph into overconfidence.  That leads them to overestimate their control over market outcomes and make decisions based upon illusory--not actual--control.

What is the solution to this dilemma?  Konnikova explains that the self-awareness of those high in self-control can help them recognize that positive emotions are a threat to their control, thus cooling them down when their confidence is running hot.  This fits very well with observations I have made in the course of working with traders: often the worst decisions are made when the trader has just made money, not when he or she has drawn down.  We don't normally think of positive emotion as a risk factor, but in fact any experience that takes our attention from markets and leads us to focus on outcomes rather than process is likely to interfere with performance.

We commonly hear that traders should take the most risk when they have the highest conviction in their ideas.  That can work as long as conviction doesn't come at the expense of self-awareness.

Further Reading:  The Lack of Profits From Market Prophets
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Three Things We Can Do To Boost Our Trading Performance

Hurdles seem small when we're on top of our game, and they can feel insurmountable when we're not.  The best traders I've known are those that work on their performance when they're on top of their game and they work on it when they're not.  Their competition is not just with markets, but with themselves.  By focusing on getting better, they end up staying profitable.

So when we're at those valley periods, the great things we see can be overwhelming obstacles or inspiring goals.  Here are three things traders can do to turn discourage into courage:

1)  Renew, re-energize - No one can deliver peak performance when they're mentally, physically, and spiritually exhausted.  As the recent post points out, we are most likely to sustain the discipline to reach our goals if we renew our resources.  There is no sustained work quality without life quality.

2)  Reach beyond yourself - The best way to clear your head is to get out of your head and engage in something outside yourself.  By finding a positive motivation far greater than the frustration you may be feeling, you tap into new sources of inspiration.  Frustrated with your work?  Double down on the parts of your life that mean even more to you than your work.

3)  Set yourself up for success - What do basketball coaches do when a player goes into a shooting slump?  They call a play that allows the player to take a high percentage shot.  Make an easy basket or two and suddenly the rhythm and confidence come back.  An important path to success is always having goals, always making sure they're challenging and meaningful, and always ensuring they're attainable.

It boils down to this:  Winners take care of themselves when they're down.  Losers kick themselves when they're down.  You are always coaching yourself, in how you approach success and in how you approach defeat.  Peak performance requires peak self-coaching.

Further Reading:  Finding Your Zone
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What We Can Learn From Options Skew

Above is a chart of CBOE options skew for the S&P 500 Index from 2014 to the present.  The skew index measures the degree to which index options traders are bidding up out of the money puts relative to calls.  The index moves between 100 and 150, with 100 meaning that traders are not pricing in negative tail risk and 150 reflects a high degree of negative tail risk pricing.  This can be viewed as a sentiment index, as it reflects the degree to which traders are hedging against market risk.

Interestingly, we've tended to see low skew numbers near intermediate term lows in SPY and high skew number near intermediate-term tops.  This is different from what we see with put/call ratios.  Here we see a higher degree of tail risk hedging following strength rather than weakness, perhaps as a strategy to lock in gains.

I divided the sample into quartiles.  When the skew has been in its highest quartile, the next ten days in SPY have averaged a loss of -.76%.  When skew has been in its lowest quartile, the next ten days in SPY have averaged a gain of +1.14%.  The most current skew reading is in the lowest quartile.

I will be refining this measure and looking at a longer history in the near future.  It appears to be a worthwhile complement to other sentiment measures.

Further Reading:  Equity Put-Call Ratio
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The U.S. Stock Market is Hostage to Macro Themes

Has the U.S. stock market been strong or weak so far in 2015?  As the above three charts from the excellent FinViz site indicate, the answer very much depends on the segment of the market you've been following and trading.

With respect to stock sectors, consumer discretionary and healthcare shares have performed well.  Note the strength in housing stocks (XHB) and retail shares (XRT), for example.  Commodity-related shares have been consistent underperformers.  Global economic weakness has contributed to commodity weakness, particularly in oil, which has been perceived as a boost for consumers.  Concerns over a normalization of interest rates by the Fed has hurt interest-rate sensitive shares such as utilities. 

