Monday, August 29, 2016

Listening to the Flow of Market Conversation

Imagine you come late to a party and a group of your friends has already arrived and is involved in an animated discussion.  What do you do?  Chances are good you might join your friends and see what the conversation is all about.  Only after getting a sense for what they're talking about might you jump in and participate.  

One theme I've discussed a number of times is that we can think of market activity as a conversation among various participants.  The flow of prices captures the transactions occurring among market makers, active day traders, longer-term thematic participants, asset managers, etc.  The skilled trader is the skilled listener, picking up on the nuances of the market conversation.  As in the example of the party, that requires a willingness to stay silent and get a sense for the conversation before jumping in and participating.

Too often, traders formulate their views and impose those on the market without truly listening to the flow of conversation.  That is like the boor at the party who talks at you, not with you, hogging the conversation with what they want to talk about.  Rarely does that work socially, and even more rarely does it provide an edge in financial markets.  When we're full of ourselves and our own views, we become less sensitive to the flow of conversation in the market, missing what is often obvious in retrospect.

That is why silence and a quiet, open mind are great tools for starting the trading day.  It's also why the questions that are most important to ask about any market are those that pertain to the flow of conversation among participants.

One heuristic I've found helpful is to divide recent market volume into quartiles:  low volume, low-average volume, high-average volume, and high volume.  At each quartile, a different class of participants has become active in the market conversation.  What are the prices at which the conversation is picking up or dying out?  When a new group enters the conversation, how "sticky" is their participation?  Do they continue and pick up their involvement or fade away?  If we look to upticks and downticks, volume occurring closer to the market bid side or offer side, how balanced is the conversation?  Do we see a growing tilt to the direction of the conversation?

If we do enter the market with a larger picture view, staying open minded with respect to here and now flows can provide us with valuable information for when our good idea becomes a good trade.  The excellent trader is the sensitive listener; emotional intelligence helps us execute our intellectually intelligent ideas.

Further Reading:  Bayesian and Static Reasoning in Trading
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Sunday, August 28, 2016

Hammers, Nails, and Improving Your Trading Toolkit

A reader recently asked the question of whether market movements are random.  At an informal level, I am struck by the number of skilled traders at each firm where I've worked who have accumulated multi-year track records of success, making money with a high Sharpe ratio trading actively in markets.  To be sure, these are not the majority of traders, but they are a distinguished minority.  As a trading coach working with them, I'm able to appreciate their talent first hand and recognize that their success represents far more than luck.   

Of course, on a more formal level, there is an entire research literature in mathematical finance detailing the non-randomness of financial returns.  These excess returns can be categorized by factors, such as value (the purchase of undervalued assets and sale of overpriced ones), momentum (the tendency of strength or weakness to persist), and carry (the returns that come from owning an asset, as in the case of dividends or interest rate differentials).  A strength of asset management comes from harvesting expected returns from portfolios that cut across these factors.  Balancing and rebalancing factor-based portfolios produces a level of diversification that smooths return streams and allows investors to count on returns superior, on average, to simply buying and holding a given asset or throwing darts at boards.

Factor portfolios have no opinions about markets; they do not trade expectations regarding the Fed, the election, data releases, or world events.  When individual traders ground their decisions on their opinions, they often are not factor neutral.  They implicitly take a position in a particular strategy, such as momentum or volatility.  Many naive traders, for example, trade from technical patterns that have them buying weak readings and selling strong ones (value) or buying/selling upside/downside breakouts (momentum).  Their weakness is that they apply the same strategies across markets and market conditions.  They are not diversified.  They are like Maslow's holder of the hammer, treating everything as nails.

So how can active individual traders achieve diversification and yet stay true to their trading strengths?  This is a challenge generally ignored in trading psychology.  Too many trading coaches assume that you'll make money if you just stay in the right emotional state.  If you trade a flawed strategy while keeping yourself in a calm, positive state, you'll most likely lose money with minimal emotional disturbance.

Participation in financial markets can be categorized broadly as trading versus investment.  Holding period is part of that difference, but only part.  Trading is predicated on microanalysis, the real-time construction of patterns by moving markets.  The trader thrives on rapid pattern recognition: the recognition of what markets are doing as they are doing it.  This requires fast, broad thinking and quick response times.  The investor thrives on the macroanalysis of broad conditions that impact markets and an understanding of their unfolding implications for future market movement.  To a large degree, trading/pattern recognition is about intuition and a feel for markets; investment is about formal reasoning and the understanding of patterns.

