Tuesday, October 21, 2014

How Moods and Motivations Impact Trading Performance

A very interesting summary of research on mood and creativity finds that people are most creative when they are in particular states.  First, when mood is positive, people solve problems more easily and are more likely to think broadly and perceive fresh alternatives.  We are most cognitively flexible when we experience positive vs. negative moods.

Second, when people are moderately energized, they are most likely to engage in complex and creative thinking.  When at low levels of arousal, we don't fully engage the world cognitively; high levels of arousal interfere with reflective thinking.  It is when we are energized in positive ways that we display superior processing speed, focused attention, flexible thinking, and creative response.  

Finally, when we are in "promotion states"--states in which we seek positive outcomes--we are most likely to respond creatively.  In "prevention states", we tend to narrow our cognitive focus and fail to see alternate courses of action.  It is when we seek positive outcomes that our attention broadens and we become most flexible in our response patterns.

If we put together these three conclusions, it is not difficult to see how negative emotional experience adversely impacts trading performance.  When markets are behaving against our expectations and positions are moving against us, that is when we want to be most open, flexible, and creative in our thinking.  Under the influence of negative mood, very high arousal, and prevention-oriented thinking, we become unable to clearly perceive all our alternatives and recruit our most flexible responses.

From this perspective, one of the most important psychological things we can do to improve trading performance is to sustain positive mood, high energy, and clear, constructive goals.  We cannot eliminate the uncertainty of markets or the stresses of drawdowns.  What we can do, however, is balance those pressures with our own positive internal environment, so that stress never turns into distress.  

In an important sense, bad trading results from a failure of creativity:  the inability to think and respond in divergent ways when markets are behaving counter to our expectations.  Maintaining an emotional and cognitive state conducive to broad information processing and flexible thinking helps ensure that we truly respond to markets, and not to our own fears and frustrations.

Further Reading:  Creativity and Finding Your Trading Zone

Monday, October 20, 2014

The Real Source of Trading Success

Thought you might enjoy this graphic I picked up from the web.  Admittedly, it's a bit extreme, but it captures something we all see in the trading world:  the allure of getting rich quick and the willingness of some to exploit that allure.  Nowhere is that more prevalent than in the world of day trading.

We know from research that persistent success at day trading does exist, and we also know that it is rare.  In a sense, that should not surprise us:  by definition, elite talent is rare.  What makes trading difficult is that, in many fields, we can make a living from our work even if we are not operating at elite talent levels.  In day trading, as well as other forms of trading, making a consistent living from trading *is* elite talent.

To illustrate some of trading's challenges, I ran a few numbers using SPY as my proxy trading instrument.  From 2012 to the present, SPY has gained a little over 60 points.  About half of those points were gained during overnight hours; half during U.S. day hours.  The traditional day trader has limited himself/herself to about half the directional opportunity by trading only during U.S. hours.

Should traders seek greater directional opportunity by extending the time frame, they will find that the correlation between overnight changes and day session changes in the stock market since 2012 has been -.01.  They might as well be totally different markets.  If the trader extends to more of a swing time frame, the correlation between today's price change and tomorrow's since 2012 has been -.02.  In other words, overall, what happens in the market during one short-term period offers no information about what will happen in the next period.  We like to think directionally, in terms of trends, but--overall--what we can extrapolate from current markets to future ones is quite modest.

I have tested many patterns in markets and can attest that a correlation between market predictors and future price change that exceeds .20 is something quite special.  Yet even that correlation implies that the predictors account for only 4% of future price movement.  Our error variance is very high relative to what we can predict, even for statistically significant research.

That, of course, leads some to create models of sufficient complexity that they will promise far higher levels of predictive accuracy.  As Derman notes, such complexity comes at the cost of fragility:  modeling the financial world is fundamentally different from the modeling of the physical world.  The laws of physics don't change readily.  The behavior of market participants does.  One of the better predictors of market bottoms in recent times was elevated volatility, particularly the "pure volatility" measure I have written about.  During this most recent market decline, volatility blew out:  what had been significant levels of volatility for calling market bottoms no longer applied to the new regime.  We can calculate the odds of a given backtest being overfit, and it doesn't take much in the way of complexity to get to that point.

