February 16th, 2016 – A blog post which will hopefully help some traders who may be struggling in the current market conditions.
There are some things which can be taught but there are some things which have to be experienced in order to fully understand them. The stock market meltdown at the beginning of the year is a good example. I can talk about something like that all day but unless you’ve actually witnessed it yourself, you cannot fully appreciate the insanity. There’s no frame of reference.
I often talk about context and how important it is in the grand scheme of trading. I will show strategies to students and teach them how to decipher clues within the order flow but whether or not I take a trade and how I manage a trade if I do take one depends on the context of the situation. Trades have to be based on what you are seeing in the moment. You have to recognize when the action is conducive to good opportunities which are worth the risk and when the action is not conducive to such opportunities.
Everyone has obviously noticed the substantial change in the markets over the last month. The volatility is not like it was earlier in the year and certainly nothing like it was during most of last year. We always see the occasional big day here and there but it’s been awhile since we’ve seen such movement on a daily basis for weeks on end. Big runs. Big reversals. Fade trades are not as reliable until they are and by then, the fade has already happened. The trend is great when it’s a one way street but there is often no way to anticipate the run ahead of time and it can be easy to join the party too late and get whipsawed into pieces on every pullback.
Things have changed. This is the nature of markets. They can go from slow and boring to batpoop crazy in the blink of an eye. However, it doesn’t always happen in the blink of an eye. There is often a build and you begin to notice the change is not temporary but is instead here to stay for awhile. This change started around the last week of January and while it was very unexpected at the time, it quickly became apparent that a fundamental shift in market behavior was taking place. This requires adaptation. What do I mean by that?
Sticking with the treasuries as an example since those markets are the ones most of my customers trade, take a look at the volume and liquidity on the DOMs. What you will see and what we’ve been seeing for a couple weeks now is that the normal bid/ask amounts are less than they have been. It’s normal to see 1000 to 2000 showing at every price in the 10-year. It may not always trade but there is typically something approaching that kind of volume available at most prices. What you are seeing now is that there may be 1000 to 2000 showing at every price which is not on the inside market but when the market actually gets to those prices, the bid or ask quickly drops down to as low as 200 at times. Then we may see only 200 trade or we may see 1000 trade but the market is moving farther faster due to the drop in supply at each price.
Contrast this with a period of time last fall when there was often 3000 to 4000 at every price and that amount of volume was actually trading at every price. There was little spoofing. Major players were in control all day. Small HFTs were there but they accounted for a fraction of the movement. There was commitment on the part of institutions on a daily basis. This can also happen on an intraday basis. If you were watching treasuries during the FOMC announcement last month, you would have seen a market react somewhat wildly on thin volume (which is normal) and then, going into the close, there was 3000 to 6000 up at every price and it was trading. A massive amount of supply and demand was there. Large institutions where adjusting positions going into the close of that day. Trading in that kind of volume is far different than trading in thin volume directly after the announcement is made. Now, over the last few weeks, it seems to be mainly smaller orders driving most of the movement, relatively speaking.
Most people look at the total daily volume and they see the same amounts each day so they assume the markets are the same each day. Nothing could be further from the truth. How that volume is traded determines whether we see tight ranges or massive runs in one direction or nasty back and forth action which has no rhyme or reason other than small HFT orders feeding on other small HFT orders. The current decrease in supply at each price is what’s leading to the increased volatility and also leading to difficult trading for many traders.
Here are some tips on how to handle this:
If you’re losing, stop trading for a day or two. This holds true at anytime but it can sometimes be difficult if a person has been having a good run and then only hits one or two bad days and can’t figure out why that is. The trader will try to force it and throw good money after bad. You have to reassess the situation and figure out if something is changing fundamentally. Some traders look at this type of action as a blessing and others view it as a curse but it should really just be acknowledged for what it is…a change in the game. If the game changes, the strategies may have to change or at the least, take a slightly different form.
I know fade trades can be deadly in this type of action. They can also pay really well when they hit. Knowing this, I am super selective in my entries. I always try to pinpoint the best price but it’s more crucial in this type of environment because there is no size to lean on for exits. If I’m wrong, the market may go through me by 4 ticks on nothing more than 1000 contracts. Or it may move 4 ticks and then hit a wall of 4000 contracts and then reverse at the exact price where I blow out for a loss. It’s hard to say due to the nature of the beast right now. I know the game has changed and so my expectations change.
Trade management also has to change to some degree because the market often does not stop at one price and reverse. It bounces on light volume in between three or four prices and then reverses. Or continues. I know I have to give trades a bit more leeway in terms of ticks. Not always but more often than I would have last year. This doesn’t mean I take 8 tick losers. It just means there will be more 3 to 5 tick losers as well as more 5 to 10 tick winners. Cutting size is often the right play here so the swings in P&L are consistent with the fact that I know slightly larger stops and profit targets may need to be set.
Don’t be afraid to jump on board a run even if it seems like it’s already gone too far. In this type of market, it often has not gone too far and may only be halfway through the run. Sometimes you just have to step up and take the shot if all the signs are pointing one way. The key is to know that the back and forth is going to be there and the market is going to jump around a lot. This goes back to the idea of trading less size and using larger stops (but not too large). I am frequently asked about this. The question goes, “Is there some way to know that the run is going to continue? Some way for me to know I’m not joining the party too late and not going to get whipsawed on a retracement?” While there are sometimes clues that the run may be stalling, you can’t see it till it happens and if you’re worried about it, you’re going to miss the next 8 ticks you want to make. If your risk management or mentality is not prepared for this, then it’s best to sit on the sidelines. Just know that if you don’t sit on the sidelines, you are going to have to step up and go for it at times with no real confirming indicators other than “This looks like a train.” That’s it. If it looks like one, it probably is.
To sum up, I don’t stay out of these markets. I trade them because I know there can be great opportunities. However, I’ve seen this type of action many times over the years so I know what to expect in terms of a ‘big picture’ scenario. If you’re a new trader and this is your first experience with it, you may want to sit on the sidelines for awhile. Watch and learn. Then, if you feel comfortable and seem to be making the right calls and have a better understanding of what to expect in this type of market, slowly get back into the game with smaller size.