Ignorance Can Be Bliss

There is an absolute limit to how much profit can be extracted from a market in any particular period of time. You will never make as much profit in the markets as hindsight and imagination can lead you to believe. Back-tested, theoretical profits will be devoured by a nearly limitless number of factors. The biggest profit eaters are shown below:Losses from slippage, not following the plan, commissions and fees, taxes, and the relative merits of different investing styles have been covered endlessly in the financial press. But the biggest factor is largely ignored. NASAYAYA: Not As Smart As You Assume You Are. Welcome to the future! The place where everything is out of sample and all that is certain or assumed goes to die a grisly death. You think you know X. You’re certain about Y. You think 10 years of intraday data is a representative sample of something other than those 10 years. The market will react the way it “should”. You feel your past results are mostly the result of skill. Whatever it is, the more you think you know, the greater the odds that you don’t know shit. Understanding comes with a curious byproduct: The more you know, the more you know you don’t know. Thus, true insight can only come with a generous side order of humble pie.

I’ve become increasingly convinced that trading nirvana is reached when you accept your near absolute ignorance in the markets. As dangerous as the inherently uncertain future is, it’s a known unknown. The unknown unknown, and even more dangerous, is what your preconceptions are blinding you to right now.

Ben Bernanke once said he was unable to imagine a set of circumstances that would convince him he was wrong about the economy. Burdened by that level of certainty he has no real choices or flexibility left. In his world he can’t be proven wrong and if you’re right, why change?

That’s the exact opposite of where you want to be in the markets. When you accept the completeness of your ignorance you’re free to listen to the market and go with the flow. Whatever theories, beliefs, preferences and biases you have lose their power to blind you because you know they’re all crap, and any help they may provide can only be temporary.

So take a seat. It’s time to start the meeting…Hi, my name is Mortalitysucks and I’m an ignoramus.

________________________________

Next time: Knowing enough to know you don’t know much of anything isn’t the end. The next rung on the ladder of enlightenment is answering whether it’s even possible to know anything. In other words, is there really such a thing as market-beating skill? How should the answer alter your approach?

Backing Over Retirement

How much money you will have for retirement depends on only two things: How much you have to invest and the return on investment, i.e. Nest egg = Money to invest + Return on investment. When it comes to retirement planning I think people too often treat the size of the nest egg they need and how much they have to invest as given, then back into the return they need to make the numbers work. From there it’s a matter of taking on enough risk to meet those expectations [1].

I think this approach is dangerously backward. For a host of reasons, people tend to devote far too much time to things over which they have little control while ignoring those over which they have sizable control. In investing for retirement it often looks like this (ranked high to low):

Degree of Control	Time Spent
1. Amount spent and saved	1. Return on investment
2. Amount needed to retire	2. Amount needed to retire
3. Return on investment	3. Amount spent and saved

Although it’s psychologically appealing, focusing too much on returns often fails due to one cold, hard fact: The universe and the market don’t give a rat’s ass what return on investment you need. There’s no guarantee you were born at a time and place where the return you need can be achieved by anything other than reckless gambling and luck – and the higher the required return the more luck you’ll need. Even an ostensibly realistic return goal (like 4% per year over the next decade) may not be achievable in practice. The psychological strain of volatile returns can make even conservative goals extremely difficult to achieve, and adding leverage or riskier assets only makes the roller coaster worse.

The better solution is to put yourself in a situation where you need as little return and luck as possible.

1. Save more money each month. Yup, that again. In basic terms return = cash + beta + alpha. There’s an excellent case to be made that alpha approaches zero (typically less than zero) over the long-term, while beta is simply another term for increasing risk, which leaves saving more as the only safe and reliable way to have more money in retirement. It’s not glamorous or exciting – Ray Dalio gets the press, not the person squeezing $5K a year in savings out of a $25K income. Yet a low-income penny pincher is relying more on skill than any stock market wizard, as well as generating a near certain [tax-free] payout. Who’s the genius now?

1a. Get out of debt. Paying off credit card debt can often yield double what Bernie Madoff was promising but with zero risk, guaranteed, in any market environment. What more do you want? You should fire yourself if you miss that trade.

1b. Make more money. I think most people are already sacrificing as much time to the pursuit of money as they can tolerate. However, keep in mind 21st century technology has made it easier than ever before to make money on the side. It’s hard for an old fart like me to believe that spending an hour writing a stupid Facebook app can generate $200 a week in ad revenue, but it can and it all adds up. Keep it at the top of your to do list and don’t rule something out simply because it seems unlikely at first glance. The entire Web 2.0 sector seems ridiculous to me but that hasn’t kept people from making equally ridiculous money from it.

2. Be a true pessimist in your projections.Whether the macro environment smiles or frowns on your investing life, there’s nothing you can do about it except to be unbelievably conservative in your projections about the future. I really do mean unbelievably. In the late 70′s and early 80′s who would have believed <1% money market yields for years on end? If your projections seem comfortably correct, they’re almost certainly wrong. Things will always go wrong, occasionally wildly wrong, so preparing for the worst and hoping for the best is always good financial practice.

3. Redefine retirement. This is the most unexplored avenue to retirement, largely because it goes against the shallow beer commercial portrayal of a life of leisure. Yet taken to the extreme it can allow you to retire tomorrow. Many people have only the vaguest notion of the details of their retirement, mere fragments of a hazy dream. Exactly what do you see yourself doing with your time each day (potentially for decades)? What’s the difference between work and retirement? You need to get paid either way. Is it getting paid by a nameless market rather than a specific person? Is it a matter of choice versus necessity? How much choice you do ever really have? It may not have been featured in your retirement fantasies but you’re going to end up doing something, if only to avoid losing your mind [2], and if you’re doing something why does it always have to be no charge? Help out a former colleague, try something new, be the first 80-year-old guy working at Victoria’s Secret. When you actually get there, I think the odds are high your retirement can produce income from something other than investments, without the constraints of ambition, career and responsibility. Consider it diversification. Is that the stuff of which dreams are made? Maybe not, but it can still be a very satisfying and liberating reality.

If you can generate a high return on your investments, congratulations! But don’t bet the farm and gamble away your nest egg on boosting returns when there are virtually risk-free alternatives. Being a mindless part of the herd is as dangerous when thinking about your retirement as it is in any investing decision. Continually redefining your retirement, your needs, and yourself will always yield a much more interesting life than nodding off in a rocking chair, no matter how great those arthritis pain pills make you feel.

____________________________

[1] In some cases this strategy be written as: Money to invest * ∞ = Needed retirement savings.

[2] The opening scenes with Michael Caine in Harry Brown do a great job of showing how dreary and empty the daily routine of actual retirement can be. More importantly, people who are disconnected from society, without meaning and purpose, tend to die sooner (and I think the downsides of that outweigh any cost savings).