So where does that leave us?  Simple patterns do not provide reliable profitability, breathless claims such as the above graphic notwithstanding.  Complex patterns are all too likely to be overfit, producing great backtests but failing in real time performance.  No, the answer is not to be simple or complex; the answer is to be different.  Of the traders I worked with a decade ago, fewer than 5% are currently trading and experiencing success.  In each case, they are doing something very different from what the standard trading books describe.  They have found sources of "edge" in markets that they have made their own, and they have been consistent in exploiting those edges.  

One trader, for example, came up with an ingenious method for identifying when trading in a particular asset was becoming highly crowded.  He then looked for indications of loss of price momentum and took the other side of the crowded trade, benefiting from the herd running for the doors.  A big part of his edge was that, if he didn't find the right patterns of crowding, he did not trade.  He only played the game when the odds were on his side.  

A very different trader at a financial institution obtained information from satellites that provided information about weather and crop planting patterns and used those data to predict yields for agricultural commodities.  When markets were mispriced relative to the new data, trades with an edge could be placed.

Still another trader found that market moves at certain times of day had more likelihood of reversing than at other times of day, as different participants impacted the market throughout the day.  By tracking the level of participation and movement and segmenting time differently from other traders, he was able to identify profitable trading patterns.

In the trading world as in the business world, "me too" is not a formula for success.  The successful entrepreneur is the one who operates with a vision, doing something differently--and better--than rivals.  It's not enough to plan your trade and trade your plan.  Those plans have to be grounded in insight and unique information if they are to lead to ongoing success.

Further Reading:  Keys to Day Trading Success

Sunday, October 19, 2014

New Views to Start the Market Week

*  Here's a really excellent look at the week ahead and the week just passed from Dash of Insight.  Very thoughtful presentation.  Also check out the "best of" from Jeff's site.

*  Why stock markets crash and other excellent links from the week past from Abnormal Returns.

*  If small caps come back, these might provide particular opportunity.

*  Thanks to a savvy trader from SMB for pointing out this article on why women are better decision makers than men, particularly under stress.

*  This looks like a particularly promising book on momentum trading/investing. Also check out this research paper on profitable momentum strategies for individual investors.

*  Interesting case for making fixed income part of a portfolio strategy.

*  While much of the trading world focuses on the epidemic in West Africa, the situation in Greece looks particularly problematic.

Have a great start to the week!


More Bottom Up Stock Market Indicators and How to Use Them

The previous post looked at three market measures that assess strength vs. weakness from the bottom up; that is, by looking at all the components of a stock index, rather than the time series for the index itself.  Above we see three additional bottom up measures that I update daily and below I will describe how I utilize these.

The top chart displays what I call the Momentum Curve (data obtained from the excellent Index Indicators site).  This enables us to see the percentages of stocks in the SPX average that are trading above moving averages of varying lengths across the past five trading sessions.  What we can see most recently is that the percentages of stocks trading above their 3, 5, and 10-day moving averages bottomed out ahead of the recent market low and now have moved smartly higher, even as we remain oversold vis a vis the longer-term averages.  We typically see the reverse pattern at cyclical market peaks, where the percentages of stocks above their shorter-term moving averages head downward in advance of an ultimate price high.

The middle chart, also drawn from data available from Index Indicators, is a multiperiod measure of breadth specific to the stocks in the SPX average.  Specifically, we're looking at the sum of new highs minus new lows over a 5, 20, and 100-day basis.  The composite new lows bottomed most recently on October 13th, a few days prior to the recent price lows.  The composite new highs topped well before the most recent price peak in September.

The bottom chart, drawn from data available on the very useful Barchart site, is a running total of the number of stocks crossing above their 20-day moving averages minus the number crossing below those averages.  This covers all common shares across the major exchanges, which makes it a broader breadth-related measure.  Most recently, the cumulative number of crossovers bottomed on October 1 and based for a while, as other breadth measures continued lower.  The cumulative number of crossovers very commonly peaks well ahead of price during cyclical topping periods, as occurred prior to the September high.

New traders often look to indicators such as these for specific buy and sell signals.  My experience is that analyzing any single indicator for such guidance is less helpful than synthesizing the information across multiple measures.  Across a series of well-constructed measures that examine different portions of the market across differing time frames, common themes will emerge that tell a story.  It's that story that ultimately provides the basis for useful trade ideas.  The story is less about what markets *should* be doing based upon share earnings, economic fundamentals, or esoteric numerological schemes and more about concretely assessing whether the individual components of indexes, on balance, are trading stronger or weaker over time.  The best way to use these indicators, I find, is to take the time to create a narrative that makes sense of all the observations--and then generate an alternative narrative suggested by data that don't fit into the original story.  Having that "Plan B" narrative is very useful in staying flexible and avoiding confirmation biases regarding your primary view.

