Tuesday, December 29, 2009

More On Planning Trades and Mental Flexibility

My previous post outlined how I use price levels to set targets for trade ideas. Note how, in the opening minutes of trade, we could not muster any significant buying interest, as we had already come off pre-market highs. At the time, I noticed deterioration in several sectors, in the intraday advance/decline line, and among the euro and Aussie dollar vs. the USD. All of that suggested that, like yesterday, the bullish context was breaking down.

As a result, my trade idea was to sell the S&P 500 Index (above) for a move back to yesterday's pivot level of 1123.50, which was also a high volume area for yesterday's trade. I sold during the 8:34 AM CT minute at 1126.25 and then watched the market move promptly in my direction by about a point and a half. Volume was light on the move, however, and the NYSE TICK never went significantly negative.

I actively considered taking a profit at that point, convinced already that we were facing a slow, pre-holiday market. After a moment, I decided to hold for the original target but not add to the trade.

Almost immediately after, we bounced in stocks, and the U.S. dollar bounced firmly against the Aussie dollar. We also got a nice bounce in gold and oil. NYSE TICK also hit a morning high, although it was not a very high level. At that point, I changed my plan and decided to exit on the next market pullback and take whatever profit the market afforded me. My usual criterion for such a "next pullback" is the next move in TICK back to zero.

We got that pullback in TICK at the 8:49 AM CT minute; I waited to see if we would get any follow-through selling. That didn't happen and I worked a bid and exited at 1125 at the 8:50 AM CT minute.

It was very similar to yesterday's posted trade: quickly changing a plan on the fly when market conditions didn't stay in favor of the idea. We did, later, pull back to almost hit that pivot target, but both volume and the restrained range of NYSE TICK told me that this was not going to be a morning market that would sustain significant movement. That diminished the risk/reward benefit of holding the trade to the target.

Once again, we see that short-term trading involves a high degree of preparation and planning, but also the ability to adjust plans on the fly. In that sense, the trader is not unlike the battlefield commander or the football quarterback: it's important to have a battle plan or a game plan, but it's also important to know when to scrap that plan or call an audible at the line of scrimmage.


George said...

Short-term trading takes considerable mental flexibility. At 8:45 AM CT, I'm in the trade; at 8:47 AM CT, I'm liking the trade; at 8:49 AM CT, I'm not liking it and getting out. I don't wait to get stopped out; if the market is not doing what it's supposed to be doing, I get out proactively. [bold emphasis mine]

On a number of occasions, you have talked about Henry Carstens and his website, Vertical Solutions (VS). There is something Henry posted on the VS site called The Axiom of the Small Edge. It states, in part:

The Axiom of the Small Edge and The Postulate of Trading the Small Edge say that what really matters in money management is that a trader always be prepared, always be able to hold a position with a positive edge that goes against him, and always be able to take the next trade. [bold emphasis mine]

The mental flexibility you are talking about runs counter to what Henry is talking about in The Axiom of the Small Edge. Isn't mental flexibility just a nice way of saying that you second-guessed the original analysis that put you into the trade in the first place? And isn't that just a nice way of saying you got scared out of the trade? And isn't that one of the big issues in trading -- getting scared and pulling out of trades early?

As I understand it, once you have a win:loss ratio and a risk:reward ratio that gives you a positive edge, working that edge requires staying with the trade until the original stop, or the original price target, is hit, as Henry suggests. Early exits will skew your win:loss ratio and quickly erode your edge because you won't always be able to turn what would have been losers into small gainers (as you did). You will also turn what would have been winners into small losers.

How do you resolve the two approaches?

Brett Steenbarger, Ph.D. said...

Great question, George; I'll be devoting a blog post to the topic later today (12/30). Thanks--