Derek Hernquist: Worry-Free Urgency

January 30, 2014

4 minute read

“Boundaries are necessary because of people’s tendency to escalate commitment to past choices.”

The hardest part about my ongoing transition from discretionary trading to systematic is the balance between planning and intuition. My goal has never been to mine past data in search of market secrets; it’s to harness the “good” me and let the flawed me act out somewhere else. By constant measurement of my own market interactions, and observation of both manic crowds and cool operators, I’ve developed a set of strategies that meshes with my personality and releases me from the need to interpret every fresh piece of “news”.

The hardest part is never the data, or even interpreting the data. It’s knowing how quickly to act on the data. Without that, the data analyst is just the quarterback with the big arm who can’t grasp the changing speed of the game enough to complete the big 3rd down pass. I’ve been there; anytime I’ve made tweaks to my process there’s an adjustment phase, sometimes a day and sometimes a month. It eventually becomes automatic through routine but not without frustration.

The best move I’ve made in balancing autopilot mode with “take charge mode” is what the Heath brothers would call a tripwire. As they explain in Decisive, the safety net of a good tripwire allows the embrace of risk by creating “safe spaces” of time and money. There is no need to worry about every little obstacle until the tripwire arrives, at which time an immediate decision is needed.

A memorable example in the book was Eastman Kodak’s Sony-inspired 1981 study on the potential of the digital film market. The report was spot on that they were OK with their position for the moment. But it also noted that once consumers were satisfied with the quality of digital images, Kodak might need an immediate push into digital. Well, future regimes either failed to set or disregarded this tripwire, and you know how that story played out.

My tripwires are numbers of market health(see the “absolute” row), like 8%, 30%, 70%, and 92%, and I never override these “breadth stops”. They are high energy battlegrounds, where the benefit from collecting evidence is dwarfed by the potential gain from decisive action. Unlike negative feedback loops near 50% where an equal number of stocks are trending up as trending down, in these tripwire areas fresh information supersedes baseline readings; the magnet of yesterday can become a pivot for tomorrow.

Why these numbers? As mentioned over and over, I organize data over 4 timeframes in evaluating the present risk appetite of key stocks. I smooth this data a few ways to extract the signal from the noise. So, with each timeframe tracking 4 measures of market health, and each of those being tracked with a fast, moderate, and slow lookback, plus a variance factor to reduce whipsaws, it’s a steady and plodding summary of market health.

But markets don’t always plod. As any trader knows, there are times we wished we had acted more quickly and times when patience was the right call. Patience is nearly always the right call in my work, but when numbers approach those listed, I scrap patience and move into a state of urgency. These are of the “roughly right vs. precisely wrong” school, and a recognition of the following:

1) When only 1 of 4 stocks is healthy, and all of a sudden that jumps to 2 out of 5, I don’t want to be short in that timeframe

2) When 11 of 12 stocks are already unhealthy, and that number stops expanding, I don’t want to be short in that timeframe

3) When 3 of 4 stocks are healthy, and all of a sudden that falls to 3 out of 5, I don’t want to be long in that timeframe

4) When 11 of 12 stocks are already healthy, and that number stops expanding, I don’t want to be long in that timeframe

Those are my tripwires. The rest of the time I can deliberate, plan, tweak, add, or trim, but when one of those conditions occurs I need to act with aggression NOW. Back to QB terms, the defense blitzed and I can’t spot a receiver…throw it out of bounds or tuck and run ASAP. For the trader, forget the opportunity you thought might come, protect your precious financial and emotional capital, and try again next time.

After a long stretch of calm and macro noise, I’ve had tripwires on 2 of the past 3 days. Thursday screamed to exit all intermediate-term longs with breadth metrics gapping out of the low 70s. Monday’s lunchtime plunge screamed to exit all swing shorts with all 12 metrics having fallen to 2-9% “health”. The selloff has even put the long-term uptrend at risk, with the end of this week my deadline for deciding if longs need to be eliminated or simply sized down in this timeframe.

We all know the famous Mike Tyson quote “Everyone has a plan until they get punched in the mouth”. Those stats are my prompt that if subtle clues haven’t already repositioned me, this is my punch in the mouth. Luckily, markets give us a chance to go to our corner, regroup, and get ready for the next opportunity. Most important, opposing tripwires can be set that will prompt us back in when the original trigger is eventually offset. You know even the best evidence can be wrong, right?

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.