Acceptance of Decisions’ Consequences

If you are wondering about Ana’s comment…. I shall have a hip replacement on June 11 and in all likelihood, shall be bed ridden until June 26. In that time, some of my students and friends will make contributions to keep the blog going while I am away. Trust readers will be generous and accept their offerings until I return.

Now to today’s thoughts.

I am sometimes asked: ‘If you could only nomimate one factor, what is the single most important factor for your success?”

That’s a tough question because there are so many elements that led to it and continue to sustain it. But if I were forced to give an answer, I say ‘trust’ that I will make the best decision possible in the circumstances. Mark Douglas (The Disciplined Trader) identified 4 fears that are barriers to our trading success:

  • The Fear of Losing Money
  • The Fear of Being Wrong
  • The Fear of Missing Out
  • The Fear of Leaving Money on the Table.

I’d add a fifth: The Fear of Succeeding.

Mark’s four fears often block us from accepting the results of our decisions. For example: I had decided to begin taking profits at the $128 level basis the nearest futures month in Crude Oil. This was due to:

  1. Ratio Targets at $130 to $131
  2. Statistically the 13-period impulse swing on a weekly chart (13-w) was way over-extended
  3. The media hype was for crude to go much higher; the figures, $150 and $200, have been bandied around

By the time Crude hit $134, I was out of 90% of the Open Positions I had so painstakngly built up these past months. I shall not re-enter until the market has at least a 13-w correction. It may be that Crude will hit more than $200.00 before correcting; but irrespective of what Crude does, I’ll stay on the sidelines until the 13-w correction occurs.

I accepted that I could experience all four fears BEFORE I planned and executed the plan to exit my mega Crude positions; and, I accepted that the market could run on without me. On the other hand, I also saw that that it could also come off quite strongly from the 130-odd level.

The same could be said for the ES positions I had taken on May 16. Over the weekend, I decided to exit the longs mainly because the rally since May 9 had been on declining average volume. So Central Time’s Sunday night session, I exited at 1425 to 1427. When the market rallied intra-day on May 19, I stayed out.

How do I feel about leaving so much money on the table?

I’d be lying if I said I did not experience some twinges of flashing regret. But I accept the results as part of the cost of doing business. I also know that the strategies have, so far at least, brought some fabulous returns. And, I accept that given my current market knowledge, there is no way I would have anticipated the ES morning rally on May 19, So, the early exit of longs was the best decision I could have made in the circumstances.

Humans are afflicted with Hindsight Bias. Once an event has occurred, we find reasons why we ought to have known what the future was to bring. This bias stops us from learning. There are some things we cannot anticipate no matter how extensive our market knowledge; there are some events that can be anticipated. To contine learning we need to distiguish between the two types of events.

The lack of volume as the ES rose was a warning signal of a possible top and, for me, the small range day on Friday May 16 was the ‘execution signal’. Nowhere in my body of experience would warn me that Monday would be a ‘V Top’.

So, by distinguishing between the two events. I can focus on the ones that may bring new understanding and insights about market behaviour.

Figure 1 shows May 19 intra-day price action.

05-21-2008-30-min-es.jpg

FIGURE 1 May 19

A Lament

In my travels as an educator, it saddens me to see so many fail despite working hard. But trading requires that we work SMART and HARD not just that we put in some sort of effort.

There are many, of course, who are looking for the ‘way to make a million that requires no effort, no capital and involves little loss’. This is a word-for-word question I was once asked. I told him: “Hmm if you know of such a method, I’ll be your student”. Some just don’t deserve to succeed.

But others put in effort, time and money; yet they experience the same lack of success. From my experience, the lack of success comes because they refuse to acknowledge that their actions are leading to failure. Instead they engage in bouts of rationalizations that would be funny if it were not so tragic.

Let me paint you a couple of pictures:

A close relative, Adam, has been trading as long as I have. Until recently he firmly held the view that he was a successful trader. Well, it is true he made profitable trades 90% of the time; but unfortunately, he never made money in any year! If you remember the Expectancy Formula, you’ll know why:

(Average $Win x Win Rate) – (Average $Loss x Loss Rate) MUST be greater than 1. If the result is a minus, then you must lose over a large sample size. (For a fuller description see The Nature of Returns) .

