The Other Side of Simple Math

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  • on November 5th, 2011

After reading my own post on Some Simple Trading Math, I realized a major omission.  I had shared the potential for increased patience in stalking better prices, which is helpful in 95% of instances.  There is one instance in which that patience is harmful…the explosive breakout.

Failing to add this qualifier puts the trader at risk of staying on the wrong side of the cleanest, most powerful moves.  I had alluded to this by specifying indices as the instruments that honor this math, but the better qualifier would be “non-breakouts”.  It’s been so rare of late to see actual breakouts in indices that it’s easy to lump them in as choppy, but to do so risks being caught patient when urgency is the better option.

Think $SPY today.  The ATR boundaries I had discussed were pushed to the limit but proved capable of holding…as an upside boundary last week and downside this week.  I have found that to be almost always the case, and worth the increased patience.  Check the following chart, (TradeStation indicator courtesy of Jeff Carroll in a great example of frictionless platforms):

Now think $SPY in late July.  After breaking to the downside on July 27, stocks never even probed higher than -1.0 ATR below the falling moving averages; an incredible persistence of selling that could ruin a trader waiting for “value”.  It was not until a full 11 sessions later, on August 10, that we bounced into even the value area.  By then, momentum had carried the index 11% lower…waiting for that 3% bounce did little to help the patient trader.

The point is…there are trends, there are ranges, but never forget there are breakaways.  By failing to acknowledge the distinction, we put ourselves in the mean reversion graveyard between John Meriwether and Victor Niederhoffer, picking up tons of nickels until the steamroller ends us.

As traders, I don’t believe we are forced to pick between a “fade or follow” approach, but there are some trades in which value and momentum cannot coexist.  Even though it may signal only once a year, a simple filter to remind us that explosive new energy says this is NOT fadeable can allow us the benefit of patience but sound an alarm when a Code Red(or Green) is underway.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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