Monday, January 02, 2017

Why Context Matters in Trading

Saarinen realized that the effectiveness of a design hinges not just on its individual attributes, but also on the context in which it appears.  We are drawn to many of Frank Lloyd Wright's structures, such as Fallingwater, because they harmonize with their natural environments.  Similarly, we furnish quite differently a home in a modernist design and one that is an American colonial.  

Context matters in terms of behavior as well.  How we behave at a funeral will be different than at a party.  How we speak with a child differs from our speech with a group of adults.  The same words can be interpreted differently depending upon the situation: texts derive meaning within contexts.

This is an important market lesson as well.  Some traders look for "setups", patterns that give them a probabilistic edge in trading, across a variety of market conditions.  As Ivaylo Ivanov points out in his recent book, this is a major mistake.  The patterns that set up in a bull market will be different from those in range conditions.  What makes his text interesting is not just the 10 setup patterns that he illustrates, but the understanding of when each of those is relevant.

Suppose the market opens with a flurry of buying activity, followed by some selling.  We could look at that in isolation and use the pullback to join the upside.  If, however, we step back and see that the market is unable to surmount its previous day's high even with the early buying, we would likely interpret the situation quite differently and perhaps take the opposite trade for a return into yesterday's range.  

Similarly, a breakout from a range that occurs with elevated volume early in the trading day is often interpreted quite differently from a breakout during midday hours.  Early in the day, we have the most liquid market conditions and the greatest activity from large market participants.  Ideally, we want their activity at our back, not in our face.  For the day trader, time of day is an important element of context.

At a broader level, suppose we notice a wide array of risk assets moving higher, including U.S. stocks, overseas shares, oil, high yield bonds, and emerging market currencies.  The macro participant views such "risk-on" behavior as part of a single trade related to global growth and will view the situation quite differently from one in which one of those assets moves higher in isolation.  

Many poor trades result from becoming so narrowly focused on the price action of what we're looking to trade that we fail to step back and appreciate the context in which the action is occurring.  That's like jumping into a conversation wanting to speak what's on your mind without taking into account what's been going on in the conversation to that point.  When we place texts in context, we achieve understanding.  The best trades set up when a smaller picture lines up with a larger one.

Further Reading:  Training Yourself in Pattern Recognition