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When
to Stop Trading - Part I
By Brett N. Steenbarger, Ph.D.
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:
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The volatility in the market is low - Does it make sense to
be in the market? Is there sufficient opportunity?
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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 three article
series, I will tackle the issue of low volatility; the second in the
series will cover challenges related to trader psychology, and the
third will suggest ways for traders to benefit from their times away
from trading.
In a previous 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 ES 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 ES 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 in
the series will deal with those and when it makes sense to take an
emotional break from trading.
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Brett N. Steenbarger, Ph.D. is a clinical
psychologist and active trader, writer, and
researcher for the past 20 years, Brett is the
author of The Psychology of Trading (Wiley;
2003) and numerous articles on trading psychology
for print and online financial publications.
Click here for full
bio >>
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