Adjusting Day Trading Strategies For Different Market Conditions

By Cory Mitchell AAA

For active stock traders, having different strategies for different market conditions is a crucial factor. Trends emerge, fade, reverse and ranges develop, all playing out in ever broader trends and ranges, all within a single trading session. Thus, the trader is faced with a choice: trade one strategy and profit only at times that suit the strategy, or trade several strategies that allow them to trade profitably, in an array of market conditions. Different times of the day pose different opportunities and threats, and must be accounted for. Once several strategies have been adopted, it is crucial that the trader know when to implement each type of strategy. (For related reading, also see Day Trading Strategies For Beginners.)

TUTORIAL: Top Stock-Picking Strategies

Three Types of Trading Strategies
For day traders, strategies will generally fall into three types of categories: scalping, trending and ranging. "Scalping" includes all trades where the trader is trying to capture a profit on order flow, such as making the spread, collecting ECN credits or riding the coat tails of a large order."Trending" includes all strategies where the trader attempts to profit from a sustained move in one direction. Lastly, "ranging" strategies are used when the market is moving back and forth between resistance and support; profits are made inside this band, instead of on a stock making new highs or new lows (as in trends).

All traders will benefit from having trending strategies and range trading strategies in their arsenal. These are then combined with scalping strategies, to provide methods which are more likely to be profitable at all times of the day.

Adapt Strategies to Time of Day
The morning, lunch hour and afternoon are very different, and require different strategies.

The morning is volatile and big moves occur quickly. This means a trending type strategy is likely better. The trader may have to aggressively enter (remove liquidity) positions in order not miss out on the largest and/or quickest moves of the day.

The lunch hour, between 11:00 a.m. and 1:00 p.m. EST, is usually a quieter time. The market generally has a more ranging quality to it; moves are smaller, volume has decreased and big money is not aggressively moving stocks. This is a time where traders should focus on adding liquidity at the extreme edges of the established range, or even slightly outside. Trades should only be taken with a very high probability of success. While there are exceptions, most days will not require removal of liquidity to enter positions, during this time. Rather, traders should wait for the price to come to where they want and if it doesn't, don't make the trade. Due to the fact that there is less volume, and trades are likely to last longer than in the morning or later in the day, traders should make sure their reward/risk compensates them for this. Thus, trades will likely be few during this time.

As traders return from lunch and the close is within sight, volume and movement usually pick up. This will occur anytime from 1:00 p.m. EST. Continuing with the noon time strategy of being very selective on entry points, the trader will be wary that trends may once again start to emerge. Breakouts from lunchtime ranges can be swift and aggressive, therefore, exit losses quickly and move to a trending strategy. Patience is still required here. Exit losses quickly and attempt to see where the trend is going, towards the close. Remove liquidity if required, but since moves may still be questionable, add liquidity when possible, until definitive trends emerge. (For more, see 3 Reasons Not To Trade Range Breakouts.)

The three times of day can be summed up by the aggression style that should be used to trade them:

  • Morning – Aggressively join momentum moves that are starting. Removal of liquidity is often required. Use tight stops, as a change in direction can happen swiftly.
  • Noon – Very conservative. Use range trading type strategies. Always try to add liquidity, unless a loss is escalating. Be very patient, let price come to the order, instead of removing liquidity to enter a position.
  • Afternoon – Watch for breakouts of lunchtime range, if there was one. Join trending moves, attempting to add liquidity if markets remain quiet. Exit noon trades quickly, if the price moves against those positions in the afternoon. Look for points where the morning trend is likely to re-emerge or reverse.

When to Shift Strategies
The times of day are only rough approximations; what really matters is noticing when the market shifts from ranging to trending and vice versa, then adjusting to it. When this shift is occurring, is much easier to see if charts are continually updated with trendlines, and horizontal support and resistance lines, as shown in Figure 1.

Figure 1 – General Electric (GE) 5 Minute Chart – July 13, 2011
Source: ThinkorSwim – TD Ameritrade

In the morning, there is high volume at the open, which even increases as the trend accelerates. In order to take part in a move such as this, the trader needs to be aggressive, removing liquidity to get on board with the trend. The trader can add liquidity to capture a retracement, but may miss the swiftest move of the day.

As the day progresses, by 11:00 a range has established, with an upward bias and a false breakout occuring at 11:30. At this point in the day, though, a trader should be less aggressive, adding liquidity and focusing more on a range-type strategy, until the market gives signals otherwise. Volume is declining and false breakouts are a high probability, therefore, this breakout is more likely to be "faded," than to be seen as the continuation of a trend.

TUTORIAL: Economic Indicators To Know

At just after 13:00 the market breaks lower. Volume remains low, so there is no need to get aggressive on entering; however, if the trader is long they should look to exit immediately, as trends can develop quickly after lunch. Through the afternoon the trader combines patience and a trend following strategy, if a trend develops; otherwise they will stay with the conservative ranging strategy, waiting for entries (potentially on pullbacks) into the overall trend.

By drawing trendlines and horizontal support and resistance, the type of environment the stock is in will be much more visible. As exemplified in the chart, trendlines should be drawn and when that trend line breaks down, a horizontal line should be drawn at the most recent swing high and swing low. In this way, we can see if a trend is reversing, or simply entering a ranging period. Horizontal lines can also be drawn during trends at reversal points; this will aid in seeing if the trend is slowing or potentially entering a range. During a range, a trendline can be drawn if price movements are biasing one direction, as we see in Figure 1 from 10:30-11:30 a.m. EST.

The Bottom Line
Day traders can benefit from having multiple strategies for different market conditions. Being able to range and trend trade successfully, will allow the trader to profit more readily, as well as know when to be aggressive (remove liquidity) and when to let price come to them. When trading multiple strategies, a trader must know the times when a particular strategy is likely to be the most useful. By continually marking the stock chart with recent price highs, price lows and trendlines, a deeper understanding of what stage the market is in, will be attained and, thus, what type of strategy to use. (For additional reading, also see Would You Profit As A Day Trader?)

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