Sunday, May 19, 2013

Anti-market-topping analogs

On Friday, I tweeted a few chart based analogs.

Since this recent 24% or so move on the SPX over the past 6 months has been relatively unusual, I was able to find a few examples that seemed to fit relatively well.  I then used the historical outcome to overlay how the current market would appear if it followed the same path (on a % move basis).

I've reposted the charts below to make it easier to see in one place. But as is the case with any type of technical analysis, there are always caveats to any type of analysis and The Reformed Broker makes a few for chart based analogs.

Why did I do this?
One of the motivations for this was based partially on the "are tops a process?" post earlier, as well as my net short bear call spread positions in my autotrading account (which is taking a lot of heat).  I personally "feel" as though we are very overextended, but my logical side tells me that the trend is still strongly up.

So based on this current "overextended" move higher, I was surprised to see how much similar moves in the past continued to go higher.  Even the move that lead to the 1987 crash eventually recovered and finished higher after a 3-4 years.

As for where this exercise could lead me, @justcharts tweeted to me a few other comparison timeframes as well as other data that could be considered, such as ISEE sentiment and other put/call related data.  Her helpful tweet opened up some new interesting directions based on some limited research I've done so far.

My bottom line takeaway?
If we're truly topping here, there's usually some good signs and a few weeks to exit.  Or, as the charts below indicate, we could just be getting started on a move higher to levels we currently find difficult to even imagine.  Always keep an open mind, the market is always right.

2011-2013 vs. 1993-1995


2011-2013 vs. 1983-1986


Monday, May 13, 2013

Are tops really a process? Analyzing 25 years of $SPX topping patterns

Anytime we approach new significant highs in the stock market, the Twitterverse lights up with "This is THE top" calls.  Well, I'm somewhat guilty of this, too.  I'm sure it has much more to do with ego -- trying to prove how right you are.  However, I've learned the hard way that being right is far from being positively correlated with profitability.

So let's look at the data.  There's a saying that "tops are a process and bottoms are an event", so I've done a little hindsight-based-K.I.S.S.-back-of-napkin type analysis to take a closer look at stock market top formations.

There's a zillion different potential approaches that could have been taken to performance this analysis, and I just did something I felt comfortable with.  This is not a statistically significant analysis nor an actionable trading system, but for me, this homework helps me to get a "feel" for the data from my perspective and also generates some interesting takeaways.

Since "tops are a process" is often repeated as an trading axiom, does there really need to be a big rush to exit a long position (or to enter a short)?  And how much time do I realistically have to act on a topping pattern?

  1. Started with a 25 year monthly chart of the $SPX to identify key highs during an uptrend
  2. On the monthly chart, down arrows were placed at pivot swing highs based on a high that had 1) two preceding highs that were lower and 2) two succeeding highs that were lower
  3. The highs from the monthly chart were then identified and marked on the weekly chart with a down arrow
  4. On the weekly chart, starting from the pivot swing high arrow, the next pivot swing low was identified, and the retracement was measured
  5. If the retracement to retest the pivot high was greater than 50%, then that point was identified on the chart with a smaller down arrow
  6. The number of weeks between the "Potential Top" and the 50%+ retracement was identified
  7. And finally, the shape of the 3 legs of the swings, starting from the high, was also drawn on the chart
Here's the high level SPX monthly chart going back 25 years (January 1998 to May 2013), with each significant high marked with an arrow:
The following charts drill down to the WEEKLY charts, with each arrow corresponding to the arrow on the monthly chart above.

July 1998 - March 2001

 January 2004 - September 2006

October 2006 - August 2009

February 2011 - December 2012

July 2010 - Current (May 2013)
[Note: significant overlap with chart above]
Doesn't look like a topping process is forming yet.

