Friday, January 30, 2015

Is Social Intelligence Related to Trading Skill?

Interesting research from Daniel Goleman and others suggests that emotional intelligence and social intelligence are important to business leadership.  As the graphic above suggests, successful business managers combine self-awareness and self-management with social awareness and relationship management.  In other words, effective leaders know themselves and use this awareness to be more effective.  They also can read others well and utilize that sensitivity to be more effective with peers.

Thanks to a savvy money manager for pointing out this article detailing how social intelligence is much more important in team-based success than IQ.  Interestingly, people who are more skilled at reading emotions from the eyes of others are also significantly more effective in teamwork.  Women also tend to be more capable at reading the emotions of others than men.  One telling predictor of team-based success is the tendency to take turns in talking:  effective people speak *and* listen.

What are markets but the outcomes of the collective decisions of others?  We frequently make reference to market sentiment and changes in market character much as we would speak of another person.  Is it such a far stretch to imagine that emotional intelligence helps traders know and manage themselves and social intelligence helps them read and respond to the actions of others?  Some of the most successful portfolio managers I know do not engage in copious quantities of original macroeconomic or market research but are quite talented in picking out the best ideas from researchers and other traders.  They are like the skilled poker players, who are classically intelligent (they know the odds of each hand); emotionally intelligent (they know their emotions and manage their risk taking); and socially intelligent (they can read the players around the table).

All of us have known traders who become so locked in their views they stop seeing and responding to what markets are actually doing.  This may masquerade as "conviction", but it is actually socially unintelligent--not unlike harping on a topic in a conversation and alienating listeners.  Research finds that social intelligence operates just as effectively in online environments as direct, interpersonal ones.  Perhaps one of the boons of social media is the opportunity for traders--including female traders!--to leverage their skills at reading and interacting with others in generating new and better trading ideas.

Further Reading:  Emotional Intelligence and Trading

Thursday, January 29, 2015

Best Practices in Trading: Finding and Focusing on Your Trading Edge

Two kinds of traders fail to find success:  those who cannot change and adapt and those who cannot focus and exploit their edges in markets.  Very often traders become frustrated with losses and abandon what they are doing, seeking ever better ideas and methods.  This makes it very difficult to ever master any particular opportunity or skill set in markets.

Today's best practice submission comes from David Blair (@crosshairtrader).  Readers will recognize him from the CrosshairsTrader site and blog.  David's best practice is all about focus:  eliminating what is non-essential in markets and developing a very specific market edge and expertise:

"When I first started trading I decided to be a sponge, soaking up all the stock market information I could, free or otherwise.  After sponging it for a few years I realized I created a monster devoid of creativity; replaced by anxiety, confusion, fear, and impatience, all of which were a result of a lack of focus.  I traveled in a black hole with a flashlight and didn't know it.

During these years I was trading with a partner:  a friend who introduced me to the business.  Each day he would have a new topic for us to study.  As a result, our trading room began to look like a war room.  8 monitors, two big screen TVs, 2 color printers for printing charts, cases of books, CDs, seminar manuals, etc.  The problem was, the more we added, the worse our performance, the worse our performance, the more we added, creating a vicious cycle of spoiled intentions.  As my partner continued to add, I began to subtract.  I began practicing minimalism by getting rid of all the things I thought were so important, realizing that stock prices cannot be predicted no matter how much I learned or added to my charts.

My process now involves a very simple, easy to understand price pattern wherein I look for stocks breaking from price boxes to either 1) continue the previous trend or 2) reverse the previous trend.  I have a well defined method for locating these trades when they trigger on two time frames, the weekly and daily.  I have prepared a watch list of stocks and have developed indicators specifically designed to alert me when there is a potential trade opportunity.  In other words, I have become a 'process specialist'.  I have developed a specific process that helps me manage the uncertainty of future stock prices.  I no longer feel the need to study everything or watch anything other than the stocks on my watch list."

