Accepting the Obvious

This past week, I received an email with an excellent question that has bedeviled me in my own work with traders: Why do traders fight breakout, trending moves when they are so obvious? Time and again, I will see traders refuse to enter a market that is breaking lower because "I don't want to sell the lows". Worse still, traders will hold onto positions against the trend because "It's going to come back" or "The market is being manipulated."

Let's get down to basics:

Volume tells you where traders and investors are accepting value at a given point in time. If the market has been trading within a narrow range and then breaks above that range on high volume, it means that the market is accepting value at higher levels. If you were attending an auction for an artwork that you own and large numbers of bidders kept offering higher prices for the painting, you would conclude that the painting has not yet found its ultimate selling value. You surely wouldn't sell your art piece as soon as the first group of bidders starts to aggressively bid!

The market works on similar auction-based principles (see Mind Over Markets, the excellent book by Jim Dalton and coauthors for a discussion of auction theory in trading and the use of the Market Profile). Each day, we see an auction for such artworks as the S&P, NASDAQ, bonds, etc. The dynamic interplay between buyers and sellers determines value for those markets. It is when we see volume expanding on a directional price move that we realize that the market is out of balance. It will continue to move in its direction until it can attract sufficient buying or selling interest to create a new balance.

Not infrequently, I will ask a trader who missed a breakout move what happened to volume during that period? Very often the response will be "I don't know". The trader was so busy focusing on price-and so busy focusing on their own reactions to the movement-that the auction-based meaning of the breakout was lost.

I would argue that this is one incontrovertible law of trading: When something important happens in the market, good traders focus on the market and the meaning of the events. Bad traders focus on themselves and their frustration over missing the events, how they can make up the money they lost, etc. Incredibly, I have seen traders miss entire trending days because they were busy convincing themselves that they had "missed the move" on the initial breakout.

Still, there can be another reason for missing those obvious moves. Let me give three different, but related, examples of "refusing to accept the obvious":

  1. A woman comes to counseling complaining of marital problems. Her husband has been staying out at night, not spending time with her. He told her he was working late, but she could not reach him at the office. One time she found someone's belongings in his car--a woman's--and questioned him. He explained that she had forgotten to take them from the car after he dropped her off at home following a late day at the office. When the counselor suggested that perhaps he was having an affair, she expressed anger toward the counselor and insisted that she just needed to "work on the marriage". Several weeks later, the husband moved out and moved in with the new woman.
  2. A cancer patient has taken a dramatic turn for the worse, and tests confirm massive spread of the cancer. When the physician raises the issue of hospice care and ways of relieving pain in the final weeks of life, the family members angrily confront him and insist that he pursue "more aggressive treatment" so that he could return home and, eventually, get back to work. Meanwhile, the patient is a virtual skeleton due to weight loss, cannot hold down food, and is visibly suffering.
  3. A victim of abuse in childhood insists that her father was caring and minimizes the pain of her childhood, despite clear evidence that she was sexually molested, physically beaten, and frequently humiliated. She insists that she must have done something wrong to upset him, and will not use the term "abuse" to describe what she went through. She undergoes periods of depression when, even now, she reaches out to him, only to be rejected.

In all three cases, the difficulty accepting the obvious is the result of a need to believe something different. It isn't just that the individual is blinded to reality: it's a desire to perceive a different reality. In most cases where traders fail to act on breakout moves--or worse, get run over by them--there is a situation where the trader was actively anticipating a different kind of market. Once this becomes part of their analysis, it becomes their opinion, and their ego gets caught up in it. The term traders use is that they become "married to their opinion".

What I've found is helpful is the active creation of "what-if" scenarios in the market that can be mentally rehearsed in a vivid way. If we are range bound, what if we break above the range with expanded volume? What if the small and midcap sectors break above their range, even as my market stays range bound? What if we probe the top of the range and volume dries up? Such what-if scenarios actively prevent the trader from getting caught up in assumptions that become opinions that become marriage partners. "Plan the trade and trade the plan" is common advice, but good traders always have a Plan B.

Finally, let's consider the reverse scenario: Traders in a range bound market who convince themselves at every move that a breakout is at hand. Once again there is a need to believe, but for a different reason. Too eager for action, bored by the bracketed trade, needing of some P/L juice, they cannot accept that the market has found value and is staying there. Low volumes speak as loudly as high ones to those willing to listen. An ES market that trades only a few hundred contracts per minute is not attracting "other timeframe" participants and will only be jostled back and forth by "locals". It is very easy to overtrade these markets by anticipating breakouts rather than waiting for evidence of their occurrence. The telltale sign of this problem is the frequent complaint of traders that "this market just won't trade". They are busy fighting what the market is doing rather than following the market's lead.

Ayn Rand was right: Many problems boil down to evasion once our needs and desires conflict with reality.

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