The Psychology of Market Volatility

The chart above displays the relentless decline in option-related volatility ($VIX) from the March stock market lows to the present. But how does this decline in volatility affect traders and their psychology?

I ask the question because three observations have struck me in the past week:

1) An increasing number of traders have contacted me, indicating frustration with their (day) trading, including greater losses during the afternoon trade;

2) An increasing number of traders have contacted me, indicating that they have been "too aggressive" in trading the current market;

3) My own trading performance, which had been quite consistent through 2007, turned flat for several months before resuming consistency in April and now becoming quite positive in May.

I don't think these observations are unrelated. The day traders I talk with benefit greatly from volatility. When markets become less volatile, they find themselves going after large moves that never materialize. This leads to frustration and over-aggressive trading.

I, on the other hand, tend to be quite risk averse in my trading: a peak-to-trough P/L decline of 3% would be a major deal for me. When I detect large volatility in markets, I immediately cut my size to standardize my returns and I trade less. Where the traders I talk with experience volatility as opportunity (and indeed take advantage of it), I experience it as risk (and benefit far less from it).

Conversely, as volatility drops in the market, I am comfortable with the market conditions, take small profits frequently, and build my account. Where the traders I talk with see the low volatility environment as low opportunity, I experience it as low risk. As soon as the VIX moved back into the low 20s, I was in my glory. The traders, on the other hand, were finding it more difficult to participate in large moves, frustrating their ambitions.

The point here is that volatility affects the psychological environment of trading. Depending on our risk appetites, we will respond differently to volatility regimes--and that will likely affect our trading performance.

A few statistics will highlight the psychological importance of volatility. I went back to January, 2008 (a higher volatility environment) and found that the median 30-minute high-low range for the ES futures was .60%. I then looked at May, 2008 to date (a lower volatility environment) and found that the median 30-minute high-low range for the ES futures was .29%. In other words, at a 30-minute time frame, markets are moving half as much now as they were in January. Is it any wonder that traders looking for big moves are becoming frustrated?

Traders don't realize that volatility scales at every time period. If we have lower daily volatility (as the chart above depicts), we will have lower volatility for every intraday time period. Whatever our average holding period might be, the market will move less in a low VIX environment than a high VIX one. That greatly affects trading behavior:

* It means that any standard method of placing stops and targets will perform poorly as volatility changes dramatically. When volatility rises, we will tend to have our stops too close and get whipsawed frequently. When volatility falls, our targets will tend to be too far away, leaving us in a situation in which we make money on trades, only to see the trades reverse before we are ready to exit.

* It means that any standard method of sizing trades will lead us to go through periods of high performance volatility as markets become more volatile. These large P/L swings can create considerable distress for risk-averse traders (like myself). On the other hand, the standard method of sizing trades will lead to lower performance volatility as markets become less volatile, leading more aggressive traders to become frustrated with the truncated range of their returns.

Markets change how they trade periodically. What we've been seeing since March, 2008 is a noteworthy change in market direction, themes, and volatility. The ideal is to recognize these shifts as they are occurring and make mid-course corrections as promptly as possible. This is especially difficult for newer traders, who lack the database of personal experience to know how to adjust to radically different trading environments.

I'm not going to name names, but if a "Market Wizards" book were to be written now, surprisingly few of the people featured in those earlier volumes would qualify for chapters today. It's difficult to succeed at trading, but--given rapidly changing market conditions--even more difficult to sustain success. It's not good enough to find winning trading techniques; one has to continually adapt these techniques to an ever-changing environment.

RELATED POSTS:

Anticipating Volatility

A Psychological View of Volatility

Relative and Absolute Volatility

An Indicator for the Coming Day's Volatility

When VIX Becomes Volatile
.

Free Trading Resources You Might Not Be Aware Of

* Market Data - A wealth of data can be found on the Online Wall St. Journal site. Also check out news and data from Reuters.

* Researching ETFs - ETF Connect offers broad coverage and excellent summaries of the various ETF alternatives.

* World News - Here's global news organized by feeds, an excellent feature assembled by NewsFlashr.

* Stock Picking Resource - StockScouter from MSN Money is an excellent research tool.

* Creative Charts - The StockCharts site features market carpets that summarize performance across markets and drill down to individual sectors.

* Tracking Markets - The Barchart site enables you to follow currencies, energies, financials, and more.