David's methodology makes sense:  stocks trading in a box are ones that have consolidated.  Both directionality and volatility have gone to reduced levels.  He is identifying opportunities in which breakouts place him on the right side of both direction and volatility.  This not only means that the market moves his way, but moves his way with impulsivity.  Psychologically, having a specific methodology like this reduces distraction and enables a trader to become a true specialist, building skills in a particular kind of trading.  Perhaps most important of all, specializing in a type of trading enables David to make trades truly his own, so that he will have the confidence to act--and also has the perspective to quickly recognize when setups are not working.  

Many successful physicians are not only specialists but sub-specialists.  They find their "edge" by knowing one area in great depth.  This can be a very helpful approach for traders as well.

Further Reading:  Fallible Edges in Markets

Wednesday, January 28, 2015

Three Perspectives on Market Breadth and the Story They Tell

There are several classes of indicators I routinely follow to track market strength and weakness.  These include measures of sentiment, breadth, momentum, volatility, correlation, and market participation (behavior of large market participants).  Among these measures, there is often considerable statistical overlap.  Because they are correlated, they are not truly measuring different things.  In an upcoming post, I will address this issue by discussing purified indicators--ones in which overlap has been removed, so that we are looking at purer forms of sentiment, breadth, etc.  For an inspiring example of purification, check out this paper from David Aronson highlighting his construction of a purified VIX measure.

Above we see three current measures of market breadth.  The top chart tracks the sum of 5, 20, and 100-day new highs minus new lows among all shares in the Standard and Poor's 500 Index.  The middle chart looks at the average of the percentages of stocks in that index that are trading above their 3, 5, 10, and 20-day moving averages.  The raw data for both these measures come from Index Indicators.  The bottom chart displays the sum of stocks across all exchanges that are making fresh three-month new highs minus new lows.  

Note that the three measures tell a similar story:  Peaks in breadth tend to precede price peaks for intermediate-term market cycles.  Until recently, successive breadth peaks were occurring at fresh price highs for the broad market.  During this most recent cycle, we've seen lower peaks in breadth and a failure of breadth strength to generate fresh price highs.  All of this is suggestive of a weakening/topping market, as recent buyers have not been able to sustain the market uptrend.  

Further Reading:  Tracking Breadth Across Cycles

Tuesday, January 27, 2015

A Fresh Look at Stock Market Sentiment

I recently took a look at changes in the number of shares outstanding of the SPY ETF as a sentiment measure.  When traders are bullish, shares are created in the ETF; when they are bearish, shares are redeemed.  This is a useful sentiment gauge, because it reflects what traders are actually doing in the market, not just their stated sentiment.  

What is interesting is that we have seen considerable share redemption in SPY since the end of the year.  Indeed, shares outstanding are down on a 5, 10, and 20-day basis.  Since 2012, we've had 23 non-overlapping periods of such share redemption.  Ten days later, SPY was up 18 times, down 5 for an average gain of 1.18%, compared with an average 10-day gain of .43% for all other occasions during that period.

Although we are not so far from all-time highs in SPY and have bounced well off recent lows, bearishness on this measure continues.  Interestingly, the put/call ratio for all listed U.S. equities has been above .90 for the last two trading sessions, also above average.  

As noted yesterday, I have concerns about the longer-term pattern of breadth among U.S. stocks.  One reason for tracking different market measures is that we can avoid confirmation bias by observing when things are not lining up.  Right now, sentiment is not lining up with a picture of a topping market.  There are times when flexibility is as important as conviction:  a big edge in markets is retaining the option of not trading and waiting for clarity before placing bets.

Further Reading:  Options-Based Sentiment

Monday, January 26, 2015

A Different Way of Tracking Stock Market Strength With Technical Indicators

Suppose we think of technical indicators as measures of strength and weakness, with each giving buy and sell signals based upon different time frames and definitions of strength.  One way to assess the overall strength of the stock market would be to track, over time, how many shares are giving buy and sell signals across different indicators.

