Saturday, May 23, 2009

Reasoning, Preparation, and Trading Success

A recent post described a framework for trading in which evolving market action (the behavior of price, volume, and volatility around key price levels) is used to form ongoing estimates of the odds of touching predefined profit targets. By observing how volume and volatility behave on upward and downward movements—and by gauging the degree of participation in those movements—we can obtain a feel for whether trade is directional or non-directional and anticipate continuation and reversal moves accordingly.

Underlying this framework for trading is a reasoning process that synthesizes ongoing information within and across markets and time frames. Much of what is learned during the process of obtaining market expertise is a refinement of this reasoning process. Psychology becomes important to trading outcomes insofar as it promotes or interferes with the reasoning needed to adapt to the flows of market-generated information.

The reasoning process, however, begins before markets open as part of the trader’s daily preparation. By observing how markets trade overnight, evaluating the behavior of correlated asset classes prior to the open, and by assimilating economic data, news, and earnings releases (and market responses to these), the trader gains a feel for the market day before the opening bell rings.

Key to the trader’s reasoning is an elaboration of “what-if”scenarios that review hypotheses regarding likely market action. What if we open with low volume, near the previous day’s pivot level on a day with no scheduled economic releases? What if we open weak in the S&P 500 Index, but see firmness among the small cap stocks and a mixed open among the major stock sectors? What if the market breaks above a key price level, with bullish behavior in bonds, the dollar, commodities, and the more speculative stock sectors? What if the market breaks below support, but breadth remains mixed?

Each of these scenarios calls for a specific trader response. Each offers potential trading opportunity. By mentally reviewing the scenarios in advance, the trader becomes more prepared to act upon them. The trader also becomes more sensitive to their unfolding, so that trading opportunities can be properly anticipated and mapped out.

Two sources of hypotheses for the day ahead can be especially useful to preparation. First, by tracking indicators such as stocks making new highs and lows; momentum measures such as Demand/Supply; and the percentage of stocks trading above their moving averages, we can gauge whether a market is gaining or losing momentum to the upside or downside (or whether it is trading in a range with little momentum). Drawing on the principle that strong momentum moves in one period will tend to carry over into subsequent intervals (and weak momentum moves will tend to reverse), we can formulate ideas as to whether markets are likely to hit particular targets today as a function of yesterday’s trade.

Second, historical market patterns—queries as to how markets have traded in the past under the present set of conditions—can help us formulate hypotheses for the coming day. For example, we might find that a low momentum up day yesterday which is also a five-day closing high has a relatively poor chance of closing higher today. That provides us with a hypothesis that enables us to anticipate weakness should we be unable to hold a particular upside price level.

From this perspective, the successful trader is one who formulates meaningful hypotheses prior to trading and then processes unfolding action quickly and accurately to determine whether or not those hypotheses are finding support. Not all traders trade this way; nor should they. What I am describing is a framework that I have cultivated over years of trading and working with traders that makes use of my cognitive strengths in synthesizing information into meaningful patterns and themes.

Your challenge is to learn what you can from my way of viewing markets, but not to mimic what I do. Good things happen when discover where your cognitive strengths lie and adapt the styles of others to create your own niche.

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3 comments:

F. said...

One of your best posts, imo.

OKL said...

Doc, just re-read some of your posts back from 2006-07.

So good its not even funny lol (some of the comments too).

I hate psychologists; how is it even possible that its almost as if you're reading my mind half a world away!? =)

Some thoughts/comments;

- I'm having a pretty good streak right now and guess what I noticed when I thumbed through my recent EOD/trade reviews? The word "should" doesn't appear that much.

Compared to my last crappy streak lasting ~35 trading days, it was... well, let's just say the word was all over the place.

It's not a 'dangerous word', but after the word 'should' appears, there has to be a 'but it is also possible that... in that case..."

What I'm saying is, in generating ideas, the word "should" or "might" is inevitable, since its idea-generation... but one has to have the flexibility of thought to debate against those ideas.

- Marc Greenspoon; an brilliant piece.

- Philosophy is just as important as psychology... I'm not sure about this, but I asked my old man and he mentioned that back in his time, Philosophy class was MANDATORY, but obviously not so these days. I wonder about its implications on today's society.

- There is no minor league for trading; i wish someone told me this when i first started, or rather, hammer it into my head.

- If an execution is well made, its worthy of praise even if it didn't turn out well.

- "Fooled by Randomness" Vs "Enhancing Trader Performance"; melding the two seemingly conflicting ideas into action is what differs success/failure, in trading at least.

- Gotta have the ability to laugh at losses/failures... then get serious about learning from it- dead serious.

- Capital Conservation; Not a lot of traders are going to be left around after this debacle... where will you be?

- Theories/Hypotheses are results of dynamic thinking, but they are "false until proven otherwise"; laugh when it doesn't work, or risk being like the fools that "modeled" financial risk and somehow, managed to sell that and get us into this mess.

- Markets and Economies are intricately linked at the hip, but that's about it.

- If you have knowledge, passion, can talk a good game about markets/trading but cannot execute the trading ideas, its fine. We need some brains in the financial media, try that out.

- "You can't win until you're not afraid to lose," Lyrics from Bon Jovi's 'Just Older'.

- "Fortune favors the brave"; talk is cheap... focus on the execution.

- "Opportunity favors the prepared"; think ahead, but don't get married to ideas.

- "The more you practice, the more lucky you get"; review, review, review.

- "Relax and let the juices flow"; focus on opportunity and performing, not the performance.

- Is Trading = Gambling? Life's a gamble and all about risks.

- If trading isn't for you, move to something else... there's a life outside the markets... what happens in the markets stays in the markets; it doesn't reflect on who you are as a person, on the whole.

Nah, I don't hate psychologists, I just find the good ones really creepy =)

Once again Doc, Thanks a million for the great posts =D

One last thing, since its Memorial Day and being from Asia, I just wanna say "Thanks" to all the folks, regardless of nationality/cause, who died in the wars in attempting to defend Freedom throughout the years gone by... to a certain extent, I owe whatever life I have right now to them.

Make love and peace, not war... or there'll be no economy/markets to trade =)

*Salutes*

TSMoulton said...

Great post once again!

I was wondering if you would ever be interested in making a video post? if you look a youtube there's a lot of traders or investors that post videos of screen captures. I've been using a free program called CamStudio for a day or two now it works pretty well for a free program. If you could do a video of your actual trading sometime with your audio commentary that would be a great learning tool for those of us who are more audio and visual learners.

Thanks once again!