Traders achieve diversification when they trade multiple, independent "setups".  For example, they may trade momentum patterns in which price movement is accompanied by volatility breakout as well as reversal patterns in which price movement becomes exhausted, with a loss of volume and volatility.  Because they trade many setups during the day, they achieve diversification--even though they may be trading a single instrument.

The investor achieves diversification by participating in multiple, independent hypotheses about the world.  For instance, an investor might buy crude oil based upon geopolitical conflict and seasonal factors and might sell U.S. assets in favor of emerging market ones based upon differential monetary policies.  The investor places fewer trades across multiple markets for multiple reasons.  The trader places many trades in a limited number of markets with a defined set of independent setups.

Either way, whether you are an investor or trader, the smartest thing you can do to produce greater returns is to diversify.  One trick ponies run out of tricks when market conditions don't favor their particular factors.  A great strategy for your trading development is to identify the kinds of markets where you typically don't make money, figure out which factors are working during those occasions, and produce a strategy to allow you to participate in returns from that factor.  There will always be a high level of randomness/noise in financial returns.  We are most likely to find success if we can exploit multiple sources of signal amidst the noise.

Further Reading: A Systematic Approach to Discretionary Trading
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Saturday, August 27, 2016

A Powerful Formula for Our Development

Here is a great way to get better as a trader--and as a person:

Identify the times in the past week in which you were most sorely tested.  When did you face your greatest tests?  When in markets did you experience your greatest challenge?  When in your relationships?  What were the most difficult situations you faced?

Those are the situations in which life is giving you a test in order to teach you a lesson.  We learn from our challenges; we develop by tackling what is difficult and expanding our boundaries.

We gravitate to comfort.  It's not fun or easy to be challenged and pushed to our limits.  But that's where we'll grow.  

Certain market conditions are challenging for us.  Certain situations test our patience and tax our concentration and mood.  When you deliberately face testing situations, you are given many lessons.  That's not a bad format for a trading journal:  tracking the occasions in which you were tested, the lessons you learned from those, and how you will apply the lessons going forward.

Development depends upon discomfort; what taxes us potentially enriches us.

Further Reading:  Supercharging Your Trading Journal
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Friday, August 26, 2016

How Ordinary Traders Become Extraordinary

What makes trading challenging is that being average is not good enough.  You can be an average teacher, store manager, or contractor and you'll be able to make a living.  In trading, however, what is average is losing.  If you stay consistently average, you'll consistently go broke.  In performance activities, ordinary is not good enough.  The ones who make a living from their performances are extraordinary.   

Two factors define the ordinary trader:

1)  Lack of innovation - The average trader looks at the same headlines, the same charts, and the same information as other traders.  Years ago, a vendor of trading software shared with me that, when they helped customers via their support service, they found out that the vast majority of traders never moved the indicators off their default values.  Even fewer utilized customized features of the software.

2)  Lack of distinctive effort - Only in trading would keeping a journal be considered diligent effort.  If an owner of a startup restaurant went from day to day and simply kept a journal to make improvements, the restaurant would be poorly equipped to exploit trends among the dining public.  Many traders focus on central bank announcements and GDP reports.  Of those traders, how many actually read the statements of Fed governors, study the papers from Fed symposia, or follow the inputs to the final GDP numbers?  

When a lack of innovation is combined with a lack of distinctive effort, the result is a passivity of perception.  The ordinary trader is not in an active mode of processing information, and that ensures that new and deep learning will not occur.  When traders look at new information and put information together in new ways and actively investigate the utility of the novel data, they exercise their creativity and their capacity for effort.  Over time, deep learning--an internalization of meaningful patterns--occurs.

Every day, your preparation for trading, your actual trading, and your review of your trading are trips to a gym.  What makes you more than average is that each of those trips is an actual workout of your talents and skills.  Innovation and effort are what turn routine activities into workouts that make you stronger.

The chart above is what I call the Power Measure, which is a running correlation of price movement and volatility.  The above version is constructed with event data; the bars are not time-based.  The power measure is a way of visualizing whether buyers or sellers are having an easier time moving the market.  Calculating the power measure with event bars takes volume out of the equation.  It tells you more purely whether a given unit of volume is more likely to move markets higher or lower.  

There's a lot you can do with this information.  A simple first derivative of the readings tells you if markets are getting easier or more difficult to the upside or downside.  A moving average of the readings (depicted above) acts as a kind of overbought/oversold measure.  A cumulative total of readings acts as a measure of whether demand or supply is dominating over time.  

You may or may not employ a power measure in your trading.  The point is that creating measures that make sense to you, tracking them every day and within the day, and observing their patterns creates a depth of learning that is impossible for someone looking at the usual charts and canned indicators.  Innovative trading begins with innovation in perception and effortful information processing.  All of us take trips to life's gym; the question is whether those trips provide us with the workouts that make us stronger.

