Trading Trendless Markets

There are few things I dislike more than flat 200 period moving averages. This market condition often indicates a lack of long term trend and makes for a choppy trading environment. That being said, there’s a time and a place for everything, even trading trendless markets.

My favorite type of setups in this environment are those that take advantage of the choppiness and mean reversion associated with flat 200 period moving averages, rather than being hindered by it. In order for this type of trade to be successful, the weight of evidence has to be leaning heavily in one direction, as price alone often gives “mixed” signals. For my process, I generally look for 4 or 5 of the following factors to be pointing in the same direction before acting on an idea; price, momentum, sentiment, seasonality, and the slope of 200 period moving average. The last thing that’s needed is a catalyst; without it you’ll likely fall victim to the whipsaws and false moves we mentioned earlier. It’s important to constantly ask yourself “what is going to force this choppy market back to its mean?” That question will also help you outline a level where you’re wrong.

Cocoa Futures in early July were a great example of this.

As we can see from the daily chart below, prices rallied sharply off the March lows after a false breakdown and were approaching the old highs where prices failed last October. Despite strong short-term action, the 200 period moving average was relatively flat on both the daily and weekly timeframes. To be sustainable, prices either had to consolidate at these levels to allow the moving average to catch up, or mean revert lower.

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In order to get a more complete picture I took a look at public sentiment and saw that it was approaching YTD highs, while commercial hedgers were aggressive sellers – adding to an already historically large net short position. From a seasonal perspective, there wasn’t much of an edge long or short, so my takeaway was that the overall market backdrop was relatively bearish.

With a bearish backdrop, momentum diverging, and prices putting in a false breakout at resistance, prices were bound to go fall right!?!?

Or so I thought… Instead, prices decided to make one more high before providing another catalyst to breakdown more aggressively. From my experience, what I often see with these types of setups is prices making one more move in the direction of the short-term trend with momentum diverging before reversing. In this case the major catalyst ultimately ended up being the bull flag resolving to the downside on 7/22, which sparked the move lower (still in progress) toward the 200 day. Again, in my experience, if you can find situations like this one with false breakouts/breakdowns or continuation patterns that fail, your probability of success will be much higher. Even if you were stopped out initially, keeping it on your radar provided a nice opportunity just a few short weeks later.

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The Bottom Line: Trendless markets can be frustrating and with plenty of other liquid products out there to trade, I often avoid them altogether. Sometimes the weight of evidence lines up in one direction or another, providing opportunity to profit from the otherwise choppy trade that takes place. That being said, patience and risk management are particularly important with these types of trades. Since you are trading against a short-term trend in the hope of a reversion toward the long-term trend, you’ll rarely get the timing right your first go around. However, as Cocoa Futures demonstrated above, revisiting a trade when price is being more cooperative can be very worthwhile.

As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can.

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