Saturday, October 15, 2016

A Great Opportunity for Women Interested in Trading and Finance

When my daughter Devon was quite young, we had a toy doctor's kit and one day decided to play "doctor" with one of her dolls.  I gave Dev the stethoscope and other equipment and I said I would help her with the examination.  She looked confused and gave the stethoscope back to me.  She said, "You be the doctor, I'll be the nurse."  When I asked her why I should be the doctor, she gave me a puzzled look--as if I should know better--and said, "Boys are the doctors!"

I was dumbfounded.  Never had Margie or I explicitly said anything of the sort to Devon.  When I reflected, however, I realized that all her doctors had been men and all her nurses had been women.  She couldn't think of herself as a doctor because she had never seen a female physician!  That was a perception I was eager to correct.

I fear much of the same thing happens in the field of finance.  As I documented in a Forbes article last year, women are woefully underrepresented in the world of money management.  During the time I've participated in recruitment of traders and portfolio managers, resumes from men have outnumbered those from women by 20:1.  Even when women are hired by financial firms, they often lack upward career paths.  For example, as my article outlines, six of the ten career fields in which the income gap between men and women is greatest are in the world of finance.

This is all the more ironic because research cited in the Forbes piece clearly shows that men tend to be more prone to cognitive biases and poorer trading/investment decisions than women, often as a result of overtrading and excessive risk-taking.  Conversely, many of the factors that account for career success are "soft skills" associated with interpersonal skill and emotional intelligence. Managers account for 70% of the variance in employee engagement scores, with relationship and communication skills making the critical difference--qualities more often associated with feminine sex roles than masculine ones.

Fortunately, efforts are under way to cultivate trading and leadership talent among women.  Most noteworthy is the trading competition being sponsored by Zolio.  The contest has just begun, but it's not too late to sign up and participate.  Contestants select a portfolio of stocks and/or ETFs that are tracked for performance.  Participants also keep a journal and manage their portfolios.  Prizes are awarded, not just for profitability, but also for process-oriented factors such as risk management and creativity.  Winners are invited to a Boston meet and greet with industry leaders in finance.  The idea is to open a door for women, who like my daughter, may never have thought of themselves as a successful person in a "male" occupation.  Because the competition is free, it's a great way to explore the field and get a feel for what it's like to manage capital.

So often, our greatest limits are those that we cannot see, that are embedded in our assumptions about ourselves and the world.  There are many opportunities possible for all of us if we can expand our vision of who we are and what we're capable of.

Further Reading:  Social Intelligence and Trading Skill

Monday, October 10, 2016

A Parable for November

You have a cross-country trip to take, and it's a must-do trip.  You have to leave immediately and all that are available is a charter plane and your choice of two available pilots.  The first pilot has flown this plane before but has a longstanding negative reputation as being someone who will overcharge you and most likely take you to unannounced stops before (possibly) arriving at your destination.  The second pilot loudly announces how great the ride will be and how dishonest the other pilot is, but has never flown a plane before.

Must-do trip.

Two pilots.

Your choice.

Further Reading:  Why Character Matters

Sunday, October 09, 2016

An Important Question for Active Traders

One question active traders too often fail to ask is, "What would I be doing with my life if I weren't trading?"

We're familiar with the direct costs of trading, such as the expenses we incur for software, commissions, and the like.  Less clear are the indirect costs--and especially the opportunity costs--associated with trading.  When we're glued to screens, there are many activities we cannot participate in.  Some of those activities may represent areas of strength, ones where we could excel and contribute.  

I meet many traders who limp along in their profitability, afraid to ask the big questions, because they not sure what they would do with their lives if they weren't trading.  They justify trading as a "passion", when in fact it's a black hole that has sucked them in so far that they cannot see an alternative future.

Is your trading giving you the financial and emotional returns you desire?

Are you a better person for your trading, or does trading interfere with relationships and other important parts of life, such as your physical fitness and emotional well-being?

Are there things you could--and maybe even should--be doing in your life that can't be accomplished because trading gets in the way?

Per Bob Marley's question above, are you truly satisfied with the life you're living?