Don’t Show Me The Money!

Money can blind you to the good bits of life

Money may not be the root of all evil, but it is the root of many poor decisions. Despite every attempt at cold, steely rationality, everything changes when money is involved. It’s no coincidence that arguments about money are one of the most common marital problems. Dealing with money is difficult. We weren’t designed for it. Once the “money” label is attached to a number it invokes a host of decision biases. How much, how little, what to do with it, and how the balance has changed can not only change decision-making but how a person feels about themselves.

A dramatic example of this is the famous Depression-era speculator Jesse Livermore. According to his suicide note he took his life because he felt he was a failure, presumably due to losing the bulk of his sizable fortune. But he died with $5 million in various trusts and assets, the equivalent of $82 million in today’s dollars. I suspect if he’d been told at the outset he would end up with that amount he would have volunteered in an instant. But the meaning he attached to those numbers and how he reached them made it intolerable.

As Livermore highlights, money plays a starring role in decision biases and The Big List of Behavioral Biases lists over 100 to choose from. There is some overlap from academics trying to make a name for themselves with their very own decision bias, but it’s clear the more that money is the focus of your life, the more biases will bedevil you. Trying to keep in mind 107 biases to avoid while making a decision is impossible. Keeping money out of mind is a more achievable solution, though it’s often easier said than done.

Decisions have been shown to use different areas of the brain when money is at stake, and the greater the stakes the worse the typical performance. Evolution has given us wonderful heuristics for avoiding predation, finding food, and improving mating success, but very few that work when dealing with the dynamics of global financial markets reflecting the valuations of billions of people (many of whom are hunting your money).

The quantification that money allows often encourages a false sense of precision. If X then Y. If I make $X dollars this year, have $X in the bank, or have $X for retirement, then: I will be happy, I’ll have no worries, people will respect me, I’ll have a great retirement, I can do what I want. It’s a seeming mathematical certainty which is almost entirely illusory. Your feelings aren’t a market with buyers and sellers competing for scarce resources. Any prices you attach to your hopes and dreams are pure, arbitrary nonsense.

Ignoring that admonition can lead to price tags on everything in life. Your self-worth, how you spend your time, what you consider worthwhile, and even your relationships can come to depend on the balances in your accounts. Further, accounting is necessarily focused on the past, so whether it makes you feel good or bad, there’s nothing that can be done about it. There is no hope without the possibility of change, so obsessing about your numbers can only lead to hopelessness.

Short of becoming a hermit in the woods, dealing with money is unavoidable in modern life, and doing so successfully requires focusing on it to some significant degree. Yet focusing on it will mess with your head. It’s a catch-22. Fortunately there may be some ways around it:

• One strategy, as Bruce Bower wrote in What’s Your Number?, is to focus on the process and enjoy the aspects of it that lead to success, rather than focusing on specific monetary goals which are often more a distraction than a help.
• Another response is to avoid absolute numbers and use percentages, ratios and other measures which disguise the potentially mind twisting amounts with which you are dealing. If your profit factor is 3.27, it really doesn’t matter whether you’re dealing with $100 or $100 million; you’re doing what you need to do.
• If necessary, delegate all the accounting functions and only allow yourself to see sanitized performance reports showing the quality of your decisions, not the quantity of money involved (but keep full control over the accounts to keep your money from disappearing with your accountant).
• Everyone does better in some situations than others so self-knowledge is vital in avoiding monetary decision traps. For example, some trade better when ahead, others from behind and artificially creating those situations can prevent unnecessary losses. If you focus better when climbing out of a hole, periodically take enough money out of your account to get your mind where it needs to be. If you do better when you are up, consider splitting your risk money into two accounts, with one as a reserve gas tank to replenish the main trading account when losses start to mess with your head.
• It’s often difficult to be objective when thinking about yourself and your money, so ask yourself “Would a great trader/investor take this trade?” By focusing on what someone else would do with their account (which you care nothing about), it’s easier to be objective. You’ve probably read about many great trades but the default scripts that govern your behavior and attitudes often keep you from capitalizing in similar situations. Think of George Soros, Ray Dalio, or whomever you prefer, and use how you think they would act to write a different script.
• The duty to others can help hurdle decisions that are difficult when they only involve your own welfare. Whether you simply focus on doing it for the kids, or actually trade your wife’s 401(k), invoking a sense of fiduciary duty will often trigger a more useful set of responses and motivations.
• Reframe it. Going from zero to $5 million is great. Going from zero to $100 million, and then to $5 million is horrible. It’s the same ending either way but the feelings attached to it depend on how you look at it. Change your perspective and change your mind.

Dealing with money will probably always be difficult but money is just a label attached to a number. What it does to you depends not on the money itself but how you view it and respond to it. Ultimately those are things you can to some degree control.

Now, as a quick test, look at the above picture again to check that you can see more than money.

You Know Things Are Messed Up…

…when you get junk mail claiming to be from Ben Bernanke (who is apparently reachable by an Aol email and an LA phone number):

From: ”BEN S, BERNANKE”<info@yahoo.com>
To:
Cc:
Date: Sun, 23 Dec 2012 22:16:05 -0800
Subject: CONTRACT FUNDS – CREDITED FROM THE FEDERAL RESERVE
ATTENTION: BENEFICIARY,

CONTRACT FUNDS – CREDITED FROM THE FEDERAL RESERVE AND WORLD BANK AND IMF BOARD!

We received the instructional letter to credit $18.7 Million to your account or any means of payment of choice you want your  Fund to be remitted to you.
Your response is required to urgently enable  us get this funds to you without any further delay and you are also required to  get back to us with the process how you choose to receive your fund , because we have two way your funds can get down to you(Diplomatic Delivery, And ATM Card ) also confirm your Full Information for us to know if what we have in file is correct and to avoid delivering your fund to wrong address.

CONGRATULATION ON YOUR CONTRACT FUND.

EMAIL : ~~~@aol.com

Please be fast on this matter. Thanks and God bless you.

Regards,

BEN.S. BERNANKE
Chairman Federal Reserve Board New York.
+1213-xxx-xxxx

When the Fed Chairman is so famous that spammers are using his name that isn’t a good sign.

Riding the Falling Knife

Everyone is familiar with the old warning about not trying to catch a falling knife, but what if you’re already holding the dull end of that knife?

Let’s say the market is down 30% from recent highs and you’ve been short most of the way down. The prior day was a 5% down day on less than impressive volume, and today is already looking just as ugly. You’re making money hand over fist, and another big down day could add 15% in a day if you’re leveraged. Jack Schwager is bound to be emailing about his next book soon. What do you do?

Get out. Now.

