Tuesday, July 31, 2007

Retracing the Trading Range: Ideas and Links

* Ranges and Retracements - Click on the above chart of the ES futures and you can see relevant ranges, breakouts, and retracements. When working with a new trader, I start with Market Profile theory and the understanding that ranges represent consensus regarding value and that breakouts from ranges represent repricings of value. The key is seeing when breakout can be sustained and when they cannot--and also seeing ranges across differing time frames. Tuesday's move was a retracement of the Friday/Monday range, as we could not sustain a move above the Friday highs. I'll be using my Twitter comments to help highlight ranges as they unfold.

* Dangers of Illiquid Assets - Excellent article from David Merkel and Seeking Alpha regarding the problems of hedging illiquid assets with liquid ones. See also the link re: the dangers of financing illiquid assets with debt, especially when debt covenants are threatened.

* More Fine Reading from Kirk - The Kirk Report covers a range of worthwhile articles, including 20 things that could go wrong in this market and 5 reasons not to panic.

* Charts Worth Watching - Trader Mike notes critical support levels for indices and the carnage in hedge fund stocks. See also Mike's updated links re: housing and tougher lending conditions for hedge funds.

* Check Out Abnormal Returns - Excellent perspectives on who's winning from the recent market meltdown and money waiting to pounce on the losers. Especially take a look at their roundup of academic finance research, much of which is relevant to the current market.

* Want Trading Systems, Free and With a Track Record of Success? - The StockPickr systems are laid out for active traders, with specific system trades of the day. Truly a unique offering on the Web. My other favorite free resource for stock picking is the MSN StockScouter.

More on Housing and Credit Woes - The Big Picture lays out how hard we've fallen. Mish tracks liquidity crunch at mortgage firms and an avalanche of leveraged loan supply.

Keeping Posted at Month's End

* Emotions Are Universal - This is an excellent article about the fear that has gripped the credit markets, particularly in the debt instruments of the investment banks. What is important to note, however, is that the small, retail trader is not trading these instruments! It's the investment banks themselves that make markets in the derivatives that are being shunned. Professional traders have access to greater information flows and financial resources than the average trader, but they seem no less affected by fear and greed. It seems almost quaint that, just a year or two ago, I was hired by two investment banks to help their traders. The problem? The firms wanted them to "take more risk". Like I said: fear and greed.

* Tightening Emerging Markets - First China, now it's India raising the reserve limits of banks in an effort to curb inflation. With India, unlike China, there's also a rising currency to contend with, which will cut into export earnings. (Although traders are also betting on an more expensive Yuan). Can these economies achieve soft landings? The history of runaway markets such as China's doesn't leave much room for optimism. While we've seen risk aversion in the credit arena, that hasn't been the case in emerging market equities: Shanghai's "A" index is at an all-time high and India's Sensex 30 is not far off its peak. At some point, tightening monetary authorities and exuberant stock markets are going to butt heads. Not yet.

* Connect the Dots - Let's see: Russia is making unprecedented arms sales to Iran. The U.S. is raising its military aid to Israel by 25% and pursuing billions of dollars in arms sales to Saudi Arabia and the Gulf States. The U.S. is pursuing a missile defense system at Russia's doorstep and Russia is abandoning treaties to develop new missile systems on its own. Methinks these things are not unrelated.

* The Primed Mind - This excellent NY Times article outlines research on how our brains respond to subtle stimuli, all beneath the level of our consciousness. How many impulsive trading decisions are made simply because we are primed to act by events that have little to do with markets or trading edges? One advantage to having clear trading plans and rules is that they provide a focus for action apart from extraneous priming.

Monday, July 30, 2007

When Traders Lose Confidence - Part Three: Structuring Your Experience

In the first post in this series, I suggested that a first step in regaining confidence is establishing perspective on the reasons for trading problems. The second post emphasized the role of self-talk in confidence and ways of changing one's internal dialogue. This final post in the series explains how we can structure our experience to build confidence.

As background for this post, I strongly recommend revisiting the post on the Devon Principle. A major theme of that post is that everything we do in life is a mirror. We experience ourselves through our life activities and the feedback that these provide.

I find this to be a profound psychological principle. What we call the "self"--how we experience ourselves--is the result of all that we internalize from people and events. If we are in loving relationships, for example, we experience ourselves as worthy of love. If we are in abusive relationships, we probably won't feel worthy and, amazingly, may even seek out similarly unhealthy relationships.

Because we are always having new experiences--and can internalize these--we are always, to some degree, remaking who we are. When I went through my emergency surgery in a very unfamiliar social environment (one in which I was the only native English speaker), I experienced people of different cultures in a very new context. Afterward, neighborhoods in that area that I might have previously regarded as "scary" now struck me as familiar. I recently revisited one of those neighborhoods on a trip to NY and had dinner without giving it a second thought. I felt confident walking the streets, because the social environment was no longer foreign to me.

Every activity we engage in provides us with feedback about ourselves: our abilities, how we're perceived by others, our character. In selecting what we do, who we do it with, and how we do it, we can structure our experience to create mirrors of success and mastery. When I first began writing, I chose to write articles for minor academic journals. The editors had more time for me than those at the more popular, top journals, and I gained valuable feedback. The experience of publishing for those journals gave me the incentive (and courage!) to pursue the more selective publications and that, in turn, led to the first of several books and many book chapters.

I did not start out as a confident writer; the process provided me with experiences of success that, over time, stuck with me. Had I structured my experience differently--pursuing topics that didn't interest me, that I didn't know much about, or that weren't relevant to the editors--the resulting failure and frustration would have led me to a damaged experience of myself as a writer.

Experience is our psychological food; it's vital that we feed ourselves well.

But what does it mean to structure our experience and feed ourselves well psychologically?

* Relationships - We are most apt to feel special if we're special to others. Nothing is as damaging as significant relationships that lack significance;

* Learning Curves - By setting doable goals, identifying and expanding strengths, and receiving feedback from others, we internalize a growing sense of mastery;

* Trading - By managing risk prudently, we give ourselves time to traverse our learning curves--and we avoid the damaging impact of severe losses;

* Exercise - We cannot experience ourselves as dynamic and energetic if we exert little dynamism and energy. Exercise provides us with our most immediate, physical sense of self;

* Doing the Right Things - When we act with integrity and see the impact of our behavior, we internalize the sense that we are good and worthy. We are most likely to find success if we internalize a deep sense that we deserve it.

The reason I'm effective as a psychologist, I believe, is not because I'm all that more educated than others or utilize such better techniques. Rather, I have an uncanny ability to see the best in people; to push aside the problems of the moment and see through to qualities of greatness that are present within most of us, however fleetingly. It's because I see the best in people that I can be a good mirror--and help others see in themselves what they otherwise cannot appreciate on their own.

Confidence comes from the right kind of mirroring--and we can choose our mirrors. Look at each day's activities; each week's schedule. How does each activity make you feel about you? It's how you structure those activities that will either contribute to self-esteem or rob you of the confidence that could be yours.

Ideas to Start a Volatile Market Week

* Tracking the Bear - I've updated the Trading Psychology Weblog; note especially the revised chart of the Cumulative NYSE TICK taken from the Weblog, which I've been tracking without an adjustment (i.e., adjusted to a zero mean). The TICK Line shows the persistent hitting of bids among NYSE stocks and has tracked the recent market weakness quite well.

* VIX Perspectives - The market is currently trading at 60% above the level of the 50-day VIX average. That has occurred on only 20 occasions since 2000 (N = 4350). All of those occasions have been up 30 days later in OEX by a whopping average of 6.43%. The track record was much more mixed from 1990-1999 (16 occurrences; 9 up, 7 down). Rennie Yang of Market Tells finds positive near-term returns following two days of 10+% consecutive gains in VXO; his latest newsletter is worth checking out for other patterns as well.

