Geography, Focus and Strategy

Way back in 2007, in Bicoastal Trading…Or Are You Trading in the Right Time Zone? I offered some thoughts on my experience trading on the West Coast versus the East Coast. At the time, I speculated that the Mountain Time Zone might be the best place to have a trading life that was seamlessly interwoven with the rest that life has to offer.

In the intervening years, I have made a few trips to Hawaii and am now convinced that at least for those who are content being an end-of-day trader, Hawaii may indeed be the ideal trading paradise – and certainly one with the most alluring geography dividend.

Last month, when I was taking some time away (or mostly away) from the markets, it struck me how much geography has influenced what I focus on, what and how I trade, and more broadly what strategies I implement.

When I am on the East Coast, for instance, I place much more emphasis on the European markets and economic data that is released just before or after the opening bell. I am much more likely to trade futures and focus my attention on the many blue chips whose earnings are released before the market opens. I may even break with tradition and turn on CNBC. In short, I have a much greater BMO focus.

By contrast, when I am on the West Coast, I find that I focus more on the Asian markets (checking in before I go to bed), trade a preponderance of West Coast technology stocks that generally report after the markets are closed and also find myself trading in the after-hours session much more often.

In Hawaii, everything is different. The markets close at 11:00 a.m. (10:00 a.m. during daylight savings time) and my routine switches to glancing at the markets, going out for a run, checking to see if the markets are relatively quiet when I return, showering and going for breakfast, then making any position adjustments just prior to the closing bell. All strategies become end of day strategies and short-term trades are much more likely to be multi-day swing trades than day trades.

In a nutshell, my geography determines where (and when) I focus my attention, and that focus has important implications for what I trade, when I trade it and what my anticipated holding period is for each position. Strategy, therefore, becomes a byproduct of geography.

There is nothing like Hawaii-Aleutian Standard Time to put the world in a different perspective and to serve as a reminder that no matter where you are – either as a visitor or with roots firmly in the ground – it is important to match your strategies and focus to your geography and time zone.

Related posts:

• Bicoastal Trading…Or Are You Trading in the Right Time Zone?
• The Education of a Trader
• Trader Development Stage Model – Version 2.0
• Draft Trader Development Stage Model
• Comfort Zones, Focus and Thinking Like a Biotech Firm
• Can Selling Options Make You a Better Trader?
• A Dozen Things My Trading Accounts are Thankful For
• On Trading Rules and Guidelines

[Future naked options sellers line up for another grueling day of work at Shipwreck Beach, Kauai]

Disclosure(s): none

The Education of a Trader

[The following first appeared in the May 2010 edition of Expiring Monthly: The Option Traders Journal, on the back page of the magazine, where the authors are encouraged to be tangential and irreverent. I thought I would share it because of the positive feedback I received from a number of readers and because I think this piece dovetails nicely with the collection of links below.]

Do you remember from your school days those students who when confronted with a complex issue, would acquire a look on their faces somewhere between consternation and dread, immediately thrust a waving hand up into the air and blurt out in a worried voice, “Do we have to know this for the test?” I can be fairly sure that none of these people ended up as successful traders.

One only has to look at the history of hiring patterns at Wall Street firms to get a sense of the evolution of thinking about how to develop a successful trader. For many years, the model for aspiring traders was considered to be a genteel Ivy League education. Over time, Wall Street firms began to favor graduates with a more humble socioeconomic pedigree who were considered hungry, hard working and highly motivated to prove something to the world. In more recent years, we have seen Wall Street seek out physicists and those with exceptional quantitative skills. Lately, a desire for poker skills has also come into play.

As I see it, all traders are ultimately self-taught. There are no required classes, readings, homework assignments or even a syllabus with recommendations. Tests are administered on a daily basis, frequently with multiple tests on the same day. Worst of all, everyone is graded on an unfavorable curve in which there are more Fs than As.

Against this backdrop, education counts, but skill and experience count even more. An insatiable curiosity helps, as does a willingness to explore unfamiliar territory. Great trades, insights and strategies present themselves in somewhat random fashion and, as Louis Pasteur observed, “Chance favors the prepared mind.”

But what kind of preparation is ideal? Malcolm Gladwell asserts that 10,000 hours of experience is a prerequisite for greatness in almost any field. In a normal career, that level of commitment usually translates to five years, but on Wall Street, 10,000 hours of experience can be crammed into 3–4 years. Of course, all hours are not created equal. A trader’s capacity to distinguish between random events and meaningful patterns is important to establish a solid trajectory of growth and development.

