🍔How I Make Money by Trading with Context
Learn to identify the market environment to improve your odds of success
Many traders get caught up focusing solely on their individual strategies or positions or setups. They forget to look at the bigger picture and understand how it's impacting their strategy. They assume they can make money under any conditions... And that is the fatal flaw.
Trade with the context.
Regardless of what your exact trading strategy is, everyone can benefit from knowing the context. The context is simply the prevailing direction of the market (up, down, or sideways). The idea is simple: in an up market, look for buying opportunities. In a down market, look for shorts. In a sideways or chopping market, switch to mean-reverting strategies with shorter holding periods.
Trading with the context helps stack the deck in your favor and increases the odds of a trade working. @theEquilibrium, a swing trader I respect a lot, said it best when he said "Environment trumps everything"; I highly recommend watching his interview. We are not trading in a vacuum! Understand the environment you're in and adjust your strategy to fit the environment; use the right tool for the right job. This can often make the difference between profitable and unprofitable.
What’s the context?
Determining the context is no easy feat. Luckily, this is where MktContext comes in. We use fundamental or "macro" clues, combined with technical indicators, to try to decode the trend.
Macro covers key economic indicators such as GDP growth, unemployment, government policy, etc. The economy is what fuels corporate earnings, in turn driving stock prices up or down. For example, if more people are employed, then more spending will occur, which means more revenues for companies and hence higher stock prices.
However, fundamental data can often lag market prices which makes it difficult to trade on macro alone. Recall the summer of 2020, in the depths of a Covid-driven recession, the stock market was soaring to new highs! That's an example of the market's forward-looking nature (plus a healthy dose of government stimulus).
For that reason, we layer on technicals to make sure we aren't getting tricked by the fundamentals. Technicals includes chart patterns, internals, sentiment analysis, etc. to determine the price action of the market. I'll detail the indicators I use in a future post. For now, suffice it to say that technicals provide us with confirmation on whether our fundamental view is correct.
Together, the fundamentals and the technicals form the market context which guides our trading and investing decisions. That's how we make money trading using context!
Storytime!
Let's look at a case study of how we used market context to trade a bear and a bull market. In the bear market of 2022, companies were coming off of an ebullient post-Covid surge. The economy was weakening as measured by GDP (with lag), and the SPX fell 28% from peak to trough. Inflation was getting out of hand, causing the Fed to aggressively raise interest rates (historically negative for stocks).
Macro: rising interest rates, decelerating growth, recession fears (bearish)
Technicals: negative sentiment, break below moving averages, downtrend and strong resistance, VIX spiking, 3-waves-down (bearish)
Positions: traders look for shorts; investors mostly in cash.
Then suddenly, something clicked in October 2022. Though the economy still looked to be on the brink of recession, the inflation numbers started to come off fever pitch and the technicals started to turn. The market performed a hammer candle (a reversal pattern) and breadth indicators (indicating overall health of the market) started to perk up.
Macro: Inflation stalled, Fed emergency 75bps raise done, corporate earnings improving (rebounding)
Technicals: Oversold conditions, “hammer” candle, multiple breadth thrusts, reclaimed moving averages (rebounding)
Positions: traders should realize bear market is ending; investors starting to redeploy into equities.
For the next year and a half, the market took off and didn't look back. Even the banking crisis in March 2023 could stop this rocket. And barring a few seasonal pullbacks, the market "rode" the moving averages to prior highs, then to new all-time highs. This was the golden moment; a new bull market had begun. Anyone still stuck in recession mode (like many economists out there) was now against the context.
Macro: Inflation cooling, interest rates falling, Fed pivot, earnings recovery, GDP resumes growth (bullish)
Technicals: Strong upward trend, more breadth thrusts, cyclical stocks start to outperform, bullish options activity (bullish)
Positions: buying stocks with both fists; we're in a new bull market!!!
Surely, it can't be that easy?!
Obviously, the above example is simplified and sounds easy when you know what to look for. In reality, at each turning point the macro was divisive and charts were fraught with whipsaws. I remember feeling skeptical of the signals even as they were playing out in front of my eyes. Such is the art of trading. But knowing the market context helped me make the appropriate trades at the right time. We may not have picked the exact bottom, but we were darn close.
The case study is meant to illustrate the power of understanding the market context. This is the whole point of the MktContext newsletter and why I started it - to clarify my own thoughts and discuss/share these signals with the world. I hope that you too can adopt a similar "big picture" approach for your own investing and trading journey.
Going forward, you can expect to see market timing calls similar to what's presented above. It won't always be perfect, but it should be enough to offer you a notable edge in your investing/trading decisions. So come along for the ride - and consider purchasing a paid subscription to get the full context! 👇That’s all for now - in next week’s post we’ll go over the current context and what I’m seeing.
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Twitter/X: @mktcontext
Disclaimer: This publication is for educational purposes only. The authors are not investment advisors and nothing here is investment advice. Always do your own due diligence.