Things took a quick turn

directions

So a funny thing happened on the way to making my next major life transition in May. I had to start making it at the beginning of February! That’s why things went a bit quiet on the blog.

I was supposed to be in Sweden at least through April per the coaching contract I talked about in my New Year’s post. Rather abruptly, though, the club told me at the start of this month that they were terminating my contract. My coaching friends were stunned – even the ones in Sweden (maybe especially them). I was told “differences in coaching philosophy”. Some suggested the real reason was probably money, but in the end it doesn’t really matter. I was getting ready for a transition at season’s end. It just came a bit sooner than expected.

Unfortunately, because things happened this way I hadn’t really begun a proper job search. I was thinking I’d probably need to wait until at least the end of February to do that given likely time lines and expectations for when I’d start a new job.

So now I’m back in the States. I did have one poker in the fire before all this happened, so it might not be long before I have a new job. Or not. We’ll have to see.

The one thing that doesn’t change, though, is my intention to produce a revised version of The Essentials of Trading and to share with people my observations about the reality of trader performance based on my PhD research.

Oh, by the way. I’m now officially Dr. Forman. I found that out about two weeks ago. Everything has been approved and ratified and I’m now a full-fledged PhD. If you haven’t already had a look, here’s some details about my dissertation and how you can check it out.

Feel like reading a PhD thesis?

PhDAt last!

On Wednesday my internal examiner approved the edits I did to my PhD thesis and I submitted it to the school’s online repository. That’s the last of the requirements on my end. All that’s left is for formal approval to be given by the Vice Chancellor’s Executive Group, which should happen this week (if it hasn’t already by the time you’re reading this). Then the long PhD process will truly be complete!

The title of my thesis is Trader Leverage Use and Social Interaction: The Performance Implications of Overconfidence and Social Network Participation on Retail Traders.

Here’s the abstract:

Overconfidence and its relationship to investor market participation is well established in the finance literature. The research into investors and social networks is only in its infancy, however. This thesis extends the literature by expanding on both subjects individually, then bringing them together.

Empirical work on individual investors in the existing literature links overconfidence and excess trading, resulting in impaired returns. The preferred activity metric, monthly account turnover, encapsulates two separate elements, though. One is trade frequency. The other is leverage use. Chapter 4 of this thesis theorizes based on the existing literature that in fact trade frequency is not a good measure of overconfidence. It then demonstrates through empirical analysis of a group of individual non-professional foreign exchange traders that leverage is much more suitable to that role.

Chapter 5 turns the focus to social networks, particularly with respect to information transfer. The literature in finance anticipates that network members benefit from their membership. Further, network position (social capital) enhances that benefit. This thesis challenges that expectation with respect to non-professional investors. Findings based on analysis of members of an online retail foreign exchange trader social network indicate that while there may be an educational benefit accruing to unsophisticated members, for more sophisticated ones membership appears to have a negative effect on returns.

One potential explanation for the negative impact of network membership is explored in Chapter 6 in the form of impression management. It is hypothesized that sophisticated investors are influenced in their behaviour by the realization they are being observed, and also the size of their audience. Analysis of foreign exchange traders indicates an increase in leverage use among sophisticated investors as their audience size increases, coinciding with a decline in trade excess returns, making the case for an observation-based rise in overconfidence.

Naturally, the thesis is heavily academic. I tried to make it as readable as possible, but you can only take things so far given expectations for language and style. If you want to have a look, you can get a PDF copy here.

The page count is 240, though there are a lot of tables. If you do actually read it, I’d be happy to hear what you think.

Are you really cut out for trading?

confused

I don’t know if this is really a recent post or not as every post on her sight seems to have the same date on them at the moment, but at some point Jessica at Rouge Traderette shared some thoughts on how to figure out if trading maybe isn’t for you. She presents a trio of signals that maybe it isn’t. I’ll address each in turn.

1) You can’t sleep
I actually think this might have more to do with either excitement or excessive risk taking. We’ve all been in situations where we’re just too excited to sleep at night. I know in my own trading there have been times I’ve awaken in the middle of the night and checked my positions to see how they were doing from a positive perspective. Do you maybe want to reign that in a bit? Probably.

