How to Extract Greater Profits From Our Trading

Bella recently posted excellent observations on finding another way to make more from the trading we do. Very often traders will look at peak and trough prices in a move and fault themselves for not having participated from one extreme to the other. There's a sense, however, in which selling top ticks and buying bottom ones does not represent optimal trading. Let's take a look at the skilled trader's reasoning during the life of the trade.

As noted in the recent posts, short-term traders profit when they track buying and selling flows and detect shifts in those flows created by the actions of large participants. At the top and bottom ticks of market moves, those shifts have not fully occurred. Indeed, my work suggests that the best time to be long is when we see meaningful selling flows that cannot move price meaningfully lower and the best time to be short is when we see meaningful buying flows that cannot move price meaningfully higher. This is true across time frames and is pertinent to longer-term as well as intraday trading.

At the highest and lowest ticks of a move under way, the conditional probabilities that you've actually detected the ultimate price high or low are relatively low. As you see flows unfold and result in diminished upside or downside, those probabilities begin to rise. At some point, the probabilities that a high or low have already been made become sufficiently great that a trade short or long is warranted. Although I'm not a trader of chart patterns, I find it useful to think about moves as having a left shoulder (a momentum peak), a head (a price high or low), and a right shoulder (a failed bounce or dip). The high probability trade lies in fading that right shoulder and participating in the move that results when buyers or sellers have to exit their positions.

In factor terms, you're a value buyer/seller (fading price extremes) profiting from momentum in the other direction.

But wait. In terms of Bella's issue regarding how to get more out of our trades, our probabilistic reasoning process does not end once we've entered a position. My experience is that, if I'm wrong in the trade--if the trade is going to be a loser--I'm going to go underwater relatively quickly. Why is that? I have identified my entry as a value entry, where movement in one direction has petered out and movement in the opposite direction is going to benefit from momentum. If I'm wrong, what I thought was a "head-and-shoulders" was merely a pause in a larger move and momentum in the initial direction resumes. I can see that on my screen by a sudden surge to the upside or downside in the uptick/downtick numbers.

If we don't see the market gain a second wind after our having made an initial entry, the conditional probabilities of getting the move in the other direction continue to increase. We are getting further confirmation that buyers can push the market no higher or sellers can push prices no lower. It is when we see that our initial position is not getting torched and subsequent market behavior is in line with our thesis that we can add a second unit of risk to the trade. We extract more from our trading by being largest when we're "rightest" and smallest when we're wrong.

Your reasoning process during the life of the trade has to be aligned with the reasoning that got you into the trade if you're to truly trade intentionally. In the next post, we'll take a look at what gets traders out of alignment.

Further Reading: Questions to Ask When We're in a Trade
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