Trader Performance

After an initial post to the blog, I am continuing my research on separate measures of buying and selling interest. So far those measures are yielding worthwhile results. One interesting finding is that, until Friday's rally, selling pressure exceeded buying interest for eight consecutive sessions. What made Friday's rally unique was that buying interest was actually below average relative to the prior 30-day average. It was selling interest that was significantly below average that helped sustain the rally. In other words, it was more the absence of selling than the presence of significant buying that enabled stocks to move higher through the day.

This raises interesting questions: Are rallies based on excess buying more durable than those supported by subnormal selling? Are the most durable rallies typified by both superior buying interest and subnormal selling? Are declines based on a deficiency of buyers more likely to reverse than those typified by an excess of sellers? This is a most promising area of research. It applies to any variable/indicator and simply requires a conceptual separation of buying events and selling ones over the course of a trading day.

December 16, 2007

Opportunity: Investment vs. Trading

Markets move thematically, reflecting money flows across national boundaries and asset classes. Once these themes appear, they can persist for a significant time. Inflation themes dominated in the 1970 and 1980s; technology was hot in the 1990s. Now, in the most recent markets, weak real estate, emerging markets, and weak dollar have been at the fore.

My most recent blog posts examine 2007 opportunity as a function of sector, national markets, and investment styles.

Moving in and out of markets can blind one to the bigger themes that shape longer-term opportunity. That is one way in which trading differs from investment.

December 9, 2007

Intensity, Distress, and Change

Research in psychotherapy suggests that people who are more actively involved in change efforts--behaviorally and emotionally--are more likely to make lasting changes. An interesting corollary of this finding is that people who experience moderate levels of distress are more likely to make changes as well. If their distress levels are too high, they become overwhelmed and can't sustain a change process. If their distress levels are too low, they lack the motivation to sustain change. The moderate distress is a powerful driver for change.

We see some of the same dynamics among those who work on their trading. The intensity of change and learning efforts is correlated with the success of those efforts. People who work on their trading each day and each week, with concrete goals and frequent feedback, are much more likely to make improvements in their trading than people who simply talk with a coach every so often and don't set specific goals or action steps.

Much of the differences in intensity related to moderate distress. It is rare for traders who are doing well to sustain intense change efforts; more often, they think that they shouldn't try to fix what isn't broken. Similarly, traders who are doing very poorly and losing great deals of money are often too distressed to keep a level-headed focus on goals and improvements. It's the traders who are unhappy with their trading but not overwhelmed that often are ready to make the intense change efforts.

The work of Prochaska and DiClemente suggests that readiness for change is a major contributor to the success of change efforts. Some people are at a "contemplation" stage of change where they are not yet ready to sustain goal-directed action. Many times, this is because consequences have not yet accumulated to the point where the emotional drive for action kicks in. Sadly, problems sometimes have to get worse and distress has to increase before traders will tackle intensive efforts at change.

November 24, 2007

Seeing the World Through Global Lenses

In training programs in professional psychology, we're encouraged to see the world through the eyes of others. With that in mind, let's look at the U.S. stock market (S&P 500 Index) as denominated in a basket of world currencies (U.S. Dollar Index):

We can see that the Dollar Index-Adjusted SPX has greatly lagged its dollar-based equivalent during the recent bull market. Indeed, while the dollar-based SPX marginally exceeded its 2000 levels, the Dollar Index-based SPX has only retraced half the bear market declines of 2000-2003.

More recently, we can see that the dollar-based SPX is less than 10% off its all-time highs. The Dollar Index-based SPX has moved all the way back to its May, 2006 levels.

This illustrates in a small way how U.S. assets become less attractive to overseas investors when the basic unit of those assets--the dollar--loses its value.

As those overseas investors--from China to Middle East sovereign wealth funds--become increasingly important to international markets and money flows, the role of currencies and interest rates will continue as key determinants of value among equities.

The successful investor will be one who can see the world through global lenses

November 18, 2007

Concentrations of Capital

My recent blog posts have examined what I call "herding sentiment", the concentration of volume into either advancing or declining stocks. In the past few months, we have seen very high herding sentiment, as we shift between extreme buying and selling with above average regularity. I am playing with the hypothesis that, with the concentration of capital in the hands of very large institutions--and the increasing participation of those institutions in the markets day to day--we may see a secular increase in herding behavior. The August decline gave us a bit of a taste of what happens to markets when multiple funds (hedge, sovereign wealth, etc.) trade similar strategies.

If, indeed, we're seeing new market patterns emerging due to increased concentrations of capital, it will be helpful to keep an eye on herding and how this affects future market performance. I see two kinds of patterns as being particularly promising. First, we have sequences of herding days: multiple buying or selling days in sequence and alternate sequences of extreme buying and selling. What does it mean when an extreme selling day is followed by a similar such day? By an extreme buying day? These are very testable patterns and may become increasingly relevant going forward.

The second promising set of patterns are a bit more ambitious: Intraday patterns of herding. Suppose volume is concentrated into advancing issues during a 30-minute period? During a five minute period? Does this affect near-term market movement? Data regarding concentrations of volume are harder to come by on an intraday basis, but may be quite relevant to the daytrader (and to longer-term market participants seeking improved execution).

Staying ahead of the market with new ways to look at supply and demand is, itself, a component of a trading edge.

November 10, 2007

Operating in the Present

In my recent blog post, I emphasized that Bayesian, discretionary decision making requires an ability to stay focused in the present. The reason for this is that traders must observe and assess new data as they come in, keeping an open mind to whether the data confirm or disconfirm expectations.

So much of difficulty with trading performance occurs because we are not "in the moment". We are looking back on past losses or looking forward to hopes of gain. We're worried about our P/L, or we think the market might move without us. All of this is interference with the Bayesian process. Just as a jury member must put biases aside and stay grounded in each new testimony and piece of evidence, we must continually render our market verdicts based on assessments of ongoing data.

This is one reason I find meditation and biofeedback so helpful to trading. These help teach us to quiet our thoughts and remain in the present. Trading discipline, in that sense, begins with a taming of mind.

November 3, 2007

What You Do When Markets Are Not Open

I'm convinced that one's market routines during periods when their trading markets are not open have a lot to do with long-term success. Evenings and weekends are ideal times for market research. They provide opportunities to step back and see larger trends and themes in markets and develop ideas for the coming day and week. I consistently find that my preparation during evenings, early mornings, and weekends is correlated with my success the next day and week.

Think of two traders. One follows markets during trading hours; the other does the same but also studies charts and related markets--as well as his/her own trades--before the open and after the close. Day after day, think of how much more exposure to market patterns the second trader has compared with the first.

The really great performers in any field are distinguished by effort and the proper direction of that effort. We see it among Olympic athletes, artists, and scientists. The more mediocre performers simply don't break a sweat. They put in the normal hours, the normal effort--and they achieve very normal (average) returns.

My work day starts faithfully by 5 AM; many days earlier. By noon I've worked as many hours as many people put it during a full work day. My weekend days are exactly the same. By the time a week has ended, I have easily exposed myself to twice as much information, twice as many market patterns, as the average trader. Compound that over time, and it's not difficult to see how my learning curve can look radically different from someone else's after a year's time.

When you love what you're doing, it's not really work; it doesn't feel like effort. So what are people confessing when they don't make the extraordinary efforts?

October 27, 2007

A Fresh Look at Trading Success

Later this weekend, I'll be reviewing Michael Covel's book "The Complete Turtle Trader". It's an excellent account of the Turtle experiment and what has happened in Turtle-style trading since then.

One topic Covel covers is the personality characteristics of those who have succeeded with trend-following. He makes it clear that these are resilient individuals who can tolerate setbacks (including drawdowns) and who maintain considerable optimism through trading challenges. Interestingly, these are some of the same qualities found among entrepreneurs.

We can differentiate three kinds of traders: one who takes trading as a job, another who treats it as a career, and still another who finds in trading a calling. The career approach presumes a degree of professionalism in one's approach: preparing each day, searching for opportunities, honing one's skills. The very successful individuals profiled in Covel's account also approach trading as a calling. The section of the book on Salem Abraham was particularly illustrative in that regard. He has pursued trading in a dogged way from the very start--and has found unusual success.

Covel emphasizes that the Turtle experiment proves that nurture trumps nature when it comes to trading success. The methods needed to profit can be taught to otherwise ordinary individuals. Still, it's not clear that everyone has the personality traits needed to follow those methods. It's difficult to imagine a highly neurotic trader--one prone to anxiety, depression, or deficient self control--being able to sustain the optimism and drive through some of the harrowing drawdowns experienced by the Turtles.

Discipline--the ability to follow rules (including risk management)--is one key to success as we examine the Turtle group (some of whom succeeded much more than others). But there's another key as well, and it relates to emotional resilience and sustaining the courage of one's convictions. Successful traders seem to lose and drawdown every bit as much as unsuccessful ones. It's their ability to control those losses and bounce back from them--to not take them personally--that generates a career and a calling from what otherwise would be their job.