Further Reading:  Calculating the Power Measure
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Thursday, August 25, 2016

To Increase Your Discipline, Focus on Your Fulfillment

In a post a while back, I wrote about two proven methods for increasing your happiness.  A very important idea from that post is "You're most likely to work on your trading if your trading brings you positive experience."  It's when we feel happy and fulfilled that we're most likely to tap into productive and creative energies.

It is understandable that competitive traders look to their winnings to bring them their positive experience.  This is also where such traders most often lose their positive mindsets.  When inevitable drawdowns in the P/L occur, they create drawdowns in energy and attitude.  That's when traders often look for their happiness in the same place that they lost it.  They hope to regain happiness by regaining profitability.  Such an approach does not gain happiness; it loses control over one's happiness.

That is why one of the most important performance principles is to approach performance in such a way that the process of doing is what brings fulfillment, not just the outcome.  If trading is truly expressing and developing cognitive and personality strengths, it will be *intrinsically* rewarding, not just extrinsically so.  Your great challenge as a trader is to develop a process that is so internally rewarding that it will not break down when external rewards aren't forthcoming.

A skilled, successful trader wrote to me about knowing all the right things to do, but not cultivating the kind of routines that would routinely ground him in those right things.  Traders in such a situation assume that "discipline" is their problem, and they push themselves harder to make themselves do the right things--only to have such a push take them further from the joy in what they do.

If you want to follow a disciplined process, you have to find a way to make the process rewarding and enjoyable.  The best way of doing that is to yoke what we *need* to do with what we're *good* at doing.  We most often lose discipline because we're more concerned about being disciplined than being fulfilled.  The first step to turning that situation around is to stop looking for our happiness in the very place we lost it.

Further Reading:  Two Proven Methods for Building Your Happiness
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Wednesday, August 24, 2016

Gaining Perspective on Markets by Shifting Perspective

Almost by definition, if you're pursuing your own, unique path--in life and in markets--you are going to face uncertainty.  If we live life solely by following tradition and consensus, we'll find the security of the known, but will never have the adventure of finding our own path by tackling the unknown.

As the recent post outlined, successful trading is all about standing apart from consensus and finding unique perspectives and edges in financial markets.  But if you pursue uniqueness, you'll pursue uncertainty--and that requires a tolerance of what is uncomfortable and unfamiliar.

Two ways of gaining perspective on markets are microanalysis and macroanalysis.  In microanalysis, we break a market down into smaller pieces and look for clues to future activity based upon the patterning of those pieces.  So, for instance, I might look at the alignment of sector behavior within the SPX to gain clues as to what is strong, what is weak, and what the patterns of strength and weakness might mean for the economy and stocks overall.  A different form of microanalysis would be to break the price action of a stock or index into intraday pieces, as in the case of tracking volume flows or upticks/downticks over short intervals.  Many times, beneath the surface, we can see evidence of accumulation or distribution that gives us a clue as to forward market behavior.

Macroanalysis, on the other hand, places market activity in a broader context and looks for patterns among larger variables.  We could aggregate global economic data, for example, and infer patterns of growing global growth and weakness that could impact the behavior of stocks.  Similarly, we could look across the policies of world central banks and assess whether monetary conditions are skewed toward liquidity or tightness.  In macroanalysis, we might view SPX as a sector itself within the broader universe of global equities.  For example, since 2015, the correlation between daily moves in shares in Europe, the Far East, Australia, and Asia (EFA) has been about +.84 with the daily moves in the U.S. (SPY).  The correlation between daily moves in emerging markets (EEM) and the U.S. (SPY) has been about +.80.  Quite simply, markets are global and what happens in one part of the world is tremendously relevant for other parts.

If you find markets are unclear and/or you find yourself trapped on a consensus path, very often the answer is to take a fresh look through a microscope or a telescope.  Looking beneath the surface of market activity by zooming in on short-term patterns can bring clarity.  Stepping back from day to day activity and focusing on the big picture can also bring fresh understanding.  To gain perspective, we have to shift perspective.  Microanalysis and macroanalysis are two ways of accomplishing that.  It is difficult to stay stuck in a perceptual rut if we have many microscopes and telescopes available to us.

Further Reading:  Market Profile as a Fresh Perspective on Trading
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Tuesday, August 23, 2016

Five Distinguishing Characteristics of Winning Traders


At every trading firm where I've worked in recent years, I've observed winning traders and ones that struggle to win.  What makes the difference?  What are stand-out qualities of stand-out traders?  Five characteristics are especially notable:

*  Successful traders trade uniquely - They look at markets differently from consensus.  They process different information and they process the same information differently.  They have found a way of making sense of markets that makes deep sense to them and that grounds their decision making.

