Traders are always itching to have a trade on if they do not have one. It’s as if they feel naked being out of the market. Giving in to the urge to overtrade can lead to many small losses that can really add up.
I confess I was guilty of this sin when I started out – it is a common problem.
An over-trader will see every small swing as significant, looking for a signal to take a position before the market runs away.
Most of the time, it is best to let the market alone. As traders, we all want to get on board the next big trend, but in reality, markets spend far more time in consolidation mode than they do making vigorous thrusts in a particular direction. But it is the directional thrusts that provide us with the profitable setups.
Trading in a consolidation zone most often leads to whipsaw losses. You believe the market is moving up. You take a long position, expecting the market to move up out of the zone in a thrust. But the market bounces back down into the zone and hand you a loss.
I love trading the Dow – but I’m steering clear right now
In recent days, one of my favourite trading markets – the Dow – has been a nightmare to figure out. It has given me at least one such false signal – and handed me a loss.
My daily chart is below. From last November to February, the market has traded within the zone contained roughly by my pink bars. Then in late February, the market moved up out of the zone, and it appeared that the upward trend would continue.
Many traders had positioned short in this period and would be expected to have protective buy stops above the zone. These buy stops, plus buying from traders who saw the breakout, would normally provide the rocket fuel for a more vigorous rally leg.
But in March, powerful selling overcame this force and the market retreated back inside the zone. That is normally a bearish sign. But the decline formed on a three-wave A-B-C pattern (corrective) with a small positive momentum divergence at the C wave low. That was a conflicting bullish sign.
So in early April, we had two opposing signals – which one would win out?
Here is the hourly chart showing the rally starting early this month: the rally has a lovely five-wave form complete with a huge momentum divergence at the wave 5 high:
If the market was about to turn down to challenge the shelf of support again, shorting near the wave 5 high was the perfect setup. A close protective stop just above the wave 5 high was the correct risk.
The equally-valid alternative scenario was for the wave 5 high to represent wave 1 of a larger five-wave affair (or even wave A of a larger A-B-C). This would imply a further move up.
Has the mist cleared this morning?
The market did not retreat hard down off my wave 5 high, but it did form an A-B-C correction (green lines). So now, we have a small consolidation zone contained by the highs and lows.
This makes the above scenario slightly more likely – a thrust above the zone in either a wave 3 or a C wave.
But the wave 5/wave 1 high has not yet been decisively broken to the upside.
Because the odds of a break down and a rally from here (Dow at 17,950) appear to be evenly matched, I will stay out of the market until I see the fog clear.
This is no time to be over-trading!