Sunday, March 22, 2009

Recognizing When You're Wrong In A Trade

Sometimes we're just wrong. We're interpreting price and indicator action one way and the market smacks us the other way. Key to trading survival is getting out of the trade quickly when it goes sour. Key to trading success is using the failed trade to revise your view and formulate new, promising trade ideas.

So let's look at Friday's market. No question about it, I was leaning the wrong way in the late morning as I watched the market between phone calls with traders. If you click on the top chart (ES, 3 minute), you'll see where the X's are that I was looking at a rounding bottom process. The TICK (middle chart) hit its low point between 10:00 AM and 10:30 AM CT, and by the time we approached that 11:00 AM period, it seemed that selling was drying up and we were making a higher low, just beneath the 20-period volume-weighted moving average.

So things were good on the long side: we moved smartly above that moving average, and TICK made a new high on the move between 11:00 and 11:30 AM. We should be able to take out those highs from between 9 and 9:30 AM and stay above our moving average if this idea is solid.

Well, look just one bar later at the bottom chart. We get vicious selling on twice the recent volume and greatly expanded volatility, propelling us below the moving average. What next?

The phrase that goes through my head at these times is "This shouldn't be happening." In other words, if we're picking up buying interest (rising TICK, staying above the moving average), there's no way we should get an influx of sellers and for the market to move down so readily in the face of selling pressure. Indeed, one of the things I liked about the long side was that the little market dip prior to 11:30 AM stayed above the moving average. The selling shortly thereafter ripped below that low and violated something I liked about the trade.

I've learned that the "This shouldn't be happening" thought running through my head is usually a good point to get out of a trade. Instead of gaining confidence in the idea, I'm losing it. I need to fight that "shouldn't be happening" feeling to rationalize staying in the trade. Those rationalizations are almost always losers.

Could it be a temporary whipsaw? It's possible, but what has a trader lost by getting scared out? If a good upmove is to follow, the trader can play an upside break of the 780 level (from which the selling started). By that time, the trader could be looking to test the AM highs and would still have a good risk/reward trade.

But when volume and volatility are going against your trade and violating your levels, more often than not, you want to acknowledge that the market proved your idea wrong and then try to learn from that. Learning to make friends with being wrong is key to long-term success.

Indeed, exiting the long trade with an open mind would prove helpful several bars later, when the downside volume and volatility continued and thrust us below the morning lows in a breakout move. And even if you did not catch that breakout, there was plenty of time to see that bounces were feeble and make money on the downside. But only if you first were able to exit your trade, accept being wrong, and use the trade as information for the next one.

Let's see if some intraday Twitter posts can identify, not only some market ideas, but some points where those ideas prove wrong. Those, we see, can also be times of opportunity. The intraday market posts via Twitter will appear on the blog page under "Twitter Trader" (last five tweets), or you can subscribe to the posts free of charge via RSS.