When to Abandon a Trading Strategy

No matter what method you use to trade the markets, be it fundamental analysis or technical analysis, there is one common element all must master if they hope to be successful, the art of discipline. Every day a traders discipline is tested as they watch the price of financial instruments fluctuate and feel the emotional urge to enter or exit a position, even when they know from their knowledge and experience that it is best to suppress such urges. However, there is another type of discipline that is required for a trader to become successful, which is especially applicable to system traders, but applies to anyone who uses a predetermined trading strategy. That is the discipline to know when to abandon or change a trading system's rules because they are resulting in poor performance versus when to continue or give the technique more time in its current form as it may just be that the system is experiencing an inevitable period of drawdown.

A technical trading system can be defined as a set of rules, based primarily on the movement of price and volume of a financial instrument(s), which are followed to make decisions on when to enter a position and when to close or exit a position. (More on developing technical systems can be found in this article.) Most system traders will inevitably have encountered the dilemma of developing a great set of rules which they believe to be thoroughly tested and have great profit potential, only to begin trading with real money and experience a serious string of losses. This process not only effects ones capital level, but also seriously affects the psyche of the trader. They begin to doubt the system, doubt their ability, and wonder if they have what it takes to be a successful trader. In other, albeit more rare cases, a trader will develop a system, start trading and find that it performs as expected. However, eventually this trader will also reach a time where the system stops producing strong profits and instead enters a prolonged period of losses. In both cases, the trader reaches a crossroads of whether to change the rules, stop trading the system completely, or continue in the hope that the performance is just an aberration.

Before a trader decides how to proceed when faced with this dilemma, there are a number of things they should examine which will increase their chance of taking the correct course of action. First of all, it must be realized that all trading systems, or even more broadly, all traders and investors, no matter what method they use, experience periods of drawdown. Luckily for system traders, due to the fact their rules for entry and exit are usually objective and developed based on testing with historical data, they can determine what constitutes a normal amount of drawdown by examining how the system performed in the past. Obviously historical levels of drawdown will not correlate exactly to future levels, but if a system is robust enough to be profitable over an extended period of time, it should not see levels of drawdown that far exceed the amount or duration experienced in the past. So, for example, if historically the average drawdown for a system was 5%, and the trader is in the midst of a 15% drawdown, this should catch the trader's attention. Traders who encounter situations like this should begin to seriously consider changing their trading rules, or developing a new system entirely, as possibly the system was over fit to historical data and is not robust enough to work on future market movements.

In relation to drawdown a trader can get an even better idea of whether the current drawdown is reason enough to change their rules by measuring the drawup in profit prior to when the drawdown began. (Drawup being the profit from trough to peak on one's equity curve, versus drawdown being peak to trough loss.) The most recent drawup should then be compared to what the average drawup was over the same historical period that was used to calculate the average drawdown. Now if the trader started trading and the losses began right away then they would examine the most recent drawup on the historical data prior to when they began trading. This can be useful in the following manner; by continuing with the drawdown example in the previous paragraph of 15%, let's say the drawup prior to this drawdown was 30%, while the historical average drawup was only been 10%. In situations of this manner what might have occurred is rather than the system rules not working in a useful manner any longer, instead the volatility in the market may have increased substantially leading to relatively larger gains and larger losses. Or in other words, while the drawdown was larger than normal, the amount of profit earned prior to the drawdown was also much larger. As such the rules may not need to be changed, assuming ones trading capital allows them to cope with the larger amounts of drawdown.

A final few stats that are helpful to examine are the percentage of trades which are profitable, as well as the profit-loss ratio (i.e. the average profit per trade on the winners compared to the average loss on the losers). By comparing these to the historical averages, in addition to drawdown and drawup, one can further determine whether their system requires changes. For example, if the percentage of trades profitable was on average 50%, but has recently shrunk to 20%, then there may be some changes required to the rules of the system. This same logic would apply to a significant decrease in the profit-loss ratio.

In addition to observing the stats just mentioned, a trader can better determine whether changes to their system are need by examining whether the condition or state of the market has changed recently. In other words, has the market moved from a trending market, to a ranging market, or possibly even changed to a market state characterized by extreme levels of volatility (i.e. late 2008). Attempting to determine this can be very helpful as often one will develop a trading system that works very well in trending markets but very poorly in ranging market. This situation is in fact the case with many systems which use moving averages as the primary entry and exit signals. One can attempt to determine if the market state has changed by examining the price charts of the instruments they trade, as well as some of the broader market aggregates, to see if price movement is showing trending conditions, such as higher highs and higher lows in a trending bull market, or lower lows and lower highs in a trending bear. Or conversely, if price is range bound and experiencing neither continued up movement nor continued down movement. Furthermore, with respect to the condition of the market, a trader can also examine measures of volatility such as the VIX. If one observes that there has recently been a significant increase or decrease in the level of volatility, this could have a serious impact on the performance of one's trading system (more on this here).

To conclude, one of the toughest decisions a system trader will face is when they encounter sharp drawdowns in their trading capital and must decide if it is best to stop trading the and change the rules or continue with the system as is. On the one hand, changing the rules may be the correct course of action as possibly the system is not as robust as had been anticipated. While on the other hand, one must be careful not to jump the gun, realizing that drawdown is inevitable and profits may be just around the corner. A trader can improve their chance of making the correct decision by examining the recent performance of the system relative to past performance. With the idea being that if the more recent performance has diverged significantly from historical levels then it is more likely that some changes are needed. One should also attempt to determine if the state of the market has changed, as a move from a trending to ranging market or vice versa may warrant a change in trading methods. Furthermore, through undertaking analysis of this type it is less likely that an individual will make the decision based on the one emotion that drives too many traders actions, fear.

Inflation versus Deflation - The Case for Deflation

Over the past year, the stock market has seen a strong bull rally off of its March 2009 low which has certainly been great for many people's investment accounts. Unfortunately, it has also led many in the mainstream financial industry (media taking heads, traditional brokers, large bank economists, politicians etc..) back to the same level of blind optimism and complacency that was seen prior to the 2008 crash. Investors who share this complacent view of the market are likely in for another shock because before the economy can return to real growth and prosperity much of the malinvestment that was built up over the years of low interest rates and easy money must be cleaned out of the system. The government and Federal Reserve Bank have been implementing significant measures to try and prevent this natural economic process from occurring, however, the economy is too large and complex to be controlled by a handful of individuals. Most of those who are proponents of free markets will likely agree that the large amount of malinvestment in the economy will inevitably lead to another crash, and one that is likely bigger than that experienced in 2008. However, there is currently an interesting debate between those who believe that the current state of the economy will lead us towards a period of strong inflation (possibly even hyperinflation) and those who believe the opposite will occur and we will instead see deflation. The occurrence of either significant inflation or deflation will have serious and drastic effects on all areas of the economy. Although that being said, a period of strong inflation will result in the financial markets performing in a much different manner then a period of strong deflation. Inflation will lead to a significant nominal rise in the price of real estate, commodities, stocks, and virtually all other asset classes other than the dollar, which will decline in value. While a period of deflation will see a decline in the price of almost all asset classes and a rise in the value of the dollar. As such an investor who can correctly anticipate which of the two scenarios will play out will put themselves in a position to profit handsomely.

Before one can examine the likelihood of an occurrence of either inflation or deflation these concepts must be properly defined. Inflation is an increase in the total money supply and credit in an economy, which subsequently leads to a decrease in the relative purchasing power of each dollar. Deflation on the other hand can be defined as a decrease in the total money supply and credit in the economy which leads to an increase in the relative purchasing power of each dollar. These definitions are different from the common perception of inflation and deflation, that being an increase in the price of goods for inflation, and a decrease in prices for deflation. It is crucial to understand that an increase in the price of goods is a common consequence of inflation, while a fall in prices is a common consequence of deflation, but the changes in price are not the cause of inflation or deflation, but rather a symptom. It is actually possible to have inflation but not necessarily see an accompanied rise in the price level, or to have an increase in the price level but not have any inflation, the opposite being true for deflation. Another common misconception with regards to inflation and deflation is to only look at changes in the money supply to make a determination on the presence of inflation or deflation. But in an economy with fractional reserve banking, changes in credit must be viewed in the same manner as actual increases or decreases in paper dollars as credit competes for goods and services and allows individuals to make purchases in the exact same manner paper dollars do. Thus, for inflation to occur there must be a net increase in the level of credit and paper money in the economy, while deflation will occur if there is a net decrease in the level of credit and paper money.