October 20, 2007

Trading Relationships

Most discussions of trading focus on "outright" trades: the trading of instruments for directional movement. Such trades are actually relationship trades, but because they are denominated in dollars, we tend to forget that there's a denominator.

When we trade relationships, we denominate one instrument in terms of another. This is common among currency trades, where one currency is expressed relative to another (Yen/Dollar). When we trade relationships among stocks, sectors, or indexes, we are actually trading a new instrument that represents the relative strength of the numerator relative to the denominator.

We may trade these in pairs fashion, expecting a relative movement of one correlated instrument vs. another to revert back to its norm, or we may trade the relative strength as an outright position in itself.

What is important is that, once we express an instrument as a function of another instrument, we create a new trading vehicle. That vehicle can be charted and studied for recurring patterns, just like any stock or commodity.

For example, if we think the dollar will continue to fall, we might buy shares in a company that has strong international sales and sell shares in a firm in the same sector that is largely domestic. We are thus trading the relative strength of the international firm vs. the domestic one. Note that this relationship does not depend upon the direction of the overall market or sector: as long as the international firm outperforms the domestic one, we will make money.

It is this relative independence from directional market and sector movement that enables such long/short trades to add alpha to a portfolio. This is an approach commonly exploited by hedge funds, but curiously neglected among individual traders and investors.

October 14, 2007

Relational Thinking in Markets

I recently posted a trilogy of studies that show how relative performance in three areas can illuminate market sentiment:

* Sector relationships

* Relationships across asset classes

* Relationships across international markets

More important than the specific findings of those posts is the type of reasoning that they embody.

By understanding how various markets are behaving relative to one another, we can gauge the sentiment of traders and investors and acquire an edge that is separate from any edge that we might enjoy as a discretionary trader of intra-market patterns.

Indeed, I find a synergy between explicit, relational reasoning (for big picture ideas) and implicit, discretionary pattern-recognition (for timing and execution).

It's when the real-time pattern recognition lines up with the bigger-picture edge that we see some of the greatest trading opportunities.

October 7, 2007

Understanding the Mind of the Trader

This coming week, I will draw upon Howard Gardner's recent work on "minds" to illustrate the kind of thinking required by successful trading. Among the categories emphasized by Gardner are the disciplined mind (a mind trained to reason in ways demanded by a field); the synthesizing mind (a mind trained to integrate large amounts of information); and the creating mind (a mind trained to identify new relationships and perceive old topics in new ways).

Gardner emphasizes that these minds develop in a progression: we first gain knowledge and discipline, then learn to synthesize our understandings, and then become able to move beyond these with creative contributions.

A good example would be the training of attorneys. They first study the law and learn legal reasoning through the socratic process. Later, they learn to assemble cases and integrate their knowledge. Later still, they learn creative ways of applying legal precedents to fuzzy cases to best make their arguments.

Such training for attorneys--as for physicians and engineers--takes years of full-time effort. I strongly suspect the same is true for traders, who must learn first about markets and market patterns, then learn to synthesize patterns within and across markets, and then perceive new relationships that promise a probabilistic edge.

One cannot help but read Gardner's work and come away skeptical of so many of the current efforts that pass for "trader education". The absence of a true trading curriculum for new traders--one that instills disciplined reasoning, an integration of market information, and practice in uncovering new, promising relationships--is perhaps the greatest barrier to success. But that, as with the law or medicine, would require years of study, application, and mentorship. One can trade for many years and still lack the mind of a trader: the discipline, the ability to synthesize, and the creative capacity to perceive fresh relationships.

September 22, 2007

Trading Epistemology: Defining the Trader's Unit of Thought

Epistemology is the study of knowledge and the process of knowing. Epistemology is important to trading, if for no other reason than to help traders differentiate knowledge from error--and to help traders understand where knowledge about markets comes from and how it can be obtained.

A recent post to the TraderFeed blog got me to thinking about the basic unit of thought for traders. Traders talk about "trading ideas" or "setups", but these mean different things for different traders.

Let me give an example relevant to the blog post. If I see we're in a trading range, I try to identify supply/demand within the range via such indicators as NYSE TICK and Market Delta. I also look at how correlated markets are behaving during the rangebound period to see if I can identify a possible lead-lag relationship that would predict a breakout.

Once I have done that, I will place a trade to take advantage of an expected move outside the range. As part of that trade planning, however, I will also have mapped out a stop-and-reverse trade in the event my initial trade is wrong.

In other words, my trade planning includes a contingency for using the initial trade as valuable information if it doesn't go my way. That trade is a feeler with small size that leaves open a web of alternatives, from adding to the trade to stopping and reversing.

In an important sense, then, the trade idea is really not a single trade, nor is it (as is so often, sadly the case for traders) a mere idea regarding entry. Rather, the unit of thought is defined in terms of market opportunity (break from a range) and can include a number of trades and trading decisions.

On a broader level, the unit of thought for the hedge fund portfolio manager is the "theme". It might be a weak dollar theme or a theme regarding relative returns in U.S. vs. international equities. That theme will subsume many trades across multiple asset classes.

Many traders fail, I suspect, because their unit of thinking is too small. They see individual entries, not entire trades (entries, stops, position sizes, targets), and they individual trades, not networks of possibilities that are updated with the results of each transaction.

The stop-and-reverse notion is simple, but it's a leap for traders who simply don't think that way. They will take a loss, stop trading, or enter an unrelated trade--not unlike a person who jumps from thought to thought without adequately expressing themselves. For them, the unit of thought is the trade. But how might your thinking (and your trading) change if that unit become the opportunity?

September 15, 2007

The Secret of Expert Performance

What creates elite performance? Is it inborn ability? Developed skill?

One of the most significant conclusions from the research I reviewed for my book on performance was the work of Sandra Scarr, Ph.D.

What she found was that genotypes shape phenotypes. People with inborn characteristics seek out particular kinds of environments, which in turn cultivate those characteristics.

Thus it is that children can be separated by only a small number of IQ points, but end up having very different developmental paths intellectually. The brighter children seek out brighter peers, who in turn stimulate each other's intellectual growth. The less bright children never seek out such social environments and thus increasingly lag their more gifted peers.

So it is with trading talent. We see young traders who pick up markets just a little faster, who are just a little more able to read market patterns. These traders are more likely to be hired by elite trading firms; they're also assigned to more stimulating and successful trading environments within those firms. As a result, these slightly more gifted traders receive far better mentorship and undergo exponential growth.

The average trader never experiences stimulating environments and thus progresses at a relatively modest pace.

It's not talent, and it's not environment: It's how talent brings you to superior environments that creates exponential learning curves and elite performance.

This, I believe, is why the vast majority of traders cannot sustain a living from their work.

September 9, 2007

If I Were a Beginning Trader

If I were a beginning independent trader and knew what I know now after 30 years in the markets, what would I do? A few ideas come to mind:

1) I wouldn't give up my day job quickly - I realize now more than I did as a newbie that only a fraction of traders make money, only a fraction of those continue to make money over time, and only a fraction of those are sufficiently capitalized to make a living from their trading. As I mentioned in a recent blog post, pursuing trading full time before you've developed a track record of success is not a dream; it's a fantasy.

2) I would undertake considerable simulated trading before trading live - When I think of all the practice hours on the basketball court working on dribbling, rebounding, passing, defending--and when I think of all the practice time in scrimmage getting plays down pat--I realize that game time is just the tip of a large learning iceberg. Trading truly is the only performance domain I know of in which a majority of participants expect to spend less time in practice than in actual live performance. No wonder so many lose money.

3) I would try out many markets and time frames before settling on any one - I'm continually amazed by how traders who are mediocre performers in one market can blossom once they move to a different market. I'm also impressed by the ways traders find time frames that work for their personal needs, capturing the right blend of market involvement and freedom from the screen.

4) I would find just one or two setup patterns and master those - It's hard to imagine successfully trading multiple patterns and markets before mastering one. By working on a specific setup, a trader can then focus attention on pattern recognition, execution skills, money management, and discipline: the skills that will be of help when it comes time to extend the trading reach. It took many, many months of printing out and studying intraday charts for me to find the few patterns that I now trade.

Most of all, if I were a beginning trader and knew what I know now, I'd realize that trading is no less of a business than opening a store or a doctor's office. It requires talents, developed skills, and a clear plan for success. It requires adequate capitalization, and it requires a firm ability to limit overhead during the early, lean years. Fantasies are exciting, but there is so much more to performance success in any discipline.

September 1, 2007

Using a Basket of Stocks to Approximate the Market

In recent posts, I've been using a basket of 40 S&P stocks, evenly divided among eight market sectors and highly weighted within those sectors, to approximate the index as a whole. With the basket, for example, I can track the number of stocks displaying positive, neutral, and negative directional movement: the basis for my Technical Strength Index. I can also track new highs vs. new lows on multiple time frames and can create a custom Advance-Decline line to see how many stocks are participating in moves. The advantage of a basket that contains equal numbers of stocks from the major market sectors is that you can then track the sectors that are gaining and losing strength, a possible consideration in a relative strength sector-based strategy.

