• Focus on the What and not on the Why

Over the past 10 or 12 years since the 2008 financial crisis when we had so many people who were talking about markets being artificially inflated by central banks, and how nothing makes sense anymore. Everything is distorted, but in the end, it might not actually matter. 

Like, the thing that matters is what people believe in, the actual flows and the story that's behind those flows. And so had you bet on, you know, stocks in 2008 or 2009, you'd be doing phenomenally well.

From a purely trading mindset, we shouldn't be too bothered about WHY the market is behaving the way it is, and instead, focus on WHAT is actually happening in the market. As a trader one is inevitably affected by the news flow, even though we all know that apart from 'surprises', the news is a lagging indicator. What we read is 'already priced' before we have read it. Newspapers try and explain price action after it has occurred, and from a trading perspective that is of little use to us. 

The news that we read is written by a person whose job is to show his journalistic skills - they tend to explain the 'why'. Journalists are more interested in being right, and they aren't interested in making money by trading markets. Hence, what our opinion or that of the journalist doesn't matter, what the market thinks of the news is the only thing that matters. In other words, we have to decide between interpreting the news flow in the correct manner or making money. As always it is better to lose our opinion than our money. 

• LUCK

Luck is an extremely important contributor to success in any specific activity and in life overall.  What we perceive as luck is often just a combination of good observation skills and the ability to seize unexpected opportunities.

• Rationality, Independent Thinking & Intelligence

Stanovich and others have conducted a great deal of research on how rationality and intelligence relate and while the two are correlated, there are areas where particular types of rationality are totally uncorrelated to intelligence. For example, highly intelligent people suffer more from confirmation bias than less intelligent people. This is why experts often underperform laymen in tasks where one would expect the expert to outperform. Confident experts have trouble taking in new information if it contradicts their existing view of the world.

My conclusion is that it is absolutely clear from the research that rational thinking is the number one trait of a successful trader. High intelligence, numeracy and financial literacy are also important. Trading with gut feel, intuition and similar soft skills is less important, and sometimes counterproductive.

An independent thinker is not someone who is contrarian all the time, disagrees with everyone, or loves playing devil’s advocate. That is not independent thinking; that is reflexive opposition. That is not good! Independent thinking means that you analyse information using your own framework and come to logical conclusions. You develop your own beliefs, incorporating as much information as possible. “Information” can include the curated beliefs of others. 

In markets, where incomplete information and group behaviour are an intrinsic part of the game, you need to make sure you are always thinking for yourself. Sometimes your conclusions agree with the crowd and you hop on the trend. Sometimes you are on the other side of consensus, so you take a contrarian view.

The cure for many forms of bias in trading (and in life) is to be flexible and open-minded. This is captured by the concept of “strong opinions, weakly held”, a framework for thinking developed by technology forecaster and Stanford Scholar Paul Saffo. Here is his description of how to think40: 

Allow your intuition to guide you to a conclusion, no matter how imperfect — this is the “strong opinion” part. Then – and this is the “weakly held” part – prove yourself wrong. Engage in creative doubt. 

Look for information that doesn’t fit or indicators that point in an entirely different direction. Eventually, your intuition will kick in and a new hypothesis will emerge out of the rubble, ready to be ruthlessly torn apart once again. You will be surprised by how quickly the sequence of faulty forecasts will deliver you to a useful result. 

Have a plan each day. Writing a quick plan in the morning anchors you and forces you to stop and think before you start trading. I should be making trading decisions based on market factors, not based on how I feel about my P&L or random, meaningless chart points.

• Overtrading

The main driver of the underperformance from trading too much is transaction costs, but even in experiments where there are no transaction costs, the subjects that trade most perform worst. Good traders wait for outsized opportunities, they don’t trade frenetically, reacting to every bit of flickering price action.

• The only God of Trading is Probability

The tricky thing with market probabilities is that unlike probabilities in gambling, they are not known or measurable. You have to estimate them. Accurately estimating probabilities is a skill that gives you an edge in trading. Incomplete information is one of the challenging hallmarks of markets as an exercise in probability.

The number one input into almost every forecast is the current level and trend of the asset. There are notable exceptions, such as the fact that everyone has been (mostly) calling for higher US yields despite a 40-year trend lower, but generally, you will see that when something is going up, it is forecast to go up more and when something is going down, forecasters expect it to keep going down. 

