A Trading Lesson

I would like to explore the sell off of the last few days. (This is written on July 26, 2007) I had an intuitive sense that a sell off was coming. However, I did not take advantage of it in my swing trading account. I made a rule that I would only trade in the direction of the trend, and the trend by almost any method of measurement, was clearly up when the sell off began. It is fun picking tops and bottoms, but doing so can be harmful to your trading account in the long run. However, my intuition told me to override my rules. I sometimes do, but I try not to. This time my discipline won, but my trading account didn’t benefit.

Sometimes intuition is so strong it is difficult to not bend those rules. The art of trading probably depends on knowing when to bend the rules.

The stock indexes over the last few days are a good example of a time when the rules should probably be overridden. There was enough evidence. I pointed out some of the evidence in the blog on a daily basis, but still made the case for the overriding trend to re-emerge and look to buy pullbacks.

Winning trades seldom teach a trading lesson. Losing trades are much better teachers. For me, missed opportunities, even if they couldn’t be taken by my trading plan, are even stronger teachers. I look for ways I could have justified bending the rules, or making new rules to allow for certain trades to be taken against the trend. I hope to explore these lessons as they occur in the future.

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The above chart is the Diamonds ETF, which is based on the Dow Jones Industrials. I chose this to start, as there was much attention on the Dow being at the 14,000 level, which is the level of those little spikes up, within the magenta colored circle. As you can see, the trend, as represented by the channel lines and regression curve, is firmly up. The topping formation through June was overcome as the market broke out to new all time highs. My short-term momentum index below the prices crossed down right in between those two peaks. The red down arrow corresponds to the red dot on the basis line of the indicator. It paints a dot when the indicator reverses on the same side as the signal line (the white line). A divergence between price and this indicator would have been a better pattern, but like most oscillators, they made highs along with price, confirming the upmove. The uptrend preceding the top was made with smaller and smaller bars, and there were three indecision bars with very small candle bodies. Finally today the swing point indicated by the blue line was broken. The long tail might indicate a washout with a bit of a bounce. Most formations like this bounce a little and then re-test the lows before a meaningful upmove begins. That, of course, doesn’t have to happen. The market can do whatever it wants to. But there have been many instances in the past where these long tails encourage a little buying, and then a re-test.

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Of more influence to remain looking for long entries was the more bullish position of the Nasdaq 100, as shown here via the QQQQ. The up trend here was more pronounced. The oscillator turned down a day ahead of that upthrust bar at the top of the magenta circle. Some traders think that the overall market is healthy if the Nasdaq is in the lead. That was obviously coined in the1990′s. Every market should be treated independently. There is no logic or reason for intermarket analysis. If the Nasdaq is strong, then one should be long the Nasdaq. If the S&P or Dow is weak, one should be short those. One market should not influence the other. Of course, that does not conform to conventional Wall Street wisdom. Trading rules based on intermarket relationships that are 10 years old have no relevance in today’s markets. It’s best to not let such things influence trading decisions. It’s hard to not let them seep in, though.

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I posted this chart on the blog as it was developing a few days back. The divergence between the S&P and the advance-decline line was really screaming to sell. I noticed a similar divergence back in the late 1990′s, but it took many months of divergences before the market finally rolled over. These divergences are good warning signs, but they should not be acted on without other confirming indicators.

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Here is a chart of the Diamonds again, this time with the double stochastic, which I use to determine where we are in the very short-term cycle, and for overbought/oversold zones. Part of the problem with be confident in this downturn was that there were very few momentum divergences. Not that trading divergences by themselves are a good idea. They just add confidence. Just a piece of the puzzle. The advance-decline line was one of the few major divergences that I saw. But there was a very clear divergence in the white line on this chart. The white line is the 5 period double stochastic, which is half the period of the longer term black line. When it diverges from under the black line, as it did here, there is usually some follow through to the move. I didn’t think there would be as much follow through as there was. There was even a little head and shoulders formation with neckline break on the 10 period double stochastic (the black line).

Trading is a long journey of learning. It takes years of seeing patterns over and over to get to the point where you can respond to them with trust and without hesitation. While trading plans are important, they must be flexible. They must be revised as more and more patterns are discovered, tested, and incorporated into your plan. This is an ongoing process. There is no endpoint where the work is complete. The markets are dynamic and changing. It is dangerous to get into a rut of old ideas and inflexible rules. Still, one must have a trading plan. Most traders don’t. And most traders lose.