Where the basket data shine is in monitoring intraday patterns of strength and weakness. Here is a chart of Thursday and Friday, 8/30/07 - 8/31/07. The chart tracks the number of stocks in the basket making hourly new highs minus lows on a closing five-minute basis. In short-term uptrends, pullbacks will normally terminate in the -20 range; in downtrends, we'll see bounces up to the +20 region. Note the drying up of new lows in the afternoon of the 31st, leading to the late rally. Also notice the modest strength of that rally, which led to the broad selling late in the day.

The broad market averages, dominated by a relative handful of highly weighted issues, don't always reflect the strength and weakness of the stock market. By looking under the hood at the stocks comprising the averages, we can see if strength and weakness are limited to a few sectors or are broad phenomena. It's when we see poor participation in rallies and declines that we most want to look for reversals.

August 25, 2007

Revisiting the Power Measure

In my March 25th posting, I mentioned the Power Measure as a way to track the market's trendiness. More recently, I posted about the Power Measure on the TraderFeed blog.

Below is the chart from the blog post. This covers a multi-day period with five minute data. Note that pullbacks in the Power Measure occur at higher price lows, suggesting an intact uptrend over that timeframe.

Below we create a higher magnification view of trendiness by using one-minute data for the trading session of 8/23/07. This time we see a turnaround (reversal) pattern: up to midday, we see Power Measure peaks at successively lower prices, an indication of downtrend. We then get a substantial rally in the Measure and a subsequent dip at a higher price low. That sets the stage for late day firmness in price and Friday's eventual rally.

As the examples suggest, it's the relationship between peaks/valleys in the Power Measure and price levels that is most important in tracking trends. Of equal importance is the nesting of peaks and valleys across time frames. It is very helpful to see what the Power Measure is doing at at least one time frame above your own. Many good swing trading ideas can follow from such analyses.

The key is to enter the market in the direction associated with greatest volatility: this puts the market winds at your back, rather than leaving you to fight them.

August 18, 2007

Time and Trend: Nucleus for a Trading System

A trend is defined not only by the price change between point A and B in the market, but also by the amount of time that lapses between A and B. A single bar that moves up or down sharply won't be defined as a trend. If, however, you break that (say, hourly) bar into 30 two-minute bars, you may well see a short-term trend.

But what makes traders *feel* as though a trend is in place?

One answer I'm playing with is that traders will label market periods as strong or weak when a high proportion of the bars covering the period are either up or down. In other words, a 30-bar period that has 15 up bars and 15 down bars will not feel as bullish as a 30-bar period with 25 up bars and 5 down bars--even if the two periods cover the same price change.

Why is it important that a market *feel* bullish or bearish? That's because a large proportion of the traders participating in that time frame will have already committed their positions. This would make the market vulnerable to reversal in the near term. A system that caught extremes of psychological bullishness or bearishness could capitalize on the market's tendency to reverse short-term strength or weakness.

The formal logic of the system would be as follows:

1) An initial alert would be triggered when X% of the past Y bars are either bullish or bearish. The bars would vary in length from 1 minute to 1 day. This would ensure that alerts could be generated for a variety of time frames.

2) Once an alert is generated, the system goes into setup mode. The setup has to consist of a series of bars in which buying (in the case of an up market) or selling (down market) dries up, as measured by volume, division of volume at bid/offer, participation of market sectors, etc.

3) Once there is a setup, the system goes into execution mode and enters a position to retrace at least half of the prior move, with entries set so that there is a 2:1 risk-reward ratio vis a vis initial stops and price targets.

This may appear to be a countertrend system and, in a sense, it is. It is entirely possible, however, that the trades would be in the direction of longer-term trends, even as they fade short-term trending moves. One of my projects is to see if trading this concept in the direction of longer-term trends leads to more favorable outcomes.

While this is not a purely mechanical system, it is potentially highly rule-governed, which would take a fair amount of the guesswork and emotion out of trade decisions. I will update my progress on this project.

August 11, 2007

Tracking Markets by Stages

I've recently read an excellent e-book called "Taking Your IRA to the Next Level" by Dr. Humphrey Lloyd. Dr. Lloyd, a physician by occupation but also an experienced trader, synthesizes a wide range of classic and newer technical analysis methods with recent developments in markets, such as ETFs. I was not surprised to learn that Yale Hirsch of the Stock Trader's Almanac had reviewed Dr. Lloyd's book favorably. It's rare to find a presentation of methods that incorporates innovative work from prior decades.

One of the ideas in the book that caught my attention was the classification of markets in stages through the use of moving averages of differing durations. In an initial stage of upthrust, a market will trade above both its shorter and longer-term averages. As the upmove loses steam, it will trade below the shorter-term average but remain above the longer-term one. Then we'll get a downphase in which the market drops below both averages before righting itself and moving above the short-term average.

It should not be a problem to quantify returns from various stocks, ETFs, etc. when they are in various stages over a defined lookback period. I will be pursuing this in an upcoming post.

I'm also thinking that one could use market indicators rather than price alone for classifying stages. For example, we could look at when current new highs/lows are above or below moving averages for these.

This could provide a worthwhile conceptual aid for traders, which is how Dr. Lloyd uses it for stock/fund selection for IRAs. More to come--

August 4, 2007

Key Elements of Trade Execution

I recently posted an example of a trade setup to the blog. The chart appears below; click here for a larger version.

I use the term trade idea or trade setup to describe the basic rationale of the trade. In the above example, we have a market that is in a downtrend, that makes a bounce from the lows, and that is expected to revisit those lows given the lack of vigor in the bounce.

I use the term trade execution to refer to the trader's ability to get the best price for his or her trade for implementing the trade setup.

For example, if I had chased the lows in the 13:42 bar above and sold the market at 1458, I would have had a good trade idea, but poor execution. I would have endured two full points of heat prior to the trade eventually going my way. If my stop was set at, say, 1462, I would have taken 4 points of risk in the trade. Given that my target was the 1456 region (bottom of the short-term trading range), the risk : reward ratio on the trade would not have been favorable.

Suppose, however, I had sold the market when the buyers could not push the market to new highs at 1460 in the 13:45 bar. Now I have minimal drawdown in the trade and only 2 points of risk, with a profit potential of 4 points. That's much better.

This is a small example, but it illustrates the importance of execution for the short-term trader. When you chase market moves, you frequently turn a good trade setup into an unfavorable risk : reward trade.

My best trades wait for us to put in a likely high or low price, then wait for a counter move to verify a shift in short-term direction/participation, and then enter on the first bounce from that counter movement. In practice, that means I'm identifying a candidate high or low and then selling bounces that cannot make new highs and buying dips that cannot make new lows.

The key to good execution is getting into the trade close enough to the candidate high or low that you have a favorable risk : reward profile to the trade.

If the trade gets away from you, you let it go.

It takes real patience to limit trading to those favorable risk : reward situations. Only when the setup is there and the execution is good do you participate. A good trade idea is only good if it can be executed well.

July 28, 2007

Non Stationary Markets: A Theory of Market Participation

Going into this past week, my trading had been much better than average. I was running 75% winning trades, and my equity curve was making daily new highs. During the last three days of the week, however, I was at best 50-50 on my trades and net lost 1% from my peak.

It's not a dire drawdown, and I'll work at getting it back. But it was the dramatic shift in the *feel* of my trading that got my attention. In a word, I lost the feel. It was as if I were watching and trading a different market--like you had taken me from the Spooz and suddenly had me trading nat gas. Alarmed, I cut my size and cut my frequency of trading, which is why I only lost 1%. I would have gotten crushed had I traded aggressively.

I'll be posting to the blog re: the change in market volatility and what that means for the short-term trader. There's no doubt in my mind that the enhanced volatility was a big part of what made the last three days feel different to me.

But I think there's more to it than mere volatility.

Volume has increased significantly during the last few sessions in the ES futures, and I believe that this represents a shift in market participation. In other words, the market is not only quantitatively different than before (more volatile), but qualitatively different. This is because a different class of trader is active in the market place.

Specifically, I propose that large shifts in volume are primarily a function of the activity of professional traders in the marketplace. There aren't enough small, retail traders trading size to account for significant increases in equity futures volume. Indeed, my speculation is that it is the high frequency "black box" trading that expands most significantly during times of enhanced market movement. This would explain why volume would be above normal throughout the day during times such as this past week.

To a trader who follows the ES market closely, a market dominated by automated trading simply feels different than one in which the black boxes are quiet. The automated trade will engage in spurts of buying or selling, often pushing the market just beyond a recognized resistance or support level. This pushes other traders to cover their positions or jump aboard, further exaggerating the move. The automated trader, however, has resting orders above or below the market to take quick profits on the move--which leads to rapid retracements.

The net effect of this trade is, at multiple time frames, many false breakout moves. It also leads to sudden rises or declines that often end up going nowhere on balance. This is what traders refer to when they say a market is "choppy".

