Three Life and Trading Lessons From a Personal Crisis

I was in Vermont on a family reunion and had just picked up a couple of snacks for the hotel room. Oddly, I couldn't find them when we returned to our resort. Only later in the day did I realize that they had been left in a storage compartment in our Jeep. I quickly took them out. One item was a container of egg salad. I didn't want that to go bad.

I didn't know it at the time, but I was 48 hours away from a medical emergency that could have been fatal.

The trip home from the reunion was not pleasant. It started with a small stomach ache in the morning and then became a fever and then developed into nausea. I was sick through much of both legs of the trip. By the time I returned to my Naperville home, however, the fever had subsided and my nausea was gone. All that was left was some stomach cramps. It was food poisoning, I reasoned, and the egg salad was the likely culprit.

Monday morning, and I'm scheduled for a flight to NY to meet with hedge fund traders. Still some cramps, but no fever, no nausea. I debate whether to call off the trip, but decide I'd rather not alter my plans. It was a fateful decision that would land me in a hospital.

The Monday meetings went well, and I took a car from the trading firm to my airport hotel. By this time the stomach pain had moved to a more specific area: the lower right side of my abdomen. I was increasingly concerned that this was appendicitis, not food poisoning. I checked into the hotel, took a look around my room, and turned right around with my bags. I asked the hotel clerk for the nearest, good hospital. She called a cab for me and away I went.

I've never seen neighborhoods like the ones the cab went through. Most of the signs on the stores were in languages other than English. I truly felt as though I was in another country. One sign alerted me to my location: Jackson Heights, Queens. Shortly after, the car dropped me off at the emergency room. There were few places to sit in the triage area; people with everything from primary care problems to broken bones to heart ailments to gunshot wounds came through here. I was the only Caucasian American in sight.

The pain grew over the next hour of waiting, and I alerted the triage nurse. She became interested in me when I told her I taught at a medical school and worked with ER staff. She moved me to the head of the queue, and I was wheeled into a holding area. A medical resident asked me questions, and now I felt on familiar turf. I explained my own medical background and why I thought the symptoms might be appendicitis.

Two hours later, I was interviewed by the full medical team, and two hours after that I received a CT scan. A friendly surgical resident with great bedside manner delivered the news: acute appendicitis. I would not be making my flight home. An hour later, I was in surgery.

It turned out, the surgeons told me, that the appendix was not merely infected, but actually gangrenous. Two-thirds of the tissue was already dead. The organ was "tissue thin" when they operated, a situation that could have spread bacteria throughout my body cavities and led to peritonitis.

Recovery was slow. Once again, I found myself the only native English speaker on the floor. The staff didn't ask what insurance I had; they asked if I had insurance. Police guards were placed throughout the hallways; many patients were loud and disruptive. Just about every bed was filled; my room was one of the few with vacancies. The nursing staff was continually on the go; it was clear that, in this community hospital committed to serving everyone, there just weren't enough hands to go around.

Still, the staff was extremely supportive. There were a number of mistakes in the system: I was brought meals that weren't appropriate for post-surgery, and I was not given the IV antibiotic the surgeon had recommended. When I called these items to the staff's attention, they eventually were remedied. When my roommate arrived--an engaging man who described himself as having major psychiatric problems--similar oversights led him to become extremely agitated. I told the nurses that I was a psychologist, and I explained how they could calm the situation. They did so, and I wound up with an excellent and appreciative roommate.

As I got on my feet, I wandered the floors and met many patients and staff: a kind man from Colombia who also had his appendix removed; an Irish security guard who told me of his own recent hospitalization and confided his frustration with the overwhelmed health care system; a third year medical student who went out of her way to find out how I was doing; a graveyard shift nurse from Poland who found a friendly way to wake up patients in the middle of the night for their care; a clearly burned out nurse from India who withheld simple comforts from a disruptive patient. After a while, I stopped noticing people's nationalities. We were all in this together.

By Wednesday I was ready to leave, and I flew home on Thursday. The outpouring of support from blog readers, friends, and family members was incredible. Several times I found myself on the verge of tears. I hadn't really eaten much in several days, and I hadn't stepped outside from Monday evening through Wednesday afternoon. Food tasted unusually good; the sky seemed especially blue. I was grateful to be alive and to enjoy these simple pleasures.

Perhaps the strangest experience of all, however, followed my release from the hospital. I needed to get a prescription filled, and the local pharmacy wouldn't take my insurance. The nearest Walgreen's pharmacy was 14 blocks away. Without hesitation, I shuffle-walked the 14 blocks through a neighborhood that only days before would have struck me as incredibly menacing. Again, I was the only Caucasian within view. But I had no problem with the walk or communicating with the helpful Asian clerk who worked everything out for me so that I could have my pills. By this time, I was part of the neighborhood.

So what are the life (and trading) lessons to be taken from all this? A few stand out for me:

1) A Little Knowledge Can Be Dangerous - I minimized my problems initially, sure that I had food poisoning. Only when I revised my view could I get the help I needed. If you're losing money in the markets, maybe it's a chance unlucky streak and a temporary phenomenon. But if it continues, make sure you consider alternative explanations--including the possibility that your trading ideas or methods are fatally flawed. Above all, be open to signs you're in trouble. I walked away from my hotel room when it was clear my pain was localized. When losses exceed normal drawdowns, go into defensive mode. It's the low-odds/high-risk events--those fat tails of risk--that can get you when your reasoning is following a normal distribution curve.

2) Advocate For Yourself - I'm sure some people at the hospital received excellent health care; I'm sure others did not. In a situation in which limited resources had to be devoted to the most pressing problems, many routine--but important--issues were sidetracked. The patients who received the best care were also the best self advocates. If you're an investor or trader, never assume that others will provide you with the tools and techniques you need for success. You'll only get out of forums, blogs, coaches, and seminars what you actively pursue and seek.

3) Networking Is Your Best Survival Tool - In a world of limited information and resources, you're best off networking with everyone who you can help and who can help you. I continually saw patients and staff help each other: it was in everyone's interest to share information and help each other out. Once I got that, the differences of culture and socio-economic class faded into the background. For traders, it means that knowledge is a social process; expertise is distributed. I "give away" information through my blog, but receive far more from like-minded readers.

I was in a multibillion dollar hedge fund working with traders; hours later I was in the holding area of a community hospital ER. Instead of walking Greenwich Ave., I hiked 14 blocks on Roosevelt Ave. Life is fragile; there are many twists and turns, and sometimes those offer life's best lessons. If you find yourself in an uncomfortable life situation, consider the possibility that you're meant to be there; that you can only expand yourself when you travel outside your comfort zone.

My deepest thanks to the fine professionals at Elmhurst Hospital Center. Many, many people in the schools, clinics, airports, and fire/police forces all across this country are quietly giving their best with strained resources. Theirs is a heroic story that deserves to be told.

And thanks again for all the warm support--

Brett

TraderFeed on Hold Temporarily

Dear Blog Readers,

On Monday, following a trip to meet with traders, I was hospitalized with acute appendicitis. It was not a good situation and required extended follow up care following surgery. Only now am I on my feet and able to make it to a computer. I hope to resume the blog and my personal site before too long. Thanks for your understanding.

