Saturday, June 24, 2017

Trading Psychology Diagnosis: Identifying the Root of Trading Problems

Every trained physician knows that diagnosis precedes treatment.  We have to understand what is going wrong before we attempt any kind of solution.  Auto mechanics engage in the same process: they listen to the engine, look under the hood, and run tests before they identify problems and begin to fix them.  

Too often, traders attempt solutions for their trading problems before they've truly understood the sources of those problems.  Equally often, mentors and coaches of traders offer their solutions without actually going through a thorough diagnostic process.  In this post, I will model for you a way of thinking that can help you identify what might be going wrong with your trading.  This way of thinking is anchored by several important questions.

Question #1:  Is there actually a problem here?

This may seem like a strange question.  You've just drawn down; you've been frustrated in your trading.  Of course there's a problem!  The issue, however, is a bit more subtle.  Any successful trading is still a probabilistic enterprise.  Hit rates and Sharpe Ratios don't grow to the sky; people are fallible and markets embed a fair amount of uncertainty.  As a result, losing periods are inevitable and frustrations will be encountered.  Just as we expect baseball hitters to strike out every so often and football quarterbacks to throw incomplete passes on occasion, we can expect losing trades.  A trading approach with a 60% hit rate could be phenomenally profitable, but it will still encounter strings of losing trades with regularity.

What this means is that we begin the diagnosis by examining a meaningful sample of past trading, not just the last few days or trades.  A frequent day trader making many trades a day might look at the month's results and compare with results from the past year.  A longer term trader might need to assemble data over a year or more before confidently identifying a problem.  In other words, to identify a problem, it's necessary to see that recent results fall short of past ones and that recent drawdowns are not similar to past ones.  That requires a proper historical view.

When traders assume that a problem exists without a sufficient historical analysis, they run the risk of tinkering with methods that work and making those methods worse.  This is very true when traders begin to trade systems.  They become discouraged when the system has a (normal and expectable) drawdown, so they begin to change the system, front run the system, etc.--only to turn the setbacks into protracted slumps.

Sometimes traders are taking too much risk--trading position sizes too large for their actual loss tolerance--and those strings of expectable losing trades create a "risk of ruin" situation.  In such a case, the trader can look at hit rates and average win/loss statistics and determine whether the problem is in risk taking or if the actual performance of the trading methods has changed.

All of this is a strong argument for keeping detailed performance metrics on your trading.  Only by comparing recent performance to past performance can you understand if you truly are improving in your trading or having an actual problem.  If you're a beginning trader, then you would compare your recent returns to the returns you achieved in simulation mode.  (For more on trading metrics, see this post; also this post.  A detailed treatment of trading metrics can be found in Chapter 8 of The Daily Trading Coach). 

Question #2:  If there is a problem present, is it associated with a change in the market(s) you're trading?

My first hypothesis when I encounter a trading problem (my own or that of an experienced trader) is that the problem has occurred for a reason, and that reason is related to a change in how markets have been trading.  Because of those changes, the methods that had been working no longer command the same edge.  

A great example of this has been the recent decline of volatility in the stock market.  Many, many traders who made money from momentum and trend trading have suffered during this low volatility period because moves no longer extend and, indeed, tend to reverse.  That, in turn, leads to frustration and discouragement.

The key tell for when trading problems are related to changes in markets is that people trading similar strategies are also experiencing performance difficulties.  This is one reason it's important to have a broad network of trading colleagues, even if you trade independently.  If the great majority of traders trading similar styles are also experiencing drawdowns, you can safely assume that not everyone has turned into an emotional basket case at the same time.  

Performance indexes for various hedge fund and CTA strategies are available from industry sources and can help identify when certain approaches are winning and losing.  For example, the Barclay's short term trading index (STTI on Bloomberg) tracks the returns of professional money managers trading short term momentum and trends.  The performance of those managers over the past year or two has been dismal, again related to the collapsed volatility of markets in the wake of low interest rates around the globe.  

