Lessons from the Pros

Knowing Your Trading Environment is Half the Battle

One of the most important aspects of learning how to trade profitably is being able to discern the type of trading environment you’re looking at. In class, I stress to students that identifying whether the market or stock they’re trading is trending, range-bound, or choppy, is half the battle. In addition, one must be aware of levels of volatility in order to calibrate stop losses.

In my experience, many new traders have a hard time distinguishing between these distinct trading patterns and conditions. Moreover, this inability leads them to trade with less than favorable odds, and to use strategies not suited for the specific setting.

One example would be when a trader that considers himself a trend follower doesn’t show the patience to wait for a trend to develop, and ends up losing money because he trades in the "Chop" (sideways phase). Below is an illustration of what chop looks like. Its main characteristic is the lack of any strong follow-through in any direction.

What makes this pattern particularly challenging is the difficulty in pinpointing support and resistance levels. Trend-following methodologies in this environment carry with them much lower probabilities of success. In general, this type of pattern is tough for most traders, consequently, it would make sense that we learn to identify this inhospitable environment quickly while losing very little money in the process.

On the other hand, in the chart below we see discernible levels of support and resistance (otherwise know as channels). These price points constitute the lowest-risk entry points in range-bound markets. When these channels begin to form, the inflection points give us more to sink our teeth into, which in turn, enable us to judge with better accuracy where our limit orders, with close stops, can be placed. Unfortunately, the majority of new traders either aren’t skilled enough to identify these points, or simply lack the patience to wait for these lowest risk entries.

The tactics used in the above example (buying support and selling resistance) are not likely to work in a strong trending market. As we can see from the chart below, in a strong upward trend, the higher likelihood is that the resistance levels will be breached; therefore, only buying on support levels as opposed to shorting at resistance, would be the favored course of action in this example.

The opposite would be true in a strong downtrend (shown below). As we can see , support levels are easily taken out when momemtum is to the downside.

One caveat though: An intraday trader shouldn’t be focused solely on the near-term trends (3 to 5 min time frames) as what usually will reverse a short-term trend, will be a longer term (15 to 60 minute support or resistance). So it is essential that one not neglect looking at the longer time frame.

Case in point, the TF (E-Mini Russell 2000) intraday chart above, is that of a trending day (lower) Oct 15. If we reference the hourly chart (below), we notice that there is a major support level going back to October 10. This would give an indication that perhaps a near-term trend reversal could be in the offing, as a major support would act as a repellent to further selling. This obviously did hold here and eventually bounced off the lower end of that range once more, before finally breaking it.

In starting your trading day, one of the first things that should be done is to look at what type of trading pattern the Globex (overnight) market, as well as the prior day, has exhibited. Was the market trending overnight? Are we approaching a support or resistance level on a bigger time frame? Did we have a big trend yesterday? If the answer to the latter is yes, then odds favor a consolidation day. If you’ve had a string of consolidation days, then expect a trending day to be forthcoming, and so on and so forth. Getting better at identifying market behavior will take some work on your behalf, but once you get good at it, it will make it somewhat easier to pick the right tools for each scenario. What’s more, the decisions to not trade will also become a viable option, because on some days, to not trade may be the best trade of all.

Until next time, I hope everyone has a profitable week.

If you have questions, comments or you’d like a specific topic covered, please email me at gvelazquez@tradingacademy.com

- Gabe Velazquez