*  Successful traders are multidimensional - They have ways of making money in different markets and in different market conditions.  They are flexible; they find ways to win in difficult market conditions.

*  Successful traders work at their trading - They work on themselves and they work at markets.  When markets are closed, they're still engaged in their work.  Their focus is on self-improvement.  They don't just set goals; they live them.

*  Successful traders know when to not trade - They wait for opportunities, they pull back their risk taking when they're not perceiving opportunity.  It's not that successful traders are always successful.  It's that their success springs from knowing how to not lose when they're not seeing the ball well.

*  Successful traders are self-aware - They know their limitations, and they know what they do well.  They are quick to recognize when they're not "in the zone" and they also recognize when they are seeing unusually good opportunities.  They are not afraid to say, "I don't know".

A very significant proportion of successful traders have been mentored by successful traders.  Success breeds success.

A very significant proportion work in teams, relying on others who they can mentor and make successfulSuccess becomes a team sport, with everyone making each other better.

There is nothing static about the successful traders I've known.  They are continually learning and adapting, and they are continually searching for fresh opportunity.  Performance is not simply something they are good at; it's a way of life.

Further Reading:  Two Great Predictors of Trading Success
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Monday, August 22, 2016

Why Do We Sabotage Our Trading Talents?

The first post in this series examined how successful performance is a joint function of talent and skill.  The second post focused on how traders can identify their core talents.  This third and final post will address the problems that undermine our trading success and what we can do about them.

The central psychological challenge for trading is that frustration and doubts over losses and missed opportunities can lead to self-doubt, and self-doubt can lead us to tinker with trading to the point of veering from our greatest talents. 

A classic example is the intuitive trader who has a keen sense for pattern recognition.  After a period of frustration and loss, he begins to overthink his entries and exits, losing a feel for markets.  This compounds the losses and turns the normal setback into an outright slump.

Yet another example is the trader whose key strength is risk management and prudence of decision-making.  She decides she should be taking more risk and sizes up positions, creating greater volatility of P/L, and destabilizing her emotionally.

In each of these cases, it looks as though the trader is self-sabotaging.  What is actually occurring is that, under conditions of stress and emotional arousal, the trader has a more difficult time accessing and acting on his or her strengths.

How can we know when we're getting away from doing what we do best?

Two tell-tale signs let us know when we're no longer aligned with our talents:

1)  Trading becomes not fun - When we veer from personality strengths, we no longer experience gratification and fulfillment in our work.  That's when we find ourselves stressed and procrastinating.  Recall the key idea from the previous post:  the exercise of talent brings our well-being.  When trading becomes work and drudgery, we know we need to pull back and get back to what we do best.  

2)  Trading becomes confusing - When we lose touch with our cognitive strengths, we no longer experience a sense of understanding and mastery.  We trade best when markets make sense to us, when the factors we look at align in ways we've experienced before.  When we are confused, it could be the case that markets themselves are confusing:  those factors aren't lining up.  Often, however, our confusion reflects a shift in our processing of information.  We're in the dark because we've gotten away from how we best make sense of things.  That's when we know we need to step back and return to our best modes of information processing.

Viewed in this way, our experience becomes a barometer of whether we're aligned with our talents or not.  The single most important thing we can do when in drawdown is reacquaint ourselves with what we were doing when we consistently made money.  Find when you've been most successful and have traded best and you're most likely to find--and return to--your signature talents.

Further Reading:  The Surprising Reason for Trading Failures
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Sunday, August 21, 2016

How to Find Your Trading Talent

The recent post looked at trading success as a function of native talent and acquired experience and skill.  Because the exercise of talent is intrinsically fulfilling, we gravitate to activities that express our talents.  This exercise is what propels us through hours, days, weeks, months, and years of deliberate practice and skill acquisition.  Whenever we see unusual passionate motivation, we are likely to see the consistent expression of talent.  

Consider four dimensions of emotional well-being:

*  Happiness - Finding joy in life's activities
*  Satisfaction - Doing things that are meaningful and gratifying
*  Energy - Doing things that stimulate us mentally, physically, and emotionally
*  Affection - Building fulfilling relationships with others

When our life's activities provide us with these four elements of well-being, we are most likely to be productive and creative.  We're also most likely to be doing what we're good at.  Talent is one of the great sources of emotional well-being.

So if you're a developing trader, how do you know where your talents lie and what you're truly good at?

