Knowing when NOT to trade - The Warning Signs
Knowing when to stand aside from the markets is just as important as knowing when to be actively seeking trading opportunities in the markets. It's something that professional traders do really well and something that beginners really struggle with.
Professional traders have the knowledge and experience to know when perhaps the market acts in a certain way that makes them think "Okay now is a good time to sit on the sidelines and wait until the market starts to show some clear direction again". Whereas beginners may not recognise when the markets are not ripe for picking and they will continue to place trades and are likely to end up getting stopped out by directionless price action. Knowing when not to trade is an area of trading which can separate profitable traders from unprofitable traders so it's important as a trader to start to develop the sense of when trading conditions are not conducive to profitable trading.
Think of it in terms of an early warning system. We can compare it to any coastal regions tsunami warnings. When the water level starts to rise out in the ocean there are constant measures that alert us to the fact something's changed. These serve as a warning sign to people around the coastal regions so they can prepare to minimise the impact of the tsunami and move to higher ground. We want to develop a similar type of warning system that alerts us to when something in the market changes which tells us to manage the risk by sitting on the sidelines until the threat passes.
Let's take a look at the recent price action we have seen unfold in the Aussie Dollar as it provides a good example of when the alarm bells should start ringing. If we take a look at the AUDUSD 240 minute chart below we can see that yesterday AUDUSD had a big selloff marked by the red down arrow. This was a result of the Reserve Bank of Australia cutting interest rates by 0.25 basis points. The Aussie Dollar quickly sold off dropping over 100 points and it continued trading lower for a good 8 hours. At this point the chart was looking very bearish as the downtrend that was intact on the 240 minute chart had continued moving lower, the bears were in charge! As a result of this price action we would expect price to continue lower in its downtrend possibly with a small pullback into the moving averages. Instead what we have seen unfold throughout the European and US sessions is a complete rejection of the lower price and a strong move higher. Price has even broken the previous high meaning that the 240 chart is now actually in a no trend stage. This is the exact point where we look at the charts and think "That price action wasn't expected, volatility has increased and something has changed in this chart, it's best to sit on the sidelines for now as I don't know where price is going next".
As a result of closely reading what's occurred in the price action we have been able to create an early warning system that tells us when something's not quite ripe for the picking. By developing this kind of sense in the markets we can start to avoid getting caught in the market whipsaws that occur when neither the bulls or bears are in control.
Here are a couple of Warning signs you can use to help alert you to situations where it's better to stand aside:
- Change of Trend - When price has been trending nicely and we get a price move that ends that trend and sends price into no trend. This signifies that the market direction may be about to change.
- Large Candles - Large candles usually occur around news events when volatility increases. Large candles can quite often signal the ends of moves when amateur traders are bailing into positions trying to make a quick buck. Professional traders get in on small candles before the price moves happen and are more likely to be taking profits once the large candles have occurred.
- Unexpected Price action - A prime example was after the strong selloff in AUD yesterday we expected price to continue lower, perhaps with a smaller pullback than what actually occurred. Instead price moved sharply higher taking out the previous high. This was unexpected and should act as a warning sign.
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