* Still Bullish - David Korn notes in his newsletter that the top 5 market timers followed by Hulbert are still bullish on this market. My own findings have been that weak market days tend to cluster, meaning that an oversold market can get more oversold before rallying. That makes the near term dangerous. Still, when you look at the specific occasions when we've been 60% above the 50 day MA in VIX, it's clear those have been good longer-term buying opportunities--even during the 2000-2002 bear market. Those dates include March, 2007; June, 2006; July, 2002; September, 2001; October, 2000; September, 1998; October, 1997; April, 1994; and August, 1990.

* How to Learn - A thought-provoking post from the Sharp Brains blog examines the stages of learning and how we can learn to learn--a topic very relevant to trading performance. See also the interesting post on building cognitive reserve through enriched learning.

* Using Visualization to Change a Behavior Pattern - Interesting example from the 59 Cedar Street blog and a vivid example of the problems faced by many discretionary traders trading off charts.

* Tracking Trading Results to Improve Performance - Here's a fine example from Stephane and the The Chart Strategist blog. He has a grading strategy for reviewing his trades and compares his performance to goals that he sets. Excellent.

* Investing Lessons - The Straight Stocks blog offers contributions from recognized bloggers re: sound investing practice. Nice collection of resources.

* The Very Long-Term Perspective - The Market Rhymes blog examines what happens following record bull market decades.

* More Links to Come Later Today!

Sunday, July 29, 2007

Are We Making A Bottom in the Stock Market?

This has been the most common question asked of me by traders over the weekend. There is both the sense that we could go much lower in a washout (a "Black Monday" scenario) and that we could be seeing an important bottom in the making.

When we get to market junctures such as the one at present, I like to consult the historical record. While the present and near-term future is not guaranteed to follow the past, I know of no better guide than actual market experience. What has happened in the market after we've had similar bouts of selling?

For this investigation, I looked at the past ten trading sessions in the NYSE and found that, if we measure volume in declining issues as a proportion of volume in both advancers and decliners, then we see that there has been an unusual concentration of volume in the falling stocks. Indeed, over 70% of volume in the past ten sessions has occurred in declining stocks.

To give a bit of perspective on this one-sidedness, we've only had 75 other occasions since 1960 (!) in which 70% or more of the volume has been in declining stocks over a two-week interval. That is out of almost 12,000 trading days. Stated otherwise, the current market is in the top 1% of all market occasions since 1960 for bearish concentration of volume.

Let's take a look at the most recent market occasions and what happened afterward:

The most recent occasion of bearish concentration of volume lasted for 2 days in July, 2002. The S&P 500 cash market ($SPX) was significantly higher five days later by about 10%.

We also had a series of four days with very bearish concentration in September, 2001 following the 9/11 terrorist attack. $SPX declined for several days by about 7% following the first such day, before ultimately rebounding over 10% in the next two weeks.

In August, 1990 there was a single day in which over 70% of volume was concentrated in falling issues. The S&P 500 Index was up more than 5% over the next two weeks.

For a series of three days in October, 1987--the infamous market drop--we had a similar concentration of volume in falling issues. After the first instance, the market dropped about 20% further before eventually rising over 13% in the next two weeks.

For a single day in September, 1981, we saw an extreme negative volume concentration. The market was higher by over 7% in the next two weeks.

Similarly, we had a single occasion in March, 1980; the S&P 500 Index was down by about 3% over the next five trading sessions and down less than a percent two weeks later.

Two occasions in October, 1979 (the second "October massacre") led to an initial drop of about 1%, followed by a 1% rally over the next two weeks.

During the first October massacre in 1978, there were 8 straight days with heavy negative volume concentrations over the prior ten days. The market dropped more than 4% following the initial occasion and could not break even ten days following the last occasions.

In late July and early August, 1975 we had four days in a row with the bearish concentration. The market fell 2% following the initial occasion, but was down two weeks following all instances.

August, 1974 saw a string of six negative volume concentration days and late June/early July of that year had seven such instances. Both times the market initially dropped 3-5% over the next week, before eventually rallying more modestly.

If we look across all 75 instances, the market was up 41 times and down 34 after a five day period for an average gain of .87%. When we look three weeks out, however, the market was up only 36 times and down 39 times, for a subnormal gain of only .08%.

Many of the weak markets bounced before retracing those gains, but we also find many instances in which weak markets became significantly weaker before putting in a short-term bottom. Out of the 75 instances of high downside volume concentration, 51--about 2/3--traded lower some time within the next 20 trading sessions. A total of 26 of the occasions *never* traded higher within the next 20 sessions.

That having been said, if you know your market history, you know that the vast majority of these occasions occurred relatively late in bear market moves. Most of those market occasions were good long-term buying opportunities, short-term weakness notwithstanding. Investors would have done well to buy stocks in 2002, 1990, 1987, 1981, etc. Most of these markets were nicely higher one year later.

That tells me that the current weakness offers risk as well as reward for shorter timeframe traders, but also is a heads up for investors seeking value. The concentration of volume in falling stocks suggests that good issues are being trounced with the bad. This creates opportunity in the long run, even as the historical record shows uneven performance near-term.

Saturday, July 28, 2007

How Trading Causes Psychological Problems

The assumption of practically every trading coach and psychologist is that psychological problems and biases can hamper sound trading. That happens of course and is well documented in the behavioral finance literature. Less discussed is the reverse: how trading can contribute to psychological dis-ease.

It's not surprising that this topic is rarely discussed. It's hard to believe that promoters of trading conferences/workshops, educators connected to brokerage houses and software firms, and coaches that assist people with trading would see much upside in promoting the view that trading causes emotional disequilibrium.

My email inbox has seen quite a few notes from traders in the past few days, as the market volatility has taken a toll on their accounts and on their psyches. Traffic on my blog routinely goes up during periods of high market volatility; it soared in late February and early March and is on track this month to set an all-time record thanks to the last few days.

The reason for this, I believe, is that volatility upsets the normal expectations of traders, as markets move more and faster than usual. In the midst of the uncertainty and discomfort of the unknown, traders seek information and turn, among other places, to the blogosphere.

I recently updated the Trader Performance page with a post on non-stationarity in markets and a theory regarding market participation. I think it's an important post, as it offers an explanation for why volatile markets are qualitatively different--not just quantitatively so--from other markets. The difference between trading a high volatility ES market and a low volatility one is every bit as profound as the difference between trading the ES market and trading, say, natural gas futures.

That is rarely if ever acknowledged. If markets become different creatures under varying conditions of volatility, it means that many trading signals, indicator readings/patterns, stop loss levels, and profit targets may become at least temporarily obsolete. And therein lies the cause for distress--and why I receive so many emails during these volatile times: just when the market becomes most enticing (greatest movement) and most risky (greatest opportunity for adverse movement), it behaves differently. What may have worked under conditions of moderate volatility no longer works in the high volatility environment because--as my Trader Performance post notes--a different class of trader, trading a different way, is dominant at those high volume/high volatility occasions.

Let's look at the objective evidence. The above chart takes the absolute value of market movement in percentage terms every 15 minutes for the ES futures (close to close) and sums the values for the past day. This provides a measure of the total market movement (excursion)--up and down--during the day. This is a true, price-based measure of volatility. What we see is that the recent values exceeding 7% are seven times higher than the values we saw in 2006 and almost five times higher than the levels seen just a few weeks ago.

