Avoid The 5 Most Dangerous Market Scenarios For Trading By Zheng Zhang Loh

Traders build profits by identifying market inefficiencies through technical or fundamental analysis and taking risk at the most opportune time. It’s one of the few pursuits in which consistent losing is the natural component of a winning equation. In fact, there are perfectly good trading strategies that produce many more losers than winners, but wealth still grows because the average win far exceeds the average loss.

Most newcomers enter the trading game emotionally and unprepared to lose money, believing they’ll find a perfect profit-making system that avoids the pain of losing positions. Of course, this is impossible given the complexity of market movement, as well as the rabid competition that characterizes our modern electronic environment. Their vulnerability becomes a secondary obstacle as they learn how difficult it is to take money out of the market on a consistent basis. (For more, see: How To Avoid Emotional Investing).

Four Steps To Overcoming Losses

To prosper in trading, the emotional burden of loss needs to be managed proactively. (See: What It Takes To Become An Elite Trader).

This requires four steps:

1. Understanding that losing money is perfectly normal on the path to profitability.

2. Taking time to examine conscious and unconscious negative feelings about money, wealth and risk.

3. Managing the loss side of the equation through a proactive trading plan and strategy. (For related reading, see: Risk Management Techniques For Active Traders).

4. Avoiding five market scenarios that can trigger preventable losses.

Experienced traders have worked diligently through the first three steps - proved by how long they last in market speculation - and need to focus on the last task, which can be the difference between mediocre and outstanding annual performance. It’s also the most difficult step because it requires well-honed defensive skills that understand why some positions go bad and burn holes in trading accounts. (See also: The Art Of Cutting Your Losses).

Five Dangerous Market Scenarios

There are so many ways to lose money in the financial markets, and if you trade long enough you'll get to know the all of them intimately. Fortunately, experience and awareness allows traders to avoid traps and pitfalls that others face. (See: 5 Rules Of Engagement For Trading In Tough Markets). The most effective step you can take right now to stay out of trouble is to recognize the five market scenarios that place you at the most risk.

Bad Markets - An attractive pattern or outstanding revenue growth won’t overcome a dangerous market environment, so sit on your hands when conflicting trends, illiquidity and stop running games take control of the ticker tape. Your survival depends on picking the low hanging fruit when it’s offered and preserving capital when it isn’t. Bottom line: don't trade when you can't measure your risk and stand aside when you can't find your edge. (To learn more, read: The Vital Importance Of Defining Your Trading Edge).

Adverse market conditions pick traders’ pockets regularly in a typical market year. Trends tend to persist just 15 to 20 percent of the time, with trading ranges in control the other 80 to 85 percent. (Read more in: Trade In The Right Direction Understanding Trend-Range Axis). This ratio translates into about 50 sessions per year in which price is ramping from one level to another, supporting trend-following strategies. Yet most trend followers continue to throw money at the market during range-bound periods, and get chewed up by the choppy conditions.

Bad Timing - Pay attention to buy and sell cycles in multiple time frames because good trades still lose money if you’re playing the wrong cycles. (See: Use Weekly Stochastics To Time The Market Effectively). Markets are fractal, where trends unfold independently within different time frames. That makes it easy to commit "trend relativity errors", in which we jump on a great opportunity in one time frame that’s an absolute disaster in a higher or lower time frame.

Overcome this three dimensional chess board by looking at the prospect’s 60-minute, daily and weekly patterns before taking risk. Then establish reward and risk targets, as well as a predefined holding period that aligns with the trends uncovered in your analysis. Stand aside if you can’t find a holding period that suits your strategies or if reward targets are unlikely to be reached within your time limitations.

Bad Trades – You can be a great trader and still take horrendous positions that are destined for failure. There’s a common theme at work when this happens, especially with folks who have already paid their dues. In most cases, the individual feels smarter than the market, and expects price action to bend to their will. We all go through this ego trip from time to time, but it’s never too late to get out of a stupid trade.

It’s easier for this type of brain cramp to happen than you might expect. The daily grind forces us through all sorts of complex scenarios that eat up our attention and deplete our energy. It’s easy to lose focus, especially when financial markets are open 24 hours a day, 5 days a week. The Peter Principle then sets into motion, punishing us the moment we deviate from our risk conscious discipline.

Bad Stops – Poorly placed stops will shake you out of perfectly good positions. (Learn more about this in: Must-Know Simple & Effective Exit Trading Strategies). Stops need to be placed outside the market noise, while keeping risk to a minimum. Instead, we come up with all sorts of independent criteria for our stop placement, often locating a flat percentage price that’s out of alignment with the dynamics of the traded security.

Many traders believe that algorithms hit their stops because they have inside knowledge. While this is true to some extent, especially in choppy conditions where stop running is prevalent, the greater truth is less mysterious. Most of us simply place stops in the same old places, like behind big round numbers, just waiting for the inevitable loss.

Bad Information – Traders rely on information from numerous sources to analyze prospective positions and take risks. (See: Pre-Market Routine Sets Stage For The Trading Day). This sets up two dangerous scenarios. First, we enter trades before reviewing all the data and viewpoints we need to justify exposure. Second, we enter trades after reviewing too much data and too many viewpoints, losing focus on the primary forces moving that instrument.

Refresh your data gathering by tossing out all your sources and examining how well each works, before adding them back into your workflow one at a time. If you use Twitter for market information, go on an "unfollow" rampage, dumping as many sources as possible until you’re watching less than 100 streams. Anything above that level will dilute your focus, exposing you to analysis paralysis.

Bottom Line

Managing the loss in trading will instantly benefit your bottom line. While a reliable strategy, healthy psychology and effective trading plan all work to build profits, recognizing the five most dangerous market scenarios can save a fortune in avoidable losses, improving confidence and setting the stage for long term success.