If your trading problems are widely shared and can be linked to shifts in how your markets have been trading, no psychological exercises in and of themselves will solve the problem.  Nor is it a solution to put one's head in the sand and hope that markets will "turn around".  Rather, the answer to the trading problems is to adapt to the new environment and search for fresh sources of edge that can complement one's traditional trading.  For example, one might find mean reversion or relative value strategies that nicely complement one's directional/trend/momentum trading.  The combination of trading approaches truly diversifies returns and produces a smoother P/L curve.  (See Trading Psychology 2.0 for a detailed presentation of adapting to changing markets).

Question #3:  If there is a personal problem present, is it--or has it been--present in non-trading parts of your life?

Here is a very, very important issue.  Many personal issues, such as anxiety, anger, depression, attention deficits, and impulsivity, show up in trading, but not exclusively within trading.  For example, a person might have trouble with patience and frustration in personal relationships, and those same problems crop up in his relationship with markets.  Similarly, a person might have self-esteem problems in life that then show up as negative thinking patterns during periods of market losses.  When the emotional patterns, thought patterns, and behavior patterns that interfere with trading are also occurring and interfering with other aspects of life, that is a strong indication that simply working on trading will not be sufficient.  It makes sense to seek professional help.

The great majority of psychological challenges can be dealt with via short-term approaches to counseling and therapy.  Research suggests that problems such as relationship difficulties, depression, anxiety, and anger can benefit significantly from cognitive, behavioral, psychodynamic, interpersonal, and solution-focused approaches. (A thorough review of research and practice in this area can be found in the textbook that I have co-edited.  A new edition will be coming out late this year).  The key to brief approaches to therapy is that they are highly targeted and make active use of exercises and experiences during and between sessions.  

In situations in which the psychological problems have been longstanding, when there has been a family history of similar problems, when those problems have been severe (significantly impairing important areas of life), and when those problems have been complex (impacting many areas of life, as in drug or alcohol abuse), longer-term approaches to helping are generally indicated.  Attempting short-term approaches to help for more significant problems runs the risk of relapse.  When problems have been longer standing, severe, and complex, it often is the case that more than one form of help is required, such as medication help in addition to therapy or group sessions (as in A.A.) in addition to counseling.  In such instances, it is very helpful to have a thorough assessment from a qualified mental health professional.  If there is meaningful depression and/or anxiety, a workup from an experienced psychiatrist is helpful, as safe and non-habit forming medications often can play an important role in addressing the problems.

Depression, anxiety, attention deficits, addictions, bipolar disorder, relationship problems--these impact a high percentage of people in the general population.  Traders are not exempt from these general problems.  Assuming that an emotional issue impacting trading is necessarily a trading issue may prevent you from getting the right kind of help.  No amount of writing in a trading journal will rebalance neurotransmitters in your brain or solve the conflicts you bring to your marriage.  When you see the problems affecting your trading also affecting other areas of your life, it's a strong indication that a more general approach to change will be needed.

Question #4:  If the problem you're facing occurs uniquely in trading settings, do you need psychological coaching or do you need further mentoring of your trading?

Here again is an important distinction.  Especially for newer traders, frustrations and other emotional problems arise in trading simply because they are still young on their learning curves.  What they need is not simply emotional coaching, but guidance from experienced mentors who can help them correct trading errors and more consistently apply trading skills.  Even experienced traders can encounter drawdowns and frustrations because they are making trading mistakes that a mentor can pick up.  I recently worked with a trader who was very discouraged because of a drawdown that occurred simply because he was not closely monitoring correlations among his positions.  What he thought were several independent trades turned out to be versions of the same trade once the central bank indicated a possible policy shift.  He lost money because he was too concentrated in that one, converged trade.

This is yet another reason why it's very helpful to be connected to networks of peer traders.  Many times such relationships offer mutual mentoring that can address situational problems and mistakes in trading. 

When drawdowns and disruptions of trading are more psychological and situational, several psychological approaches can be helpful, including behavioral methods (exposure therapy) for anxiety and performance pressure; cognitive restructuring techniques for perfectionism, overconfidence, and negative thought patterns; and solution-focused approaches to identify and expand one's own best practices.  (Specific applications of these methods can be found in The Daily Trading Coach; the creation of best practices is a major topic within Trading Psychology 2.0; an overview of cognitive and behavioral techniques for improving trading performance can be found in Enhancing Trader Performance).