The most common argument that those in the inflation camp make to support their premise is that the massive and accelerating spending by government can only be funded by an increase in money supply and government debt and this will inevitably lead to inflation. At first glance it is hard not to agree with this idea especially with government debt (federal, state, and local) currently standing around $10 trillion. Also this number is very likely to continue to grow with the possibility of massive health care reform, social security and Medicare obligations, and other spending programs on the horizon, the only feasible way to fund these programs (as well as pay the interest on current debt) is to print more money. Other than printing money the only other way the government can fund their growing size is to raise taxes, and most politicians realize that this is extremely unpopular and as such would much rather raise money through the "silent" tax of money printing. Inflationists also point out that with declines in the private sector and rising unemployment levels, governments will see the need for continued and larger stimulus packages in the future, and again the vast majority of the money to fund future programs will come from increasing the money supply and government debt. While these arguments are certainly warranted, in order to make an educated hypothesis on the likelihood of either inflation of deflation one needs to examine the economy more closely and look beyond just the supply of money and the size of government debt by additionally examining the entire pool of credit in the economy.

When people say that the United States is in the midst of a credit bubble they are not kidding. While the total money supply as measured by its broadest aggregate, M3, is approximately $14 trillion (refer to this chart), the total amount of credit based on Federal Reserve statistics is $53 trillion or almost four times that of the money supply. The fact that the amount of credit dwarfs the amount of "real" paper dollars in the economy makes it obvious that any changes in the level of credit will have a serious effect on the existence of any inflation or deflation. In the United States the largest holders of debt are the financial sector, households, and businesses. More specifically the domestic financial sector holds approximately $16 trillion of debt, households just under $14 trillion, and businesses approximately $11 trillion (these stats can be confirmed here in this Federal Reserve release, as can the other stats for the remainder of this paragraph and the next). The rest of the debt is split among the federal government with $7.6 trillion, state and local governments who hold $2.3 trillion, and foreigners with $2 trillion. The fact that the amount of debt outstanding between the financial sector, households, and businesses is almost 200% higher than M3 is quite staggering. Furthermore, given that private debt is approximately 80% higher than M3 plus total government debt (federal, state and local), shows that the behaviour of private credit will have a huge impact on any inflation or deflation.

Now before getting ahead ourselves it is important to examine how credit is currently behaving and whether a credit collapse is likely. First of all, the three largest portions of total credit, the financial sector, households, and businesses have all seen a collapse in credit over the past year to year and a half. The financial sector is currently leading the credit collapse with declines over the first three quarters of 2009 of 10.4% (-$1.78 trillion), 12.5% (-$2.13 trillion), and 9.3% (-$1.53 trillion). Household credit on the other hand, of which $10.3 of the $14 trillion is home mortgage debt, has experienced a more moderate decline since the third quarter of 2008, having lost a total of 7.6%, the largest single quarter decline of 2.6% coming in the third quarter of 2009 (which is the most recent quarter reported on). Finally, business debt began to decline in the second quarter of 2009 and has since fallen a total of 4.8% over the last two quarters. In terms of government debt, those in the inflationist camp are correct; the government is indeed increasing in size with accompanied massive increases in their debt level. In total federal government debt has rose a staggering 161% since the 1st quarter of 2008. However, while this would indeed be inflationary if the other larger portions of credit were increasing or staying flat, they are not. For example over the first three quarters of 2009 financial sector debt declined a total of $5.44 trillion, household debt declined $0.73 trillion, and business debt fell $0.48 trillion, for a total decline of $6.65 trillion. On the other hand the sectors which have seen rising credit over the same quarters in 2009 are led by federal government debt increasing $4.82 trillion, state and local government debt increasing by $0.3 trillion, and foreign debt rising by $0.66 trillion, for a total increase of $5.78 trillion. Therefore, even with federal government debt increasing 71.4%, state and local government 13.1%, and foreign debt increasing 34.6% over the first three quarters of 2009, the change in credit over this time was still a net decline of $870 billion. This shows the massive uphill battle that the government will face to cause inflation if there is to be a serious collapse in the private credit bubble, as even relatively moderate percentage declines in financial sector, household, and business debt over 2009 could not be offset by a massive increase in government debt.

While the declining levels of credit in 2009 do provide evidence for a coming deflationary period it is essential to examine whether the decline in 2009 was an aberration, or whether economic conditions will lead to continued and accelerating declines in net credit levels. It is highly likely that government spending will continue at high levels, and probably even accelerate, as such for deflation to occur the economy will need to see falling credit in the private sector of the economy. Those who support the deflation hypothesis, however, believe that this is indeed what will happen as conditions are ripe for a collapse which will be led by declining credit in the financial sector, household sector, and business sector. There are obviously many interrelated reasons why a credit collapse is likely to occur, however, possibly the two strongest come from a change in consumer psychology or mood and the continued decline in the real estate sector.

Many economists often overlook consumer psychology as it is very difficult to measure objectively. However, it is an extremely important driver of the economy and directly relates to increases and decreases in credit. Credit cannot just magically increase; it will only increase if individuals or businesses are willing to take on higher levels of credit, no matter what politicians and government officials want to believe. From the early 1990s until around 2007 individuals were continually willing to take on ever increasing amounts of credit, and the government and Federal Reserve were happy to oblige. This consumer mind frame was largely influenced by a continued rise in housing prices, a fantastic bull market, and a relatively low unemployment rate. Given that humans are notoriously bad at making predictions, the majority just assumed that these housing market, stock market, and job market trends would continue in the same bullish direction for the majority of their lives, and thus they would be able to continue to service their rising debt levels. However, this view quickly changed in 2008 with the stock market crash, the collapse of the housing market (which unlike the stock market has yet to rebound), and an unemployment rate which if one includes those who have given up looking and those who have only been able to find part time work is at a staggering 17%. Consumers have now seen a decline in home values of up to 50% in some regions, a stock market that even with the huge 2009 rally is still about 30% off its 2008 high and is no higher than it was at the turn of the century, and are also experiencing an economy where almost 1 in 5 people are unemployed or underemployed. In other words these events have led to a crushing blow in consumer psychology which will have a drastic effect on the amount of debt consumers take on as well as the amount they can pay off in the future. After seeing home values crash no longer will so many want to take on massive mortgages, nor will they continue racking up massive credit card bills believing they can supplement their incomes with stock market returns and increases in home equity, and those who are out of a job will not be able to obtain credit even if they wish to. In other words, without a doubt the consumer's tolerance for credit and ability to service it has greatly declined, and this is definitely a deflationary sign.

Furthermore, in terms of psychology, the psychology of the public towards government also has a significant influence on the level of credit in the economy, as the public’s mood has a serious impact on politicians’ ability and willingness to act. While the government may want to impose massive spending bills, bailouts, and stimulus programs they can only do so as long as public disapproval does not become too great. While in many cases the government seems to ignore the will of general public they can only go so far, if anger and frustration mounts and opposition towards increasing government size and debt becomes to0 great the government will be forced to scale back, or at least not expand as fast. This is one point inflationist tend to ignore, for while it is true the government in its current state can print as much money as it would like, and can take on massive amounts of debt, ultimately this can only be done for as long as the public mood permits it. Another point relating to psychology and government debt is that the US government can only continue to increase its debt if those in the debt market continue to accept government bonds and treasuries. If government debt continues to see a massive growth market participants are likely to require higher and higher interest rates on government debt instruments to counter the risk of the US government defaulting. This again is a limit on the growth of government debt, and shows that the existence of inflation or deflation is contingent on the willingness of individuals to take on more debt themselves and furthermore to allow the government to continue to expand the size of its own debt.