Extrapolation bias is a form of recency bias. Humans tend to overweight more recent information in most analyses simply because that information is more available (i.e., top of mind). Events from years ago are harder to remember and incorporate. This is why you see analysts put out bullish predictions for oil when it is trading at $100 and bearish predictions for oil when it is trading at $25.

Since estimating probability is a critical skill in trading, you must understand: It is more difficult to estimate high and low probabilities than those near the middle.

• Round Numbers

When you fill your car with gas, do you sometimes have the urge to round it off to the nearest dollar, even though you are paying with a credit card? Do you get a tiny thrill watching a car’s odometer roll over from 99,999 to 100,000? For many amateur marathon runners, a finishing time of 3:59:58 is a great success while 4:00:02 is a disappointment. These are examples of round-number bias. Human beings tend to pay attention to round numbers and treat them as special or more important than other numbers. OK, sure Brett… Who cares? You should.

• Turnaround Tuesday 

Turnaround Tuesday is well known and has existed for many years. It is founded on a reliable and repeatable pattern of human behaviour and a persistent fear and greed cycle that repeats around weekends, even if statistically savvy investors know about it. Also, as a short-term strategy, it is fairly expensive to execute (in terms of transaction costs) so large institutions are unlikely to quickly arbitrage it away. During periods of market fear, there is a common intra-week pattern that stock markets often follow. Markets don’t always follow this pattern but they do follow it a surprising proportion of the time.

The most reliable part of this pattern is “Turnaround Tuesday”. This is the tendency for stocks to rip higher on Tuesday if they sold off the Friday and Monday before. It is a simple human pattern that occurs because when the news appears bad, traders get nervous into the weekend and sell some of their holdings on Friday. Then, they read all kinds of negative media reports about the big scary thing and that scares them into selling more on Monday. 

Investor selling pulls in momentum traders who go short on Monday. This adds to the selling pressure. Then, Tuesday comes and there is nobody left to sell. Then the shorts get squeezed and that triggers Turnaround Tuesday. 

In case you think this sounds silly, have a look at this evidence. First, here is how the S&P performs in the most extreme Turnaround Tuesday setup which is when it falls Thursday and Friday and then is down more than 5% on Monday. This is rare but check out the returns in Figure 7.13.

In contrast, if you study all days after a 5% one-day drop, the average return the next day is just +0.9%. Not terrible, but nothing amazing. 

Second, to give you more evidence supporting Turnaround Tuesday, Figure 7.14 shows SPX performance for Tuesday vs. all other days in 2008. Note that 2008 was one of the worst bear markets in history so Turnaround Tuesday was a thing almost all year. If you traded in 2008, you probably find this chart pretty mind-blowing.

• Sentiment

Always be on high alert for turns in sentiment. If you ever notice bullish sentiment at the low or bearish sentiment at the high: pay attention. Generally, sentiment almost always follows price. If something is going up, people will be bullish. If the price is falling, most people will be bearish. There are exceptions (many are always bearish in the stock market, even when it’s at the highs) but in general, that’s how sentiment works. Very rarely, though, you will see the opposite and those moments are meaningful.

A prime example is the US dollar in March 2020. The COVID-19 pandemic triggered a liquidity crisis and there was a mad scramble for dollars. The Great Dollar Shortage drove EURUSD from 1.1300 to 1.0800 in very short order (stronger dollar, weaker euro). Then, the Fed went all-in, announcing a massive QE and dollar liquidity program. Due to ongoing pressures in emerging markets and equities, though, the USD remained in demand. At that time, you could see a subtle but important change in sentiment happening. The market, which had been raging bullish USD, started to think about the future impact of all this new USD liquidity and sentiment slowly turned from bullish USD to modestly bearish USD. But the USD was still at the ding dong highs! This is a rare but extremely high EV setup. If you notice a subtle shift away from a popular narrative, but the price hasn’t moved yet, get ready to go the other way. Often price will lag sentiment. A market that is bullish on the lows or bearish on the highs is getting ready to turn.

• Counterintuitive Math Facts & Position Sizing

Education has made all the difference for me. It builds software for your brain. Mathematics taught me to reason logically and understand numbers, tables, charts, and calculations. Even more valuable, I learned at an early age to teach myself. EDWARD O. THORP, A Man for All Markets

When it comes to trading, the more obvious the conclusion, the more likely it is already priced into the market and thus the more likely the trade you enter based on the conclusion will lose money.

