DIA March 27 quick thoughts (and psychology insight)

Mar 28, 2007: 1:05 AM CST

Today provided a great example of how one day, your system will work and the next day, the system does not. Nevertheless, the insight is that it is crucial to follow your system, rather than take random trades and achieve random results. Compare the 15 minute charts of yesterday and today.


While I trade with more complex information than I simplify here, assume that our system is to take trades in the direction of the market breadth (negative for both days) and (in this case) enter short when price rallies back to the 20 period moving average. Stop is placed beyond the 50 period moving average (or include time stop component). The target is the most recent price swing low.

If this is the case, then four trades occurred (red arrows). The first was stopped out. This could lead to frustration and could cause you to pass on the next opportunity (signal) from your system which occurred the next day (today).

The next two trades were perfect, textbook winners. No rinse, no wash, no gimmics. But what if you passed on these trades, as many of us are so likely to do?

The fourth signal occurred late in the day and maybe you decided to take it because you see the system working now. The outcome of this trade is a scratch, as the trade must be closed prior to the close. The trade could be closed with a slight profit, but the target was not achieved.

Also note that price nicked just above the moving average, and if your stop was too close, you would have been rinsed right before the intended move.

 

Market Psychology Insight!

We have our own way of determining when to enter a trade and where to place a stop, yet our emotions and past experience influence this greatly. As discretionary traders, we have great leeway about how to make these decisions. If we have a proper, established framework, it can become difficult to execute flawlessly because no system is 100% perfect; all systems will have losses (usually to the tune of 50%, which is pure chance).

What happens when we take a signal and it results in a stop-loss? We are less likely to take the next signal.

What happens when we avoid a signal that turned out to be a winner? We are more likely to take the next signal.

In probability theory, avoiding trades doesn’t make logical sense. This is another example of how our emotions influence how we trade, with the result being sub-par results. If you have a system with an edge, you must commit yourself to taking ALL the trades it offers. Doing so keeps the thinking and emotion to a minimum, while statistics and the odds play out in your favor over time.

(Market Education Hint: Notice the possible momentum divergence developing. Price also seems to be establishing temporary equilibrium.)

5 Comments

5 Responses to “DIA March 27 quick thoughts (and psychology insight)”

  1. Alan Says:

    Hi Corey,

    I have the problem you explained, 2 days ago I had a bad day (I was biased short most of the day) and yesterday I was overly caotius because of that.
    One thing I would like to comment. I noticed that I am more inclined to take trend trades, wich is good if there is a trend. But usually I see trend where it isnt one. So I decided to use countertrend tackticks most of the time and switch to trend trading only in cases where is so obvious. In a way I have to go against my emotions.
    thanks,
    Alan

  2. Corey Says:

    Hey Alan,

    I hear you. My strategy is based on trends and momentum – they just make more sense to me as well. Trend analysis can be complex but it really is simplified to higher highs and higher lows (or the reverse). Just eyeball the trend rather than use complex indicators (if you do that) – trust your eye and price.

    As for switching strategies, I’ve done that as well based on what I perceived as market action, but what happens is that the market leans left and by the time you realize the market’s slant and then you lean left, the market is already leaning right and you’re on the wrong side yet again. It might be best to constantly lean left and raise positions when the market appears to be leaning left and go lighter (positions) but still lean left even when the market isn’t – you never know when it might snap back left.

    What this means is – if you try to chase the market through various strategies, you will always be one step behind and out of step (because the market is so difficult to predict). We want to be comfortable and right and want order out of choas. What really works is probabilistic thinking, a strategy with an edge, and committment (discipline) to the system.

    My best to you!

  3. Jordan Says:

    Hi Corey,
    I can certainly identify with the market psychology here. You lose a trade, and then you are fearful of taking the next one, which then turns out to be a winner you did not take. And then the next trade comes along, and not wanting to miss it, you jump on board recklessly and that turns out to be a loser and so the cycle goes on until one is able to break out of it.

    On this DIA chart, I’m not sure if I would have taken the 2nd, 3rd and 4th setup as the momentum was not making new low despite the gap down on opening (though price also didn’t make new low).