Brett

A Look at the Stock Market to Start the Week

* Solid Momentum - On Friday, my Demand indicator (stocks with significant upside momentum) hit 161; Demand was 26. Given that momentum peaks tend to lead price peaks, I'd expect further upside this week.

* Broad Rally; Resilient Market - Just this past week, on Tuesday, we saw 1649 stocks make fresh 20-day lows. On Friday, however, there were 1388 new 20-day highs. These pullbacks in money flow toward the 200-day average, noted earlier, have been great buying opportunities.

* Strength in Small Caps - I notice that, on Friday, 80 S&P 600 small cap stocks registered fresh 52-week highs, the highest level in months. If this market were just going to turn around and crash, I wouldn't expect such broadening of strength. Fourteen NASDAQ 100 stocks also made 52 week highs on Friday, the highest level in months.

* Breakout Move in CRB Index - Note the multi-month upside breakout move in the CRB Index of commodity prices. Not something we'd expect from a weakening economy. The correlation between the move in stocks and commodities over the last few days is worth watching.

* Volatility Still Up - Trader Mike notes the whippy price action of late. Note that the VIX closed near 14 on Friday, well up from the low VIX numbers posted after prior price jumps. I continue to believe we've put in a long-term bottom in volatility.

* Rally in the Dollar? - Great weekend linkfest from Barry Ritholtz includes a perspective on a rising greenback. See also the excellent post on cognitive biases that affect our decision making.

* Good Reading - Abnormal Returns offers a view on the oversold bond market, a test of a popular trading system, and investments in wind as alternative energy source.

Trade Like a Scientist - Part Three: Three Common Mistakes of Traders

In the first two posts in this series, we examined a scientific mindset and how it affects trading practice. Let's now turn the tables and view three common trading mistakes through the scientific lens:

1) Mistake #1: Trading Without Understanding - Sometimes traders put their capital at risk without taking the time to observe market patterns and integrate these into a concrete explanation of what is happening in the marketplace. A number of traders I work with observed the recent rise in interest rates very early in the move and formulated ideas of shorting rate-sensitive sectors. They tested their understandings with initial positions and scaled into the idea as markets confirmed their views. How different this is from simply putting a position on because a market is making a new high or low!

2) Mistake #2: Oversizing Positions - Many psychological problems in trading can be traced back to excessive position sizing. Traders trade too large for their account size in order to make windfalls, not in order to test their ideas. Scientists conduct many tests before any hypothesis is truly supported, and they test many hypotheses before they accept theories as versions of truth. If you were a lab scientist, would you risk your entire grant funding on a single experiment? Of course not; a single study could fail for a variety of reasons, including experimenter error. Similarly, any single trade or idea can fail for a variety of reasons. A true scientist knows that his or her understanding will always fall short of reality. That is why scientists will conduct doable experiments to refine their ideas before they dedicate significant resources to large investigations.

3) Mistake #3: Not Knowing When You're Wrong - A scientist does not actually test his or her hypotheses. Rather, each experiment is framed as a test of the "null hypothesis": the proposition that variables of interest do *not* affect the outcomes under study. Scientists thus never accept their hypotheses; they at best only reject null hypotheses. Embedded in this perspective is the idea that it is crucial to know when it is necessary to accept that mull hypothesis and conclude that a view is not supported. Can you imagine a qualified scientist becoming emotional because an experiment produces no significant differences and then conducting numerous revenge studies?! Traders, however, sometimes do just that. They don't have rational stop losses identified and so can't terminate their "experiment" at a prudent time. That leads them to take on excessive losses and react out of frustration rather than understanding.

A simple checklist would aid many traders who would become their own performance coaches:

1) What is my understanding of this market and what is the evidence behind it?

2) How much of my capital am I initially willing to devote to my understanding of this market?

3) What outcome(s) would lead me to devote more capital to my idea and what is the maximum portion of my portfolio I'm willing to put at risk on this idea?

4) What outcome(s) would lead me to abandon my idea and how much am I willing to lose on this idea?

Many bad trades could be avoided simply by requiring oneself to answer these questions aloud prior to any trade.

Trade Like a Scientist - Part Two: Framing Trades Scientifically

In the first post in this series, we examined the process of science and its relevance for trading. In this post, we'll look more specifically at how we frame our trading ideas as scientists.

If I am trading like a scientist, I am carefully observing the market and watching for patterns. I already have observed many markets in many conditions and have some theoretical understanding of what makes markets move across different time frames--from interest rates and liquidity at longer periods to the aggressiveness of large traders at short ones.

Perhaps I notice that, as selling hits the market, volume is declining and fewer individual stocks are making fresh price lows. I also notice that one sector of stocks, the semiconductors, are actually moving higher and gaining money flow. Bonds, which had been falling with stocks, are now catching a bid. I hypothesize that the market is running out of sellers, that we are in the process of bottoming, and that we will likely see short covering as a result. That should propel the market higher.

Having formed this hypothesis, I make note of a recent short-term high price in the semiconductors and the low price. I say to myself, in essence, "I think we will hit this price (prior high) before we touch that price (recent low)." In other words, I am willing to risk a possible move back to the low in order to participate in the hypothesized move to the high.

This is only a hypothesis, however; it is not truth. For that reason, as a scientist, I must remain open to data that tell me my hypothesis is not supported. A fresh influx of sellers hitting bids; a fresh drop in bonds--many factors could alert me to a potential problem with my hypothesis. I also must keep my bet on this hypothesis modest: to risk much of my capital on the idea is to treat the tentative formulation as absolute truth.

It is in this context that every good trade tests a hypothesis. When we observe a pattern, frame an idea, test the idea with a trade, and actually profit, our idea--our theory--is supported. That may lead us to another trade that extends this idea. Conversely, if we do not profit from our theory, we may need to go back to observation mode and revise our explanations.

Thus it is that a scientific trader will gain confidence and become a bit more aggressive when his or her ideas are confirmed; a bit more cautious when ideas do not pan out. When you trade like a scientist, every good trade provides you with information, because every good trade is a solid test of your market understanding. For this reason, the scientific trader values losing trades. They, no less than the winners, are data to be assimilated and can push you to further market insight.

In the third and final post in the series, I'll look at three common mistakes traders make from the scientific vantage point.

Trade Like a Scientist - Part One: The Scientific Mindset

A theme I emphasize with new traders is that it is important to trade like a scientist. The scientific mindset is one that can be rehearsed and cultivated--and eventually internalized.

What do scientists do? First, they observe regularities in nature. They look for patterns: repeated sequences of events and commonalities among structures. Those regularities differentiate what is meaningful from what is random.

After observing regularities, scientists attempt to explain these. Explanation is the role of theory. The theory is the scientist's way of making sense of the world. Theory is not truth; it is a first approximation at truth.

Scientists gain confidence in their explanations by testing them. If a theory is meaningful and accurate, we should be able to use it to generate future observations. These predictions are hypotheses for the scientist. By testing hypotheses, we keep an open mind with respect to our observations and explanations.

Finally, once empirical tests provide fresh observations, scientists revise their explanations of nature and use these to generate further hypotheses, observations, and revisions. Knowledge, for a true scientist, is always provisional: that is what separates science from dogma.

