Friday, November 28, 2014

The Three P's of Excellent Trade Execution

One of the best ways to gauge a trader's state of mind is by tracking his or her entry and exit execution.  Two traders can have the exact same idea and either make or lose money depending upon how they get into and out of the market.  Here are three P's that I look for in excellent execution:

1)  Planned - Do you have entry and exit criteria mapped out in advance, so that you know exactly your risk and reward at the time you enter a position?  Too often traders fool themselves into thinking they have a feel for markets and simply enter and exit when it feels right.  That means that they are entering when the market is going their way and exiting when it's going against them.  In a low volatility market, that leads to getting chopped up.  If you're looking for a great review exercise to improve your trading, track adverse price movement after your entries and favorable price movement following your exits.  If you're entering at poor times, you will see sizable adverse excursions early in the lifespan of the trade.  If you're exiting at poor levels, you will see the market move your intended way after you've jumped ship.  Such a review will tell you whether the feel you think you have is really providing you with an execution edge.  By planning entries and exits based upon tested criteria, good execution can become a part of your trading edge.  For instance, entering longer-term buy positions in stock indexes when the majority of shares are trading below their short-term moving averages shows more favorable return characteristics overall than going long when the majority of stocks are already stretched to the upside. 

2)  Patient - Is the trader patient about getting into and out of the market, or do they become fearful of missing opportunities and chase trades at bad price levels?  This is the natural outgrowth of planning.  When we have an execution plan, we have a grounding for patience.  We can choose to bet when odds are more favorable; stand aside when those odds are not present.  Without planned criteria, it is easy for entries to be based on greed and fear of missing out and exits to be predicated on pain.  A common problem faced by traders is dealing with the pain of gain:  the temptations to book profits prematurely.  This can lead to a deadly situation in which we let losses run longer than gains, ensuring fat negative tails in our P/L distribution.  When we are patient with planned entry and exit criteria, we don't have to be glued to screens.  That means that trading will deplete less of our willpower resources and we will be most likely to stay focused, in the zone, and grounded in good decision-making.

3)  Prompt - Once our criteria for entries and exits are met, do we act decisively, or do we become anxious and perfectionistic, hoping that good levels become great ones.  A common manifestation of performance anxiety is to wait for everything to line up perfectly before entering or exiting.  This rarely occurs, resulting in lost opportunities at entry time and suboptimal exits.  One advantage of planning trades is that it means you face risk and reward squarely before you get into the position.  Being at peace with the risk/reward profile of a trade makes it much easier to act promptly when our criteria are met.

One important point:  It is very possible to be an intuitive trader and also one that is planned, patient, and prompt in execution.  You may have a gut feel that stocks will break out of a range based upon patterns you've seen in the past.  That trade idea may be entirely intuitive, but the trade itself can be set up with planned breakout criteria and stop levels that enable you to be patient and prompt in getting into and out of the trade.  

And, oh yes, the chart above is a moving two-hour window of net buying and selling activity across all NYSE stocks from November 7th to the present.  Think of it as an intraday overbought/oversold indicator that is not price-based.  In an uptrend, the periods of net selling will occur at successively higher price levels.  That provides a nice basis for planned, patient, and prompt entry execution and highlights useful price levels for stop placement.

Further Reading:  Executing the Trade

Thursday, November 27, 2014

Stock Market Update: Three Views of Buying and Selling Activity

The recent market update emphasized that we have been seeing a moderation of buying interest among stocks, but not an expansion of selling interest.  The point was that we need to see the latter--not just the former--to turn a market cycle around.

The most recent market action has continued this pattern:  we've seen moderate buying interest among participants, but significantly below average selling pressure.  In other words, what's been keeping stocks high is as much an absence of sellers as a historically large presence of buyers.

When we examine net buying and selling activity, that means that buyers remain in control.  Above we see cumulative net upticks vs. downticks:  1) across all NYSE stocks; 2) across all U.S. stock exchanges; and 3) across the Dow 30 stock universe.  In each case, we've been on a steady ascent and most recently have moved to highs.  That is wildly different from what we saw in September, when net selling exceeded net buying well in advance of the market peak.

To be sure, market breadth has not been roaring:  stocks making new one- and three-month highs this week have run about half the level we saw at the end of October.  Still, those one- and three-month highs have continued to exceed new lows, as we're not seeing the kind of breadth of weakness that characterized the market tops in July and September.  Simply assuming that overbought markets will reverse in the absence of demonstrable weakness can be hazardous to a trader's wealth.