If we define an intraday trend as a movement of a given amount in a given period of time, we can see that the volatile markets of late have offered many more short-term trending moves than prior markets. A discretionary trader who has developed a feel for normal markets--and their intraday reversals--now finds that the market moves far further before reversing and these reversals themselves travel much further, much faster. It's as if a slow-pitch softball player suddenly had to face a baseball pitcher: the game seems the same, but everything from the batter's perspective has changed.

Moreover, the recent period of hugely different movement is not unique. We can see from the above chart that the vast amount of market days have moved a total of 3% or less in their total excursions. At times, however, markets have suddenly moved twice that amount or more.

Consider further: From March 15, 2006 to July 19, 2007, the average 15-minute period in the ES futures traded 37,071 contracts and there were an average of 1893 trades. The average high-low range for each 15-minute period was .17%.

Since July 19th, however, the average 15-minute period in the ES futures has averaged 79,676 contracts and there have been an average of 4963 trades. The average high-low range for each 15-minute period since July 19th has been .34%.

In short, we've seen more than a doubling of volume and trades and a doubling of price movement.

If we just look at the market since July 26th (the last two days of trading), the average 15-minute volume in the ES futures has been 106,391 contracts, and there have been an average of 7418 trades during each period. The average high-low range for each 15-minute period has been .51%: three times the average from the sample going back to March, 2006.

What would happen if you took a golf player and made him play on greens that were three times as fast as normal ones? What would happen if you took a racecar driver and had him compete on a course at three times his normal speed? What would happen to air traffic controllers if planes began moving at triple speed?

They would lose their feel for their work. They would perform poorly. They would become distressed.

Volatile markets compress time. What normally happens in a day can happen in an hour. Once time compresses, performance activities become different. That's why lightning chess is a different game from standard tournament play.

When you have many more traders in there--professional traders who are moving size--markets become faster and traders become like the air traffic controllers in the example. They cannot keep up; they become disoriented. Trading, which had been a source of mastery, now causes discomfort.

Of course, no one really makes radical changes in the surfaces of golf courses, the speeds of racecars, or aircraft speeds. Markets, however, change their speed continuously--and at irregular and unpredictable intervals. During one period, stocks may trade slow like Treasury bonds; at other times they are volatile like agricultural commodities.

Moreover, highly volatile periods are sufficiently rare that most traders have not experienced enough of them to develop a true feel for their movement. That is why such periods offer as much risk and danger as reward.

Is there an answer to this dilemma? I believe there is: as markets trade faster, traders can reduce their size and moderate their trading frequency, so that each trade and each trading day will not put capital at enhanced risk. That can give the trader sufficient time to adjust to the higher volatility environment and develop his or her feel.

If traders trade their usual size--and especially if they get carried away with the volatility and trade more often--they now place their portfolios at twice or three times the normal risk--maybe more. With the quicker and different movement, drawdowns become far more likely, and they can be deep. It's not at all difficult to lose as much in a single day as one would might ordinarily lose in a week.

Keeping statistics on your trading at low volatility times, moderate volatility periods, and high volatility occasions will tell you whether, in fact, your trading changes as a function of market movement. If your percentage of winning trades differs significantly under these conditions or if you see meaningful differences in the average sizes of your winning vs. losing trades, that will tell you that changing markets are changing your trading.

In markets, as in medicine, above all else do no harm. You can't win the game if you don't stay in the game. When markets change their trends and movement, give yourself time to adapt. Overtrading a volatile market without a good feel for what's happening is a sure path to ruin--and I have the emails to prove it.

Updated Psychology of Trading Resources

* New Book on Trading Psychology - SFO Magazine has come out with a book that is a collection of articles specific to trading psychology. I've written or co-written four of the articles, dealing with such topics as training new traders, diagnosing your own trading psychology problems, improving coping and resilience, and staying in "the zone". Other articles were written by Van Tharp (brief trader self-assessment), John Forman (coaching), Toni Turner (changing negative thinking), Mike Elvin (emotional intelligence), Denise Shull (role of the unconscious mind), and Linda Raschke (positive thinking). Nice overview of some of the thinking out there.

* My Other Psychology Resources - I maintain a collection of free articles on my personal site and Blogger keeps the archive of my TraderFeed posts on the blog home page. Altogether you'll find well over 1000 articles and posts. So how do you make your way through all that? Go to the Alexa site and, at the top of the page to the right of the area where you type in what you want to search, click on "Advanced" and you'll get to a customizable search page. Then type in on the top line the words you want to look for (such as "stress") and, where it says "Search within a site", type in the URL for the site you want to search (www.traderfeed.blogspot.com for the blog; www.brettsteenbarger.com for my personal site). You'll get a list of posts and articles that refer to the topic you selected. Technorati is also an excellent search site for blogs, with similar advanced searches.

* Trading Psychology Blogs - The Afraid to Trade blog combines market analysis and trading psychology; Dr. Bruce Hong brings his medical training to bear in his excellent Trader Psychology blog; Doug Hirschhorn, trading coach, offers his views on the Head Coach blog; Dr. Richard Peterson draws upon his behavioral finance and neurofinance backgrounds in his Stock Market Psychology blog and Van Tharp provides coaching insights from his Smart Trader blog.

Friday, July 27, 2007

Views on a Bearish Market: What Comes Next

* Five Weak Days - Over the past five trading sessions, declining stocks have constituted over 60% of issues traded on the NYSE. Going back to 1990, we've only had 69 such occasions. The market bias going forward in the S&P 500 Index ($SPX) has been bullish 5 - 20 days out. Indeed, SPX has averaged a gain of 3.21% when we look 20 days out (51 up, 18 down). That's much stronger than the average 20-day gain of .72% (2682 up, 1659 down) for the remainder of the sample. Among the dates with weakness most similar to the current situation have been 9/2001; 5/2004; 8/1998; 5/2006; 7/2002; 10/2002, 3/2007, and 4/1994. All were up 10 days later and most were good longer-term buying opportunities.

* Perspective From SentimenTrader - Jason Goepfert's excellent service notes that we had 23% of NYSE issues traded hit 52-week lows on Thursday, one of the highest readings in the past four decades. He notes bullish intermediate-term average returns going forward following such occasions. His commentary re: this market is worth reading.

* Perspective From Market Tells - Rennie Yang's fine newsletter notes that we've had 2 days in the past three in which 90% or more of the volume has been to the downside. This is rare, but has led to near-term market strength when it's occurred. He also notes favorable expectations following a jump in the VIX such as we had on Thursday. I also strongly recommend his commentary on the current market.

* My Commentary - When we were making new highs, I highlighted cracks in the market foundation. Now we're making new lows and the historical odds are shifting to the bulls. It doesn't mean we can't go lower; indeed, it's not unusual for high momentum bear moves to test their lows at least once and sometimes more than that. Nonetheless, the historical record suggests that we are entering a period in which it makes sense to start shopping for good stocks that have been unfairly beaten up during this period of risk aversion. It's when we start to see the market making new price lows with fewer stocks participating in the decline that I will become particularly aggressive to the buy side. As long as we see that risk-averse trade continue (Yen strength; money poured into Treasuries, lowering yields; weaker performance from small caps; weak NYSE TICK), I won't be bottom fishing for other than short-term trades.

* Recommended Readings on the Bear Move - Trader Mike, who had a great call on the market retracing its move to the bottom of its recent price channel, chronicles the technical damage to stocks. Charles Kirk posts a number of excellent links on the edge of this market move, including an eye-opening article on how mutual funds have been abandoning stocks lately. The Big Picture notes the shift in credit sentiment as a driver of this market correction. Abnormal Returns offers a number of views on the bear, including rising spreads on high yield bonds; credit market concerns and their impact, and a regime shift in portfolio management.