Most traders ask how they can become better traders.  Few ask whether they truly should be trading.  

Sometimes the answer is not trading versus not trading, but figuring out how to make trading fit into your life, rather than fitting your life to marketsWhen I developed a medium term trading model, I discovered that opportunity is asymmetrically distributed during any given year.  There are stretches of time with little opportunity, other periods with more opportunity, and a few periods with unusually good opportunity.  It's possible to participate during occasions with high opportunity, profit from markets and market involvement, and still have a life for a fulfilling career, family, and personal pursuits.

The goal is not to be a profitable trader.  The goal is to profit from the life you live.

Further Reading:  Trading as an Addiction

Saturday, October 08, 2016

Assessing Positioning in the Market: A Measure of Pure Sentiment

Traders are often concerned that their ideas might fail simply because they have become "too consensus".  That is, if many other participants are positioned in the same idea, the risk/reward may become negatively skewed.  There aren't many traders left to move the position further in the desired direction and, should prices start to move the other way, there can be a stampede for the exits quickly putting positions under water.

Sentiment in the stock market is one way of gauging market psychology and whether there may be a bullish or bearish consensus.  Unfortunately, the standard measure for assessing sentiment, the put/call ratio, has several weaknesses.  First, it often mixes together put and call trading for stock index options and for the options on individual equities.  My work shows those are different distributions, with different impacts on markets.  The equity-only put/call measure, where options across all exchanges and all listed issues are included, has been the best measure for sentiment.  A second problem with the standard put/call ratio is that it is itself impacted by past price movement and volatility.  When markets rise, the ratio tends to decline and vice versa.

The pure sentiment measure I created is akin to the pure volatility measure, which adjusts implied volatility for the amount of realized volatility and past price movement.  Pure volatility thus tells us how much movement is being priced into options for a given amount of recent movement and realized volatility.  In other words, it shows us how VIX may be under-reacting or overreacting to recent price behavior.  Similarly, pure sentiment adjusts the put/call ratio for recent price movement and volatility.  The pure sentiment measure (shown above) tells us when we are "too" bullish or "too" bearish, given recent price behavior.

Interestingly, going back to 2014, pure sentiment has been a decent near term predictor of stock index prices--so much so that I added it to the ensemble model recently described.  By a simple median split, when pure sentiment has been high (too bearish for the amount of market movement we've seen), the next ten days in SPX have averaged a gain of +.71%.  When pure sentiment has been too low (too bullish for the amount of recent market movement), the next ten days in SPX have averaged a loss of  -.17%.  The numbers stand out even more at the extremes.

Notice how, in the recent market, we've had quite a few high readings in pure sentiment.  (Friday closed bullish on the pure sentiment measure; the overall ensemble model closed at a flat 0).  We've seen weakening breadth in stocks and many participants have been anticipating a market top, but prices have tended to bounce higher after we've seen selling.  The bearish sentiment/positioning may have something to do with that.  It's a facet of the market I'll be tracking closely in coming days.

Many, many market indicators can be improved by looking at whether and how they anticipate forward price movement once correlated market factors are removed.  It doesn't help to look at 12 different market indicators if they all are significantly correlated.  When we remove the correlations, we come closer to measuring the true factors that move stock prices.

Further Reading:  Pure Volatility

Tuesday, October 04, 2016

Tracking Speculative Sentiment in the Market

I recently posted on the importance of identifying who is in the market as a way of gauging how the market is likely to move, tracking the behavior of large institutional participants.  A different way of assessing market participation is by looking at speculative sentiment in the market.  This can be accomplished by looking at total options volume, not just the ratio of put volume to call volume.  

When total equity options volume (volume of options trading for stocks listed across all options exchanges) is in its lowest quartile going back to 2014, the next 10 days in SPY have averaged a loss of -.51%.  When total options volume has been in its highest quartile, the next 10 days have averaged a gain of +.91%.  If we strip out the role of total trading volume from total options volume in a regression model, we find that when pure options volume is in its lowest quartile (as was the case after Monday's close), the next 10 days in SPY have averaged a loss of -.41% versus an average gain of +.49% for the remainder of the sample.  