From a negative perspective, if you can’t sleep because you’re worried about the market going against you then you’re probably trading too big. You’ll sometimes hear the advice that you should set your position size to the point where you can sleep at night. If insomnia has you up can checking your positions in fear of taking a loss, then it’s probably time to cut your size.

That said, if you are really hesitant to even pull the trigger on a trade regardless of size for fear of losing money or simply being wrong then maybe trading isn’t for you. I once had a student in a class who wouldn’t even do a trade in a demo account out of fear. Not a good sign for a would-be trader.

2) You are overly concerned with your losses
Jessica actually presented this in terms of denial, which is definitely something to be worried about. If you can’t face up to your losing positions, that’s not a good thing! You’re going to have a lot of losers over a trading career. You need to learn to be able to handle them. Going down the denial route will almost invariably lead to disaster.

Think of it in these terms. Traders who don’t abide by their stops are the ones who tend to take the biggest trade losses because their positions just keep running against them. What do you think is going to happen if you are in so much denial about a losing position that you won’t even look at it?

3) You can’t separate trading from real life
As with anything else, you don’t want trading to become your whole life. That’s not a healthy situation. On the relatively mild side of things it can lead to early burnout. At the more extreme end of the spectrum is things like lost relationships and disastrous trading because you’re taking things personally.

I admit, trading can be very stimulating for any number of reasons. For that reason, though, caution is required. There’s nothing wrong with trading as a form of entertainment, so long as you understand that’s what it is and set your financial expectations and commitments according.

I would add one BIG thing to this list:

You think that you will change your life overnight.

Trading is work and like anything takes time. If you’re looking for a quick fix, walk away.

Is technical analysis useful in the stock market?

statistics

A while back zigfred at The Polymath Investors wrote a 2-part piece (Part 1, Part 2) sharing his views on why technical analysis is of no use in stock market trading – at least by itself. His reasons are three:

  1. Its nature
  2. Its tools are flawed
  3. A lot of credible long term studies reveal that it does not work

OK, I have to address the last one first as being a non-argument.

Basically, he’s saying that technical analysis doesn’t work because studies have shown it doesn’t work. That’s not a causal statement at all. It’s like saying, “I can’t run a 100m dash in under 10 seconds because I’ve never been able to run it in under 10 seconds.” It’s providing evidence of the fact, not a reason why it’s true. As such, you can basically toss that out, but I won’t quite do that because the evidence needs to be addressed, which I do later.

Tackling things in their proper order, though, let’s start with #1.

The flawed nature of technical analysis
As zigfred rightly points out, the basis of technical analysis is market psychology. Taking that as given, he then presents the argument that on this basis, using technical analysis to trade the markets is a kind of recursive effort in that it turns back on itself because the act of using market psychology to trade influences that market psychology.

While it is certainly true that a definite issue with technical analysis is that it can create a kind of self-fulfilling market dynamic, zigfred presents things as if everyone is trading on technical analysis. Obviously, that’s not the case.

He also seems to be implying that trading on technical analysis is the cause for markets being more volatile than fundamental valuations would seem to suggest. In a truly efficient market – which zigfred seems to think one driven only on fundamentals would be – price would change relatively infrequently, only when new information arrives. Reality is far, far different. Even in the absence of technical analysis there are market mispricings. It’s the under/over-reactive nature of markets driven by individuals who are not perfect in their analysis of information and forecasting of future events. This isn’t even mentioning well-known psychological biases and other factors.

One need only look as far as the housing bubble for a major example. You can’t tell me that technical analysis was the main driver of that!

From a more market-specific perspective, what about the way prices react to data and news with sometimes extreme volatility? You cannot attribute that to technical analysis.

So while I agree that a market overly populated by technical analysis will tend to see TA losing its effectiveness, where fundamentals are still a major factor it remains a useful way to view prices.

Flawed technical analysis tools
The second argument against technicals zigfred makes is that the methods of analysis are basically no better than throwing a dart at a board. His major point is that even technicians don’t agree on which techniques are best or how to interpret charts and indicators.