The scientific mindset is one of humility: a recognition that our best theories are only approximations and that many of our tests of hypotheses are apt to fail. When we trade, we have an implicit or explicit theory about the current market, and our trade tests a hypothesis that we frame around our explanation. That is why a scientific trader never wagers too much on any single trade. Nature will always be more complex than our science, and our understanding will always be partial. Such a perspective is a powerful antidote to overtrading and overconfidence.

In my next post, we'll walk through a trade from a scientific perspective.
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Protracted Buying Interest in the NYSE TICK: What Comes Next?

A very sharp upward spike in the NYSE TICK is often a sign of buying panic; my general leaning is to sell those moves, as they're often overdone. That led to a nice short trade on Tuesday.

But what if we have prolonged high peak NYSE TICK readings? I went back to 2004 (N = 861 trading days) and looked at all occasions (N = 74) in which the five-day average of the highest TICK reading for the day was above 1300 (as was the case on Tuesday). Five days later, the S&P 500 Index (SPY) averaged a respectable gain of .59% (49 up, 25 down).

Conversely, when the five-day peak TICK reading averaged less than 1100 (N = 149), the next five days in SPY averaged a loss of -.18% (70 up, 79 down).

When the five day maximum TICK reading averaged 1100-1300 (N = 638), the next five days in SPY averaged a gain of .21% (380 up, 258 down).

Interestingly, prolonged buying interest tends to carry forward in the short run, while an absence of buying interest over five days has been associated with subnormal near-term returns. I will be exploring this pattern--especially in light of lowest TICK readings of the day--in a coming post.

RELATED POSTS:

NYSE TICK and Momentum

NYSE TICK: Does It Matter?

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Stock Market Correlations and Other Wednesday Ideas

* Excellent Book - I've started reading Richard Bookstaber's very engaging "A Demon of Our Own Design", an explanation of how the complex strategies utilized by the most sophisticated trading firms end up contributing to unforeseen market crises. I particularly like this quote:

"As the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is that you cannot always predict ahead of time if the correlation will be positive or negative." - p. 26

This dynamic--instruments becoming increasingly correlated during buying and selling panics--occurs on multiple time frames and across varying widths of asset classes. A simple panicky selloff in stocks may tank all sectors, for example, but not necessarily spread to bonds. One implication is that you can quantify panics by the breadth of the increased correlations and by their duration.

Bookstaber's observation is that such periods of unusual correlation can also represent "spectacular profit opportunities for those who can stand the heat" (p. 26). Might a multiple correlation indicator provide insight into those emotional periods when traders grab or toss aside all stocks indiscriminately, creating inefficiencies (temporary inflation of bad stocks/sectors; temporary depression of good stocks/sectors)? Food for research...

* A Number of Valuable Ideas - Take a look at the most recent links posted by The Kirk Report, particularly the articles on the prospects for rate hikes; cardboard box production as an economic indicator; hedge fund leverage as a recipe for market disaster; and a Senator's view on a major threat that could capsize the economy. Great stuff.

* How to Track Hundreds of Financial Blogs - Craig of TAZ Trader Blog very helpfully walks readers through the process of subscribing to a reader and adding favorite blogs for automatic updating. Also check out their post on action zones for swing trades, designed to capture market reversals.

* Another Stock on My Radar - ADBE has positioned itself very well for the digital publishing age. This includes such online developments as its Creative Suite, but also underappreciated potentials for Acrobat as a vehicle for rich multimedia publication. Analysts expect a good earnings report for Thursday; the chart above shows that we've had solidly rising dollar volume flows into the stock over the last 200 days--a good sign of institutional sponsorship. Money flows over the past 10 trading sessions have pulled back to their 200-day average: a situation that has marked recent buying opportunities.
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Ideas Floating Around on a Tuesday Morning

* On the Radar - A while back I blogged about INTC and the favorable money flows in that issue. Since that time, despite the recent market pullback, INTC has shown positive money flows and a 10-day flow well ahead of its 200-day average. I note that, thus far today in a weak market, INTC is holding its own. Worth keeping an eye on.

* 10-Year Rates Hit 5.225% - Tuesday AM has been another one of those periods where identifying and trading a dominant theme has paid off handsomely.

* Views From Trader Mike - His updates are a regular part of my daily reading; now he offers his own interview from TradingInteviews.com.

* Playing the Long Side Safely - Some stock ideas from Barry Ritholtz. His screening criteria are most informative.

* More Fine Idea Links - Abnormal Returns finds more nuggets in the Blogosphere, including a view on overvaluation in China.

* Overvalued ETFs - A hedge fund manager writing for Seeking Alpha offers his view on some sucker bets among ETFs. Great example of doing your homework and generating an idea.

* Dreams and Visions - Dr. Bruce Hong offers a valuable perspective on the difference between being a daydreamer and a visionary.

The Trading Coach Project: Coaching Gets Started With an Assessment

I recently announced that I would be coaching a single trader free of charge for a month and posting the process to the blog to illustrate how to improve trading performance. The trader selected for this round of the Project is Trader C, a professional trader who has worked for a trading firm for several years. He has a track record of success over those years, even as many other traders have had to leave the firm. Expenses at his firm (commissions, fees) are not cheap, so that his ability to make a living from trading after all costs is itself a noteworthy accomplishment.

Trader C. has a number of strengths beyond his profitability. Unlike many of the traders I've worked with in Chicago and more like traders I've worked with at hedge funds, he trades many different individual stocks. He also trades different time frames, holding many positions intraday, but also carrying longer-term swing positions. I was immediately impressed by his ability to detect and trade themes in the market. For example, he noticed early on the rise in rates and was quick to short interest-rate sensitive issues. He will hold such short positions at the same time that he is long other stocks and sectors, creating a diversified portfolio.

Trader C. tracks his profitability by spreadsheet daily and has numerous printouts of his trading metrics, including his largest wins and losses, average wins/losses, profitability by day of week, and profitability by the particular stock traded. He keeps a journal in his spreadsheet, commenting on the day, and he has utilized cognitive techniques to improve some of his trading shortcomings. These shortcomings are what brought him to volunteer for the Project.

The histogram above shows the distribution of Trader C's trades thus far during 2007. (X-axis is profitability of the trade in ranges or bins; Y-axis is the number of trades with that particular level of profit). This is taken directly from his trading log/spreadsheet. When I work with a trader, I don't start with their psychology and try to use it to improve their trading. Rather, I start with their trading and use that to understand what is happening for them in their thinking, feeling, and acting. Keeping accurate data on your trading is one of the most important things you can do to identify both strengths and weaknesses.

What we can see from the above distribution is that:

A) Trader C is making modest money for the year; he hasn't been as profitable as he has been in the past;

B) He has many small winning trades;

C) The left side of his distribution shows a good number of large losers that negate many of his small winning trades.

When I examined the distribution of his profitable and unprofitable trades as a function of time, what I found was that he was losing money for much of the early part of 2007 and only recently had turned profitable for the year. His last 18 trades were 12 winners and 6 losers with only one relatively large loser, but four large winners.

In Trader C's initial email to me, he stated:

"I tend to break my rules in position sizing, get careless about keeping my stops and keeping my losses small, and finally taking profits off the board when I have a windfall because i think I can "get more". With the elimination or reduction of these bad habits, I would probably triple my income."

Later he elaborated:

"What I have been doing right is my feel for the turning point, or breakout, or direction of a group, but my drawback is the initial sizing in them. I find that I tend to go full size and more after I see the confirmation, but I chase a bit and have quite a bit of heat before going my way."

