Wednesday, January 22, 2014

Trader Psychology: The Importance of Knowing When to Trade, and When to Stand Aside

Traders usually have expansive dispositions; they tend to be ambitious people who are seeking more from themselves and from life.  Generally speaking, I think that's a good trait: after all, one doesn't get very far in life with little or no ambition.  However, like most personality traits, there's a positive and negative side to ambition (incidentally, have you ever noticed that your spouse is exceptionally aware of the negative side of every single one of your good traits?  For example, your friends say you're "tenacious," but your spouse says you're "stubborn.").  Anyway, one of the dangers of having an expansive disposition is that not every problem in life can be solved by an aggressive push forward.  Some problems require us to wait patiently, while others actually require us to retreat temporarily.

Markets must be approached with those options in mind.  Sometimes the best trades are the ones you don't make -- and (as I've been known to remark on occasion) cash is a position, too.  Sitting idly by can be an incredible challenge for those of us who are used to accomplishing our goals by pushing ahead through sheer willpower.  Yet no matter how great our willpower or personal fortitude, we cannot force our accounts to increase every moment of every day without pause.

Like most things in life, there is a time and a season.  We wouldn't plant crops in the winter and still expect them to grow (well, okay, out here in Maui we do -- but you know what I mean).  In trading, there is a right time to expand capital and a time to preserve capital.  A big part of successful trading is learning how to tell the difference between the "seasons" -- and then an even bigger part is having the discipline to take action or stand aside in accordance with the time.

We can draw analogy from the physical world:  Think of your account like a solar panel which, instead of sunlight, collects money.  When the market is illuminated and direction is clear, then that energy can be harnessed to grow your account.  Capital can and should be expanded in those situations.  But when the market is dark and hazy, there is simply no energy coming in and nothing can be done.  Capital cannot be expanded during the dark times -- at best, it can be preserved for the next moment of clarity.  Getting frustrated and climbing up on the roof to smash the solar panel with a hammer because "it's not working anyway" in the middle of the night isn't a solution that understands reality.  The panel still works just fine -- once the sun rises again. 

If we fail to acknowledge the reality that there's a time for action and a time for stillness, then our accounts will be a huge roller-coaster of inconsistent ups and downs.  Our trades will be winners during the bright times... but then we'll give most (or all) of that profit back by trying to expand when we should be conserving during the dark times.  Over-trading is as futile as trying to force the solar panel to work at night.

Conversely, if we sit still when we should be taking action, then we also fail to align with reality.  If we don't capitalize on the moment to enter a good trade, we must often wait through an entire cycle before another opportunity arises.  In my opinion, the times just after a missed opportunity are some of the worst moments for traders psychologically.  There's a pressure that comes with the feeling of "missing out," which is why we sometimes find ourselves forcing trades when we should be sitting quietly:  We're hoping to catch up with an opportunity we missed, so as to relieve that pressure.  Yet opportunity in the market comes at its own pace, not at ours.  We cannot "rewind the market" to the position it was in last month for that low-risk trade we should have taken.  And we cannot force opportunities to appear simply by randomly entering trades.  What's done is done, as they say -- we cannot call the exchange and have them "un-ring" the opening bell.   

These are some of the reasons that discipline is so incredibly important for traders.  The market will pull our emotions in every direction imaginable, so if we allow our emotions to dictate our trades, then we'll pretty much take the exact wrong trade day after day until we're flat broke. 

Entire books have been written about trading discipline, so that's beyond the scope of this article.  My main point today was this:  Before you enter that next trade, ask yourself, "Is this the right moment to be trying to expand my capital, or should I be in conservation mode?"  By the same token, when you find yourself acting like a deer in the headlights and watching that next low-risk trade entry pass by, ask yourself the same question.

Moving on to the charts, this remains, in my opinion, an ambiguous market in its current position -- however, I feel we finally have some high-probability near-term levels to watch.  Before we get into that, though -- I've had a number of readers over the years ask what I mean when I say "sustained trade," so I thought I'd take a moment and address that.

Sustained trade has less to do with time and more to do with how price reacts to a given level.  It's fairly easy to learn to recognize what it looks like, and even easier to learn what it does not look like.  The chart below contains several recent examples, and learning to recognize these moves in real-time and adjust accordingly can save one considerable cash over time.

Yesterday the S&P 500 (SPX) head-faked below 1835 and reversed.  It has expanded its boundaries a bit, but near-term, I feel these boundaries now mark reasonably high-probability trade trigger levels.

In the big picture, we still have indicators flashing warning signals for bulls, one of which is noted on the Dow Jones Industrial Average (INDU) chart below.  That said, there's nothing actually bearish about the price action in this chart yet -- it's a chart with bearish potential energy.

In conclusion, I feel SPX has set up some reasonably good near-term trade triggers, and sustained trade beyond those triggers should have above-average odds of reaching the noted targets.  Bigger picture, we still have warning signals in a number of indicators, but (as I've noted previously), this bull market has defied all top calling for a long-time now, so take that under advisement.  I'll continue to watch the price action and patterns for stronger indications of the next move.  In the meantime, trade safe.

Follow me on Twitter while I try to figure out exactly how to make practical use of Twitter:

Reprinted by permission; Copyright 2014 Minyanville Media, Inc.

1 comment:

  1. Pretzel- It's surprising how often your head is in exactly the same place as mine (maybe it shouldn't be, we're both looking at the same charts through an EW lens). I haven't made an ES trade in over two weeks, just haven't seen enough clarity in the market to justify the risk. I suppose there have been some day trading opportunities, but I'm not a day trader, more of a position trader, and what I look for just has not been there. The big challenge now is recognizing a change in the situation when it occurs and then acting on it - as you allude to in the post.