A simple check you should always employ when analysing data is to compare the average to the median. If they are similar, you are probably good but if there is a big difference, then something is up and you need to dig deeper.

The 1956 classic “How to Lie with Statistics” by Darrell Huff does a super job of explaining the basics of how to handle statistics like this. I think every human being should read that book, even if they don’t care about statistics or finance.

In a random walk process, there is not a uniform distribution of highs and lows throughout the day, week, month or year. Instead, we see a U-shaped pattern with more highs and lows near the start and the end of the series. This fundamental property of random walks is described by a counterintuitive branch of probability known as Arcsine law.

1. Even Simple Problems can be counter-intuitive.
2. People don't always understand log returns.
3. People don't always understand averages.
4. People don't always understand random walks.
5. People don't always understand probability.
6. People don't always understand non-linear relationships
7. People don't always think about whether their sample is complete or biased.
8. Position Sizing: In trading your bet-sizing should: (a) Eliminate risk of ruin, (b) Be proportionate to conviction level and (c) Be large enough (even if it’s a low conviction trade) to move the needle toward your goal.

Bad traders always put on the same position size. 

Many traders are not very good at adjusting their position size and risk management strategies in response to volatility. If S&P futures are moving 1% per day, should you have the same position size or stop loss parameters as if they are moving 3% per day? Clearly the answer is no. Actively adjust your trading as volatility changes. 

The easiest way to volatility-adjust (or vol-adjust, as most professionals say) is to use a spreadsheet that determines position size and stop loss parameters based on a volatility input. This does not have to be complicated.

I cannot emphasise this enough. Your position size should change as volatility changes. This is the easiest and most automatic adaptation you can make as markets change.

• Understanding Narrative - Reflexivity

The narrative is the internal story of your market.

The what and the why of market movements are never simple and as you gain experience, you will realise more and more that many explanations in the financial press are way off base.

Surprisingly, the narrative often turns before the price, because the price has momentum of its own and a propensity to overshoot.

Speculators invested in a trend have confirmation bias and will ignore the changing narrative until the turn in price forces them to pay attention. Those turning points when the narrative has changed but price remains in the old trend can be some of the most exciting and profitable moments in trading.

Quite often, the price rise itself will also change the supply and demand dynamic at this stage. There is a saying that “the best cure for high prices is high prices”, which means that higher prices ultimately reduce demand and increase supply and that eventually leads to lower prices. Be sure to understand what price levels in your market might lead to major or non-linear changes in supply or demand. If you are expert in your market and keenly attuned to its driving narrative, you will recognize moments when the story has changed but price is not yet paying attention. Those can be some of the juiciest setups in finance.

Understand the stories the market is telling itself and learn to identify when the market is falling in or out of love with a narrative.

• NewsPivots - Keynes Beauty Contest

The first price a security trades after news comes out is called the NewsPivot. These are critical price points going forward. NewsPivots become significant reference points in the mind of the market and if price subsequently recaptures the NewsPivot, it often means that either a) the news wasn’t all that important or b) larger medium and long-term players are using the news as a liquidity event to go the other way. If bad news comes out and your stock goes back above the NewsPivot: watch out!

A big level isn’t a level that is important to you, it is a level that is important to the market. This is a big distinction. You need to have your own views and thoughts but Alpha traders are also inside the mind of the market and know what matters most to the market as a whole. 

This concept is best captured by Keynes’ beauty contest analogy from The General Theory of Employment, Interest and Money (1936). Keynes asks us to imagine a newspaper which holds a contest where readers are rewarded for choosing which contestant will be chosen by the most other readers. The task is not to choose the most beautiful woman, but instead to choose the woman others will think is most beautiful. Sometimes that’s the same woman, but not always!

A NewsPivot is the last trade in a market before important, market moving news comes out. I find that NewsPivots are the most powerful reference points in trading. You should be aware of all NewsPivots in your markets.

• Trends & Catalysts

Strong up trends hold above major support, and they break through major resistance. 

There does not have to be an obvious exogenous catalyst for every market move, reversal, peak, or bottom.

• Volatility

Generally, when stocks rise, volatility falls and when stocks fall, volatility rises. This is true almost all the time because investors buy puts to protect themselves as markets fall. In a normal rising market, investors sell calls to take profit, earn income and monetise gains. When vol rises as stocks rise, it can be a warning sign… Something weird is going on. 