Behavioral techniques are skills-building methods that you practice in real time, during problem situations.  You literally are teaching yourself new skills and new habit patterns.  For example, a very simple behavioral technique would be to take a break during trading whenever you feel anxious, frustrated, bored, or discouraged.  You quickly recognize that you're not in the right mindset for trading and you take a break from the screens.  During that break, you might engage in other skills-building activities, such as relaxation training to slow oneself down and reduce tension.  Behavioral methods are typically practiced outside of trading hours so that the skills become automatic in real time, when problems crop up.  

Cognitive restructuring methods are techniques that you use to identify and challenge patterns of negative thinking that can distort your emotions and interfere with sound decision making.  Many traders, for example, become highly self-critical when they miss a trade or when they take a loss.  This can interfere with their focus on the next opportunities.  In cognitive restructuring, keeping a journal helps the trader become more aware of his or her thinking and challenge that thinking when it's harsh and negative--or when it's overconfident!  

Solution focused techniques are ones that examine what you are doing during your best trading, both in terms of trading practices/processes and psychological self-management.  The goal of solution focused work is to "do more of what works" and become more consistent so that best practices can turn into repeatable best processes.  Trading Psychology 2.0 contains 57 best practices contributed by myself and other traders; the chapter on Building Strengths also embraces a solution-focused approach to identifying what you do best and building your trading around it.

The bottom line is that how you work on your trading should reflect the diagnosis you make of your trading challenges.  Sometimes we encounter challenges because of tricky markets; sometimes because of our psychology; and sometimes those challenges are just a normal part of risk and uncertainty in markets.  In this post, there are quite a few ideas tossed out.  For more information on those, you can simply Google the relevant topic by entering "Traderfeed" and the topic of interest.  Thus, enter into the search engine "Traderfeed solution focused" and you'll see quite a few posts relevant to that topic.  If you want even more depth and detail, the above book references will be useful.

In an upcoming series of posts, I will identify 20 top challenges that traders face and highlight specific approaches to work on each of those.  Yet another series will look more into detail into evidence-based techniques that help traders and when to use those.  All of this is part of a grander plan to eventually link all the posts into a free, user-friendly, comprehensive online encyclopedia of trading psychology.  

Thanks, as always, for your interest and support--

Brett

Friday, June 23, 2017

Online Encyclopedia of Trading Psychology

Image result for greatest enemy of knowledge is not ignorance

In the coming days and weeks, I will be transforming TraderFeed into an online encyclopedia of trading psychology.  Since 2006, there have been over 4700 TraderFeed posts, as well as the four books on trading psychology that I've written.  I just finished editing a third edition of a textbook on brief therapy that highlights new research and techniques relevant to helping people make changes. There are huge applications of these methods for traders.  Much of what we think we know in psychology (and in applying psychology to trading) is just not true.  By collating the top posts, creating new posts that include fresh perspectives, and indexing posts by topics for easy reference, I hope to create a lasting resource for traders.

Stay tuned, and thanks for all the interest and support!

Brett
.

Sunday, June 18, 2017

When Discipline Works--And When It Doesn't

Trader A has a preferred trading style.  It might be a momentum style; it might be a directional style.  It's a style that fits Trader A's personality and that has made money in the past, so Trader A sticks to that style.  In sticking to what fits his or her personality, Trader A demonstrates discipline.

Trader B has preferred trading "setups".  These are patterns in the market that make the most sense to Trader B.  Those patterns might be breakout patterns; they might be patterns of mean reversion.  Trader B has seen these patterns work out, so Trader B sticks to trading those setups.  In sticking to what fits his or her understanding of the market, Trader B demonstrates discipline.

Trader C studies the kind of market we're currently experiencing.  Trader C has used some basic dimension reduction methods to boil markets down into a few categories, such as price change and volatility.  Once Trader C figures out the kind of market we're in, Trader C studies the edges present in that type of market.  In trading only the edges present in the current market, Trader C demonstrates discipline.

Three traders, three forms of discipline.

Two of those traders are losing money.

Are you trading what you subjectively prefer, or are you trading what is objectively present in the market?

I submit that the answer to that question accounts for much of the success and failure we're currently seeing among traders and trading firms.

.

