Monday, December 22, 2014

Two Hidden Virtues of Successful Traders

One of the most interesting aspects of working as a trading coach is the ability to see, first hand, what contributes to the success of traders.  So often the factors that lead to success are not those emphasized in mainstream articles and books.  Here are two unappreciated virtues I see among successful portfolio managers and traders:

1)  The ability to tolerate uncertainty - Suppose you take any particular configuration of price in a market; say, trading x% above or below a Y period moving average.  Then look at what that market does on average over the next Y period.  The odds are great that for any value of x and Y, the market's directional tendency will be swamped by the variability of price within that next Y period.  What that means is that, on average, the signal to noise ratio for a directional trader is low.  Whatever directional tendency is present is not statistically significant and is not readily tradeable.  Given such a situation, the modal opinion of any trader should be "I don't know".  Uncertainty is itself a view and should be one's base case.  When a trader cannot tolerate uncertainty and needs to manufacture conviction, the result inevitably is overtrading the objective opportunity set.  It is impossible to properly manage risk if you are intolerant of uncertainty.

2)  The productivity of time spent away from trading - I consistently find that successful traders spend more time identifying good trading opportunities than actually putting on and managing trades.  Csikszentmihalyi conducted a fascinating study with artists in which they were shown 27 objects and asked to arrange a small group of them into a composition and generate a sketch.  They had one hour for the task.  The artists fell into two categories.  One group quickly identified the objects for the composition and spent the better part of the hour refining their sketch.  The second group spent most the hour figuring out what to draw.  They selected objects, started sketches, changed the objects, sketched some more, rearranged objects, etc.  By the time they found the composition they liked, they spent only a few minutes on the final sketch.  The drawings of the second group were rated as significantly more creative by a group of art critics than those of the first group and, after a five year period, the second group demonstrated significantly greater success as artists.  The less successful artists spent most their time sketching.  The successful artists spent most their time finding compositions worthy of sketching.  It's a great analogy for trading.

Good things happen when these two strengths come together.  The ability to accept uncertainty frees the mind to maximize time away from trading and creatively generate sound trade ideas.  For the successful trader, uncertainty provides the opportunity to get away from screens and look at markets through new lenses.  Overtrading exists when the need to trade exceeds the need to understand.

Further Reading:  How to Deal With the Uncertainty of Trading

Sunday, December 21, 2014

Fresh Views and Savvy Wisdom to Start the Market Week

*  The above chart tracks buying vs. selling programs executing in the stock market every minute of the day.  The underlying logic is that I take a basket of stocks and identify when they are upticking and downticking at the same moment.  This basket execution is only undertaken by institutional players, so tracking buying vs. selling baskets is a great way to gauge how institutional participants are leaning.  As you can see most recently, when we were making lows this past week, buying programs were already exceeding selling ones.  The rally since then has seen very strong buying interest from institutions, exceeding that in early October.  Note also how at the market highs in late November/early December sell programs began to outnumber buying ones.  This is an unusually valuable indicator, and I will be updating periodically.

Very useful end-of-year perspective from Barry Ritholtz on 10 basic principles for investors.

Great brain science links from Abnormal Returns, including redefining discipline in our childrearing.

*  One of the things I'm looking at is the relationship between message volume on Stock Twits, trading volume on the NYSE, and volatility in stock prices.  Here are the recent data on SPY.  I would expect superior returns during periods when message volume is highest.

*    Always excellent perspective from Howard Marks, this time on the oil drop and failure of imagination among investors.

Have a great start to the week--


Saturday, December 20, 2014

Is the Market Rally Broadening or Narrowing?

One of the hallmarks of trading this year has been the underperformance of small caps relative to large caps.  As you can see from the top chart, the Russell 2000 Index (IWM) has pretty well underperformed SPY for most the year.  Recently, however, that relationship appears to have turned around.  At the recent market lows, we did not see relative lows for IWM to SPY and, indeed, IWM is trading very near its highs for the year.  Similarly, microcaps (IWC) are trading at multi-month highs.  This is relevant, because it suggests that the recent market strength has been broadening in its breadth, not narrowing like recent rallies.

In the middle chart, you can see that the cumulative NYSE TICK has bounced from recent lows, but remains below its highs for the year.  When we take the cumulative TICK for all U.S. stocks, however--which captures the buying and selling of the broadest market--we can see in the bottom chart that that has moved to new highs and never corrected significantly during the recent weakness.  

I will be watching breadth measures carefully here.  Given the expanding relative strength from the smaller caps, this does not appear to be a weakening market--which suggests that the rally should have legs.

