Saturday, September 24, 2016

How to Find Your Trading Biases

One of the exercises I've found most helpful for traders and portfolio managers is a thorough review of trading performance.  Many times, the ups and downs of profit/loss reveal biases and patterns in our trading.  Some of the patterns worth looking for include:

*  How you trade after you've made money versus after you've lost money:  Do you trade more?  Larger?  Do you trade differently based on recent P/L?  Do you become risk averse after recent losses?  Does that affect your future P/L?

*  How do you trade when you're taking more risk versus less risk?  Does different size/risk exposure cause you to trade differently?  Are you actually making more money when you're taking more risk? 

*  What kinds of markets and market patterns provide you with your greatest profits?  Losses?  Do you trade selectively to maximize your best opportunities?  Do you overtrade markets that are not ones providing you with opportunities?

*  What is your ratio of winning to losing trades?  What is the ratio of the size of average winners to the size of average losers?  How successful have you been in finding large winners?  In preventing large losers?

Many times, our greatest biases and psychological mistakes come through when we thoroughly review performance.  The decision to not review performance is perhaps traders' greatest bias blind spot.

Further Reading:  Training Yourself in Pattern Recognition

Friday, September 23, 2016

Why Traders Lack Creativity

So much of creativity is the ability and willingness to look and move in a direction different from the well-worn path.  After I wrote the most recent post on emotional creativity, I had the honor of speaking with Dr. James Averill who pioneered research in the area.  He made a very important point.  Much of the way the business world is structured (and I believe this includes the trading world) does not lend itself to emotional creativity.  If anything, emotions are dampened, not explored:  no one really focuses on identifying and cultivating unique emotional responses to daily challenges.

I recall speaking with a successful trader who told me that he was excited about the opportunity in the marketplace.  I responded by saying that he was the first person I'd spoken with to tell me that.  Everyone else was lamenting the lack of opportunity in markets.  He said, "That's right.  I've always made my money going against the consensus!"  That was shortly before the events of Brexit.  That trader was able to capitalize on opportunity because he not only saw the world differently, but experienced it differently.

Another skilled trader I know claims that his idea generation is aided by yoga exercises.  He believes yoga gets him into states where he sees the world more clearly.  This is in line with research that identifies a physical dimension to creativity.  In accessing different physical states, we create opportunities to see and experience the world differently.  

If I wanted to create an environment in which creativity was to be minimized, I would have people sitting or standing at desks, relatively stationary and rarely shifting their physical activity.  I would encourage little talking and insist that such talk be about the external world, not about internal experience.  I would encourage people to share trades and focus on the same research, rather than generate their own views.  That is the environment that typifies so many trading floors:  there is little in the structure to encourage and cultivate cognitive, emotional, and physical creativity.

A truly creative trader would create a radically different trading environment and a radically different set of routines for approaching the trading process.  Turning creativity into a routine rather than become prisoner to one's routines: that is a promising direction for development as a trader.

Further Reading:  Trading Psychology for the Experienced Trader

Thursday, September 22, 2016

Emotional Creativity: A New Theory of Trading Success

As Averill notes above, there are two views on emotions.  One, the most common, asserts that emotions are givens:  biologically wired.  A second view is that we can cultivate what we feel and how we express it.  That second view suggests that creativity is possible in our emotional responding as well as in our thought processes.  This emotional creativity is what enables people to adapt to situations and respond to them in novel and effective ways.
Averill's work suggests that emotional creativity has three components:

*  Preparedness - The ability to learn from the emotional experience of self and others;
*  Novelty - The ability to experience and express unusual emotions;
*  Effectiveness - The ability to express emotions honestly and constructively

Research suggests that emotional creativity is different from emotional intelligence.  Emotionally intelligent people--those who can read and respond well to the emotional experience of others--are not necessarily emotionally creative people.  The emotionally creative person responds uniquely to situations, enabling them to deal with those situations in fresh ways.

Four competencies are essential to trading:

*  Cognitive intelligence - The ability to process and understand market-related information and use research, analysis, and pattern recognition to identify trading opportunities;
*  Emotional intelligence - The ability to read the intentions of other market participants and use their sentiment and positioning as inputs to one's own decision-making;
*  Cognitive creativity - The ability to put market information together in unique ways and detect opportunities that others miss;
*  Emotional creativity - The ability to respond uniquely and effectively to market-relevant events.