Friday, June 16, 2017

Four Ways to Read the Psychology of the Markets

In the recent webinar (here is a link to the recording of the event), I touched upon two themes that will be part of my program at the upcoming Chicago workshop.  The first theme is using our emotional responses to markets as market-relevant information.  Very often, we first notice changes in market regimes--shifts in volatility, in trend, in patterns of correlation--experientially.  When we reasonably expect a market to do one thing and it begins to do something else, we experience confusion, frustration, and concern.  The emotionally intelligent trader uses emotion to take a second, objective look at that market and reevaluate ideas and positions.  The less emotionally intelligent trader becomes caught up in that emotion and responds reactively, often with impulsive and ill-considered actions.

The second theme is that we can read the psychology of other market participants and thereby gain a sense for when their buying and selling intentions are waxing and waning.  The ways in which markets transact provide us with important clues as to the leaning of large participants, giving us early identification signals on breakouts, failures of moves, and momentum.

There are four ways that I've used to gauge the psychology of the markets:

1)  Market Profile - The profile is a tool for identifying where markets are setting value and how volume is behaving relative to value areas.  Are we breaking out of a value area and accepting value higher or lower?  Are we oscillating within a value range?  Viewing profiles on multiple time frames can help us understand market behavior in a multidimensional way.

2)  Upticks/Downticks - The NYSE TICK (and related measures) is a tool I have used for years to assess real time sentiment in the stock market.  It measures the number of stocks trading on upticks minus the number trading on downticks every 10 seconds or so.  When large market participants are actively buying or selling, we see TICK values jump to extreme positive or negative levels.  Shifts in the distribution of TICK readings over time commonly accompany market turning points.  

3)  Market Delta Footprint - Whereas the NYSE TICK assesses upticks and downticks across all stocks in the NYSE Index, the Market Delta footprint tracks each transaction in a particular instrument, such as the ES futures.  It identifies when a transaction is occurring at the current bid price or offer price and cumulates that information over a variety of time periods.  As a result, we can see when volume is dominantly lifting offers (buyers are aggressive), hitting bids (sellers are aggressive), or relatively balanced.  Shifts in the footprint very often accompany changes in market direction.

4)  Event Flow - As described in the recent post, event flow divides the volume in any instrument into many thin slices and examines price behavior within each slice to infer the relative dominance of buyers or sellers.  That information is cumulated across slices to depict changes in buying and selling dominance.  Unlike upticks/downticks and the footprint, event flow does not rely upon aggressive behavior of buyers and sellers to infer the intentions of participants.  This is particularly helpful in markets where sophisticated market making can disguise those intentions.

These are multiple lenses through which traders can read the psychology of other participants, much as a skilled poker player in Las Vegas can read the tells of players around the table.  The ability to see markets through multiple lenses enables traders to develop ideas and--most importantly--revise those ideas based upon real data.  I look forward to elaborating on the reading of market psychology at the Chicago event
.

Wednesday, June 14, 2017

Turning Emotional Trading Into Informed Trading

Apparently there were some sound quality issues during the latter portion of my webinar presentation yesterday.  For those who missed some of the ideas that I will be covering in the summer workshop in Chicago, I'll sketch those out in two posts.  

The first idea is that many of our patterns of poor trading are themselves triggered by shifts in emotional state.  Among the more common emotional triggers are:
  • Overeagerness and overconfidence - Winning can skew our subsequent decision making;
  • Frustration and anger - When we lose, our frustration can lead to impulsive decisions;
  • Anxiety and uncertainty - Fear of losing can interfere with proper risk taking;
  • Negativity and depression - Losing can begin to feel like being a loser 
An important principle is that many, many of these emotional triggers are themselves set off by changes in the marketplace.  When markets change their volatility, trend, etc., the trading patterns that worked at one time no longer work.  Patterns that had not worked now suddenly seem to come to life.  The wise trader entertains the hypothesis that emotional state shifts are potential indications of changing market regimes.  The emotions we feel are information that tell us to step back and reassess market behavior.  

In other words, we can use our emotional awareness to become more emotionally intelligent.  Once we shift states and recognize that a trigger has occurred, we step back from trading and reevaluate our expectations and ideas.  Emotions become a tool for flexibility and adaptability--not a trigger for rigid behavior and poor trading. 