Especially in the current climate, the conditions described are the perfect fuel for large, unpredictable, ham-fisted interventions. Banning short selling, closing markets, direct Fed purchases of whatever they feel like, even banning selling altogether has been tried in some countries (though it didn’t work either). Even without outside interventions, volatility cuts both ways. When the daily range gets too large in a one-way trade it’s a virtual certainty it will soon be equally large in the opposite direction, vaporizing your profits as quickly as they appeared.

It isn’t easy to abandon your fantasies when a short trade is wildly exceeding expectations. Getting out early will often leave money on the table, sometimes a lot of money, which can be very hard to tolerate. But consider how it would feel being stuck in a short while the exchanges and government engineer the biggest rally in human history before reopening the market, or if the market leaps over your stops and keeps on going, vaporizing your paper profits with the fill from hell.

Climactic declines happen the way they do because there really aren’t that many people willing to try catching falling knives. When they happen it can be a great time to be short, but don’t let greed blind you to the danger of trying to ride that falling knife all the way to the ground.

* For the bulls feeling ignored by this post, turn your tablet upside down while you read and think of Apple’s recent parabolic rise.

That’s Gonna Leave A Mark

It’s often said that picking bottoms is easier than picking tops. Logically this can really only be the case if people are using somewhat different definitions of bottoms, but I think for most it remains true in practice. However, bottom calling based on one or two indicators, while ignoring the larger context, can lead to trouble.

I always think of Tommy Boy getting bashed in the head with a 2×4. When a significant decline or negative event happens, it’s going to leave a mark. There will be echoes that reverberate through the markets as people adjust to the new reality, and how long that lasts will be somewhat proportional to the size and circumstances of the decline.

As an example, here’s a fairly run of the mill decline from the Fall of 2011:

The first drop wasn’t huge, less than 20% top to bottom, and ended with a typical volume spike. The EU troubles were in the news, along with the usual wall of worry, but mostly the market had gotten overextended. After the first bottom, the market chopped around for a while before it retested the lows, but on lower volume. There was another low volume head fake, but that’s pretty much all she wrote. Basically a slap in the face with no lasting damage, consistent with the overall context.

On the other hand, the late 2007 to 2009 period provides a great example of leaving a mark:

Though the news near the end of 2007 might have predicted otherwise, the initial drop in early 2008 was fairly normal. The period between the two bottoms was perhaps longer than the percentage drop would indicate, and the rally attempt was somewhat abortive, but the action still reflected a market taking a fairly typical heavy blow. But at that time that reaction itself was a problem since it didn’t reflect the magnitude of events that were happening. The news continued to worsen but the market rallied for a couple of months in Playtex mode (no visible means of support) before failing to make new highs.

The initial bottom after the Playtex rally could easily be rationalized as the start of a long trading range along the lows while things worked themselves out. Looking only at the chart, it was a good place to scale back in; all that was needed was a rally and retest. In fact, without paying attention to the broader context, there were four, and maybe five, justifiable candidates for a good bottom as they were happening. Instead, context grabbed a 2×4 and swung it with both hands, and jumping in at those seeming bottoms would have been ugly.

There are many indicators which can be used to signal a bottom: Breadth, volume, new lows, daily range, volatility, options ratios, and others. But nothing is foolproof in the markets – banks have paid a lot of bonus money to people who’ve proved it – and considering what mark the broader environment will leave can help improve your odds. Was that a fist or a 2×4? 

My One Investing Rule

There are many lists of investing rules, and many contain very worthwhile, valuable advice. I’ve even read some of them. The trouble is investing is a complex cognitive process, frequently accompanied by extreme pressure, and there are limited cognitive resources available to cope with it. In those circumstances, your odds of thinking of the most relevant principle out of a list of five, let alone a dozen or more, is near zero. So I try to stay out of trouble with one, and only one, rule:

It’s never that easy.

I know what you’re thinking. That’s freaking brilliant! Why didn’t anyone else think of that? But it’s not just the usual idea that you can’t get something for nothing that makes this rule important. It’s that very rarely it can seem like you can, and it’s those rare instances that are your worst enemy.

Investing is a process which takes time, effort, and execution in order to succeed. It also inherently involves a significant element of randomness. You may find a deal or trade that makes your head spin with the riches that await you, and the nature of the game means there’s always a chance you’ll be correct. Everyone has heard stories about some lucky bastard or other, and human nature makes it all too easy to believe it’s your turn to be that one lucky bastard. But it’s far more likely you’re simply overlooking something important and the seeming manna from heaven landing at your feet will later cause you to grab your head in both hands, wail and moan like a wounded animal, and wish that god had struck you dead before you got out of bed that morning.

Markets aren’t completely efficient, but they are mostly efficient. Easy money tends to be rapidly removed by the largest, fastest, most connected participants. In other words, someone other than you. When you’re in a groove, trading can indeed be easy, but not that easy. If you think it’s your lucky day, always think again. Twice. Do you really feel that lucky, punk?

The Sweet Pain of Success

On the first page of Tyler Hamilton’s excellent book, The Secret Race, he almost unintentionally gives what I think is some of the best advice I’ve ever heard about success:

You can’t block out the pain. You have to embrace it.

Solving any problem in life involves some sort of pain, and embracing that pain is the first step to success. Fortunately for the rest of us, success outside of athletics is rarely the result of deliberately creating more pain to embrace, but of embracing it early before it gets worse.

• Taking the pain of a small loss on a trade prevents a more painful loss later
• Dealing with the short-term pain of change prevents years of life wasted in something (job, marriage, etc) that only creates misery
• Embracing the pains of embarrassment, shame, or alienation allows you to follow your own path and goals, rather than those of others

It’s natural to avoid pain, whether mental or physical. It evolved for just that reason. However, we’re no longer condemned to fight or flight as our only responses (though if you are facing predation they remain great choices). We can choose to act rationally on the message of painful emotions. Choose to embrace them, listen, and act. You’ll thank you later.

An Ode to Personal Responsibility

Attitudes are a major determinant in achieving success or failure in any endeavor, and attitudes about responsibility for what happens to you are among the most important. Take this short quiz to assess yours.

Whose fault is it if:

1. Your commingling broker loses your money?
2. Your spouse takes all of your money and runs?
3. You do a good job but get fired anyway?
4. Your family irritates the hell out of you?
5. You are hiking in the wilds of Alaska and a refrigerator falls from the sky and hits you?

I have no idea what the epistemological answer is to those questions, but the best answer is that it’s in some way your fault in every case. Not because it’s 100% true, or 100% your fault, or even something over which you could ever hope to have control; but because acting as though it could have been your fault will more often lead to success than assuming it couldn’t have been.

If you assume nothing is your fault, you forego any chance of improvement. Things you can control will be overlooked and your life will be a rudderless ship. On the other hand, if you assume you are responsible for everything that happens to you, no opportunities to improve your lot in life will be missed. It doesn’t mean you’ll be able to take advantage of them all, but you’ll always have the chance to try.