I would argue that most traders have a reasonable degree of cognitive and emotional intelligence.  Their success or failure is more a function of the presence or absence of creativity.  Unsuccessful traders generate consensus ideas and respond to markets in line with "the herd".  The successful trader experiences the flow of market information uniquely, and that emotional creativity enables her or him to generate novel trading ideas.

This is a unique theory of trading success.  If it is correct, much of training in trading and much of coaching has been focusing on the wrong things.  Creativity can be cultivated.  Perhaps a key to trading success is not controlling one's emotions, but learning to view and respond to the financial world in novel ways.

Further Reading:  Cultivating Emotional Creativity

Wednesday, September 21, 2016

Trading With Your Signature Style

One of the things I've found among successful traders is that they develop ways of looking at markets that:  a) are original and b) that make great sense to them.  The originality of their perspectives helps them see what others don't.  The familiarity of the perspectives helps them align their cognitive strengths (how they best process information) with their decision making.  Very often this means that successful traders trade with a signature style, not a generic one.  Working with mentors and researching markets and market patterns are very helpful in developing the raw materials for one's signature style.

Above is a chart of the ES futures from August 22nd to the present (blue line).  Each data point represents 500 price changes in the contract; these are event bars, not time-based bars.  The red line is what I call the Power Measure.  It's a running correlation of price change and volatility.  In short, the Power Measure tells you when volatility is fueling directional moves:  when that fuel is waxing and waning.  That makes sense from my perspective, because I ideally want to participate in directional moves in which volatility is rising in the direction of my trade.

When you develop your own metrics and ways of looking at markets, the patterns that repeat themselves become ones that are intimately familiar to you.  It's because they are *your* patterns that you are able to follow them, test them, and ultimately trust them.  I have never met a successful trader who traded someone else's style, just as I've never seen a successful painter who copied others.  We see markets best when we cultivate our own vision.

Further Reading:  Calculating Power Measure

Tuesday, September 20, 2016

Understanding Gut Feel and Trading Success

A great recent research article documents the role of "gut feel" in short-term trading.  Traders who are more self-aware with respect to their bodies tend to outperform those who lack such awareness.  Interestingly, if you read the report carefully, you'll see that a second variable predicted trading success independently of body self-awareness:  heart rate variability.  We've encountered heart rate variability before in explorations of biofeedback as a means to developing calm focus and increasing access to intuition.  The recent study hints at the possibility that these two factors indeed work in tandem:  the ability to sustain a calm, focused state during turbulent markets provides access to our gut feel, which in turn helps us sustain sensitivity to market patterns that emerge in real time.

If this is the case, then access to our intuitive capabilities indeed can be trained and cultivated.  This may not help trading that relies upon explicit reasoning and analysis, but would be very useful for active daytraders and those looking to use short-term market patterns to achieve superior entry and exit execution of longer-term trades.  It was interesting to see in the study that medical students in the sample scored lower in their body self-awareness than the successful traders.  Medicine requires careful analysis and synthesis of information to arrive at diagnoses and potential treatment options.  It is less purely intuitive than scalping short-term patterns in stock index futures.

The key takeaway is that different strengths predict success in different fields, and different strengths predict success in different forms of trading.  Much of trading success comes from aligning your strengths with your approach to markets.  It may well be that the greatest success comes from the ongoing strengthening of our strengths, training ourselves to become better in utilizing our signature modes of processing information.

Further Reading:  Improving Your Trading Toolkit

Monday, September 19, 2016

What is Most Essential in Markets

This was Mali at 2 AM this morning.  It's not much of a conflict when part of you wants to sleep and another part of you wants to cuddle a blind, purring cat.  The purr is worth a tired day!  It's all about staying focused on what's essential in life.

In markets, it's easy to become focused on non-essentials.  We tell ourselves stories about the state of the world or the state of market charts.  Far more essential is what buyers and sellers are actually doing in markets.  Are there many buyers participating in today's market?  Many sellers?  What is the relative balance of buyers and sellers, and is that changing?  It's all about the auction process.

So let's go to the data.  We'll go back to 2012 and look at every transaction in every NYSE stock each day.  Those occurring on upticks we will categorize as initiated by buyers.  Those occurring on downticks we will categorize as initiated by sellers.  The total number of transactions occurring on upticks and downticks, we will call participation in the market.  Participation differs from volume, because a given unit of volume can be broken into many transactions or fewer depending upon the sophistication of the execution platform and the urgency of the traders.  Increasingly, we're seeing volume broken into pieces, creating multiple transactions.  How these transactions occur--on upticks vs. downticks--provides a useful sense for the flow of supply and demand moment to moment.