Too often, we treat emotional responses as things to overcome or avoid.  If we are closely attuned to the markets we're trading, how we feel can often provide the first clues as to something different in those markets that we need to pay attention to.

.

Tuesday, June 13, 2017

Tracking the Psychology of the Market with Event Flow

When we think of trading psychology, we typically think of the psychology of the trader and the factors that either contribute to or distract from a peak performance mindset.  Another facet of trading psychology is reading the intentions of other market players.  This is very similar to psychology in poker.  The mindset of the poker player is important, and it is also important to read the psychology of the other players at the table.  The skilled poker player reads those tells from other players to infer if they are bluffing or if they might be holding the nuts.  When short-term trading/market making occurred on the trading floor, reading the other participants in a market truly was more like reading other poker players.  With most market activity being electronic, we need other ways of inferring the intentions of market participants.

Above we see a chart of what I refer to as Event Flow for yesterday's session in the ES futures (6/12/17).  I will be discussing this measure during this afternoon's free webinar and in particular detail at this summer's workshop in Chicago.  (Here are details regarding the webinar and workshop).  In a nutshell, what I'm doing with event flow is breaking down the day's action into volume-based events, where each bar represents the price action of each 1000 contracts traded.  What I'm interested in is the price behavior *within* each bar.  If price closes more toward the high end of the bar, I will categorize that bar as a "buying" bar and vice versa.  The chart depicts a cumulative running total of buying and selling bars, in the manner of an advance-decline line.  

Most of the time the Event Flow line will follow price relatively faithfully.  It is the divergences that are of particular interest.  Notice, for example, how sellers were dominating in the afternoon, but ultimately were unable to push prices below their morning (and below their previous day's) low.  The inability of sellers to move price lower (or vice versa) creates a situation where those participants will be forced to cover when flows and prices turn.  Note the nice rally in ES (blue line) after sellers are trapped in the afternoon.

Event Flow is a complement to other ways of inferring the psychology of market participants, such as upticks/downticks (NYSE TICK) and Market Delta.  Event flow is easily constructed for any instrument trading centralized volume.  It is also relatively robust with regard to the participation of optimal execution algorithms, as noted in quant research (see here and here).  Algos may be buying bids and selling offers in an efficient manner.  This would not necessarily show up in measures of upticks/downticks but would be reflected in price behavior within thin volume slices.  Event Flow can be aggregated over longer time frames to provide bigger picture views of market participant bullish/bearish psychology.

I've generally found traders much more interested in focusing on their psychology, rather than the psychology of the markets they're trading.  That's a big mistake.  Typical price charts are far too blunt as tools for assessing the psychology of the marketplace.  With Event Flow, we don't have to track the market transaction by transaction but can still obtain a relatively finely grained assessment of how those close to the market are behaving.

I look forward to sharing more at the webinar this afternoon and the workshop in July.

.

Sunday, June 11, 2017

Great Readings to Prepare for the Market Week

Here are a few unusually good readings to kick off the market week:

*  Advice from top bloggers on how to simplify our lives and our finances.  Part of an excellent series from Abnormal Returns.

*   Excellent summary of the week and perspectives on valuations of momo stocks.  Excellent summary of relevant data each week from A Dash of Insight.  

*  Preview of Fed meeting and upcoming market data; great perspective from Calculated Risk.

Tuesday at 4:30 PM EDT I'll be participating in a free webinar previewing the Chicago workshops dealing with evaluating and trading the behavior of market participants. 

Have a great start to the week!
.

Thursday, June 08, 2017

Three Day Workshop on Reading the Psychology of the Markets

Understanding our own psychology and how it affects our trading is only part of the trading challenge.  Another part is understanding the psychology of market participants.  How do we know who is in the market, how they are leaning, and whether their participation is likely to move prices higher, lower, or not at all?  Many trading problems occur, not because of the trader's poor psychology, but because of the trader's inability to recognize the market's psychology.

