Reversion To The …. Blown Account

The markets have been trending nicely of late and one could argue it has been since the beginning of the year. For those who aspire to use the most over-hyped phrase in trading, ‘the trend is your friend’, the markets have provided some interesting trading opportunities, even if you couldn’t catch them all.

On the other hand, different trading styles are having a tough time of late. Strategies using a ‘reversion to the mean’ concept can at times be like trying to catch a falling knife.  Day traders using tools such as Bollinger bands, keltner channels and even some market profile concepts are finding winning trades to be a tough go. These methodologies that some diehards claim to be an ATM machine during summer doldrums or December holidays are finding it frustrating of late and landing continuous stop-losses due to a failure of price to reverse.

The challenge I see when mentoring traders is their inability to identify the type of market as well as  adjust their trading style when they do recognize them. Traders tend to be loyal to their strategies; just like a dog to their master. Why not? These methodologies have proven beneficial to them over time. The problem is that the market doesn’t care about your history nor your stop.  I noticed newer traders last week were reacting to news and not watching their charts. I was observing one SPY trader who kept telling me this area is a double top and shorted with a tight stop. Justifying it with solid risk-reward, he took the stop out. Not a problem but the next four times he tried it, it was a huge problem; not to mention several trading plan rules that were violated.

Reversion to the mean strategies can be very effective in a consolidating market. Lunchtime hours often show shrinkage in the average true range and price can simply oscillate within a narrow range; perfect for the reversion trader.  Market profile has a small but loyal audience. Their view is that price is either in a balanced or imbalanced state. Simply put, in a balanced state, price is being ‘accepted’ in a given range and price is anticipated to oscillate with such ‘value areas’. The problem is not with the strategy but more with trader’s reliance on such holy grail in an ‘imbalanced state’.  Here is where the market has simply had enough with the current accepted price and bidders or sellers look to find a new level of acceptance. Playing reversion or fade trades can be deadly for a trading account.  I actually cringed a few times overhearing chatter of a potential short while all I see on my screen is DOW +180, green bars everywhere on high volume, rising moving averages and trading rules saying ‘long or nothing’.

So how do I overcome such a reversion mentality? As you trade these wild markets, always be sure to ask yourself in your pre-market strategy; ‘Are we in rotation?’, ‘Are we consolidating?’ Often times the overnight globex session with give a hint with its range in relation to its average. Lastly, it is critical to have different strategies in your arsenal that supports each type of market condition. Can conditions change throughout the day? Of course. That’s when I’ll gladly take a stop rather than trying to pick tops and bottoms because a dotted line told me to do so.

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By Michael Toma

Michael Toma is a certified risk manager and specialist in trading the equity index and futures markets in the U.S. Toma is the author of ‘The Risk of Trading – Mastering the Most Important Element in Financial Speculation’ and is a frequent speaker on the industry trading conference circuit. His first book, released in 2010, titled ‘Trading with Confluence’, provides a first-hand perspective of risk-based trading and the challenges that new traders are forced to overcome.