Bottom line: the market at 10 VIX is both qualitatively and quantitatively different from the market at 24 VIX. Trading patterns are not the same (the assertions of technical analysts to the contrary), and the expectations following given setups are not uniform. This is what statisticians mean when they say that stock market returns are non-stationary: they are not generated by a single, common process. This is because the makeup of the market--its participants--differ as a function of volume and volatility.

This is why good traders can have a feel for the market at one time and seem to entirely lose it at other times. When markets shift volatility significantly, they become different markets and discretionary traders need to immerse themselves in the new patterns to regain their feel. Very high volatility markets may be the hardest to trade of all because they rarely stay at highly elevated levels for enough time to allow traders to gain their feel. For that reason, volatility is as likely to represent risk and danger as opportunity.

July 21, 2007

Reflections on Learning Styles and Trading Performance

In my recent article, I took a look at four dominant learning styles--verbal, auditory, reading/writing, and kinesthetic--and how those might affect how traders process information. What makes one trader a chartist and other a quant? It may well be a function of learning strengths and preferences.

I see two points of intersection for learning styles and trading performance:

1) The Learning Process - Might traders struggle to succeed because the ways in which they learn trading don't match well with their learning styles? Chart displays won't be helpful to a trader (such as myself) who doesn't possess visual strengths. Similarly, trading books won't be useful to a trader who doesn't process information well through reading and writing. Traders may seek out seminar events and webinars because they are auditory learners. Still, it is difficult to sustain the learning process through the auditory channel unless you have a trading coach/mentor on site. The learning curve for traders is necessarily extended, as traders must experience and internalize patterns from a variety of markets: trending, consolidating, volatile, slow, etc. When the mode of learning does not fit with a trader's strengths, however, the curve will be needlessly frustrating. Similarly, if the trader's desktop does not display information in modalities that are most useful for the trader, decision-making will be hampered. An important implication is that effective trading education (like all effective education) needs to be multimodal. This is not only because students in a group will process information differently; it's also because information encoded through multiple modalities is more likely to "stick". Seeing, doing, discussing: this cements learning for students with multiple processing competencies.

2) Trading Psychology - What happens when traders experience high degrees of flight-or-fight fear and frustration? Under emotional duress, they regress to modes of coping that were learned at an earlier phase of development. The trader who learned to deal with conflict through withdrawal as a child may find himself withdrawing from markets following a a loss, regardless of the opportunity that may be present. Similarly, traders under stress may also abandon their mature learning strengths. I recently encountered a situation in which a trade unexpectedly went against me. My own strengths in processing information are reading/writing, followed by kinesthetic. Nonetheless, I found myself furiously glancing through charts to figure out what was happening in the market. I have never been a chart reader and anything of worth I get from a chart is by luck only. Still, charts were the first thing in front of me and, in the heat of the situation, they were the first things I turned to. It was only after steadying myself that I switched over to reading the real-time flow of volume at bid vs. offer to see if the move against me was caused by an influx of large traders. It wasn't and the trade retraced its adverse move. Had I stuck with my frantic chart review, I'm sure I would have found a reason to bail out of the good trade. How many trading problems occur because, under duress, traders abandon their strengths as information processors and decision makers?

Traders hope that success will come from the right indicators, the right software. That's like a golfer hoping to win a PGA event by buying the right golf clubs. Success comes from the process of skill acquisition: it is an intensive learning process that adds knowledge and skills to basic talents. Traders are most likely to progress along their learning curves if they figure out how they best learn and adapt their education--and trading styles--to that.

July 15, 2007

Breaking Down Your Performance for Quality Improvement

Several readers have recently contacted me to share their performance statistics and ask for advice on making improvements. By keeping those stats, they've made an important first step in understanding what they do well, what isn't working, and how to make the most of their strengths.

One set of statistics that I particularly like is a breakdown of performance as a function of the specific setups being traded. For example, you might categorize your trades as either breakout trades, countertrend (mean reversion) trades, or trend trades. Further categorization would break each of these setups down by time of day, instrument being traded, long/short, and size being traded.

What you are likely to find is:

1) A few setups are providing most of your profits;

2) Setups work best as certain times of the day; other times, there is little or no edge;

3) Setups work best when aligned with larger timeframe trends;

4) Setups work better with some instruments than others.

Once you have a global sense of what is working and what is not, then you can place your trades under a microscope. Look at your entries. Could you have been more patient and gotten meaningfully better prices for many of your trades? Look at your exits and stops. Could you have made more money overall by holding trades longer? Look at your losing trades. Are a few large losers depressing your overall P/L?

In monitoring these metrics, you begin a transition: from thinking of yourself as a trader to thinking of yourself as a portfolio manager. Your various setups are strategies that you trade within your portfolio. Are the returns from these strategies strongly correlated from day to day, week to week? If not, might you become more intentional about allocating portions of your capital to each strategy to diversify your risk?

It is one thing to study markets. Successful traders, I find, also study themselves. Continuous quality improvement (CQI) is a norm at many companies: they assess their products and processes to ensure that they are both effective (achieving desired ends) and efficient (making the most of limited resources in pursuing those ends). Such a CQI mindset is equally applicable to traders.

July 8, 2007

Anticipating Market Volatility

As I mentioned in my recent blog post, traders sometimes focus on market direction at the exclusion of volatility. How volatile the market is--how much price movement is likely to occur during the day--is quite important to risk management (the placement of stops and sizing of positions) and to the maximization of profits (the setting of profit targets). When traders don't adjust their trading for enhanced volatility, they are likely to exit good positions too early and set stops too close, resulting in whipsaws. Similarly, when traders don't adjust their trading for reduced volatility, they fail to take profits when they're available and see those winners quickly retrace. They may also place stops too far away, making it difficult to recoup losses.

The predictive variable I found to be most related to the current day's volatility is the prior day's closing VIX, the option volatility. Going back to 2004 (N = 883 trading days), VIX has varied between 9.89 and 23.81. Here is the high-low range of the current day's S&P 500 Index (SPY) as a function of the previous day's closing VIX:

VIX = 12 and under: .78% Average Range (N = 251)

VIX = 12.01 - 14.00: .86% Average Range (N = 285)

VIX = 14.01 - 16.00: 1.03% Average Range (N = 209)

VIX = 16.01 and over: 1.18% Average Range (N = 140)

What we can see is that a high VIX reading yields an average daily trading range that is 50% greater than that seen under a low VIX regime.

We also know that the current day's volatility is related to the current day's volume levels. By noting the prior day's closing VIX and then updating estimates of volatility based on present volume, we can ascertain whether the market is likely to show above average or below average volatility for that particular VIX level. For instance, when the VIX is 12 or below *and* volume is below average for that VIX level (N = 126), the day's average high-low range is only .64%. With the same VIX level and above average volume (N = 125), the average range rises to .91%.

Knowing the volatility expectable at a given VIX level and then knowing whether or not we're trading with above or below average volume for the trading day provides us with a superior handle on the day's likely movement. And that will tell us quite a bit about the opportunity present for daytraders.

July 1, 2007

Trading by Sentiment

I met Trevor Harnett yesterday AM at Starbucks to catch up on developments at Market Delta. Our conversation led to an interesting idea that I'll be pursuing through the Market Delta program and trying out in my own trading. Barcharts are usually denominated in time units: 1 minute, 5 minutes, etc. Occasionally we see traders create volume based bars (new bars form every time a given number of contracts/shares trade) or volatility based bars (new bars form every time the market moves a given number of ticks). The advantage of the volume and volatility bars is that they adapt to market conditions, creating fewer bars during slow market periods. That is helpful in reducing overtrading at such times.

Suppose, however, that new bars on a chart form as a function of sentiment. Every time a threshold number of contracts trade at the offer vs. bid, a new bar forms. We would thus tend to form more bars during high volume periods and during periods of directional market activity. Rangebound periods, in which volume at bid roughly equals that at the offer, would take longer to form new bars. Moreover, one could draw the bars solely on the basis of the volume of large traders, isolating their directional participation. New bars would form more readily when large participants are active in the marketplace.

My initial sense is that such a way of drawing charts would highlight trendiness or directionality, helping traders see emerging moves more clearly. It's a novel concept; more to come as I experiment with this.

June 24, 2007

The Power of New Lows: Fading the Herd

The market's inefficiencies, and hence its greatest returns, occur when traders and investors behave in a herdlike manner. That's when they're buying or selling indiscriminately, lifting or pummeling all shares. One way of assessing such herdlike behavior is tracking the number of stocks across the major exchanges (NYSE, NASDAQ, ASE) that are making fresh 65-day lows.

Going back to 2004 (N = 814 trading days), there have been 82 occasions in which 65 day lows have exceeded 700. Fifty days later, the S&P 500 Index (SPY) has been up by an impressive average of 3.65% (73 up, 9 down).

Conversely, when we have had fewer than 100 stocks making fresh 65 day lows (N = 52), the next 50 days in SPY have averaged a loss (!) of -.08% (21 up, 31 down).

For all other occasions (N = 679), SPY has averaged a 50-day gain of 1.61% (466 up, 213 down).