Thursday, July 26, 2007

NYSE TICK Distribution and a Bear Market Day

I'm writing this early in the afternoon on Thursday, July 26th. The S&P 500 Index has been down by over 50 points during the day thus far, making it one of the weakest days we've seen in quite a while. The chart above shows the distribution of the NYSE TICK during the day, with a blue, horizontal line at the zero level. That zero level has been a mean value for the TICK ever since the repeal of the uptick rule changed short sales and led to a downward shift in the TICK (reflecting the ability of sellers to hit bids).

You can see from the chart that the distribution of TICK values below the blue line is much greater than that above the line. That is also reflected in NYSE Advance-Decline figures that went steadily downhill over that period. Clearly, it is dangerous to go bottom fishing when you see large traders persistently hitting bids and keeping the TICK negative. Indeed, as I've emphasized in my intraday comments, selling bounces during such periods of risk aversion has been the best strategy of all.

The takeaway is that sentiment matters. A large move can get larger when sentiment becomes highly one-sided. Trying to anticipate a shift in sentiment risks catching the proverbial falling knife. Waiting for that shift to materialize and riding it while the other side is frantically covering positions is a far more promising alternative.

When Traders Lose Confidence - Part Two: Changing Your Self-Talk

Confidence is not something we have, like money or a car; it is something we do. Confidence is our appraisal of our capacities relative to the challenges we anticipate. Within the confines of our minds, we are judge and jury. We render the verdicts as to whether we are able to face reality as we perceive it. The emotional expression of those judgments manifest themselves as confidence--and more globally as self-esteem.

When we lack confidence, we have made an active judgment as to our ability to deal with a situation at hand. Sometimes, that is a realistic judgment. I do not at all feel confident in my abilities to perform mechanical tasks, such as fixing things, around the house. From an early age, IQ tests found me remarkably deficient in this area. My lack of confidence dampens any motivation I might feel to jump in and fix the leaky pipe in my bathroom. That is adaptive. I call a plumber, and the job is done right.

Other times, however, our judgments are based on faulty perception. Suppose I have two losing trades in a row, wipe out a week's worth of profit, and now am frustrated. I call myself an idiot and I start worrying that maybe I'll lose the month's gains. My negative self-talk is an expression of my frustration, but it is also a self-appraisal that leaves me feeling less capable of facing the market going forward. I become hesitant; I won't trade until I see the market set up perfectly. But it doesn't set up perfectly, and I miss the trade. That adds to my frustration and my negative self-talk. In such ways, slumps--both emotional and trading--are born.

Confidence can also be eroded by excessive expectations. If, in the back of my mind, losing is not acceptable, each normal loss in the market will lead me to feel that I have fallen short. I've worked with a number of traders who tell me that they can have four winning trades and one loser and will focus on the loser. That perfectionism is not a drive to achieve (though it often masquerades as such); it, too, is an expression of frustration. The result is that we can turn winning performances into psychological losers by emphasizing shortcomings at the expense of strengths.

The bottom line is that how you process information relevant to your performance will impact your level of confidence. The first question to ask when you're experiencing a loss of confidence is: Should I feel confident? If the market is not behaving normally; if you don't identify a clear edge to your trade ideas, perhaps a lack of confidence is realistic and a worthwhile signal to stay out of the market until you have the advantage.

If, however, you find yourself lacking confidence at the times you most need it and should have it, then you want to get into the mode of thinking about your thinking. Keeping a journal of daily situations, how you're thinking about them, and how you're feeling is an excellent initial step. That will enable you to identify patterns of negative thinking that may be eroding your sense of confidence. In my Psychology of Trading book, I refer to this as "taking your emotional temperature": every so often just asking yourself: "How am I talking to me?" If it's not in a way that you would talk to a best friend or loved one, you know that it's time to change the self-talk.

The key to changing the self-talk is to become aware of when you're doing it. Most often, the negative talk is automatic. Journals are effective because they force us to reflect on our thinking and interrupt those automatic patterns. Similarly, I've had great results working with traders who talk their thoughts out loud into a tape recorder and then play them back. It's an excellent way to become aware of your thinking, stand apart from it, and break the flow.

Yet another strategy is to go through guided visualizations of challenging market scenarios while you're calm and focused (before trading starts) and then mentally rehearse the self-talk you'd like to engage in during those situations. This helps to build new, positive patterns of self-talk.

The key to all these strategies is repetition: you're training yourself to process information in new ways, and such training requires practice. At AA, they encourage new members to attend 90 meetings in 90 days. "Bring the body and the mind will follow," is the slogan. Repetition is the key to internalization. Engage in a desired behavior pattern 90 times over 90 consecutive days and it is likely to become part of you.


* Using brief methods to become your own trading coach.

* In the Enhancing Trader Performance book, Chapter 8 details cognitive strategies for changing self-talk, including the use of journals.

* This post contains links to self-help articles on my personal site.

Wednesday, July 25, 2007

When New Lows in the Stock Market Explode

I notice that we made over 1500 fresh 65-day lows across the NYSE, NASDAQ, and ASE on Tuesday. Since 2004 (N = 858 trading days), that's been a pretty rare occurrence. Interestingly, following the 10 occasions in which we've exceeded 1500 new 65-day lows, the S&P 500 Index (SPY) has been up five days later all 10 times, by an average of 1.00%. By contrast, the average five-day gain for the remainder of the sample has been .17% (473 up, 346 down).

Nor have superior returns following an explosion of 65-day highs been limited to a short time horizon. When we look 30 days following the days in which we've had more than 1500 new 65 day lows, SPY has been up by an average of 4.28% (9 up, 1 down). Even when we relax the criteria and examine all occasions in which we've had more than 1000 new 65-day lows (N = 39), SPY has been up 30 days later by an average of 3.26% (35 up, 4 down).

In short, declines such as the recent pullback have been excellent opportunities to step up to the plate and buy stocks. It's been when no one has wanted a broad range of issues--pushing many of them to multi-month lows--that investors have found relative value.

When Traders Lose Confidence - Part One: Gaining Perspective

One of the questions I first ask traders who are going through a drawdown is "Were you wrong, or were you trading poorly?" It's a key question. There will always be risk and uncertainty in markets. Even the best traders I've worked with at the top firms go through strings of losing trades and losing periods of time. A losing trade is not necessarily a bad trade. Sometimes the odds can be with us and we can lose the bet. Sometimes we're just wrong.

That is different from trading poorly. Trading poorly means that our process was incorrect, not just our idea. We sized the position too large; we ignored our stops; we overtraded a slow market.

The key, whether we're wrong or trading poorly, is to gain perspective by transforming downturns into opportunities. If you've been wrong, you may have an opportunity to reassess the market and revise your ideas. Many times wrong trades lead me to realize that the market is stronger or weaker than I realized, and that sets up some very good trades.

If you've been trading poorly, you have an opportunity to revisit periods in which you've traded well so that you can get back to basics and work on becoming more consistent with your strengths. This is where trading journals can be invaluable: they keep you in touch with what you do well and help you build on those strengths. It is at those drawdown times that you most need to be reminded of your strengths, so that you can return to those and draw confidence from them.

In the end, confidence comes from developing as a trader, not from being right all the time. Confidence is knowing that you'll lose, but also knowing that you can recover those losses. At the end of each trading day, I used to ask rookie traders to write down the one thing they did well that they wanted to continue and the one thing they did wrong that they would work to correct the next day. Imagine the cumulative impact of intently addressing just these two questions every day for a full year! The net result is a building of confidence, a deep knowing that you can expand your strengths and correct your shortcomings.

Confidence comes from mastery--and especially self-mastery. That is why I love trading: it's an intensive vehicle for self-mastery.

