Friday, February 20, 2009

Learning From Good, Losing Trades

The top chart (click for detail) is a three-minute chart of the ES futures. You're at the 13:12 PM CT bar and you observe that we're in a downtrend. The trend of the NYSE TICK has been down; VWAP (40-period MA) has been downtrending and price remains below the 761.75 level from which a high volume decline launched at the 11:48 AM CT bar. The market has bounced, volume has pulled back on the bounce, so you decide to sell in anticipation of at least a test of the day's lows. At 759.25, you're risking 2.50 points in hopes of making at least 6.75 points on a retouching of the day's low. Not the worst trade idea one could generate.

Now we advance one bar and we see in the bottom chart (click for detail) what happened. The market has screamed upward on volume that has more than doubled the expanded volume on the market decline. Whether it's the President reassuring the market about bank nationalization or a surprise news or earnings announcement, these rogue events are apt to occur from time to time.

You've had your stop in place and your risk/reward set, so you're blown out of the trade well before the three-minute bar is complete. It's frustrating, but hardly something that needs to ruin your day or week. You compose yourself, pull back from the screen briefly, and return to watch and size up your opportunity.

Another trader did not set a stop. He watches as the bar expands away from his entry, hoping for a pullback to break even. The market marches ten full S&P points against him before the hour is up. That can easily wipe out a day's or week's worth of effort, leaving him in a bad mental state to start next week.

A third trader sees the stop hit on expanded participation from large traders. The market is now soaring above the point where significant selling had begun, so the trader concludes that this is a major shift in demand. We've seen the day's low, he concludes. He waits for the first pullback in TICK, notes the reduced volume on the pullback, and buys the market around 765. He is rewarded with a near-immediate gain that more than offsets the loss on the first trade.

The failing trader does not set or honor stops and is left with a deteriorating position. The good trader sets a stop and limits his loss. The excellent trader extracts information from the losing trade to generate profits.

A losing trade is not necessarily a bad trade. When markets don't pay you for a good trade, they are telling you something important. It's difficult to listen, however, if you're holding the loser or consoling yourself about the loss. It's the trader who quickly accepts the loss that is able to stay market-focused, learn from the reversal, and find the next opportunity.