All discovery is made by trying to answer something that can’t currently be answered, so in analyzing what is in reality uncontrollable, there is always the possibility of discovering something new. Something which could have been controlled, or that may apply in another situation. Acting as though you have control will also make you feel better, since even the illusion of control has been shown to lower stress levels. [1]

It’s all about considering the possibilities. Is having a heart attack your fault? It might be entirely in your genes, but it’s a question worth considering as you polish off that double bacon cheeseburger before having sex with your mistress. [2]

__________________________________________

[1] Control Your Life, Help Your Heart

Rats Develop ‘Illusion Of Control’: Experience Sculpts Brain Circuitry To Build Resiliency To Stress

[2]  Men who cheat on their wives more likely to die of a heart attack

Speculating in Life and Markets

Trading and life are both unavoidably speculative ventures. The future is always unknown and every choice is made in uncertainty. It stands to reason that dealing with life and with trading and investing should be very similar. Yet it often doesn’t work out that way. As Josh Brown wrote in Nine Financiers, “…The life of a professional speculator is an unpleasant one, filled with highs and lows but ultimately unsatisfying and, in all probability, mentally ruinous…” It’s not a very alluring sales pitch. But even though life beyond the market can be quite brutal as well, relatively few people view it in similarly stark terms. Are people overlooking the difficulty in life, or focusing on the wrong things in trading?

The most likely answer is both. Perceptions, and the resulting emotions, make all the difference in the quality of experience. Humans have an inherent optimistic bias in life. Evolution favors those that keep trying despite the facts in order that a few may get lucky. That bias can get derailed in trading and investing because the market is in some sense designed to prey upon our inherited decision-making heuristics. But that doesn’t mean it should be an inherently intolerable place. Life can be made as hectic as any trading day, or trades can come as rarely as you wish. Responsibility can mean burden and blame, or the freedom of controlling your own destiny. A loss can be a mortal wound to your inner self, or simply the act of buying an admission ticket. Money can be the focus of your life, or just the means to enhance it.

People bring the same basket of personal qualities to all of life. Troubled trading means a troubled life; a troubled life means troubled trading. They are both a reflection of you. At the most fundamental level, markets of all kinds exist to facilitate getting people what they want. If that’s not happening, the solution to your troubles is most likely to be found by looking in the mirror.

10 Answers To The Biggest Market Questions

As part of my continuing commitment to public service, here are the answers to the biggest questions about the markets. You can finally stop asking them.

1. Why did the market do X? There are so many participants in the market, someone probably bought or sold today because their favorite popsicle was out of stock at the grocery store. Whatever reason you can invent, someone somewhere probably acted on it. The result of all that foolishness is the market price. Thus, the real answer to “Why?” is always the same: All of the above. A useless answer to a pointless question.
2. Are the markets rigged/manipulated? Of course they are. Face it, if you don’t think you know something the other guy doesn’t, you shouldn’t make a trade. Don’t act surprised that everyone else tries to gain an advantage too. But until some legislator passes a bill that requires you to invest, your participation is voluntary. Figure out a way to deal with “unfair” markets, or take your ball and go home.
3. Don’t I have to be in stocks to be able to retire comfortably? No, you need to save money in order to retire comfortably. What you do with it after you save it isn’t that important. When your costs decrease, the options you have in life increase. You become more free. People die to be more free, while you fritter your freedom away buying $5 cups of coffee, a McMansion, and a mid-life-crisis-mobile. Making up for that is what requires taking bigger risks.
4. Is there a secret to success in the market? Yes, stop looking for a secret. One of the things that makes the markets so fascinating is that investing can be as hard as you want to make it. Like a Chinese finger trap, if you stop trying so hard it’s easier to succeed. Being simple doesn’t mean a strategy can’t work. Simple is often the hardest thing to do, so it will continue to work because few people will actually do it. It’s so much more fun to keep tinkering until you achieve a Rube Goldberg level of complexity and then sell it to some sucker, probably in local government.
5. How can I turn $10 into one billion dollars? There are three ways: 1) Become a central bank 2) Use a magic marker, a lot of confidence, and a winning smile 3) Become immortal and avoid currency collapses. The second method is probably the most achievable.
6. What will the market do (tomorrow, next week, next year)? Trying to predict the future is almost as foolish as thinking anyone who could would give you an honest answer to the question. Based on my proprietary indicators and years of research, I can guarantee that over any period of time the market will do one of only four things: Go up, go down, do nothing, or be closed. Be prepared for any of those events to occur at random and find a way to make money in all of them.
7. Should I become a full-time trader? If you have to ask, then the answer is no. When you’re ready to be a full-time trader, you will take a vacation from work and one year later realize you never went back. When you have tough times, getting a job again won’t be something you consider. It’s like masturbation: You know when you’re ready and don’t need to ask someone else if you should.
8. Which is better, fundamental or technical analysis? Both. All value is subjective so no truly objective measurement of it is possible. Fundamental analysis ensures you will eventually have a number of similarly deceived fools on board your ship, while technical analysis tells you what the rest of the fleet of fools is doing.
9. Why should I believe what you say? Because you are a self-selected sample. You have no idea what to do, otherwise you would never click on a headline like the one I used. More importantly, I can help rationalize your decisions, while flipping coins can’t.
10. ___________? The markets, like life, are full of disappointment. I’ve omitted the tenth question to allow you to hone your coping skills.

Auditing for Dollars and Deniability

Should you trust a public company’s audited financial statements? Of course not. Would a Big 4 firm knowingly sign off on fraud? Maybe not frequently, but almost certainly. Human behavior tends to at least drift, and often rush full speed, toward rewards. It needn’t be immediate nor conscious, but over time it’s inexorable. Auditors are paid by the firms needing audited statements, not by the investors who stand to lose from fraud, and that conflicted incentive permeates the industry.

Nobody says to an auditor, “Hey Bob, we’re committing fraud on a massive scale and draining the company cash straight into our pockets. Can you just play ball with us here?” Instead, they provide money and plausible deniability to the auditing firm in exchange for a seal of approval. Documents are dutifully provided; all showing that the books appear to be in good order. Questions of interpretation are met with defensible, if sometimes strained, justifications until the auditor eventually goes along rather than waste more billable hours on it. Naturally, if the deceit is too obvious they’re going to balk, but this is rarely a problem since the very nature of fraud is that it’s hidden.

Unless they’re complete imbeciles, auditors know which industries and clients are the most likely frauds, and can probably do a reasonably accurate ranking by dollar amount of fraud too. But whether an auditor merely suspects, or actually knows, fraud is taking place is irrelevant. What matters is whether they will be able to show they did their job, regardless of the facts, if fraud is discovered by someone else. If they can, it’s don’t ask, don’t tell, and everyone’s happy. The audited company gets their sanctified financials, the auditing firm racks up more revenue. Investors? Well, they aren’t paying the bills. Why would they matter?

