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Why did you enter a position on your last
trade?
Let’s take an example from my trading this morning:
The Dax was according to my analysis beginning a downtrend and I
wanted to sell short on any retracements. The Dax retraced 61.8% of
the move from the previous day, and I placed a “sell short
“position.
Let’s summarise what I have done:
- I have analysed the past (done my homework)
- I have found a spot where I think the market will turn
- I have placed a stop a suitable amount of points away from the
entry to ensure that if I am right I will not be stopped out before
the move gets underway. If I am wrong, I will know how much I have
lost.
Later in the morning I am rewarded with 60 points for my work.
If I had lost on the trade, my loss would have been 12 points.
What about you?
Are you placing your trades on the back of hunch? Are you doing
your homework? Did your trade come from a breakout from a trading
range? Did your system that you purchased generate a signal without
you knowing why? Or maybe you entered because you felt the market
was overbought or oversold. There could be any number of reasons
why and where you have entered a trade.
First of all you should have a trading plan in place to
determine your entry and exits. All successful traders know exactly
why they have entered a trade and more importantly they know
exactly where they want to get out in case a trade goes against
them. Many novice traders pay far too much attention on their entry
levels only. Your exit point is just as crucial and deserves equal
attention.
Once you have entered a trade based on your opinion or
methodology, you are at risk. At this point you should already have
a stop in place for protection. Assume that the trade moves in your
direction and you are now in profit. What is the best thing to
do?
There are various schools of thoughts on this matter. Some say
raise your stops from the recent pivot low so that you are trailing
the market. Others say keep your stop fixed at the lowest low so
that you can give your trade room to move.
If you are a conservative trader then yes you would want to
trail your stops to minimise losses. However this method does have
its faults where your stop may be triggered only to find that your
trade moves back in its original direction.
One of the safest strategies to employ after your trade has been
initiated is to at least get to break even. In other words, your
trade moves into profit and once it has cleared your entry level,
remove the stop from where you had originally placed it and move it
to your entry price.
Example:
Long entry on stock ABC is at 12.50 with a stop at recent low of
12.00 the risk on this trade is 50 points.
A few days later, your stock is now trading higher at 13.50.
Remove your stop from 12.00 and place it at your entry level of
12.50.
Your risk is now at zero - unless of course in an extreme event
where the market may suddenly gap lower below your stop Level.
(Spreadbetting allows you to use guaranteed stops where you can
only lose a specified amount).
This method of breaking even is one that I recommend. It allows
you to feel that your trade is now a free trade where your profits
can run.
What about exiting a trade?
You have heard the saying Cut your losses and let your profits
run. Well that’s great in theory but still difficult to apply for a
novice trader.
Have you ever been in a trade which is profitable and then
starts to pull back to eat away some of your profits? You then exit
because you do not want to give back your profits. That is fear
coming into play. After you have exited, your trade moves back in
the direction you first anticipated. So what do you now?
You jump back in chasing the market and hoping to catch more
profits. This is greed coming in to play.
This scenario figures again and again in the financial markets.
How can we deal with these emotional situations?
One way is to set a target for exits based on risk reward
ratios. Let’s say that your current position has a 50 point risk.
You could use a strategy that at least gives you 3:1 profits on
your trades. So for every 1 you are risking, you should receive 3
back. This means that you can afford to take one loss, followed by
another loss, followed by a profit - and still stay in the game
without damaging your account. For your 50 point risk you would aim
for a trade which will generate 150 points in reward.
Of course, you never know if your profit target will be reached.
However, if you have a decent strategy based on the above method
you should at least have a better chance of survival in the
markets.
On the other hand, you can aim for much larger profits as taught
in Trend Trading. Great in theory but unless the markets are in a
runaway mode this can be difficult to achieve. It can get very
emotional with the up and down swings. However, this is where the
big money can be made.
For more information on this topic, read my previous articles on
Trading or investing and What is a trading plan?
Just remember, if every trader knew exactly where to get in and
where to get out then trading would be easy and the markets would
be too efficient.
Happy trading!
Tom Hougaard
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