Thursday, June 25, 2009

The Most Common Mistake I'm Seeing Traders Make

I performed an interesting little exercise with data for the S&P 500 e-mini (ES) futures this morning. I looked at 3-minute bars and calculated a ratio: the absolute value of the movement from open to close to the total movement from the bar high to the bar close.

Think about this for a minute: What we're looking at is the ratio of directional movement per three-minute period to total movement.

The median ratio yesterday was .50. The ratio did not change after the Fed announcement. Total movement increased as volume increased, but directional movement stayed as about half of total movement.

If you're more visual, think of a candlestick bar on a chart. On average, half of that bar will be filled in; the other half will be "tails" above and below.

When traders buy into strength and sell into weakness, they tend to enter positions in those tail regions. Much of their trade is occurring during the half of price movement that is not directional. How much P/L does that cost them over time, chasing strength and then chasing weakness? So often, traders who are afraid of missing moves end up seeing those moves reverse.

It's the most common trading problem I'm seeing active traders make.