While changes in the psychology of consumers and market participants will play a massive role in any changes to total credit, the current economic sector that is likely to have the biggest influence in a credit collapse is real estate. The reason for this is because a massive portion of the total credit, not only in the household sector, but also the domestic financial sector, and the business sector is tied to the real estate market. The household sector's connection to the real estate market through mortgages alone is enormous, in December 2009 (based on this Fed release) single-home mortgages made up $10.8 trillion of the total household credit of $13.6 trillion, or in other words a staggering 75%. The commercial mortgage level on the other hand, which is related to business debt, is not nearly as high, but still significant at approximately $2.6 trillion. Now if you include farm mortgages and mortgages on multifamily residences the net level of mortgage debt in the US economy is around $14 trillion, or in other words almost twice the value of the entire federal government debt, or approximately equal to that of the entire M3 money supply. These numbers make it quite clear that the performance of the real estate market will play a significant role in the presence of either inflation or deflation.

However, the influence of the real estate market on credit levels is not contained to the household and business sector but is also seriously tied to the domestic financial sector. The domestic financial sector, which as was mentioned earlier holds around $16 trillion of debt, is made up of primarily government sponsored enterprises (GSEs, main ones are Fannie Mae and Freddie Mac), commercial banks (i.e. Bank of America), savings institutions, asset-backed security issuers, and financial companies (i.e. Goldman Sachs). To delve a little further into this sector 80% of the debt held by these institutions is comprised of corporate bonds, GSE issues, and mortgage pools. Mortgage pools, which are obviously connected to the performance of the real estate market, are basically groups of mortgages with similar characteristics which are pooled together and sold to investors on the secondary market as mortgage-backed securities. As of December 2009, according to the Federal Reserve, these mortgage pools totalled approximately $7.6 trillion, and as the footnote on the Fed release states this total is based on the "outstanding principal balances of mortgage-backed securities insured or guaranteed by the agency indicated." A good explanation of mortgage pools and their role in the domestic financial sector is provided by Thomas Woods in his book Meltdown:

"Traditionally, a homeowner took out a mortgage at his local bank and made monthly payments to that institution. More recently, banks have been able to sell these mortgages on what is called a secondary mortgage market to institutions like Fannie Mae, which then are entitled to receive the monthly mortgage payments associated with them. Fannie, in turn, bundles many of these mortgages together and markets them as mortgage-backed securities. When an investor buys one, he is buying a share of the pool of income that results from all the mortgage payments homeowners make on these mortgages every month."

The realization of the vast amount of private credit in existence and the fact that a large percentage of this credit is tied to mortgages allows one to see how the performance of the real estate market will have a significant impact on whether the economy experiences inflation or deflation. Currently the trends in the economy are more strongly pointed towards a continued deterioration in the real estate market then an improvement, and this could lead to the destruction of a lot of credit if an increasing number of mortgages go delinquent and more homes get foreclosed. The credit collapse of 2008 was caused largely by declining home values and an increased rate of foreclosures and these trends are accelerating even though the stock market has experienced such a strong bull rally. The high unemployment level will likely exacerbate defaults on loans, as obviously those out of a job will have a lot of trouble making mortgage payments, and this is indeed what appears to be happening. The percentage of home loans in delinquency or foreclosed reached a whopping 14% in the third quarter of 2009, with the number of homes foreclosed increasing to 4.47%, up from 2.97% in 2008.

Another interesting trend is that historically home prices do not turn up until after unemployment has peaked, this is represented by the following graph, which shows the unemployment level in relation to the Real Case-Shiller index, which is a measure of US home values. Also, in terms of mortgages another harmful sign is the fact that as adjustable-rate mortgages (ARMs) reset to higher rates, this will force more and more homes into foreclosure. It is estimated that approximately 88% of ARMs were taken out between 2004 and 2007, with as many as 1.3 million issued in 2004 and 2005 alone. Given that rates on these are set to reset between 2010 and 2012, this could potentially bring another crushing wave of foreclosures. Due to the massive influence that the real estate sector has on the level of credit in the American economy it is essential for investors to monitor the trends which drive it as they will provide a lot of evidence about whether we will experience inflation or deflation.

It is also important to realize that the economic trends driving the deterioration in the real estate market are also affecting other areas of the economy. For example an increasing number of people losing their jobs and declining home values will change the spending habits of individuals while also influencing their ability to pay off other types of debt such as car loans, student loans, and credit card debt, and this will lead to a further deterioration of credit. Which is what is happening as the latest consumer credit number from the Fed indicate that in November 2009, revolving credit (i.e. credit card debt) declined at an annual rate of 18.5%, while non-revolving credit (student loans, car loans etc...) declined at an annual rate of 3%. While the total level non-revolving and revolving consumer credit is $2.5 trillion, far less then mortgage debt, it is still significant. Furthermore a declining level provides more evidence of changing consumer psychology and spending patterns and these changes will affect areas like the retail, auto, and manufacturing sectors of the economy. So even while mortgage debt is certainly the most dominant area of credit in the economy it is by no means the only area seeing a contraction.

While a current credit contraction is something that most will agree on (especially after examining the numbers), due to the dominance of neoclassical economic thought in today's society, many may still come to the conclusion that it will not be too damaging to the economy. Ben Bernanke, sums up the neoclassical view of an unwinding credit bubble in his book the “The Macroeconomics of the Great Depression: A Comparative Approach”, where he dismisses the view proposed by Irving Fisher that it was in fact an unwinding credit bubble that led to the Great Depression :

“Fisher’s idea was less influential in economic circles, though, because of the counterargument that debt-deflation represented no more than redistribution from one group (debtors) to another (creditors). Absent implausibly large differences in marginal spending propensities among the groups it was suggested, pure redistribution should have no significant macroeconomic effects.” (Bernanke 1995, p17)

This view is extremely flawed, as a collapsing credit bubble does not result in a net redistribution from debtors to creditors, but rather a decline in the real wealth of both parties. Debtors who are unable to service their debts eventually go bankrupt and lose their assets which makes them poorer. Creditors also become worse off as they lose the interest payment stream on the loan, a portion of the principle, and in the instance where they do receive an asset back in return, those assets are in most cases extremely devalued. One only needs to look at the impact of the current housing market collapse to see that the decrease in the wealth of homeowners was not made up by an equal increase in wealth by banks; both were undeniably made worse off. The fact that the individual heading the Federal Reserve Bank subscribes to such wildly unrealistic, purely theoretical views only makes an impending crisis more likely, and unfortunately direr.

To conclude, in attempting to determine whether a coming wave of inflation or deflation is more likely it is essential not to concentrate only on the money supply in the economy but also more importantly on the aggregate level of credit. While the main premise of inflationists is that the expansion of government debt and money printing can only lead us to inflation, one must take into account that total government debt (federal, state and local) is only about $10 trillion of the total $53 trillion of credit, or a meagre 18%. For this reason, if private debt which is much larger then government debt collapses then the inflationists can only be correct if the government is able to expand at a much faster pace than private debt contracts. Another important point is that while in theory the government could print as much money as it wanted and expand its debt to extraordinary levels, this is only possible if the public allows for it and if those in the debt market are willing to take on the debt the government issues, and these are big ifs. Finally, one thing that most of those in the inflation camp and those in the deflation camp will agree on is that economic bubbles, like all other bubbles are ephemeral in nature, and without a doubt the US is currently in the midst of a credit bubble. So the question becomes does the government have enough power to keep this bubble inflated or has the time come for it to pop.

Note: There is an excellent series of interviews on the website financialsense.com which provide insight on the views of inflationists and deflationists. I highly recommend listening to them as it essential for any serious investor to come up with their own conclusions after being presented with evidence from both sides. The interviews can be found here, listed under the December 26th 2009 broadcast.

The Effect of Changing Market Psychology and Volatility on Technical Trading Systems

With the rapid advancements in computer and internet technology, technical trading systems are one of the more realistic means an individual trader has at obtaining long term market success. A technical trading system can be defined as a set of rules, based primarily on the movement in the price and volume of a financial instrument(s), which are followed to make decisions on when to enter a market position (long or short) and when to close or exit a position. A technical trading system does not necessarily have to be a set of rules that can be automated and executed by a computer, but can involve human judgment (i.e. drawing trendlines or detecting chart patterns). To be successful investing in a traditional manner (i.e. fundamental analysis) requires access to significant amounts of information about individual companies, sectors, and the overall economy, which is sometimes difficult for those who are working on their own to obtain in a timely manner. However, developing and trading a technical system only requires access to historical market data for the development of the system, live data for the trading of the system, and a computer program to develop and test the rules of the system, and these things are all easily accessible to the average trader.