Further Reading:  NYSE TICK

Wednesday, November 26, 2014

Expanding Our Trading by Imposing Constraints

James Clear has an excellent blog post on the topic of how constraints can make us better.  His example is futsal, a soccer-like game played in a small indoor space with fewer players.  The combination of fewer players in a smaller space means that players touch the ball much more often than in traditional soccer and have to develop better ball-handling skills due to the lack of bounce of the futsal ball.  Because of the constraints of futsal, it is an idea training ground for soccer players.

When we create new constraints, we force ourselves to adapt.  This, in turn, exercises skills that otherwise might never be tapped.  When I supervised interns at a Chicago proprietary trading firm, I found software that replayed the day's market action at twice normal speed.  The faster price movement forced trainees to adapt and recognize market changes very quickly.  When they returned to live action, it seemed slow by comparison and they were able to recognize patterns occurring in an unhurried way.

Another constraint exercise for traders that I have found useful is to approach the market day by assuming that you can only place three trades all day long.  With only three bullets to fire, you have to adapt to the constraint by exercising unusual patience and selectivity, focusing on best setups at very good price levels.  This selectivity can be cultivated as a habit, as the constraints prevent traders from overtrading.

Clear's point is that constraints foster creativity.  We have to perform in new ways to adapt to challenging constraints.  If I only allow myself 30 minutes to read a book, I will cultivate the ability to skim chapters and glean main points.  If I'm only able to meet with someone for three counseling visits, I will plan exercises for those sessions that will make the greatest use of the limited time.  As Clear observes, limiting himself to 50 words enabled Dr. Seuss to write a best-selling book.

Constraints are a great example of how we grow by challenging ourselves.  Suppose you practice trading with a holding period one-tenth your norm...or ten times your norm.  How would you adapt and make money?  Suppose you could only watch one screen while trading...suppose you had to manage long and short positions that were entered for you randomly.  How would you make the most of the situation?  

By imposing limits, we expand our performance.

Further Reading:  Priming as Trading Preparation

Tuesday, November 25, 2014

Turning Your Best Practices Into Best Processes

When I began working at a counseling center years ago, waiting lists for services were the norm--both at that center and across similar centers.  In many cases, people had to wait weeks to begin meeting with a counselor.  From my perspective, waiting lists were an accident waiting to happen.  It was only a matter of time before someone on a waiting list deteriorated significantly in their functioning, leading to an unfortunate outcome and potential legal liabilities.

So when I was asked to lead a counseling center at my next institution, I set a policy of no waiting lists.  In order to accomplish that, I engaged in exhaustive research concerning the types of clients who most could benefit from short-term intervention; those that were most likely to benefit from medication; those that were most likely to require longer-term therapy; etc.  I also scoured the research literature for criteria to determine approaches to counseling most likely to benefit particular people and problems, drawing upon evidence-based guidelines.

Each research-based finding led to a best practice.  For instance, I learned that outcomes were best for people with certain kinds of depression if structured cognitive-behavioral therapy was combined with anti-depressant medication.  The combination of many best practices led to a best process:  by routing people to the right kinds of help that were most likely to be successful, outcomes were improved and waiting lists evaporated.  Therapy became more efficient as well as more effective once an evidence-based triage process was established.

The previous post reached out to readers to ask for their best practices:  actions that have been most reliably associated with successful trading.  These, too, should be evidence-based.  That means that you are actively tracking what you're doing in markets and how you're doing it and seeing what works and what does not.  It also means that you're tracking yourself and the personal factors that account for your good and bad trading.  For example, I have consistently found that placing trades only when backtested relationships are providing current signals increases my hit rate and my profitability.  Starting my trading day by investigating those relationships is a best practice.

When we string together a number of best practices, we arrive at best processes.  My best process for market preparation includes starting the day with exercise; eating lightly; updating markets for those backtested relationships; planning criteria for entries and exits; and writing down my game plan for the trading session.  I have learned that each of these best practices is associated with my best trading.  Combining them into a process creates a preparation routine:  I am turning best practices into ongoing work habits.

The reason my new book stresses the creation of best processes from best practices is that the old trading psychology--the one that links trading success to "discipline"--is woefully limited.  When we established the new triage system at the counseling center, no one had to work on their discipline to conduct the right kinds of assessments for new clients.  Those assessments became part of an ongoing process:  they developed into routines.  The challenge for traders is not to motivate behaviors but to automate them.  First you study yourself and learn your best practices; then you find ways to assemble those best practices into a replicable workflow.

Thanks to readers who already have submitted their best practices.  I especially encourage those involved in mentoring traders to share their best practices.  By creating a database of best practices, we can generate the building blocks for best processes and lay the foundation for more consistent trading performance.