The simple answer is to examine what makes you happy, what provides you with meaning, what energizes you, and what brings you fulfillment with others.  Your talents are hiding in plain sight, bringing you your most positive life experiences.

Look to your passions and you will find your talents.

When I worked in Chicago, a number of successful daytraders were video game junkies.  They would spend hours in front of screens, trading actively, and then go home and go in front of screens and play actively!  Their talent was for hand-eye coordination and quick decision making, particularly in a competitive context.  Suppose I tried to turn them into long-term investors, researching the fundamental strengths of assets and creating balanced portfolios.  The activity would no longer express their strengths.  They would lose their intrinsic motivation.  They would likely become mediocre performers at best.

Conversely, a talented long/short equity manager I work with is a phenomenal detective, identifying value in places where others fail to look.  His great talents are intellectual curiosity and attention to detail.  If I were to try to turn him into a daytrader, he would find the activity utterly meaningless.  He could never sustain a learning curve.  It's no surprise that, before he started trading, he ran a successful eBay business as a young kid.  He was finding value and buying and selling it before he knew what the stock market was.

So often, talents can be found in the activities we choose to perform when we're not required to engage in activity.  No one has to tell me to rescue cats or write blog posts.  I don't have to get up at 4 AM daily to greet and feed my cats, follow overseas markets, and write my 4500th post to TraderFeed.  As Ed Seykota pointed out, it's not even that I have those talents.  Those talents have me.  

You will find your success, in life and perhaps in trading, by leveraging the talents that have you.  In leveraging our talents, we have the best chance of living a life filled with happiness, satisfaction, energy, and affection.

Further Reading:  Finding Opportunity Amidst Adversity
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Saturday, August 20, 2016

Awakening Your Trading Talent

Talent is what we're born with; skill is what we acquire with practice and experience.  Exemplary performance, such as that at the Olympics, lies at the intersection of talent and skill.  Without the hard work of skill development, talent becomes unfulfilled potential.  Many hours of hard work without distinctive talent, on the other hand, can produce competence, but rarely more.

We have one great advantage in our quest for exemplary performance:  talent loves to be exercised.  When something comes naturally to us, when we gravitate toward activities in our free time, when we lose ourselves in the flow of an activity--the odds are good that talent is involved.  Skill building is not always a labor of love; sometimes it is much more labor than love.  When we yoke skill building to talent, we can find the motivation to get through difficult drills and detailed performance reviews.  When skill building is attempted in the absence of talent, it is sheer drudgery, and it is rarely sustained.

Can anyone succeed as a trader?  Of course not.  Not everyone succeeds as an athlete, and not everyone can succeed as an opera singer, surgeon, or graphic artist.  Performance follows from talent and intentional efforts to cultivate talent to its fullest.  Without the right kinds of bodies, we won't be Olympic sprinters, wrestlers, or swimmers.  Without the right kinds of minds, we won't be chess grandmasters.  Raw material matters.  It may not be sufficient for greatness, but it is necessary.

Show me a great trader, and I will show you at least one great talent.  Great traders play to their great talent; they maximize their strengths.  

Show me a great trader, and I will show you a passion for his or her work.  Why?  Because talent loves to be exercised.  A great talent is like a great horse.  You can't keep it in the stall indefinitely.  You have to let it run.  Great talent loves to run and run free.  The result is unusual productivity.  But only if the talent is awakened and refined by skill development.

Trading success comes with greater difficulty in recent years, because the machines have at least two sources of talent:  processing speed and processing breadth.  Machines can "think" faster and can integrate more information than those relying on the unaided mind alone.  What person can trade dozens or hundreds of strategies across multiple time frames and multiple assets to create smooth profit/loss curves?  Little wonder that asset management firms relying on such processing power have amassed hundreds of billions of dollars of assets.  Markets work by the golden rule: those who have the gold, rule.  Market movement is a function of capital flows, and those who have the greatest capital are in a position to most influence those flows.

Great size comes at the expense of great maneuverability.  When you have hundreds of billions of dollars, you cannot easily sell out of your holdings without greatly disrupting markets and getting very poor prices as a result.  Large money managers have to build and trim positions over time, and that building and trimming leaves footprints.  Among the traders who are succeeding in the current environment are those who possess the talents and skills to read those footprints.  Opportunity does exist in the trading world, but it is a different opportunity set from the one I encountered when I first began trading in the late 1970s.

But you cannot exploit those opportunities if you don't understand your strengths, how to exercise them, and how to refine them with skill development.  How can we know what we're truly good at?  That will be the focus of the second post in this series.

Further Reading:  Creativity and Greatness in Trading
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