Trading Best Practice
Trading presents many challenges. One of the greatest challenges is accepting and operating in trading’s environment of risk and uncertainty. When we do this, we are engaging in a trading best practice.
In everyday life, many things appear routine and commonplace. Our days go by generally consistent and orderly. If something unexpected happens, we tend to view it as a ‘surprise.’ If we do think about the probabilities surrounding that surprising event, we judge it as unusually bad luck and a momentary anomaly. Things will soon return to ‘normal.’
We Don’t See the Risk
We fail to see the randomness of life and that surprising events could have occurred at any time and that we are constantly at risk (albeit a low risk). Take, for example, driving a car. The everyday risk of driving seems very low. We get in our cars, go to work, go shopping, or go out for dinner and think little of the risk. If we do have a car wreck, we see it as an “accident” – it happened at random, a fluke. It was not a normal occurrence.
Trading Is Different
Trading forces us to change our perspective on probabilities if we are to be successful traders. Every day we trade, we leave a world where surprise events occur infrequently for a world in which the unexpected is the norm. Mark Douglas pointed out that “every moment in the market is unique” and “the market can do anything.” What he meant is that market events are more random and difficult to foresee because we never have complete information and market participants are constantly changing. Thus, the same trade setup that worked perfectly yesterday may easily fail today.
There is Always a Probability of Loss
The key idea is that in every trade we make, we always have a level of risk that is certain. This is very different from our day-to-day lives where risk seems infrequent, temporary, and arises in an “accident.”
Mental Skills Important
Reducing risk in trading’s uncertain environment requires strong mental skills and awareness of common mental traps. Overweighting recent events and believing they factor into the current trade is one such mental trap. A string of winning trades, for example, may make a trader feel bulletproof and lead her to think an increase in position size is warranted when it is not. Not only is risk increased but probability is ignored. The trader is operating like they do in the everyday world. Concern for risk evaporates. The fact that every trade has a certain probability for loss is forgotten. When the supersized loss occurs, it feels like an accident.
Align Yourself with the Probability of Market Movement
Knowing the common mental traps is essential. Knowing how to put yourself in harmony with the probabilities of market movement when taking a trade is equally important. This means taking trades consistent with background conditions, knowing what the next market move is likely to be, identifying the “danger point” and entering as close as possible to that point, and understanding what needs to happen for your trade to work.
Understanding background conditions means knowing market structure and where and how price is currently trading within that structure. When price is showing signs of weakness at known resistance as seen in the accompanying chart, for example, the savvy trader is alert for signs of a market reaction. A downturn becomes more likely than a continued rally. The question now becomes: Are buyers exhausted and will sellers step in? How will this unfold?
As the trader watches the market push up towards the resistance highs and sees little volume behind the push, the sign that buyers are exhausted is recognized. The danger point is identified (i.e., just above the resistance highs). The danger point defines the risk. Should price trade and close above this level, the trade is cancelled.
Enter Near the ‘Danger Point’
Price action around the danger point shows not only are buyers unable to advance price higher, but also sellers are stepping in. The likelihood of a reaction has significantly increased. Trade entry occurs near the danger point as sellers obviously push price down and price closes under the resistance highs. The path is clear for a drop. This is the line of least resistance and the most likely next move in this market. Price then falls with sellers clearly in control.
The above trade shows how a trader can assess the signs of buying and selling to understand where the probabilities of the next market move lie. The trader seeks signs of buyer verses seller control near the edges of market structure where a reversal is likely and the danger point can be defined to reduce risk.
By assessing the market in this way with probabilities fully in mind, the trader reduces the potential for loss by avoiding low probability trades. We never have complete information and can never be certain, but we can put the probabilities on our side by paying attention to market structure, who has control, the danger point, and what the next move will look like.
A version of this article originally appeared in Synergistic Trading, a feature of TraderPlanet.com. You can see the article here: Synergistic Trading