What is happening, it seems, is that Trader C is getting too aggressive on his entries, sizing positions too large initially, and then taking larger-than-necessary losses when his ideas don't work out. This creates the distribution pattern from his above histogram and is observable in a single statistic: the average size of his losing trades has been greater than the average size of his winners.

So why would an experienced and sophisticated trader like Trader C fall into this pattern? It's not enough to simply say he's "losing discipline". Successful coaching demands that we understand *why* these lapses are occurring. Diagnosing the problem--and understanding his strengths--will be the topic of the next post in this series.

RELATED POSTS:

Coaching the Professional Trader

Performance Coaching: When It Works, When It Doesn't

Why Coaching Fails: Stages of Change

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Trading 2.0: Expertise Becomes Transparent

The rise of the Web as a social medium has changed the ways in which traders and investors manage their money. Growing social and information networks have provided us with greater information and more money management options than we've ever had before. It is this changed financial landscape that I'm referring to as Trading 2.0.

One of the important elements of Trading 2.0 is that expertise becomes transparent. Thanks to the online medium, we are now able to see exactly what expert traders are doing and how they're doing it.

Consider the VesTopia site, which is now in beta and offering free registration for traders. A group of pre-screened "investment directors" (experienced money managers with verified track records) post their strategies and their specific trades to the site. Site visitors can follow the directors whose strategies most interest them and develop trading/investment ideas from the portfolios of those directors. Best of all, blogs written by the directors explain their strategies, market views, and stock picks. This latter feature turns what would be a fine informational source into an educational one.

A great example of the educational content is Mark Hines' recent post in which he illustrates specific stocks to buy that enable investors to participate in hedge fund returns. It is rare that individual traders would get to hear ideas from managers of billion dollar funds and model their ways of thinking. That's a huge benefit of Trading 2.0: the opportunity to learn within a social network.

A different form of transparent expertise can be found in James Altucher's StockPickr site. Here stock picking becomes a social activity, as members share their portfolio selections. An added, unique feature, however, is that the site also tracks the portfolio maneuvers of leading money managers, so that you can see what the pros are doing. James constructs a variety of spotlight portfolios, such as "Great 5-Year Charts", which highlight stocks that have attractive technicals, fundamentals, and sponsorship.

The appeal of the StockPickr site is that it takes traders and investors down the path of thinking thematically. Instead of narrowly focusing on single markets and instruments--which may or may not have opportunity--visitors to the site can identify broad themes that are attracting professional interest.

Over time, I expect the Trading 2.0 wave to bring additional innovations, as trading and portfolio management become public activities that attract attention (and assets) by combining ideas and education. In upcoming posts, I will explore further changes to the financial landscape wrought by the social revolution in computing.

What's Behind The Bull Market: Breakout in Money Flows

Suppose we have an indicator that keeps a running total of every trade made in a stock. It multiplies the price of the stock times the volume of the trade to provide an indication of the dollars that go into the trade. If the trade occurs on an uptick, it is added to a daily cumulative total; if it occurs on a downtick, it is subtracted from the total. The resulting measure at the end of the day is a measure of money flow: the dollar volume that enters or leaves the market.

Above, I have gone back to 2005, calculated the daily dollar volume for the 30 Dow stocks, and summed them to provide a picture of the dollars entering and leaving the Dow Jones Industrial Average. The chart shows a five-day moving average of the Dow's dollar volume (pink line) vs. the Dow average itself (DIA; blue line).

We can see that dollar flows have pulled back of late in the Dow stocks on the heels of rising interest rates. Still, those flows remain net positive. Similar pullbacks of late have represented good buying opportunities.

More important, we can see that a major shift in investors' allocations occurred following the June/July, 2006 lows. There was a surge in dollar volume, suggesting that much more money was being put to work in the stock market. After the late February/early March pause, that surge continued. This shift in allocations is what bull markets are made of. In my latest update to the Trading Psychology Weblog, I chart the money flows specific to eight S&P 500 sectors. This shows us that, while flows have slowed, they remain at positive levels--and in some cases remain above their long-term averages, even after the market weakness of last week.

The chart above shows us that money flows into stocks broke out from a long-term range. That has created a sustainable rally. Do such money flow breakouts occur in individual stocks, and might that become a basis for stock picking? More to come on this promising measure.

RELATED POSTS:

Tracking the Dollar Volume Flows of Stocks

Dow Returns Following Extreme Money Flow Days

Idea Generation for a Sunday

* Money Flows Are Near A Buying Zone - I've updated my Adjusted Relative Dollar Volume Flow figures for eight S&P 500 sectors and for the S&P 500 Index as a whole. We've dipped below the 200 day average level of flow, a situation that has recently marked good intermediate-term buying opportunities.

* How to Track Trends on an Intraday Basis - My latest post to the Trader Performance page outlines my four favorite tools for staying on the right side of short-term trends.

* How You Think Affects How You Trade - IMO, this is one of my best TraderFeed posts of late. It helps to explain why traders can oscillate between overconfidence/overtrading and lack of confidence/anxiety.

* Diversifying Your Capital - Here's a very thoughtful post from Dave Johnson. Also take a look at Dave's backtest of a McClellan signal and what it's saying for the current market and Dave's discussion of market myths. Flat out great site.

* Three Perspectives on Peak Performance - Some of you might not be familiar with this free video from the Chicago Mercantile Exchange featuring Doug Hirschhorn, Denise Shull, and yours truly. Out of the talks, you might just come away with concrete ideas for working on your trading.

* Using a Tool to Improve Performance - Trade Ideas has posted a very interesting case study of a professional trader who consulted with their staff to develop new trading strategies. I see they are now making such consultation available to users. Their Odds Maker tool backtests strategies over a 3 week lookback period without users needing to do any programming--and then screens the market and issues alerts when the strategies are triggered. Interesting concept for discretionary traders looking to solidify a market edge.

* How to Test Market Ideas - Interested in testing your market ideas? Victor Niederhoffer reports on a promising book that explains correlational tests. See also his interesting review of a book that explains the benefits of free markets. I heartily suggest you scour the archives of the Daily Speculations site for a variety of interesting perspectives and reviews that you'd never find elsewhere. Hats off to Victor and Laurel Kenner for keeping the Spec List alive and well day after day for many years. Great resource for idea generation.

Short-Term Stock Market Trends and Intraday New Highs and Lows

In my recent post, I illustrated intermediate-term market patterns with 20-day new high/new low data. Above we see 60-minute new highs and new lows among a basket of 40 stocks evenly divided across eight S&P 500 sectors: Materials, Industrials, Consumer Discretionary, Consumer Staples, Energy, Health Care, Financial, and Technology. These 60-minute new highs/lows are updated every 5 minutes during the trading day. The pink line plots the difference between new highs and new lows vs the S&P 500 Index (SPY; blue line) for a bearish day (Thursday) and then a bullish rebound (Friday).

You can see how the levels of new highs minus lows identify the falling market, the transitional period in the middle, and then the bullish thrust. The key is tracking the proportion of time that the new highs/lows are above or below the zero line. In falling markets, we'll see readings hitting -30 and a majority of readings below zero. In rising markets, we see the reverse. It's when the new highs/lows oscillate around the zero level with a preponderance of readings between +20 and -20 that we see consolidation/transitional periods.