The above data track the cumulative buy vs. sell signals for every stock in the NYSE universe based upon the CCI, Parabolic SAR, and Bollinger Bands indicators (raw data and signals via the Stock Charts site).  I find it interesting that the cumulative measures have largely lagged price gains since the October lows.  This is what I would expect in an environment of weakening stock market breadth.  In the wake of dramatic central bank actions this past week, I am watching breadth measures closely to see if the expansion of global QE breathes fresh life into stocks.

Further Reading:  Tracking Strength With the Bollinger Balance

Sunday, January 25, 2015

Best Practices in Trading: Building a Learning Network Via Social Media

One of the greatest psychological challenges of trading is a cognitive, not an emotional, one.  It is the challenge of bandwidth:  our limitations in processing large amounts of information at any given time.  Many portfolio managers I've worked with have developed ways of expanding their bandwidth, including building out teams to help with research and execution; connecting with savvy peers to discuss market ideas; and staying in touch with colleagues on the trading floor.  Turning trading into a team sport increases the number of eyes and ears on markets and is valuable in spotting emerging trading ideas.  How many times have I observed traders so focused on their particular trades that they miss what is happening in the broader market?  Tunnel vision is a great way to get blindsided in markets.

What social media is accomplishing is a leveling of the bandwidth playing field for individual traders.  Most independent traders do not have a trading floor to turn to for market color and cannot afford to build out teams of analysts.  Through social media, however, they can turn their trading into a virtual team sport.  Cultivating a focused network of insightful peers adds to the eyes and ears on markets and sparks thinking about fresh sources of opportunity.

This is why building a social learning network is a best practice in trading.  This is a network of peer traders who value your input and provide you with valuable observations and insights into markets.  The key to creating an effective social learning network is selectivity.  A great deal of the commentary via tweets, blog posts, and chat is high on noise, low on signal.  You want a network that provides very high signal value.

A great place to start a learning network is Stock Twits.  The Stock Twits feed is a curated stream of tweets with high information value.  Via the feed, you'll notice certain contributors come up again and again.  These are often high value sources of information you will want in your network.  Of particular value are the Saturday $STUDY sessions from the Stock Twits feed that select specific tweets and links for their valuable content.  In general, the $STUDY postings offer a broad range of observations, analyses, and information.  You'll find particular good links via founder Howard Lindzon and head of community development Sean McLaughlin

Yet another place to build your learning network is through sites that comb through content on the financial web and curate selections.  Abnormal Returns offers a broad range of links daily and each week selects top podcasts and highlights the most popular links of the week.  This also is a great way to discover valuable sources of information that can become your regular listening and reading.  On the podcast side, there are the offerings from Michael Covel and Barry Ritholtz that feature interviews with top professionals in finance.  Other excellent sources of links are Josh Brown via The Reformed Broker blog and Barry Ritholtz's The Big Picture site.    

The acid test for any addition to your learning network is that what you read or listen to actually does contribute fresh and useful perspectives to your understanding and trading of markets.  There is much to be said for entertainment and it's easy to get into surface readings of many sources, but what is ultimately valuable is what feeds your head.  You can't solve fresh puzzles unless you have the right pieces.  And you won't get all the pieces if you're locked inside your head.  Through social media, you can move from research to building a virtual research team.  It doesn't matter how emotionally controlled and disciplined you are:  you can't trade the opportunities you never see.

Further Reading:  Finding Trading Mentorship

Saturday, January 24, 2015

Best Practices in Trading: Using Biofeedback to Manage Trading Stress

The body's flight or fight response that we know as stress is often a reaction to perceived threat.  When we care about an outcome that is uncertain--and especially when we perceive a threat to that outcome--our bodies mobilize for action, with adrenaline pumping, muscles tensing, and heart rate accelerating.  That is an adaptive response for dealing with physical threats, such as avoiding an oncoming car, but often gets in the way of careful, deliberate action when the threats we perceive are coming from the trading screen.  It is ironic that, just as we most need to be grounded in the rational activities of our frontal cortices, we typically activate our motor areas and risk acting before thinking.