By fading the herd, buyers at times of broad selling would have doubled the market's average return. By going with the herd, they would have lost money on average.

In terms of trading performance, such parameters provide guidelines for possible criteria for lightening up core positions and adding to them, adding to buy-and-hold returns.

FYI, the most recent signal occurred on 6/13, when we registered 760 new 65-day lows. If the precedent of the past 3-1/2 years holds, we should see higher prices into the fall.

June 10, 2007

Tracking the Trend

In my recent post regarding stock market performance as a function of hour of the day, I found that the first hour of trading has accounted for about 3/4 of all gains in the recent bull market. A finer grained look finds that most of this gain is attributable to overnight action: the movement from the close of the prior day to the open of the next trading session. What this means is that the trend of prices for the daytrader is not necessarily the trend of prices for the longer-term trader. One of the most common mistakes I see very short-term traders make is extrapolating trends from daily charts to their own, intraday trading. In point of fact, from market open to close, there may be no such trend whatsoever.

To remedy this problem in my short-term trading, I like to see trending moves emerge during the course of the day. Four indicators have proven particularly useful in this regard:

1) Tracking Intraday New Highs/Lows - By following a basket of stocks that highly correlate with the S&P 500 Index (and are highly weighted within the SPX), I examine how many issues are making hourly new highs and lows. As my recent post indicates, shifts in these new high/low numbers can alert us to transitions between short-term market trends.

2) Tracking the Trend of the NYSE TICK - I calculate the Adjusted NYSE TICK by adjusting each one-minute TICK reading for the 20-day average value of the TICK. This measure is sensitive to small cap movement as well as the large caps and provides a useful gauge of shifts in sentiment. When we see the NYSE TICK providing readings consistently above or below its 20-day average, this provides a nice alert for a trending market.

3) Tracking the Emerging Moving Average of the NYSE TICK - With this measure, I calculate and update the average NYSE TICK reading for that specific trading day and then see if the readings are sloping upward or downward. The emerging average is sensitive to breakout moves in the TICK, which often signal shifts in short-term trader sentiment. I'm trying to see, over time, whether more traders are hitting bids or lifting offers across the broad universe of NYSE stocks.

4) Volume Transacted at the Market Bid and Offer for the ES Futures - Here we're focusing on large traders and whether they are dominantly hitting bids or lifting offers in the market. The Market Delta program charts this indicator quite effectively, catching shifts in large trader sentiment. The idea is to ride the coattails of the largest market participants: they create the trending moves.

Price is not always the best indication of market trending. False breakout moves are legion in the stock market due to the influence of a handful of highly weighted issues within an index. By looking underneath the market hood at strength (new highs/lows), sentiment (TICK), and large trader behavior, we can observe trends in the making--and shifts among them.

June 2, 2007

Followup to the Trading Coach Project

Last week's announcement of a project in which I would provide free coaching to a trader for a month brought a significant response. I greatly appreciate the time and effort people spent in volunteering for the project. Note: I have selected the first trader for the project on 6/3 and cannot accept further applications at this time. Those who have responded, however, can be considered for the project at a later time if they're interested. In this post, I thought I'd provide some feedback about the submissions and raise some issues that might help those who expressed interest. Here are some observations:

1) About 80% of the submissions were from traders relatively early in their development. The remaining fifth were from traders who have an established track record of success. The established traders spent more time talking about their trading methods, risk management, etc; the developing traders spent more time talking about psychological barriers to success. My sense, having read the submissions multiple times, is that many of the traders trying to find their success are too quick to attribute their problems to psychological sources and not sufficiently critical of their trading methods. This was particularly true of traders who described rather plain vanilla technical analysis strategies for trading.

2) A major problem among the traders, experienced as well as new, was that their goals for coaching and self-development were vague. They expressed a general sense of what they wanted to accomplish ("I need to let profits run and cut losses sooner"), but did not seem to have a concrete understanding of how, specifically, they would do that. My sense is that many of the traders who wrote to me are *not* ready to jump into trading psych exercises and techniques for change. Rather, they would benefit from working with a coach to explore their successful and unsuccessful trades and get a more concrete handle on their strengths and the areas needed for improvement. From such specific exploration, the traders could develop positive, measurable goals that would spark their progress.

3) The "discipline" issue is overrated. I'll write something for TraderFeed on this topic. Suffice it to say for now that many of the traders are working with relatively fixed trading size and trading strategies. Markets, however, are not fixed--especially with regard to volatility. When volatility expands, the traders are taking profits "too quickly" and letting losses get away from them; when volatility contracts, they are letting small gains turn into losses because they're holding positions for follow-through that never comes. I'm suggesting that the problem is not necessarily one of discipline. It's a lack of flexibility, and it's an inability to adjust to shifting conditions of volatility.

4) Some traders expressed goals that struck me as unrealistic. Some traders expressed an interest in full-time trading (e.g., trading for a living), but also reported account sizes that were very small. It was not at all clear to me how a person could support themselves on such a small portfolio without taking major risks that, eventually, would damage both the account and the trader. I think a trader who can average 20% (after expenses) over many years of changing market conditions is a rare, superior trader. Even given that level of skill and success, such a trader could not support a family on a portfolio under $100K. There's nothing wrong with trading a small account; it's a great way to get your feet wet and preserve your capital during your learning curve. The problem is when the account is small and the goals are huge. It's a setup for frustration.

5) Very few traders provided me with metrics. I did not get the sense that the majority of traders who responded to the project have done the hard work of actively reviewing their trades, identifying what they're doing right, and isolating their mistakes. Had any trader quoted detailed metrics to me, I would have considered that person very seriously. I don't get the sense that the majority of traders have that Tiger Woods/Lance Armstrong/Nolan Ryan mentality that picks apart every performance to find things to improve--even in the midst of success. Last week a trader I've worked with contacted me with an urgent request to meet. He had one of his best weeks that week, making six figures two out of the four trading sessions. He analyzed what had worked for him and wanted to meet with me so that he'd keep the momentum going. That's what winners do: they're fanatical about keeping score and getting better. The keeping score part--the detail focus--is huge.

Most trading coaches would not provide the above feedback to traders. They're too afraid of losing business to raise the hard challenges. A coach that cares about your success, however, will want to know:

1) What specific methods are you using for entries, exits, stops?

2) What evidence do you have for the value of your methods (your trading edge)?

3) How are you sizing positions to take advantage of your edge, but also protect yourself against ruin?

4) How are you specifically, concretely identifying what you're doing right and wrong and making efforts at improvement?

5) How do you adapt your trading to changes in market trends? Changes in market volatility?

The best way to coach yourself is to clearly identify your edge; keep score religiously; and set concrete goals based upon your identified strengths and weaknesses. I hope to illustrate this process in the Trading Coach Project.

Thanks again for your interest!

Brett

May 28, 2007

The Trader Coaching Project

With this post I'm announcing a coaching project that, to the best of my knowledge, will be a first on the Web. What I propose is that I collaborate with a trader over the period of a month in a coaching arrangement to help the trader enhance his or her performance. The coaching would be entirely free of charge. The catch would be that regular summaries of the coaching would be posted to the TraderFeed blog so that the coaching can be an observational learning experience for all readers. To protect the trader's identity, the summaries would not have to name the trader--a pseudonym could be used. The details of the coaching, however, would be shared openly.

If you're interested in being considered for the project, all I need from you is an email sent to the address below. The subject header should read: Coaching Project. Please no attachments--just a straightforward email.

Your email should include the following information:

1) Background on you: Who you are, what makes you tick, where you're located, your skills and career background, etc.

2) Background on your trading: market(s) you trade; your trading methods; your success as a trader; your trading history; whether or not you trade full time, your strengths/weaknesses, etc.

3) Your goals: What you hope to accomplish via coaching. Be specific.

4) Your view of the project: Why you think the project would be helpful to you and to other traders who read about you.

Please provide enough detail so that I can get a sense for you and your interest, but don't feel like you need to write more than a good paragraph for each of the above points.

To begin, I will select only one trader. If the project goes well and proves to be of interest (and helpful) to readers, I'll be happy to reopen the search. I hope to have gone through the emails and selected a trader for coaching by next weekend.

TERMS AND CONDITIONS: Please note that the coaching will be trading focused. I will not be providing any clinical, psychotherapeutic services for the project; nor will I be diagnosing or treating any emotional disorders. The coaching will be slated for a month's duration but can be terminated before that at the request of either party. As part of the coaching, the trader may be required to complete homework assignments, including the keeping of a journal and collection of statistics on his/her trading. The coaching may also require phone and email communications both during and outside of market hours, as well as participation in writing the summaries for the blog. In other words, this will be a real commitment of time and effort by the coach and the trader; please don't apply if you're not ready for such a commitment.

I'm looking forward to this. Coaching invariably takes place behind closed doors. This will open things up and hopefully make the experience a learning exercise for all of us. We will track the trader's strengths and weaknesses, work on himself/herself, work on his/her trading, and actual trading progress. My hope is that, by the end of a month, the trader will have some tools to be able to sustain his or her own progress through self-coaching.