The new high/low measure is also helpful in identifying breakouts from ranges--we want to see readings above +20 and below -20 on sustainable breakouts--and is useful in identifying bounces in bearish trends and dips in bullish moves that will not be sustained (readings between +20 and -20 and often within +10 and -10).

The above data came straight from my real time feed (RealTick) and were archived and charted in Excel. Alternatively, a trader could create a basket of stocks within a screening program such as Trade Ideas and track new highs/lows in real time. Readers interested in the specific stocks that I utilize in my basket can check out my "Tracking the Trend" post to the Trader Performance page of my personal site, which will be uploaded later today.

RELATED POST:

Anticipating Market Turns With Intraday New Highs and Lows

Attribution and Bias Among Traders in the Financial Markets

Perhaps the cardinal contribution of behavioral finance research is the elaboration of the ways in which people depart from strict rationality under conditions of risk and uncertainty. How we process information affects our behavior, creating situations in which we can risk our capital more for psychological reasons than for logical ones.

Much of how we process the world consists of attributions: qualities that we attribute to ourselves and explanations that we attribute to events. As human beings, we are driven to make sense of our world, and attributions are an important element of that sense-making.

One of the most basic attributions traders make is to their gains or losses. Are profits and drawdowns attributable to the self; the result of positive or negative actions that we take? Alternatively, do we attribute gains and losses to outside forces or to sheer chance? How we attribute the outcomes of our trading performances will necessarily play a large role in what we do about those performances. If, for instance, we tend to attribute gains to the self, but losses to bad luck, we might stick with faulty trade ideas, exacerbating initial losses.

In point of fact, research finds that people are reliably biased in their attributions, a situation that cannot help but affect traders. Football fans, for instance, tend to attribute their team's successes to skill, but their opponent's victories to luck. When CEOs successfully complete acquisitions and attribute the success to their own skill, they tend to become overconfident and make further acquisitions--which then realize lower returns. CEOs also tend to be paid more money when the share price for their firms increase, as boards (falsely) attribute the price move to the executive's skill. This, too, is reliably associated with subsequent CEO underperformance.

It is when we indulge in self-serving attributional biases, however, that trading results are put most at jeopardy. Social psychologists refer to the "fundamental attribution error", which is the tendency to over-emphasize personality-based explanations for other people's behaviors and minimize situational influences. When we're subject to the "actor-observer bias", we tend to attribute our own outcomes to situational forces, rather than to fundamental personality traits.

How does this affect traders? Traders with a self-serving bias tend to give themselves too much credit when trades go their way and rationalize situations that lose money. As a result, they are likely to become overconfident after a string of winning trades, raise their trading size/frequency, and place themselves at risk.

Indeed, a consistent predictor of trader failure in my own experience is the tendency to attribute losses to a shadowy "them": the large traders and institutions that supposedly manipulate the markets. In years of working with traders, I have never seen one succeed over the long haul who reliably blamed outside forces for losses. Those traders, in fact, are subject to considerable anger and frustration, which leads them to become impulsive--the well-known phenomenon of "revenge trading".

Reason dictates that there is a difference between a good trade (one placed with an edge in one's favor) and a winning trade (one that makes money), just as there is a difference between a bad trade (one that lacks an objective, positive set of expectations) and a trade that loses money. Sheer chance alone can create situations in which good trades lose money and bad ones happen to get lucky. The self-serving trader who overemphasizes the role of chance in losses creates a situation in which learning from experience becomes impossible.

But there is another kind of trader--one with an overinclusive attributional style--that tends to own losses and gains with equal fervor. By minimizing the role of chance, the trader attributes all outcomes to the self, feeling good when the profits are rolling in and becoming discouraged during (inevitable) periods of drawdown. This is the "illusion of control" documented in the research of a London Business School research team, who found that traders who thought they could predict markets shown to them (which were actually random price series) performed worse than less confident traders. The result is that you can reliably track traders' moods by their P/L statements.

Traders tend to blame their losses on such factors as "loss of discipline" and "overtrading" when, in fact, these are frequently the results of attributional biases. The majority of traders spend more time trying to understand market movements than trying to understand their own thinking about markets. An interesting line of research finds that individuals who experience increased emotion tend to shift their attributional styles, reducing their tendency to own negative outcomes. Successful traders not only need to be able to think about markets, but also think about their thinking. Awareness of a tendency toward bias can be a powerful antidote to biased decision-making.


RELEVANT POSTS:

How Traders Can Become Their Own Coaches

How Trader Personality Affects Trading

Stalking the Market With New Highs and Lows

Here is the five-day simple moving average of all stocks (NYSE, NASDAQ, ASE) making new 20-day highs minus those making new 20-day lows. (Click on chart for greater detail). We can see, going back to 2005, that pullbacks below -5000 have been excellent indications of intermediate-term market lows.

We can also see that deterioration in the new highs has preceded market corrections, including most recently. Intermediate-term bull runs have tended to see at least one dip well below the zero line prior to terminating. We have just made such a dip this past week.

Notice how we spend considerably more time above the zero line than below. That is the mark of a bull market: over time, stocks keep making new highs. Despite the recent correction, nothing in that dynamic has changed thus far.

RELEVANT POSTS:

New Highs and New Lows: What They Tell Us

The Four Legs of Market Psychology

New Highs and Lows in the Stock Market

Using Intraday New Highs and Lows to Anticipate Market Turns

Trading Ideas and Tools for a Friday

* Strong Downside Momentum - I found that the number of stocks closing below the volatility envelopes surrounding their short- and intermediate-term moving averages outnumbered those closing above the envelopes by 10:1 on Thursday. We've had only 7 such occasions since 2004; on six of those occasions the market continued lower in the short-term over the next several days.

* Easy Way to Track Your Performance - This plug-in feature for StockTickr enables traders to pull trades from their account statements directly into the program for analysis and charting. StockTickr then allows you to collect metrics on your trades, journal and track your goals, and share the information with selected peer traders.

* Nice Integration of Simulation Trading - I see Advantage Futures is offering the Ninja Trader platform with free simulation trading and collection of metrics. Excellent way to build skills; even the market data are free.

* Day Trading Indicator - Kevin finds a daytrading tool in the bond-stock relationship; excellent application of theme-based thinking at a short time frame.

* Ways to Review the Market Day - I like the recaps carried by Trader Mike, with clear, annotated charts. For review of news and market stats, Between the Hedges provides fine reviews of the day. For keeping on top of market blogs, I like the link selection at Abnormal Returns.

* Reviewing the Broader Picture - The links at the Kirk Report are comprehensive and never fail to turn up an interesting perspective; I also look forward to Barry Ritholtz's weekend linkfests and daily commentary and the intermarket and economic perspectives from Mish.

* Searching for Fresh Ideas - I appreciate the fresh take on economics and markets from Jeff Miller. For stock ideas, the portfolios at StockPickr contain very interesting themes and the theme-based screening from Charles Kirk on his Member's Site offers plenty of inspiration for further investigation. CXO Advisory can also be counted upon for a fresh take on market wisdom, with a research bent.

Extraordinary Opportunity - Suburban Chicago Area

I had the pleasure of joining a Chicago area money manager for coffee yesterday, and he shared with me his plans for developing an innovative new website. The site would blend elements of current events that move markets and stock picking.