Further Reading:  More About the U.S. TICK

Friday, December 19, 2014

Tracking Stock Market Dynamics: Demand and Supply

Two of the questions most important to understanding market behavior are:  1)  Who is in the market? and 2) What are they doing?  We need the broad participation of buyers and sellers to move markets, and we want to see if there is a skew in the participation of buyers and sellers.  So, in a sense, we can characterize any given market as being quiet, average, or busy with respect to volume and selling, neutral, or buying with respect to the relative dominance of buyers vs. sellers.

Above we can see the tracking of buyers vs. sellers over the past several months.  The top chart tracks buying pressure and is a measure of total upticking among all NYSE stocks.  The zero line means that we have average buying interest; positive values suggest strong buying and negative values indicate weak buying.

The general pattern during market cycles is that we come out of a market low by attracting longer timeframe participants, who respond to the lower prices as value.  This creates a surge of buying pressure out of market lows, as we saw early in October and as we have been seeing recently.  It is this sharp turn from diminished buying (levels below zero) to strong buying (highly positive values) that tells us that the skew of market participation has shifted.

The bottom chart tracks selling pressure and is a measure of total downticking across all NYSE shares.  The zero line represents average selling pressure; positive values represent below average selling and negative values indicate above average selling pressure.

As we move to market lows, selling pressure expands to a crescendo and typically hits its most extreme level shortly before we get a price bottom.  When those low prices attract longer timeframe participants, we see selling pressure reduce significantly, as the balance between buyers and sellers quickly inverts.

During the early phase of a market's topping process, we typically see above average buying pressure and below average selling pressure.  As the market cycle matures, we characteristically see buying interest wane and actually go below average, while selling pressure also remains low.  In the later stages of a market upturn, selling pressure picks up, while buying remains restrained, eventually pulling prices lower.

By tracking buying and selling pressure separately, we can more clearly identify where we're at in an intermediate-term market cycle and gauge the odds of reversals vs. continuation of recent moves.  In my next post, I will take a look at how overall levels of market participation vary across phases of intermediate-term cycles.

Further Reading:  Who Has the Upper Hand in the Market?

Thursday, December 18, 2014

When V Bottoms Are Not V Bottoms

Well, here we go again:  another V bottom!  Stocks rallied sharply yesterday and are up substantially in overnight hours to add to gains.  But perhaps V bottoms are only V bottoms if we focus on price.  Might there be changes in momentum patterns that precede the price reversal?

Above are a few things I've been focusing upon.  The top chart is what I call the momentum curve:  it depicts the percentages of stocks in the SPX universe that are above their 3, 5, 10, 20, 50, 100, and 200-day moving averages over the past several days.  (Data from the Index Indicators site).  What we can see is that the percentage of stocks trading below their shortest moving averages (3 and 5-day) actually bottomed ahead of price.  (They actually hit their lows on 12/10).  There was no V in short-term momentum.

In the middle chart, we track the number of NYSE stocks closing above their upper Bollinger Bands vs. those closing below their lower bands.  (Data from the Stock Charts site).  The number of stocks closing below their bands peaked on 12/12 and did not confirm the actual price lows.

In the bottom chart, we track the number of buy vs. sell signals across all NYSE stocks for the Commodity Channel Index (CCI).  (Data from the Stock Charts site).  It, too, hit its lowest downside point on 12/12, prior to the price lows.  

What I'm seeing is that, recently, tops have been distinguished by price divergences; bottoms have been characterized by momentum divergences.  It's an observation and hypothesis only at this point, but one that warrants further investigation and testing.

Further Reading:  Bollinger Balance

Wednesday, December 17, 2014

Measuring Stock Market Sentiment Minute by Minute

Suppose we could ask all participants in the U.S. stock market whether they are bullish, bearish, or neutral on the market's direction and get a fresh reading every minute?  That might be useful information, as it would show when bullish or bearish sentiment is turning; when it is becoming extreme; when it is staying bullish or bearish over time, etc.

When market participants pay up to buy a stock by accepting the best offer price ("lifting the offer"), they display urgency getting into their positions.  Similarly, when they sell a stock at the best bid price ("hitting the bid"), they show their urgency getting out of positions.  If a participant has no particular urgency, they will leave orders in the market to achieve better execution by buying at bid prices and selling at offers.  

Urgency reveals sentiment on a moment-to-moment basis.  

Above we see a chart for yesterday's price action in SPY (blue line) and a measure of bid/offer sentiment.  (Raw data from e-Signal).  This measure looks at where each trade in each stock occurs relative to the best bid/best offer at that moment and tells us how many stocks in the NYSE universe are executing at offer prices minus those executing at bids.  Savvy readers will recognize that this is similar to the logic behind the Market Delta measure and is similar (but not identical) to the NYSE TICK measure I've covered in the past.

Notice the dramatic shift in sentiment near the day's high price and how later periods of bullish sentiment occurred at successively lower price levels.  In short, the bulls were lifting offers, but their sentiment was not able to lift price higher.  That's a nice tell for a weak market.