Adam never kept an equity journal, let alone a psychological journal. His way of dealing with losses was not to open the statements. Whenever I visited him, I could tell at a glance how he was doing by noticing the pile of unopened trading statements. If it was a large pile, he was losing; a small one meant he was winning. His refusal to face the ‘true’ results kept him from remedying the problem.

Let me now turn to Bob. Bob had almost completed the STC mentor course. He knew his stuff, but the knowledge was not being translated into profits. The problem was, once in a trade, Bob became myopic. Any information that did not support his mindset would be filtered out. Bob’s saving grace was he had learnt to faithfully place stops.

I saw in Bob a great potential to succeed. If I could find a way through the myopia, I knew his results would improve tenfold. The good news is we did find a way and when Bob completed STC, he had an approach he had learnt to execute consistently.

So, what about you? In which camp do you fit? Will you change to succeed? Or will you dig your heels in and stay within your comfort zone? Ultimately success or failure falls on your shoulders alone. That’s the beauty of trading.

The Psychology of Mastery and Decison-Making II

In my last blog, I considered the process of becoming an expert. In this one, I want to consider the process of excellent decision-making. I am indebted to Ms Ana Wang (www.awanginvest.com) for the free e-book: Psychology of Intelligence Analysis by Richards J Heuer. (https://www.cia.gov/library/center-for-the-study-of-intelligence/csi-publications/books-and-monographs/psychology-of-intelligence-analysis/index.html)

It is also available from Amazon (http://www.amazon.com/Psychology-Intelligence-Analysis-Richards-Heuer/dp/0160590353)

It is by far the best book I have read on the subject. It was commissioned by the CIA and recently declassified. It’s not my intent to review the book here. What I want to do is to examine its application to trading.

Behavioural Finance has revealed the barriers we face to clear thinking. What it has not done is told us how to overcome the problem. Indeed, some of the advocates have made the point that mere awareness of the problem does not of itself prevent the errors.

I agree. But certainly awareness will at least reduce the incidence of the errors – if we adopt a decision-making process in tune with how our minds work. Heuer provides the best process I have seen to date. To understand the process, we need to understand how our mind works.

The theory I think is correct is how our minds work ‘Bounded Rationality’ first suggested by Herbert Simon (http://en.wikipedia.org/wiki/Bounded_rationality): our minds cannot cope with the sensory input from a complex world. To prevent being overwhelmed, our mind construct relatively simple mental models to make our decisions. The models determine what we take in as important, how we organise the material and how we process it. In turn the model depends on our belief system, values, experiences, education, etc.

Models are useful because they help us make sense of the world. But they have one major drawback: they can lead to myopia if we fail to update the model. As new and conflicting information comes in, we can either update the model or force the information into our current model. If we adopt the latter course, our model diverges too far from reality and ultimately fails to provide the outcomes we seek.

The question then becomes, how do we prevent a locked mental mindset i.e. how do we create an environment that allows us update the model despite the discomfort we may feel?

The first step is to accept the discomfort. When reality hits us we have only three options: we can accept it, change it or walk away from it. In the case of the model, we accept the model, review the information and change the model – not the information.

Let me give you an example of what I mean.

Let’s say your outcome is to become a successful trader, and so far the year-end results show that you still have to make a profit. You have a couple of obvious choices. You can deny the results, rationalize them or accept that something you are doing is causing the results. To succeed you need to identify the causal action and change it.

This brings me to the strength of Heuer’s book. He suggests an interesting approach and unique tools using both the left and right brain.

For the left brain, one tool he suggests is a decision matrix. This call for identifying the essential aspects of the question seeking the answer e.g. what is the one to three-day direction of the ES and then to identify the information relevant to the question. In a trading context, Heuer would argue that only two types of information are necessary:

  1. Information concerning the probability attributed to the aspects included in the analysis and
  2. Information concerning which aspects are most important and how they relate to one another.

What traders don’t need is:

  • More information about the aspects included in the analysis. For example if you are using the RSI as an overbought and oversold indicator, you don’t need the stochastic and rate of change to tell you the same thing.
  • Additional variables without taking into consideration the importance of the variables – more information does not lead to more accurate results.

If you think through these ideas, you may find a wealth of information.

