Market Direction: Why It Determines Your Trading Success More Than Any Setup
- FinancialWisdom
- Jul 24, 2023
- 7 min read
Updated: Jan 17
Trend Following Using Two Simple Techniques
Summary:
Market direction plays a decisive role in long-term trading success. Profitable trading is not about making money in all conditions, but about pressing advantage during favourable market phases and protecting capital when conditions turn hostile. By aligning strategy, position size, and risk exposure with broader market trends, traders can compound steadily during bull markets while avoiding destructive drawdowns during corrections and bear markets. This guide explains how to identify market direction, adapt trading behaviour accordingly, and use objective tools such as trend structure, moving averages, and performance feedback to improve consistency, protect equity, and trade with maturity across market cycles.
Introduction
Here we discuss the role of market direction and the profound impact it has on trading success.
Good trading is not about making money all the time. It’s about making significant money when conditions are right, and preserving capital when conditions are not. Traders who fail to understand this distinction often give back years of gains in a single hostile market phase.
I frequently share my equity curve, covering the last eight years, not as a boast—but as evidence of what is possible when market direction, risk control, and discipline work together.
You’ll notice periods of strong growth, but also periods of stagnation. Those flat periods are not failures, they are controlled phases where capital was protected while the market environment was unfavourable.
The goal is not perfection. The goal is survival, consistency, and selective aggression.
Markets Move in Cycles — Always
Financial markets operate in cycles, not straight lines.
Broadly speaking, markets rotate through:
Bull markets, which can last several years
Corrections or consolidations, often lasting 6–18 months
Bear markets, which tend to be sharp, emotional, and destructive
New traders are often drawn in during the boom phase. Easy wins create confidence, sometimes overconfidence. The real test comes later, when markets turn choppy or decline. Without a framework for adapting to these conditions, traders often lose not just profits, but capital.
Understanding where you are in the market cycle is essential. Good periods do not last forever. Neither do bad ones. But failing to adapt during transitions is what ends most trading careers.
Why Trading the Same Way in All Markets Fails
One of the most common mistakes traders make is applying the same rules, position size, and expectations in bad markets as they do in good ones.
When the market is trending higher:
When the market is declining:
Long trades fail more frequently
Volatility increases
Correlations rise
Risk compounds quickly
A strong rising market lifts most boats. A declining market sinks them.
Ignoring this reality is one of the fastest paths to large drawdowns.
Case Study: What Happens When Market Direction Is Ignored
A clear example of this failure can be seen in the ARK Innovation Fund.
During the strong bull market from 2020 into early 2021, ARK benefited massively from momentum and speculative growth. However, when the broader market environment changed in 2022, there was no meaningful risk management at the portfolio level.
The result?
Positions were held through a full market decline
Drawdowns exceeded prior gains
Capital erosion accelerated
Even more concerning, some of the fund’s strongest future performers such as Nvidia, were sold near the beginning of the next uptrend, compounding the damage.
This highlights a crucial lesson: buy-and-hold without market awareness is not risk management, it’s hope.
Why Market Direction Drives Win Rate
It’s not difficult to understand why market direction matters so much.
When the broader market is falling:
More long trades fail
Breakouts lack follow-through
Stops are hit more frequently
When the broader market is rising:
More trades work
Trends extend further
Risk-to-reward improves naturally
Trading success is not just about finding good setups, it’s about deploying those setups in the right environment.
How to Identify Market Direction
There is no single perfect tool for determining market direction, but there are several effective approaches.
Dow Theory: A Foundational Framework
Dow Theory defines trends as follows:
Uptrend: Higher highs and higher lows
Downtrend: Lower highs and lower lows
Applied to major indices like the S&P 500, Dow Theory provides a clear structural view of market direction. However, it is inherently lagging, as swing highs and lows are only confirmed in hindsight.
That doesn’t make it useless, it makes it a foundation, not a timing tool.
Moving Averages: A More Adaptive Approach
To improve responsiveness, I rely heavily on moving average analysis, specifically the 10 and 20 exponential moving average (EMA) crossover applied to the S&P 500.
This approach has become the backbone of my strategy for defining:
When to trade aggressively
When to reduce exposure
When to remain largely in cash
Had this method been applied consistently prior to the 2022 market decline, portfolio damage would have been dramatically reduced. It is not predictive, it is adaptive, and that is its strength.
Using Your Own Trading Results as a Market Signal
One of the most underutilised tools in trading is your own performance data.
If your recent batch of trades shows:
Declining win rate
Faster stop-outs
Poor follow-through
It is often not a failure of execution, but a sign that the market is not conducive to your approach.
Conversely, improving trade outcomes often coincide with healthier market conditions.
This feedback loop allows you to adjust position size and exposure without relying solely on external indicators.
