Saturday, October 29, 2016

When You Trade With Flexibility, You Won't Get Bent Out Of Shape

When we trade with confidence and conviction, we run the risk of becoming a stiff tree in Bruce Lee's terms.  I find that successful traders are cognitively flexible, able to bend with changing winds.  Traders often lament that markets are choppy.  In many cases, the real problem is that winds are changing more quickly than traders can bend.  We attempt holding periods of X, when markets are moving to a beat of only a fraction of X.

A nice example of this occurred in Friday's SPX trade.  As longtime readers know, there are three things I find important to focus upon in the market.  Those include an assessment of who is in the market and which way they are leaning.  Two of the ways I measure this in the trading model I created is the total number of upticks and downticks among all listed stocks in the market (a measure of institutional participation) and a measure of "pure sentiment" that adjusts the put/call ratio for recent price movement and volume.  Interestingly, both were elevated on Friday:  we had increased institutional participation and this participation was significantly bearish.  Since 2014, when this has occurred, the next five days in SPY have averaged a gain of +.62% versus an average loss of -.07% for the remainder of occasions, with 65% of occasions resulting in a winning five-day period.

Indeed, stocks did bounce later in the session and we'll see how they fare this coming week.  The important point is that knowing what to look at told the trader that the odds in the market had shifted; that a downside edge that might have been there the day before was no longer a downside edge.  The inflexible trader, not reading this shift, might end up frustrated, convinced that the market was being "manipulated" and not allowed to drop.  The reality is that the odds in the market had shifted because new, large participants were bailing out.  That bailing out tends to attract value participants who treat the lower prices as great buying opportunities.

Too many traders think of their edge in markets as a fixed thing.  Rather, edge in markets is always waxing and waning, depending upon who is in markets, what they are doing, and the time frame of their activity.  When we view edge dynamically, we are able to be flexible and bend with changing market winds.  It's the inflexible bull or bear that is most likely to break.

Further Reading:  Controlling Emotions is NOT the Goal of Trading Psychology