In other words, when speculative sentiment has died out, the market has been most vulnerable to correction.  Bear moves tend to end in a frenzy of activity, as value and momentum participants become involved at multiple time frames.  Bull moves tend to end in complacency and lack of interest, as the market becomes too dull for momentum participants and too rich for value players.  It is the interplay of high and low participation, tracking the activity of different participants, that creates the dynamics of market cycles.

Further Reading:  Volatility and the Dynamics of Market Cycles

Saturday, October 01, 2016

An Update of the Trading Model

TraderFeed will be taking a sabbatical during the month of October, with occasional postings on the market and on trading psychology.  During the sabbatical, I'll be finishing a co-edited book on brief therapy and completing a personal project.  That personal project will be a major subject during November's posts.

Over the October sabbatical, I'll also provide occasional updates of scores from my multivariate model, which I've revised to include a new measure of sentiment.  That new measure views put volume and call volume as independent variables, rather than simply taking the ratio of the two.  So we look for occasions when put volume is unusually high or low and the same for call volume.

Model scores range from +6 (very bullish) to zero (neutral) to -6 (very bearish).  The chart above shows average 10-day returns as a function of model score from 2014 to the present.  Hit rates on trades taken mechanically have been as one would expect from the above chart, with 64% of trades finishing up when scores have been 1 or 2; and 63% of trades finishing down when scores have been between -2 and -3 and very high hit rates at the bullish and bearish extremes.

We closed Friday with a score of +2, moderately bullish. 

Further Reading:  What We Can Learn From Quant Models

Friday, September 30, 2016

Looking for Your Trading Edge

Just thought I'd update this post on what it means for stocks when we see a high degree of institutional participation in the US equity market.  Yesterday's reading was in the highest quartile, which has been associated with significantly above average returns over a next 10-day period.  Interestingly, we also saw an elevated equity put/call ratio, also associated with favorable next 10-day returns in SPY.

Meanwhile, several of my cycle measures have been pretty toppy.  

There are times when things line up and there are times when they don't line up.  A useful psychological exercise is to assume that, at some point, everything will line up.  What would you need to see for such a line-up to occur?  Anticipating potential price paths is a first step in preparing to trade them.  Being aware of when things aren't lining up is a great way to avoid overtrading.

Further Reading:  When to Exit Winning Trades

Thursday, September 29, 2016

What Quant Models Can Teach Us About Trading Psychology

Above we can see SPY (blue line) plotted against a six-variable trading model that I developed using ensemble modeling.  When we have a positive score, the model is deemed to be bullish over a next 10-day horizon.  When we have a negative score, the model is deemed to be bearish.  The model is flat as of yesterday's close.  The model includes such variables as market volatility, breadth, buying/selling participation, and market cycle status.  

When the model has been at a score of +2 or higher, the next 10 days in SPY have averaged a gain of +2.08%.  When the model has been at a score of -3 or lower, the next 10 days in SPY have averaged a loss of -.83%.  Between scores of +1 and -2, the next 10 days in SPY have averaged a small loss of -.08%.  

The model has a couple of important implications for trading psychology:

1)  Out of the 573 days of my in-sample and out-of-sample periods, nearly half are scores less than +2 and greater than -3:  in other words, days with essentially no edge 10 days out.  That doesn't mean sources of edge can't be found on different time frames with different models, but this finding is important.  Even with a solidly researched source of edge, there are plenty of occasions when not trading is the best trade.

2)   The model signals have been good, but even with their edge, there is plenty of noise.  Note, for example, that the model was bearish during much of mid-2015, when prices chopped around quite a bit.  We were also bullish during fall, 2015 during a volatile bottoming period.  A trader could have an edge with a model but be unable to survive the noise around signal, especially if sized quite large.  

3)  I suspect the model works because it's exploiting cyclical behavior in markets at a time frame that is too long for active traders and too short for true investors.  A key to trading the model, as we've seen, is not placing trades when there is no clear signal.  There have been no solid signals from the model in the last 14 trading sessions; such periods are not rare.  It's the selectivity of the model that might be its greatest advantage.