Further Reading:  Upticks vs. Downticks for All Stocks Across All Exchanges

Tuesday, December 16, 2014

An Important Reason Why Trading is so Difficult

Central to sound trading is taking trades that offer favorable reward relative to the risk taken.  This assumes, however, that we can accurately estimate both risk and reward--and the likelihood of achieving those.  That may sound easier than it proves to be in practice.

We know that volatility in the stock market is intimately connected with the volume of shares traded.  As the VIX has recently climbed from low double digits to over 20, volume in SPY has moved from less than 100 million shares per day in late November to close to 200 million shares in recent sessions.  Average daily true range has gone from about .50% in late November to over 1.5% in recent sessions.

Complicating the picture is that the relationship between volume and volatility itself changes over time.  The measure of pure volatility charted above shows the average amount of movement that we get for a given unit of market volume.  As markets peak, volume contracts, but a given unit of volume gives us less movement.  As markets fall, volume expands, and a given unit of volume gives us increasing volatility.  

The bottom line is that markets move much less near market tops and much more near market bottoms than we typically expect.  Both volume and the relationship of volume to volatility change frequently, so that traders who anchor expectations to the recent past are going to become poor estimators of movement going forward.  That will result in poor placement of stops and targets and poor decisions regarding when moves are likely to reverse vs. extend.

When traders leave too much on the table or overstay their welcome in trades, it's not necessarily emotions and poor discipline doing them in.  Rather, they are shooting at targets that are proving to be more fast moving than stationary.

Further Reading:  Pure Volatility and Market Efficiency

Monday, December 15, 2014

Three Ways to Achieve Better Trading Results for 2015

The recent post outlined a way of setting goals for the new year based upon a breakdown of key elements of trading process.  Two mistakes that traders can make in such a review are 1)  the comfortable inaction of casually reviewing without taking the next steps of setting concrete goals and steps toward reaching those and 2) the tackling of too many goals at one time, diluting efforts to fully work on any of them.  My experience is that selecting a very limited set of highest yield goals--no more than three--and working on those intensively produces the best outcomes over time.

So if you are limited to a couple of trading goals for the new year, what might they be?  Here are some areas where I find traders need the most work:

Generating better ideas - Looking at 2014, most traders can find plenty of missed opportunities.  Many times the opportunities are missed simply because we were not focusing on the right markets or the right stocks in the right time frames.  Improving our data set--looking at more things in different ways--is an important step in feeding our pattern recognition.  Reading fresh perspectives from knowledgeable writers and speaking with insightful traders similarly can fuel our creative thinking.  One of my goals for 2015?  I've chosen the Abnormal Returns site as a source of readings and podcasts and will hold myself to keeping a daily Evernote journal of market-relevant ideas.  Indexing those ideas over time should produce a valuable database for future reference.

Better risk management--and opportunity management - It helps to look at the tails of your P/L distribution.  Do fat tails on the left side--outsized losses--hold your overall returns down?  That is a challenge for risk management:  sizing positions appropriately, utilizing reasonable stops, ensuring that multiple positions are sufficiently uncorrelated, using options rather than cash where prudent, etc.  On the other hand, are you missing fat returns on the right side of that P/L distribution?  Cutting opportunity short can significantly weigh upon overall returns.  Plotting your P/L for each trade and looking at the shape of the distribution will tell you a great deal about your management of risk and opportunity.  

Better entry and exit execution - It doesn't show up in the P/L stats directly, but looking at how your trades performed after you entered and after you exited will give you some idea as to whether your execution is adding value.  Too often traders will chase market moves and enter at bad levels and/or puke out of trades on noise and exit prematurely.  A review of market paths following recent entries and exits can identify those problems.  No one should hold themselves to buying the low tick and selling the high one.  Overall, however, you should be aware of the heat you take on trades once you enter and the amount you leave on the table when you exit.  My goal for 2015 is to be quicker at entering good ideas with at least a small position.  Too often I've become perfectionistic about entry levels, missing good portions of good trades. 

Everyone likes to identify the next big trade, the can't fail setup.  It's like throwing the long pass for a touchdown.  In reality, however, the game is more often won by the unsexy blocking and tackling:  gathering information to generate better ideas, managing positions better, and having clear and useful entry and exit criteria.  Work on trading process is the best way to achieve better trading outcomes.

Further Reading:  What Works in Goal Setting

Sunday, December 14, 2014

A Process Framework for Reviewing 2014 Trading Performance

Ah, yes:  more wisdom from those purveyors of Despair!  A positive attitude may be necessary if we're to learn from experience, but it's not sufficient.  Change only happens when we turn observations into goals and goals into corrective actions.

As we get to year's end, I find a look back on the year's trading to be very helpful in identifying goals for the coming year.  One way of accomplishing that is to break trading down into component processes and map out what you've done well in each area and what you need to improve.  Goals can be all about extending strengths and becoming more consistent with what you do well as well as shoring up weaknesses and correcting mistakes.

