How Do I Know If A Trading Approach Is Still Working?

By November 8, 2012Market Psychology

In recent years, markets have become more volatile and many traders are having difficulty adapting. When the going gets tough, traders inevitably ask themselves “Is my trading approach still working? Do I still have an edge in the markets?

Image Source- Minh Uong/The New York Times

To answer that question, we must first understand that all trading approaches / strategies require certain market condition(s) to be present before they can perform at their optimal level. For example, if we were trading an iron condor, we would prefer the market to move very slowly, or go nowhere with declining volatility. With these supportive conditions, it would be easy for the iron condor to reap handsome rewards. However, if market goes into hysterical mode with panic selling and volatility rises at break neck speed, we would likely end up with an injured condor.

With the above understanding, let’s discuss how do I know if a trading strategy is still working.

Assuming a trader makes no mistakes with execution or money management, declining trading performance must be studied in relation to market conditions. If supportive market conditions are occurring less and less frequently, we must recognize that the market is changing and the strategy that has worked in the past is becoming less and less relevant. In other words, the old trading strategy is losing its edge.

The flexible trader will need to adapt by employing a different strategy. Sometimes just modifying the existing strategy will do the trick.

Recognizing when and how to adapt is where most traders encounter problems because they have spent most of their time learning trading strategies, money management, emotions management but insufficient time is invested in appreciating or recognizing the various market conditions. Therefore, when market conditions change, they are unable to detect the change and much less know how to respond.

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One way to appreciate the various market conditions is to ask yourself what conditions are required for your chosen strategy to work well? How should the chart look like? Should it be trending strongly or sluggishly? Should it be going sideways? What about the range of the sideways movement as measured from highest to the lowest point? Will a large ranged sideways consolidation be more supportive of my strategy than a narrowly ranged consolidation? What about the presence of big candlesticks with large average true ranges? Does that matter? And how should volatility behave?

In this discussion, let us be acquainted with 4 broadly categorized market conditions so that we may jump start our own cataloging of market conditions.

  1. Trending and non volatile
  2. Trending and volatile
  3. Non trending and non volatile
  4. Non trending and volatile

(Please understand that the above is by no means an exhaustive list but nevertheless a good start)

One reason why seasoned traders can adapt well and even thrive in changing market conditions is because they know how to choose the most suitable strategy in their tool box to match prevailing market conditions. And when conditions change, they change strategy early. Perhaps what’s more important is they recognize sometimes, they just don’t have a suitable strategy for the prevailing market condition. As such, they stay out of the market and wait patiently for more supportive conditions to develop. There’s a reason why seasoned traders often say “Not taking any position IS a position.”

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We must learn from the seasoned traders and be more sensitive to market changes. Start developing the ability to identify different market conditions, choose the most suitable strategy in our tool box to match the condition and let’s take our trading to the next level.

Know what you are doing and know it well. This is even more important if you are trading options as options have limited life. There are no short cuts in trading. It’s hard work and requires continuous sharpening of the saw. It’s one of the toughest professions. Get real. Will you be right all the time? No. But try to increase the occurrences of being right.

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Take care and continue to sharpen the saw, continuously
Ethan

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