Hard to disagree. There are a great many indicators out there that are derived from the fields of math and statistics and such which are either poorly understood or incorrectly interpreted. The same can be said of chart patterns and what the underlying causality of their development means. To my mind, this is largely a function of people failing to do the work and the study to really know what it is they are using to analyze the markets.

As flawed as the technical tools may be, let’s not suggest there aren’t major issues with the way fundamental analysis is applied.

Studies show that it doesn’t work
In zigfred’s post he specifically mentions a couple of studies which suggest that technical analysis methods don’t work. I’m not really surprised because I personally believe that rote application of the techniques aren’t really effective in the long run. The markets are too dynamic and changing for things to hold their usefulness consistently.

That said, however, academic research has consistently pointed out a momentum effect in the markets. I don’t have a reference at hand, but it came up a lot in the readings I did while developing my PhD thesis. Momentum in the academic usage of the term is basically trending. If there are trends that can be measured and anticipated, then at least one element of technical analysis has firm grounding in the research.

Now, this post is not me saying that technical analysis is the best thing. As you’ve seen, I’m quite willing to admit it’s problems. I just want to make sure the discussion is done on balanced terms. In my own stock trading I combine it with fundamental analysis. In other markets, and especially in shorter time frames, though, I rely on technicals more heavily.

Picking the best forex pair(s) to trade

currencies

Chris as Winner’s Edge Trading did a post a couple months back with suggestions for how to go about picking the best pair or pairs for your forex trading. Essentially, his list came down to a handful of key considerations:

1) Your strategy or analytic methodology

2) Currency correlations and diversification

3) Liquidity

The list actually has eight factors in it, but I consider several of them to be essentially the same type of consideration. Thus my list of just three.

Let me expand on them.

Strategy considerations
In terms of #1, you are best off looking at currency pairs which are well suited to the approach you’ll be taking in your trading. Generally speaking, that will either be trend oriented or range-trading oriented. Thus, if you are a trend following trader you are going to be best off working in pairs which have strong trending characteristics in your chosen time frame. Likewise, if you favor a more mean reversion oriented approach, you’ll want pairs that tend toward ranging and/or sharp counter-trend moves.

Note that one currency pair can fall into both categories depending on time frame and market phase. If there are strong underlying factors at work, then in the higher time frames the pair will tend to trend, but maybe in the shorter time frames it may go through ranging periods. These things can and will change over time. As such, it makes sense for you to have a way to identify current market conditions.

Correlation/Diversification
If you’re trading primarily the major currency pairs it is very hard to truly have an uncorrelated portfolio of positions. You can only go 3-4 deep with majors and major crosses before you have one currency in multiple pairs, which automatically introduces correlation. And even then, certain currencies will tend to naturally be correlated based on the current economic environment. For example, the CHF and EUR will often be positively correlated because both are impacted by the fundamentals of the European economy.

You can certainly trade multiple pairs which share the same currency (e.g. USD/JPY, GBP/USD, AUD/USD). If so, however, you need to account for that in your risk management strategy. It is highly likely that all the pairs you trade sharing that common currency will move together based on the same factors. That’s great when the market goes in your direction as it will multiply your gains, but the same thing happens with your losses when the market goes the other way.

Liquidity
For the most part, liquidity isn’t a major concern for retail forex traders as your orders will usually get filled at or very close to your order price. Yes, during major news events there can be slippage when trading outside the major pairs and crosses – and even in the majors on occasion. If you’re operating in a higher time frame, though, that’s likely not a major concern.

The bigger consideration here is the cost of trading. The more liquid pairs have narrower bid/ask spreads. That can significantly impact your returns if you’re an active short-term trader, but maybe not so much if you playing the longer-term market moves.

How many?
One additional consideration I would add into the mix is how many pairs you should trade. This is a question which comes up a lot in trading forum discussions. To my mind, this all depends on your time frame. If you’re a day trader you’re likely going to want to keep your focus fairly narrow – especially if you’re in and out frequently (e.g. scalping). As you go out the time frames, though, you probably need to be tracking more pairs. It’s simply a function of providing yourself with enough trading opportunities.

In Chris’s post he also mentions personal preference, which I suppose can be an additional factor. If you want to truly be a good trader, though, you should be able to trade whatever market makes the most sense at the time.