How we react to perceived plays an important role in determining whether stress brings distress.  Today's best practice comes from Daniel Hunter, who outlines his use of biofeedback in dealing with trading stress.  Readers will recognize biofeedback as a tool that I have emphasized both on the blog and in books, as it's a great way for us to become aware of our stress responses and deal with them proactively rather than reactively.  Here's what Daniel has to say:

"I am a scalper in the forex markets, so anxiety, excitement, and apprehension can creep into the trading day.  I combat this with a device that measures heart rate variability.  The device I use is the Emwave2.  It has an earlobe attachment that I use during trading.  I use it along with the computer program provided and have a visual, real time status of my current state.  If my emotions start to waver and my breathing starts to change, it alerts me, often before I realize my state.  With breathing exercises, I can bring my emotions back under control and focus on what is actually happening in the market.  It is also a fantastic practice before bedtime, as you fall asleep faster and your quality of sleep is much improved.  It is basically an objective meditation monitor."

Daniel also mentions that considerable research supports the use of heart rate variability feedback in controlling stress and enhancing well-being.  Because the monitor gives us real time feedback about whether we are in or out of our performance zone, it serves as a tool for mindfulness.  Once we are aware of our stress responses, we can channel them in constructive ways and prevent them from driving our next trading decisions.  If we choose to trade, we choose to operate in an environment where there is risk and uncertainty.  That ensures that we will experience stress.  Our challenge is to turn stress into a stimulus for self-mastery:  to control our responses rather than allow them to control us.

Further Reading:  Three Uses of Biofeedback for Traders

Friday, January 23, 2015

Tracking Real Time Market Sentiment Through Buy and Sell Programs

In past posts I've mentioned that I track a basket of institutional favorite stocks and monitor upticking and downticking across the group every minute of the trading day.  The logic is that when large market participants want to buy or sell with urgency, they will lift offers or hit bids across a range of liquid stocks.  This simultaneous upticking or downticking across a range of shares--the execution of buy programs and sell programs--leaves a footprint that provides a very useful view of instantaneous market sentiment.

The top chart tracks sell programs on a rolling one-day basis from October, 2014 to the present.  Note the expansion of sell programs at relative market lows and the diminished level of sell programs at relative market highs.  That is pretty much what we would expect to see.

When we go to the second chart, tracking buy programs, we see the same pattern, however.  At relative market lows, we see more buying activity.  At relative highs, buying dries up.  This is very important.  What makes market lows is that lower prices attract longer timeframe buyers--the ones who execute in baskets.  Volume ramps up at relative market lows because one group of participants is actively selling and another group is actively scooping up the shares now offered on sale.  At relative market highs, nothing is on sale and longer time frame participants are not incentivized to buy.  Total volume dries up.

It is the third chart, tracking the relative balance between buying and selling programs, that tells us who is winning the tug-of-war.  At market lows, sell programs diminish while buy programs continue to fire.  That creates a situation in which buying pressure spikes early in a market cycle.  (Note that this is what has happened recently in the wake of the ECB action).  As a market rise matures, sell programs begin to exceed buy programs and we see the balance between the two top out ahead of price.  The recent significant expansion of program buying suggests that we should see upside momentum from recent central bank actions.

I included the fourth, bottom chart to make a separate point.  Notice in the third chart how we had intensive selling pressure among the institutional favorite shares prior to the recent market rise.  Despite that, the cumulative NYSE TICK (the sum of upticks vs. downticks across all NYSE shares) stayed strong and now has made new highs.  What that means is that we were seeing intense selling (downticking) among the liquid large cap issues, but not across the broad market.  It was that discrepancy that set up the recent strength.