    Stocks that have a reasonable gap on open would most likely have a new high/low momentum, but not all would have worked out if one buy/sell when pullback to moving average. Is there other tools or indicators you use to aid in your decision of taking a trade to improve the probability?

    You’ve mentioned looking at market breadth a few times. There are several similar indicators for this (I’m using prophet)and I’m not sure which one is better to use: A/D line (breadth), Advance/Decline ratio, Advancing/Decling Issues, Advance/Decline Line (this one looks different from the rest-not sure why?)

    Thanks,
    Jordan

  4. Corey Says:

    Hey Jordan,

    It really is a vicious cycle and your term “break out” is perfect for describing how to overcome this spiral. Just realize the process and realize you have a good system (if you do) and trade each signal without thinking and without fear (again, far easier said than done!).

    As for the trades indicated, they were not trades I took, but rather existing to validate my point of how you should follow your system. I created a super-simplified system for ease of instruction. The “system” used no indicators other than breadth (for direction) and moving averages (for entry and stops). I am in no way advocating using this system.

    Correct. Stocks with a gap (or indices) often constitute a new momentum high/low and with a gap, odds favor closing the gap and once the gap is closed, playing in the direction of the gap. This would be a pure price play with defined stops as well. It plays off the Momentum Procedes Price principle in its purest form. It is often wise to comapre price and momentum with recent action, though. Always remember no set-up is perfect.

    You are also right in stating that momentum was decreasing (to the downside, as price kept swinging lower and testing lower boundaries, while the momentum oscillator made new higher lows – this is a warning sign at the least). Remember you can still play for small targets with waning momentum, but trade smaller on each reaction and do not get aggressive toward the end (when it is confirmed what type of trend we are in… this is often before the trend changes slightly).

    I do look at breadth, which to me is the ratio of advancing to declining issues on the NYSE (or Nasdaq). In TradeStation, I have programmed a small chart to track the $ADV and $DECL in a line graph. Others subtract these two and arrive at the breadth or A/D issues line.

    I need to study more regarding the Prophet Chart indicators you mention, but I assume the A/D Ratio would be the subtracted (difference) amount between the two (positive or negative) and the A/D Line would be more akin to my plot, but in its own differnet way. I do not use Prophet so I cannot comment at this point on how they set-up their indicators. Check with a help page or explanation page in the program/website for the precise explination.

    Realize also that the Breadth is technically a lagging indicator and is good for overall trend or ‘mood’ of the market for scalping that day. It has many uses, and other traders use it differently (some like to find divergences – like Dr. Steenbarger) and it can be used for longer periods than intraday. It can be compared on daily and weekly charts as well.

    Addendum: Personally, I use the standard settings stochastic and standard MACD at times too. I always have a chart of the DIA or $INDU up on a monitor and follow also SPY and QQQQ (S&P and Nasdaq). I also always view the NYSE TICK, TRIN, and Breadth. I will view the $VIX but only just to glance. I know this doesn’t sound simple, but it really is easier than you might think. You get used to it and things find their place.

    As for not all trades working, that’s fine. If a system or strategy worked 100% of the time, well you know what would happen. No strategy and no system – as well as no indicator or combination of indicators – comes close to 100% accuracy. It’s just a trading fact, unfortunately. Find what works for you and makes sense, and works most of the time (greater than mere chance) and train your eye to identify those opportunities and filter out everything else.

  5. Anonymous Says:

    Hi Corey,

    Yes I am using just price, trendlines and MACD for divergencies, nothing more. When I started trading I used quite a bit of indicators but now I look just for clear higher lows and lower highs entrys.
    Now I am using different kind of entrys:
    1. Higher low & lower high
    2. Breakout trades (it works better for stocks in my opinnion)
    3. Trend trade, entry on support&resistance after a retracement (we have to be in a strong trend)
    4. exaustion entrys in the direction of the main trend (I do not wait for HL&LH to form, difficult to put proper stop loss)

    Some of this entrys work better in rangebout markets and some better in trend markets. I think it is important to read higher time frame chart good so we can decide on what kind of entrys pursue that day. But I agree, it is dangerous to switch strategies.

    best to you,
    Alan