* Global Financial TV - You can watch Bloomberg TV from around the world by going to their site and launching their video player from the left hand tool bar.
.

Treasury Yields: A Real-Time Market Sentiment Gauge

Suppose we could conduct a poll each day of traders and investors, asking them for their outlook on the strength vs. weakness of the U.S. economy? That might provide some useful sentiment data.

Well, we have something better than a self-report poll, which may or may not reflect the actual market behavior of these participants. The rise and fall of Treasury yields provides the market's real-time assessment of whether the economy is weakening or strengthening.

If the economy is weakening and requires stimulus, anticipations of Federal Reserve easing will lead to falling short-term yields. If the economy is encountering inflationary pressures and may require monetary tightening, short-term yields will tend to rise.

Like any sentiment gauge, yields can overdo things on the upside and downside. Take a look at the chart above, which tracks two-year Treasury yields versus the cash S&P 500 Index from mid-year 2007 to the present. The correlation between the two is striking. As stocks were falling and housing and credit issues dominated the headlines, yields fell all the way to 1.41%--a negative return vis a vis inflation.

Since March, those concerns have abated to a degree. Stocks have retraced essentially all of their year-to-date losses and yields have moved steadily higher to 2.47%. If traders and investors expect the Fed to put inflation fighting ahead of liquidity provision, we should continue to see rate firmness. That is bullish for stocks, because it means that the Fed is not so worried about bank failures and economic collapse that they need to engage in Japanese-style quantitative easing.

Should we see rates move back toward their March lows, however, it would signify a resumption of worries regarding the financial system and a pricing in of expectations regarding Federal Reserve ease. When new economic data are released, it's worth keeping an eye on short-term yields for a quick poll of market reaction.

If you understand how yields serve as sentiment gauges, then it's not too far a leap to see how the relative movement of yields from country to country reflects real-time pollings of economic strength and weakness on a global basis. This has important implications for currencies, as well as the flows of funds from one global market to others.

RELATED POST:

It's All One Market
.

When the Trading Demons Get Out of Control

The following is a direct quote (with the trader's permission) from an email I received just a little while ago. It illustrates a dilemma that many traders face at some point in their career:

"I was doing ok for a few days, then I went back to my old trading ways and just suffered a big loss of my account today. I committed all the the trading sins, etc double my position size, go against the trend, being stubborn and hold onto a losing position. I think I know the correct way (maybe I am fooling myself), but I don't seem to be able to control the demon inside of me and just can't break the old bad habits."

So let's imagine this is happening at one of the trading firms where I serve as psychologist/coach? How would we tackle the situation?

First off, we would tackle it quickly. Times of crisis are also times of opportunity, when it comes to psychological change. That's when people are most motivated--and most open--to making changes. "Strike while the iron hot" is an apt principle when situations feel desperate.

Second, I would immediately institute a three-way meeting with the trader, myself, and the firm's risk manager. We would greatly cut back the trader's risk (i.e., trading size), so that no further harm could be done to the account. "Above all else, do no harm," is a principle that works for physicians and traders alike. The idea is that, with profit/loss (P/L) pressures removed from the equation temporarily, it is easier to focus on problem patterns, their causes, and possible solutions.

Third, I would interview the trader extensively (and observe him trading, if possible) in order to identify the specific situations that are associated with the loss of discipline. In other words, I would ask in detail about what is happening in markets when the trader's discipline is good and what is happening when "the demon inside of me" comes out. What we're looking for are *patterns* that we could then address with specific change techniques.

Here are the patterns that I find to be most common:

1) The trading problem is the result of a broader emotional disorder - This is more common than is commonly recognized. About 5-7% of the population suffers from a diagnosable emotional disorder during any given year, with a similar incidence of substance use disorders. As a result, at least one in ten traders can be expected to experience emotional disruptions that interfere with trading, but are not specific to trading. These disruptions include anxiety disorders (such as panic disorder and generalized anxiety), mood disorders (depression), and disorders related to attention deficits and hyperactivity. Many of these problems can be addressed effectively--and without debilitating side effects or addictive potential--through the use of medications. Many of them also benefit from counseling/therapy assistance from a qualified professional. If the problem affecting trading is also occurring in other spheres of life (relationships, work) or has predated trading experience, the odds are high that it could benefit from professional assistance. The proper course of action is to get a high-quality referral to a licensed professional, not a self-proclaimed trading coach.