Further Reading:  Four Pillars of Trading Process

Monday, November 24, 2014

A Call for Best Practices: Trading Psychology 2.0

Well, I don't know if I can land you a spot on the Hollywood walk of stars, but I can feature you in my upcoming book, Trading Psychology 2.0!

For those who are interested, here's how it works:

The book's final chapter will be devoted to "best practices".  These are routines and methods that traders have found to be useful.  These can be psychological techniques; ways of organizing time; activities before, during, or after the trading day; ways of managing positions or risk; ways of finding trading opportunities; techniques for setting stops or price targets; etc.  Ideally the best practices are things that you do when you are trading very well.  Please note that I am not looking for trade setups or specific trade ideas, so no charts or code.  Rather, these should be elements of process that contribute to success in an ongoing way.

That final chapter will share many best practices, both my own and those I've observed among successful traders.  I thought, however, that reaching out to readers for their best practices would enrich the book and provide an opportunity for readers to receive recognition for their ideas and good work.

If you are interested in submitting a best practice, please write it up either as an email or as a Word document attached to an email and send to the address in the star above some time during the coming week.  Please keep the writeup short; certainly no more than two or three paragraphs.  

I may not be able to use all submissions (especially if there's significant overlap), but will be as inclusive as possible.  For each accepted best practice, I will acknowledge the contributor in the book along with the contributor's website address and/or Twitter handle.  I will also do the same in a future blog post.  If you would prefer keeping the submission anonymous, just let me know in your email.

My hope is that this provides readers with some well-earned recognition and also broadens the ideas presented in the book.  Thanks for your interest; I look forward to learning more about the practices that contribute to your success!


Further Reading:  

Best Practices During Trading Slumps

Previous Best Practices Submitted by Readers

Sunday, November 23, 2014

Good Reads to Wrap Up the Weekend

Some interesting findings about gratitude:  it is significantly and positively correlated with life satisfaction, vitality (energy), happiness, optimism, and empathy.  It is significantly and negatively correlated with anxiety and depression.  People who write a journal about things they are grateful for vs. people who keep a journal of their daily hassles and problems end up experiencing more positive emotion, better health, and greater optimism.  We can train ourselves to be more grateful, and that brings significant positive benefit.

*  Views on all-weather portfolios, Tony Robbins, simplifying your life, high yield divergences with stocks, and much more from Abnormal Returns.

*  Excellent perspectives on trading as a peak performance activity from SMB.

*  Thanks also to Steve from SMB for calling attention to this article on how automation can make us less intelligent.

*  Valuable look at facts and fantasies regarding factor-based investing.

*  Why unsexy low-beta stock sectors can be better investments than high beta/high volatility ones.

Have a great start to the week!

Is This Market Weak, Strong, Not Weak, or Not Strong?

The recent post on market strength and weakness made the case for looking at strength (buying pressure) and weakness (selling pressure) as independent variables.  We can have markets in which both buyers and sellers are active, and we can have ones in which both are relatively dormant.  By measuring upticks and downticks across all stocks separately, we can gain some insight as to the behavior of both buyers and sellers. 

The two charts above update views on strength and weakness.  The top chart looks at all stocks within the NYSE universe and tracks those closing above their upper Bollinger Bands versus those closing below their lower bands.  (Data from the StockCharts site.)  The idea here is that in a strong market, we'll have more shares closing above their upper bands and vice versa for a weak market.  In a market in which buyers and sellers are relatively dormant, we will see few stocks close above or below their bands.

Note how this is exactly what has happened in recent sessions:  we have had a waning of strength (fewer stocks closing above their bands), but not an excess of weakness (net stocks closing below their bands).  At the market peaks in July and September, we saw an excess of stocks closing below their bands *prior* to the reaching of an ultimate price high for those cycles.  In other words, it wasn't just diminished buying but net selling that preceded the market fall.  Markets don't get weak unless some market components are actively leading the way.

This is similarly reflected in the bottom chart, tracking the daily balance of upticks versus downticks among all NYSE shares.  That balance has come down in recent sessions, but is nowhere near the levels of net selling pressure that we saw prior to the October drop.  In recent sessions, buying and selling pressure have been relatively balanced; we have not seen selling pressure swamp buying activity.  Again, the takeaway is that markets don't get weak unless sellers become active and dominant.

To be sure, small cap stocks have been underperforming large caps of late and shares in the energy sector (XLE) have been understandable laggards, given the significant drop in the value of crude oil.  Thus far, however, weakness in those areas has not been sufficient to bleed over to the broad NYSE universe.  Buyers are not grabbing bargains as aggressively as in the latter portion of October, but neither are sellers taking advantage of high prices the way they were in September.  With prospects of monetary stimulus most recently from China, following Japan and Europe, prices that looked frothy a couple of months ago have not found broad selling lately.