Another tool he suggested was to use the concepts of ‘proven’, ‘unproven’, and ‘disproved’.

First we need to define for ourselves what we mean by the terms. For example rather than say/think that an Upthrust Pattern often leads to a change in trend (See Nature of Trends http://www.amazon.com/Nature-Trends-Strategies-Successful-Investing/dp/047082235X/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1210593601&sr=8-1),

we can use the words “ES showed an Upthrust Change in Trend Pattern. (Unproven). You then need to define what you need to see to make the pattern ‘Proven’ or ‘Disproved’.

Why should we do this? Because once we have labeled a piece of information, we will find it difficult to change its meaning within our mental model. By leaving the meaning open, we’ll find it easier to accept new information that conflicts with the initial assessment.

I recommend you study the book and apply its lessons. It has certainly led to new insights for me. Chief among them: I changed my analytical approach and I changed my matrix. I use the matrix to ensure that I trade what I see – rather than what I expect to see or want to see.

Changing the approach and thinking through how and what to change in the matrix took effort. But it was worth it. Today, I spotted an error in my thinking for my long gold and short AUDUSD positions; I covered both first thing this morning. It also led me to anticipate the correction to the Crude Oil and allowed me to plan my response in a way better than I previousy would have done.

It will do the same for you.

The Psychology of Mastery and Decison-Making

One of the areas I seek to improve is my decision-making ability. I assume that the better I make trading decisions, the better will be my bottom line. And, I believe this to be true for both the mechanical and the discretionary trader. For the mechanical trader the decision-making process lies at the heart of the system design; for the discretionary, it lies over the spectrum of the trade.

Recently, I read two pieces that are worth reading. The first is an article by Philip E. Ross called “The Expert Mind”. The question raised by Ross is important to traders: how do experts acquire their extraordinary skills? His conclusion is that experts are made not born; so, what path do we have to take to become an expert trader?

Before I develop the piece, I want to draw a distinction between an expert and a ‘genius’. While I agree that experts are made, I believe geniuses are born e.g. with enough of the right training even I can become a maths expert (this is from someone who failed all his maths exams in secondary school in Hong Kong!); on the other hand, no amount of training will raise my ability to the level of an Einstein.

The keys to acquiring expertise are now well established. We acquire it through a commitment of deliberative practice and time spent i.e. time that is spent not only at real-time trading but also at deliberative practice.

What is deliberative practice? It has a number of elements:

  1. we break down the desired goal/goals into the component parts.
  2. each goal is just outside our comfort zone.
  3. we set and take the action that will achieve the goal.
  4. we review the results of the action with the view of taking another step towards acquisition of the skill. This may mean abandoning or altering our past actions.
  5. we drill the actions so that skills become habits.

Item (5) is particularly important. As we’ll see Monday, long-term learning requires we integrate the new knowledge into an already existing mental model (schema) or build an entirely new schema. In the process we need to ensure that ‘cognitive dissonance does not operate to distort the new knowledge.

That last sentence may require an explanation. The human mind is unable to deal with the complexity and uncertainty of reality. To manage we construct simple mental models whose goal is to allow us to navigate life successfully. When we received new information, information that conflicts with our mental model, we either adapt our model or deny, distort or generalize the information so that the conflict is resolved. If we adopt the latter course, the model will eventually fail.

The better course would be to adapt the model – but since this involves the pain of change, and since we are hard-wired to move away from pain and towards pleasure, we tend to stay within our comfort zone. This human tendency explains why so many want-to-be traders fail to make the grade.

Expertise comes from deliberative practice and time spent in real-time trading and deliberative practice. But since deliberative practice means ‘actions outside our comfort zones’, most traders prefer to fail than change.

In trading what does deliberative practice involve? You know the answers:

  • Plan your trades, including risk: reward assessment.
  • Execute consistently
  • Keep equity and psychological journals for the purpose of identifying empowering and disempowering patterns.
  • Experiment with remedial action including visualization and simulation (http://tradingsuccess.com/blog/the-steps-to-success-2-199.html).

Assuming we take time to engage in deliberative practice, what skills need we adopt to improve our decision making? We’ll consider this on Monday.