As with the other measures, I will be updating these periodically to keep up with evolving market conditions.

Further Reading:  More Posts on Indicators and Patterns

Saturday, October 18, 2014

Looking at Technical Indicators From the Bottom Up

Typically, if we want to use a technical indicator to gauge the strength or weakness of a given market index, we will simply apply that indicator to the price series for that index.  Suppose, however, we took a different approach, from the bottom up, rather than the top down.  Suppose we applied the indicator to every single stock within the index and gauged strength and weakness via the breadth of individual buy and sell signals.

Above are three charts that take a bottom up view of the recent market.  (Data obtained via the excellent Stock Charts site).  The top chart will be familiar to readers; it's the balance of NYSE stocks trading above their upper Bollinger Bands vs. below their lower Bands.  The middle chart utilizes the Parabolic Stop and Reverse (SAR) indicator developed by Welles Wilder and takes the number of NYSE stocks at the close each day giving buy vs. sell signals.  The bottom chart shows the number of buy vs. sell signals for each NYSE stock for the Commodity Channel Index (CCI)

Note that there is a family resemblance among the charts, but differences also.  Each indicator operates with different parameters on different time frames.  The links in the paragraph above explain how each indicator is constructed and how buy and sell signals are derived.  I think of each of the indicators as a prism through which we can see the breadth of strength and weakness across the entire market.  No one prism provides a perfect signal all the time, but when you see common patterns among the prisms, it's generally worthy of attention.

As a rule, we see peaks in the numbers of stocks giving buy signals ahead of cyclical peaks in the broad market (SPY) and we see peaks in the numbers of shares giving sell signals ahead of cyclical troughs.  You can see how the indicators peaked--but stayed positive--prior to the recent September market top and how they have troughed ahead of yesterday's rally in stocks and have now turned positive.

We have many ideas about whether markets *should* trade higher or lower, but bottom-up measures like this show whether they are actually strengthening or weakening.  I will feature regular updates of the indicators for those interested in following the signals.

Further Reading:  Breadth Volatility and Market Cycles

Friday, October 17, 2014

What Market Breadth Has Been Telling Us Lately

Here are two updated views of stock market breadth.  Recall that it was waning breadth that gave us a heads up on the recent market weakness.  What we're now seeing is the reverse.

The top chart monitors all common stocks traded on the major exchanges making three-month new highs vs. three-month new lows.  We can see from the chart that this decline has been much broader than ones previous.  New lows hit their maximum level so far on October 10th and then held slightly above that level at the market low on October 15th.  With yesterday's buying interest--my Buying Power measure hit its highest level since 2012 yesterday--new lows dried up and so far in premarket today we're seeing continued buying interest.  This suggests a momentum low has been put in place.

The second chart tracks the number of NYSE issues closing above vs. below their upper/lower Bollinger Bands, which I refer to as the Bollinger Balance.  Note again the recent persistent weakness, the failure to expand the number of shares closing below their bands at the recent lows, and now the drying up of that weakness.

As I've stressed in the past, it helps to think of topping and bottoming as processes, not as fixed points on a chart.  Markets make bottoms when they hit a momentum low, bounce, and then subsequent weakness occurs with less downside momentum and volatility and fewer shares making new lows.  It would surprise me if this bottoming process is over--a general rule is that more extensive declines undergo more protracted bottoming--but a continued drying up of weak breadth is something I'll be on the lookout for to find opportunities to scoop up some value.

Further Reading:  Finding Opportunity in Stock Market Cycles

Thursday, October 16, 2014

Why This Market is Moving So Fast and Far: The Explosion of Pure Volatility

How big was the volume during yesterday's decline?  Apparently large enough for even the dark pools to turn away customers!  I show about 380 million shares traded for SPY, compared with an average of 84 million from June through August of this year.  What that means is that entirely new sets of participants have been active in the marketplace, creating a complete change in market movement.

We can see that in the chart of pure volatility from late 2013 to the present.  I introduced the idea of pure volatility in an earlier post and have since refined it.  It is a measure of the amount of price movement we get for a given amount of volume traded in the ES futures contract.

