While the search for the ideal trading method or system takes up a large portion of a trader's research time, it may be worth noting that, while these are important elements of trading, there is one element which is arguably even more important - knowing when not to trade. During certain market conditions even the best systems can break down, and very few strategies will work in all trading environments. Thus preservation of capital during times of low profit probability is paramount in achieving excellent returns. Profiting handsomely on one, several or a string of trades matters little if the trader continues to trade when conditions do not warrant such action, and the profits are ultimately lost.
TUTORIAL: Stock Picking Strategies
Why "Not Trading" is Important
Experienced traders know when to "sit on their hands." They realize that trading during times that do not suit their trading style can cut deeply into profits, or create a sizable deficit that will need to be regained.
New traders, often in their enthusiasm, begin to trade more as losses mount. Instead of stepping back, they step into the market trying to make back losses. Trading when conditions warrant it is prudent, but it becomes a problem when a trader begins to try to find more trades to make up for losses. Often these trades are outside of the trading plan and are low-probability trades, based on hope and not on solid analysis. (Sound familiar? Check out Tips For Avoiding Excessive Trading for advice.)
Knowing Your System
Different systems perform well in different types of market environments. Some will experience peak profitability in choppy markets, others will perform well in trending markets and others in long-term ranging markets. For each system that performs well in a respective market, other systems may perform very poorly.
Thus, it is up to the trader to know and understand a system, and what type of market caters to the system being profitable. Volatile markets may hurt a "scalper" who generally scalps the markets for small profits but the increased volatility exposes them to a larger risk. A choppy or ranging market will hurt a strategy that attempts to isolate only long-term trends – the environment is likely to trigger multiple false signals.
It becomes imperative that traders are able to decipher when it is a high probability time to trade, and when it is not. High probability times include times when the overall market is exhibiting characteristics that compliment the strategy. Low probability times are when the market is showing behaviors which are not congruent with the system that is to be implemented. The following examples will help visually show how certain environments create high and low profit probabilities using different strategies. Not all trading systems can be discussed, but hopefully the trader can extrapolate from the examples how they can avoid in certain market conditions in order to increase their own profitability (or reduce the amount of losses).
Examples of When Not to Trade
The first example comes from the Dow Jones Industrial Average. The uptrend was strong until late January, 2010 when the trend line was broken. The fall resulted in short-term downtrend. A rally occurred breaking the short-term downtrend line. From the chart we can see a short-term trendline drawn (and one horizontal resistance level), one of which will be broken shortly due to the small price range where they converge.
|Figure 1: Dow Jones Industrial Average, Daily Chart|
|Source: Free Stock Charts (http://www.freestockcharts.com)|
When trendlines are consistently being broken, it can be hard to implement a trend-following system. The time frame covered here is short term for investors, but long term for swing traders. Yet the principles apply to whatever time frame a trader trades on. Markets that are whipsawing but not making new significant highs or lows (for the time frame) show indecision and that a trend=following system is likely to see a number of losing trades if the current dynamic continues. No damage is done by waiting for a clear signal that a trend has once again emerged.
In this case, waiting for a horizontal resistance line above 10,400 to be broken would indicate a higher probability that at least the short-term uptrend is in play. For the downtrend to be renewed in this the market would need to go below the lows just under 9,900. If price remains inside this price range a longer-term trend trading strategy will not make a profit. (For more, see our article on Support And Resistance Reversals.)
Figure 2 looks at the EUR/USD which started a strong downtrend in late 2009. Towards early January, 2010 the selling in the euro stalled and the currency pair entered a more ranging environment. A trader may have been tempted to start range trading this pair during such a time, and a few profitable trades may have been made, but ultimately the EUR/USD was still trending and the range trade strategy would have been short lived on this time frame; the pair resumed its downtrend in late January.
|Figure 2: EUR/USD, Daily|
|Source: Free Stock Charts(http://www.freestockcharts.com)|
In this case, the trader should have marked the range on their chart and been aware of the overall trend playing out. When the range was broken the trader could then exit their range trades (if they had implemented a range trade strategy) and implement a trend trading strategy once the re-established trend was confirmed – downward breakout, pullback and then resumed its move down. For both range traders and trend traders, in this chart example there were points in time where their methods would have experienced low and high probability chances of success. (Learn more in The Anatomy Of Trading Breakouts.)
From these examples we see that it is important to be aware of what is occurring now, but also to be able to transition our strategies to accommodate changing market conditions. This can be done by changing strategies to suit the current environment, or a longer or shorter time frame can be looked at to help us gauge whether we should be trading or not. Traders must know their trading plan and trading systems, and know under what type of conditions they perform well and perform poorly. When conditions arise where they are likely to perform poorly, traders must exercise discipline and cease trading. (For more on this topic, see Disciplined Strategy Key To High Returns.)