Tuesday, July 24, 2007

The Trader as Entrepreneur: A Different Take on Trader Personality

Trading coaches frequently emphasize the importance of treating trading as a business. Indeed, many find it helpful for traders to develop formal business plans to guide their pursuit of profits. Interestingly, however, there are few discussions in the trading literature about traders as entrepreneurs--and how the challenges that face traders are similar to those that confront business founders.

A recent book by Jessica Livingston entitled "Founders at Work" takes a look at tech-sector entrepreneurs through interviews (a bit like the Market Wizards series). Included are founders from such firms as Yahoo!, Adobe, Apple, PayPal, Research in Motion, and Flickr. They provide insight into the early days of their firms and what it took to put those enterprises together.

Here are a few themes that dominated the interviews and that shed valuable light on trading success:

1) Entrepreneurship is a Team Activity - Many entrepreneurs started their businesses by recruiting friends and classmates. The quality of the teamwork--and the relationships between the founders--was essential to success. Later, venture capitalists became critical team members, not only for their funding, but for their industry connections and business savvy. Similarly, the best traders I've known have developed networks for information, batting around ideas, and social support. At professional trading firms, they benefit from the assistance of risk managers and the guidance of more senior traders. They also benefit from the deep pockets of the firm, enabling them to leverage their skills by trading portfolios and position sizes much greater than could be traded with their own accounts. Even the solo trader operating from home now benefits from a host of Web 2.0 resources, from forums/chat rooms to blogs to social investing sites that encourage sharing of ideas. One neglected element of the trader's team that I've found to be crucial to success: the supportive spouse.

2) The Entrepreneur is Immersed in Building the Business - One interview after another speaks to the long hours and heroic efforts made by startup teams to get their products out before the competition. In many cases, the drive was not for money--no venture capitalists were as yet in the picture. Rather, the founders of the firms loved the process of building from scratch. I find the same dynamic at work with the best traders. They love markets. They are absorbed in developing their trading. I've met many traders who work during market hours and then seek a relaxed lifestyle from 3:15 PM CT onward. I've yet to find one of these traders who have sustained career success. It's the trader who pours through market research, company screens, trading journals, and business news who continually builds the trading business. I'm continually impressed how the best performers at banks and hedge funds religiously work on their trading. The work on the business is never done.

3) The Entrepreneur Loves Entrepreneurship - Once the founders establish their business and perhaps sell it to a larger firm, they frequently move on to other entrepreneurial ventures. Indeed, many of the founders interviewed by Livingston set up their firms before they even knew what they would be producing. Often, the firms started out with one business concept, only to eventually stumble upon the winning one. The primary motivation was to create something from scratch, and creativity played a large part in the success of these firms. All of the founders were steeped in tech before they started a venture and most started ventures before they founded the business that gave them success. Similarly, the successful traders I've worked with often spend a good amount of time in the markets before they settle on the specific markets and trading styles that provide them with long-term success. They are not the traders looking for quick riches or holy grails; rather, they find a creative way of viewing markets and trading that provide them with an edge. They love trading and often continue trading long after there is financial need.

4) The Entrepreneur is Resilient - Many of the firms described by Livingston and the founders nearly went under on multiple occasions. There were harrowing tales of running out of money, running into roadblocks, and trying to accomplish much with little in the way of resources. Through it all was uncertainty. There were no guarantees in the early phases of the ventures that they would ever truly have a superior product, whether people would buy that product, or whether there would be funding to bring the product to market. Traders face a similar landscape of risk and uncertainty. Many traders have gone through nerve-shattering drawdowns before finally achieving lasting success. Only a deep belief in self and the value of one's pursuits can sustain the individual when it seems as though the odds are stacked high.

So often we hear that the ideal trader personality is one of discipline and emotional restraint. When we view trading as a business and the trader as an entrepreneur, a different set of personality strengths come to the fore:

* Passionate
* Creative
* Hard-Working
* Committed
* Resilient

* Able to Thrive Amidst Uncertainty

* Visionary

* Collaborative

These are the traits help to distinguish successful entrepreneurs and traders. Not everyone possesses this constellation of traits and talents. In evaluating yourself, don't just think of your trading as a business; think of it as a start-up venture. Then consider yourself to be a venture capitalist. Would you fund you? Do you have what it takes to define a creative strategy in the market and bring it to fruition against many obstacles and constraints? Is trading your way to escape the rigors of real work or do you consistently exemplify the eight qualities above?

Feet on the ground and eyes on the stars--it's a rare but powerful combination, in business and in markets.


A Visit With a World-Class Trader

Monday, July 23, 2007

Opening Range Breakouts--And False Breakouts

One of the most reliable patterns I've found using the Trade Ideas Odds Maker is the fading of opening range breakouts. The nice thing about the Odds Maker is that it enables you to backtest various opening ranges and breakouts to see if there's been a solid edge to trading or fading those breakouts. Most often, the edge can be found by going against the move.

This is particularly the case when the new highs (or lows) from the breakout fail to attract significant volume. That occurred early this morning (see chart above; click for greater detail), when we had a breakout to the upside that was quickly followed by a drying up of volume. If large traders are truly repricing equities, they would be quick to jump on board the breakout move, expanding volume and volatility and creating a short-term trend. When volume dries up, it tells us that the largest market participants (literally) are not buying the breakout.

One tell that helped me be skeptical of the breakout (beside poor volume) was the fact that there were no large, trending moves in interest rates or currencies. There was also no economic news out for the day to cause a fundamental repricing of equities. Without these catalysts, it is difficult to sustain trending moves in stocks.

Note that, once the opening range breakout fails, the market quickly returns to its range. The high probability trade is for a retracement back to the midpoint of the range. In practice, however, it's not unusual to see markets retrace the entire range, testing the opposite extreme. This is particularly the case when many traders have been suckered into the breakout and now have to bail out of positions, accentuating the return move.

In the case of the morning trade, not a lot of traders were suckered into the move--the breakout was short-lived and not on extreme volume--and so volume was modest on the retracement. As I noted in my intra-day market comments, such a situation frequently leads to rangebound trade, as we lack conviction among large traders both to the upside and downside.

One of the intriguing conclusions of research on the development of expertise is that, in the learning process, performers alter their perception. Instead of seeing individual pieces, the developing chess expert perceives configurations. Rather than see individual bars on a chart, the expert trader perceives relationships among markets and ranges within markets.

Training your eye to see ranges in various markets enables you to see when we are repricing assets--and thus likely to trend--and when we are not and are thus likely to stay range bound. Markets trick us by offering nice breakout moves one day (such as Friday) and then false breakouts the next. If you see the ranges and see how markets trade around the edges of these, you are most likely to make the right choice between trade 'em and fade 'em.


Trading Pattern: Failed Opening Range Breakouts

Trading Opening Range Breakouts

Toby Crabel and the Epistemology of Trading Expertise

Assessing Intraday Stock Market Sentiment and Other Observations

* Intraday Equity Put-Call Ratio - In the chart above, we see the equity put/call ratio for each 15 minute segment of the trading day from 7/17 through 7/20. You can see the lack of bearish sentiment as the market peaked and then the flood of put buying as we made new lows on Friday. A series of readings below .60 have tended to occur near short-term peaks; a series of readings above 1.0 at short-term lows. Worth keeping an eye on. See Adam's comments also re: how the VIX anticipated the recent uptick in market volatility.

* Looking Ahead for the Week - I've updated the Trading Psychology Weblog and track continued weakness among indicators.

* Florida Recession? Housing is especially weak in Miami, threatening to drag down the state economy. Bloomberg's regional stock market index for Florida has been treading water this year; weaker than many segments of the country and certainly weaker than the stock market overall.