Further Reading:  International Stock Performance

Saturday, November 22, 2014

How to Build Discipline and Conscientiousness

The recent post highlighted why conscientiousness is the single personality trait most consistently associated with life success.  We commonly hear traders extol their passion for their work.  Desire alone, however, is only half the success equation.  It's conscientious follow-through that makes the difference between dreaming of success and waking up to make it a reality.

Can we cultivate conscientiousness?  Can we improve upon our ability to pursue goals in a disciplined, intentional way?

Michael Posner's work in cognitive neuroscience suggests that a key element in self-regulation is the development of executive attention.  This makes sense:  the opposite of conscientiousness is not laziness; it is distractibility.  The distracted person is one who cannot sustain directed action:  intention requires attention.  Posner's work finds that attention can be trained through the use of challenging video games and through such processes as meditation.

Indeed, a study of short-term integrative mind-body meditation training found that it was effective in improving both attention and the regulation of emotional responses.  By learning to focus attention, build mindfulness, and control the body's state of arousal, subjects were able to lower their cortisol response to stress; lower their negative emotionality; and improve positive emotional experience.   

Similarly, training in the arts appears to lead to changes in the brain that are associated with improvements in attention and general cognitive functioning.  Cognitive discipline, a precondition of behavioral discipline, appears to be a capacity that can be trained.

An interesting study looked at conscientiousness as a set of behaviors, not simply a trait that people have or don't have.  Behaviors negatively correlated with conscientiousness included "avoid work"; "impulsivity"; "antisocial"; and "laziness".  Behaviors positively correlated with conscientiousness included "organization"; "cleanliness"; "industriousness"; "appearance"; "punctuality"; "formality"; and "responsibility".  Viewing conscientiousness as behaviors opens the door toward cultivating habit patterns that are conscientious. 

By building habits that make us more conscientious, we avoid the circularity of needing conscientiousness to follow a program of building conscientiousness.  Each of the conscientious behaviors listed above can be turned into a daily action that is repeated as part of an ongoing routine.  By making the behavior routine, we take it out of conscious control and automate it--enabling us to cultivate the next positive habit.  A particularly promising strategy is to use the mind-body meditation training described above to start the day with regulated attention and arousal and then use that mindful state to enact a conscientious behavior.  Over time, that would build habits of both cognitive and behavioral self-control.

The important takeaway is that disciplined lives start with disciplined days and those start with disciplined acts.  If we do not achieve a degree of mastery over mind and body, it is difficult to believe that we will sustain a path toward life mastery.

Further Reading:  Turning Success Into a Habit

Friday, November 21, 2014

The Personality Trait Most Important to Cultivate for Success

If, indeed, success is traversed by staircase and not elevator, what would be the best predictor of success?  

It might be quite simple:  the propensity to take the next step.

That propensity is part of what is known in psychology research as conscientiousness.  People who are conscientious tend to be very organized, very responsible, and very planned in their actions.  Do you get your work done before you relax and play?  Do you get work done well ahead of deadlines?  Do you attend to details in your work?  Do you think and strategize before you act?  All of those are manifestations of conscientiousness.

There is much to be said for being laid back and going with the flow.  A conscientious person would leave time in their schedule for chilling--and would make relaxation a positive habit pattern.  That is very different from chilling whenever the mood strikes.  

It turns out that, out of all personality traits, conscientiousness is the best predictor of success.  Not all conscientious people have talent, but talent is most likely to be honed as skills via conscientiousness.  After all, what is deliberate practice if not conscientiousness applied to learning?

Research finds that people who are high in conscientiousness have higher incomes and get better grades.  Recall the research of Angela Duckworth:  two factors predict success:  grit (the ability to persevere even after setbacks) and self-control.  Perhaps conscientious people are successful because they set and pursue goals with steady determination.

Conscientiousness brings other benefits as well.  Conscientious people tend to be healthier, perhaps simply because they are more consistent in engaging in healthy behaviors.  The "discipline" so often emphasized as a component of trading success is conscientiousness applied to the creation and following of trading rules.

There is interesting evidence that conscientiousness consists of two subtraits:  industriousness and orderliness.  The conscientious person is hard working and achievement oriented and is also organized and perfectionistic.  That sounds a lot like Duckworth's formula.