I deeply appreciate the interest readers have shown in the work I have shared.  These are proprietary measures (all data from e-Signal and all calculation and charting done in Excel), but I will update periodically to stay on top of where we stand in market cycles.  I will also be sharing information about the breadth and sentiment measures I track in my upcoming book. 

Further Reading:  A Look Back on a Previous Instance of Program Buying Surge

Thursday, January 22, 2015

Best Practices in Trading: Using Rules to Achieve Consistency of Performance

Think of the successes of great sports teams or businesses.  In so many cases, consistency in execution is a common feature.  The great football team doesn't just block and tackle well; they do so every play, every game.  A business like FedEx or UPS doesn't just deliver on time; they hit their time targets consistently.  How can traders achieve high levels of consistency?
The answer is by turning trading practices into trading rules.  Rules are what turn best practices into habits--and habits are what give us consistency.  Contrary to popular conception, discipline is not about forcing yourself to do the right thing.  It's about turning right things into habit patterns.

Today's best practice comes to us from reader Markham Gross (@MarkhamGross), who is the founder of Anderson Creek Trading, LLC.  He explains how the use of rules and systems bring consistency to trading:

"A trader or investor cannot control markets or the outside world.  All that is under the trader's control is his or her reactions to what is happening in markets or what is perceived to be happening in markets.  Therefore, systems should be applied.  The best systems are often simple.  Spreadsheets can work as an implementation tool and some light programming skills will also go a long way.  Systems should be comprised of specific rules for when to enter, exit for loss, exit for profits, and size of the positions.  These rules can match the trader's personality and temperament.  They should be testable.  Although there are limits to backtesting, performing some backtests will help the trader know what to expect so they are not surprised by normal drawdowns.  To approach the market without rules on a daily or weekly basis would be a mistake."

What I find in my work with traders is that many of the best work in a hybrid fashion:  they make decisions on a discretionary basis *and* their decisions are guided by explicit and tested rules.  For example, one trader I worked with years ago examined price breakouts that tended to continue in the direction of the breakout versus those that reversed back into the prior range.  He found several factors differentiated breakouts from fakeouts, including the volume of the move, where the move stood with respect to longer time frame activity, and the time of day of the breakout.  He turned these factors into a checklist, so that he only took breakout trades that scored highly on his criteria.  Those rules not only helped him find winning trades, but kept him out of many losers.  

When that trader first generated the rules, he used the checklist everyday to guide his actions.  Eventually, the criteria became solid trading habits and he implemented them routinely.  Repetition is the mother of habits and habits are the backbone of discipline.  Turning your successful strategies into rules is a great way to ensure that your best practices become robust processes.

Further Reading:  Success as a Habit

Wednesday, January 21, 2015

Tracking Market Cycles With Short-Term New Highs and Lows

Above are two charts from the excellent Index Indicators site that I find useful.  The top chart tracks the percentage of SPX stocks making fresh five-day highs.  The bottom chart tracks the percentage of SPX stocks making fresh five-day lows.

Typically we see five-day highs wane and five-day lows expand as market cycles top out.  We also have been seeing five-day lows crescendo ahead of cycle price lows.  

Yesterday, we closed modestly higher in SPX, but new lows expanded and new highs contracted.  Rob Hanna of the insightful Quantifiable Edges service recently issued a query study that noticed downside tendencies when the market rises but the proportion of rising stocks falls short of 40%.

Price action during the current market cycle has been somewhat distorted, but I'm viewing the current cycle as having begun with the mid-December lows, having peaked at the late December highs, and now in a down phase.  If that is the case, we should see at least one further down leg to the market that would take us below those December lows.  A dramatic expansion of new highs would contradict that scenario.  Tracking short-term strength/weakness via new highs/lows on a daily and several day basis is a useful way of determining if markets are strengthening or weakening going forward.

Further Reading:  A Look at Market Cycles