  • After a "Potential Top" was established, ALL examples had a bounce from the succeeding pivot swing lows of at least 50% that retested the highs (based on weekly chart)
  • After "THE Top" (2000 and 2007) was been established, there was adequate time to exit on a retest bounce to highs (a 50+% retracement) within a 2 week period.
  • After a "Potential Top" was established (13 incidents), there was adequate time to exit on a retest bounce to the highs (a 50%+ retracement) within an average of 4.5 weeks
  • During the last 2 run ups to new all time highs (2000 and 2007), there were 6 significant swing highs (false tops) before the "THE Top" was established
  • For both the 2000 and 2007 tops, once the pivot swing low that preceded the high was broken, it potentially indicated "THE Top"
  • The 2000 pivot swing low was broken after about 8 months, and 7 months after "THE Top"
  • The 2007 pivot swing low was broken after about 5 months, and 3 months after "THE Top"

Long term investor:
Over the very long term perspective (i.e. years/decades) which is the timeframe for the long term investor, the stock market has an overall bias to go higher. 

So unless you have a highly accurate method of picking tops, just wait for some confirmation that the trend has changed before exiting.  Otherwise, you're likely to get many false signals until you get it right.

Something as simple as waiting for the pivot swing low that preceded the high to be broken (blue lines on the monthly chart), in conjunction with other signals seems to makes the most sense.  You get several months to make your decision.

So yes, don't need to rush to the exits.  Based on a longer term horizon based on monthly charts using the break of the pivot swing low criteria described above, the topping process lasts 3 to 7 months based on 2 incidents, over the past 25 years This is loosely identified as "Topping Formation" on the weekly charts.

Longer term trader:
If you're looking for a trade lasting up to a few weeks and don't really care about picking "THE Top", then every potential top had a bounce that exceeded 50%. 

That could be a good area to potentially exit long positions or even go short, with a reentry or max stop on short above the "Potential Top."  But all the losses from getting stopped out could likely negate the profits you gain from eventually catching "THE Top."

You can also keep an eye on the monthly/weekly charts to see whether a potential top is lining up so that it can give some bias to the daily chart timeframe.

In the case of the shorter term timeframe, the topping process, where a bounce up retests the 50+% mark to the highs on a weekly chart, lasts on average almost 4 weeks.

Day trader/Swing trader:
Don't even bother reading this, except for entertainment and cocktail party purposes.  (And yes, I essentially fit into this category).

Monday, May 6, 2013

2 Years of Trading - Lessons Learned (Part 3 of 3) - The Mental Game

This is a continuation of the prior posts in this series: 


Once you're fortunate to find a style that works for you, it's all mental
Perhaps it's human nature to want to deviate from something you know works.  Let's say you have a trading system that's right 95% of the time and generates 5:1 reward/risk.  You've found the holy grail! 

Doesn't matter, our mind plays tricks on us.  It's easy to think we can do even better and get 100% accurate and/or generate a 10:1 reward/risk.  Or maybe the holy grail is a counter trend system but you like going with the trend and catching the big moves, so it doesn't quite fit your personality.  You tweak the system to the point where it's no longer the system that originally had an edge.

When we deviate from our system just that one time, the next rule break becomes just a little easier to do, and so on...  Your mental discipline starts to crack.  And if you don't watch out, it eventually snowballs into something very ugly. Yes, this has happened to me many times.

Even if you know you have a system that works and fits your personality, staying disciplined to consistently execute your trades, through the good times and bad, requires considerable psychological efforts.  This is especially true when you're not at your mental best due to lack of sleep, personal issues, illness, etc.  Awareness of the state of your mind and being able to act appropriately, is key criteria for success.

So once you've achieved a certain level of trading ability, managing your trading psychology becomes one of the biggest factors to successful trading. A great instructor of the mental aspects of trading is FuturesTrader71 (FT71) who is a part of Stage 5 Trading.  His webinar #3, available via a donation to charity, is something I consider a trading classic.  Recommended to all types of traders who have a solid understanding of trading fundamentals and want to get to the next level.

There are also a lot of great books about trading psychology available written by Brett Steenbarger, Mark Douglas, Ari Kiev, Ruth Barrons Roosevelt, Denise Shull, Steve Ward, to name a few.  But look in any other performance based field, such as golf, baseball, or even archery which I wrote about last year, and there are some real gems.