Thanks as always for your interest--

Brett

May 20, 2007

What Is A Market?

Anytime you have one thing traded against something else, you have a market. Normally that something else, for U.S. traders and investors, is the dollar. The reality, however, is that you can trade U.S. large caps vs. small caps, vs. another currency, or vs. any other asset class. Just as we can identify historical patterns in common markets (trading the S&P 500 Index vs. the dollar), we can find patterns that capture the relationship among the markets that interrelate asset classes. The most tradable markets, from that vantage point, are the ones with the patterns that capture the greatest historical edges.

My recent TraderFeed post contains a chart of a market from January, 2004 through May 18, 2007. The market is the relationship between Materials stocks in the S&P 500 Index (XLB) and Technology stocks (XLK). We're looking at the tendency of investors and traders to put their capital into physical assets vs. intellectual assets.

When the relationship between XLB and XLK is up more than 2% on a 20-day basis, the next 20 days in the relationship averages a gain of only .23% (99 up, 75 down). When the relationship is down more than 2% on a 20-day basis, the next 20 days average a gain of .81% (65 up, 38 down).

This is but a very simple pattern identified with no optimization whatsoever, but it suggests the kinds of trading patterns one can find when you trade markets in the broadest sense.

May 13, 2007

Revamping of the Trading Psychology Weblog

The opportunity has arisen to significantly expand my work with traders at hedge funds and investment banks. Just as crisis can bring opportunity, sometimes opportunities also yield crises. In my case, the crisis is one of identity: whether I want to devote my primary energies to trading (especially in light of very promising research with the money flow indicators) or whether I wish to focus on my work as a psychologist. As I've done consistently through my career, I've opted for the latter. What that means concretely is that I'll be working with a large cohort of traders managing tens and hundreds of millions each--and sometimes much more than that. It's a unique opportunity to work with the best in the world of finance, and I greatly look forward to the experience.

I've entirely discontinued my daytrading as a result and will not be tracking the market nearly so intensively on an intraday basis. Rather, I'm pulling back in my research to identify larger prospective market movements and unusual stock and sector opportunities, as I transition from an index trading perspective to portfolio management. Largely because of the promise of the money flow research, I am convinced that I can obtain larger returns from a diverse and hedged portfolio of stocks held over an intermediate time frame than from intraday trading of stock indices.

The Trading Psychology Weblog will be published on a weekly basis, focusing on the intermediate-term picture. The usual indicators will be a Weblog focus: strength (new highs/lows); momentum (Demand/Supply); sentiment (Adjusted TICK; relative put/call ratios); and money flows (adjusted relative dollar volume flow). I'll especially stress occasions in which these indicators provide skewed readings that are associated with a historical directional bias. I'll also use the Weblog to sketch promising market themes among sectors and styles. In short, the Weblog will continue as a kind of trading diary or sketch pad for my thinking, with an emphasis on the markets' larger picture.

My hope is that the revamped Weblog will be of help to traders, even as it serves as my guide through this sharp and unexpected transition.

May 6, 2007

Simple Setups

I've been working on simple market patterns that contain an edge over the past 1-3 years of trading history. There's no attempt to establish that these patterns are equally effective across all market periods and conditions. Rather, the setups reflect the recent tendencies of the market. They can be thought of as the rules that the market has been playing by. I refer to them as "simple setups", because they are straightforward conditions that capture a future directional tendency of the market. I'm not looking for complex historical patterns.

The idea is not to trade these simple setups mechanically (although they could be the starting point for system development). Rather, they serve as a heads up to alert readers of a directional leaning to the market based on recent precedent. When intraday conditions then set up in such a way as to confirm this leaning, it is possible to take positions with a solid winning percentage. The key is ensuring that conditions in the current day's market fit the conditions of the simple setup. For instance, if a simple setup calls for rising prices over the next five days of trading, I'd wait for an intraday decline, look for selling to dry up, and then get on board the subsequent rise. A portion of the position could be left on for the five day period with a trailing stop; another portion could be taken as profits once pivot targets were hit. A break below the lows where selling had dried up would clearly stop one out of the position.

These simple setups are more numerous than traders might think. Rennie Yang's Market Tells newsletter does a particularly good job of identifying these; see also Jason Goepfert's SentimenTrader service. In Sunday's Webinar, I will offer a couple of setup examples for discussion. It's a way of combining historical analysis and odds with discretionary entries and exits. When multiple simple setups point in the same direction, particularly good trades are often signaled.

April 29, 2007

Developing Ideas for Active Investment

The daytrader closes out positions by the close of trading each day; the swing trader typically holds over a several-day time period. Between swing trading and long-term investment is a broad territory I refer to as active investment. An active investor, for example, may overhaul a portfolio several times during a year and rebalance positions even more frequently. Individual positions may be held for a long time frame, but generally there is an effort to take money off the table when price targets are hit, and there is an effort to put money to work when valuations look attractive.

What I'm finding is that the indicators that are helpful in monitoring strength and weakness on an intraday basis do not necessarily capture the patterns that would benefit the active investor. (Just as the indicators used by a scalper, such as DOM, don't capture the patterns that benefit a swing trader). As a result, short-term trading may catch pieces of moves during the day, but leaves much on the table by missing the moves of the active investor--especially since much of those moves occur between the market close and the next day's open.

The active investor doesn't so much invest in single stocks as broad themes. An example of a theme might be "weak dollar, strong international companies that rely on exports" or "strong oil, strong alternative energy stocks". These themes may be derived from an analysis of news events, economic statistics, and the like. I'm finding, however, that some of the themes can be identified in a bottom-up manner by tracking the money flows into various market sectors and industries. Before a trend becomes noticed by the mass media--and even before it becomes evident on a chart--it can be identified by distinctive shifts in dollar volume flows.

By investing in a portfolio of themes that combine long and short equity exposure, it is possible to not only outperform index benchmarks, but to do so with reduced risk. It is also possible to add a source of performance (alpha) that is independent of one's intraday trading. This is a direction I'm finding increasingly promising.

April 22, 2007

Tracking Shifts in Sentiment

I recently posted on the topic of creating an "emerging average" of the NYSE TICK to track shifts in sentiment within the trading day. The emerging average is different from a moving average in that the starting point for the average is fixed as the first data point of the day. The emerging average at 9:00 AM CT, then, would be the average of all TICK values from the 8:30 AM open to 9:00 AM. The emerging average at 9:05 AM would be the average of TICK values from 8:30 AM to 9:05 AM. As a result, you're always looking to see if the current TICK values are greater than or less than the average for the day up to that point.

Here is the emerging average of the TICK vs. ES futures for Friday, April 20th. Notice how, in early trade, the TICK was above the average level of 300 for the prior 20 days. In spite of this, price couldn't make fresh highs on the high TICK values, and the emerging average TICK began to wane. Conversely, you can see how the ES moved higher as the slope of the emerging average for the TICK turned positive. I'm finding a number of tradable patterns from this indicator, especially as it relates to that 20-day average TICK value.

April 15, 2007

The Trading Report Card

My recent TraderFeed post described how I use tax time to review each trade from the previous year and evaluate the strengths and weaknesses of my performance. Here are some of the elements of a trading report card that I focus upon besides overall profit/loss (P/L). These are metrics that help me understand the patterns of my trading:

1) Number of winning vs. losing trades - For my style of trading, I should have a clear plurality of winners vs. losers. This would not necessarily be the case for a different kind of trader, such as a trend follower.

2) Largest number of consecutive winners and losers - I like to look at what was happening in markets during lengthy streaks. This can help me identify markets I tend to trade best and worst.

3) Average size of winning vs. losing trades - Having a few large losers was a pattern that I needed to change, as this can make a trader unprofitable despite having more winners than losers. A trend follower especially needs to have larger winners than losers. This measure helps me see how well I've utilized stop-losses.

4) Largest period of drawdown (and longest period of drawdown) during the year - This would be the greatest drop from an equity curve peak to a low point. It's one way of measuring risk. Being profitable with small drawdowns means that risk-adjusted returns were probably good. Being profitable with huge drawdowns is a warning flag. Returns may not be superior on a risk-adjusted basis.

5) How well I traded after one or more up days and after one or more down days - This provides some insight into psychological factors (greed and fear) and how they might affect performance.

6) P/L broken down by long and short trades - I like to see if I had more success trading from one side vs. another and whether this might be due to my trading style vs. market conditions.

7) P/L broken down by trade size - I tend to put on larger size when I have more confidence in a trade. Breaking the P/L down by trade size tells me if my confidence was warranted.

Out of these metrics, I like to formulate goals for the coming year. The goals aren't P/L goals. Rather, they are process goals. I usually like to have one positive goal--something I did well that I want to continue--and one remedial goal: something I could do better next year.

In 2006, my risk management was excellent. My winning trades were larger than my losers and I had more winners than losers. I did not have any large losers all year. That's what I want to continue. My remedial goal is to up my size and to be more consistent in leaving a small piece of a trade on when there's the opportunity to hit a further profit target. I'm finding that I continue to do much better with short-term trades than those held overnight. My review confirmed this in spades. As a result, I want to take full advantage of what I'm doing well before branching out.