The Mental State for Scenario Planning

One of the critical mental states for Scenario Planning is the ability to hold competing ideas at the same time without having to resolve the discordance. Among my mentor students, this lesson is one of the hardest to learn. I believe this is because humans are wired with two traits:

  1. Hindsight bias and
  2. The need to resolve apparent conflicts – cognitive dissonance

Hindsight bias leads us to believe that ‘we ought to have seen that coming’ (but often it’s obvious only after it has occurred) and cognitive dissonance leads us to ignore information that is inconsistent with a held view. In a recent book, ‘The Opposable Mind’, Roger Martin argues that the most successful leaders are the ones who practice integrative thinking. He defines this as ‘the ability to hold two opposing ideas at once and then reach a synthesis that contains elements of both but improves on each’.

While the synthesis aspect may not be available to a trader – if we are trading directionally, we’ll be either long or short – by holding opposing ideas and by constantly looking for clues that confirm or deny a scenario, we become better traders and risk managers.

The ability to do this allows me to deal with the issues raised in Derrick’s question: How would I deal with a close above 1416 and a fall to 1253?

If this question were posed by one of my students, I’d say there were certain assumptions she’d have to challenge:

  1. The first is the need for certainty. A trade we take is based on our belief that the probabilities favour a successful result. But any trade we take can move against us. Most times a student needs to deal with the unconscious belief that his model of reality is reality i.e. whatever he believes will happen must happen. The result of this belief is a block against thinking in probabilities.
  2. The second I raised above – the blocking of information (rather than acceptance) that is contrary to the original assessment.

Scenario Planning trading requires just the opposite. We accept the discomfort of holding two opposing ideas; we accept the probability of loss; we accept that we’ll sometimes act in a less disciplined manner (while constantly seeking to improve discipline). Doing this allows us to form a high probability view and then constantly review market information to confirm or deny the views: our original view and an opposing one.

This means that the probability of success is constantly undergoing reassessment. If at any point during a trade, we assess the probability no longer favours, we need to exit the trade or at least tighten our trailing stops. Then, we need to accept the consequences of our actions. Sometimes, we’d have been better off not exiting or tightening our trailing stops. But if we do it right, most times, we’ll be better off taking the action.

So, Derrick, a short answer to your question: I would handle that situation in the same way I handle all trades. Before entering, and during a trade, I ask:

  • What do I have to see to remain in the trade?
  • What do I have to see to exit the trade?

The answers to these questions would involve price points as well as structural benchmarks.

The Power of Questions

Something different today. One principle I live by is CANI: constant and never ending improvement. In this blog, I want to tell you about a process I have found invaluable.

I think it may have been Anthony Robbins who said that the quality of our lives depends on the quality of the questions we ask ourselves. This is certainly true in trading.

Below are questions I ask myself when I do my monthly review:

  1. What worked for my trading this past month? What did not work?
  2. What do the metrics tell me – in what instruments did I make money? In which did I lose? Is there a pattern?
  3. Did I keep to my exercise and meditation schedules?
  4. Was there a correlation between my trading and how I felt for that day?
  5. Did I monitor the Ebb & Flow position sizing or did I persist with too large or too small a size even after market conditions changed?
  6. What were my greatest challenges/lessons?
  7. Of what am I most proud? What do I most regret?
  8. What attitudes and actions will I take with me into the new month? What lessons have I learned this month?
  9. What limiting beliefs did I shift? What negative emotions did I shift?
  10. How did I grow, improve, and expand myself?

I started using this process on the recommendation of Dr. George Lianos. At the time, our aim was to identify self-destructive behaviour that came from limiting beliefs. It worked so well that I adapted it to trading. Behavioural patterns are easy to identify; they are what my wife, Chris, calls ‘the tail of the rat’. From there I can trace the emotions and the circumstances that gave rise to the behaviour. Once I have done that, it’s only a short hop to identifying the limiting beliefs or what Denise Shull calls ‘the echoes of perception’ (www.traderpsyches.com).

The one resource you need to keep for this exercise is, of course, a journal. Here are some ideas for newbies who are asking: ‘What I do write in my journal’?

(For Dr. Steenbarger’s article go to “Articles on Trading Techniques'”(4th Heading down from the top of the page, following “Psychology Articles”. The article is about the 17th article from the bottom in the section “Articles on Trading Techniques”).