Position Sizing as a Response to Market Direction
This is where adaptive risk management becomes powerful.
I use a dynamic position sizing approach influenced by the Kelly Criterion, which adjusts exposure based on:
Win rate
Reward-to-risk
Recent performance
As market conditions deteriorate, position sizes naturally reduce. As conditions improve, exposure increases. This keeps drawdowns contained while allowing capital to compound when probabilities are favourable.
Market direction and position sizing should never be treated separately, they are deeply linked.
Discipline Matters Most in Bad Markets
Hostile markets expose weaknesses quickly.
Without clear rules:
Losses compound
Emotions take over
Revenge trading creeps in
Risk expands at the worst possible time
This is why discipline becomes more important, not less, when conditions deteriorate. Trading smaller, trading less frequently, or not trading at all is often the most professional decision.
Preservation is not passive, it is strategic.
Final Thoughts: Trade With the Market, Not Against It
Good traders do not try to force returns in every environment.
They:
Press when probabilities are high
Pull back when conditions deteriorate
Let data,not emotion,dictate exposure
Market direction is not a secondary consideration. It is the context that determines whether your strategy thrives or struggles.
If you align your strategy, risk, and position size with the broader market environment, you give yourself the greatest possible edge, not just to profit, but to endure.
And in trading, longevity is everything.
Frequently Asked Questions (FAQs)
1. What is market direction in trading?
Market direction refers to the overall trend of the broader market—whether it is in an uptrend, downtrend, or consolidation phase. It is typically assessed using market indices such as the S&P 500 and helps traders determine whether conditions are favourable for taking risk or whether capital preservation should be prioritised.
2. Why is market direction so important for trading success?
Market direction heavily influences win rates. In rising markets, long trades tend to work more frequently, while in falling or choppy markets, even good setups often fail. Trading without considering market direction increases drawdowns and reduces the probability of success.
3. Can a good trading strategy work in any market condition?
No strategy works equally well in all market conditions. Most strategies perform best in specific environments. The key is not forcing a strategy to work, but adapting exposure, position size, or activity level based on whether the market is supportive or hostile.
4. How do professional traders determine market direction?
Professional traders use a combination of tools, including:
Market structure (higher highs and higher lows)
Moving averages (such as EMA crossovers)
Breadth and momentum indicators
Performance feedback from their own trading statistics
No single tool is perfect, which is why confluence and adaptability matter.
5. What is the 10 and 20 EMA crossover strategy?
The 10 and 20 exponential moving average (EMA) crossover is a trend-following method used to identify broader market direction. When the shorter EMA is above the longer EMA, market conditions are generally more favourable. When it is below, risk is typically reduced or avoided.
6. How can my own trading results help identify market conditions?
If your recent trades show a declining win rate, faster stop-outs, or poor follow-through, it often indicates that market conditions are not conducive to your strategy. Improving results can signal a healthier market. Using your own performance as feedback allows for adaptive risk management.
7. Should I stop trading completely in bad markets?
Not necessarily. Many traders reduce position size, trade less frequently, or focus only on the highest-quality setups during poor market conditions. The objective is not to maximise profits, but to minimise damage and stay mentally and financially prepared for the next favourable phase.
8. How does market direction affect position sizing?
Market direction directly impacts position sizing. In favourable markets, traders can gradually increase exposure. In hostile markets, reducing position size limits drawdowns. Adaptive sizing methods—such as expectancy-based or Kelly-style models—help align risk with market conditions.
9. Why do traders often give back profits after good periods?
This usually happens when traders fail to adjust risk after market conditions change. Applying the same aggression in bad markets as in good ones leads to larger losses, erasing prior gains. Awareness and adaptation are what prevent this cycle.
10. Is market timing the same as predicting the market?
No. Market timing, when done correctly, is about reacting to objective signals, not predicting tops or bottoms. The goal is to align exposure with prevailing conditions, not to forecast future prices.
Related Reading
Inside the Financial Wisdom Weekly Consolidation Breakout Framework
Risk Management in Trading: The Foundation of Long-Term Profitability
Published by FinancialWisdomTV.com Trading Education | Risk Management | Trading Psychology
Hey man, huge fan of your channel. I was hoping to ask you a genuine question.
I watched the 10/20 EMA crossover video you mentioned in this recent video, and I was very excited by the prospects of how simple yet effective it is. However, doing some of my own backtesting didn't end in the same result. In your 10/20 EMA crossover vid, your video shows a 411% return from 2002 to 2023. But I ran the same 10/20 EMA crossover strategy, on the weekly timeframe from 2002 to 2023 in TradingView and it's only a 217.58% return, underperforming the SP500. Would love to discuss anything my backtest is doing differently than the backtest you did. My simple code:
The chart…