I have found the mental challenge of trading similar to dieting or exercise.  Once you find a type of diet or exercise program that works for you, it's a matter of "simply" sticking with the program, with slight tweaks along the way, day after day, week after week, and so on.  Much easier said than done!  I've accepted the fact that I will need to constantly work on my mental game in order help ensure my long term success.

"Successful" behavior in the corporate world, could lead to failure in trading
Those who cross over from the professional fields or corporate environments seem to have extra challenges with retail trading.  Those who have been successful in their respected fields are used to getting their ways by managing others to help accomplish your goals, always taking the initiative and action to make things happen, and knowing how to successfully politic (BS) and influence the origination.  When things go wrong, their ability to act and quickly do "something" gives the perception and aura of confidence and competency.

But utilize those behaviors within certain aspects of trading and it's good recipe for failure.  The market is always in charge, it's the ultimate boss, and it's never wrong.  You can't tell it what to do, you can only react and be submissive to it (price).  The market doesn't care how confident you appear to be, it just doesn't care about you, period.

If you constantly take the initiative to be in a trade so that it appears you're doing something (looking like you're working hard) instead of being patient waiting for your setup, it could mean you're overtrading or rogue trading.  And if you're "wrong" and lose money on a trade, then trying to take immediate action to fix the situation (without a plan) most likely means you're revenge trading.  We've seen this many times by politicians and corporate types as a "knee jerk" reaction to an event.  But do this to the markets, and it will most certainly punish you, if not this time, then later.

I come "brainwashed" from years in the corporate world, so I can now clearly see how many aspects of good corporate behavior can be so counter-intuitive to good trading behavior.  So the longer you've been successful in the corporate world, the longer it may take for you to truly change your behavior when you begin trading.  However, constantly being aware of your behavior is one step that could help shorten the learning curve.

Finding true mental breaks is important
Like most who are passionate (addicted?) about the markets, I find it tough to switch gears and focus on non-trading activities.  Without checks and balances, I could probably spend 16+ hours day, just about 7 days a week studying the markets (again, addicted?).  But I'm finding that having the ability to take a true mental break has been critical to create balance and prevent burnout (and prove to myself, I can stop anytime, unlike an addict, ha!).

Most have an activity they do regularly that will switch the focus of the mind from trading to something else.  If you're a daytrader, some traders find it helpful to have a diversion to help deal with the boredom of trading, or as a way to cool off after a bad losing streak.  Even a swing trader needs to help balance their days in order to stay sharp and ready for a setup.  Unlike a daytrader, swing setups happen much less often, so missing one could impact your overall performance with greater impact.

So what is a true mental break?  Examples I've heard include: meditation, listening to music, playing a musical instrument, triathlons, mountain bike racing, yoga, reading (non-trading) books, learning new languages, writing a blog, cleaning the house, yard work, etc.  The important part is that your mind gets completely engaged in some other activity completely devoid of anything trading related. In my case, also having a couple young kids most certainly helps to creates a break, whether I like it or not.

I've personally found that group exercise classes can be very motivating.  When you're in a kickboxing class with a few 60-70 year old grandma types demonstrating clearly that you don't want to get into a fight with them, it's quite the motivation to keep up and not look like a wimpy girly-man.  Consequently, unless you maintain maximum focus and get totally absorbed in the class, you will likely embarrass yourself.  So not only is it a great mental break, it's also great for your health.

A hobby I've had is to roast my own coffee, primarily for espresso shots.  Ever since moving away from the SF Bay Area where there were many amazing artisanal coffee roasters and cafes, I got spoiled and couldn't find the same level of quality and freshness in my current neighborhood.  Yes, I became a coffee snob.

So I started to roast coffee on my own and quickly realized that what seems so simple, is full of never ending complexity and nuances.  But most importantly, working on this hobby requires absolute concentration and focus, which for me, results in a complete mental break from trading.  Plus, having a great shot of espresso to get the day started is a huge positive benefit.

In the end, it's important that I take these true mental breaks so that I can maintain some semblance of a balanced life.  When that happens, my trading becomes more centered, clearer, and generally improves.  This also spills over throughout all aspects of my life in a very positive way.