If you want more trustworthy information, look for a source that’s paid for finding fraud, like short-sellers or independent research companies (even Anonymous has a stock research arm now). Financial statements are always useful, but only as a starting point for deeper analysis and investigation. There’s no harm in being a cynical pessimist while doing your due diligence. Save the optimism for when you’re ready to pull the trigger and really need it. Ronald Reagan liked to say, “Trust but verify,” but in light of the revelations out of Wall Street over the last decade, investors are probably best served by ignoring that “trust” bit.

 

****Update: I overlooked the best comparison – rating agencies. Both rating agencies and auditors share the same basic business model: Providing a service to their clients that will enhance the marketability of the company’s securities. If they fail to provide that enhanced marketability, they lose clients. The rating agencies are now widely reviled, laughing stocks, while auditors are still working on it.

Abnormal Returns: Winning Strategies From the Frontlines of the Investment Blogosphere

After reading thousands of books on investing I concluded years ago that, absent a severe toilet paper shortage, most aren’t worth the paper they’re printed on. As a result, I’ve read only a handful in the last decade, but I made a recent exception for Abnormal Returns and found it well worth my time.

I cringe every time I hear the phrase “risk-free rate of return” so any book whose first chapter is “Risk” and first section is “There Is No Such Thing as a Risk-Free Asset” is bound to quickly get in my good graces. The rest of the book succeeds in maintaining that view. A consistent theme is that given the nature or markets, and of investors themselves, simple and cheap is a far more certain path to investment success than complex or expensive. Robust mediocrity proves more valuable and survivable for the majority of investors – and the rest may simply be lucky.

Abnormal Returns covers a remarkable amount of ground in just under 200 pages, yet achieves its brevity without being overly shallow or simplistic. It’s primarily geared for newer investors, and in that regard is an excellent introduction to the basics of investing, covering all the major issues and asset classes. But for experienced investors there is also enough meat to make it a welcome reminder of the many decisions and assumptions that went into developing their current approach to the markets, and a prod to reevaluate those in light of present circumstances. In fact, after finishing the book I realized I should bump my long-ignored TAA project up to the top of my to do list since it fits better with my current desire to spend as little time as possible on trading.

It’s well-written, easy to read, and the hardcover version also smells pretty good. I will be pushing the kids to read it next, and I recommend you read it too if you know what’s good for you.

 

____________________________

By buying from Amazon through this link I get a small percentage at no cost to you. You get the book and my appreciation. Amazon gets lower margins. Two out of three ain’t bad. Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere

Your Personal Circuit Breakers

One of the most important lessons to learn as a trader is when to stay out of the market. If either you or the market strays too far from normal, it’s time to pull the plug. Exchanges have circuit breakers and so should you.[1]

Having stop-loss orders in place every time you enter a trade should go without saying, but there is more to risk management than position sizing and stop placement. Your edge exists only in conditions similar to those in which you developed it. If you can’t objectively identify what those conditions are, you will at some point be placing trades where you have no edge at all. No matter how obvious this sounds, don’t assume you’ve already sorted it out. Make a list of the conditions in which you have an edge, to prove to yourself you know them. If those conditions aren’t present, stay out. No excuses. Go to Vegas if you want to roll the dice.

In addition to keeping you out of unfavorable markets, personal circuit breakers must also address the single biggest danger to your account: You. Markets have six standard deviation moves only rarely; individuals often do. A risk management plan that doesn’t include the events in your life and your mental state is a plan to fail. Divorce, death in the family, illness, accidents, legal troubles, fatigue, disinterest, burnout, your losses and gains, extreme market volatility, and even how wobbly your chair is (see here) can alter your judgment and ability to appropriately respond to the stresses of trading. No one can handle an unlimited amount of stress. A single, small event may be all it takes to put you over your limit to the point where trading would be a mistake. Make assessing your mental state a part of your daily routine. Know and respect your limits.

If you’re often the last to know when you’re losing it, pay more attention to the reactions of those around you. Rather than arguing about whether you’re acting like a crabby two-year old, or whether you’re in a bad mood all the time, recognize those reactions as a sign that your circuit breakers have been triggered and it’s time for a break. Being taken out by your circuit breakers can be hard to stomach, but returning refreshed with a new perspective is often when performance breakthroughs are made.
________________________
[1] Except your circuit breakers should be meaningful, effective, and unbiased.

There’s No Magic Pixie Dust

One thing that seems to keep getting lost in all of the Eurozone bailout/default talk is that losses are the destruction of capital, of part of the productive capacity of society. Accounting rules can be changed, bailouts can be arranged, and free money can be dropped from the sky, but sooner or later someone somewhere is going to take that hit.

All government and central bank actions under discussion are nothing but trade-switching schemes. A coerced version of musical chairs with bureaucrats determining the losers, while the total wealth of society remains diminished. The prevailing assumption seems to be that by passing these trade-switching transactions through the halls of power, a magic pixie dust is applied which causes that problem to disappear. The negative effects aren’t immediately apparent in the statistics, speeches are given, the economy is saved. Hooray!

Unfortunately there is no magic pixie dust. Losses have an unavoidable impact. Increasing prosperity isn’t due to a historical imperative, but from the ability of human ingenuity to outpace the capital consumption of successive rounds of government waste, bubble blowing and socialized losses. Though in the very long-term human ingenuity has always prevailed, there is nothing to prevent destruction from taking the lead for centuries at a time.

This doesn’t mean markets can’t rally for long periods before succumbing to the death by a thousand cuts. The amazing resilience of human ingenuity can overcome great odds and mask the effects of incredible amounts of stupidity. Ever greater amounts of credit will be required to keep the bubbles expanding, with decreasing results each time, but since the purported resolutions of the resulting banking crises are all in some way infusions into the financial markets, they naturally tend to rally to some degree.

Is the leader board for the race between ingenuity and destruction about to change? There’s no way to be sure. However, when central banks all over the world are pushing uppers through garden hose IV tubes and the patient still can’t get out of bed, it’s likely not a good omen.

Sorry, Your Bottom’s Not My Type

There are any number of objective measures of the financial markets, the current price being an obvious one. However, the meaning of any of these objective measures is unavoidably subjective and dependent on the individual.

When a pundit says it’s a bottom [substitute top if you prefer], people tend to implicitly assume what the speaker is referring to as “a bottom” matches their own idea of “a bottom.” After all, some agreement about words and the ideas they represent is the basis of all communication. But whether something is a bottom or not depends on the time frame, view of the market, and a variety of other personal factors. Even the question of whether the market is going up or down depends on the time frame in question. A boring, nothing bar on one time scale may be a nauseating roller coaster on another.