Small and midcap stocks have performed well so far in 2015, but large cap stocks are relatively flat and mega cap shares are actually down on the year.  The idea here is that a strong U.S. dollar hurts large companies that depend on overseas sales, but a strong consumer economy can benefit small and medium sized domestic firms.  If you've equated the stock market with capitalization-weighted indexes, you've had a distorted picture of performance.

Finally, on the bottom chart, take a look at U.S. listed shares as a function of their country of origin.  Shares from Greece and Brazil have been hurt greatly; shares from much of Europe and Japan have performed well; and U.S. shares are relatively flat.  Stocks in countries that have been implementing quantitative easing programs (Europe, Japan) have been stronger than those exiting those programs (U.S.).

All this means that stocks, to a fair degree, have been hostage to macro themes.  Two visions of the future collide:  1)  The pace of economic growth in the U.S. slows and strong consumer and smaller cap shares roll over with the commodity shares and large caps; or 2) Global growth picks up and lifts the weaker segments of the market as part of a reflation trade.  I'm watching the stock market leaders and laggards closely to handicap those scenarios.

Further Reading:  Five Macro Themes Influencing the Market
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Adding Vision to What You See in Markets

Strangely, I find that traders who describe themselves as visual--i.e., they make extensive use of chart displays of prices and indicators--are among those who trade with the least vision.  They make inferences from what they see; not from an understanding of what lies behind the displays.

Take VIX, the popular measure of volatility implied by options pricing, as an example.  We might make inferences about whether stocks will go up or down based upon VIX being stretched to the upside or downside.  What we know, however, is that VIX tends to move inversely with index price.  VIX also tends to move up or down with realized volatility.  So when we look at a display of VIX, are we truly seeing a reading of options-implied volatility or are we seeing a conglomeration of several correlated variables?

To illustrate the point, I built a simple model of VIX that eliminates the overlapping influence of previous price movement and recent realized volatility.  This adjusted VIX measure captures the degree to which implied volatility is high or low relative to what we would expect based upon previous price movement and realized volatility.  A high adjusted VIX means that options are pricing in more volatility than we would normally expect from the recent price movement; a low adjusted VIX means that options are pricing in less volatility that we would normally expect.

I went back to 2012 and divided the adjusted VIX into quartiles.  When the adjusted VIX was in its strongest quartile, the next five days in SPY averaged a gain of +.49%.  When the adjusted VIX was in its weakest quartile, the next five days in SPY averaged a gain of +.72%.  When the adjusted VIX was in its middle two quartiles (i.e., when VIX was pretty much in line with what we'd expect from recent price action), the next five days in SPY averaged a loss of -.01%.

In other words, all the market's gains since 2012 can be attributed to "mispricing" of VIX.  But you would never see that in a simple chart of VIX.  

Trading by sight does not always bring vision.

For those interested, the adjusted VIX is currently in its lowest quartile, understating the price movement we've seen recently.

Further Reading:  Pure Volatility
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Promising Ideas to Start the Trading Week

*  I've found it helpful to track the correlations among the various sectors of the SPX by using creating an overall correlation index from the sector ETFs.  What you typically find is that, as cycles top out, there is divergence among the sectors.  That shows up as a drop in correlation.  Conversely, at market lows, there tends to be a risk-off washout across sectors.  That results in a rise in correlation.  I went back to the start of 2014 and divided the sector correlation data into quartiles.  When correlation was in its highest quartile, the next 10 days in SPY averaged a gain of +1.87%.  All other occasions averaged a loss of -.01%.  In other words, periods of elevation in correlation have accounted for all of the market's gains over that time.  We're not in that highest quartile at present.

*  The techniques I'm currently working on for improving concentration, mood, and performance are ones that involve a major shift in states of consciousness.  When we are in radically different states, we can access new information (intuition) and fresh energy.  We can also break old, undesirable patterns of thought and behavior.  This post outlines the essence of the approach.

*   A great and simple crowdsourcing strategy for finding good ideas is simply to track the top clicks on the Abnormal Returns site each week.  I inevitably find something of value, such as the very interesting post on why pursuing yield might not be the wisest investment strategy.

*  Here's a great post on a great site:  combining value and momentum strategies, from Alpha Architect.

*  Thanks to a savvy manager for pointing out this very promising line of research from an excellent site:  what it means when returns on stocks and bonds are positively correlated, from MKTSTK.