2) The trading problem is the result of trading-specific performance pressures - Many times traders experience performance anxiety regarding the uncertainty and risk of markets and the pressures to make money. This anxiety leads them to trade in fearful ways, and it sometimes leads them to overtrade in the desire to make things work out. Many times the disruptions of trading occur during periods of drawdown and slump, when performance pressures become most acute. Common to these performance problems are difficulties with negative self-talk, including self-imposed, perfectionistic pressures. The key to this set of problems is that they are trading-specific. Other areas of life don't exhibit the same patterns of pressure and disruption. Many of these concerns can benefit from self-help methods, including the cognitive and behavioral methods that I outline in my book on trader performance.

3) The trading problem is literally a trading problem - This is most common when traders put their money at risk before they've gone through a proper learning curve. They have read a little, observed a little, and now try their hand at trading. Because they don't understand how markets move--and what makes them move--they rely on simple patterns for entry and exit that provide them with no statistical edge whatsoever. The result is increasing frustration and loss of capital. Although the problem may look psychological, the emotional distress is really the result of the more fundamental absence of skills and experience. I would guess that easily half of all people who seek my advice and assistance fall into that category. When I ask trading and market-related questions, it's clear that they don't understand even basic fundamentals. The proper solution for this situation is to go through the learning curve the right way, starting with observation and practice (simulated) trading, and then gradually moving toward real-time risk as skills build.

A major shortcoming of seeking help from trading coaches is that they are usually only experienced and knowledgeable in area #2 above. They are not trained as professional psychologists to help with #1, and they lack the trading experience to be of assistance in identifying #3. Additionally, it is in their financial self-interest to lump as many traders into category #2 as possible, since the first and third categories are unlikely to build their book of business.

Because I don't work with individual, independent traders myself--either as a coach, psychologist, or trading mentor--I don't feel wedded to any of the scenarios above. The key is for traders to accurately diagnose the problem, so that they can follow a promising, structured plan of action. There are many reasons why the trading demons can get out of control: understanding the why of the demons is half the battle of figuring out what to do about them.

RELATED POSTS:

Coaching the Professional Trader

When Coaching Doesn't Work, Part One

When Coaching Doesn't Work, Part Two

Performance Coaching

A Referral List of Mentors and Coaches
.

Year to Date Global Equity Returns by Style

By clicking on the above chart, you'll be able to see comparative year-to-date returns for EAFE (Europe, Australasia, Far East) value stocks (EFV); EAFE growth stocks (EFG); S&P 500 value stocks (IVE); and S&P 500 growth stocks (IVW).

Here are a few noteworthy observations:

1) Across the world, equities have retraced most of their year-to-date losses (though they remain below their 2007 peaks);

2) Growth has been outperforming Value among the EAFE stocks since the January market lows, and now in the last month has outperformed Value among U.S. stocks;

3) U.S. Value stocks were relative performance leaders during the market decline, but have been laggards since the March lows;

4) EAFE stocks were relative performance laggards during the market decline, but have been leaders since the March lows.

I believe these results suggest an improvement in overall market sentiment, which has led investors away from safety (large cap U.S. value) and back toward growth themes. That is not to say that the key bear market themes (weak housing, credit concerns) have gone away; only that global markets are according these themes less weight in their asset allocations.

RELATED POSTS:

Tracking the Style Box

Tracking the Style Cube
.

Gauging Market Strength After a Move to New Highs

Whenever a market makes new price highs or lows over a period of time, I like to examine whether the number of individual stocks making fresh new highs or lows has expanded. This tells me whether the move has been broad-based or simply dominated by a limited number of sectors. Interestingly in the recent market, we've seen considerable sector rotation, with new highs lagging as the stock indexes moved higher. Most recently, however, as noted in my Twitter comment, we've seen leadership from the small caps as well as NASDAQ stocks, suggesting a broadening of the rally.

Today we hit fresh price highs in the NASDAQ and Russell 2000 indexes, as those markets have moved nicely off their March lows. As the above chart of the NYSE Composite Index indicates, we came close to price highs in the broad market before backing off in the afternoon. The helpful chart from Decision Point shows, however, that new 52-week highs among NYSE common stocks expanded, reaching a fresh post-March high.