Next year's review will track my progress on those goals.

April 8, 2007

Trading Market Breakouts

The chart below shows the upside breakout from April 5th. A valid breakout will show greatly enhanced volume, indicating that large traders are repricing value. We see not only a large volume increase on the breakout move in the chart below (white is ES futures; red is NYSE TICK), but also very strong NYSE TICK levels, suggesting broad buying among stocks. If a breakout is for real, we should not retrace the initial upthrust; hence I'm content to buy at the market and place my stop at the price that represents the most recent low in the NYSE TICK (labeled in yellow). I will then hold until my price target, usually defined by the pivot-based levels defined each day in the Weblog. We handily exceeded the 1450.75 R1 target, encouraging us to leave at least a piece of the position on for a test of R2 (1453.25). If we do indeed have an uptrend in the making, we should see waning volume on selling following the breakout, as large traders continue to lean to the long side. That's exactly what happens, as noted with the yellow arrow. Indeed, the next upmove hit our R2 target.

Here's a larger view of the chart. The key to trading the breakout is making the identification as early as possible when the breakout is occurring and then having the patience to stick with your stop. Note that, following the second upmove (not shown here), the stop can be raised to the price corresponding to the prior TICK low around 12:45 PM (about 1451). No sense giving up all profits should a large reversal materialize.

April 1, 2007

Reconceptualizing Trades

Here's a different way of thinking about how I trade that I've been pondering over the last couple of days:

I've mentioned before that my research finds that about 85% of all trading days are *not* inside days. That is, in general--particularly when we're trading average or above average volume--we will either take out the previous day's high or low.

Knowing that, one can then use an array of market indicators--NYSE TICK, relative volume, Market Delta, Advances/Declines, etc.--to handicap the odds of which extreme we'll take out. Those same indicators, with a particular nod to relative volume (which correlates with volatility) will also enable us to handicap the odds of hitting pivot-based targets (the R1, R2, S1, and S2 levels tracked in the Weblog).

But it turns out that this dynamic occurs across time frames. About 80% of all 30 minute bars are not inside bars. About 80% of all 5 minute bars are also not inside bars.

What that means is that whenever you close a bar off the high or low, the odds are good that you'll take out one of the prior bar's extremes. Moreover, you can use the data from the prior bar to calculate pivot-based trade targets. And you can use indicator data relevant to that time frame (from order flow from the depth of market screen to 10-second TIKI readings to 1 and 5 minute TICK readings to intraday new highs/lows) and trend information from larger time frames to handicap the odds of hitting those targets.

Indeed, any price move of any duration can be conceptualized as a single bar and a trade idea can be formed by trading the following bar for a move beyond the initial bar's extremes. In that context, any trade might be thought of as a "breakout" trade. Once you condense time into a single bar and think about the action in the next bar (and the bars preceding), it opens the door to a different way about thinking about the duration of trades, definition of profit targets, and placement of stops. I'll illustrate in future posts.

March 25, 2007

Power Measure

Suppose you constructed a moving correlation between price change every 15 minutes and volume for the S&P emini (ES) futures. This correlation would be updated every 15 minutes and would cover the last day's worth of trade. When the correlation increase and are positive, it means that you're getting increased volume as markets rise. When the correlations fall and are negative, it means that you're getting increased volume as markets fall. When we get higher/lower prices but not expanding volume, we see divergences in the correlations. I call that indicator the Power Measure, and it does a good job of telling me when higher or lower prices are attracting participation from large market traders. The beauty of the indicator is that it can be constructed for any stock, index, or futures contract. It can also be constructed for any timeframe. In a rangebound market, you look to sell rollovers when high Power readings are decreasing; you look to buy upturns when low Power readings are improving. Combining the Power Measure with readings of new highs/lows is especially useful.

March 18, 2007

Caution Kills

I've heard a great deal lately from traders who feel that their performance is lacking because they're not taking as much out of good trade ideas as they should. Indeed, I experienced some of the same problem on Friday, as I had a fine short sale idea in the morning when it became clear that we were moving back into the day's range. I had my initial target at the previous day's average price, waited patiently to reach the target, and took 3-1/2 ES points profit. I didn't continue to press the trade, however, as my bias (my belief that we'd have a range bound day) prevented me from continuing to sell bounces in the TICK. I ended the day with a respectable profit, but my caution kept me from a banner day.

Over time, such caution kills. During my recent CNBC appearance, one of the panel members--Ari Kiev--made an astute observation. He pointed out that 3% of all trades account for the lion's share of a trader's profits. I believe my own percentage is higher than that, but the same principle holds: it's the big winners that contribute most to the bottom line. Caution cuts those big winners short.

The very successful traders I've known are very aggressive. When they're right, they press their advantage. They add to good positions or keep re-entering in the direction of their idea as long as nothing is proving them wrong. "No one ever went broke taking a profit" is not how the best traders operate. What Dr. Kiev was saying was get out of losing ideas quickly, but really milk the winners. A good trade is valid until proven wrong. Just a few more big winners make a big performance difference by the end of a year. Risk management is not just cutting losers short; it's also ensuring that the average size of your winners handily outstrips that of the losers.

March 11, 2007

Tracking Sentiment For The Broad Market With The Flow Index

The sector analyses for segments of the S&P 500 market are now up on TraderFeed, as well as an analysis for the S&P 500 Index overall. By aggregating the sector data on Adjusted Relative Dollar Volume Flows, I'm able to get a sense for whether large traders are predominantly transacting at the market bid vs. offer as a short-term measure of sentiment. This is helpful, because it's based on what traders and investors are actually doing--not upon their stated beliefs about market direction.

The next step in the Flow research is to track sentiment for the broad market by tracking 40 stocks that are highly weighted in the ES universe. These are evenly divided among the following sectors: financial, energy, technology, industrial, consumer discretionary, consumer staples, health care, and materials. The measure I'll be using is quite simple: If a stock shows a daily Dollar Volume Flow reading that is above its 200 day moving average of Dollar Volume Flow, it will count +1 for the index. If the stock shows a Flow reading below its 200 day moving average, it will count -1. I will sum the scores for the 40 stocks and this will be the day's Flow Index for the S&P 500 Index.

We will then see if the Flow Index helps us predict future price changes in the ES market based upon historical patterns. This will provide an acid test of the value of the data. More to come!

March 4, 2007

Tracking Sector Sentiment

The next step in the Relative Dollar Volume Flow research is to take the most important stocks across various sectors and track their trading on upticks vs. downticks by weighting the trades by size. This would tell us something about sector sentiment. Of particular interest would be sectors that are holding up well during market downmoves and those that are displaying waning buying interest during market rises. My leaning is to create the sectors out of the S&P 500 Index universe (e.g., sector Spyders), so that, taken together, the stocks could provide a direct measure of size hitting bids/lifting offers in the S&P market. This line of research continues to look promising; eventually it could be replicated among NASDAQ and small/mid cap stocks. The key is creating a metric that enables you to compare one stock to another (and one sector to another) on an equal basis, either by expressing net dollar volume flow as a function of total volume or by tracking dollar volume flow as a function of a prior moving average. More to come--

February 26, 2007

Relative Dollar Volume Flows

Well, stoked on far too much caffeine and music from Children of Bodom, Fler, and my all-time favorite video of Barney the Dinosaur, I've been researching a new (for me, at least!) market indicator.

My goal has been to find a measure that tracks the activity of large institutional traders in individual stocks (as opposed to the index futures).

The indicator looks at each trade in the stock and determines whether it has occurred on an uptick or downtick. The price at which the trade was executed is multiplied by the number of shares transacted to give the dollar volume of the trade. If the trade occurred on an uptick, the dollar volume of that trade is added to the cumulative total for the day. If the trade occurred on a downtick, the dollar volume of the trade is subtracted from the cumulative total. At the end of the day, the session's cumulative total is its dollar volume flow for the day.

The *relative* dollar volume flow divides this daily dollar volume flow by the day's total volume in shares. What you're measuring, therefore, is the proportion of the day's volume attributable to buying (positive flow) vs. selling (negative flow).

If you follow the logic of the indicator, you can see that it is very sensitive to large trades. When institutions transact a large block of stock on an uptick or downtick, this will affect the cumulative dollar volume flow far more than small trades. As a result, the day's dollar volume flow is a proxy measure for the buying and selling activity of large traders.

Where the relative volume flow becomes important is in comparing the dollar volume flows for one stock vs. another. Ten million dollars flowing into Exxon-Mobil stock, for instance, is far less significant than ten million dollars flowing into a microcap issue. By measuring dollar volume flow as a function of daily volume, we have a metric that enables us to see, in relative terms, which stocks are attracting more buying vs. more selling.

Note that this measure can also be used to track dollar volume (and relative dollar volume) flowing in and out of sector and index ETFs. I will be posting an ETF analysis of the Dow Jones Industrial Average based on relative dollar volume to TraderFeed very shortly.