He is looking for a Chicago area high school or college student interested in working on this project for a paid summer internship. The student should live near the Western suburbs of Chicago and should be computer and Web-savvy. It's an unusually good opportunity to see how a money manager operates and to help build a project from the ground up.

If you or someone you know and can recommend is interested, have them contact me at the email address on the blog home page, in the "About Me" section. I'll be happy to describe the position in greater detail and get the student connected. Thanks!

Brett

A Few Perspectives on the Recent Stock Market Weakness

* Pessimism Returns - As of Thursday, we once again see equity put volume exceeding equity call volume. That was one of the patterns that stood out during the late February/early March market decline. Since 2004 (N = 843 trading days), we've had 49 occasions in which equity put volume has exceeded equity call volume. Twenty days later, the S&P 500 Index (SPY) was up by a very strong average of 2.27% (42 up, 7 down), much stronger than the remainder of the sample (.63%; 514 up, 280 down). It has not been a winning strategy of late to sell into such pessimism.

* Swelling New 20-Day Lows - We registered 1999 stocks making fresh 20-day lows across the NYSE, NASDAQ, and ASE on Thursday. Since 2004 (N = 843), when we've had more than 1500 new 20-day lows, the next 20 days in the S&P 500 Index (SPY) have averaged a gain of 1.16% (43 up, 20 down), stronger than the average gain of .69% (514 up, 266 down) for the remainder of the sample. Again, it hasn't paid traders to sell into broad declines in which a large number of stocks are making new lows.

* Market Tells Tells All - Rennie Yang finds a number of very interesting historical patterns in the recent decline; his current issue of Market Tells is a must read. One interesting perspective: When we've had 10:1 negative breadth (as we did Thursday), there has been a tendency to see higher prices over the next three weeks.

* Overnight Interest Rates Hit Another Recent High - I see that September 10-year Notes pushed past 5.20%, sending stock futures lower overnight. That interest rate-stock market link noted yesterday continues to dominate trader concern; let's see if we can get to multi-year highs in rates.

* Huge Downside Momentum - My Demand indicator closed Thursday at 20; Supply was 225. So we have stocks with significant downside momentum outnumbering those with significant upside momentum by over 10:1. The normal tendency is to see some continuation of weakness prior to any sustained rally; that certainly was the case following Feb. 27th, another huge downside momentum day. It's when we see lower lows on improving momentum numbers (as we did in early March) that we start identifying a bottoming process: one of those longer-term transitional structures.

Trading By Intermarket Themes

Very large traders--those managing portfolios of 50, 100 million and more--cannot simply dump that kind of money on individual stocks or futures contracts without disrupting the market and getting terrible prices. What this means in practice is that, once you've gotten truly big, you have to trade themes, not just individual positions. Those themes can be expressed through multiple trades and markets, enabling the portfolio manager to put significant capital to work.

One of the themes emphasized on this blog recently has been the relationship between interest rates and equity prices. The above charts, taken from this morning's trade, illustrates how awareness of a theme can benefit even the short-term trader. Once ten-year rates blew through 5%, we saw significant selling pressure in the NYSE TICK and a move of the S&P 500 Index to multi-week lows.

You could play the theme by selling bonds, selling stocks, selling interest rate sensitive sectors vs. other, non-sensitive sectors, etc. Such themes wax and wane: sometimes they're sector themes (energy shares outperforming tech); sometimes they're market themes (international bourses outperforming U.S.); and sometimes they intermarket themes (falling bonds, falling stocks).

A savvy trader can think like a portfolio manager by observing the emergence of themes and generating alpha not only through market timing, but by shrewd selection of markets to trade. Once you begin to think thematically, it's easier to be long certain areas, short others. This creates natural hedges and diversifies your capital. I'll have much more to say on how traders can think like portfolio managers in an upcoming post.

RELATED POST:

Are Rising Rates Taking a Toll on the Stock Market?

Are Rising Interest Rates Taking a Toll on the Stock Market?

Here's a longer-term picture of 10-year interest rates. Note how the steep rise in 1999 choked off the stock market rally in 2000. It took a precipitous drop in rates to get the stock market going starting in 2003. Now we see rates once again rise over 5%, not far from multi-year highs.

What this tells us is that it takes some persistence of rising or falling rates to affect the valuation of equities. A single move higher in rates is not sufficient to induce a bear market. Still, the recent pattern of higher lows and higher highs is worth noting as a yellow flag for this market. Note that rises in rates early in 2004 and during mid-2006 were associated with stock market corrections.

Rates have risen from a low of approximately 4.6% to the current 5% over the past 20 trading sessions. I note that, as of Wednesday, only 434 stocks across the NYSE, NASDAQ, and ASE were making 20 day highs against 1001 new lows. My Demand indicator stands at 23 vs. 165 for Supply. That tells us that stocks with significant downside momentum (those closing below their short- and intermediate-term moving averages) outnumber those with significant upside momentum by about 7:1. It does appear that the rising rates are taking a toll on stocks.

In upcoming posts I'll look at which sectors are responding most notably to the rising rates, and I'll update my money flow indicators to see if the rising rates are leading institutions to withdraw money from the large-cap equities that have sustained this rally.

RELATED POST:

When Yields Are High, Should We Buy?

Stock Market Performance by Hour of Day

Here we're looking at the Dow Jones Industrial Average on a daily basis (light blue line) from 2004 to the present. I've broken the Dow down into three components and set these to equivalent prices as of 2004 to highlight differences in performance (click chart for greater detail).

The first component is the Dow's performance during its first hour of trading (dark blue line). Note the steady ascent, as we've seen solid performance during the Dow's first hour. Indeed, nearly three-quarters of the entire bull market since 2004 has occurred during the Dow's first hour of trading. Had you done nothing more than buy at the previous day's close and sell at the end of the first hour of trading the following day, you would have picked up almost 3800 Dow points.

The second component is the Dow's performance during its middle hours (pink line): the hours between the end of the first hour and the start of the last hour. Observe that this time period has not participated in the bull market whatsoever. In fact, from 2004 to the present, the middle hours have *lost* a total of about 42 Dow points. What that tells us is that a good part of the daytrading market has not seen a directional bias, despite the significant ascent of the Dow over that period.

The final component is the Dow's performance during the last hour of trading. Rennie Yang of Market Tells notes that this has been weak of late, which he interprets as caution on the part of the smart money. We can see that the last hour has underperformed over the last two years. About a quarter of the Dow's overall gain since 2004 is attributable to the last hour of trading; since 2005, however, the Dow's last hour has actually lost money.

My interpretation of these findings is that the U.S. market has been a follower, not a leader, of other world markets. When overseas bourses rise in value--and we've seen stronger gains in EAFE than in the States--that strength is reflected in the next day's open in the U.S. and thus the first hour of trading in the Dow cash index. If that is the case, then an important implication is that participation in the bull market has hinged upon the trader's ability to hold U.S. positions overnight and capture that overseas strength. My breakdown of S&P 500 returns by overnight vs. day session supports this conclusion.

The takeaway? Just because a market is trending overall doesn't mean it's trending at the time frame you happen to be trading. Extrapolating from the day to day market to shorter time frames can be hazardous to your wealth.

RELATED POSTS:

The Last Hour of Trading as a Sentiment Measure

Who Controls the Markets?