Have a great start to the week!

Brett
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New Highs and Lows in the Stock Market and What They Tell Us

If you've followed the blog for a while, you know that tracking the number of stocks across all exchanges making fresh one- and three-month new highs versus lows is one of my favorite measures of broad stock market breadth.  Above we see the three-month new highs vs. lows (raw data from Barchart) going back to the start of 2014.  We can see that breadth improved recently, as small and mid-cap stocks outperformed large caps.  Even with that improvement, however, we still see fewer stocks registering new high vs. low strength relative to the end of 2014.  Contributing to recent weakness has been not just large caps, but also commodity-related shares.  I continue to view this as a rotational, range environment and most likely part of a broad topping pattern that will eventually lead to a meaningful correction.

Going back to 2012, the new high/low data have mattered.  If we just look at one-month new highs and divide the data with a median split, we see that when new highs have been high, the next five days in SPY have averaged a gain of +.11%.  When new highs have been low, the next five days in SPY have averaged a gain of +.55%.  It's yet another great example of how markets that look the best yield the worst returns on average.  The results are similar if we look at three-month new highs.  When those have been high, the next five days in SPY have averaged a gain of only +.01%.  When they have been low, the next five days in SPY have averaged a gain of +.64%.

Overall, chasing new highs and stopping out of long positions on expansions of new lows has brought subnormal returns.  We have had a trending environment since 2012, but not a momentum environment.  Understanding that distinction has been crucial to stock market returns.

Further Reading:  VIX and Stock Market Returns
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Shifting From Negative Emotions to Positive Performance

A portfolio manager I recently met with was stressed out, frazzled from long--and frustrating--hours of following overseas markets.  He wasn't concerned, however.  He simply explained to me that he was going to engage in a vigorous workout in the gym--a rapid sequence of stretching, running, and lifting exercises.  By the time he was finished, he explained, he was so pumped up that the endorphins overcame any sense of stress or distress.

The light bulb went on in my head.  His key to overcoming pressure and fatigue wasn't to chill out.  Instead, he found a way of accessing a positive, pumped-up state that was more powerful than his state of stress.  What enabled him to move from negative emotions to positive performance was emotional transformation:  a gear-shift of experience that overwhelms negativity with positivity.

The problem most of us make is that we address negative states by attempting to reduce our negative thoughts, feelings, and actions.  That keeps us in our same form; it doesn't transform.  When we are sad, trying to reduce our sadness will not bring happiness.  When we are stressed and drained, trying to slow down will not re-energize.  Counting to ten when we're angry can be helpful, but it won't bring gratitude.

The key to self-mastery is to improve access to our most positive emotional states.  What gets a trader out of a frustrated funk after taking losses?  Doubling down on generating the next set of ideas and letting the excitement of discovery wash over the sense of frustration.  Once we learn from negative experience, we want to put that learning into practice--but that requires a shift to a new and constructive mindframe.  As the recent article suggests, we cannot access that mindframe from within our existing form; we need to transform.

Here are five gateways to transformation that I have found useful:

*  Meditation, imagery, using music to achieve a different sense of mind and body;
*  Vigorous physical activity, exercise
*  Social activity, having fun, connecting with others in a meaningful way
*  Generating fresh experiences, going to new places, pursuing new ideas
*  Reaching out to others, engaging in activities that are larger than oneself

The common ingredient is the creation of new experience that accesses new states of mind, body, and emotion.  Turning negative emotion into positive performance means that we become very good at operating the gear-shift of consciousness, where we determine the states we're in and don't simply allow them to determine our course.

Further Reading:  Building Emotional and Physical Health
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Making Your Trading Fist: Five Fingers of Preparation

Coach K has it right: a finger by itself is far less powerful than five fingers joined into a fist.  When a championship basketball team prepares for a game, it doesn't just work on one thing today, another tomorrow, and focus on something else another day.  Rather, it works on fundamental skills and strategies every single day of practice.  That way, each finger of preparation makes a fist of preparation for success.  Coaches know that if a team can't fire on all cylinders in practice, they won't be prepared to give their all at game time.

