Saturday, October 17, 2009

Proactive and Reactive Trading

When trading ranges are restricted, the amount that intraday traders can take out of any given market move will be limited. This makes execution--the ability to obtain good prices that maximize reward relative to risk--particularly important in choppy market conditions.

I define reactive trading as trading that is impulsive, often initiated by a fear of missing a move that seems to be getting under way. Instead of being guided by a forward sense for where the market is likely to go, the trader jumps aboard moves that look like they're going. More often than not, those moves reverse, leaving the trade underwater and the trader frustrated.

This is one reason why I like to start trades with profit targets, not entry setups. You enter a business venture only if you see significant profit potential: if the big picture isn't right for an entrepreneur, the venture isn't worth pursuing. Each trade is a business venture in miniature: it begins with a recognition of meaningful potential for gain. Only then does the entrepreneur/trader figure out how to pursue the venture so as to limit overhead and maximize profit.

In a range market, and especially in slow market conditions, it is necessary to temper one's expectations. Early in the morning when in a range, I'm looking to see if we are more likely to take out the overnight high or low; yesterday's high or low; the R1 or S1 level; etc. Incoming relative volume helps us understand how much participation there is in the market, which will provide useful guidance for how far we're likely to move.

Measures of intraday sentiment, such as NYSE TICK and the Cumulative Market Delta, will give us important guidance as to the likely directionality of movement.

Together with profit targets, our estimates of volatility and directionality help us frame proactive trades in which we wait for pullbacks from the expected direction of movement to enter anticipated moves to our targets. By defining price and/or indicator levels where our trade idea is clearly wrong and sizing the initial entry with a fraction of one's total buying power, we both define and control risk, even as we pursue profit with an entrepreneurial spirit.

Discretionary trading need not be reactive trading. A good entrepreneur passes up many business ideas before setting forth with a specific venture. So it should be with trading. If you're a developing trader, the links in this article will help get you started.