The best answer to any market question is “It depends.” Most of all it depends on you. Your trading methodology, market outlook, account size, position size, risk tolerance, your portfolio, and even what your spouse will do to you if they find out, can all change the meaning of a chart. Further, since those factors can all change over time so can the meaning of a particular chart pattern for the same individual.

I don’t mean to piss on the social parade, it’s great to learn from other opinions and trading ideas, as well as use them as a gauge of shifting sentiment. But never forget that markets, like beauty, are in the eye of the beholder. Regardless of the pedigree of the pundit, or quality of the trade idea, that beauty may just not be your type. Having a wingman is fine, but you still need to get your own girl (or guy).

A Brief Note on Expectancy

Positive expectancy is the true holy grail of trading. Regardless of the methodology used, if the odds aren’t in your favor you’re doomed. But this focus also obscures a broader truth: Life itself has a negative expectancy. Start with life, end without. A certain loss which no strategy can circumvent. How do you salvage this trade?

To maximize returns when forced to play a negative expectancy game the best strategy is to make one bet and go all in. Nature has already put a hard limit on how many times we can play the game, so the only choice left is how many chips to put on the table. Don’t hold back.

Follow the example of casinos in keeping people coming through the door for negative expectancy. By making it entertaining and exciting, by focusing your attention on something other than just money, you may not even notice you’re being fleeced.

[I'm still looking for the free buffet.]

Another Stab At Beijing Residential Vacancies

After the previously released Beijing housing vacancy numbers caused a lot of internet chatter, The Powers That Be in Beijing apparently felt the need to use the press to do some damage control (see here 北京警方：空置房概念基于电子地图 与房地产无关 and here  中国网事）房产空置率到底有多高？——“北京空置房屋３８１．２万户”引网络热议, via Sinocism.com). Combining the data from various articles I think there is now enough information to come up with a more reliable estimate for Beijing residential vacancies.

The previously reported vacancy numbers were based on their Orwellian mapping project, which this article, The Beijing Police Have an Electronic Map That Shows Where You Live, says is 87.7% complete. To date 4.269 million housing units have been assigned to people in the mapping project. Assuming a constant assignment rate the remaining 12.3% of the survey should reduce vacancies by ~600K, and the previous 3.812 million vacancies becomes ~3.2 million.

Since it’s now said there are 13.205 million existing housing units, the vacancy rate can be calculated as 3.2/13.205 = 24.2%. Still quite high, but certainly more believable. Then there is commercial…

___________

**One of the above articles claims 28.9% vacancies but uses the earlier [unadjusted] vacancy number of 3.812 million.

Damn, It Feels Good To Be A…Loser

There is a good post on Abnormal Returns, Rapidly learning the lessons of risk and return, on bear markets as learning opportunities. The subject of learning opportunities got me thinking about all the interviews with traders I’ve read over the years. A theme with many is the often disastrous consequences of starting out early in your trading career with a string of winners. Beginning with a series of winning trades makes it all too easy to conclude you’re a born trading genius because it’s so clearly easy for you. Naturally, rationality then demands you lever up and start making trading history.

The inevitable soon happens and your account is blown up, and maybe even your house and marriage are gone. But if your initial success was long and large enough even that might not stop you. Armed with a Teflon-coated brain from your early success, new knowledge is prevented from intruding on your fantasy and in short order only a few minor tweaks are deemed sufficient to guarantee success. Then the second blow up happens.

I long ago concluded the absolute worst thing that can happen to a trader starting out is an unbroken string of success. In that regard I was very lucky. The first mutual fund I ever bought ended up a $5000 loss. The first individual stock trade I made was a loser. The second futures trade was a loser. Seven of the first eight options trades I ever made were losers. In fact as I see it now the single best trade I ever made was a loss. The largest loss I’ve ever had in fact.

It happened not long after I started trading stock index futures, in the good old days before pint-sized e-mini contracts. Though I would have been horrified to think so, I was executing my version of the forex trading ads, “When properly positioned, $1.57 can become $27,000,000,000 – in two weeks!”  For reasons which now elude me I decided to make a big increase from my usual position size, to roughly $2 million in S&P contracts – on a very modest account…on a Fed day. Of course the market immediately went against me, blew right past my mental stop, and then briefly paused at an inflection point. I felt 90% sure it would turn around and blast off, but then I thought of that 10% chance it could go the other way. The losses would be huge and very hard to come back from, both financially and mentally. After 3 seconds I got on the phone and pulled the plug – right at the low of the day. I lost 20% of my account in 10 minutes, but strangely enough I felt pretty good about it. Despite being blinded by greed and my near certainty it would end up a winning trade, I had done the most important thing: I prevented disaster.

Many are probably thinking how horrible it was that I missed out on such a great trade. If only I had stuck with it! But if I had stayed in that trade I shudder to think how things would have turned out later. That one trade would have been monstrously profitable on my small account, but I also would have been richly rewarded for doing nearly everything wrong [1]. Being over-leveraged, having a hazy trading business plan, not having stop orders in place, ignoring a high risk situation, and best of all really having no f-ing clue what I was doing. At some not too distant point in the future there would have been a blow-up for the ages patiently waiting for me to stumble through the door. Because of that painful loss I was spared that fate, so to me it remains my best trade ever.

The next time you take a loss thank your lucky stars it happened. Celebrate it. You did what you needed to do. Smile, secure in the knowledge that you have been spared the curse of the Teflon brain and been given the chance to learn something very valuable before it’s too late. Over time the returns could well be enormous.

_____________

[1] Insert unflattering comparison to Wall St here.

Inside Information

If you’re one of the tormented souls upset that you didn’t get any information from a Facebook insider, consider yourself lucky. As any short seller can tell you, corporate insiders are the last place you should be getting your information. They are often either lying or have downed so much Kool-Aid they wouldn’t know the company is in trouble until bankruptcy attorneys are fighting in the lobby to get a meeting. Even if the information provided is correct there is still no certainty about the extent to which it’s already reflected in the stock price, and it only takes a rumor or big player’s hunch to move prices enough to dash your dreams of underhanded fortune.

But whatever the advantages of inside information, focusing on the unfairness of access to inside information ignores the obvious. Every trade has a buyer and a seller, each thinking they’re going to come out ahead. If you want to make a trade and you don’t think you know something the person on the other side of the trade doesn’t, you shouldn’t be making the trade. The essence of having an edge is possessing some information, insight, experience, or methodological superiority that allows you to know when buying what the other guy is selling is a good idea, despite him being equally convinced of the opposite.

Information is inherently asymmetric in every transaction and we all try damned hard to keep it that way. When you buy a house do you really think the disclosure statement is telling you every problem the seller knows about the property? Do you tell the seller area rents show he could make 8% a year after tax by renting the place out? Hell no, because it’s your inside information. We all use what we have, and all want to get whatever edge we can while still being able to sleep at night.