While the basic requirements to develop and trade a technical system are relatively minimal, this does not change the fact, but instead contributes to it, that the overwhelming majority of technical system traders do not succeed in their quest to become profitable. While this can certainly be attributed to a wide array of factors, a primary one is the misconception that one can develop a technical trading system that will earn them money for as long as they care to trade it. Often individuals will begin developing a system with the belief that once they have found the right set of rules essentially their work will be done and they can then just sit back and watch the money roll in. Traders who stick to this view will never find a system that performs in the manner they desire. Even systems that see profitability initially, if they are not adapted over time to the periodically changing behavior of the markets will eventually reach times where the performance of the system is so poor that trading it is not wise or in some cases (due to the losses produced) not possible for very long. As such a technical system trader must realize that success over the long term requires constant work and testing in order to properly adapt ones rules to the evolving financial markets.

The changing psychology of market participants is what drives movements in the prices of all financial instruments. Changes in the aggregate psychology of market participants is influenced by a wide array of factors including things such as economic and earnings reports, political events, natural disasters, pandemics, and levels of pessimism or optimism among individual investors to name but a very few. While fundamental analysis concentrates on a limited set of these influences (primarily earnings reports, financial statements and economic data releases), technical analysis on the other hand is so powerful because by focusing on changes in price and volume one is paying attention to the only two factors which reflect the collective beliefs, views and emotions that all market participants have towards a financial instrument. (More on the relationship between market psychology and technical analysis can be found in this article). While the power of technical analysis comes from it focus on changes in market psychology, this focus is also the reason why one set of technical rules cannot be profitable forever. To be more specific while the composition of factors that influence the psychology of market participants may stay relatively static over short periods of times, in the long run these factors inevitably change, sometimes slowly, other times rapidly as the economy evolves, human knowledge expands, technology advances, and even as investment methods change.

Obviously the largest influence on market psychology is the overall performance of the economy and there is now an increasing amount of evidence that the economy is a complex adaptive system (more on this here). Essentially what this means is that over time the economy will not inevitably drift to equilibrium, like traditional economic theory suggests, but will instead display a wide range of behavior such as exponential growth, radical collapse, and even oscillations depending on the interactions among individual agents in the economy. Thus as the behavior of the economy changes so to will the patterns of price movement which form as a result of investors reactions to this changing behavior. Some proponents of technical analysis will argue that while the influences on market psychology are evolving over time this does not change the way one should interpret price movement as the same chart patterns and indicators will continue to work in the same manner. While this is partly correct in that technical analysis as a whole will continue to work, it does not take into account the fact that over time the success of different individual technical analysis methods will vary greatly and if a trader wants to have continued success they must adapt their system from methods that are not working, to ones that are. The reason why techniques vary in performance over time is due to the fact that most technical analysis methods are very sensitive to the level of volatility in the market and as the influences that dominate market psychology evolve this leads to changes in market volatility.

The best way to determine the role that volatility plays in the performance of trading systems is for one to discover it themselves. This can easily be done by coming up with a set of trading rules and then testing and recording the results of the system over historical periods of time that have seen different levels of volatility. A strong recent example would be to first test the selected rules over the 6 month period from September 2008 to February 2009 when volatility levels were very high, and then over a six month period in a year like 2005 or 2006 when volatility levels were much lower. In doing this one is likely find is that the performance over these two periods differs significantly, and more importantly differs in a manner traders would not want to experience in their own trading accounts. Volatility plays such a big role in the performance of technical trading systems because technical indicators, chart patterns, levels of support and resistance, moving averages, volume patterns, along with virtually all other technical analysis components perform much differently during times of high market volatility when levels of fear and greed are elevated versus times of lower to moderate levels of volatility. Some may be inclined to point out that the volatility in late 2008 reached unprecedented levels and as such those levels are unlikely to be seen very often, however, this a very risky guess to hinge once success on, especially given how easy it is to have ones entire capital base wiped out if one leaves their success to luck and guesses.

Realizing the importance of periodically adapting ones system is the easy part, knowing how and when changes to the trading rules are warranted is much more difficult. Traders struggle with this problem constantly and it is one of the things that determines the difference between successful traders and unsuccessful ones. Successful traders make rule changes only at times that warrant them, understanding the reason for the rule change and why it should improve their system. Unsuccessful traders either never change their rules because they are scared that if they do they will miss that next 'big' trade, or on the other side of the spectrum constantly make changes to their system with virtually every new idea that pops into their head. While only hard work and experience will allow a trader to reach the happy medium, there are certainly a few things traders can do to improve their ability at making optimal changes to their rules to fit the evolving financial markets.

First of all it is essential to be able to determine times when the performance of one’s system has begun to see a significant change as these times often signify the possibility of a changing market environment. For this reason it is essential to keep detailed records of one’s trading statistics (i.e. dates and levels of entry and exit, profits and losses, and reasons for entry or exit) as in doing so one will be better prepared to notice performance changes. Secondly, a trader will be better prepared to adapt their trading rules in an appropriate manner if they test and explore new methods not only during times when their system is performing poorly, but also during times of strong profitability. The constant work will provide the trader with a larger plethora of ideas on how to change ones rules to better fit a new trading environment. Also in general a trader who is constantly exploring and testing new ideas will have a better intuition of when they have discovered a rule change that will improve their system’s performance as well as what methods work better in the various trading environments they may encounter. Finally, a system trader will benefit immensely in their success at evolving their system if they not only pay attention to the group of financial instruments which they trade, but also to the price movement of all the main global markets (i.e. sectors, countries, indexes). An easy way to do this is to periodically examine the price charts of say the twenty to thirty exchange-traded funds with the highest volume as collectively they encompass the main sectors, industries, global economies, and stock market indexes from across the globe. Doing this is extremely beneficial as a trader will provide themselves with a better chance of detecting times when market psychology may be changing to such a degree that the associated market volatility will also change as often there are a few individual markets which see the change before it spreads throughout the economy (i.e. real estate and financials preceded the 2008 change). For as the saying goes, time is money, and the earlier one detects the possibility that some rules will need to be changed the better.

To conclude, technical systems offer great potential for traders to achieve long term market success, but only if they are developed and used correctly and in reality only a relative few ever gain this ability. However, for those who hope to achieve this success it is essential that they understand that a profitable trading system is never a finished product, but always a work in progress. This is due to the fact that the composition of factors which influence changes in market psychology are always evolving and this leads to changes in market volatility levels. These changing volatility levels result in different technical trading methods performing better or worse and as such a system will only see long-term profitability if the rules are adapted to these changes in the market environment. The greatest difficulty for even those who are aware of the need to periodically change ones trading rules is determining when rules changes are actually warranted. All too often traders fail because they either never change their rules or at the other extreme change their rules too often. But fortunately, or unfortunately, depending on how you look at it, the only way to obtain the skills, intuition, and knowledge required to be a successful trader is with continued hard work and an open mind.

Technical Analysis - Distinguishing Between Noise and Useful Chart Patterns

Technical analysis has been around since the 18th century and over the past few decades more and more individuals have been turning to this form of analysis partly due to the continued advances in computer and internet technology, but also due to the increased literature on the subject. Although an ever increasing number of traders are attempting to fulfill their dreams of riches earned on the market through day-trading using technical analysis techniques, the reality is very, very few of these traders ever become successful. Consistently earning money on the market (i.e. not from a stroke of luck) is extremely difficult, and unfortunately the majority of introductory literature on technical analysis portray it in a manner that makes one believe that all it takes to earn money with technical analysis is the ability to detect certain chart patterns. However, this is a massive oversimplification as instead it is extremely difficult to master technical analysis in a manner which allows for consistent long-term profitability, and is certainly not as simple as just entering trades each time a certain chart pattern forms. The majority of books on technical analysis are full of explanations and pictures of chart patterns such as rectangles, pennants, head and shoulders, and saucers to name a few, which the author will suggest that when formed offer an excellent time to enter as these patterns consistently precede significant moves in price. New day-traders look at the examples provided in books as well as online tutorials and are led to believe that once they gain the ability to detect these patterns in a timely manner they will then see the dollars roll in. However, not surprisingly a technical trader with this mindset will soon discover that it is not nearly as easy as most of the literature on the subject makes it out to be. Instead after the formation of these supposedly all powerful patterns, price is just as likely to go sideways or in the opposite direction then what is taught, as it is to move in the expected direction. Now this is not to say that technical chart patterns are worthless, as in fact they can be very valuable, but in order to make use of the great power one can obtain from technical analysis a trader must learn how to discern true signals from the noise in price movement. (Just to note before continuing, when I use the term noise, I am referring to movement in price with which technical analysis does not have the ability, at least in its current state, to interpret in any useful manner.)