During my time at Duke, one of the preparation drills for the basketball team was the requirement to make 10 consecutive free throws at the end of practice.  In other words, you couldn't go to the locker room, take your nice hot shower, and get back to your dorm room until you made 10 consecutive shots from the line.  Think about that:  you're tired, sweaty, just wanting to get into that shower--and now you have to concentrate and nail 10 in a row.  Imagine the frustration of making five and clanging the sixth--and then starting over.  Imagine the frustration of seeing your teammates drain their 10th shot and you're still struggling on the line.  

It plays with your head.

And that was the purpose of the drill:  If you could pull it together and make those shots in a challenging practice situation, you'd be better prepared to make that key free throw down the stretch in the heat of a tournament game.  

*That* is preparation:  placing yourself in realistic, challenging situations and training yourself to perform at your highest.  Preparation is not simply writing in a journal or scanning a bunch of charts or reviewing various pieces of research.  Each one of those things is a finger.  Preparation joins the fingers into a fist through full-throttle practice.

Imagine that, after every day, week, or month of poor trading in markets, you had to replay those periods one time unit at a time, make new decisions, and keep replaying those markets until you made the right decisions for the right reasons.  You could not resume real time trading until you successfully relived the periods of bad trading and--in realistic simulation--corrected your errors.

Such an exercise would force you to stay in the right mindset; focus on the right pieces of information; follow the right trading rules; make the right decisions; and manage the positions the right way.  It would join those five fingers of preparation into a practice fist.  

It wouldn't be fun, but it would be a powerful way to ensure that bad trading doesn't turn into bad habits.

Further Reading:  NCAA and Trading Upsets
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Why Courage is Key to Trading Success

As we can see from the above chart, which tracks the five-day moving average of VIX versus the SPX for the past three years, important lows in markets have tended to see spikes in short-term implied volatility (credit to Index Indicators for the chart and data below).  

Interestingly, if we bought SPX when the five-day moving of VIX was less than 15, the next five days in SPX averaged a loss of -.04%.  That would have resulted in a cumulative loss of -3.42% during a period in which the market rose by almost 47%!

Conversely, if we bought SPX when the five-day moving average of VIX was greater than 15, the next five days in SPX averaged a gain of +.52%.  That would have resulted in a cumulative gain of nearly 41%, versus the buy-and-hold of 47%.  In other words, the vast majority of the market's gains have occurred during periods of elevated short-term volatility.

My point here is not to suggest a trading system, though it's not difficult to conceptualize one from the idea of relative volatility spikes.  Rather, the point is that comfortable markets--those with modest volatility--have yielded negative returns.  Uncomfortable markets have yielded the bulk of market returns.  

A trader's returns have been directly proportional to his or her ratio of courage to fear.  Buying ugly markets has made superior returns; stopping out of long positions on ugliness has led to negative timing alpha.  Buying stocks when fear is gone and markets are orderly has not paid off.  

If there's a formula for trading success, prudent courage is not a bad start.  If there's a formula for trading failure, acting on fear--fear of missing out, fear of losses--is also not a bad start.  It's amazing how ramping up trading risk/size and trading frequency can turn prudently courageous traders into fearful ones.  If there's a formula for risk-taking, trading the largest size that enables you to stay prudently courageous during times of ugliness is a good starting point.

Further Reading:  Why Success Lies on the Other Side of Fear
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The Three R's: Winning Practices of Successful Traders

For this post, I reflected on the traders I've worked with who have been particularly successful and some of their common practices.  Here are three practices that seem to distinguish the best from the rest:

1)  Reviewing and Learning - The best performers keep score.  They review their performance--good and bad--and they made dedicated efforts to learn from mistakes and best practices.  It's much more than keeping a journal.  The successful traders use their observations of performance to fuel specific goals that they then track relentlessly.  They are not always making money, but they are always learning.  That helps keep them constructively engaged when profits are not flowing.

2)  Rejuvenating - Trading is not an easy business.  Income is very uncertain and markets can change on a dime.  Working twice as hard does not guarantee success, but working half as hard pretty well ensures failure.  Average performance keeps you a job and a paycheck in many areas of life, but in trading it leads to bankruptcy.  Successful traders have strategies for staying happy and healthy through the ups and downs of performance.  My recent post outlines a four-fold scheme for staying happy and healthy.  Successful traders turn wellness into a positive habit pattern.