We can all hope Josh Brown’s war on the Wall St status quo succeeds, but fair or unfair, right or wrong, love it or hate it, you have to deal with the market as it is right now. Blaming others for your losses leaves no solution other than avoiding the markets entirely. The brutal truth is if you lose money it’s your fault. Period. But this is also the best possible news because your choices are one thing you can change today, all by yourself. So stop worrying about how Wall St is screwing you and work on creating an edge of your own. Just don’t forget to keep it to yourself.

Is This Time Different?

Going over the post-game wrap ups this chart from a TBP post, Graphic: Comparing FB with other Tech IPOS  got my attention. Check out the timing of the most recent IPO spikes. Especially if you hedge the way JPM does, it may be time to think about something other than just Facebook.

Is this time different?

A Daily Chart Review

I’m breaking down and doing a stereotypical trading post today. Since I brought up the necessity of keeping market information simple and consistent in the intuitive trading series I thought I’d give an example, and yesterday’s chart is more interesting than most. This is what I look at each day (along with an equivalent chart for the NYSE):

Top to bottom the indicators are: volume, a breadth oscillator, cumulative breadth – based on the same formula, AD indecision (similar to the Fosback Absolute Breadth Index), and breadth efficiency (similar to McGinley’s AD Power). There are also a handful of the hundreds of systems I mentioned in the intuitive trading series shown, though I truly have no idea what they are on this chart.

What’s notable about the chart at the moment is the bottom two indicators. Indecision is typically very low at a bottom as breadth becomes more lopsided, and breadth efficiency is typically very high as buyers retreat and cause large percentage moves. Neither is the case here, which could mean the fat lady will only stick her head out to clear her throat before turning around and heading backstage for a drink.

__________________

For a very comprehensive guide to breadth indicators, see The Complete Guide to Market Breadth Indicators: How to Analyze and Evaluate market Direction and Strength

___________________

Disclaimer: Nothing in this post or blog is intended as specific investment advice, recommendation, or inducement to buy or sell anything. It is my opinion only, and as such is something not intended for any particular individual and something even I rarely give any credence. If, despite this, you or your attorney believe this constitutes investment advice or any other actionable category, immediately stop reading this blog, read my About page, review the idea of a reasonable man standard, and reconsider. If the notion persists reduce your intake of recreational drugs until it passes and you can resume acting like a responsible adult.

The Importance of Mindset

Brian Lund has a good post up, 5 Mistakes I Made In Trading Yesterday.  I want to expand on something he said: “…go back through your trades with the mindset you had contemporaneously to try and figure out what you did wrong.”

In my opinion the mindset, more than the specifics of a mistake, is most often the real problem when mistakes are made. Correcting the mechanics of an error is important in minimizing losses but unless the mindset that led to the error is addressed, the next time around you’ll simply find ways to make new mistakes. The number of potential errors you can make is practically infinite so a rule based response to prior mistakes quickly becomes unworkable (and insulting to your creativity). Finding out the why of your mistakes is more important than the what. For example, is poor stop placement more an issue of number crunching or a fear of losses that leads to avoiding the subject?. Failing to find the answer will come back to haunt you.

The motivations, beliefs and attitudes that lead to mistakes are where lasting changes in the process are made. Think of it this way: If you aren’t hungry, taking a big bite of delicious, mistake-filled apple pie is easier to avoid.

A Quantitative Approach To Intuitive Trading – Part 5/5

Intuition in real life

When applying intuition to daily life three problems are readily apparent:

1. A very limited and distorted set of data to use for training
2. Figuring out what subset of that data is relevant to future decisions
3. A profound difficulty in back-testing any “system.”

With those seemingly insurmountable problems in mind it’s tempting to throw in the towel. However, evolution has already wired a number of time-tested unconscious decision-making heuristics into our brains. They get a bad rap in behavioral finance (even though how problems are presented can dramatically alter the results), but after a million years in beta testing they can work quite well in day-to-day life. Looking at a single photograph of someone allows better than chance guesses about intelligence, honesty, and other traits, so there’s no need for you to go through 10,000 intimate relationships in 5 years, or 10,000 jobs (though some might hope for the former), in order to develop decent intuitions about many decisions in everyday life.

Practice by following some of the everyday intuitions and feelings you get. If someone coming toward you on the street gives you a weird vibe do something to avoid their trajectory. If someone on the job rubs you the wrong way make up some excuse to avoid them, and if someone strikes you as worth more of your time arrange things to facilitate it. For whatever reason, acting as though intuitions mean something to you brings them more clearly to the fore in your mind.

With evolution providing much of the training off the shelf, the biggest impediment to implementing an intuitive approach to life is the mass of culturally transmitted assumptions acquired while growing up. Jobs should be evaluated on pay, career progression, and industry vitality. You aren’t a success unless you have an expensive car and at least an n+1 car garage (where n = number of household members). Everyone has hundreds of unstated assumptions about the world. They may have begun as good rules of thumb for another person, another era, or simply as part of our evolutionary heritage, but shouldn’t automatically be limiting principles in your own life. Learning to see your life as an outsider would, preferably one from another planet, is a valuable skill for taking control of your life.

What isn’t so apparent with the intuitive approach is that the mental housekeeping required, along with learning to listen to your intuitions, may not lead you where you intended. I started down the path to intuitive trading with the sole intention of improving my trading results and twice the process of resolving internal conflicts ended with me quitting trading for a significant period. In both cases my life was significantly improved as a result, but not by the means I had imagined. Life often seems to involve its own uncertainty principle: You can get what you want or choose the means used to pursue it, but never both.

I think most dissatisfaction in life comes from the confusion of means with ends. The things most often dreamed about or striven for are in fact only the means to some unrecognized end (and often the wrong means). In early human conditions of extreme scarcity a mass of stuff was a means of survival, today it’s more a measure of how well you’re maintaining your pace on the treadmill. Become a two-year old again and keep asking why. Why do you want this or that? If you keep pressing the issue long enough, the answer is often something you could already have.

For a modern brain burdened with multiple layers of conscious rigmarole, learning to listen to intuitions, evaluate them without prejudice, and trust them enough to act upon them is a big hurdle. But in my experience it’s inevitable that successfully using those skills in the market will percolate through the rest of your life, and the mental housekeeping needed to go with the flow in the markets will make life flow more smoothly as well. For me that’s been a far greater benefit than the contents of my trading account.

Wrap up

The best one line summary of my approach is that I analyze everything to death before going entirely by feel. I’ve tried to eliminate myself from the process and spent a number of years trying to automate my intuition but I’ve never succeeded. As far as I can tell my unconscious is using a weighted consensus system where both the weights and which elements are polled is constantly changing based on news, market action, a variety of technical indicators, and the passage of time, which are themselves fluidly weighted. More or less. Probably.

