Know Why You Trade the Signals You Do

Apr 11, 2007: 1:47 AM CST

Do you know the “whys” of how you trade?

What I mean is, when you take a signal, do you consider why you are taking that signal? When you exit, do you know why you do so?

On the surface, you might say “I enter when I perceive prices moving a certain direction, and I want to flow in that direction” and “I exit when I feel the move will no longer continue, or the move did not unfold as I expected.”

That is exactly what you should say. But do your trade entry and exit signals say this at a deep level?

Let’s assume you use an oscillator to enter trades. When the oscillator reaches a certain value (oversold/bought), then you will enter. But what does that oscillator value really mean?

If the RSI is reading 20, it may mean that the market is “oversold” and due to rebound back up – but you cannot take this (or any) signal in isolation.

Ask: “Does this signal tell me information about the most likely price movement?”

In fact, a better question might be: “Will this new information cause traders to alter their perception of the current environment and switch their positions as I expect them to?”

In other words, if you are expecting a price reversal to the upside, think a minute about what is likely to CAUSE that price reversal.

Is it because an indicator hit a certain value? Probably not.
Is it because a market hit a certain level, be it a previous support zone or moving average? Probably not.

Prices move because traders – in aggregate – reach certain conclusions at different times. Where one is buying, another is using the exact same price for selling. What matters is the aggregate decisions of all participants at a specific price level or zone. If a signal works, it is because enough traders perceived it and acted on it to cause the movement, and disturbed the market balance of supply and demand.

When price reaches resistance, some may sell their position, others may enter a short trade, others may hold because they have not identified potential resistance, some will buy because a fundamental or news reason has occurred (which has nothing to do with technicals), some may buy early, anticipating a breakout, others may buy because they cannot take the pain any longer of mounting losses in a short position, and various other esoteric reasons.

Each person – or groups of traders of like-mindset – will put buying or selling pressure on the market at a given price, and the true “battle” between seller and buyer will move prices. Some will enter and the market will move against them and be proven wrong and exit. Some will enter, be proven right, and enter a larger position.

Conclusion:

Price movement occurs as a result of a complex interaction between buyers and sellers for reasons that are often unknown. It does NOT occur because an indicator said price would move a certain way. It does not move because the ADX is low, the Stochastic is oversold, the MACD is crossing, or the market has pulled back to a moving average.

The next time you take your trade, identify possible forces that will work to support your trade idea and forces that will work against it. See if you can anticipate the winner of the “battle” between buyers and sellers at a given price and if you think and analyze deeply enough – and capitalize on the side that is losing – then you should improve the accuracy of your signals. Always think of others.

4 Comments

4 Responses to “Know Why You Trade the Signals You Do”

  1. Alan Says:

    Hi,

    Just one short comment.
    Recently I read something that sounds very true to me. Apparentlly 80-90% of price action is credited to stop loss execution. It is not that traders come to some conclusion, in most cases they are forced to act. Feer is much stronger than greed.

    Alan

    P.S. I apologize for my bad English.

  2. Rahul Says:

    The way I look at it is that people (I would have said “I” but I don’t really use indicators for trade decisions, not yet) use indicators for the very reason that it is extremely difficult to do what you are suggesting be done.

    I agree with the first paragraph of your conclusion and general tone of the post that indicators don’t move prices so don’t hold them as be all and end all. But what you are asking to do in second paragraph – I wish I could do that or find someone who could do that. Because identifying all possible forces that will work to impact prices cannot be practically identified, there is reliance on indicators to provide a map of possible paths the price can take.

    Rahul
    http://www.tradernirvana.com

  3. Corey Says:

    Alan,

    Thank you for your comment. I don’t know that I would say 80% of action is stop-loss behavior (because some traders – both professional and beginners – trade without them), but I would agree that a large percent would be. I’m not even sure it would be 50% but I will look further into the topic to see what I can find. I do know that “games” are played and some traders (myself included) have developed strategies that seek to take advantage of failed patterns where the majority of (new) traders will enter and place their stops in masses, and when the “mass stop placement” zone is reached, the trade (price action) continues quickly as expected (but not before the “rinse or wash” of stops).

    Traders also initiate positions with stops, as well (buy market or buy limit stops).

    You are correct that fear is much stronger than greed. Look at the recent market declines. They say the market takes an escalator up and an elevator down. It’s true (from my experience). Price falls much faster than it rises (which is why many professional traders prefer the short side). Fear and shock declines (or gaps) certainly force traders to act, you’re right. And it is also my experience that many beginning or even novice traders act (enter or exit a position) when forced to, and not by choice. What I mean is, they let their emotions (and interpretation of price action) dictate their entries or exits.

    Think “The price has fallen too low. I can’t take the pain anymore. I must exit” or “The price has risen so quickly! It will keep rising without me. I just have to buy now!” And you can guess what happens next (right – the market reverses on them and the cycle begins again).

  4. Corey Says:

    Rahul,

    Indicators simplify the choices and the data, and (when used properly) ‘indicate’ facts that are already there in the pure price movement. You’re right – analyzing the whys and hows behind price action is difficult and often unknowable in total. There are so many market participants taking positions for so many reasons (both good and bad) and what matters is the aggregate.

    What I mean by the second paragraph might be illustrated in an example. Assume price is now reaching resistance and has achieved a “Technical Decision Node” and MUST either break-out or fall back down into the range (thus, truly acting as resistance). Indicators may call the price “overbought” and a “slave” to indicators will enter a short trade (or exit a position that is held). But what is really going on? Traders on both sides are betting simultaneously for resistance to hold or break, and the indicator has little to do with it. In fact, some may be taking a position with no regard at all to the price action, but for a news related event.

    Anyway, if price breaks out of the range a bit, stops will be triggered (for losses) and also for entries. New traders will take positions. What happens if price breaks out and then falls back down inside the range? A lot of people will be underwater (and simultaneously, others will be profitable). Traders with low risk tolerance (who bought the breakout) will “puke” their shares and stop-losses will be triggered. At this point, if you anticipate the what people were thinking when they bought AND what they are thinking now, odds now favor a test of the lower range (support) because people will be slowly “puking” their shares for losses (as Alan just indicated, fear motivates people more than greed).

    This is why failed (or busted patterns, as Thomas Bulkowski calls them) chart patterns can offer much greater risk/reward (or pure price movement) than pure patterns. It’s because the CROWD entered at one point and price moved against them, and now they will reach ‘reality’ at different times and will begin selling while others (professionals… kind of like vultures) see the defeated crowd and short the stock (which drives it lower still) and exacerbates the process and their losses (causing more to sell).

    Does it work all the time? No, but anticipating not only what most people are about to do IF price reaches a boundary, or IF an indicator renders a signal can be helpful especially when price action moved in favor of the indicator and then suddenly reversed. It can create pockets or vacuums of price movement.

    I guess my point is “don’t be a slave of indicators” and think ahead of the crowd. You’re right – doing so is quite difficult, but achievable through experience.