Intergrity, Honesty, Responsibility

The successful traders/investors I have met in my travels all share these three qualities: Integrity, honesty, responsibility. In this blog, I’ll first explain what I mean by the terms and then proceed to give examples on how their lack stops us from achieving our dreams.

  • Integrity: I see three levels of integrity. The first is keeping promises to others; the second is living our lives in alignment with our professed values and beliefs (we ‘walk our talk’); and the third is keeping promises to ourselves. (Landmark Forum)
  • Honesty: The refusal to pretend that facts are other than as they are (Ayn Rand: the refusal to fake reality)
  • Responsibility: The ability to personally respond (Fritz Perls). We are accountable for the responses we have to life’s situations. For example: we are not responsible for an accident caused by the negligence of another party but we are responsible for the way we respond to the consequences of the accident.

In my role as mentor, I see a wide diversity of personalities. Yet despite variances in human nature, those who succeeded all evidenced the three traits. Those who ultimately fail – those that surrender without completing the course – are the ones who never acquire one or all of them.

For example: I have one student who has the ability to be making money now. Yet, he is merely breaking even. Given the time and effort put in, the breakeven result would be, for another, an excellent result. But in his case, given his talent and feel for the market, the results could be much better.

When we examine the metrics, the reason for the mediocre results is clear: he takes profits much smaller than his losses. The cause for this is not hard to find: he trades two timeframes – FX for swing trades, ES for day trades. Whenever the market moves rapidly in his favour in the swing trade, he grabs the money rationalizing that he may as well put some money in his pocket. He figures that should the market correct, he can reinstate the position.

You can imagine the result. The very best trades do not retrace and as a result the profits he took and what he ought to have taken are wide apart.

To deny the facts, he focuses on the occasions that the early grab gave a better result. What he ought to be doing is focusing on the whole spectrum of trades. He chooses not to on the basis that ‘things are different now’.

Because, because ……we can rationalize away just about anything.

Actually in his case, I am optimistic that he’ll see the light. He is bright, intelligent and has a great feel for the market. I think it is only a question of time before the penny drops. The fact that he is breaking even rather than losing is testimony to his ability.

Another student may not share the same result. In this case, the program has always been a struggle. The student has been seeking success for over 5 years after leaving his job as a bank dealer. Having him change his ways has been a hard- fought victory, won inch by inch. We are now at the stage where he has to write out his trading plan.

Normally writing out the trading rules, takes no more than a month; some do it in a week. In his case, we have been at it for 3 months and there is still no plan in sight. I understand the source of the barrier. As long as the plan is not written down, failure to achieve his goals can be laid at the feet of ‘something out there’: it’s the market’s fault, I am having girl-friend problems, it’s Ray’s fault, he ……

Once the plan is down in black and white, then he perceives that long-term success rests squarely on his shoulders. And right now, he is playing the avoidance game.

How do we tell if we lack integrity, honesty and responsibility? It’s a question of self-awareness of the consequences of our actions. Dr. George Lianos once said to me: “If you repeat a behaviour, then no matter how valid the reasons for each individual occurrence, focus on the fact that you are repeating the behaviour – that is the reality”. Once we identify the behaviour, then we act to change it.

Trauma of Loss/Roadmap S&P

I hope you all have kept safe. Tonight I write on two topics. I touch on the trauma of wipeout and I look at the S&P’s roadmap for the coming week.

TRAUMA OF LOSS:

Many sent me this link: http://www.youtube.com/watch?v=2qlPW4wSzM8 (you may need to copy and paste)

It also appeared in a number of blogs: e.g. Dr. Brett Steenbarger’s “Traderfeed”: http://traderfeed.blogspot.com/

Watching it re-ignited some deep-set memories, memories of the many failures and of repeated lessons unlearned. I am full of admiration for the traders who learned from one dramatic failure; my journey took 7 years of losses and rehashing the same mistakes before I turned things around. Watching the video brought up the thought that ‘but for the grace of God and the patience and support of Chrisy (my wife) go I today’.

The video is a stark reminder that success in this game rests on the trinity: ‘Plan x Risk Management x Psychology’. Note that multiplication signs: a zero in any factor results in failure.

