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Managing and understanding the nature of trends

December 28, 2011 By 2 Comments

A trend represents the evolution of public sentiment, specifically, the psychology between optimistic market participants (bulls) and its pessimistic counterparts (bears). Moreover, the angle of a trend can determine whether the market’s mood is extremely optimistic or extremely pessimistic.

One thing that is very common of traders is that they consistently take a pounding from the market because they do not understand the underlying forces of trends. If the market is visibly moving down, sellers possess greater authority while buyers are countering against the seller’s strong influence. In the bigger perspective, such upswings are mere counter-moves on the way down. Buying is thus a much more challenging proposition than going with the dominant force. The opposite applies to rising markets in which buyers are in control.

If a market is in a decline and a trader is short, there is no point in covering, buying, and shorting again lower and lower because he will not be accomplishing anything of greater significance. What is the advantage in being exposed to new risk if a market is in an obvious decline already? You should stay short in a downtrend and not be overly concerned about reversals against you. On the contrary, there is no point in buying into every dip in hope for a massive recovery rally. New spikes on the way down are a necessity and a chance for bears to adjust their stops lower, thus reducing their risks or even secure increasingly more profits.

If you think about why markets move up and down: It is because there is an ongoing war between bulls and bears. These two opposing groups behave like armies on a battlefield. The aim of the bulls is to push markets up because they make money if they are successful, but they forfeit money if they are not. Then you have an opposing crowd that is just as intense as bulls in moving markets to the opposite direction. We basically have two enemies with two very different goals.

The bottom line is that all up and down movements are actually the result of a dynamic battle being fought out between these two forces. Significant battle lines are drawn days to weeks before, and have an immense impact on how the market moves the following day. A fight for control is taking place at these lines and are what we call a support or resistance area. As the bulls advance, the bears retreat and regroup at the next resistance. There, more bears enter the market in hope to overwhelm the bulls in a larger number to push the bulls back down toward support. Bulls regroup at support with the goal to push the bears back up towards resistance again. It is a cycle that appears in all markets.

What is being exploited for profit is the dominant trend of the market. We do not make money by predicting support and resistance areas, but by catching turnarounds there. Once a trend is initiated after such a turnaround, it is not going to stop right away, but it will continue for an extended period. The ignition will trigger a chain reaction of orders that will predominantly serve the winning army’s interest. In an uptrend, bullish traders are making more and more money while bearish investors need to cover their shorts and reverse their position which, in turn, gives further boost to the ongoing uptrend.

Obviously, those market participants holding long positions will not easily give up their money-printing machine and stick to this position for as long as possible. Same for the former bearish participants who are finally starting to profit, expect the trend to continue. A trader’s fear that the market would turn against him any moment is usually unjustified. The challenging part is to stick with a position through thick and thin until the position is stopped out for good. Prior to this, a trend follower’s job is easier than you might imagine: wait and sit on your hands.

Filed Under: Trader Education Tagged With: , ,

The cat and mouse game of newbie traders

November 27, 2011 By 5 Comments

An ubiquitous urge, particularly among beginners, is to predict how markets are going to evolve in a given course of time. In fact, having predictions subconsciously leads to trading them instead of actual market conditions. They become so inextricably enmeshed with a trader’s bias that objective judgments are not possible anymore.

If I were to review your trades of a given day, I would probably find numerous trades coupled with little proceeds you got from them. Such activity points out that you have been trading an expectation which failed to materialize. Second thoughts forced you to close a position before the market turned against you big time.

While the market wiggles and you take one loss after another, the experienced trend follower has been staying in his position during the whole time. No action was taken at all, but yet the trend follower ends up with a more advantageous position than the one who is being assertive. Why is that so? That experienced trader listened to the market and is thus convinced of his strategy, his bias, his position, his stop, even himself. Be more convinced of yourself. To avoid fearful closing of trades, you have to know why you are opening a trade in the first place, based on objective observation of price action. What is your rationale for going long or short? Every single trade of yours should be planned out with great care.

The majority of traders who begin with futures trading, choose to scalp out of fear and are so focused on the tiny wiggles that everything looks like an opportunity. We witness this behavior in various trading forums and online chats. What’s happening is subjective trading out of gut feel and fooling oneself with regards to progress made. This getting in-and-out every minute never seemed to me a paradigm for success in the long run. Let me attempt to redirect you to the right path if you feel that you still belong to this majority of self-deceiving traders.

The market is a master in tricking the average person. Since one cannot predict markets – or turnarounds for that matter – another plausible explanation for hyperactivity (besides prediction) is that a trader tries to catch up with the market. He missed out on the easy move down and is now at a disadvantage. Consequently, the only solution that he can think of is to buy into every spike, hoping to participate in a big rally. While the anticipated move fails to materialize, he is taking one pounding after another.

This show turns into real comedy after the market has actually turned around. Now the trader is feeling left out all over again. He subconsciously reverses his habit, and keeps shorting on the way higher. He is playing cat and mouse with the market all day long, only to lick his wounds in the end.