What is evident from the chart is that pure volatility has gone through the roof.  We are not just getting a lot more volume; that volume is moving markets more than twice as much as they did at our market highs.  The reason for this is that the added market participation is directional in nature, so that moves find more buyers and sellers.  Think of e-Bay auctions for a very hot item whose popularity has gone viral.  The price movement would be much greater than for items that are not popular.

I will be watching volume and pure volatility closely from here, as we will need to see normalization of those numbers as part of any bottoming process.

What Volatility Means for Your Trading Psychology

Ah, if it were only that easy!  I took a look at the average true range for the past five trading sessions in SPY.  It was almost 2.1%.  By contrast, at the July peak, the five day average true range was almost .53%.  So basically, in terms of realized price movement, we have quadrupled volatility in a span of about two months.

What does that mean for trader psychology?  Imagine quadrupling your trading size over the span of a couple of months.  How might that impact your trading?  By placing a magnifying glass on the dollar size of your P/L moves, it accentuates the potential psychological impact of wins and losses.  A random streak of four losing trades on quadruple size could wipe out a substantial portion of prior profitability.  Conversely, random large winning trades could convince a trader of his hot hand and lead to overconfidence and overtrading.

When volatility increases by several orders of magnitude, not only are the moves in the direction of the trend accentuated, but also the moves against the trend.  That means it's very easy to have a trade move 1% against you in minutes, where it would have taken a few days for such a move to materialize in the slower, low volatility market.  If your trading size is the same in a high volatility market as a low volatility one, you have effectively magnified your size by several times.  That does not mesh well with many people's risk tolerance.

The reason this is important is that spikes in volatility associated with intermediate-term market pullbacks are more common than recent experience would suggest.  Check out this very helpful blog post from Philosophical Economics.  Since World War II, we have seen 10% market corrections about 20% of the time and 15% corrections over 12% of the time.  This ensures that buy and hold investors will have meaningful drawdowns, and it also guarantees that career short-term traders will experience spikes in volatility.  Such spikes can represent meaningful opportunity, but only if one's emotional volatility is not tied to that of the market.

Further Reading:  Volume and Volatility

Wednesday, October 15, 2014

A Fresh Look at Small Cap and Midcap Stocks

A while back, I noted that the bull market was over for the majority of stocks, observing the relative weakness of small cap and midcap shares.  After quite a bout of weakness, I'm now seeing the emergence of the opposite situation:  the number of small cap and midcap shares making fresh 20-day lows has not been expanding, even though we've seen recent price weakness and a new low for the large cap Dow average.  (Credit to Index Indicators for the charts).

Meanwhile, the equity put-call ratio over the past 20 days has exceeded 1.0, levels seen during the May-June, 2010 correction; the August-September, 2011 break; and the decline of May-June, 2012.  All were good intermediate times to be buying stocks; all were also choppy, stairstep declines with extended periods of basing that included sharp rallies as well as price erosion.  While my Selling Pressure measure has been seeing new lows lately, that pressure is not translating into more stocks trading below their 20-day moving averages, either among large caps, small caps, or midcaps.  That is very much on my radar near term.

Apps for Improving Your Concentration and Productivity

Between following markets, engaging in chat with fellow traders, and keeping up with news sources and social media flow, it is difficult to maintain a high quality of concentration during the day.  When we are distracted, we are more likely to make decisions on a reactive basis, without the mindful planning that comes from being in a zone and activating our brain's executive capacities.  Here are some resources designed to improve your focus:

Lift is an app that helps you track your goals, participate in structured plans for everything from diet to meditation and yoga, and connect with people with similar goals.  

*  Check out these online apps for improving focus curated by Lifehack.  These include tools for blocking unwanted online content when you're wanting to concentrate; create to-do lists that can be accessed from all your devices; and engage in brain games that train your concentration.

Lifelogger is a wearable video device that enables you to capture life events as they are occurring.  With 8 hours of video storage and wi-fi capability, it allows you to stream whatever you are seeing to others.  It is promoted as a tool for augmented memory, as anything--from market reactions to news to how we traded the recent breakout pattern--can be captured forever.

*  Here are 10 more apps for sustaining a calm and focused mind, including a mind-mapping tool for capturing your ideas visually and apps for brain training, meditation, mindfulness, and stress management.

Focus @ will is an interesting app that creates the right musical environment to enable people to concentrate on their work.  Here's an explanation of the science behind the tool.