Update on Today Show Appearance

I just found out that my segment of the NBC Today Show will air at 8:38 AM tomorrow (Thursday, 6/7). The general theme of the segment involves the challenge of investing and weathering the market's ups and downs.

On a related note, I'm preparing a post on this new breed of Website that can automatically pull information from online brokerage accounts to document the performance of traders or portfolio managers in real time. The Investment Directors at VesTopia maintain blogs describing their market views; definitely worth a read--

Brett

Trading Patterns: Failed Opening Range Breakout

Here we see an annotated chart (click on chart for clearer detail) of the Russell 2000 (ER2) futures (white bars); NYSE TICK (red bars); and volume (bottom axis) for the morning of Friday, June 1st. Notice that we were trading in a pre-opening range of several points. An initial dip in the first minutes of regular trading stayed within that range and then a surge of buying (as seen by volume and the NYSE TICK) broke us above that range.

The preopening and opening ranges are extremely important, because they locate the market's estimate of value. By observing the preopening range, we see how economic reports and overseas trading have impacted valuation in the U.S. market. If we get a breakout from the preopening range on expanded volume and strong NYSE TICK, it means that the market is undergoing a new valuation: this is fresh buying from large traders.

The key principle to keep in mind is that, if this revaluation is genuine, we should not return to the prior trading range.

We did indeed remain above the trading range in the minutes following the breakout, as upward momentum carried us further. Notice from the volume and TICK readings that quite a few traders jumped on this breakout bandwagon.

Whenever we get a surge of volume and extreme TICK values, we want to consider the possibility that a momentum peak is being put into place as part of one of those transitional structures described in my recent post. Indeed, we see just such a structure emerge: the momentum (volume) peak; the subsequent price peak on reduced upside momentum (but very strong TICK); and then the failure of positive TICK readings to achieve new highs (inefficiency). Throughout this transitional structure, we see a downward shift in the NYSE TICK distribution and a drying up of volume among buyers.

This drying up of buying emboldens the sellers and it becomes increasingly clear that this is a failed opening range breakout in the making. Knowing that, we can anticipate a move back to the midpoint of that opening range; i.e., a return to the prior level of valuation.

Notice how the chart above integrates a number of market dynamics over time: valuation levels, volume, TICK, and price. It is the shifting of these dynamics that are crucial to the market's short-term movements. With frequent chart review and simulation-based trading, you can become sensitive to these patterns as they emerge, enabling you to jump on board moves in the making. Rookie traders tend to get lost in each bar, looking for simple patterns of price. It is the broader shifts in demand and supply that create the larger trading swings.

RELATED POSTS:

Trading Patterns: Identifying Transitional Structures

Trading Opening Range Breakouts

Toby Crabel and the Epistemology of Trading Expertise

Anatomy of a Stock Breakout

Trading Ideas and Resources for a Tuesday

* The Themes Continue - In my weekly post to the Weblog I noted the inverse relationship between the Yen and the S&P 500 Index. Note how the theme continued on Tuesday, with strength in the Yen and weakness in U.S. stocks. Note also that we continue to move higher in the 10-year interest rate, per the recent post that warned of reduced stock returns with rising rates. (Rennie at Market Tells links inferior stock returns to 52-week bond lows; Trader's Narrative offers a contrary view).

* InstantBull Continues to Add Value - Nice to see that this excellent aggregator of blogs, news, and chat is receiving recognition in the business community. Now a new feature lists blogs by their popularity, as ranked by Alexa and Technorati. Great way of staying on top of the most popular blogs--and discovering some new ones. Also check out the "hot" tab on the home page (top left); it lists stocks that have received the most search interest over the past four days. I might just check out some of those issues vis a vis money flow and other trading patterns to generate trade ideas.

* Winning Streak for Stocks - Another aggregator I really like is Seeking Alpha, which organizes a wide range of posts by category, including ETFs, China, energy, market outlook, currencies, economy, and much more. This post from Bespoke Investment Group looks at what we can expect when the S&P 500 Index has been up 5 days in a row. My own results suggest that momentum within that five day period, as measured by my Demand/Supply Index, helps to identify whether prospects are bullish or bearish after five days of strength. We had been losing momentum going into Tuesday's dip, with Demand at 54 and Supply at 54; down from 121 and 36 on May 31st.

* Mean Reversion Among Portfolio Managers? - Charles Kirk has a fascinating observation regarding the portfolio selections of hot managers. This might be one way of identifying shifting themes in the markets: what was hot previously is now underperforming. Also check out the excellent links compiled by Kirk, including a provocative chart of the stock market denominated in gold.

* Trader Mike Nails a Theme - Thanks to Mike for his recent links re: Covestor and VesTopia, including this interesting piece from David Jackson of Seeking Alpha. This is Web 2.0 for investors, and the methodology of pulling trades from account statements is quite clever. Not as emphasized, for obvious reasons, are contrarian applications of the data. Great way to see which sectors/themes are drawing interest. See StockTickr for another Web 2.0 implementation, but for traders.

* A Blog Resource You Might Not Know About - The TraderBlogs site is a collection of blogs with a variety of themes, including some sophisticated perspectives from John Ehlers and trading wisdom from Ryan Jones. See also Robert Colby's tracking of top ETFs. Good stuff!

More fine links to come!

Is Money Flow Making This Market Go?

The market's rise continues apace. On Friday, we saw 1129 stocks make fresh 65-day highs across the NYSE, NASDAQ, and ASE. That is the highest level we've seen since mid-April. This is a function of the renewed strength among the small cap stocks, which had been lagging large caps. Despite a number of divergences in the market data and strong interest rates, we've been able to hold off a significant correction to this point.

The chart above helps to explain why. Only very recently have we seen money flows in the 30 Dow Industrial stocks (pink line) move below their 200-day average (the zero line on the chart). Flows thus far have not only been positive, but above the average level we've seen *during a bull period*. When institutions are pouring money into stocks, it is difficult to sustain a correction.

Note that dips below the zero line--periods of below average money flow--have represented good buying opportunities in the Dow (DIA; blue line).

I decided to look at the past 10 trading sessions and compare those to the past 200 trading days. Dow stocks showing positive 10-day flows that are above their 200-day average include AA, BA, CAT, DD, GM, JPM, KO, MMM, MO, MRK, PG, UTX, VZ, and XOM. Notice the preponderance of old line industrial names.

Dow stocks with outright negative flows over the past 10 trading sessions include MSFT, JNJ, and INTC.

Money flows have slowed in recent days, but remain very close to average. That average has been sufficient to sustain a market uptrend. Until we sustain below average readings, it's difficult to expect a major market correction. The adjusted relative dollar volume flows have proven their worth in my own trading, as they've consistently reflected the recent market strength.

RELEVANT POST:

Overview of Relative Dollar Volume Flow

Brett Steenbarger's Appearance on NBC Today Show

Just a quick note to let you know that I'll be part of an NBC Today Show segment on personal finance on Thursday, 6/7/07 at the 7:30 AM hour. Today's Jean Chatzky has done a fine job of addressing the psychological challenges faced by investors trying to navigate their way to retirement. Interestingly, many of these challenges are similar to those faced by active traders, particularly with respect to the need to cultivate self-efficacy. In upcoming posts, I hope to elaborate on the Today segment to further address the need for investors to take control of their finances and craft a secure retirement. At a time when Social Security appears to be less than secure and baby-boomers are hitting those retirement years, it's a crucial topic for those working Americans who will be supporting the system.

