The market is never 100% bullish or 100% bearish. There will always be some bullish factors and some bearish factors. Here’s what you should do when market signals conflict with each other. Remember that trading and investing is all about probability. There is no such thing as a “sure thing”.
Some signals will override other signals
Inexperienced traders will tally up the number of bullish factors and count that against the number of bearish factors.
- The trader will be bullish and go long when there are more bullish factors than bearish factors.
- The trader will be bearish and go short when there are more bearish factors than bullish factors.
This is not the proper way to trade when different market signals conflict with each other. This strategy implies that all market factors are equally important. This isn’t true. Different market factors should be weighted differently.
You should always rank the factors that you consider from most important to least important. For example, let’s assume that you consider 10 factors when trading or investing. You must rank these factors from Most Important to Least Important.
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Factors that are more long term tend to be more important than factors that are more short term. For example, weekly RSI (momentum indicator) is more important than hourly RSI. Fundamentals are more important than short term technical indicators because fundamental indicators impact the market’s long term direction.
Short term factors can easily be overwhelmed by short term market forces. For example, let’s assume that the long term factors are bullish but the short term factors are bearish. The market might not make a pullback at all if the market’s “buy the dip” mentality is strong enough right now!
What happens when it’s not clear whether there are more bullish factors or bearish factors? What if your list of signals looks like this?
- Signal #1: bullish
- Signal #2: bearish
- Signal #3: bullish
- Signal #4: bearish
- Signal #5: bearish
- Signal #6: bullish
- Signal #7: bullish
- Signal #8: bearish
- Signal #9: bullish
- Signal #10: bearish
This tends to happen after major consolidations when the market is deciding to breakout or breakdown. Too many signals conflict with each other.
Always focus on the one factor that is the most important for your market when the factors are neither decisively bullish nor bearish. For example, the U.S. economy is the most important factor for the U.S. stock market’s medium-long term direction. I will ignore the technicals and focus on the fundamentals if the economy is improving but the market’s technicals are bearish. Strong enough fundamentals can easily override bearish technicals. This is what happened in 1995 and 2017. The stock market was overbought throughout the entire year but the fundamentals were strong enough to override the bearish technicals.
Focus on risk reward
I cannot stress enough the importance of risk:reward. Risk:reward will help you trade when the market is sending you conflicting signals.
Let’s assume that 50% of the factors are bullish and 50% of the factors are bearish, but the risk:reward is heavily skewed towards the upside. Focus on the risk:reward. The stock market’s probability of going up or down is 50% each, but the market’s percentage movement (MAGNITUDE) is a lot higher if it goes up than if it goes down.
Here’s a simple example.
Nobody could have called the stock market’s exact bottom in March 2009. The stock market’s short term probability was 50-50. It was just as likely to go down as it was to go up. However, the economy was improving and the stock market was undervalued. Hence, the downside risk was limited while the upside potential gains were massive. The risk:reward was heavily skewed towards the upside. Anyone who traded purely based on probability would have been sitting on the sidelines while the market soared. Anyone who traded based on risk:reward would have made huge profits from the long side.
There’s no shame in staying in cash
There will always be times when the market is not convincingly bullish or convincingly bearish. You don’t have to trade during times like this! There’s no shame in staying in cash when your market outlook is unclear.
Remember, trading is about probability and risk:reward. It’s best to just not trade when the probability is 50-50 and the risk:reward favors neither side of the market. Otherwise you’d be rolling the dice.