For my personal education process, unlearning was more important than learning. My formal schooling consisted of an undergraduate degree in political science and a traditional MBA program. After two decades of business strategy consulting experience deeply rooted in fundamental analysis, I was ill-equipped to excel in a short-term trading time frame. In order to embrace technical analysis, I first had to jettison my fundamental perspective on investments and build a new foundation based on technical analysis and market sentiment.

In my opinion, the best way to approach trading is to consider the educational process to be a lifelong endeavor, crossing as many multi-disciplinary boundaries as can be digested. In a way, I like to think of the foundation of trading success as building a large idea stew and developing an eye for spotting high potential new ideas. The trick is to have the right breadth and depth of knowledge so that when one stumbles on the next great strategy, it can be easily identified, captured and developed. Call it opportunistic research and development, if you will.

As luck would have it, some of the most successful trading strategies I employ are based on areas in which I had limited knowledge when I first encountered them. No matter how well things are going, I take the approach that I never have the luxury of being satisfied with the status quo and need to embrace the idea of getting out of my comfort zone. In trading and in life, it pays to constantly refresh the pipeline of new ideas and continue to tinker with them, because you never know what will be on tomorrow’s test.

Related posts:

• Trader Development Stage Model – Version 2.0
• Draft Trader Development Stage Model
• Comfort Zones, Focus and Thinking Like a Biotech Firm
• Can Selling Options Make You a Better Trader?
• Chart of the Week: U.S. Open Scorecards
• A Dozen Things My Trading Accounts are Thankful For
• On Trading Rules and Guidelines

[source: Expiring Monthly, May 2010]

Disclosure(s): I am one of the founders and owners of Expiring Monthly

The Art of Being Wrong

Kathryn Schulz, a self-described ‘wrongologist,’ is the author of Being Wrong: Adventures in the Margin of Error.

I can’t say that I have read her book, but I think her interview with Victor Niederhoffer at Slate, Hoodoos, Hedge Funds, and Alibis: Victor Niederhoffer on Being Wrong should be required reading for all investors. One of the most difficult things to do in life is to learn from the mistakes of other people – and while Niederhoffer is famous mostly for his two large blowups, he is also reflective, insightful and a fun read. Perhaps more importantly, outside of those two blowups, Niederhoffer has a superb track record and is highly regarded for his trading skills. Many think that Niederhoffer’s blowups should negate the value of what Niederhoffer says. I think quite the opposite. Here is a trader we can all learn from, including both his successes and his failures.

For instance:

“Unfortunately I was so successful for so many years in that particular field that I began to believe in my own success. I thought that because my method worked in markets that I knew about and had quantified, I could apply the same methods to something I didn't know about.”

And later:

“I didn't have the capital to be strong enough to provide a backup in the case of unforeseen events. I didn't have a proper foundation. I was playing with adversaries who were stronger than me and who actually made the rules. My base of operations was not diversified enough, and I was vulnerable to forces I couldn't withstand. I was too vainglorious. In my opinion, those are recurring errors behind most disasters.”

But don’t stop at these excerpts. Click through to read the full interview at Slate.

If you are interested in Schulz thinking in a broad range of subjects outside of the investment world, Slate has captured a great deal of her content in her column The Wrong Stuff.

Many others have written about Niederhoffer. One of the better pieces I have encountered is John Cassidy’s lengthy feature in The New Yorker from October 2007 (coincidentally, right at the market top), with the title, The Blow-Up Artist: Can Victor Niederhoffer Survive Another Market Crisis? Another interesting article about Niederhoffer comes from James Altucher from February of this year and appeared in the Wall Street Journal as Ten Things I Learned While Trading for Victor Niederhoffer.

Niederhoffer has two books of his own that have quite a few valuable insights:

• The Education of a Speculator (1998)
• The Practical Speculator (with Laurel Kenner, 2005)

The prolific Niederhoffer also co-authors the Daily Speculations blog with Laurel Kenner. I am a big fan of that blog, but feel obliged to comment that the steady stream of content can be a little overwhelming at times.

For more on related subjects, readers are encouraged to check out:

• A Dozen Things My Trading Accounts Are Thankful For This Year
• On Trading Rules and Guidelines
• Chart of the Week: U.S. Open Scorecards
• Comfort Zones, Focus and Thinking Like a Biotechnology Firm

Disclosure(s): none

Chart of the Week: U.S. Open Scorecards

I was pulled in quite a few different directions when considering this week’s chart of the week. There was the rally in the euro, some positive debt offerings in Spain, new highs in gold, BP’s $20 billion escrow fund, etc. On the volatility front, the last week was the first time ever that the VIX fell more than 15% in consecutive weeks.