* Perspective on Chinese Growth - Excellent post on supply driven growth in China and the implications, via Seeking Alpha.

* Swing Trading Views - The Kirk Report, in its members section, offers a Q&A session with Alan Farley. See also Kirk's links re: the subprime situation.

* Lots of Good Reading to Start the Week - Links from Options Trading Beginner with some worthwhile posts on money management and sector rotation. Trader Mike updates links, including problems looming for Fannie and Freddie. See Millionaire Now and views on the commodity supercycle (and more). Abnormal Returns tracks subprime disease and the repricing of credit risk. The Big Picture offers the week in preview, including a bullish perspective on AXP.

Sunday, July 22, 2007

Adjusting the Adjusted NYSE TICK

As readers know, I used an adjusted figure to assess the day's TICK readings (the number of NYSE stocks trading at their offer prices minus those trading at their bids). Specifically, I cumulate each one minute's average TICK reading (high-low-close) after subtracting from it the average TICK level of the past 20 trading sessions. In this way, we see how short-term market sentiment for today compares with recent market history.

With the abolition of the uptick rule, short sellers can now hit bids rather than wait for upticks for their transactions. The net impact, it appears, has been a downward shift in the distribution of NYSE TICK values. From March 1, 2007 through July 2, 2007, the average raw NYSE TICK reading was 253. Since then, the average has been 21.

As I mentioned earlier, if this downward shift is attributable to the end of the uptick rule and its impact upon the location of trade, then we should see a similar shift in the distribution of the Dow TICK (TIKI). Sure enough, from March 1st through July 2nd, the average Dow TICK reading was .37. Since July 2nd, it has been -.53.

Eventually, once we have 20+ trading sessions under the new trading regime, the adjusted TICK will automatically adjust itself. In the interim, I am simply trading with an assumption of a zero mean for the TICK. If, as the trading day evolves, we chart the one minute TICK and have more area above the zero line than below, that will indicate net positive sentiment. If, as on Friday, we have more area below the zero line than above, that will suggest net bearish sentiment.

Most important, I will continue to track shifts in the distribution of the TICK from one time period of the day to the next. These shifts will remain important clues of institutional sentiment whether they're starting from a positive mean or from zero.


Identifying the Sentiment Trend

Stock Market Mood: Risk Seeking and Risk Averse Money Managers

The business of the professional money manager is to attract and retain capital. Performance is the most immediate means toward that end. The performance that matters to sophisticated holders of capital--from high net worth investors to large pension funds--is risk-adjusted return. Savvy investors want bang for their buck.

The trading and investing public hears about the big blowups, such as Amaranth, and thus assumes that professional money managers are highly speculative risk takers. Not so. Each well-run firm carefully monitors and manages its exposure to risk and its commitments to various markets. That monitoring filters down to the portfolio manager (PM) level, where PMs are regularly evaluated for risk-adjusted performance and either granted more capital to manage or not.

If a money management firm does not keep up with benchmarks, it cannot justify its fees and it cannot justify its allocation of capital from investors. Similarly, if a PM within a firm does not display solid risk-adjusted performance, he or she cannot justify an allocation of capital within the firm. Money is pulled from PMs that don't perform; they are "de-levered". Over time, their allocations can shrink to the point where they no longer represent a meaningful share of assets at the firm and can lose their position entirely.

For the firm, then, and for each PM, there is the Scylla of risk and the Charybdis of performance. The goal is to be sufficiently risk-seeking that you take advantage of opportunity and outperform benchmarks, but also sufficiently risk-averse that you avoid blowups. Moreover, firms and PMs have to keep up with competitors. You can't sit out a bull market; you can't be fully invested in a bear.

These realities mean that money managers tend to move as herds, oscillating between risk-seeking modes (and moods) and risk-averse ones. Consider late 2005 and early 2006. Markets were risk-seeking; the great performers were high-yield debt and emerging markets equity. From May through July, however, the mood turned decidedly risk-averse. Money flowed out of those popular markets and themes. The carry trade unwound. Emerging markets submerged.

If you're going to outperform the market on a relatively short time horizon, you have to think like the portfolio managers and money management firms that move the markets. You can't be putzing around with idiot wave patterns, numerological schemes, chart wiggles, or other foolishness that captivates the retail trading public. You have to look at the flows in and out of various assets and make a reasoned determination as to the moods of those large market players. Are they growing more risk-seeking, or are they growing more risk-averse? The answer to that question will tell you a great deal, not only about which markets are likely to move, but also how they're likely to move relative to one another.

So what do you look for in gauging market (and money manager) moods? Here are a few relevant to the current market:

1) Health of the Financial Sector - Many of the large PMs work at investment banks and hedge funds. Check out the stock performance of the publicly traded banks and funds. PMs know their own businesses. If they're not buying into their own sectors, that tells a story. (See the chart of hedge fund manager FIG above; see also the train wreck that is the BX IPO and the entire sector chart for $BKX). Right now, the large investors see more risk than reward in holding assets in their own, financial sector.

2) Performance of Treasury Instruments - When investors are frightened, they seek the safety of Treasury yields. That has the effect of pushing bond prices higher and yields lower. At the same time, they will shun higher-yield corporate bonds that are perceived as riskier. The net effect is to widen the yield spreads between the safest and riskiest fixed income sectors. On Friday, for example, Vanguard's High-Yield Corporate fund lost -.33%, while the Intermediate-Term Treasury fund gained .38%. No one wanted risk on Friday.

3) Performance of Equity Sectors - Risk-seeking equity investors will pursue beta. They'll gravitate toward small cap stocks within the U.S.; higher volatility international markets; and emerging markets. Risk-averse equity investors will stick with safe and secure large caps and shun more speculative sectors. Which sectors are leading the upside? Which the downside? On the surface, we've looked fairly risk-seeking, as the NASDAQ has been a strong performer. But a closer look finds that it's the large cap NAZ names doing the heavy lifting; more stocks on the exchange have been making new annual lows than highs. Keep an eye on China; among the BRICs, it's the poster child for risk-assumption and will be a leader in times of risk-aversion.

Moods come and go. We were risk-seeking in the late 1990s and tech was the primary vehicle by which this mood was expressed. Equities were in wide favor. When the mood shifted in 2000, large caps outperformed tech and smaller caps and equities went out of favor. We've been risk-seeking in loan practices (residential, private equity/corporate) until recently; now we're swinging toward risk aversion. Markets are interconnected; at times of great risk-assumption and aversion, correlations tend toward 1 and -1 across the board. Those are times of maximum inefficiency, when asset pricing will be most affected by greed and fear.

Moods--and especially large shifts in mood--create opportunity. But, like a great football quarterback, you have to see the entire field to capture that opportunity. There is far more to markets (and their movement) than the market you and I happen to be trading at the time.


What Makes a Professional Trader

Coaching the Professional Trader

Saturday, July 21, 2007

Assessing the Learning Styles of Traders

My recent article examined the role of learning styles in trading, and I extended the discussion to trader performance on my personal site. Here's a further resource: the Index of Learning Styles (ILS) questionnaire. Unlike the VARK measure linked in my initial post, the ILS assesses learning styles across four bipolar dimensions:

* Active - Reflective
* Sensing - Intuitive
* Visual - Verbal
* Sequential - Global

You can take the questionnaire online free of charge. Here's an article about the background of the measure.

I came out to be very high in Reflective, Intutitive, Verbal, and (somewhat) Global. That strikes me as quite accurate. I'd love to see a more comprehensive assessment that evaluates how people sequence these various learning modes. For example, I tend to think quite a bit (Reflective) about the big picture in the market (Global) by reading and writing about the economy and various markets (Verbal), but then my actual entries and exits have a strong Intuitive component. I suspect other traders blend these learning modalities differently. The question is what works for each trader. I don't see a lot of attention placed on that in the trading world.

