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    Why do I get chopps in my trading?

    ZEMS BLOGBy No Comments4 Mins Read

    The last article took a look at the reasons why we can do well in the markets, then suddenly make poor decisions and explode. We will now examine the second common complaint of traders, especially in recent markets: how we develop good ideas for trades but then engage in actually trading those ideas. This often happens when we rely on momentum or trend — shorter or longer-term extensions of trend movements — only to experience reversals.

    Shredding can cause great psychological distress, but I'm not sure it's a purely psychological problem. Let's look at the last 10 years of stock market data to illustrate this point:

    For the first investigation, I divided the VIX daily cash close level into quarters and examined futures returns on the SPX. When the VIX has been in the lower half of its distribution over the past 10 years (less than 16.66), the next five days on the SPX have generated an average gain of just +.06%. When the VIX was in the upper half of its distribution, the next five days on the SPX yielded an average gain of +.36%. The results widen over time, so that the SPX's next 20-day return for the VIX conditional is +.32% versus +1.39%. We know that the VIX tends to fall in a bull market and rise in a bear market. In fact, there is a very important relationship between the VIX and the most recent 50, 100, and 200 day returns. What the data is telling us is that we are likely to get a meaningful five-day bounce in a weak and volatile market.

    For the second investigation, I examined the daily 5-day RSI for each stock in the SPX and the overall average level of those 5-day RSIs. I then divided the average daily RSIs into quartiles over the past 10 years. Sure enough, when the RSIs were in their weakest quarter, the next five days the SPX averaged +.49% versus +.11% for the rest of the sample. When the market sells within a five-day period, the returns for the next five days outperform all other market occasions.

    For the third investigation, I examined the percentage of stocks in the SPX index that closed each day above their five-day moving averages over the past 10 years. When this ratio was at its highest quartile, returns for the next five days averaged just 0.06%. When the ratio is in its lowest quartile, the five-day average net returns are +.51%.

    Historically, strong markets have led to more modest forward returns and weak markets have led to superior returns. This happens on multiple time frames. In fact, by constructing a momentum curve across different time periods, we can develop reasonable expectations of future market movements.
    We break out when we expect momentum and trends to extend. Our expectations put us in a state of frustration. This becomes a particular problem if we wait for “price confirmation” to enter a bull or bear market. By the time this confirmation occurs, expected forward returns have diminished. One way to overcome this problem is to check for cycles in market data and use short-term cycles to trade trending markets. I have consistently found that how you trade a market idea is just as important to profitability as the idea itself. If we can find short-term cycles within the market movements we trade, we can become much better at finding higher risk/reward, both at entry levels and take profit levels.

    Not all problems that affect our psyche are psychological in origin. Our tendency to think in straight lines and ignore cycles generates great frustration.

    Good trading is the best formula for achieving winning psychology.

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