Plan your breaks from trading...and DO IT
As mentioned above, I've learned that taking a true mental break throughout the day is important.  I seem to do better when I go exercise mid-morning, shortly after the market opens.  Since I'm primarily swing trading, this is not an issue, since I basically adjust my orders/positions shortly after the open.  However, even for daytraders, I believe it's very helpful to take a significant break during the lunch hour.

And more often than not, it's those days I do NOT feel like taking a break (because I'm feeling emotions about something market related), are the days when I truly need to force myself to get away.  Otherwise, I've become aware that I become too fixated about something, and lose sight of the bigger picture.

On a longer timeframe, such as every 2-3 months (or whatever works best for you), taking a week completely  away from trading seems essential for good mental health.  Otherwise, you'll be subject to burn out since trading (especially daytrading) can be so intense.  I find it's very hard to get completely away, but remind myself, the market will always be there. 

Explore, learn, push your boundaries...but know when to stop trying so hard.
It's no secret how some of the best players in the NBA (or any other sports) such as Kobe Bryant and Lebron James, have incredible work ethics.  At their elite levels, there's not much of a difference in physical abilities, so a lot of of their edge comes from honing their mental game through rigorous hard work and focused practice.

Growing up, I used to think that once someone became a superstar, they are simply so good that they can just kick back and continue to perform at peak levels.  Well, how wrong I was.  Being a superstar requires tremendous passion and dedication to never stop learning and pushing your boundaries, since everyone else is doing the same.  You have to keep pushing hard simply to maintain and/or improve, but it's so easy to let it all go.

Trading is similar.  When you first start learning, you need to constantly explore and learn everything you can so that you can eventually figure out what works for you (your strengths) and what doesn't.  It's OK to make mistakes, but for the sake of progress, you have to continue to focus hard on areas for improvement based on discovering your strengths and weaknesses gained through painful experience. 

I've gotten to a point where there's a certain style, timeframe, and setups that seem to work best for me.  However, I'm still lured at times to "chase success", although thank goodness it's no where near what it used to be.  In the past when I read about a successful trader, I wanted to quickly put aside what I was doing, and learn how to trade just them.

But now that I'm finally figuring out what works for me after trying (and failing) so many different trading styles and methodologies, my focus has become more on maintaining the proper focus as well as refining a process so that I can replicate it every day.  Now when I read about a successful trader, I understand what type of trader they are, and accept the fact that I can/can't trade like them because I've already explored it in the past.

Now that I don't need to work as hard to figure out what works for me, I realize it's becoming more important to know when and what specific areas to back off from (or stop chasing).  Like stop trying so hard to be like or be influenced by someone else, or stop trying to force a trade in market conditions that isn't suited for my style, or stop trading simply out of boredom.  I consider this a sign that I need to continue to work hard on my mental discipline, and most likely, this work work will never end.

Golf is a good analogy.  Getting good at the fundamentals of golf takes years.  But after a while, you will realize what type of player you are, and whether you are the type that can drive the ball 300+ yards.  You may really want to be a long drive golfer, but may never get there -- it's just not your strength.  At some point, you will realize that to improve, you need to focus on different aspect of your game.  And along the way when you stop trying to swing so hard, you realize that the ball actually goes farther with greater consistency and accuracy!

In trading, I've learned that I need to always push hard in many areas, but then also realize that I need to back off in other areas.  Knowing which area to focus on and to back away from requires a lot of awareness. 

I'm still as passionate as ever about trading, but feeling more detached about every trade
Maybe it's the 1,000+ revenge and rogue trades I've taken over the past couple years that have finally gotten much of the overtrading out of my system.  After seeing time and time again how taking trades based on negative emotions results in a negative P&L, common sense might finally be making it through my thick skull. 

It's common to hear some say that you should not feel any emotions when you're trading.  I don't completely agree with that, since we're all different, and since we all react to situations in our own personal ways.  Have you ever watched how Paul Tudor Jones traded back in the '80s?   He's far from emotionless when he's trading, that's for certain!