3)  Reflecting and Preparing - Perhaps the single best predictor of trading success that I've found is the ratio of time spent in preparation relative to the time spent actually trading.  Successful traders spend more time researching markets, observing markets, thinking about markets, and reflecting on their trading of markets than they spend placing orders and managing positions.  A very common pattern of trading failure is ramping up the frequency and sizing of trades, both of which tend to increase the proportion of time spent in a flight-or-fight state and decrease the proportion of time spent in planning and observing.  Successful traders are selective in risk-taking and use the time between trades to work on self and markets. 

So those are the three R's of trading success.  They are all about working on oneself in addition to working on markets.  It's what the trader is doing when not trading that contributes greatly to trading success.

Further Reading:  Traders' Checkup
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Best Practices in Trading: Conducting Video Reviews

One of the limitations of reviewing our trading and constructing plans based on our reviews is that our look back usually is tainted by what we recall and what we do not.  Particularly if we trade actively during a day, it's unlikely that we will recollect all the factors that went into good and poor trades.  We may even forget what specifically happened during a particular trade that might have made it work out or not.  Our memories are biased by our emotions, as well as hindsight and the factors that most stick out in our mind.  It is difficult to effectively review our trading if we can't accurately recall our trading!

The way sports teams get around that, of course, is by videorecording each play and examining the video in detail to spot best and worst practices.  Today's best practice is offered by reader Chris Britton, who video records his own trading and uses the review to work on his performance:

"I am a discretionary day trader and I trade the 10 year note and 30 year bond futures.  My pre-market analysis consists of identifying key support/resistance levels (yesterday's value area high, low, vpoc, etc).  For actual trading and getting a feel for the market action, I watch the depth of market with support from a chart to watch for emerging support/resistance levels.  

What I find helpful in doing trade reviews is recording my trading session (using Camtasia or the like).  At the end of the day, I cut down the video to the important parts that consists of trades that I make and trades that I missed or whatever I feel may make an important point.  Then I add in notes on the video that point out interesting clues that I keyed in on or missed.  The finished video is anywhere from 10 to 30 minutes long depending on how many trades I make.  The key points in the video present the context of the price action, the order flow on the depth of market that show why I entered (or did not enter), and, in some cases, why I exited when I did.

How does this help me?  First, the recording helps me identify strengths and weaknesses in my ability to correctly read the order flow.  From that, I have built a library of my own "best setups" or "avoidable pitfalls".  For example, I can review trades that had a successful breakout at some resistance level and compare the order flow from those to trades that had a failed breakout.  The key element is spotting what the order flow was doing that made the difference between the two.  If my skills can't explain it, then at least I have the library to review in the future for when my order flow reading skills will be improved.  

Second, the trade reviews at the end of the day are actually enjoyable.  Even if a trade is a loser, I enjoy watching the video.  That is because in some way, I improve my depth of market reading skills. Before I was making recordings, I dreaded the losing trade reviews and trying to remember what I did wrong.  That opened the door for bias to creep in which make learning from the mistakes harder.  With the recording, I learned that I can't escape my own accountability in making errors.  

Finally, play back reviews during slow periods or on the weekends actually help keep my mind sharp and prepare me for the next trading session.  I have found that while watching these reviews, the dialogue in my mind takes on an instructor type role where I try to explain the play by play action."

I particularly like Chris' observation at the end, where he notes that watching reviews places him in an instructor role.  That reflects the impact of self-coaching.  When Chris watches the videos, he is like a coach reviewing game film with players.  Going to specific portions of the video, reviewing the elements of performance in detail, and noting what could be done differently adds a level of detail to review that is impossible to replicate with a retrospective journal.  As Chris notes, the reviews become enjoyable, because they are constructive--they teach--and don't simply point out negatives.  

If pattern recognition is a function of cognitive focus and amount of exposure to those patterns, then a focused, video-based review is a great way to accelerate a trader's learning curve.  The trader who has watched markets during the trading session and then focused on patterns in post-market review simply has more learning experience per unit of time than the trader who fails to conduct review.  The video review is a powerful tool for learning and self-coaching.

Further Reading:  Viewing and Reviewing Your Performance

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