Further Reading:  Proven Methods for Building Happiness

Tuesday, October 14, 2014

How Worried Are Investors About This Stock Market?

There are many ways of measuring investor and trader sentiment about the stock market:  put-call ratios, surveys, measures of breadth, etc.  One interesting measure is to see how actively people conduct searches on a topic via Google.  It turns out that a measure of worry about market related topics can be an effective predictor of prices.  Above, we see the chart for searches conducted on the topic of "bear market", as captured via Google Trends

Notice the spikes in searches beginning in January, 2008, before the worst of the bear market had taken hold.  We also see smaller spikes in August through October of 2011 and still smaller ones in April-June of 2013, and this month so far.  As the stock market has become less volatile since the GFC, we see lower volatility in the time series of searches for "bear market".  Note Google's extrapolation to forecast search activity for 2015:  it also remains tame.

While we have a blip higher in bear market searches, those are so far nowhere near as high as the searches in 2011 and certainly not as pervasive as in 2008.  Investors are not exactly complacent:  October's search level is 24--higher than any other month of 2014--and the month is only half over.  Still, the level of bearishness by this measure is consistent thus far with what would be seen in a bull market correction, not an outright bear market. 

Further Reading:  Equity Put-Call Ratio

Monday, October 13, 2014

Unusual Perspectives to Kick Off the New Market Week

*  With global economies slowing, it's interesting to put recent international equity markets in perspective.  While the major U.S. averages have largely surmounted their highs of 2000 and 2007, many international bourses show weak returns over that period.  We typically refer to the Great Financial Crisis in the past tense, but the lingering impacts are still making themselves felt globally.  Credit to Abnormal Returns for linking this excellent piece on the relative state of economies around the world, as well as linking this very interesting analysis of returns from low volatility stocks.

Eye-opening look at the results of analyses that can be done *after* a trading system is tested and optimized. 

*  Why do stock markets crash?  An interesting quant look that suggests the current environment is quite different from that of 1987.

Why it's absolutely essential to adapt, and a great example in the financial advisory world.

Have a great start to the week!


Sunday, October 12, 2014

How Goal Setting Helps Performance

A while ago, I wrote about what works in goal setting, according to the research of Locke and Latham.  One of their more interesting findings is that there is a positive, linear relationship between goal specificity and difficulty and performance.  When goals are specific, they direct and energize behavior far more effectively than when they are vague.  Difficult, challenging goals inspire greater efforts--and hence greater attainment--than easy goals.  If we think of goals as representing visions of the future, it is the most concrete and stirring vision that will bring out the best in us.

Key to the achievement of goals, according to the researchers, is self-efficacy.  People are much more likely to buy into and pursue goals if they believe themselves to be competent to reach those goals.  This is why the best goals embrace our strengths:  they represent ways in which we can leverage the best of who we are.  

Sometimes, people have gone through so many setbacks that they lack the sense of self-efficacy.  They come to believe that they can never reach their goals.  In that case, setting distant, difficult goals will not be helpful; the focus has to be on achieving small wins.  A series of small goals that are achieved provides multiple experiences of efficacy.  When you win, win, and win--even with relatively small goals--the boost to self-efficacy can inspire larger goals, which energize even further.  It may seem too daunting to lose 30 pounds for a heavy person, for example.  By focusing on losing one pound per week by eating smarter, it is much easier to create experiences of goal achievement, which then fuel the larger goal.

Where traders often fall short is not in goal setting, but in the feedback process following the pursuit of goals.  If a goal is not reached, something went wrong.  It is important to figure that out and make corrective efforts to pursue the goal in a new way.  Goal setting with feedback provides deliberate practice, because the feedback hones our efforts to reach goals.  It is very common in my experience that, when traders keep a journal, they write about their problems, but do not take the next steps of translating problems into challenging, specific goals.  Even when they do outline such goals, it is rare that the goals are revisited with concrete feedback that is used to guide future efforts.

Too much of life occurs in auto-pilot mode.  We take life--and markets--day to day, without an overarching plan and with no deadlines.  We act as if experience itself will teach us all we need to know, when it is guided experience--experience informed by goals and feedback--that gets us where we want to go.  One of the most important functions of a trading journal is as a chronicle of our goals, feedback, learning, and achievement.  We deliver our best efforts when we're on the path to becoming our very best.

Further Reading:  Setting the Right Goals