Examination of a large sample of chart patterns inevitably reveals that while in some cases entering after their formation does indeed provide excellent profit potential, unfortunately at least as often the patterns lead to either movement in price in the opposite direction then what is to be expected, or prolonged sideways movement. It is in the ability of the day-trader to be able to distinguish between the patterns which have a high probability of leading to a significant up or down move and those which are just noise that determines whether a trader will be successful. While there are many ways that a trader can do this and most successful day-traders will in fact develop their own unique methods, there are two simple and obvious ways a trader can begin to improve this ability; firstly, a trader should be aware of the underlying longer-term momentum of the market which they are trading, as this can really help a trader filter out some of the patterns which are unlikely to produce winning trades. Secondly it is extremely beneficial for traders (especially day-traders) to know when any significant news announcements are going to be released (earnings reports, GDP numbers, employment numbers, Federal Reserve rate announcements etc..) as these are times that can see an increased level of noise in the movement of price.

Understanding the longer-term trend or momentum of the market is important because chart patterns which are counter to the direction of the underlying momentum are less likely to be profitable then patterns which form in the same direction as the momentum. Now obviously longer-term is relative to the the frequency that one trades, if ones makes trades based on 1-minute charts then longer-term might mean just a day, if one trades on 5- or 15-minute charts, longer-term could be a few days to a week, while if one trades on daily signals, longer-term would be measured in weeks or months. However, whatever longer-term means for the individual trader, longer-term momentum can be determined by examining charts of a longer periodicity. A trader need not make determining the longer-term momentum too difficult or complex a task, but instead should find a simple method that works for them. For example, this could include things such as examining the slope of moving averages, moving average bands, or the relationship of previous peaks and troughs in the movement of price (the idea being that if one sees consecutive higher highs (peaks) and higher lows (troughs) they are in an uptrend, opposite for downtrend). Essentially what the trader wants to do is to be able to with a fair degree of accuracy, determine whether the momentum is up, down, or sideways (range bound) and tailor their strategy accordingly keeping in mind that when the momentum is strongly upward, long trades are more likely to be profitable, and when the momentum is strongly downward, short trades should be preferred. Obviously there will be times when discerning the momentum is quite difficult, especially during times of high-volatility, or at times when the market is switching from one underlying momentum to another, but even not knowing provides the trader with useful information about how they should react to price patterns as times of high volatility and uncertainty are often good times for day-traders to be on the sidelines. However, the longer one studies and works on the market the better they will become at identifying the underlying momentum and its associated strength which will greatly improve their trading performance.

Along with being aware of the longer-term momentum of the market, a trader can improve their ability to enter trades that have a higher probability of producing a profit if they are aware of times when significant economic or earnings announcement are going to be made. This is important because after a significant announcement the market will often see an increased level of noise (or in other words meaningless price movement from the point of view of technical analysis patterns and indicators) and as such when a trader is aware of an impending announcement they can be better prepared to react (or not react) in a suitable manner. Too often technical traders are of the belief that the chart will tell them all they need to know, and while in one respect they are correct as the price of a financial instrument does reflect the aggregate market psychology of all participants (more on this in these articles here and here), the fact of the matter is that not all price movement is as valuable to a technical trader and times following significant announcements often produce price movement which is extremely difficult for even the most experienced traders to correctly interpret. For example the following chart is a 5-minute candlestick chart of EWZ (an ETF derived from the MSCI Brazil Index) from September 23rd 2009 which was a Federal Reserve rate announcement day, the first chart shows the movement of price that day up to 5-minutes after the 14:15 announcement, so up to 14:20.

Now if one were unaware of the Federal Reserve announcement they would likely believe that the price movement on this chart was very bullish and provided a good entry level due to the fact that price had formed a bullish price pattern known as an ascending triangle, and furthermore at 14:20 (candlestick represented by blue arrow) price broke out of the triangle and at the same time closed at a new daily high on a strong bullish candle. However, a trader who was better prepared and was aware of the Fed announcement would hopefully have realized that after significant announcements market participants need time digest the new information and conflicting opinions and emotions can lead to very volatile, noisy price movement which unfortunately in many cases traditional technical analysis can reveal little about. As the chart below shows, any trader who entered long based on the break out of the ascending triangle was in for a disappointing remainder of the day as price quickly turned sharply down for the remainder of the trading session.

To conclude, in order for a day-trader to have any chance at consistent profits over an extended period of time using technical analysis methods it is essential that they abandon the notion that it is as simple as just identifying and entering with the formation of each and every chart pattern. Instead one must learn how to distinguish between patterns that have a high probability of leading to a significant price move in the expected direction, and patterns which are nothing more then noise or in other words price movement which technical analysis has no business interpreting. While a trader who truly finds success will no doubt discover a unique method of their own to achieve this, the two ways mentioned above are simple but important initial stepping stones. Knowing the longer-term underlying momentum allows a trader to ignore some of the false patterns which form in the opposite direction of the momentum, while a trader who is aware of times when significant announcement are going to be made will be better prepared for times when the amount of noise in the market often greatly increases. For as the saying goes, if something is too good to be true, it probably is, and this is definitely the case for the simplistic picture of technical analysis that is too often painted in so many introductory books.

Complexity Economics - Implications for Investors

The vast majority of investors make trading decisions based on their belief of how the economy will behave in the future. Changes in economic conditions have a significant impact on the price of financial instruments and those who believe conditions are likely to improve will buy (go long), while those who believe that conditions will deteriorate will sell (go short). However, while so many individuals make their investment decisions based on economic predictions derived either by themselves, or others, the fact of the matter is that most of these predictions turn out to be wrong. While there are certainly times when an individual will make a correct call relating to a specific time or part of the economy, to find an individual who consistently makes correct and timely predictions is extremely difficult, if not impossible. The majority of the predictions, or maybe a better word would be guesses, and especially those voiced through the mainstream media outlets are typically based on traditional economic theory and analysis models. However, a relatively new way of viewing the economy, known as complexity economics differs strongly from the views held by traditional economists and may help reveal why predictions based on traditional theory are so often incorrect, and as such also has significant implications for investors utilizing these methods.

Traditional economic theory has long made the assumption that over time markets move towards an equilibrium level, and by determining this level one can predict the future level of economic activity. More specifically, traditional economic theory holds the view that as long as there are no exogenous shocks to the economy (i.e. things such as changes in interest rates, innovation, increases in productivity, etc...) then one can use traditional models to determine future equilibrium levels and as such hopefully make an accurate prediction. However, in order to justify the assumption that markets always move towards equilibrium traditional economists had to make another massive assumption which in essence is the cause of traditional economics lack of success at making predictions, and this assumption was that the economy is a closed-system. A closed-system can be defined as "a system having no interaction or communication with any other system - no energy, matter, or information flowing into or out of it" (Beinhocker, 2006), and a defining characteristic of closed-systems is that unlike open-systems over time they have a predictable outcome, equilibrium. While viewing the economy as a closed-system allowed economists to believe that future economic activity could be predicted with a fair degree of accuracy, the fact of the matter is that the economy is an open-system and the behavior in open-systems is so different to that of closed systems that models that are developed for closed-systems will have absolutely no predictive capabilities when used on an open-system.

