How do you know when to stay out of any given market? Toni Hansen explains.

This is one of the shortest questions I’ve received, but it’s an extremely good one. We spend so much of our time watching and waiting for opportunities to develop in the markets that it’s easy to forget how crucial the ‘waiting game’ is. The best times to act are few compared to the time spent on the sidelines. Too many traders fall into the trap of thinking that being a trader means pushing that buy or sell button. Often, showing restraint is the best position to have.

There are many reasons to stay out of the market as a whole, but for now I’m going to focus upon some of the main technical reasons to stay out of particular markets. Whenever I am hunting for a new position, my thought centers upon whether the potential reward is worth the perceived risk.

Every position has a degree of risk associated with it, but risk is going to be substantially higher in some cases than in others. The most desirable positions are, generally, those that have the greatest potential for a strong momentum move in your favor shortly after a trigger. This leaves little room for second-guessing and little chance of being flushed out, which happens when a stop is hit and then prices return in the direction you favored.

To demonstrate some of the risk factors to consider before initiating a position, I will use a 5-minute chart of American Express Co. (AXP). Although AXP does have some nice intraday price moves and can offer day traders low-risk, high-return trades, the sessions shown in figure 1 do not offer examples of such moves. Instead, the action they depict could easily wreak havoc on your account.

At first glance the price action in figure 1 may not seem bad. There are clearly identifiable trend moves in both directions and most of the key elements used by technical analysts, such as support and resistance zones, trend development rules, and so on have held very well. For example, previous lows served as strong support when tested a second time. The drop into the second low consisted of three waves of selling, which typically indicates trend exhaustion. Nevertheless, risk remained elevated throughout the time span shown and the best action would have been no action.

Why? Although prices did rise following the second low, there are several factors to examine. First, pay attention to the entire price range shown on this chart. The lows were just above 43.00, while the highs were just under 43.75. Throughout more than two days of trade, AXP had a range of less than 0.75. This may not seem too bad, but on the day I am writing this column the range is over 1.50. When the range of a security is constricted, the reward versus risk potential on a new position is diminished.

One of the best signs to help identify likely constriction in the price range of a security is a larger than average price move that takes place in a relatively brief time. In figure 1, AXP established a 0.75 move in less than two hours, with a faster than average drop into support at 43.00.

To determine what constitutes a faster-than-average price move, look at previous trend moves within the security where V-shaped reversals occur off support or resistance. If a move is faster than the drop or rally within that V formation, then it is stronger than average.

The rapid drop in AXP at the beginning of the period shown here was one of the first warning signs that risk was increasing. Another tell-tale sign of increased risk is when an unusually high number of tails form on the chart of the security or market in question (see ‘#2’ in figure 1). The rectangular part of a candlestick chart is its ‘body’ and the vertical lines above or below it are the ‘tails’. Tails represent underlying price action.

Having more tails, particularly long ones, represents greater uncertainty. Even when a strategy is triggered and a buy or a sell is initiated, a large number of tails is a sign that it is easy for the security to whip back against you, trigger your stop, and then continue in the direction you originally anticipated. As a result, it can be difficult to determine ideal stop placement. If a stop is too tight, you will be taken out easily, whereas larger stops will greatly affect your reward-to-risk potential.

Related to this is the risk when there is a higher than average degree of price overlap from one bar to the next on a given time frame (see ‘#4’ in figure 1). Smooth moves back and forth, even within a period of congestion, are preferable to price action that has a high degree of overlap from one candlestick bar to the next in a given time period. It becomes more difficult to anticipate upcoming price moves, which are easier to predict when there are changes in pace within a period of congestion. This can mean false buy or sell triggers and also increases the risk of premature stop triggers. Sometimes dropping down to a smaller time frame can minimize or eliminate this risk by showing smoother price action, but this is not always the case.

Changes in pace, or momentum, within a trend help to identify future price action. The failure of expected changes to occur can serve as a warning sign. After hitting a high (shown in the middle of figure 1) at approximately 14:00 ET, AXP began to pull back. It had been in a choppy uptrend since early that morning and was beginning to favor a break in the lower channel of that uptrend.

When it pivoted off highs and hit the lower channel (shown in red), ideally it would have paused and hugged that support level before
breaking lower. This would have changed the momentum of the price action with a strong downside move followed by a slower upside one, favoring another strong drop.

Instead, AXP pushed through the lower end of the trading channel without that expected change in pace. This signaled a higher chance of a false break of the trend channel. In the case of an uptrend, such behavior can lead to a trading range, or even a correction in a larger uptrend instead of a trend reversal. Bears shorting the channel break would hope to see that reversal.

Even when the trend does reverse, as in figure 1, there is a high risk of a stop being hit before the reversal confirms. Although that did not happen in this case, the rapid rally at the end of the session, before the continuation of the downtrend the next morning, offers a glimpse of that possibility.

Every trader has his or her own comfort levels regarding risk. If the cons start to overpower the pros, however, it’s smart to step aside and wait patiently for a better opportunity. And there will always be one, as long as you’re still around to catch it!

Toni Hansen is a full-time trader, as well as a popular lecturer and market columnist, who has been sharing her knowledge with others over the past decade. To learn more about Toni‘s methods, go to www.tradingfrommainstreet.com.

This article was originally published in the Jan/Feb 2011 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd. 
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