On Monday, July 24th and on Tuesday and Wednesday the 25th and 26th, there will be two unique workshops in Chicago focused on reading the psychology of the market.  Market Delta will be sponsoring the event; here is the post describing the program.  The focus will be on using and integrating Market Profile (how volume behaves at different prices and times) and Market Delta (how traders behave in their trade execution) to gain a dynamic sense of the psychology of the market.  The first day will be an introduction to these concepts and how they relate to one another; the two remaining days will focus on advanced integration of the approaches and their application.

There will be a free webinar on Tuesday, June 13th to introduce traders to the speakers and provide a flavor for what will be offered in the July event.  Here is the information regarding signing up for the webinar.

In my portion of the program, I will share specific techniques and research from my own trading that are relevant to reading market psychology.  I will also conduct group coaching sessions to address specific challenges that traders are facing in their own psychology.  The goal is to take away specific methods that can help move your trading forward.

If you decide to sign up for the Monday event only or sign up for the entire three-day event, you can use the code traderfeed50 for the Monday sign up or traderfeed500 for the entire event sign up.  That will take 50 and 500 dollars respectively off the registration fees for the events.

The webinar on Tuesday should give you a good idea of whether the program will be helpful to you and your trading.  Look forward to seeing you there!

Brett

.

Tuesday, June 06, 2017

What Do We Truly Know About Markets?

Let's do a little exercise.

Here's a question.  Please write down your answer to the question before reading on:

WHAT DO YOU KNOW WITH A HIGH DEGREE OF CONFIDENCE ABOUT TRADING/INVESTING THAT DOESN'T REQUIRE ANY STATISTICAL SUPPORT?

Knowledge is what has statistical support; wisdom is what we know to be true from hard-earned life experience.  What do you truly know about markets and trading?  What wisdom do you draw upon in your best trading and investing?

Once you've written out your answer, please compare your wisdom with the answers offered by a number of thoughtful market participants.  This blog post from Abnormal Returns has plenty of insight to inform our trading. 

Good trading is grounded in knowledge; great trading reflects wisdom.  The best market lessons are also phenomenal life lessons.  Your best trading will result from acting on your greatest wisdom.

.

Sunday, June 04, 2017

How Do You Warm Up For Trading?

Notice how in most performance activities, top performers engage in warm up exercises.  Singers, musicians, athletes--all have their warm up routines.

What is your trading warm up, and are you truly warming up the functions you want to exercise?

Some time ago, I learned a simple trick for getting rid of any nervousness or tightness before giving a talk to an audience.  I showed up to the auditorium early and greeted guests as they arrived.  I chatted with them before the talk and generally had a good time.  By the time my presentation was ready to begin, I had already been speaking for a while and many people in the audience were familiar.  Exercising sociability as a warm up helped me be more engaging with my audience.

So it is with all warm ups.  We exercise the functions we most want and need to employ.  That means different warm ups for different performers.

Here are a few warm up exercises that come to mind for traders:

*  Self-awareness activities - Meditation and visualization exercises help us enter a calm, focused, self-aware state.  By warming up our self-awareness, we make it difficult to lapse into frustrated overtrading.  Reviewing journal entries to mentally rehearse our goals and how we will pursue them is an excellent self-awareness warm up.

*  Flexibility activities - I love to mentally rehearse different market scenarios as we approach the open.  The scenarios include how I would respond to early weakness or strength, what I would look for in a range or trend day, etc.  Contemplating many market possibilities helps ensure I don't get locked into any one.

*  Aggressiveness activities - Many times the difference between a decent trading day and a great one is the ability to take enough risk when solid opportunities are present.  Pumping up with active physical exercises while mentally rehearsing aggressive trading tactics in the right situations acts as a way of priming good risk taking.

*  Creativity activities - Scanning many markets prior to the open and/or watching many stocks in premarket trading can many times serve as an alert to early influences on the market(s) we're trading.  When we look at many things and identify commonalities, we can detect important market themes that may well persist into the trading day.  Conducting these scans in a team format, interactively, can further warm up our creative thinking.

No serious actor/actress, musician, or athlete considers going into a major performance without warming up.  Warm ups practice the functions we most want to employ.  Your trading warm up should put you in the mental, physical, and emotional state you need to be in to do your best trading.  Many, many trading problems occur simply because the right functions were never warmed up.  Your warm up should be your way of priming the functions you're employing when you're trading at your best.

.