An open system is a system that allows both energy and matter to flow into and out of it, and all one needs to do is to look up into the sky to realize that the economy is certainly not a closed-system as the sun provides a constant flow of energy into the economy. While the significance that the sun plays in the economy is quite obviously, it is surprisingly ignored by traditional economic theory in the classification of the economy as a closed-system. Furthermore, classifying the economy as a closed-system also contradicts the laws of thermodynamics which govern both open- and closed-systems, and given that the economy exists in the physical world these laws which are believed to be of a universal nature cannot be ignored. The laws of thermodynamics are as follows:

1. Energy can neither be created nor destroyed. It can only change forms
2. The entropy of an isolated (closed) system not in equilibrium will tend to increase over time, approaching a maximum value at equilibrium
   

The first law is fairly straightforward, and was in fact understood when traditional economic theories were first being developed. However, the second law had yet to be discovered when traditional theories were in their infant stages and is the law which traditional economic theory strongly contradicts. To further clarify the second law, entropy is basically the level or measure of disorder in a system, and in a closed-system the level of entropy is always increasing until equilibrium is reached at maximum entropy (or disorder). So for the economy to be classified as a closed-system this would mean that the amount of disorder within the economy would constantly have to be increasing with equilibrium being reached at the maximum level of disorder. But in reality this is certainly not the case as order is in fact increasing in the economy with the advancement of technologies, the building of structures, and the increased organization of people. Thus, when order is increasing (entropy decreasing) in a system (as it does in the economy), that system inherently must be an open-system as it needs new energy to flow into it (from the sun) and entropy to flow out of it (in the form of heat). For these reasons economic theory must classify the economy as an open system and not a closed one just for the convenience and simplification that doing so provides, and this is exactly what complexity economics does.

Complexity economics not only looks at the economy as being open, but also views the economy as being a specific type of open-system, a complex adaptive system (CAS). The following is how John H. Holland, one of the pioneers in the field of complex systems defines a CAS:

"A Complex Adaptive System (CAS) is a dynamic network of many agents acting in parallel, constantly acting and reacting to what the other agents are doing. The control of a CAS tends to be highly dispersed and decentralized. If there is to be any coherent behavior in the system, it has to arise from competition and cooperation among the agents themselves. The overall behavior of the system is the result of a huge number of decisions made every moment by many individual agents." (Holland, 1994)

While this definition can be used to describe numerous types of systems including the immune system, the brain, ecosystems, and even ant colonies, the definition also definitely applies to the economy. The economy obviously consists of a network of many agents (individuals, firms etc..) constantly acting and reacting to what other agents in the economy are doing. Also control of the economy is dispersed and decentralized as no individual or small group of individuals can control it themselves (even though certain governments may be trying to do so). And finally, the overall behavior of the economy, like that of other complex adaptive systems does indeed arise from the cooperation and competition of the individual agents, as in the economy cooperation and competition leads to innovation, growth, and an overall increase in order (decrease in entropy). Viewing the economy as a complex adaptive system differs significantly from traditional views which by characterizing the economy as a closed-system essentially led to oversimplified models which are primarily composed of linear relationships amongst variables all leading to the predictable end-state, equilibrium. However, the behaviour of complex systems is much more intricate and the following explanation by Beinhocker in his book The Origin of Wealth certainly reveals this;

"Sometimes opens systems can be in a stable, equilibrium-like state, or they can exhibit very complex and unpredictable behavior that is far from equilibrium - patterns such as exponential growth, radical collapse, or oscillations." (Beinhocker, 2006)

Due to the wide variety of behavior displayed, complex adaptive systems are extremely sensitive to initials conditions and this is another reason why the economy is so difficult to predict. What sensitivity to initial conditions means is that even if one were able to develop an accurate model for predicting the future behavior of a certain part of the economy, if the inputs into such a model (let us say for example the unemployment rate or inflation rate) are even the smallest amount inaccurate, because of the complex behavior and non-linear relationships displayed in an open-system like the economy, the results will vary significantly from the correct results had the inputs been exact. Sensitivity to initial conditions obviously posses significant problems for making economic predictions as to obtain exact values of variables such as the unemployment rate, the inflation rate or gross domestic product to name a few is nearly impossible. For example if one wanted to obtain the exact unemployment rate one would need to poll each and every member of the work force, instead of just taking a small sample as is done now and obviously undertaking a survey this massive is quite unrealistic. However, while sensitivity to initial conditions does make any hope of consistently making accurate economic predictions all that more difficult, one cannot just make massive assumptions (such as that the economy is a closed-system) and believe that by doing so they can overcome the problem posed by complex adaptive systems and actually make good predictions. Instead if future economic theory is to be more useful it must take these difficulties into account and work to obtain methods that can realistically overcome them without completely ignoring them.

This new school of economic thought is offering a lot of insight into the faults of traditional economic theory and is also casting significant doubt on the validity of consistently producing profitable investment returns based on "predicting" the economy using traditional models. Viewing the economy as a complex adaptive system makes it easier to understand why it is so difficult to accurately predict the future behavior of the economy, and why so often the economy behaves in a manner that traditional economic models cannot explain. Furthermore, complexity economics really signifies the need for serious investors to stop listening to the economic predictions made by economists, politicians, media talking-heads, and other self-anointed experts because in doing so they are in essence just relying on the lucky chance that the predictions turn out to be right. Instead investors need to explore new and innovative investing or trading strategies, including but not limited to things such as technical analysis, shorter-term fundamental analysis, and new economic analysis techniques that do not make the assumption that the economy is a closed-system. A good way to conclude is with another quote from Beinhocker's excellent book on the subject which really sums up the problem with traditional economics:

"One can thus begin to appreciate why economic forecasters have such a tough job and an even lower reputation than weather forecasters. The combination of sensitivity to initial conditions, path dependence, and immense dynamic complexity makes the economy, like the weather, unforecastable over all but the short term." (Beinhocker, 2006)

The Problem of Diversification

Diversification has always been a relatively common concept to investors and is certainly one of the first things covered in introductory literature on the topic. In general, diversification can be defined as "a risk management technique, that mixes a wide variety of investments within a portfolio". The basic purpose of diversification is to minimize risk as by spreading your capital amongst a variety of investments one is less likely to be seriously adversely effected by a sharp and unanticipated move in one or a few of the holdings. However, even though diversification has become a very common practice there are still a number of misconceptions and problems relating to its use among proponents of both traditional investment techniques (i.e. fundamental analysis) and those on the technical analysis side. On the traditional side, diversification has created complacency as many investors do not look past any ideas that differ to what they believe to be the one and only sound investment method; extensive diversification across a large number of markets in a net long manner. However, this complacency which is widespread throughout the money management industry has resulted in returns that in the long-term are on average no better than the overall returns of the broad market. On the technical side the problem with diversification is much different, the majority of traders who use technical analysis ignore diversification and too often will trade only a single financial instrument. However, to be truly successful (meaning profitable in the long-run during both bull and bear markets) from either the traditional or the technical side it is essential to abandon the complacency relating to the common uses of diversification (or lack there of, for technical traders) and instead develop more unique and creative approaches to diversification and ones trading strategy in general.

While most money managers will attempt to attract new clients with pitches about how their great diversification and portfolio management will lead to smooth long-term returns exceeding those of their competitors, the truth of the matter is that investing in the traditional manner as so many in the money management industry do, on average only does as well as the performance of the overall economy at best. That being said it should not be overlooked that traditional investing methods can produce decent returns if the economy is growing strongly, which is why it has become so popular, but if the economy is contracting or stagnant over a long period of time investing in this manner will not be very profitable at all. The only way an investor using traditional methods will be able to consistently produce greater returns then the broad market is if they have an incredible knack for picking companies, market, or sectors etc.. that outgrow the overall economy. While many investors will tell clients that they (or the company they work for) have this great ability, the fact of the matter is that the reason why the vast majority diversify in the first place is because they do not. If an investor truly has an uncanny ability for picking investments that will outperform then they will not have much of a need for broad diversification, as they will be better off investing in the strong areas they have discovered. Interestingly, this is in fact how Warren Buffett initially made his fortune, as contrary to popular belief when he first started investing his money was not diversified among a wide variety of companies but instead invested heavily in a small group of companies he believed had very strong growth potential. While obviously very, very few people have the ability to become a Buffett, this does not mean that they cannot attempt to improve the traditional methods which historically perform quite poorly during bear markets or times of prolonged economic decline or stagnation.

