When To Stop Trading
Much of the advice given to traders concerns
either what to buy or sell or when to buy or sell. This makes
sense, as it is doubtful that brokerage houses and advisory services could make
much of a living by telling traders not to trade. My experience with
professional traders, however, suggests to me that they frequently wrestle with
the question of when to stop trading. This question typically emerges in two
contexts:
- The volatility in the market is low –
Does it makes sense to be in the market? Is there sufficient opportunity? - I’m not trading well – Does it make
sense for me to continue trading? Do I need to take a break?
In the first installment of this two article
series, I will tackle the issue of low volatility; the second in the series will
cover challenges related to trader psychology.
In a previous Trading Markets
article, I presented statistical evidence that suggested a serial
correlation between forty day periods of volatility. Going back to the 1960s in
the S&P 500, I found that the correlation between the volatility of the current
forty days and the volatility of the next forty days has been over .70. This
means that you can accurately predict over half of the future variation in
volatility simply by knowing past volatility. I have observed similar serial
correlations of volatility at other time frames, including intraday.
Here we are measuring volatility as the standard
deviation of price changes for a given period. This means that, in a high
volatility market, we would see large variability in average price change: some
days would have large winners and large losers, others would have smaller
changes. In a low volatility market, we’d experience low price change
variability. The size of price changes would tend to cluster relatively near the
mean for that historical period. Because of this, volatility is one measure
that we can use to determine the movement that we are likely to see during our
trading time frame; it is a measure of expectable opportunity.
Among the statistics that I make sure traders
keep is the average holding time of positions. Holding time also determines the
opportunities available to traders, as markets can be expected to vary more in
price over a longer time period (multiple days) than over a shorter one
(multiple minutes). (The reverse side of that coin is that holding time is a
determinant of risk, as drawdowns are likely to be larger on positions held for
multiple days vs. minutes). Your typical holding time is an essential part of
your trading personality and, ideally, is also a key ingredient in your trade
planning. Knowing the expectable volatility of the market for your holding
period can be invaluable in telling you when to get out of the water.
An example is a trader I will call Bam. Bam is a
scalper of the E-Mini S&P 500 futures
(
4ESZ05 |
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PowerRating) and typically holds
positions for a minute or two, trying to get long at good prices when the offers
dry up and sell at favorable levels when the bidding wanes. Lately Bam has been
feeling like a jackass. He has been getting in at what seem to be good prices
only to have the market fail to go his way. Eventually he has to puke these
positions for one or two tick losers. Over time this has cost him significant
money.
A review of the sequencing of Bam’s trades
reveals that he has been experiencing strings of losing trades and strings of
winners, a clustering that seems non-random. Direct observation of Bam while
trading finds that his frame of mind during trading is generally calm and
focused, only becoming frustrated after a losing cluster of trades. Importantly,
however, these clusters tend to occur at certain times of day and on certain
days. These are times of day (and also during days) when volume is particularly
low.
When we look at 1-2 minute charts for slow times
of day–particularly on slow days–we find that many of the bars are only two or
three ticks wide. Quite simply, there is not enough volatility at Bam’s time
frame for him to consistently profit. He cannot be assured of always buying the
low tick and selling the high one, so, as a result, he gets chopped up in
between. When we look at periods when Bam has been making money, we see that
these are during busier times of day and on busier days. A breakdown of
his trading results finds that, if the volume of the E-Mini S&P 500 futures has
been averaging at least 1500 contracts per minute, he has tended to do better
than if the one-minute volume has been under this level and much better
than if the average one-minute volume dips below 1000.
This makes good statistical sense. Since the
beginning of June, the correlation between one-minute volume in the ES and the
high-low range of the one-minute bar has been .72. High volume brings high
volatility and vice versa. By monitoring volume levels, Bam learns when to stop
trading. It makes no sense to be seeking 2-3 tick profits when the market is
unlikely to move 2-3 ticks during his time frame. Rather than change his entire
trading style and start holding positions during slow times, it is better for
Bam to simply exit the market when opportunity isn’t present.
Bam is a scalper, but his situation–and the
potential solution–really applies to any time frame. I have worked with other
traders who hold for hours at a time, but become frustrated when they cannot get
their desired 5 point winning trades. Once again, a review of average volatility
at their holding period and an analysis of results as a function of volume
generally finds that they should either get out of the markets during slow days
and slow times of day–or they should readjust their expectations. If
volume and volatility determine opportunity during a day, it makes sense to set
exit levels and stops in a manner that reflects true reward and risk. You can
often identify when this is a problem if you see many of your winning trades
returning to scratch before you exit. Your expectations most likely exceed the
opportunity that is available at your holding period’s volatility and volume.
Sometimes it isn’t trading problems that
frustrate the trader, but frustrations interfering with trading that create
challenges for the profit/loss statement. My next article will deal with those
and when it makes sense to take an emotional break from trading.