Fast markets are temporary, but changes in volatility can be more permanent. Do you know how to size your risk correctly to reflect current levels of volatility? Does your methodology respond systematically to changes in volatility? It should. For example, higher volatility means you should be trading smaller positions. Lower volatility means larger positions.

• Correlation - Causation & Technical Analysis & Strategy-Execution

Correlated variables give you a hint as to where your product is going, but not the answer. 

Technical Analysis gives you an important set of tactical execution and Risk Management tools. It does not help you forecast market direction. 

Your intention while reading about technical analysis is to find 2 to 5 simple indicators or patterns that you like. Use these as your primary risk management and market screening tools. Then, you can add a few more over time.

Make sure you allocate enough time to strategy (coming up with trade ideas) and tactics (entry point, stop loss, etc.) Many traders find it is more fun to come up with trade ideas and do not allocate enough resources to the tactics of extracting as much money as possible from the ideas.

Be thoughtful about the product you choose to express your view. It matters. Tactics are just as important as strategy. You need both to succeed in trading.

• Trading Events

Sticking with the topic of events, there is a subtler way that upcoming events can influence markets. Often, when a major risk event is coming up, risk managers and traders lean on the conservative side until it is out of the way (due to gap risk and concerns about extreme volatility). They reduce their risk as the event nears, regardless of their view. 

Speculators put on the trade they wanted to have before, because now that the event (and associated gap risk) is out of the way, it’s safe to do so. This is one of my favourite setups. When there is a strong consensus view but no positioning to match the view, you often see highly impulsive moves. Once the event passes, the consensus move is free to unfold at high speed. Often the event itself contains no new information, it is simply the passing of the event (and thus the elimination of gap risk) that allows the move that should have happened earlier to happen now. This setup is powerful and has a high expected value, so watch for it.Once the event passes (regardless of the result), risk appetite returns to normal and a move that probably should have happened before the event happens afterwards.

• Month End Dollar Effect

On the morning of the last trading day of the month, European pension funds execute massive rebalancing trades. Any month that saw significant moves higher in US equities will see large USD selling by pension funds as 4 p.m. Approaches while any month where US equities tumbled will see large USD buying. This pattern has existed since at least 2005. It does not work every time (nothing works every time) but it is about as reliable as patterns get. 

This hedging goes the opposite direction of stocks and only matters when US equities have moved meaningfully during the month. Here is why it happens: imagine a foreign holder of US stocks who owns a billion USD of S&Ps and is short one billion USD to hedge the position. If stocks rally 10%, he now has 1.1 billion of stocks and 1.0 billion of USD hedges. So he needs to sell 0.1 billion ($100 million) USD to rebalance his hedges. 

These asset managers are benchmarked to 4 p.m. London on the last day of the month so activity peaks at that time as managers attempt to match the benchmark rate. The huge volumes going through on the last day of the month create some large and often illogical moves and these dislocations can create significant patterns and opportunities for astute traders.

• Bankrupt Stocks Usually Rally on the Open

When stocks re-open after being halted for a bankruptcy announcement, that is often the ideal time for shorts to take profit. This is because once a stock trades sub-$1.00 after beginning bankruptcy proceedings, it can take months or even years before the stock is zeroed out. It is not worth it for speculators to stay short all that time where the is so little juice left in the trade. 

This is kind of a ridiculous trade given you are buying the shares of a bankrupt company but it doesn’t always have to make sense. Often, buying the shares of a bankrupt company when the stock reopens after the halt for the bankruptcy announcement can be highly profitable as a short-term (1 day to 1 week) trade.

• Miscellaneous

1. Realise no trading method works always and forever.
2. If everybody is doing the same thing, the odds are low that it will make money.
3. Efficient Markets usually prevail. Always.
4. When there Is a major change to the structure of markets, STOP AND THINK.
5. Since the market is a huge, adaptive system, you need to constantly adapt to it. As the Red Queen in Through the Looking-Glass (Lewis Carroll) says: 
Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!
6. You need to work twice as hard as everyone else if you want to get ahead. Understand the market regime and fit your trading strategy to that regime. Don’t embrace a trading style and hope the market complies with it. “Trading style” should describe your time-horizon, risk management approach and preferred analysis methodology, it should not describe the specific strategies you prefer. Specific strategies work in specific market regimes and you need to adapt your overall style to the regime. 
7. Everybody's Bearish and nobody's short or vice-versa means that there is an  opportunity. For example watch from a change in sentiment to buying the dip as against selling the rise. In other words, participation matters.