What to Do When Your Strategies Stop Working

06/20/2014 8:00 am EST

Focus: TRADING

Michael Bellafiore

Author, One Good Trade: Inside the Highly Competitive World of Proprietary Trading

Traders spend a long time developing strategies before they hit upon one or two that work, but what if your erstwhile dependable strategy stops working? Mike Bellafiore of SMB Capital addresses that very same question here.

"Hello Mike, I have an interesting question for you. Its about the life cycle of a trade set up. I've realized that like businesses, trading setups are also cyclical. There will be periods where the setup produces an edge, and there will be periods when the setup is not producing an edge. Does this mean the setup no longer works and it has become extinct like a dinosaur? Or does this mean the market conditions are currently not favorable for this setup and it would be best to revisit this setup at a later date? What does one do when a setup has stopped performing?

I've also heard the term "There is always a bull market somewhere," which may indicate that maybe rather than changing the setup, finding another stock/commodity or instrument where your setup can perform for you may be the right way to go. What do you suggest?"

When we develop patterns that make the most sense to us, and place them in our PlayBook, we first start with the big picture. Too many traders undervalue market structure before placing a trade. I was in Connecticut yesterday with three of our traders visiting a top US hedge fund, where a market veteran implored our traders to grasp the importance of a market structure's effect on all trades. A bullish flag pattern to them is traded the same whether we are in a range-bound market, bull market, or bear market. This makes no sense. They trade a bullish flag pattern whether the stock is In play or not. This makes no sense. When you build your PlayBook, you must develop setups that will work factoring in the big picture.

So let's start with momentum trading as this is what most of our are. We may call ourselves long-term players or micro players, but most of us are momentum trend traders. Short-term momo trading worked very well in '07 and '08 because of the increased volatility in the market. Today we sit in a low vol environment. Add to this, HFTs have developed strategies against ours. If you do exactly what worked very well in '07/'08, you will see your results change from quite positive to decidedly negative. This will not be a matter of you trading poorly, it will be that your strategy needs tweaking or shelving until a different market environment.

Does this mean you cannot momo trade in this environment? Of course not. It means you must be more selective with your momo trades because of the new market structure and environment. So the momo strategy will still work, but only in more selective setups. If a sector gets very hot, a momo strategy will still work well. If a stock has real order flow, a momo strategy will still work.

In this new normal, we recommend expanding your trading horizon and making sure there is a clear catalyst behind your trades.

I heard a trader of late chirping that some traders get hot and then they get cold. And saying this as if this is just the way it is in trading. Well it might be. But only if those traders undervalue market structure, or as we say the big picture. And do not adjust their trading setups for the market and/or dip into other setups that will work best in a new market.

By Mike Bellafiore, Co-Founder, SMB Capital

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