S&P ROADMAP

Speaking of plan let’s have a look at a roadmap for the S&P for the week and possibly next week:

Figure 1 shows the S&P basis cash with an 18-day Swing (the monthly trend), a completed Ray Wave Count and a Market Profile Structure. The first question is: what is the trend of the 18-day?

figure-01-18d-swing-mktp-rwc.jpg

FIGURE 1 S&P 18-day

To answer that, let’s turn to the 12-M (the yearly trend). The 12-Month has triggered a possible Upthrust change in trend from up to down (See Figure 2). To complete the signal I need a monthly bearish bar close below 1455. Right now that looks the case but only an end of month bearish close will confirm. In the meantime, if we assume the start of a bear market, how should the 18-d unfold?

figure-02-uothrust-cit.jpg

FIGURE 2 12-M S&P

Normal technical analysis theory suggests that breakouts are retested. I have found that the retest zone is generally (in a downtrend) between the upper boundary of the Primary Buy Zone (1406 basis cash) to the Maximum Extension (1360) (see Nature of Trends for definitions). There is also 13-w resistance (13-w breakdown point at 1370/1371). This is a pretty wide zone but does serve as a starting point (See Figure 3).

figure-01-18d-swing-mktp-rwc.jpg

FIGURE 3 18d Breakdown Points

Figure 4 shows a projection of a likely termination zone for the first wave down assuming a 3-wave structure. I consider the old wave-5 as the new wave-(2). A 69% retracement is equivocal on whether we see a 5-wave or 3-wave 1st move. We do know that a 3-wave move will not exceed 1.618 wave-(1). This provides a target to 1238 basis cash. I’ll assume the more conservative 3-wave target until the market says different.

figure-4-wave-3.jpg

FIGURE 4 Wave-(3) Target

Figure 5 shows the 80-min Ray Wave Count. For this count to be correct, the market needs to hold below 1334.20. Wave-2 was simple; Wave-4 will be complex and the structure as at the close on Tuesday 01-22-2008 has qualified as a complex wave-4. If so, wave-5 ought to begin tonight.

figure-5-wave-5.jpg

FIGURE 5 80-Min S&P

Wave-5 will be either the longest or the shortest wave. If the shortest wave, we’ll probably see it end at 1276 to 1248 with the most likely level to be 1258 to 1276. 1258 is the maximum extension of wave-4; 1276 is the minimum projection for wave-5.

This is the preferred scenario. If correct, I expect to see a rally of 1.97% to 2.22% (with a lesser probability of 2.66% to 2.83%) off yesterday’s close. This figure ties in with a wave-(4) around 1324 to 1350. I’ll consider the alternate count (wave 5 is the longest if the need arises).

To summarise: if we do get a wave-5 terminating around 1258 to 1276, we can expect a rally to 1324 to 1350 with the preferred target being 1335 to 1345. This is an area where I’d look to go short IF VOLATILITY has returned to normal. For the moment, I’ll abstain from trading the US stock indices.

[The 1.97% to 2.83% was taken off a study done by the Quantifiable Edges site:

http://quantifiableedges.blogspot.com/2008/01/time-cbi-indicate-bounce-could-be-near.html

(Thanks Brett Steenbarger [http://traderfeed.blogspot.com/)] for the heads up to the excellent Quantifiable Edges site)]

That’s the roadmap for the coming week in the S&P. It’s only a roadmap and I am sure that there will be detours as reality pans out. But by having a roadmap, each detour will provide information to make a more accurate picture against which to take a low risk trade when the current rally ends.

Volatility and the Trader

I was told when I first began trading that ‘volatility is the life blood of a speculator’. Like all trading truisms, this has an element of truth. Imagine trying to eek out a living when ranges are tiny and market direction flat.

But there are times when markets become ‘too volatile’: the meaning of ‘too volatile’ is personal and varies from individual to individual. The important thing is to have some measure of ‘too volatile’. My definition is two consecutive days of ranges greater than an ATR of mean + 3 standard deviations. The definition is instrument specific so that I can have, say the ES being too volatile while BPJY may not be.

