“Go with the flow” is a popular piece of advice that you might get from friends when you are trying to cope with some adverse development in your life over which you have little or no control. The same advice might be appropriate when it comes to dealing with markets.

Life – and markets – have frequently been compared with a flowing river. You may not realize you’re even on that river or where you are going, but the river flows on anyway. When you float with the direction of the river, you move rather smoothly and quickly. When you try to go in the opposite direction against the flow of the river, you may be putting in a lot more effort but not making much headway.

It’s a struggle, and you seem to be losing it as the river takes you wherever it wills. Yet, most people continue the struggle because they have their own idea about where they think the river should take them or they want to be in control.

It may not take long to become frustrated fighting the current, but the problem is not the river (market) – the river (market) will do what rivers (markets) do. The problem is how YOU react to the river (market) conditions presented to you.

Giving in, not giving up

A familiar adage for traders is “Trade with the trend,” another way of saying go with the flow. In theory that seems like reasonable advice to follow but how many traders can actually follow it?

Let’s say prices move up and exceed some point that most traders believe is “too high.” How many traders will buy high and try to sell higher? Instead, many will fight the flowing trend to higher levels, and the market will go on without them.

Or how many traders fail to grasp the concept of selling something they do not own so they only take long positions? If that’s the way the market is flowing, they are in good shape, but they may well be fighting the current and missing good downside trending opportunities. 

Or how many traders have a hard time taking a loss? They stick with a position too long because they don’t want to accept being wrong, even when the flow of the market is beating them down.

Every one of these situations has nothing to do with what the market is doing but with the trader trying to make something happen or unwilling to accept what is happening. The market is not against you but you may be going against the flow of the market, which can be a recipe for disaster for your trading account.

The 90% ‘winning’ loser

Learning to flow with the market is more than just trading with the trend or getting out when the trend turns against you. It also means having the right size of position at the right time. Successful traders often say that 90% of their profits come from 10% of their trades. Richard Dennis, a legendary trader and developer of the turtle trading concept in the 1970s and 1980s, once contended that most of his profits came from 5% of his trades.

That suggests that many of the positions that traders initiate will never turn out to be winners, even for the best traders. The key to trading success is realizing that a trade isn’t working and exiting the position before it can hurt you – cut your losses short.

But there is another side to that coin, according to Brett Steenbarger, a clinical psychologist, author of The Psychology of Trading and a contributor to www.TradingEducation.com.

“If 10% of trades are going to account for the lion’s share of profits, traders must be willing to milk very good trades,” he points out. “It means being willing to trade sufficient size to maximize returns from a good trade.  The worst traders I know put on their maximum size when they’re trading at their worst.  Typically, they have just lost on one or more trades and are trying to get their money back.”

Van Tharp, a well-known trading coach/consultant whose market comments appear on www.TradingEducation.com and www.TraderBlogs.com, adds another twist to the 10% success ratio.

“Let’s say that 90% of your trades lose money and that your average loss is $100,” he writes. “On the year you make 100 trades so you end up losing 90 of them for a total loss of $9,000. However, let’s also say that your average winning trade is a big R-multiple of 100 or a $10,000 winner. You have only 10 of those in a year, but you end up making $100,000 on your winning trades. If you subtract your winnings from your losses, you’d end up with a profit of $91,000 at the end of the year, yet 90% of your trades are losers.

“My guess is that 99% of the trading population could not trade a system that would produce those kinds of results,” he continues. “The reason is because traders don’t get to be right enough and have too many losing streaks. In such a system you could easily have 25 consecutive losses. At that point you become certain that your system is broken, and you try something else.

“Let’s look at the opposite end,” he adds. “Suppose you got to be right 90% of the time. Suppose your average win was $100 and your average loss was $2,000. This means that you’d have a total of $9,000 in winnings and $20,000 in losses on 100 trades. You would lose $11,000. Would people trade that system? Yes, they would. They would probably trade it for a number of years until they went bankrupt. Why? Because they get to be right most of the time.”

Setup for success
 
Tharp advises traders to adopt a four-step process in analyzing markets:

1. Observe what the market is doing, which means looking at charts to see the trend, if any.
2. Orient yourself by putting the market’s current price into the context of broader market conditions including price action in interrelated markets.
3. Decide on a course of action based on your observations.
4. Act on your analysis to make a trading decision based on your assessment.

The key, of course, is putting these steps into action before the market masses do and acting aggressively with larger size when the best opportunities arise. Of course, a trader must have some basis for identifying when conditions are right for jumping on a position with both feet and when to lay off. Various types of trading techniques can provide this confidence, but one method takes us back to our illustration comparing the market to a river flowing within channels.

Figure 1 uses a couple of moving averages – in this case, the predicted medium-term trend (blue line) and the actual medium-term trend (black line) produced by VantagePoint Intermarket Analysis Software – to identify when a trend is picking up speed and when it is slowing down and may be about to turn around. 

After meandering, the GBP/JPY pair begins to spill out to the upside in late November. The wider the distance between the predicted and actual trend, the stronger the current (trend), enhancing the possibility for building a larger long position. When the distance between the two moving averages narrows, momentum is getting weaker, suggesting lightening the long position and even turning short in early January before jumping back to the long side in mid-January.

Figure 2 looks at VantagePoint’s predicted highs (red line) and predicted lows (blue line) for the next day to form the channel on the GBP/USD chart. For the most part, price action tends to stay within these predicted points the next day. However, when prices begin to overflow the left bank (predicted highs), the price action looks like it’s shooting upward through a narrowing canyon (although the distance between the predicted highs and lows hasn’t changed that much).

As you probably recall from your school science days, trying to push a volume of water through a narrower passage is likely to increase the force and velocity of the flow. Just this visual picture indicates the trend of the British pound is gushing upward in late November and again in mid-January and makes a good case for maximizing a position – strike while the iron is hot. Then the market slips back into the high-low channel and calms down, indicating a good time to reduce or close out a position.

Size matters

“Success is partly a function of putting size on for the logical, not psychological, reasons,” Steenbarger notes. “It is an unusual blending of traits that allows someone to be prudent with risk, scratching trades that don’t move promptly as expected, while at the same time milking opportunity. Successful traders risk manage their market exposure.  Successful individuals risk manage their life exposures.  It is not just how much we undertake, but how much we scratch in life that determines our ability to benefit from the episodes of promise that come our way.”