The One Chart Signal That Warns You When NOT to Enter the Market

A few days ago I explained how our brains can make wrong decisions.

I said that high emotions and fast thought patterns can be destructive to good decision making… specially in trading.

A good trader needs tools to assess the risks better. Specially if those tools can also calm down your emotions.

Let me tell you about one of my favourite tools to quickly calculate risk. This tool allows you to objectively see when it is too risky to enter a market and also keeps you emotionally calm.

Let’s start with an example. Take a look at a chart of crude oil, which since late March has put in a nice rally:

Crude Oil

After looking at the above chart, ask yourself this question: when was the worst time to buy crude oil? What price level was the most risky to enter the market? This will not be clear or obvious from the chart.

You see, most traders are too concerned with “when to buy” or “when to enter the market”. Very little thought is given to when NOT to enter the market.

Now take a look at the chart below of crude oil and the answer becomes immediately obvious:

Crude oil and Sigma chart

The LT Sigma Chart divides a normal price chart into 3 zones: safe, moderate and extreme. The red sigma zones are the “extreme” price levels and the blue sigma zones are the “safe” price levels.

This brings me to my Rule #1: We never “go long” or buy into a market when the price is inside the upper red sigma zone. This tells us the price is “extremely overvalued”.

It is much safer to wait and then buy when the price is at fair value (the blue zone).

Take a look at another example on the British Pound, 4-hour chart:

GBPUSD and Sigma Chart

Notice that in both charts of crude oil and British Pound, we avoid going long when the market is inside the upper red sigma zone. The price was extremely overvalued at that point, and therefore too risky to enter.

When the price is extremely overvalued we stay out, and thankfully avoid the painful drop back into the fair value zone.

I think you’ll agree that this makes total logical sense.

For example, why would you buy a house or a car at overvalued prices? It makes sense to wait for a “sale” or a “discount” and then buy at fair market prices.

You may ask at this point a very good question: “Why wait for the price to improve before you buy, if you still believe the price will go higher?”.

The answer is simple: because you want to get fair value (or below fair value). Even if you believe the price of a house you’re investing in will eventually rise, you still want to get a good deal when you buy it, right?

The same applies if you buy a commodity like gold:

Gold Sigma Chart

Anyone who bought gold at extremely overvalued prices would have been punished – and quite rightly so!

Notice that by NOT entering the market when the price is at an “extreme” sigma level, we are also not allowing our emotions to overpower us. We remain calm and objective, and wait for the price to drop back to “fair value”.

Waiting for the price to reach fair value is also good practice when a market is in a strong upward trend. And this applies to ANY timeframe.

Take a look at this 1 hour chart of the British Pound (GBPUSD):

British Pound Sigma Chart 1 hour

The British Pound rallied strongly in mid-April. Even so, the smart and informed trader never enters the market by buying at overvalued prices.

As you can see from the charts, the market usually punishes people who go long at extremely overvalued levels by making a pullback to fair value.

Instead we wait for the price to adjust to the sigma fair value before we buy.

Once again, the Sigma succeeds in warning us NOT to enter the market at the wrong time.

You may ask at this point whether it would have been wise to perhaps “short” the market when the price reaches an extremely overvalued zone.

Yes, it is possible to do that. However, the safest thing to do is to first check the Sigma Momentum. I prefer to trade in the same direction of the sigma momentum. Take a look at this 1-hour chart of the GBPUSD below:

British Pound Sigma Chart 1 hour

Below the Sigma indicator, we see the Sigma Momentum indicator (in blue). When the momentum bars are above zero and rising, we prefer to focus on long trade setups and avoid short ones. The reverse applies if the momentum is below zero.

This ensures that we trade with the momentum and force of the trend, not against it.

In conclusion, the Sigma indicator provides a powerful and invaluable tool for traders in deciding when NOT to enter the market. It helps keep our emotions in check and keep us safe in a very volatile market environment.

For more updates and strategies on trading the markets, join our trading service on: www.leadingtrader.com

Comments are closed