Trading Discipline: Cause of Problems or Effect?

Among the dozens of submissions for the Trading Coach Project, the issue of discipline--sticking to plans/stops--was far and away the most common problem reported by traders. My general experience is that lapses of discipline are usually the result of a problem, not a cause. A key challenge, then, for work on oneself is identifying the cause of the departures from prudent trading.

There are three frequent causes worth investigating:

1) Personality Traits - Some people score low on a trait called Conscientiousness. They do not plan and follow through well, and they can be impulsive. This, of course, can manifest itself as a problem with discipline in trading. The key to identifying whether or not personality is a cause of discipline problems is determining whether a similar loss of discipline occurs in other facets of life (outside trading). If a person is disorganized and lacking in conscientiousness in their work, social relations, personal finances, etc., then it makes sense that this trait would carry over to their trading. Such individuals frequently need external brakes on their trading, such as risk managers at a firm who will enforce a "drop dead" level (and prevent further trading) once a loss limit is hit. Individual traders with impulsivity and low conscientiousness benefit from very explicit, structured rules that they follow without variation and reinforce with mental rehearsals. If the lack of discipline is so great that even such rules and rehearsals can't work, I personally do not believe such individuals should be trading. This includes traders with clearly addictive patterns of behavior, both in their trading and in other facets of their lives.

2) Market Volatility - Many, many times traders are quite conscientious and self-controlled in most areas of their lives, but experience lapses of discipline specific to trading. When this happens, it's often the case that the trading itself--*how* they're trading--is artificially creating the failure to follow trading rules. A key culprit in all this is market volatility. Volatility changes from day to day and week to week. It also varies as a function of time of day. Frequently, traders trade a fixed size and set fixed targets and stops, heedless of the underlying market volatility. In a low volatility environment, they fail to hit their targets and get stopped out, criticizing themselves for leaving money on the table. In an environment of enhanced volatility, the market will blow through their stops or exceed their targets, leaving them feeling that they did not trade well. This is especially true when traders find themselves unable to take what is normal heat in an environment of raised volatility. In such cases, it really isn't a lapse of discipline causing the problem. Rather, the trader is not adapting to market conditions. Adhering to fixed rules in a variable environment is not necessarily a virtue. Changing markets can prevent us from enacting those fixed rules.

3) Position Sizing - It is very common that smaller traders or aggressive traders will see a good trade and place too large a bet (i.e., a bet that is large relative to their account size). This makes it difficult to ride out normal movements against the position and leads to frustration and emotional arousal that result in loss of discipline. A good way of determining whether or not this is the case is to compare your largest trades with your smaller ones. If discipline problems tend to occur on the largest positions, you know that the increased perceptions of risk are interfering with consistency. The answer to this problem is to size all positions in such a way that individual losses in a trade cannot prevent you from making money on the day; losses during a day won't prevent you from being green on the week. Large trades relative to position size run the risk of ruin: a series of losing trades can dig a monstrous hole for the trader and cause significant emotional damage. In a sense, trades should be boring--not so large as to create undue fear *or* excitement. It is easiest being consistent and maintaining discipline when those emotional factors don't kick in.

It is common for trading psychologists to emphasize that our psyches affect our trading. Equally true, however, our trading affects our emotions. Trading inflexible strategies with inflexible targets and stops; trading size that is too large for our personal risk tolerance and account sizes: both of these can create "discipline" problems even for conscientious traders. Trading well is often the best psychological strategy of all.

RELATED POSTS:

Top Reasons Traders Lose Their Discipline

Understanding Lapses in Trader Discipline

Controlling Emotions is Not the Goal of Trading Psychology

TraderFeed is Up and Running Again

Of all the indignities! Blogger's bots identified TraderFeed as a "spam blog" and shut it down for a couple of days. I don't mind if readers disagree with my posts, but to label them as spam?? That cuts to the quick... :-)

In any event, I'll resume posting shortly. Please note that several new posts appear on the Trading Psychology Weblog. In the future, if TraderFeed is ever shut down, I'll simply post to the Weblog.

Thanks, and sorry for any inconvenience!

Brett

Wall of Worry: Are Traders Getting More Bearish As The Market Acts More Bullish?

Rennie Yang, who authors the excellent Market Tells service, notes an interesting pattern. Despite the recent market rise, investors in the AAII survey are 33% bulls and 45% bears. He notes bullish implications when we have a surplus of bears in this survey during a rising market period. That's the classic wall of worry that bull markets are said to climb.

Above we see a pattern that seems to confirm Rennie's observation. QID enables traders to place double-sized bets on a market decline in the NASDAQ 100 Index. As such, it is an excellent speculative vehicle for traders. Note in the chart above that, as QID has declined (i.e., the NASDAQ 100 has risen), the volume in QID has exploded.

In other words, traders are making more and larger bets against the NASDAQ as that market grinds higher. That's more than a wall of worry; more like a wall of pessimism!

Interestingly, since July, 2006 (N = 217; when my price data for QID begins) when QID is down on the day (rising NASDAQ) and QID volume is up for the day (N = 67), the next day in QID averages a loss of -.51% (41 down, 26 up). That is much weaker than the average loss of -.07% (87 down, 63 up) for the remainder of the sample.

It appears that, at least in the near term, a rising NASDAQ (falling QID) with rising bets on QID has been bullish, as the market confounds the pessimists.

RELATED POST:

NASDAQ Volume as a Sentiment Measure

NASDAQ TICK and Other Market Insights for a Friday

* Using the NASDAQ TICK - The screenshot is a bit dim (click for larger view), but a reader asked me about using the NASDAQ TICK in trading the Q's. Here we have the NASDAQ TICK (red bars) plotted against the NQ futures (white bars) and volume plotted below. I find these overlay charts in RealTick very helpful for seeing how market and sentiment move together (or diverge). The chart is taken from midday trade on Thursday; note the divergences between price and TICK (yellow arrows), as buyers are lifting offers across fewer stocks prior to the dip and hitting bids across fewer stocks prior to the bounce.

* Charting the Course for GOOG - Trader Mike finds an interesting pattern at the recent market highs.

* Insightful Article - Abnormal Returns takes a very thoughtful look at making investment decisions by trying to ride the coattails of famous investors and institutions.

* Great Reading to Kick Off the Weekend - The Kirk Report has quite a few excellent links, including one worth reading on how trading chat rooms might help call the top in China's market.

* Pictures Worth a Thousand Words - They tell the story of the housing weakness at The Big Picture.

* Options Insight - Adam Warner reflects on the relationship between the S&P 500 Index and the Buy-Write Index (BXM), building on the work of VIX and More. That'll be one for my research mill this weekend; very interesting idea.

* A Look at China's Tax and How It's Affected Stocks - Yaser Anwar passes along a little history of how Chinese investors have responded to past shifts in the Stamp Duty.

* Utilities Off Their Highs - Rising rates taking their toll; the Afraid to Trade Blog passes along a relevant lesson regarding momentum and price.

* A Classic Buy Trade - Kevin finds a pattern worth tracking: an opening gap reversal that exploits trader fear.