So here's a starting point for a report card for your year's trading.  Give yourself an A, B, C, D, or F grade in each category, followed by a strength or weakness-related goal for each:

  • INFORMATION COLLECTION - Consistently gathering useful information that is relevant to your trading
  • IDEA GENERATION - Engaging in creative thought to turn information into unique and promising ideas
  • TRADE STRUCTURING - Expressing ideas as trades that possess promising risk/reward
  • EXECUTION - Entering trades at levels that provide promising risk/reward; exiting trades at planned targets
  • POSITION/RISK MANAGEMENT - Sizing positions appropriately for risk control and targeted reward; using hedging and scaling in and out of positions to dynamically manage risk/reward
  • PORTFOLIO MANAGEMENT - Assembling ideas and trades into a coherent whole where each trade provides potential unique returns; monitoring correlations and managing risk and reward effectively across the portfolio
  • SELF-MANAGEMENT - Keeping yourself in optimal mental, physical, emotional, and spiritual condition to make sound decisions and sustain a high energy level
Your own trading may include fewer or more categories; these are ones I find particularly relevant across traders.  The idea is to approach your trading the way a physician approaches diagnosis:  assessing the health of every facet of your functioning.  By turning your performance review into a process review, you are more likely to pinpoint areas of work that can make a meaningful difference to the bottom line in 2015.

Further Reading:  Goal-Setting and Performance

Saturday, December 13, 2014

The Two Brains of Trading: Toward a New View of Trading Performance

I propose that there are two primary ways in which traders engage markets:  via the intellectual functions of the brain and via the social functions of the brain.  This distinction underlies the differences we see between traders who are primarily quantitative and systematic versus those who are more qualitative and discretionary.

When a trader engages markets intellectually, decisions about buying and selling are made empirically based upon observed relationships.  Growing revenues and promising new product development at a company may lead to higher expectations for earnings and a higher price multiple, leading an equity manager to place the company on the buy list.  The decision is governed by a model that links inputs (revenues, profit margins, expenses, contributions of new product areas) to outputs (price-earnings multiples, target prices).  When operating in the intellectual mode, the trader is looking at current pricing relative to historical norms, finding a discrepancy, and placing trades that exploit this discrepancy (mispricing).  The intellectual mode thus involves considerable analysis and research.

When a trader engages markets socially, decisions about buying and selling are made qualitatively, based upon the perceived intentions and anticipated behaviors of other market participants.  For example, if I see--going into year end--that positioning is stretched in a number of markets and I know that traders will be reluctant to lose too much money in December because of year-end bonus conventions, I might anticipate greater than normal volatility in the stretched markets.  That could lead to a profitable options trade.  The trade is predicated on a situational theory of the behavior of market participants, not a historically generalizable theory about market volatility.  The social mode thus involves considerable synthesis of information about markets and market participants.

The social brain hypothesis suggests that the brain has evolved in size and function as our social networks have expanded.  From this perspective, the brain is as much a social organ as an intellectual one, with distinct brain centers coordinating knowledge of our own minds and knowledge of those of others.  In his excellent book A User's Guide to the Brain, John Ratey explains, "...traditional psychologists and neurologists have been slow to acknowledge that social behavior is, at least in part, a brain function just like memory or language...Neurologists and neuroscientists have shown that damage to the cortex can affect one's ability to be empathetic, that problems in the cerebellum can cause autism and its social ineptness, and that deficits in the right hemisphere can make it difficult to understand life's overall picture.  Together, these parts and others make up the social brain" (p. 296).

Having worked with many traders and portfolio managers, my observation is that the very skilled ones have either:  a) very developed intellectual capacities; b) very developed social capacities; or c) a very developed integration of the two.  The first we see among world-class systems traders and those with keen analytical frameworks; the second we see among short-term traders who can read order flow and sentiment and anticipate the behavior of "the herd"; and the third we see among skilled portfolio managers who factor logical and psychological factors into their idea generation.

A great example of the latter recently showed up in a meeting I had with a manager who explained the anticipated action of the Fed in coming months based upon an analysis of incoming data.  He then referenced the internal dynamics of the Fed and the relationships among the members and explained how the group was likely to process the incoming data.  It was apparent that he displayed a level of expertise regarding the central bank in terms of the logical and psychological factors at work in its decisions.

This perspective suggests that brain function--and cognitive strengths--may be more important than personality in determining trading success.  It also suggests that understanding and playing to our cognitive strengths may be particularly important in guiding our own trading success.  I suspect many traders fail at the kind of trading they're doing, not because they lack emotional control or discipline, but because they are not wired for the cognitive demands of that particular approach to markets.

Further Reading:  Inside the Trader's Brain