I certainly don’t recommend intuitive trading for everyone. If what you are doing works for you, keep doing it. If you can’t seem to follow any other method because you keep sabotaging yourself in some way and intuitions are often to blame, work on the training and other steps I’ve outlined. It could be just what you’ve been looking for. I can’t emphasize enough how important resolving internal conflicts is for intuitive trading, and it’s equally important in getting what you want from life in general, so there is really no excuse for not addressing them.

Finally, I want to apologize for the inconsistent terminology I’ve used in this series and for leaving so many things inadequately explained. This is the first time I’ve tried to present it for public consumption and it probably shows. I almost never feel something deserves a book-length treatment but this topic probably does – just don’t hold your breath waiting for me to do it. If you have any questions leave a comment or feedback and I’ll do my best to answer coherently.

I’m glad this series is finally done. As my father told me when I headed off to school, “Good luck and good riddance.”

—————————————-

The complete series: Part 1, 2, 3, 4, 5

A Quantitative Approach To Intuitive Trading – Part 4/5

Maintaining intuitive calibration and controlling execution

Check yourself before you wreck yourself. Like any trading method it’s important to start each trading day with a self-assessment. This is even more important when using intuition since your state of mind can directly alter the results. From the journal or spreadsheet used to identify your intuitive trade signals in Part 3 you also should have discovered some factors that lead to poor trading. What is your mood? Energy level? Stress level? Would you rather be doing something else? Can you visualize making a great trade? What are you expecting to happen in the market? What are the other possibilities? How will you respond? What is your maximum position size? Where are your stops? Assess your preparedness and have a plan before you start. Even if circumstances prevent you from fully implementing your plan, coming up with one forces you to walk through the possibilities.

Controlling execution. The human mind is capable of coming up with amazingly complex, compelling and horribly erroneous rationalizations for virtually any action. This is true regardless of trading methodology. When at the point of making a trade the best way I’ve found to avoid self-delusion and assure consistency is to use a checklist. Make a list of what conditions you expect to accompany a good trade, whether it’s related to price, volume, breadth, time of day, options activity, or other factors. After you have a list of criteria, establish a cutoff, like 4 out of 6, to confirm the right conditions are present. Flexibility in changing conditions is the biggest advantage of intuitive trading so don’t eliminate that advantage by using an overly long checklist or restrictive cutoff. The purpose is to confirm your intuition is plausible in the current situation, not to serve as a substitute for it.

The checklist can also increase confidence and keep the naysayers in your mind in check by highlighting that there is in fact a rational basis for the intuition. Have the checklist with you at all times when a trade is possible. In evaluating the conditions versus your checklist consider whether you would tell someone you care about that the criteria are met and they should take the trade. For whatever reason fooling yourself is often far easier than it should be so invoking the consequences to someone else can help maintain objectivity.

Maintaining calibration. When you get the feeling of your trade signal, how do you know whether your intuition is still in line with the market? As mentioned in Part 1, one way to keep things on track is to keep your data inputs consistent. News feeds in particular can change with site or editorial changes so even if you are consistent on your end, your inputs may still change over time. But even assuming your preparation and current state of mind are perfect it’s still possible that a subtle drift in your intuition has occurred. Generally this happens in line with your natural market bias, whether bullish or bearish.

To keep these, and other, biases under control as an intuitive sense develops a good method is to use a variety of mechanical systems to give an objective interpretation of the market. Your intuition will likely show a preference for trades in certain types of situations and having mechanical systems for those setups provides confirmation you’re on track, or a warning that you may be going astray. In my case, this has ballooned to several hundred systems based on a variety of indicators, with multiple systems for each specific setup. The signals from these systems have become my primary way of checking my intuitive calibration. If there are a number of bottom picking systems going off and I have no feel for a trade I go back and run through all the factors I know feed into my intuitive process to make sure I haven’t ignored something, as well as check for biases that may be hampering my intuition. For example, if I’ve been reading a lot of negative news I make a point of reviewing the positive side of the situation. Similarly if I get an intuitive signal and there haven’t been any mechanical systems signaling recently it’s a warning for me to review my internal state and be extremely honest in evaluating my checklist before pulling the trigger.

If you’re inherently bearish and always find it easier to go short than long, try to develop more long-only systems to offset that bias. Naturally if you’re inherently bullish try to develop more short-only systems. One of the biggest benefits of keeping a journal of your trading is to be able to step back and see your flaws objectively so you can take steps to address them.

Maintaining objectivity. It’s very common for so many things to be going on in your head that you lose perspective and have difficulty regaining the proper frame of mind. In that case try taking a third-party perspective. It’s always easier to be objective about someone else so take a deep breath to relax, then ask yourself if a great trader would make the trade. The intensity of your answer is a good guide to the quality of the trade. Asking yourself how you will feel next year about taking this trade, or how you will feel about not taking it can also help clarify your intuition by moving the question away from the stress of making a trade in the present.

If your intuition becomes hazy when you feel it shouldn’t be, one of the best ways to stimulate a stronger response is to make yourself consider doing the opposite of what you think the situation indicates. Often that prospect will trigger a more dramatic negative response. If this happens it confirms your intuition is working properly but suggests there is some problem with the trade you are considering, whether internal or external. In my experience it almost always means the timing simply isn’t quite right and I should watch the market and wait for the signal to come. Intuition often detects flaws in a setup that the conscious mind doesn’t.

The technique of considering the opposite trade is also a very good indicator of the quality of an intuition. Good intuitions are logically consistent; poor ones generally aren’t. If you have an intense feeling you should go long but don’t have an equally intense revulsion about going short, something is wrong. This is often due to forcing a feeling that isn’t ready or isn’t valid, generally because some part of you is pursuing another agenda. Wanting to win back a loss or some other irrelevant desire can be frequent saboteurs of good trading

Though I’ve written this from the point of view of a swing trader the process is the same regardless of time frame. The steps are just condensed or diffused depending on the type of trading. Even very long-term trading, where the intuitive signal can build over a period of years, at some point results in a decision being made to make a trade and at that point the checklists and other double checks come into play the same as they would in day trading.

At this point the process may seem overly complex, with too many pieces for it ever to work. In reality most of the time it’s quite simple. A large percentage of the time you feel nothing simply because there are no good trades to be made; a small fraction of the time the intuition comes with such force and urgency it leaves no doubt whatsoever about not just doing the trade but going all in. The middle area is where all the steps outlined in this post come into play. Reducing bet size in the muddy middle is an obvious step to take, but never forget doing nothing is always an option. Under-trading may leave you disappointed, but over-trading can leave you broke.

In the last part of this series I’ll try to tie up some loose ends and cover a little about using intuition where it’s really important – life outside of trading.

————————————-

The complete series: Part 1, 2, 3, 4, 5