Of all the things that stuck in my mind this week, however, the one I found the most compelling was the course the United States Golfing Association assembled this week at Pebble Beach to test the world’s best golfers in the world for the U.S. Open championship.

While this was a relatively short course, the challenges posed by natural obstacles, difficult greens and the U.S. Open’s notoriously long and unforgiving rough were such that not one of the 156 golfers was able to break par. In keeping with tradition, the U.S. Open course was set up to extract the maximum penalty for any missed shot.

In fact, as I see it, the championship was decided not by how many birdies a golfer was able to make, but by how well he was able to avoid trouble. The scorecards of the top three finishers tell the story and together comprise this week’s chart of the week. In the end, the winner, Graeme McDowell, persevered by not allowing the course to bully him into anything worse than a bogey. Runner-up Gregory Havret had only one double bogey on his scorecard, but it was just enough to keep him one stroke back from McDowell. Third place finisher Ernie Els, who plays with the demeanor of someone who is always unflappable, ended up with two double bogeys and finished two strokes back. In the end, it was the disastrous double bogeys – and one’s ability to avoid them – that spelled the difference.

The reason the Pebble Beach odyssey stuck in my mind is that it reminded me that traders should approach trading the way they would approach a golf course like Pebble Beach. The goal should be to play for pars and look to capitalize on any birdie opportunities that arise. To the extent possible, this means keeping the ball away from hazards and obstacles, as well as avoiding low percentage plays. It also means not compounding small mistakes by pressing and trying to make up lost shots in a hurry. Impulsive play is almost always penalized; patience and discipline are the only way to survive.

In golf and in trading, it is better to be able to drive the ball into the fairway than to hit it 300 yards and not control where it is going. Consistency, precision, patience and opportunistic aggression. That is the recipe for winning golf and winning trading – at Pebble Beach or in your own back yard.

For more on related subjects, readers are encouraged to check out:

• Bernard Lagat and Trading Strategy
• Comfort Zones, Focus and Thinking Like a Biotechnology Firm
• What My Dog Can Tell Us About Volatility
• Dogs and Earthquakes: Dueling Metaphors?

[source: U.S. Open]

Disclosure(s): none

Trader Development Stage Model – Version 2.0

I was delighted to see the positive response to my draft trader development stage model, which I rolled out last Tuesday in a post with the unlikely title of Draft Trader Development Stage Model and put immediately to work in an option context in The Trader Development Stage Model and the Jump from Stocks to Options. Clearly this framework resonated with quite a few traders, from beginner to advanced.

With my penchant for not knowing when to leave something alone, I thought it might be helpful to expand upon the simplified version of the original trader stage development model and introduce a second version.

The graphic below adds only two new boxes (Technical Analysis and Strategy Management) to the original stage development model, but also adds some explanatory notes, labels for clarification (Issues, Theme and Unit of Focus) and further identifies each of the three stages with what I call Unit of Focus, but can also be interpreted as a Level of Abstraction or something similar.

As was the case the first time around, I am not going to spend too much time adding interpretive commentary other than to note that the two-way arrows represent tension between issues that are closely linked, sometimes because they compete with each other and other times because they are complementary. Also, while I never spelled it out the last time around, the background colors are meant to represent when the trader is likely losing money, breaking even and finally making a profit.

There is the potential to take this trader stage development model and get much more specific with it, use it as a diagnostic, etc. For now, the current level of detail is probably appropriate for most future applications I anticipate in this space.

As this is a mental model that is highly subjective, I would be glad to field to any feedback, criticisms, suggested enhancements, etc.

For more on the trader stage development model, readers are encouraged to check out:

• Draft Trader Development Stage Model
• The Trader Development Stage Model and the Jump from Stocks to Options

Draft Trader Development Stage Model

One of the under appreciated joys of blogging is the wide variety of people who you end up corresponding with across the globe – and whose paths would likely never have intersected my own had it not been for the blog.

Partly as a result of the blog, I have a better sense of what goes on in the heads of other traders, what issues they struggle with and how they do – or sometimes don't – overcome obstacles to success.

I have enough anecdotal evidence that suggests there is something of a typical development path that many retail traders follow as they grow and develop as traders. In an effort to start a dialogue about this and to give the blog a framework to refer back to in future posts, I thought I would post a draft of the mental model that is forming in my head.

Frankly, I am surprised I have not seen a similar graphic and if there is one out there, I would be interested to hear about it.

Keep in mind that as best I can, I have attempted to keep the model simple. Once the basics have been debated and reformed, then it is a lot easier to add in some of the complexity.