I have also constructed relative dollar volume flows for each of the Dow 30 stocks and used the summed values to arrive at an understanding of how much money is flowing in and out of the Dow on an absolute (and relative) basis. What I can say at this point with certainty is that the summed dollar volume flows for the individual Dow 30 stocks contain useful information not obtainable by simply looking at dollar volume flow in the Dow ETF.

The very significant application of the research is in the construction of long-short portfolios, in which you assess the relative dollar volume flows for, say, Dow stocks over the past X days. You then buy those with the most bullish configurations and sell those with the most bearish outlooks, balancing the holdings so that the entire portfolio is hedged with respect to directional moves in the Dow.

The important thing in terms of performance is to always be seeking new sources of edge. I don't trade individual equities, and I don't trade intermediate-term time frames. That is precisely why I decided to tackle this project. If you don't develop new strategies over time, you're in danger of becoming outdated as markets change. And the best time to be developing new methods is when you're ahead of the curve, not when you're in a hole and feeling pressured to bring in the family's next mortgage payment.

February 19, 2007

Improving Trading Performance by Utilizing Volume Information

I typically use volume to track the presence of large traders in the stock index futures markets. This is because large traders control the stock indices; they account for a small percentage of all trades during an average day, but a large proportion of total volume. For that reason, volume is highly correlated with price volatility. In a recent post, I found that emini volume in the Euro FX futures also correlates quite highly with volatility. That led me to conjecture that the emini Euro FX volume might be a "tell" for large, institutional volume in the much larger cash currency market.

It's interesting to see how volume is distributed in the emini Euro FX market. I took Friday, February 16th's morning market as an example. We had 12,648 emini Euro FX trades that morning and a total contract volume of 80,728. Fully one-third (N = 4390) of those trades were one lots. About half of the trades were either one or two lots (N = 6015), accounting for 7640 contracts, or less than 10% of the total.

On the other hand, only 818 of the trades--about 1%--were 20 contracts or larger. These accounted for 30,644 contracts, over a third of the total volume. Trades of 10 contracts or higher accounted for only 2081 trades--about 2-1/2% of the total--but accounted for 48,149 contracts. That's about 60% of the volume.

What we find in the emini Euro FX futures, it seems, is very similar to what we find in the stock index futures: a small proportion of trades from large traders account for a large amount of the total volume and for much of the market's movement. Knowing how the large traders are trading--whether they're participating in market rises or declines; entering or fading breakouts--is crucial to understanding the action in the Euro currency market.

My strong impression is that this same dynamic applies to trading in individual stocks as well. It's the large traders that move the markets, and ferreting out their behavior provides a meaningful edge for the active trader.

February 11, 2007

Thoughts About Best Practices

Today I posted a proposal for using the TraderFeed blog to share the best practices of traders: methods that have helped them master markets--and themselves. The idea is to create a repository of what works: a collection of ways of looking at markets and trading that can sustain continuing learning and development. Hospitals commonly track the best practices of physicians to help make health care more efficient and effective; manufacturing firms identify best practices in the search for quality improvement and cost control. Best practices can be considered as a kind of evolutionary process, in which further growth and development by emphasizing what works.

One of the great obstacles to developing such a framework for the trading world is our set of beliefs. What we believe defines our limits and, all too often, narrows our field of possibilities. In particular, three beliefs run contrary to the best practices paradigm:

1) The belief that expertise resides outside of us - It is all too easy to divide the world into gurus and followers. Placing the locus of expertise outside of us keeps us dependent on others, many of whom are pretenders to guru status. Each of us has experience, and each of us has learned. In sharing our expertise across a wide network, we magnify learning, absorbing lessons from others that would take years of experience on our own.

2) The belief that ideas will lose their power if shared - We often hear the fear that, if we share an idea, then everyone will use the idea and it will no longer provide an edge. But once you're connected to a network of creative individuals, your edge is not dependent on any single idea. Your edge comes from the ability to continually generate new and better ideas. It only makes sense to hoard ideas if you begin with the premise of scarcity. That premise keeps us isolated from learning from others.

3) The belief that we should not imitate others - Yes, it's true that, in the long run, we must develop our own, individual trading styles. The same, however, is true of artists and scientists: they must find their own niche, but usually begin their learning by absorbing lessons from others with more experience. Our style will be an amalgamation of what we pick up from others; the more input we get, the richer our synthesis can be. There is no contradiction between depending on others for ideas and developing one's independence. In learning from others, we acquire the building blocks that we will assemble into our own unique structures.

Imagine if you had a group of just 100 hard-working, dedicated traders who decided to view themselves as teachers, not just as students. If each of those traders shared just one valuable trading lesson, the entire group would have two excellent pieces of learning every week for a year. All it takes is a shift of belief, a willingness to look inside and find your own strengths and the experience you have to share. In that group of 100 dedicated traders, sharing one's ideas doesn't mean losing an edge: it means you'll have the opportunity to acquire 99 more.

February 4, 2007

Short Term Modeling With Energy Stocks

I've noticed for a while that the energy stocks among the S&P 500 issues have a weaker correlation with the other issues than do the stocks from other sectors. This is because the energy stocks react not only to broad movements in the equity indices, but also to commodity energy prices (oil, natural gas, etc.). This had me wondering if the relative performance of energy stocks during short-term moves in the S&P 500 Index (SPY) might have some forecasting value.

Since 2004 (N = 757 trading days), we've had 464 occasions in which SPY has been up over the prior 10 sessions. When SPY has been up over the past 10 days and the energy stocks (XLE) have been relatively strong (N = 232), the next ten days in SPY average a loss of -.34% (111 up, 121 down). Conversely, when SPY has been up over the past 10 days and the energy stocks have been relatively weak (N = 232), the next ten days in SPY average a gain of .58% (162 up, 70 down). That's quite a disparity in performance.

Now let's look at the 293 occasions since 2004 in which SPY has been down over the prior 10 sessions. When SPY has been down over a ten-day period and the energy stocks (XLE) have been relatively strong (N = 147), the next ten days in SPY average a loss of -.01% (74 up, 73 down). On the other hand, when SPY has been down over a ten-day period and XLE has been relatively weak (N = 146), the next ten days in SPY have averaged a gain of 1.32% (114 up, 32 down). Once again, we see a huge disparity in performance.

In sum, it appears that when we have two-week strength in both the S&P 500 large caps and among the S&P energy issues, returns are noticeably subnormal over the next two weeks. When both the large caps and the energy components have been weak over a two-week period, returns are notably superior. I have examined the tech and financial sector components of the S&P 500 Index for similar dynamics, but have not replicated these results. There appears to be a unique relationship between energy and non-energy large caps that is worth considering when anticipating results over the next two weeks.

January 28, 2007

A Schematic of My Trading

In recent posts, I outlined how I trade, setting price targets and handicapping the odds of reaching those based upon measures of sentiment and volume. In this post, I'd like to pull together some of those ideas and lay out the steps I take in developing and executing trade ideas.

The first step comes prior to the market open and involves research to identify a directional edge to the next day's trade. My recent article on market reversals and implementation of that research in early morning trade the next day is a nice example of that. Many times, the research examines the momentum, participation, and sentiment of the recent market and identifies the odds of hitting key price levels, such as the prior day's high, low, or average trading price. If I have strong odds on a trade, I will be open to using my maximum size if intraday setups align with my research. If I don't have strong odds, my maximum permissible size is automatically cut in half and I may not trade at all that day. The idea is to align position sizing and opportunity.

Immediately prior to the market open--for at least 90 minutes prior--I am watching to see how overseas markets are trading and I am watching to see how economic reports impact the index futures. Many of my initial ideas about trading ranges and breakouts from those ranges come from noting the overnight range and the action of the European bourses. I'm also watching how fixed income, oil, and the dollar are trading to see if global/macro forces may be at work. My goal is to identify lead-lag relationships that might be at work in the recent markets, such as stocks following bonds or the DAX leading the ES. Noting a breakout in a leading market may lead me to entertain trade ideas in my (lagging) market, especially if that move is in the direction of my prior research.

Once the market opens, I continue the search for lead-lag relationships. This time, however, I'm scanning for leading market sectors, such as small caps, semiconductors, or value stocks. If I see a leading sector breaking out of a range, I will not trade my market in the opposite direction. I can't tell you how many bad trades that single principle has kept me out of.

Also early in market action, I'm watching the NYSE TICK, the volume at bid vs. offer in ES, and five-minute volume in ES to gauge if there is a directional bias to the market (more activity at bid vs. offer) and if there is heavy participation in the market (above average volume). From these readings, I formulate my ideas as to whether or not we're likely to be in a range bound market, a trending market, a volatile market, a slow market, etc.

My first trade almost always occurs in the first 30 minutes of the trading session. Very often it's a trade with a very concrete near-term price target, such as a breakout from the overnight range, a test of the prior day's average trading price, etc. On average, I'll hold such a trade for 20 minutes, and I generally have a tight stop on the trade. For instance, if we bounce off the overnight high and start to see some selling, I'll be quick to join the selling, with a stop just above that ov