My best guess is that we would see meaningful differences in learning styles between mechanical systems traders and discretionary traders and between short-term traders and longer-term investors. Just as learning styles differ for people going into particular occupations, it's likely that they differ for people selecting different modes of money management.

Do traders approach decision making differently (from a learning style/information processing vantage point) when they're trading well vs. trading poorly? My own trading results are much poorer when I haven't done considerable preparation/research in advance of the market open. That makes sense, given my need for Verbal, Global, Reflective processing to support my Intuition. This strikes me as a fruitful area for research--and self-study.

Cracks in the Market Foundation

I recently mentioned in my Twitter comments that we're seeing a mixture of strength and weakness in the market over the past week. For example, we had 569 stocks making fresh 20-day highs on Wednesday against 1292 new 20-day lows. Then on Thursday we had 1197 new 20 day highs against 642 new lows. On Friday, we returned to 630 new highs and 1287 new lows.

The mix of strength and weakness can be seen in the 52-week data as well. The Dow recently made fresh all-time highs, breaching 14,000. Nevertheless, on Friday we saw 118 stocks on the NYSE make new annual highs and 138 make new 52-week lows. Similarly, the NASDAQ 100 Index has been quite strong, making new bull market highs this week. New 52-week lows among NASDAQ stocks have been leading new highs, however. On Friday, we had 74 annual highs among NASDAQ issues and 194 new lows.

Going back to 2004, I could only find 8 occasions in which a day with over 1000 20-day highs among NYSE, NASDAQ, and ASE stocks was followed by a day with over 1000 new 20-day lows. On five of those eight occasions, the S&P 500 Index (SPY) was lower over the next week of trading. The reason for this is that good bull markets pull pretty much everything off their lows. When averages make new highs amidst many new lows in individual issues, the new highs most often are a function of selective strength among the most highly weighted stocks in the indexes. Most traders don't realize that the largest 50 stocks in the S&P 500 account for nearly 50% of the index's weighting.

When you're as old as I am, you've seen these movies before. From 2/1/2000 to 3/10/2000, the NASDAQ Composite rose almost exactly 1000 points: a 25% move. Out of those 28 trading days, only 14 had more advancing stocks than decliners among NASDAQ issues. In fact, 10 of the last 15 days of that runup (in which we gained over 600 points!), we had more declining stocks than advancers.

And as we were making fresh all-time highs in the NASDAQ? New 52-week lows were creeping higher, exceeding 100 and hitting 20-day peaks on several occasions. The day after we hit the peak in the NASDAQ Composite, we had more annual lows than highs on that exchange.

And how about the market peak in July, 1998? We hit an intraday high--and a high for that bull market--on July 20th. Leading up to that peak, five of the prior nine trading sessions saw more losing stocks than gainers among NYSE issues. At the very peak, we only had 128 new annual highs among NYSE stocks against 73 new lows. The next day, 52-week new lows outnumbered new highs.

Does this mean we're necessarily heading for a bear market akin to July-October, 1998 or the 2000-2002 debacle? Of course not. Rather, my point is that there are cracks in the market foundation. We're seeing a flight to quality in Treasuries, with risk aversion in fixed income. We're seeing a U.S. dollar hitting all-time lows against the Euro--and now even losing some strength vs. the Yen. That's helping us record fresh highs in commodity prices, such as oil, that are denominated in dollars.

And the banks: they dominate the 52-week low list. Financials are hurting, as fears of overaggressive lending are now spreading outside the subprime housing sector.

Yes, you could say it's a wall of worry. The problem is that many stocks are not climbing that wall. We've been up over the past three months of trading. But new 65-day lows currently outnumber new highs by more than 2:1. We've certainly been up in the major averages over the past year. But if we count just the common stocks trading on the NYSE, we find that 84 made new annual highs on Friday and 67 made new 52-week lows. And small caps? We had 14 stocks make annual highs among the S&P 600 issues on Friday against 42 fresh 52-week lows.

Dow 14,000 made a great headline. For my part, I'll keep an eye on that market foundation.

Friday, July 20, 2007

Catching the Breakout Trade

Catching a good breakout trade can make your week. The start of catching this trade was actually at the beginning of the week when we saw that the indicators (advances/declines, new highs/lows, money flow, momentum, TICK) were not keeping up with the market's attempts to launch new highs.

We then saw that risk aversion owing to the subprime concerns was manifesting itself in a rising Yen (unwinding of the carry trade) and falling 10-year Treasury yields (flight to quality in fixed income). We could see such risk aversion pressure equities: people don't want to own stocks when they're concerned about contagion of debt problems.

All these factors came into play this morning. We started out (top chart) in rangebound mode as noted in my real-time Twitter comments on the market. (Last five comments always displayed on the blog). Note then how volume hit bids heavily as we moved to the bottom of the range on the heels of the rising Yen and falling Treasury yields. That told us that institutional investors were unloading stocks, and shifted us from range mode to bearish intraday mode.

The real takeaway is that it's valuable to coordinate the market's larger-term picture (how indicators have behaved over the last week or two) with intermarket observations (regimes) and a shorter-term perspective (range support/resistance; expansion of volume). It's not so much a matter of predicting what's happening as *understanding* it.

Trading and Learning Styles

The medical student who came to my office for counseling was panicked. An important test was coming up the next day and she wasn't prepared. A bright, motivated student, she nonetheless had very poor reading skills. Every day she audiotaped the lectures from class and listened to them at home. Unfortunately, the professor announced that the test the next day would be taken from the textbook--and the book wasn't available in audio form.

She told me that she would fail for sure. What should she do?

Digging into my solution-focused playbook, I pointed out that this had no doubt happened before. After all, not all textbooks are available as audiobooks.

She nodded and explained that she went to college near her parents' home. When she couldn't get a book on tape, her parents read the chapters to her.

It made sense.

So, for the next couple of hours, I read the book to the student and she asked questions. She passed the test with flying colors and ended up graduating near the top of her class.

It was a dramatic example of learning styles in action. My student had a learning disability in the area of reading; visual processing was not her strength. But if she heard the information and had the opportunity to talk about it, she could comprehend and retain the material quite well.

Even those of us without formal disabilities have certain learning strengths and weaknesses. When I need directions to an unfamiliar location, I find maps only minimally helpful. I translate the map into a set of verbal instructions--"Right on Rt. 43, left at 34th St."--and then memorize those. Reading and writing the written word is my learning strength.

Educators describe four dominant learning styles:

* Visual
* Auditory
* Reading/Writing
* Kinesthetic

Together, these form the acronym VARK. Here's a quick, simple questionnaire to see where your learning style falls on the VARK dimensions.

Perhaps the different approaches to trading are mere reflections of the learning preferences and strengths of their proponents. Many technical analysis strategies--from chart reading to the CCI patterns championed by Woodie--rely on visual processing. The market maker at the investment bank who is constantly on the phone with customers--or the local standing in the pit assessing activity by crowd noise--is processing information through auditory channels. A market quant, researching ideas through financial publications and assembling data to test hypotheses, leans toward reading and writing.

But how about the kinesthetic learner? I recently had a humbling experience working with a kinesthetic trader.

Kinesthetic learners learn from direct, hands-on experience. My son Macrae would never think of reading a manual to assemble a new piece of electronic equipment. He looks it over, holds it, tries a few things out, and figures out how to put it together. He learns by trial and error. (He also assembles the item long before I've finished the manual!)