Once I see a ‘too volatile’ reading in an instrument, I cut all positions (usually profitable ones; losing trades have probably been stopped out). The reason I do this is twofold:

  1. Quantitatively, my setups are validated by price action that is ‘normal’. When markets get too volatile, the population has been too small to date to draw meaningful conclusions. So in accordance with my first philosophical rule for trading (preservation of capital), I take myself out of the market.
  2. Qualitatively, my psyche is comfortable with only so much volatility. Beyond a certain point, I know I am likely to think the dollar value of the tic fluctuation rather than dwell on the info the market is providing. I can become accustomed to increasing volatility if the increase is gradual. But too rapid an increase places my in a zone of discomfort.

The message I am pushing here is take care if you are feeling uncomfortable with the ranges and market movement.

In line with the theme of this post, let’s turn to the ES.

To identify the boundaries for this structure (in Market Profile Terms – distribution) are off the 13-w swing low prior to the sideways price action (development). I notice that although the swing low occurred June 14 2006, the directional move did not start until July 18 2006. I prefer to anchor the July low to start my retracement levels.

The Primary Buy Zone lies within 1272 to 1229 (basis the CSI perpetual contract). The current difference between the CSI-p and ESH8 is about 5 points (ES is lower than CSI-p by 5). This makes the Primary Buy Zone 1267 to 1225.

01-22-2008-sp-18d.jpg

FIGURE 1 S&P Primary Buy Zone

Last night we edged into the Primary Buy Zone. This is an area where I usually par my position size to no more than 1/3 the initial size.

In addition, the last time the market reacted so strongly, Greenspan came in and cut rates prompting a 5% rally. Now this does not mean Bernanke will cut rates today but he might. Whether or not he does, will only provide more fuel to a market that is volatile.

All in all this is a good time to put some $ in your pocket. Oh sure, the market may head lower but then again it may not. I’ll part with this story: A student was long gold and sitting on some very nice profits. He was looking to exit at the Primary Sell Zone. The market got to within about a dollar of the minimum price.

To say he was excited …well that would be putting it mildly.¬† As he pointed out, the weekly bar looked good (opening near the lows and closing near the highs). Based on it, there was every reason to believe that the profit levels would be reached. However I did warn him that the daily’s painted a weaker picture and that he should establish some level beyond which he would cut the position.

He decided to place a breakeven stop but I could tell that he did not feel his stop would get hit. Well it did. The market opened lower on the Monday and proceeded South.

The point of the story is this. If you have profits in the ES, Gold etc, identify a level beyond which you will cut the position: Nothing feels worse than letting large profits turn into losses. When I say ‘identify’, I mean treat the loss as having occurred – feel it – rather than just give lip service to the level.

Reviewing Decisions

My assessment last night on what the FED was likely to do was off the mark. I assessed a 67% probability that it would cut the Fed Fund Rate by .25 and the Discount Rate by .50. Instead it cut both by .25.

I always do a post analysis assessment especially if it proves off the mark. I review the decision components to see what I may have done differently, being careful to avoid hindsight bias.

The Decision Tree I constructed rated the probability of rates being raised and remaining unchanged as being so low that I did not spend much time on them. I focused instead on the various scenarios (branches) for a cut in the rates. I pruned the scenarios to three:

  • a) One of the rates would remain unchanged and the other cut by .25
  • b) Both would be cut by .25
  • c) One of the rates would be cut by .25 and the other by .50

The inputs to the branches were:

  1. The state of the US economy;
  2. The need to protect the US $ and
  3. Bernanke’s view of the cause of the 1929 depression.

Reviewing my inputs, it’s clear that I placed too much weight on (3). Given what has been said today about the FED alternative tool box, I was relatively spot on (1) and (2). But where I went wrong was thinking that given Bernanke’s theory of the causes of the 1929 slow down, he would seek to solve the liquidity problem through the Discount Rate. Instead the FED will be seeking alternative means.

What I did get right was the first part of the scenario I had crafted: what would happen if (b) took place. I reasoned that the ES would tank and that this would be followed by two inside days ahead of the CPI on Friday. This is subject to the PPI and Retail Sales not being greatly outside expectations. Once Friday is over, I’ll review the Tree again and see where improvements could have been made.

I do the reviews because I feel it’s important to review one’s decision-making processes. Making decisions that accord closely with reality is as important as reviewing¬†your trading plan etc. Revision of decisions is an important rule for constant and never-ending improvement. And, I feel the review ought to be done not only when we get it wrong but also when we get it right. That way we may identify enabling patterns and limiting ones.