What makes the traditional investing and diversification method even less desirable then what proponents make it out to be is the fact that in the vast majority of instances money managers using these methods are essentially long on almost all their positions at all times. What this means is that when confronted with a broad bear market (such as the one in 2008) where virtually everything goes down a diversified net long portfolio will not be beneficial at all. Instead accounts structured this way will see returns in line with the markets, and in some cases even worse, which after the 2008 bear market meant a substantial loss. Therefore, if one is attempting to achieve returns that consistently exceed those of the broad market they must seek out ways to overcome the problems that tie traditional diversification to the returns of the market, and without exception this is what the extremely successful investors have done. Be it an investor like Buffet who was able to determine which companies had the greatest prospects for growth and then investing heavily in them, or be it investors who study the macro conditions of the economy and are better able to anticipate times when a net long portfolio is a detriment and thus act accordingly. However, while grasping the problems associated with the traditional method is fairly easy, actually developing a strategy to consistently produce positive profits over the long-term is extremely difficult and only achieved by a very small percentage of investors. Furthermore, a likely reason for the continued popularity of traditional investment methods is that if executed correctly one will rarely experience a swift and drastic decline in capital, and that is more then can be said then for some of the foolish ways certain individuals attempt to make a fortune on the markets.

The problems that tie traditional investment methods to the returns of the broad markets has led many individual's to technical analysis, with that number continuing to grow due to advances in computer and internet technology. Interestingly, unlike traditional investors most technical traders and especially day traders have a preconception that technical analysis does not require much if any diversification and instead one can be successful by trading a single system on a single financial instrument. However, this preconception is a large contributor to the fact that the majority of technical traders like their traditional counterparts do not see returns consistently exceeding those of the broad markets. In fact, unfortunately technical traders (and again especially day traders) who maintain this dangerous preconception are less likely to experience returns close to those of the broad markets like those investors following traditional methods, but instead are more likely to experience various routes (sharp swings in capital, extended sideways movement, or even incredibly swift and sharp losses) all of which more often then not lead to a voluntary or forced ending to ones trading career. This is why a technical trader who is determined to become successful must overcome this preconception and realize that along with a tendency to over fit ones system to historical data, the lack of diversification plays a significant role in a majority of technical traders lack of success. Diversification for technical trading does not mean simply adopting the traditional diversification method and trading ones system on a large variety of financial instruments, but instead is comprised of two main elements; firstly it requires the use of multiple technical systems, and secondly requires trading more than one financial instrument.

The first element, using more than one system, is not often considered by technical traders but is crucial for long-term success. As was already mentioned too many technical trader are stuck on the belief that one needs to just develop a single set of rules for entering long and short positions and then they can just sit back and watch the dollars roll in. However, not surprisingly, what really happens to traders with this mentality is that after developing a system and back testing it on historical data, when they actually begin trading real money they soon (and sometimes right away) find that the system produces nowhere near the returns that they had expected. Now there are certainly situations where an individual will get "lucky" and start trading a single system only to experience significant profits, but more often then not this turns out to be a curse rather than a blessing. These "lucky" traders often become overly confident in their one system and when it stops working they are too blinded by their prior success to abandon it or change to a system that better fits the new market conditions. And it is because market conditions change over time, or in other words due to the fact that the markets exist in various states throughout time that require the use of multiple systems. For as anyone who has spent a significant amount of time developing technical trading systems will know, creating a system that is robust enough to be profitable during all the different market states is extremely difficult.

There are four basic market states each of which is driven by a different collective psychology of market participants and as such requires a different system or set of rules to be profitably traded. The four main states are an up-trending (bull) market, a down-trending (bear) market, a sideways range bound market, and possibly the most difficult to trade, an extremely volatile sideways moving market (like range bound but with much sharper moves). If one examines price movement during times when the markets are characterized by these different states they will quickly see that each requires a different set of entry and exit rules to achieve strong profitability. For example, a simple system based on something such as entering on the break of new highs or lows may work well in an up-trending market, but during a range bound market will perform extremely poorly. Furthermore, one may be inclined to believe that a system that works during a bull market will work equally well during a bear market, however, this is not always the case as the psychology behind the two differs. A bull market is primarily driven by greed and/or complacency (depending upon its length), while the psychology behind a bear market is primarily fear, and fear definitely produces different price movement then greed and/or complacency and is why bear markets are usually much more swift and dramatic then bull markets.

The need to trade a multitude of systems invariably brings a technical trader to the question of how to know when to trade which system, and overcoming this separates the extremely successful technical traders from the rest of the pack as there is no simple answer. However, logically there are two obvious ways one could potentially overcome this problem; firstly, one could try to develop systems that when traded during the market state to which they match are extremely profitable, but when traded during states to which they do not match only produce slight losses, or even better are near break even. If one is able to develop systems in this manner they can trade all their systems at once as the systems that match to the current market state should hopefully produce profits that greatly exceed the small losses of the other systems. The second way to attempt to overcome the problem of when to trade what system is for one to develop a method for accurately determining when the market state has shifted and then changing the system they are trading accordingly. Which of these methods, if either, is better is certainly up for debate, but what is not up for debate is the fact that to overcome this challenge is extremely difficult and requires immense amounts of hard work.

The second element of diversification for technical traders is trading a variety of financial instruments and while obviously the easier of the two elements to implement, it is still very important. By trading a variety of financial instruments across various markets, sectors, and industries one is more likely to trade a financial instrument which is in the correct state to be profitable with one of their systems at any given time. Trading just a single financial instrument means that a trader is tied entirely to the movement and state of that one instrument, and if it enters a prolonged period of tight range movement, or extremely volatile sideways movement it may be very difficult to earn profits. Similar to the reason that traditional investors diversify, technical investors also benefit by not being too heavily reliant on one or a few financial instruments. However, unlike traditional diversification it is probably not as important or reasonable for a technical trader and especially a day trader to be spread out amongst too many financial instruments as they may soon find it difficult to monitor and execute orders in a correct and timely manner. Instead what a technical trader must do is find a good variety of financial instruments that if possible are not too correlated to each other (obviously this can be difficult during sharp bear markets), that have all historically performed well with the systems that have been developed, and finally that fit the traders level of capital and risk tolerance.

To conclude, while diversification is a very common concept among participants of the financial markets the manner in which the majority of investors and traders use it is quite limiting. That being said it is essential for anyone who is considering trying new and innovative ways of investing to understand that there are a lot more creative ways to quickly lose your money then there are to make money and as such careful, dedicated, and a lot of hard work is required. An investor who attempts to develop a new strategy will inevitably face many failures, setbacks, and times of severe frustration, but those who are able to make it through these difficult stages without losing their trading capital will greatly increase the chance that they will be one of the very few who actually achieves great success on the markets.

Trading as a Performance Activity

When a person makes the choice to become a trader, few if any really understand the difficulty associated with becoming a profitable and successful trader over the long-run. Many enter the markets with visions of grandeur believing that all they need to do is find the "holy grail" of trading systems and they will be set for life. But in reality trading is an extremely difficult task, one in which most give up on either because they lose their trading capital or because they cannot cope with the frustration that all traders inevitably experience. However, a trader can better prepare them self for trading by viewing it as a performance activity, or in other words as an activity that requires the application of ones knowledge and skills to a real time, dynamic (always changing) environment. Traders face a similar task as professional athletes such as basketball or baseball players, who also must apply their skills in real time dynamic environments. For example in baseball a batter must react in a seconds to whether a pitcher has thrown a fastball or curve ball, similarly a trader may need to react in a matter of seconds when deciding whether to execute an order if the price of a financial instrument breaks to a new high or low for the day. Looking at trading as a performance activity helps reveal one of the main reasons why so many traders ultimately fail, and often in a dramatic fashion, and this is because like any performance activity not only is it essential for a trader to have immense knowledge and skills related to the market, but it is also equally important that the trader has the right mindset which allows them to utilize their knowledge and skills in what can be a very stressful environment.

