Choppy vs Trending Markets

Periods of great opportunities are often followed by periods of great challenges. Challenging market environment is not a market correction. As long as there’s clearly defined trend, up or down, there are many more opportunities than uncertainty. There’s never 100% certainty, so stop looking for it. There are times that are simply more challenging for traders. I refer to them as choppy markets. Choppy markets change direction frequently and shake out both overly active traders from both, long and short setups. Choppy markets frequently go above and below their 5, 10 and 20-day exponential moving averages.

The biggest troubles in trading come from overtrading in a choppy market environment. Those periods don’t last long. There’s only one cure for them – do less, trade less, use smaller position sizing. The goal is to keep any capital drawdown to a minimum and protect our confidence. Why is protecting our trading confidence so important? Because market environment constantly changes. Periods of choppiness are regularly followed by periods of great opportunities. If you lose too much of your trading capital during choppy markets, you are likely to second-guess yourself when a trending market comes around and miss on some great opportunities because of fear of further losses. Many traders are fearful when they should be bold and bold when they should be proactively taking gains and raising cash positions.

The Obvious Rarely Happens

Financial markets constantly swing between sentiment extremes – from fear of missing out to fear of losing, from complacency to second-guessing yourself, from enthusiasm to apathy. The majority of people tend to lean in the wrong way at pivot points. I like to look for anecdotal evidence of the latter on social media. For example, in the midst of the selloff on Thursday, I posted the following poll on Twitter:

1

About an hour after posting it, the market rallied hard. At the time, the results were predominantly in favor of “there’s no reason to be long here”. I didn’t have a time machine. I just noticed that indexes were down a few days in a row, an increasing number of stocks were finding support, the McClellan indicator reached levels that led to a bounce in the near past.

sc

The same scenario repeated last week when many index and sector ETFs were had overbought RSI readings and more and more stocks were breaking down. Most people were super complacent at the time. Here’s a poll I posted on June 7th, shortly before the stock market dived.

2

As Jesse Livermore said in his infamous book: “Remember, the market is designed to fool most of the people most of the time.”

How Trading is Different than Poker

People like to compare trading with poker. They have a lot in common. Both deal with probabilities. Both accept that there is never 100% certainty. What matters most is risk and reward over time. Statistics, pattern recognition, cognitive psychology, and studying past wins and losses is extremely useful in both games.

In both disciplines, psychology matters more than fundamentals. In poker, you might win with a weaker combination of cards than your opponents if you manage to convince them that you hold something strong. In trading, a current sentiment often overrules underlying fundamentals in short-term perspective – a stock with high short interest could double and squeeze short sellers out of the game before it ultimately reverses lower and head near zero.

In both games, participants operate with a different time frame in mind. Some poker players might be willing to create an illusion that they like to bluff. They could intentionally lose a few small bets early in the game, so they could win big later in the game. In trading, some people operate intraday, others are swing traders, market makers, value investors, etc.

There are many similarities, but they are also two very different games.

Poker is a zero-sum game. Every dollar won by one is lost by another. Trading/investing might be a zero-sum game, but it is not. Markets often rotate periods when almost everyone is a winner with periods when almost everyone is a loser.

In poker, you know exactly what is the probability of having a winning combination of cards. In trading, the probability of a setup being profitable and its potential reward to risk could vary significantly based on the market environment. For example, a breakout setup has a much higher likelihood of making more money in a strong general market that is rising above all its major moving averages – 10, 20, 50 and 200-day. The same setup is prone to failure or delivering much smaller profits in a declining market that is falling below all it major moving averages.

Professional poker players know the exact risk and potential reward for each bet. They are willing to take a bet with 20% probability to win if the potential reward is let’s say ten times their risk. They accept that with a 20% probability to win, they will lose four out of five times. The one out of five times they win will more than compensate for their losses.

In trading, taking setups when they have a much lower probability of delivering leads to overtrading, deep drawdowns and eventually to frustration and loss of confidence. This could lead to second-guessing a setup and under-trading when a more accommodating market environment comes around.

In poker, you are dealt one hand. You don’t get to choose. In trading, you could choose to play whatever setup you want. You could buy breakouts when they are more likely to work and deliver bigger profits. You could use a different setup or stay on the sidelines when the market environment is not favorable for buying strength.