When to Stop Trading, Part 1 of 3
By Brett N. Steenbarger, Ph.D.*
Posted: Dec 22, 2006
Much of the advice given to traders concerns either what to buy or sell or when to buy or sell. This makes sense because 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:
Context 1: The volatility in the market is low -- Does it make sense to be in the market? Is there sufficient opportunity?
Context 2: 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 another article, I've presented statistical evidence that suggests a serial correlation between 40-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 40 days and the volatility of the next 40 has been over .70. This means that you can accurately predict over half of the future variations in volatility simply by knowing past volatility. I have observed similar serial correlations of volatility in other time frames, including intraday.
In this instance, 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 a lot of variability in average price change: Some days would have big winners and big losers; others would exhibit 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 we can use to determine the movement we are likely to see in our trading time frame; it is a measure of expectable opportunity.
Among the statistics I make sure traders keep is the average holding time of positions. Holding time also determines the opportunities available to traders because 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 because drawdowns are likely to be larger on positions held for multiple days versus 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, clusterings that seem non-random. Direct observation of Bam while trading finds that his frame of mind during trading is generally calm and focused. He only becomes 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- to 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 in Bam's time frame for him to consistently profit. He cannot always be assured of 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 1,500 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 1,000.
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 seek 2- to 3-tick profits when the market is unlikely to move 2 to 3 ticks in his time frame. Rather than change his entire trading style and start holding positions during slow times, Bam is better off simply exiting 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 within their holding period and an analysis of results as a function of volume generally find that they should either get out of the markets on slow days and during slow times of day -- or they should read just 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 available at your holding period's volatility and volume.
Sometimes, it isn't trading problems that frustrate the trader but, rather, frustrations interfering with trading that create challenges for the profit / loss statement. My next article in this series will deal with those and when it makes sense to take an emotional break from trading.
*Reprinted (and modified) with permission from Brett N. Steenbarger, Ph.D. of www.tradingeducation.com.
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