I then examined new highs specific to the S&P 500 large cap stocks and the S&P 600 small caps. These also expanded to post bear-move highs: we had 38 annual highs among the large caps and 2 new lows; 25 new highs and 7 new lows among the small caps.

On a shorter-term basis, we also saw strength in the market, with 968 NYSE, NASDAQ, and ASE issues making fresh 65-day highs and 195 registering new lows.

Yet another way that I assess market strength during a move to new highs is to gauge the number of stocks closing above their moving averages. On Wednesday, we saw 54% of S&P 500 stocks close above their 200-day moving averages, the highest reading of 2008. Similarly, we had 46% of S&P 600 small cap stocks closing above their 200-day averages, also the highest reading of the year.

Because the proportion of stocks closing above their moving averages tends to crest ahead of price peaks during bull moves, an expanding reading suggests that we should see higher prices ahead, even if there is some corrective action in the near term.

By looking at new highs/lows and percentage of issues above moving averages for multiple indexes, we can gain a multifaceted perspective on whether markets are gaining or losing strength. This is quite helpful in identifying trends that are more likely to continue, and those that are more likely to reverse.

RELEVANT POSTS:

When New Highs Get Higher

What Happens When New Lows Expand

Intraday New Highs and Lows
.

A Few Resources to Prepare You for the Market Day

* Morning Twitter - Thanks to readers who have emailed re: their use of the Twitter posts as a help in preparation for the trading day. The last five posts appear on the blog under the heading "Twitter Trader"; the full set of posts can be found on my Twitter page (which is also where you can subscribe for automatic updating). Each AM I post market indicators, including new 20-day highs and lows across the major exchanges and figures for Demand (index of number of stocks with strong upside momentum) and Supply (index of number of stocks with strong downside momentum), as well as the percentage of SPX stocks trading above their 50-day moving average. By tracking these numbers from day to day, you can gain a feel for whether the market is strengthening or weakening in the short-term. I also link important news stories via Twitter to identify themes impacting markets and send out a heads up notice for upcoming important economic reports. These items are part of my daily market preparation, and I hope they can be helpful for you as well.

* Looking for Stocks in Play? - That may be another part of your morning preparation. Trader Mike's watch lists each morning summarize market-moving events and stocks on the radar. He also offers swing trade candidates.

* Ideas for Shorts - Charles Kirk posts a simple screening idea for stocks that may be overextended. See also his morning posts that are helpful in preparing for the trading day, including a list of stocks rising and falling pre-market.
.

Eternal Truths About Trading Success

A portfolio manager lent me an interesting small book from the late 1800s written by Dickson G. Watts and reprinted by Traders Press. Entitled "Speculation as a Fine Art and Thoughts on Life", the book begins with a description of the "qualities essential to the equipment of a speculator" (p. 8). Here is the author's perspective, written well over a century ago:

* Self-Reliance - "A man must think for himself, must follow his own convictions...Self-trust is the foundation of successful effort."

* Judgment - "...equipoise, that nice adjustment of the faculties one to the other...is an essential to the speculator."

* Courage - "...confidence to act on the decisions of the mind...be bold, still be bold; always be bold."

* Prudence - "The power of measuring the danger, together with a certain alertness and watchfulness, is very important."

* Pliability - "The ability to change an opinion, the power of revision."

I especially like Watts' formulation: "There should be a balance of the two, Prudence and Courage; Prudence in contemplation, Courage in execution."

This very much fits patterns of success I detect among the most profitable traders. They are prudent in contemplating their ideas--they wait for the odds to be in their favor and conserve their capital when the edge is not there--but they are courageous in executing those ideas.

Equally important, they can be courageous without getting their egos tied to their ideas. If markets are not confirming their views, Pliability ensures that they can revise those views and not hang on to losing trades.

"The qualifications named are necessary to the makeup of the speculator," Watts explains, "but they must be in well-balanced combination. A deficiency or an overplus of one quality will destroy the effectiveness of all" (p. 9).

Too much courageousness and too little prudence leads to impulsive risk-taking. Too much pliability and too little self-reliance leads traders to get chopped up, reacting frantically to the last market movements.

Some trading truths never go out of date.

RELATED POSTS:

Four Overlooked Qualities of Successful Traders

Resilience and the Courage of Your Convictions
.