The kinesthetic trader I worked with came to me with issues of performance pressure. He was relying on setups that, I observed, depended on trending markets. He was profitable, but his win/loss ratio of trades was not especially high. I suggested a simple trend filter that would eliminate many of the losing trades. When he tried it, his stress level rose considerably.

What went wrong?

It turns out that he *needed* his losing trades. Not because he had a desire to lose, but because he--like Macrae--learned through trial and error. The losing trades gave him information about whether the market was trending or not. Feeling his way through the market early in the day with small trades gave him the information--and confidence--to place larger trades when his setups were present in a market that was moving.

Ironically, it was his attempts to improve his P/L by eliminating "bad" trades--a trap I also fell into--that was creating his performance pressure. He was working against his own learning style, and his anxiety was a warning sign that he was not playing to his strengths.

How many other traders are stressed out in trading because they're attempting to process information in ways that don't work for them? How many coaches fail to help traders because they offer information in one format and traders need to process it in another?

Traders are in the business of processing information. How much do you read? How much do you rely on charts? How much do you discuss ideas with others or get ideas from videos, TV, and other media? How much do tiptoe into the market, getting a feel for the action with small positions? Like my medical student, you're most likely to find your success if you stick to your strengths as a learner.


Trading and Information Processing: Why Traders Sabotage Themselves

Thursday, July 19, 2007

The Personality of the Stock Market...and Much More

* The Personality of the Market - One of the great challenges of a short-term trader is identifying whether a trading day is likely to be rangebound or trending. As noted in my Twitter comments, I started entertaining the idea of a rangebound market today by mid-morning. Some of the telltale clues: reduced volume compared with recent norms; drying up of volume as we approach range extremes; choppy trade with frequent reversals of market moves--a sign that locals are dominating trade; and the absence of trending moves in markets that often drive stocks (bonds, currencies). It's much easier to frame intraday trading ideas if you can figure out the character of the trading day.

* Great Trading Resource - Michael Covel has assembled a large group of articles, including ones on money management, dealing with uncertainty, and an interesting view on the frequency vs. magnitude of being correct. Excellent site.

* Fascinating stats on the S&P 500 Index - The IndexArb site displays an updated list of the market capitalizations of all stocks in the S&P 500 Index. The top 50 stocks in the index account for nearly 50% of the entire capitalization. The bottom 50 stocks account for only 1.2% of the index's value. The site also updates the weighting of the stocks within the S&P 500 Index. The top 20 stocks comprise 30% of the index weighting. The bottom 100 stocks account for only about 3% of the weighting. Tech is well-represented: Microsoft, Cisco, IBM, Intel, Hewlett Packard, Google, and Apple are among the top 21 most weighted stocks.

* Great Call on Tech - The DK Report nailed this one; hats off. See also his post highlighting the recent surge in NASDAQ new lows. Here's more perspective on NASDAQ lows from Trader's Narrative.

* Secret to Investing Success? - Excellent post from CXO Advisory showing how low volatility of returns is a major ingredient in market outperformance among hedge funds. That is definitely true in my own trading.

* Reflections on Remorse - Dr. Bruce Hong examines how remorse affects traders. See also his insightful post on how to put cognitive dissonance to work in trading.

* Alexa for Firefox - Thanks to Trader Mike for the heads up on the new Alexa toolbar for the Firefox browser.

* Tracking the Market Down Under - Davin's Trading Report follows the SPI futures and looks for moves at particular times of day. Interesting approach.

* Shipping Gone Wild - Excellent post from The Kirk Report on the performance of the shipping sector and why it's showing up so frequently in his Screen Machine output.

* Yield Perspectives - More good links from Abnormal Returns illustrate the dimensions of the mortgage mess and how investors are fleeing to safe bonds, reducing treasury yields.

* Dollars Unloved - The Big Picture offers a sneak peak at weekend links, including a post on the unloading of dollars by Russia. See also Trader's Narrative long-term picture of the dollar and Tom Lydon's post for Seeking Alpha re: ETFs for trading the weak dollar.

Opening Gaps to the Upside in the Stock Market

Here is a replication of an earlier study relevant to the current market:

As I write, we're headed toward the opposite of yesterday, with the prospect of a large opening gap to the upside. Going back to the start of 2004 (N = 890 trading days), we've had 74 upside opening gaps that have exceeded .40% in the S&P 500 Index (SPY). From the open to that same day's close, we don't see any edge for the strong opening gap day. When we look from the open to the *following day's close*, however, the average gain in SPY has been .14% (43 up, 31 down). That is stronger than the average open to next day close for the remainder of the sample of .04% (437 up, 379 down).

I then broke down the strong upside gap days on the basis of whether SPY had been down or up the prior day. When we've had a strong upside gap following an up day (N = 27), the average gain from the open to the following day's close has been an impressive .33% (19 up, 8 down) for SPY. When we've had a strong upside gap following a down day (N = 47), the average gain in SPY from the open to the next day's close has been only .03% (23 up, 24 down).

In sum, as in the prior study, I don't see any open-to-close edge following a strong market open. Indeed, returns even to the next day show no bullish edge when, as currently, the prior trading day had been down. There is some indication, however, that strong upside gaps following an up market may lead to superior returns in the near term--an apparent momentum effect. This is a pattern of interest to many stockpickers, but may require more than a day trade to fully exploit.


Do Opening Gaps Tend to Fill?

A Simple Measure of Trend and Trajectory

Of interest to traders is not only the trend of markets, but their trajectory. A rising market that is losing steam tells a different story from one that is picking up momentum.

I was reading a past article in Formula Research and came across a simple indicator that was used to assess relative strength. The indicator took the price changes for each market over 5, 15, 25, and 35 days and simply averaged those together. In so doing, they created a composite trend measure that is sensitive to trajectory.

I've charted this trajectory measure for the S&P 500 Index (SPY) going back to the start of 2004. (Click on chart for greater detail). You can see that the trajectory measure has tended to top out well ahead of price during market rises and that a dip toward or below the zero level has tended to precede final pushes to market highs. Trajectory has also tended to bottom coincidentally or ahead of price during recent market declines.

Trajectory has made a meaningful difference in terms of future returns. When the trajectory has been above zero (N = 581 trading days), the average gain in SPY 20 days later has been .35% (366 up, 215 down). When trajectory has been below zero (N = 272), the average 20-day gain in SPY has been a much stronger 1.50% (197 up, 75 down).

Interestingly, when we look at very positive trajectory markets vs. weaker (but still positive) ones, we also see a difference in future returns. When trajectory has been above 3% (N = 103), the next 20 days in SPY have averaged a respectable gain of .93% (80 up, 23 down). When trajectory has been above zero but below 3% (N = 478), the next 20 days in SPY have averaged a gain of only .23% (286 up, 192 down).

Finally, when trajectory has been very weak (below -3.0%; N = 37), the next 20 days in SPY have averaged a very strong gain of 2.89% (31 up, 6 down).

These results mirror those from my investigations of momentum with the Demand and Supply indicators. We tend to see above-average returns from very strong markets--those with high upside momentum/trajectory--and from very weak ones. Moderately strong markets have yielded subnormal returns.

There are many interesting applications of this research. For instance, along the lines of the Formula Research work, we can track the trajectories of different sectors to map out a trading strategy based on relative strength. We can also investigate trajectories and returns over longer time frames with weekly data or over shorter periods with intraday data. It's relatively easy to whip up a trajectory measure for any instrument--stock, futures contract, or index--with a price history. It also wouldn't be difficult to assess trajectory for market indicators, such as advance-decline lines (along the line of a McClellan Oscillator) or sentiment measures (options ratios; VIX).

I'll be posting more on this topic, exploring the applications.


Trajectory--Not Just Trend--Is Your Friend