Rhythm is important. Without the rhythm of the tides and seasons, there would be no life on Earth. When the rhythmic pulse of our heartbeat, breathing, or neural activity is disrupted, we suffer greatly. Rhythm moves in us and through us, and we know it–children in Brazil beat samba rhythms at play, there is pleasing regularity in the rhythmic bounce of a ball, the guy in the suit waiting on the subway platform taps his toe to some unheard beat–even the throaty rumble of that train drives a relentless rhythm in the dark of the tunnel. The market has a rhythm, too, and one of the keys to successful trading is being in synch with the market’s beat.
Today, stocks sold off. Yes, there were several explanations and potential catalysts, but many traders had sensed a breakdown was coming. Looking objectively, momentum on shorter timeframes showed the market was “going down a lot easier than going up”, but there were also many subjective factors: Buyers seemed to be stepping away from bids. The market felt jittery, as the underlying buying conviction seemed to fade. For weeks, I had been advising my research clients to initiate hedges, put on shorts or offsets, and to have a clear plan to manage the risk in long positions–we had also entered a short in German stocks last week, and had no potential long entry in stock indexes.
Days like today (10/1/14) get a lot of attention in the media and generate social media traffic through the roof. Everyone is talking and everyone has an opinion. However, most traders find success by stepping away from that noise. You have to execute with the rhythm of the market, and to look to rush and short on a day the market is declining, well, that only works for nimble daytraders. This is very important, though it is perhaps a slight oversimplification: in general, swing traders need to be selling when everyone is talking about buying, and shorting before the move is apparent in the market. We get paid for being a little bit ahead, and it’s possible (sometimes, not always–remember, markets are very random) to feel the groove of the market.
Reading the rhythm of the market is not so difficult, but executing around that structure takes considerable skill, iron discipline, and a kind of mental flexibility that is almost unique in the human experience. Expect to be wrong often; being wrong cannot generate anger, frustration, or fear because those emotions will throw us further out of synch with the market. Being wrong is perfectly fine, but staying wrong is fatal.
So, what now for the market? In general, we should expect markets to reverse and to recover much of a drop like that. Bearish sentiment is rising, and technicians are pointing out broken trendlines, “levels”, ratios, and making dire predictions of the coming crash. The cynical trader ignores all of that, and focuses on discipline. Maybe he starts looking for certain patterns that could generate long trades, and sees how they play out. Maybe he takes some profits on shorts, tightens stops, and reduces exposure. Almost certainly, he is watching for that next bounce, knowing the character of that bounce (quick and sharp snapback? If so, look out new highs! Slow and reluctant recovery? Probably a consolidation setting up another breakdown, and could be soft into first quarter 2015…) will tell us a lot about the next steps.
If you are troubled by the market’s movements, relax. Step back, out of the noise. Focus on the message of the market, and find the rhythm. Let the market take the first steps–and maybe we can hope to dance a few steps before the tune changes.
Thanks for the great article!
If I look at the ES Dec14 back adjusted on a monthly timeframe I see an extreme bullish market for more than 2 years which looks quite overextended and could make a retracement which might offer long entries. The weekly TF looks like a Pullback structure even though it shows momentum divergences (which has it shown many times before only to stay on the long track). But on the daily TF the daily candle on Sept. 19 and the candle on the following monday look like a Failure Trade structure (especially in hindsight 😉 and we might see now the first pullback which could set up a short which I would not trade cause it is contradicted by the long pullback context on the weekly TF.
In my experience contradictory patterns on different TFs offen result in a kind of balancing or noise which is not an easy trade.
I certainly agree… there’s no easy trade here. There’s potential for a 200+ handle pullback in the S&P, which is just fine based on the larger monthly trend, but that would mean being down for 3-6 months, and would shift much of the sentiment to bearish. No easy trade, exactly as you said.
Adam,
one point concerning the latest market pattern you described: it is my observation that patterns stop working once they become obvious to everybody. It is of course impossible to predict when a patterns stops to work, but the latest rhythm seems to be very obvious by now. Wouldn’t it therefore make sense to take a more prudent approach and simply not buy this pullback?
It’s so easy to overthink… maybe what you say is true, but I don’t know. Maybe there’s a difference between buying to cover shorts and buying long? At any rate, there is no easy, obvious trade here.
Good article, Adam. How does a trader bounce back after they fall out of rhytm and sustain 4-5 consecutive losing trades? Some were because the system simply did not work and others due to errors. Due to strict money management, the account hasn’t been too affected but the psyche has. What are your thoughts on how to shake it off and ease back into it?
Dan, you can use classic math or simply Monte Carlo analysis to gather your own numbers, but for a system with e.g. 55% win ratio and 500 trades per year you can expect a loss streak of 4 in a row more than 20 times per year or 5 in a row more than 9 times, i.e. about once a month. Personally I’d expect even higher numbers as your trades may see a certain correlation. If your win ratio is lower expect this number to increase extremely.
Feel happy and thankful for your money management and focus on erasing the errors. Also, I would not call it “the system did not work” but rather “the trade did not work” – unless it is really the system…
I know it is easier said than done…
Fair enough. Thanks for the answer. Having the statistical backdrop definately helps keep things in perspective. The rest is up to sound judgement and avoiding dumb mistakes.
Yes, I’ve always found understanding the statistics to be critical, but it simply comes down to doing that right thing. Just follow your rules. (The answer to most trading problems (assuming you have a system with an edge (and most people don’t!))) is just that: simply follow your rules.