Indicator Review for May 12th

My Technical Strength measure is a quantification of trending behavior over an intermediate-term time frame. The measure tracks five highly weighted stocks within eight different S&P 500 sectors. Scores range from -500 (near perfect downtrending) to +500 (near perfect uptrending), with scores near zero suggesting the absence of trending.

Here are the sector scores as of Friday:

Materials: +20
Industrials: -180
Consumer Discretionary: +200
Consumer Staples: -220
Energy: +300
Health Care: -280
Financial: -260
Technology: +220

What stands out is that we have sectors moving in very different directions. Beneath the action of the broad index is considerable sector rotation, as noted in a recent post. Although we've recently moved to price highs following the March lows, a limited number of sectors have accounted for essentially all the strength. That is not a healthy market situation and helps to explain why broad buying sentiment has been lagging.

It is this very mixed sector performance that also helps explain why the advance-decline line specific to NYSE common stocks, as nicely illustrated by Decision Point in the above chart, has been lagging. While the S&P 500 Index has vaulted above its February highs, the broad advance-decline line remains significantly lower. Moreover, as stocks moved to new price highs early this past week, the AD Line failed to follow.

Indeed, when we look at advance-decline lines specific to each of the above S&P 500 sectors, we can see a similar pattern of mixed performance. The line specific to energy stocks is hovering at its April highs, which are also all-time highs. The line for consumer staples stocks, however, hit a new bear low this past week. We are very close to bear lows for financial and health care stocks, but technology shares remain well above their bear lows (though nowhere near their bull highs).

Finally, the broad stock market indexes are nicely higher over the past month, but Friday's market showed 797 new 20-day highs and 747 fresh 20-day lows--more mixed performance. I cannot imagine the market sustaining a significant bull move on such a selective basis.

RELEVANT POST:

Last Week's Indicator Review
.

Stock Picking and the Value of Sub-Sector Perspectives

The excellent Barchart site divides the stock market into 232 sub-sectors and tracks their performance relative to the broad market. The charts above represent the relative strength of the sub-sectors, not price. A zero value means that the sub-sector matches the strength of the broad market. Negative readings signify underperformance; positive readings indicate relative strength.

From these sub-sector perspectives, we can gain unique stock picking insights. Note, for instance, how the independent oil and gas companies are significantly outperforming the majors. Similarly, regional banks in the Northeastern part of the U.S. (which has been less hit by the housing crisis) are significantly outperforming regional banks in the Pacific region (which have been affected by housing weakness in California).

Themes dominate markets, not only at the sector level, but also among sub-sectors. This has important implications for traders and investors alike.

RELATED POST:

The Importance of Stock Picking
.

The Importance of Stock Picking

If a commodity is hot, stocks of companies that deal in that commodity should be hot as well, right? Well, not necessarily so. To be sure, energy shares have outperformed the stock market indexes during the recent period of oil price strength. Take a look at relative performance of two energy shares (XOM, top chart; VLO, third chart down) vs. oil itself (DBO). From these charts (kudos to the MSN Money site), it's clear that the stocks have greatly underperformed the commodity.

In the two money flow charts (XOM, second chart down; VLO, bottom chart), you can see the reason for this: as a whole, funds have been flowing out of these issues over the past six months. Forays above the neutral, blue line (the point separating five-day inflows from outflows) have been relatively brief and contained.

With oil making fresh price highs over the past two weeks, one would expect these stocks to be making new peaks as well. XOM, however, has moved from 92.45 to 88.82 in that time, with only one day out of the last ten displaying positive money flows. VLO has seen a particular sharp outflow over this period (as the money flow chart above displays), and the stock has moved from 52.93 to 44.56. Only three in the last ten sessions have shown positive money flows for VLO.

The moral of the story is twofold:

1) Assuming a stock will be strong just because a related commodity is strong is surface reasoning that can get you in trouble. Oil prices might be strong, but it doesn't mean that particular oil companies are drilling or refining more of it.

2) Money flows matter. Regardless of the attractiveness of the story, if investors are taking money out of a stock over time, it is going to be difficult for that issue to perform strongly.

I notice that HAL and XTO have seen net inflows to their shares for five of the past ten trading sessions; both of those energy issues are higher over the last ten days, unlike XOM and VLO. Stock picking matters, and the flows of funds in and out of shares and sectors is one important factor in determining relative stock performance.

RELATED POSTS:

This Post Explains Dollar Volume (Money) Flows

Money Flows and Sector Rotation
.