There are differences in brain structure among people who are high versus low in conscientiousness.  There is also evidence that conscientiousness contributes to the integrity of the brain during the process of aging.  Can we learn to become more conscientious and cultivate this as a trait, in effect rewiring our brains?  Research on self-regulation training suggests that this, indeed, is possible. In my next post, I will outline the components of a self-directed program that can improve our abilities to take the next step on the staircase to success.

Further Reading:  Are lapses of discipline the cause or effect of trading problems?

Thursday, November 20, 2014

Who Has the Upper Hand in the Stock Market: Buyers or Sellers?

The recent post noted that we've been seeing diminished strength in the stock market rally.  As earlier this year, a big part of the weakened breadth has come from smaller cap shares.  Above are three charts that track market strength and weakness in a unique way.  This is based on work that I introduced in August and have since refined significantly.  It is a proprietary measure that assesses the number of stocks within the NYSE universe that are trading on upticks (buying pressure) versus the number of stocks trading on downticks (selling pressure).  The balance measure (bottom chart) represents the difference between buying and selling activity.  

Please note that each chart is normed so that zero represents an average level of buying, selling, and balance going back to 2012.  When we see buying pressure above zero, that represents above average buying activity.  When we see selling pressure below zero, that represents selling activity that is greater than average.  When the balance measure is above zero, we have an above average net level of buying relative to selling.

It turns out that buying and selling are not flip sides of the same coin.  During 2014, daily buying pressure has correlated with daily selling pressure by -.33.  That means that only a little over 10% of the variance in selling can be explained by buying activity and vice versa.  A market in which buying is getting weaker is not necessarily one in which selling is expanding--and that turns out to be important for understanding where we're at in market cycles.

As you can see from the top chart, buying pressure typically ramps up as markets are making intermediate-term lows, as we see longer timeframe participants scoop up bargains.  That increased buying continues early in the cycle's rise, as the market moves higher on strong upside momentum.  As the cycle matures, we see diminished buying pressure, with buying actually turning negative (below average) during the topping phase of the cycle.  This was very evident during the topping processes of July and September.  Note that buying pressure started very strong out of the October lows and most recently has turned negative (below average).  This is an indication that the current cycle is in a mature phase.  In itself, it is not predictive of the kinds of drops we had in August or October, however.

When we turn to the middle chart, we can see that selling pressure is most extreme at market lows as we'd expect and then dries up during the early part of intermediate-term cycle rallies.  As the cycle matures, we see selling pressure pick up, as an increasing number of participants take advantage of high prices.  Note how selling pressure picked up meaningfully during the July and September topping phases.  Most recently, we've seen selling pressure pick up (below zero; more selling than average), though not to the degree that we saw prior to the recent market corrections.

Finally, the bottom chart integrates the two and shows how the balance between buying and selling evolves over time.  The balance is very much skewed toward buying early in the rising phase of a market cycle and then turns negative as the market tops out.  Note that we have turned negative on balance in recent trading sessions, though again not to the level seen at recent market peaks.  If we are indeed in the topping phase of a market cycle, this waning of buying and expansion of selling should continue, eventually leading to an inability of buyers to push index prices to fresh highs.

Further Reading:  Market Cycles

Wednesday, November 19, 2014

The Challenges of Global Disinflation

Above we can see the collapse of commodity prices over the past six months, as reflected in the Goldman Sachs Commodity Index (GSCI); oil futures; the gold ETF (GLD); and wheat futures.  In an inflationary environment, we expect to see rising commodity prices and a weak currency.  What we've see of late is a strong U.S. dollar and falling commodity prices:  a much more disinflationary environment.

Indeed, disinflationary forces have emerged as a key concern at the Bank of England and the Bank of Japan sounds less clear that it can reach its 2% inflation target.  We are also hearing recent reports of "entrenched" disinflation across Asia.  Falling commodity prices are also disinflationary for producers of raw materials such as Australia.  Across much of the world, disinflation has taken hold of economies, and that has included the U.S.

So what happens in a world of growing disinflation?  We see competitive devaluations of global currencies to stimulate inflation, with Europe seemingly following the recent lead of Japan.  Risk-free yields remain crushed in a disinflationary world of zero interest rate policies, encouraging yield-seeking through stocks and longer-duration bonds.  That has been very good for the long stocks/long bond trade.

With the much stronger dollar and G20 promises of more economic stimulus to come, will global economies pick up some of the strength of the U.S. economy (which has benefited from lower commodity prices and restrained rates), or will that strong dollar become an anchor to the U.S. economy, restraining overseas demand for U.S. goods and forcing the U.S. to join the competitive downward race?  I will be watching the relative performance of overseas equities markets to the U.S. stock market; the behavior of U.S. and overseas rates; and the forward trajectories of commodities as ways of handicapping this key issue.