So at the end of the day, we have a total score of transactions occurring on upticks (buying pressure) and a total score of transactions occurring on downticks (selling pressure).  What can we learn from these measures?

If we divide the sample from 2012-present into quartiles, we find out that when daily upticks are lowest, the next 10 days in SPY have averaged a loss of -.05%.  When daily upticks have been highest, the next 10 days in SPY have averaged a gain of +1.02%.  Heavy buying tends to beget further buying.  That's a momentum effect.

If we then look at when we have the fewest downticks, we find that the next 10 days in SPY have averaged a gain of +.13%.  When we have the greatest number of downticks, the next 10 days in SPY have averaged a gain of +.96%.  Heavy selling tends to beget future buying.  That's a value effect.

If we now combine total upticks and total downticks to create our participation measure, we find that when we've had the lowest participation, the next 10 days in SPY have averaged a loss of -.10%.  When we've had the highest participation, the next 10 days in SPY have averaged a gain of +1.33%.  

So this is what's essential:  There are value participants in the marketplace that scoop up stocks when they have traded weakly.  There are momentum participants in the marketplace that buy shares when they're moving sharply higher or lower.  Market lows are created when value and momentum participants are interacting with one another, first selling falling shares, then scooping up the fallen assets, and then picking up the rising stocks.  Market highs are created when prices get to the point where they no longer attract value participants and lose their momentum.  There is relatively low participation at those times.

This is why, when SPY volume has been lowest, the next 10 days in SPY have averaged a loss of -.24%.  When volume has been highest, the next 10 days have averaged a gain of +1.15%.

Who is in the market?  What are they doing?  How is their behavior shifting over time?  Those are keys to understanding markets.

Now I'll focus on another essential: sleep!   

Further Reading:  Reading Market Footprints

Sunday, September 18, 2016

What is Your Rut?

"I'm in a rut."

That's what we hear when someone finds themselves doing the same thing and getting unsatisfying results.

Trading can be in a rut.  Relationships can be in a rut.  We can be in a rut with respect to our social lives, our physical well-being, or our spiritual lives.

A rut is a habit that has outlived its usefulness.  At one time, it may have had value.  Now we've outgrown it, but it remains a habit.

Because ruts are habits, each time that we fall into the rut, we reinforce the wrong habits.  The rut grows a bit deeper and starts to look more and more like a grave.

The best way to break habits is to create new ones.  The things we're doing now that are useful--that bring happiness, success, fulfillment--those are the things that we should be looking to habit-ize.  

But do you want to know the true key to staying out of ruts?  It's to turn habit breaking into a habit.  If we get into a routine of identifying strengths and making them automatic, then habit breaking and the creation of new, positive habits itself becomes a habit pattern.  

That is why we can never innovate occasionally.

The people who innovate have made a habit of innovation.  They make a habit out of rut-finding and creating new paths.

We can't necessarily move mountains or climb over them, but we can get to the other side if we turn our ruts into tunnels.

What is the rut you're in now?  What is on the other side of your mountain?  Life is so much more satisfying when we stop digging and start tunneling.

The only difference between a rut and a tunnel is the direction of the digging.

Further Reading:   How to Find Your Trading Talent

Saturday, September 17, 2016

The Importance of Trading With an Open Mind

Here's an interesting set of statistics.  During 2016, the correlation between today's volume and tomorrow's volume in SPY has been about +.68.  The correlation between today's true trading range and tomorrow's has been above +.60.  Both are in line with long-term averages.  The correlation between daily price change today and daily price change tomorrow in SPY is -.11.  In other words, the recent past tells us much more about who will be in the market and how much the market will move than which way the market will move.

But wait, you might say, perhaps there is more consistency of price movement on an intraday basis.  During 2016, if we look at 5-minute bars for SPY, we find an almost identical pattern.  The correlation between the current bar's volume and the next bar's volume has been +.75.  The correlation between the current bar's range and the next bar's range has been +.69.  But the correlation between the current bar's price change and the next bar's change has been -.03.

Given these stats, as a trader you'd want to have an open mind as to market participation (after all, about 50% of the variance in volume is *not* accounted for by prior volume), but especially as to price behavior.  We might think one thing or another with respect to market trend or mean reversion.  The reality is that only about 1% of the variability in price direction in the next period is accounted for by the price movement in the present period.

