The role of Market Context and do you need it?
Market context is the greatest trade management technique
Markets operate in cycles, so after every bull run comes a bearish phase. The size of the bearish phase depends on the size of the previous bull run. If we trust that the market operates in cycles—and I believe it to be the ultimate truth, equivalent to enlightenment—then we have to trust that the bearish phase will come after the bullish phase, and the bullish phase will come after the bearish phase.
There are certain characteristics of both phases. One such characteristic is that you make a lot of money in bull markets because it’s easier on the mind to play long only. Short trades are generally triggered by panic, setbacks, or bad news, where the sentiments of the traders are always extreme. If you are a trading Buddha, you might be able to maintain calmness amidst the chaos, but the instruments in which you are trading won’t remain calm. They will be volatile, sometimes beyond your control. This is why trading short positions feels different from trading long positions.
So, most traders avoid trading in that phase. The progressive question is: how do you identify such phases? Even more important is why you should identify such phases. If you, as a trader, choose to play only one phase of the market, then you must have some defense against another phase of the market that could harm you. For long-only traders, it’s the bearish phase they must safeguard against. For bearish traders, it’s the momentum in a bull market.
The need is clear: it’s a defensive strategy to save the trading account from drawdowns and higher losses. How do we do it, then? That is where traders are most divided because there is no objective way of defining what the favorable market condition is. For long-only traders, it’s the bullish phase, but how bullish? What’s the objective definition of it? There is no objective way of defining it because the market isn’t objective; it’s random.
Money comes from your interactions and interplay within the market environment. But the market environment is chaotic and random. One cannot expect any objectivity to come out of such an environment, so the objectivity has to come from you. This is the primary reason why every trader adopts a different method to define market context. Although there are some common tools most traders use, the methodology must be unique to their understanding of the market. Objectivity only comes from your understanding of the market, as the market has no nature of its own except eternal randomness fueled by human sentiment—often extreme.
If you think I am digressing, then I apologize. But in my defense, I am taking you to the depth of your fundamental understanding of the market. It is through that individual understanding that you can add meaning to the market’s randomness. There is no inherent context to the market; it is whatever you give to it.
Your trading strategy is a tactical play to extract money out of the random market. Based on your engagement tactics, what are the things that you need in your favor? More importantly, what can go wrong? If you are a short-term swing trader whose strategy is to take 8-10% of the gains from a sudden burst of movement with good position sizing, then the apparent question is not when such moves can happen, but when such moves cannot come.
If you think your strategy can comfortably work during both bearish and bullish phases of the market, then the only thing you need to focus on are the opportunities, as they might reduce. If your strategies highly depend on the larger tide of the market, such as momentum strategies, then you need to identify when the larger tide has turned for the worse. A good indicator of that could be the 10, 20 EMA crossover on a weekly timeframe. A positive crossover could mean that sentiments have turned positive.
Another strategy is to analyze all the tradable stocks by their milestones. How many of them are trading strongly above their key EMAs, like the 200, 50, or 20? How many of them are hitting yearly and all-time highs? People make one common mistake of finding extreme zones in the hope of taking contrarian bets, which is a fool’s errand, in my opinion. You built your strategy to make money, which will do its job in a favorable market condition. The purpose of market context tools is to tell you when the conditions will be conducive to your strategy.
Additionally, you can analyze all the stocks according to their returns and performance in the last 1 month, 3 months, and 1 year in Google Sheets. You can rank them based on their performance. You can even create an automated sheet with more information and build your own market context indicator.
A lot of market context analysis comes from your trading journal. When you have a habit of journaling your trades for performance analysis, you can find patterns in your best and worst performances. Compare that with the broader market conditions, and you’ll know why things were working in your favor. That’s why a trading journal is the most important aspect of trading; it not only exposes your trading style and biases but also tells you a lot about the market condition.
You need to do an exercise with your trading journal in front of you. Inquire what makes your strategy work. What is the underlying principle behind the workings of your strategy? If you simply buy breakouts, then the next question is: at what point do you prefer to buy? A simple base breakout will not work with the same efficiency as it would during a favorable market condition. So, choose what can tell you that the market conditions aren’t favorable. Will you refer to Dow theory on a weekly timeframe, the number of stocks hitting yearly or all-time highs, or the number of stocks above key EMAs?
If most of the base breakouts are giving positive results then so would yours, at least there’s a high probability.
This brings us to another important aspect of market context: do you really need it? The answer is simpler than we realize. It entirely depends on how many opportunities you get in your strategy. If your screener frequently throws 20-50 stocks for you to scan the base and buy breakouts, then you need to analyze broader trends. Because the math wouldn’t work in your favor otherwise.
Imagine taking 4-5 trades a week. In a year, you would take 200-250 trades. Even on a conservative scale, you would take 150 trades, give or take a few. That’s a lot of trades. With the right market cycle, good position sizing, and a high reward-to-risk ratio, you could make a fortune—but then you need to learn the art of sitting out of the market. This sitting out part can last as long as a full year.
Some traders prefer to capitalize on opportunities arising during counter-trends. There’s nothing wrong with it, except you need to be nimble-footed to enter and exit with equal swiftness. As a trader, you need to understand that observing market context is an interesting way to optimize your trading performance, but it is by no means mandatory. A lot of trend followers do not optimize their trading based on market context. Traders who swear by rule-based trading do not prefer to modify their trading style or stop it based on market context.
If you are someone who has yet to see bigger profits with consistency, you need to first figure out a profitable way of trading. This means focusing on stock selection and money management to survive for at least 300-500 trades.
I do not bother to check market context because of the nature of my trading style. I look for trending stocks for the long term, ranging from 6 months to 18 months. My trading approach is so binary that if the market is not favorable, I won’t get any opportunity to place random trades. Some trades may fizzle out, but there are no breakouts in my trading—there are trends. The stock is either trending or not. There’s no third alternative. The trading system empowers me to avoid market context because the core of my strategy is doing precisely that.
If your trading setup has a fundamental logic that helps you eliminate bad markets by giving you fewer opportunities or none, then you have no need to focus on market context to further optimize performance. You have already done that through your trading system. If you worry about making sense of overall market breadth, you can either apply a simple filter like a stock must be above the 20 SMA to even qualify for your screener. It could be anything you’re comfortable with.
Good traders do not have good systems; they have excellent trade management techniques. Trading only during favorable market conditions is one such management technique, which allows them to limit their drawdown and achieve super performance. But that is not the only way to achieve super performance. It’s certainly the most popular way. Ultimately, you will have to decide the path, and it can only happen through your trading system. The market only understands your buy and sell orders; everything else makes sense only to you, and nobody else.
Love reading your post. Only few in India write about trend following. Most are busy in buying daily breakouts.