One can get a better idea of just how essential a proper mindset is for a trader by again looking at sports. Often it is said that what distinguishes the average professional athlete from the truly great ones is not so much a huge differential in skills, but rather a difference in the athlete’s mindset and thus ability to perform consistently in very stressful circumstances. If you look at truly great athletes, Tiger Woods possibly being the best current example, it is obvious that they have an uncanny knack for performing and executing under great levels of pressure. For example, while most professional golfers have the skill to sink 10 foot puts with relative consistency, few have the ability to do it on the 18th hole of a tournament for the win as consistently as Tiger Woods does, and this ability as Tiger himself has often eluded to is not because of greater physical talents or skills, but instead due to his ability to put himself in the right mind frame to execute during these incredibly pressure filled moments. This ability to create the right mindset to perform under pressure is just as important for traders as it is for athletes. More often than not a new trader will obtain a significant amount of knowledge and skills relating to trading the markets, but when they actually begin trading they find that they are unable to adequately apply what they have learned and instead see themselves making repeated poor and irrational trading decisions which are not at all in line with the way they had hoped to trade based on their study of the markets. The reason that so many traders encounter this type of situation is because the pressure and stress associated with trading real money in most cases will create a mindset in an individual which does not allow them to access and utilize their knowledge and skills in the most optimal way, but rather leads them to crumble under the pressure. The ability to consistently trade with the correct mind set to allow for the proper utilization of ones skills is likely one of, if not the main factors that separates novice traders from experts, but unfortunately few traders even give this much consideration. However, when a trader does come to realize the importance that their mentality has on their trading results there are certainly ways in which one can work on improving the mindset with which they trade.

The proper mindset for trading, which for the remainder of this article will be referred to as the zone, is the mindset which allows an individual to best utilize and access the knowledge and skills they have obtained from their study of the markets, while executing trades in real time. While the mindset which constitutes a trader being in the zone will not be exactly the same for each trader, there are a number of general characteristics which are beneficial to all traders looking to reach the zone and they are; experiencing a high level of concentration when trading, enjoying the task at hand, experiencing minimal to no feeling of stress or pressure, having a clear and open mind, avoiding extreme emotions such as fear or greed, and feeling truly confident in ones decisions. Anyone who has ever written an important exam, competed in a sporting event, or participated in public speaking for example, will quickly realize the great benefits that these characteristics have for any performance activity, including trading. This type of mindset will allow a trader to perform at their peak given their skills and knowledge as by maintaining this mentality when trading ones brain is in the best condition to quickly and effectively access and apply the skills the trader has developed. That being said, even after the realization of the importance of trading in the zone many traders fail to consistently reach it, instead reverting back to destructive mindsets and wondering why after so much work they still fail to become profitable. Fortunately, if an individual is serious about becoming a successful trader then there are certainly ways in which one can work on consistently reaching the zone.

The first thing that one must realize is that in order to truly excel at any performance activity one must have a high level of passion for it and obtain a great deal of enjoyment from it. A trader who wakes up each morning dreading the coming trading day has likely already been defeated and should look at changing their profession. In relation to reaching the zone, one will find it immensely easier to create the positive mindset while at the same time immersing them self in the task at hand and reaching great levels of concentration without even realizing it when one has a true passion for the markets. Also a trader with a true enjoyment for trading will better handle a string of losses than one who does not really like what they are doing and instead just trades because of the desire for money. When confronted with a series of losing trades, a trader who does not enjoy trading will easily become frustrated and discouraged and this can lead to a damaging snowball effect as these emotions move a trader further away from the zone and as such can lead to more and more poor trading decisions. On the other hand a trader who really enjoys trading will be more likely to take a series of losses in stride, understanding that it is part of the profession and just means that they are going to have to continue to work to overcome the challenges they are faced with, and because they have a passion and derive enjoyment from it this will not cause them to stop but often motivate them even more. The need for one to enjoy trading to be successful cannot be overstated; traders who enter the markets only because of a desire for fast money will have an extremely difficult time reaching the performance level that is essential to be successful over the long-term.

In addition to only trading if one enjoys it, one can further increase their chances of reaching the zone by not concentrating on profits too much while trading. This is not to say one should not be aware of the amount of profit or loss they have for each position they are in, but in terms of the ups and downs of ones overall equity line one should not obsess over it too much. This is important because one who solely concentrates on profits as a gauge of their success will easily become discouraged and frustrated after running into string of losing trades which is inevitable for a new trader. Instead of concentrating on profits one should concentrate on whether they are making the correct decisions and utilizing their knowledge and skills to the best of their ability. If one gauges their success on consistently improving their trading decisions rather than the absolute dollar amount they make on each trade one will find it much easier to maintain a positive, stress free mindset while at the same time avoiding as much as possible feelings of frustration and regret. For example, when a trader is experiencing a prolonged period of drawdown, or sideways movement in their profit level, one who is gauging their success purely on the amount of money they have earned will find it very difficult not to get frustrated, upset, and annoyed at the lack of any perceived progression. On the other hand a trader who is measuring their success by continually making better trading decision based on the market environment they are faced with, even when enduring periods of drawdown are able to find reasons to be satisfied with their performance as they will often realize that even times like these provide them with invaluable lessons which will only help them in the long run. Furthermore, often these lessons are missed by the traders who concentrate on their profits too much as their frustration causes them to not pay close attention to what the market is revealing to them about their methods. As such one will greatly increase their ability to reach the zone by not obsessing over the amount of money they make each day, week, or month, but instead concentrating on the improvements they are making.

If an individual is to consistently reach the zone it is essential that they exhibit confidence in what they are doing. This is critical for trading in the zone as when one is confident in their method of trading they will not allow scenarios which may just be fluke (such as getting swung out of four consecutive trades for example) to plant doubt in their mind. Often traders will develop a trading strategy and be extremely excited about its potential only to start trading and encounter a prolonged series of losses which leads to doubt and frustration in their ability to be successful. A mindset full of these emotions will in many cases result in a trader making rash and poor changes to their trading strategy which only leads to worse results and a deteriorating mindset. In order for a trader to gain the confidence which allows them to consistently trade in the zone it is essential for a trader to continually work at improving their trading and overall knowledge of the markets. Hard work and practice creates the confidence needed as the more one is familiar with something be it playing an instrument, a sport, public speaking, or trading the better they will perform when the pressure increases. This is crucial for success but something that is usually overlooked by beginner traders. Often a trader will begin trading after just a few months or less of study and then be surprised when they quickly lose money. However, looking at it in a logical manner would a beginner tennis player be surprised if they started playing and only practiced for a few months before playing a professional only to be beaten in an embarrassing fashion, likely not, and the need for a lot of hard work and practice is no different then if one wants to succeed against professional traders.

Another thing that can greatly help traders stay in the zone during the trading day is to concentrate on staying calm and mentally rehearsing possible scenarios that may unfold in the markets. In terms of concentrating on staying calm, when ones finds that they are getting stressed during the trading day, if they are not already in a trade it is often beneficial for the trader to step away from the computer and allow themselves to return to a stable mindset before trading again (this can be done by things such as deep breathing, meditation etc...). On the other hand if one finds them self getting stressed out while in a trade this is where mentally rehearsing possible trading scenarios can help. What this means is that after one enters they should visualize the possible scenarios that may unfold and what the proper reaction to these scenarios would be were they to actually occur. Doing this can allow a trader to feel more confident and in control as the trader is accessing their skills and rehearsing proper reactions before for example, price reaches a certain level or forms a specific pattern. The visualization should be a continuous process because as the market moves throughout the day the trader should adapt to the possible scenarios which may occur. Mentally rehearsing or visualizing possible trading scenarios goes hand in hand with hard work and studying the markets, as the more one studies the markets the more effective they become at being able to narrow down the likely scenarios which may unfold and as such these traders will find themselves less and less in situations which greatly surprise them and lead them out of the trading zone.

While long term trading success is very difficult one will certainly increase their chance of obtaining it if they view trading as a performance activity and thus understand the importance of trading with a clear, confident, highly concentrated, and positive mindset, or in other words trading in the zone. The ultimate goal for a trader is to reach the stage where they do not need to concentrate on putting themselves in this mindset each day, but instead are able to naturally reach the zone each day as if it is second nature. Consistently reaching the zone is often the last hurdle that a trader must overcome to reach the level of success they often so desire, however, it also without a doubt one of the most difficult aspects of trading to master. Applying the methods mentioned above will certainly help a trader create the optimal mindset for accessing and applying their skills, but it cannot be stressed enough the importance of one having a passion and being able to derive enjoyment from trading if they are to truly reach the pinnacle of success.