In an interesting recent post, Mike Bellafiore from SMB draws upon a recent TED talk to make the distinction between thinking like a scout and thinking like a soldier.  The scout reads the terrain and looks for what is happening now.  The soldier defends terrain and follows battleplans.  In an environment characterized by high uncertainty, the open mindset of a scout is necessary.  If we become too locked into what has just happened, we can easily fail to see what is going on now.

Conversely, if we're following battle plans as a soldier, we must be mentally prepared for the "fog of war" and uncertainties of battle.  Those statistics tell us that, in terms of directional price movement, noise is very high relative to signal.  Regardless of our time frame, we will face uncertainty during the life of our trade.  How we deal with that uncertainty greatly impacts how we manage our positions.  The wise trader might follow a plan, but never stops being a scout.  It's when markets significantly deviate from their normal noise that opportunities arise.

Further Reading:  Bayesian and Static Reasoning in Markets

Friday, September 16, 2016

The Psychology of Dealing With Choppy Markets

Stocks have traded in a volatile range lately, with significant moves frequently reversed.  This has proven challenging for those looking for trends.

If we think of markets as auction processes, we can identify volatile and non-volatile markets based upon the amount of participation in the marketplace.  We can also identify trending and non-trending markets based upon the relative balance of buyers and sellers.  

Our job is to read the auction process and adapt to the conditions before us.  We are in a very different environment than several months ago.  When we have a volatile range, we have large participants active as both buyers and sellers.  The move in rates and uncertainty over central bank direction has created a different auction process.

How do we talk to ourselves about market conditions?  Do we frame the situation as a challenge and as a problem to be solved, or do we frame ourselves as victims of unknowable market forces and passively hope that things will change in our favor?

Victim self-talk is the surest way of disabling ourselves when opportunities arise.  How we frame situations determines how we respond to them...and how we will be prepared for the future.

Further Reading:  Questions to Ask About Your Trading Psychology

Thursday, September 15, 2016

Replacing Risk Taking With Intelligent Risk Taking

We all know the saying, "No risk, no reward."  In markets especially, we cannot make money if we're not willing to take risks.  Frankly, however, my experience working with traders is that the greatest problem is not with taking risk, but with the intelligence of risk taking.  Traders take risks that, ultimately, they are not emotionally prepared to handle.

I recall the trading days in which you could get filled on a long position at the market's bid price and either get out a tick lower or wait and see if you could get a larger gain when it traded at the offer price.  Most trades could be scratched that way and you got plenty of free looks at larger moves.  Once market making became algorithmic, that level of risk control--the hallmark of true scalping--became impossible.  The noise was simply too great for the amount of signal traded.

The same has been happening at larger time frames.  The most common concern I hear from active traders is the "choppiness" or noise of markets.  High Sharpe, trending moves are the exception.  Very often, the market will take out previous highs before moving to lows and vice versa.  This makes it easy to stop out of trades at poor levels.

Risk taking becomes unintelligent when the amount of risk we take is ultimately more than we can handle, either emotionally or business-wise.  The trader who routinely gets stopped out of good ideas--ones that often work out in the end--is trading more size and taking more risk than they can handle, given the market's signal to noise ratio.  Traders overestimate the precision of their entries, leading them to seek trades that seemingly give them a reward-to-risk ratio of 2:1, 3:1, or even higher.  The reality, however, is that this becomes a losing strategy if the ratio of winning to losing trades is even higher.  The problem is magnified many times over when traders, out of overconfidence from a winning streak, take greater risk--particularly when market volatility has itself expanded.  The increased market movement and greater P/L volatility from the increased size places an emotional magnifying glass on moves against the position, increasing the odds of a bad stop out.

How do you know if you're taking risk that is not psychologically sustainable?  One simple yardstick is to observe your behavior during the life of a trade.  If you have a highly diversified portfolio; if you have  moderately sized positions with wide stops; if you express trades in risk-limited ways with options or relative structures, you should not be hanging on every tick in markets.  If you're glued to screens, if you're constantly checking your phones, if you're unable to conduct market research and attend to your trading business because you're preoccupied with market movement during the life of your trades, you no longer have emotional control.  You are much more likely to make reactive trading decisions that have low odds of success.

Risk taking that is threatening is not emotionally intelligent risk taking.  We cannot control markets, but we can control the risks we take.  When we size positions larger than we can ultimately tolerate given market noise, we give up our control--and that surrenders any edge we may have possessed.

Further Reading:  The Real Reason Traders Trade Emotionally