So…without further ado, I have appended below the first draft of the trader development stage model, which is hopefully relatively self-explanatory. Note that the vertical gray arrows are supposed to represent tension between related issues (leverage vs. position sizing, minimizing losers while maximizing winners, developing an edge vs. diversification.) Also, while I consider all the issues to be iterative, I suggest that the iteration process in the third stage is continuous.

As always, all feedback is appreciated.

Comfort Zones, Focus and Thinking Like a Biotech Firm

In Wednesday’s post, Kafka, Surrealism and Trading, I talked about the importance of getting out of one’s comfort zone in order to enhance trading. One reader expressed concern that that pushing the envelope too far and straying from one’s comfort zone was an excellent way to learn some expensive lessons and potentially an approach that invites disaster.

The reader makes some excellent points, so let me expand upon and clarify my thinking.

Consider a biotechnology company as a metaphor for trading and specifically for trading strategy development. A biotechnology firm manages a pipeline of drugs in development and in many cases, also has drugs on the market that are generating revenue. Think of the drugs in the pipeline as analogous to investment ideas that the trader is still incubating, testing and deciding whether or not they have sufficient potential to warrant implementing with trading capital.

For drugs in the pipeline, there are various stages of development before the drugs are tested for efficacy and side effects. As drugs progress through the pipeline, they go through internal gated approval processes known formally as Phase 1, Phase 2 and Phase 3 and eventually through an FDA final approval process that determines whether the drug can be sold to the public. Only a small percentage (approximately 8%) of potential new drug ideas make into pre-clinical trials and less than 1% are deemed sufficient to warrant the investment associated with Phase 1 trials. As drugs encounter the gated approval process at the end of each trial phase, the number of high potential candidates is continually winnowed down, as issues related to efficacy or side effects are subjected to rigorous statistical analysis. As these drugs advance through the pipeline, the financial investment increases substantially. Ultimately, only about 1 in 10,000 of the original drugs involved in the drug discovery process makes it all the way through to FDA approval and ends up on the market. On average, the process takes about ten years.

Investors should look at their investment ideas and strategies as a pipeline management process too. There is limited capital available and only the best strategies should be funded. At the beginning of the pipeline, investors should focus the most attention on getting out of their comfort zone, formulating wild new trading ideas and translating these into actionable strategies. This is the best time to get out of one’s comfort zone and embrace some chaos. As the ideas then progress through some sort of internal approval process, then focus become more important. Is the idea robust? Can the idea be translated into effective strategies? Is there enough liquidity to implement these strategies? What will the slippage costs be? What do the initial backtesting results show in terms of potential? Etc.

As new ideas progress through an internal approval process, the trader should move from an area of discomfort to an area of extreme comfort. By the time a trading strategy is ready to be deployed, the trader’s mind set should have evolved from one of high chaos and low comfort to low/no chaos and high comfort. A corollary of the trading idea development process, which I have sketched out in the graphic below, is that the more one is able to get out of their comfort zone at the beginning of the trading idea pipeline, the better the trading results and the more likely there will be uncorrelated strategies when the chaos of idea generation is translated into focused strategies.

For more on trading strategy development, four excellent blogs to follow are:

• CSS Analytics (David Varadi)
• MarketSci (Michael Stokes)
• Quantifiable Edges (Rob Hanna)
• Trading the Odds (Frank)
  

On Trading Rules and Guidelines

Last Friday’s post, Can Selling Options Make You a Better Trader? prompted quite a few emails and comments, including a request that I share some of my trading rules.

To be perfectly honest, I used to keep a list of trading rules handy to refer to at all times, but this is no longer the case. The rules are still valid, but after five years of full-time trading, I have retrained myself in the way I think about, react emotionally to and ultimately respond to the markets.

I do think, however, that the process of developing and codifying a set of trading rules and guidelines is one of the most important exercises that a new or inexperienced trader can undertake. Also, I firmly believe that veteran traders should constantly be evaluating their beliefs about the markets they trade and the guiding principles that provide the basis for various approaches to trading.

Before I decided to make trading a full-time business, I sat down and attempted to capture most of my beliefs about the markets. I originally started out with about 80 "axioms" (beliefs would probably be a more accurate term) and as I traded, I added to this list.

Originally I grouped my axioms/beliefs into the following categories:

• Overriding Principles
• Market Technical Analysis & Sentiment Indicators
• Stock Selection - General (long-term, swing and day trading)
• Stock Selection - Day Trading
• Stock Selection - Shorts
• Opening a Position
• Taking Profits
• Taking Losses
• Pre-Market Activities
• Intraday Activities
• Post-Market Activities
• Risk Control and Drawdown Rules

After a year or so of trading, I found that I had standardized on about 15 rules/guidelines that have changed only slightly since then.