Although I've always known, I have finally started to believe and accept that the outcome of each individual trade is essentially random.  We don't truly know how a particular trade will turn out, however, we have total control over whether we enter the trade, at what point the trade is wrong so that we exit with a loss, as well as where we exit if the trade is profitable.

Assuming we have a plan, there's simply not much else we can do after we're in a trade, other than to follow the trade plan.  When you first start trading, this is the most exciting part, being in the trade.  But these days, it's relatively boring, and that's good because being emotionally detached helps me to better ensure that I follow my plan.  And over time, it seems like I'm becoming both more detached as well as intuitive, which then helps me to follow my process and trade plan..

Here's another quirky way I've come to understand and accept this particular type of detachment.  After decades of making hundreds of boxes of mac & cheese in my life, I'm still as passionate as ever about it.  But unlike the first few exciting times I made it all by myself, carefully following the directions, I'm detached and unemotional when I'm preparing it now.  I don't even need to read the directions on the box anymore, the process is pretty much intuitive and on autopilot.  It just took a lot of time and experience to reach this stage.

Develop your sense of awareness, and more importantly, be able to act on it
Knowing when NOT to trade because you're not in the right frame of mind, AND most importantly, being able to take action to stop trading, is one of the most important risk management tools.  This was inspired by a video of Denise Shull, and I wrote a blog post about this last year. 

Recently, @thetradingwife said she passed up a good trade setup, simply because she felt emotions about that particular stock.  She recognized that due to a bad experience with the stock, she felt a level of emotion beyond her normal threshold, recognized it, and acted on it by making the decision not to take the trade.  It was simple and decisive.  For whatever reason, this was one of those defining moments that I'll always remember.

There have been so many times when I know I shouldn't trade, whether it's because I started the day with 2 losses in a row (a big daytrading revenge trigger for me), or because I'm sick, or my kids are causing trouble, or lack of sleep, or whatever.

Most of the time, I'm completely aware of my negative condition(s).  I tell myself exactly why I should not be trading.  However, in my mind, my mental chatter says, "I know I shouldn't take this trade, but screw it, I'm going to do it, I really don't care.  I'm going to make up my 3 previous losses with a huge winner.  So I'm going to do it.  [Click]"  That attitude is extremely toxic to trading.  Especially when your "screw it" attitude results in a winning trade, which further reinforces bad behavior.

Once those emotions are bubbling under the surface, that's a sign of danger to your P&L.  Having the awareness is one thing, but taking action so that you back off and actually stop trading is huge accomplishment.  To be able to stop trading means that means you have the ultimate risk management control over yourself.

Those with a I'M NOT A QUITTER attitude have an especially tough time, since taking this action of walking away feels like quitting.  I fall into that category and have had my fair share of P&L damaging revenge trades.  Roughly 25% of my 4,000+ trades in the past 2 years were revenge and/or rogue trades.  My statistics show that these were very poor trades.  Imagine if I had simply walked away from taking these trades. 

When under mental conditions of emotional distress where you've lost nearly all sense of self control (it's akin to driving drunk), backing away from trading is not quitting, it's protecting yourself (your capital) from harm's way. And protecting your capital is one of the most important goals of trading.

I have found that building awareness is key to gaining control of the mental game.  Awareness of: revenge triggers, strengths, trading style, best timeframe, any heightened emotions, when not to trade, and so on.  The ability to differentiate between impulse and revenge trades vs. intiutive trades is also a big milestone.  Initially, I thought there was a fine line between them.  In many ways, they are very similar, but factor in awareness, and there is a huge gap between them.

I've found that as I continue to become more aware of my own emotional triggers, and consequently more aware of the respective outcomes, a greater ability to take action based on my awareness is gained.  And because of that increased level of control over myself, I've become a lot more emotionally detached and accepting to many other aspects of trading.

The end result?  I've experienced improvement to my overall trading P&L and consistency.  But I still have a long journey ahead of me.  I'm looking forward the 3rd year. 

*  *  *  *  *

I'm looking forward to rereading these posts in 2 years and telling myself, "If I only knew back then what I know now."