Adapting for Success in All Markets

06/24/2014 8:00 am EST

Focus: STRATEGIES

Learning to expand your trading skill set to apply different strategies can allow traders to better capitalize in trending markets, range-bound markets, or other conditions that may exist through the course of each day's session, says Cory Mitchell on Investopedia.com.

For active stock traders, having different strategies for different market conditions is a crucial factor. Trends emerge, fade, and reverse, and ranges develop, all playing out in ever-broader trends and ranges, and all within a single trading session.

Thus, the trader is faced with a choice: Trade one strategy and profit only at times that suit the strategy, or trade several strategies that allow them to trade profitably in an array of market conditions.

Different times of day pose different opportunities and threats, and these must be accounted for. Once several strategies have been adopted, it is crucial that the trader know when to implement each type of strategy.

3 Types of Trading Strategies
For daytraders, strategies will generally fall into three types of categories: scalping, trending, and ranging.

Scalping includes all trades where the trader is trying to capture a profit on order flow, such as making the spread, collecting ECN credits, or riding the coattails of a large order.

Trending includes all strategies where the trader attempts to profit from a sustained move in one direction.

Lastly, ranging strategies are used when the market is moving back and forth between resistance and support. Profits are made inside this band instead of on a stock making new highs or new lows (as in trends).

All traders will benefit from having trending strategies and range-trading strategies in their arsenal. These are then combined with scalping strategies to provide methods which are more likely to be profitable at all times of the day. 

NEXT PAGE: Adapting Your Strategy to Time of Day

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Adapting Your Strategy to Time of Day
The morning, lunch hour, and afternoon are very different and require different strategies.

The morning is volatile and big moves occur quickly. This means a trending strategy is likely better. The trader may have to aggressively enter (remove liquidity) positions in order to not miss out on the largest and/or quickest moves of the day.

The lunch hour, between 11:00 am and 1:00 pm EST, is usually a quieter time. The market generally has a more ranging quality to it; moves are smaller, volume has decreased, and big money is not aggressively moving stocks.

This is a time when traders should focus on adding liquidity at the extreme edges of the established range, or even slightly outside. Trades should only be taken with a very high probability of success. While there are exceptions, most days will not require removal of liquidity to enter positions during this time. 

Rather, traders should wait for the price to come to where they want, and if it doesn't, don't make the trade. Due to the fact that there is less volume and trades are likely to last longer than in the morning or later in the day, traders should make sure their reward/risk compensates them for this. Thus, trades will likely be few during this time.

As traders return from lunch and the close is within sight, volume and movement usually pick up. This will occur anytime after 1:00 pm EST.

Continuing with the noontime strategy of being very selective on entry points, the trader will be wary that trends may once again start to emerge. Breakouts from lunchtime ranges can be swift and aggressive, therefore, exit losses quickly and move to a trending strategy. 

Patience is still required here. Exit losses quickly and attempt to see where the trend is going towards the close. Remove liquidity if required, but since moves may still be questionable, add liquidity when possible until definitive trends emerge.

The three times of day can be summed up by the aggression style that should be used to trade them: 

  1. Morning: Aggressively join momentum moves that are starting. Removal of liquidity is often required. Use tight stops, as a change in direction can happen swiftly
  2. Noon: Be very conservative. Use range-trading strategies. Always try to add liquidity, unless a loss is escalating. Be very patient and let price come to the order instead of removing liquidity to enter a position
  3. Afternoon: Watch for breakouts of lunchtime ranges, if there was one. Join trending moves, attempting to add liquidity if markets remain quiet. Exit noon trades quickly if the price moves against those positions in the afternoon. Look for points where the morning trend is likely to re-emerge or reverse

NEXT PAGE: When to Shift Strategies

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When to Shift Strategies
The times of day are only rough approximations; what really matters is noticing when the market shifts from ranging to trending and vice versa, then adjusting to it. When this shift is occurring, is much easier to see if charts are continually updated with trend lines and horizontal support and resistance lines, as shown in Figure 1 below.

chart
Click to Enlarge

In the morning, there is high volume at the open, which even increases as the trend accelerates. In order to take part in a move such as this, the trader needs to be aggressive, removing liquidity to get on board with the trend. The trader can add liquidity to capture a retracement, but may miss the swiftest move of the day. 

As the day progresses, by 11:00 am, a range has established, with an upward bias and a false breakout occurring at 11:30. At this point in the day, though, a trader should be less aggressive, adding liquidity and focusing more on a range-type strategy until the market gives signals otherwise. 

Volume is declining and false breakouts are a high probability, therefore, this breakout is more likely to be "faded" than it is to be seen as the continuation of a trend.

At just after 13:00 the market breaks lower. Volume remains low, so there is no need to get aggressive on entering; however, if the trader is long, they should look to exit immediately, as trends can develop quickly after lunch. 

Through the afternoon the trader combines patience and a trend-following strategy, if a trend develops; otherwise they will stay with the conservative ranging strategy, waiting for entries (potentially on pullbacks) into the overall trend.

By drawing trend lines and horizontal support and resistance, the type of environment the stock is in will be much more visible. As exemplified on the chart, trend lines should be drawn, and when that trend line breaks down, a horizontal line should be drawn at the most recent swing high and swing low. 

This way we can see if a trend is reversing or simply entering a ranging period. Horizontal lines can also be drawn during trends at reversal points; this will aid in seeing if the trend is slowing or potentially entering a range. During a range, a trend line can be drawn if price movements are biasing one direction, as we see in Figure 1 from 10:30-11:30 am EST.

The Bottom Line
Daytraders can benefit from having multiple strategies for different market conditions. Being able to range and trend trade successfully will allow the trader to profit more readily, as well as know when to be aggressive (remove liquidity) and when to let price come to them. 

When trading multiple strategies, a trader must know the times when a particular strategy is likely to be the most useful. By continually marking the stock chart with recent price highs, price lows, and trend lines, a deeper understanding of what stage the market is in will be attained, and with that will come the type of strategy to use.

By Cory Mitchell, Contributor, Investopedia.com, and Founder, VantagePointTrading.com

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