As requested, here are ten overriding principles that have survived the past five years, through bull and bear markets:

1. Always live to fight another day
2. Entries must have a statistical edge
3. Patience and discipline
4. Be a jellyfish (swim with the current)
5. Trade only liquid securities
6. Focus on trying to capture the middle 80% of a move
7. Know your exit points when you open a position (and stick to them!)
8. When in doubt, reduce position size by 50%
9. Limit losses to 2% of total equity for any single trade
10. Start each day with a clean financial and emotional slate

The above list is relatively generic, but it helped provide me with a framework for organizing how I would approach trading as a business, what strategies I should adopt, how those strategies should be executed, and ultimately defining what success should look like.

Trading rules are vitally important – as is knowing when they should be broken. Even more important, I believe, is the process that one goes through in order to arrive at these rules and to make sure that as new market situations unfold and new blind spots are revealed, the rules and guidelines are enhanced to maximize the opportunity for the trader to continue to grow and develop.

A Dozen Things My Trading Accounts Are Thankful For This Year

I am a strong proponent of taking stock of what is working and what is not working on a regular basis.

That being said, if my trading accounts could speak, these are some things they would be thankful for so far in 2007:

1. More active use of trailing stops (probably the #1 reason for increased trading success in the past few years)
2. Increased use of the VIX (and VWSI) to aid in timing the market
3. Emphasis on put to call ratios (especially the ISEE) to evaluate market sentiment
4. Lack of hesitation in initiating short selling positions (the end of a long bias approach)
5. Blogging – and all the cross-pollination of ideas that it has engendered
6. ETFs – to diversify, go short, apply leverage, etc.
7. More time stops (including hybrid price/time stops such as a Parabolic SAR)
   
8. Better strategies for taking partial profits in options positions
   
9. Following the China trend, whichever direction it takes me
10. Iron condors and other strategies to capture premium associated with high volatility and/or non-trending securities
11. Numerous enhancements to a detailed and continuously evolving spreadsheet I use to track and analyze all my trades
12. Standardization on a single momentum indicator for my charts: Williams %R

Bicoastal Trading…or Are You Trading in the Right Time Zone?

Last week I had a chance to trade on both coasts of the United States. Even though I grew up on the East Coast, I must say that I am more enamored with the manner in which the West Coast trading day fits into my life than the East Coast variant.

Assuming that you are trading NYSE hours of 9:30 to 4:00 ET, here the pros and cons of each time zone, at least as I see them.

East Coast / ET

Pros

• Anything that happens overnight can be fully digested before the market opens the next morning
• No need to bother to check with Asia or do any homework before you go to sleep
• If desired, you can easily put in 3-4 hours of preparation time before the market opens
• Working hours are closely correlated with those of your friends and family

Cons

• If you have all that time after waking and before the market opens, there is a tendency to think you need to fill it up with research and analysis
• After hours trading, West Coast earnings conference calls, and other end of day activities can easily screw up dinner plans
• The market seems like it is open all day long
• If you hope to trade in addition to another full-time job, there is too much time overlap for intra-day trading
  
  

West Coast / PT

Pros

• The market closes at 1:00 p.m., so if you manage your time (and investments) well, you can have many of those afternoons off
• After hours trading and earnings conference calls are a breeze – and still leave you with half of the afternoon free
• Because of the lack of extended morning preparation time, there is a greater tendency to watch and wait during the first half hour the markets are open, rather then rush to open positions
• A part-time trader can get at least 1-2 hours of live market action in before going to work

Cons

• No sleeping in
• If you have to commute anywhere, you are forced to become part night owl
• Either you get up really early or (perhaps ‘and’) you must check on Asia and Europe each night before you go to sleep
• There is no guarantee that you can absorb all the relevant information and formulate a solid trading plan in the time available before the markets open
  
  

The Solution?

Since I started trading full-time, I have often thought that the perfect time zone to trade in was Mountain time. Jackson Hole? Telluride? In theory, at least, this would provide a good balance between having the necessary morning preparation time and the opportunity to take the better part of the afternoon off after the markets are closed for skiing, hiking, mountain biking or whatever the local environment offers. Since I mentioned Jackson Hole, Wyoming has an extremely advantageous set of tax laws (save property taxes) too.

For now I’m staying in the San Francisco Bay Area, getting up early, and paying a 9+% state income tax. Every afternoon I have off, though, I thank my lucky stars and try to spend my geography dividend.