What is a Trend?

We need to acknowledge that markets do not move like elevators, but like waves within a current. Uptrends are always interrupted by frequent reactions, whereas downtrends will witness just as many rallies. What we focus on, is the overall current in the shape of trends because this tells us the path of least resistance.

According to the Dow Theory, an uptrend is defined by a sequence of higher highs and higher lows. A downtrend is a sequence of lower lows and lower highs. Look at the ES in the 1H or 4H time frame, for example, and you will surely get a clear picture of trends that you can take advantage of.

If a market is still showing a series of lower lows and lower highs, one simply does not go long in this environment. Buying is a much more challenging proposition because a long position will most likely fail sooner or later. This is due to the strong underlying market forces that are able to break support areas sooner or later.

At some point you may be lucky enough to have caught the bottom, but is it worth it? Let’s be realistic. Even if you did catch the perfect bottom, you have most likely exited prematurely out of fear of another sell-off anyway. So much energy is expended on catching turnarounds, resulting in so little proceeds while you could have it much easier.

Trends take time to shift from bearish to bullish. You will notice a shift soon enough once sellers stop selling where they are supposed to and buyers are cracking a significant resistance area. This all becomes visible in the aforementioned time frames.

Alternatively, regard price action from a psychological standpoint: Imagine yourself in the position of the buyer, then in the position of a seller. What would you be thinking in each case? Would you be contented with what’s happening in the market? What would you like to see to stick with your bias? It is a chess game. This thought process is very powerful because it gives you a more objective view on the market and makes you reflect on the price action.

Listen to the Market

Beginners focus too much on the random moves intraday, than the actual trend in the broader perspective. Trade those, and you will witness far greater success. It is evident that a trader gets confused every single trading day anew. Randomness has no logic, so do not seek logic in randomness. Random profits also create the delusion of progress in your trading. You get random rewards playing craps, too. But that does not mean that you know what the dice are going to do at the next roll.

To escape randomness, you must feel comfortable with holding your position over night, even several nights. It is a common misconception communicated among beginners that you need to close your trade within the same day. Trends last more than a single day. They last multiple days to weeks, sometimes months. Why? Because public sentiment does not shift from one moment to the next but takes a long time.

To trade such multi-day trends, you will need to figure out which support and resistance area is of real importance, and observe the price closely at those areas. They will stand out visibly as a trend unfolds and your eye will be trained to spot them by the time. A break of such zone is a potential entry for a new trade. By trading longer term time frames, you will not trade randomness, but trends that sustain themselves over multiple days. A welcome side-effect is that your broker commissions sink drastically.

Only take action if you observe clear evidence for a reversal. Otherwise you are better off doing nothing and letting the stop-loss order work for you. A stopout should happen where the original reason for your entry is no longer given due to objective observation of price action – not your gut feel.

Filed Under: Psychology Tagged With: , , , ,

What overbought and oversold really means

November 18, 2011 By Leave a Comment

In the trading universe, you often get to hear from people who claim that a particular market was “overbought” or “oversold” according to their magical indicator – sometimes even gut feeling. Oftentimes this message implies to be cautious with new commitments and expect a dirty reversal anytime soon.

Unfortunately, the inexperienced trader all too often interprets an “oversold” condition as a signal to buy into a falling market. If you cannot expect to earn much with the current downtrend anymore, the reward must be waiting on the opposite side, mustn’t it?

Not quite. The general wisdom among trend traders is that as long as a market is falling, support areas are going to give way to the sellers eventually. What appears to be support for a moment will henceforth break for new lows because of an underlying bearish force in the market. This indicates that optimistic market participants are not going to succeed in the long run. It is simply the nature of downtrends that buying into them is a very challenging proposition. You can characterize downtrends as a sequence of lower highs and lower lows in a daily time frame. An uptrend is consequently defined by a sequence of higher highs and higher lows.

Take a chart of the ES, for example, and look out for decisive highs created during a downtrend. As long as visibly striking intermediary highs have not been taken out by the bulls, the trend is still regarded negative. Buying in a downtrend is a fool’s game.

How can we trade an “oversold” market then? If you are in a position already, the easiest answer is to evaluate whether a tighter stop-loss makes sense. Set it to the most recent peak that was formed on the way down to protect your profits, and continue to participate in the current trend. This is the most straightforward tactic I came across so far. We will never know the exact outcome after all.

If you have no position, be on the lookout for promising entry opportunities. You want to make sure that price is smashing through a visible resistance area with momentum. An example would be the break of an intermediate horizontal resistance that is visually striking in the 1 hour chart.

You should not jump into the market or close out a good short position in panic just because some random trader shouts “oversold”. Stick to your trade as long as there is not enough evidence for a turnaround. What can be more painful than a loss is to close out and bitterly see how everyone else continues to profit from the trend you used to be in.

Filed Under: Trader Education Tagged With: ,