4)  Such models don't have to be traded mechanically.  For instance, a short-term trader could use the model to decide when to trade with a directional bias and when to take short-term setups without such bias.  More fundamentally grounded traders could use models such as these to help with the execution of longer-term positions.  Good models provide good information; that information can be useful in discretionary decision making.

The act of developing models itself gives one a feel for markets.  The model inputs are there for a reason: the model simply captures when those reasons line up.  It is interesting that the most rational of analyses can feed the deepest intuitions.

Further Reading:  The Psychology of Quant Analysis

Wednesday, September 28, 2016

Trading Success and Calculated Risk Taking

There are risk-averse traders who never make significant money.  There are risk-seeking traders who blow up.  Then there are smart traders who take calculated risks.  They make selective bets.  Like the skilled poker player, they know when they have a good hand and they know how and when to bet that hand.

But to take calculated risks, you have to know how much risk you're truly taking.  Several factors impact the risks in your trading:

*  The sizing of your positions - It's not uncommon for small traders to have big dreams and take positions that are unusually large for the amounts of capital they're trading.  Any trader can experience strings of losing trades merely by chance.  When position sizes are too large, those strings of losers incur a risk of ruin.  Once you're down 50%, it takes a doubling of remaining capital just to return to break even.  

*  The volatility of your markets - Volatility can change dramatically from day to day, week to week, depending on the participation in your markets.  This can be particularly true around major events, such as central bank meetings, earnings reports, etc.  You want to size your positions, not only for the current volatility of the market you're trading, but also for the expected "vol of vol":  the expectable variation in volatility over the life of your intended holding period.

*  The correlation of positions you are trading - When the positions you are trading are negatively correlated, the overall risk in your book can be smaller than the risk associated with each of the positions.  Conversely, when you trade multiple positions that become correlated, your total risk exposure can grow exponentially.  Some short-term traders only hold one position at a time, but can experience correlation-related risk if they habitually lean one way in markets (long or short, for example).  They end up taking bets that are not truly independent ones.  Traders of individual equities often treat their positions as independent when, in fact, those positions can respond very similarly to large moves in the overall market.

Risk is important because it impacts trader psychology.  If the amount of risk you're taking dramatically expands or shrinks, you're likely to react to the change in the ebb and flow of your P/L.  In order to take calculated risks, you have to be able to estimate and calculate risk--and the possible ways risk can shift over time.  We often think of trades as directional bets, when in fact they are also implicit bets on *how* markets move.

Further Reading:  Risk Intelligence and Trading Success

Tuesday, September 27, 2016

Mind Shift: A Different View of Trading Psychology

One take on trading psychology says that we should control our emotional experience so that we stick to our processes and our discipline.

Another take on trading psychology says that we should become better at listening to the feelings that represent intuition and gut feel for markets.

This recent article, however, suggests a different approach altogether:  we become able to see and trade markets better when we can make mind shifts that allow us to experience markets differently.

Like a car, we can make a mind shift by changing gears, allowing us to approach the world with more torque, greater intensity.

Also like a car, we can achieve a mind shift by changing lanes, opening a new path.

The key idea of the article is that what we see and what we can act upon is a function, not only of the information we process, but also the state we're in.  When we achieve a mind shift, we not only can process new information, but become better at processing old information in new ways.

In short, emotional and physical creativity are paths to achieving fresh, creative trading ideas.  This opens the door to entirely new techniques for self-mastery in trading.

We see markets better when we shift from passive information processing to active:  actually playing and experimenting with the information.

We see markets better when we shift from active processing to interactive processing:  encountering information from multiple perspectives.

We see markets better when we shift from interactive processing to multi-active processing; processing multiple perspectives through multiple modalities. 

If we always stayed in one lane, in one gear, we'd be quite inefficient in our travels.  Trading psychology should not be about dampening your feelings or enshrining them.  The mind that can shift is one more likely to effectively reach its destination.

Further Reading:  Becoming More Creative