Trading Mistakes
Neophytes think their trading mistakes will vanish after a few million hours of experience but that just isn’t true. Even professionals still make costly mistakes that should have been avoided. Trading mistakes run the gamut from mental errors to misguided opinions. The most common ones also cause the most damage. For example, just consider how much money your bullishness cost you in the last two bear markets.
Trading mistakes can’t be eliminated but you can curb their considerable influence. Start by listening to the little voice in your head, and let it question every decision you make. In no time, you’ll uncover a dozen ways you’re losing money for no good reason.
Fortunately, we can control our own fates most of the time. To this end, it’s vitally important to recognize the circumstances that place us at the most risk of making bad decisions. Realistically, the following scenarios will keep draining our accounts but their impact can be reduced substantially when we see them coming, and initiate defensive countermeasures.
- Out of Synch – There’s nothing worse than playing a trend in a choppy market, or a chop in a trending market. Make sure you know the type of environment you’re trading before pulling the trigger.
- Pressing The Bad – You don’t want to admit it when you’re wrong so, rather than cut your losses, you press on with bad positions, trying to turn lemons into lemonade.
- Cutting the Good – You’re in a great trade but something inside doesn’t want that wonderful experience, so you exit with a small profit just before the position takes off like a rocket.
- Being Early – You get ahead of yourself by jumping into a position that isn’t ripe and get shaken out, just before the pattern does exactly what you expected.
- Being Late – You’re unable or unwilling to pull the trigger on a great setup, because you’re waiting to see what everyone else does. As it turns out, everyone else is ready to get out by the time you’re ready to get in.
- Bullishness – You think the market is ready to go up after every leg down, forgetting that real buyers can be real hard to find at times.
- Bearishness – You spend more time listening to doomsayers than reading the charts and miss buying opportunities, even when they’re smacking you across the face.
- Ignoring Gravity – Markets go down when they can’t find buyers, regardless of how few sellers are out there at the time.
- Forgetting The Big Picture – You get so wrapped up in current events that you forget to step back and check out the weekly or monthly charts.
- Forgetting The Little Picture – You confuse macro events with micro plays and let the big picture obscure what’s right in front of your nose.
- Fear of the Squeeze – The squeeze crushes short sellers in the early phases of downtrends but your anxiety is misplaced when negative momentum replaces a two-sided tape.
- Last to the Party – The fear of missing out overcomes your better judgment, and you jump in. The trend ends immediately, and you’re stuck holding the bag.
- Margin Fever – You have a small account but want to be a big player, so you overtrade margin and get into a heap of trouble.
- Getting Even – You lose money and vow to get it back the next day or next week. Bad move, Charlie Brown, because you’ve just abandoned your trading plan.
- Listening to Pundits – You shoot yourself in the foot because you let someone else tell you what to buy or sell.
- The Agony and the Ecstasy – Pleasure makes you feel like Mr. Market, setting you up for a big fall, while pain attracts positions you don’t want and can’t control.
- Chasing The Open – You go to bed so excited that you can’t wait for the next day’s opening bell. Guess what, you’ve just put a big target on your back.
- Software Fever – Pretty colors can’t make you a better trader, but they can make you a poorer one. Sadly, kilobytes are no substitute for a lack of skills.
- Lottery Ticket – How often do you carry a position into an earnings report, hoping to get a pop from the news? Hmm, I thought so.
- Counting Your Chickens – You forget that profits on open trades aren’t real until you put the green into your pocket.
Off To Europe
I’m headed to Czech Republic later today (April 16th) to participate in the Czech Money Expo and do a full day seminar on April 22nd. You can find information on the program here.
I’ll be back at my workstation in Phoenix, Arizona on April 26th. Morning Trader and column updates between now and then will be sporadic. I’m sorry for the inconvenience.
Rinse Jobs
The rinse job denotes a sudden dislocation during a rangebound phase, in which price thrusts above or below support/resistance and then reverses, closing back within the boundaries of the sideways pattern. These buying or selling spikes shake out stop losses and trigger all sorts of contrary entry signals. Rinse jobs can unfold in many ways, but two manifestations are most common in our modern diabolical markets:
- Bull or Bear Trap – The instrument gaps out of a 15-minute or 60-minute range at the opening bell, draws in breakout or breakdown traders, and then reverses hard, filling the gap.
- Stop-Gunning Exercise – The instrument grinds sideways for a few hours, attracting the continuation trade. Price suddenly jumps out of the quiet range, thrusts a few ticks and then reverses hard.
Trapping behavior is most common in the latter phases of established trends, in which one side is controlling the tape. As a rule, complacency runs high in long uptrends, setting up abnormally low put/call readings. Flip over this tendency in long downtrends, when chronic fear yields equally high put/call readings. Both scenarios present ideal conditions for gaps against the prevailing trend that shake out weak hands and reestablish a balance between positive and negative sentiment. In most cases, these gaps fill quickly and the trend resumes, until the next imbalance yields another trap.
Traps are also set when one side of the market gets overcrowded because a large-scale news shock is so bullish or bearish that traders overreact and chase one strategy too aggressively. The capture of Saddam Hussein in 2003 and the London bombing in 2005 both yielded this type of extreme reaction, with massive gaps that filled immediately, trapping bulls after the first event and bears after the second event. These contrary dynamics play out all the time, to a lesser degree, after economic or earnings releases that shock the prevailing wisdom.
The Nasdaq-100 Trust closes at high tick (1) on May 4th and pulls back the following day. It closes just under the high and breaks out on May 6th, in a healthy gap. Sellers enter the market immediately, knocking the fund back under the two-day high (2) in a rinse job that yields a vertical selloff. The decline breaks the low of the prior day (3) and then recovers strongly, closing about 35-cents under the opening high. The Trust gaps above the prior day’s recovery high (4) the next morning and sells off (5), in yet another rinse job. This decline also breaks the low of the prior day (6). Price tests the multiday low (7) in the next session and closes strongly. A third rinse job erupts the following morning, with a down gap (8) that undercuts the multiday low and then zooms higher, trapping early short sellers.
Overnight rinse jobs, especially on the major indices, get most of our attention but midday events are also common, especially in dull or sideways markets. These rinse jobs take on two distinct scenarios.
- A morning trend reverses and pulls into a common support or resistance level. Pullback traders jump in, price cuts sharply through that level, and shakes out those orders. The instrument then reverses and reestablishes the early trend.
- A trading range, lasting days or weeks, is broken suddenly by a vertical rally or selloff, triggering a variety of entry and exit signals. Price takes in these orders and then reverses, closing the session back within the daily or weekly range.
This manifestation has great predictive value when it occurs on the index futures because intraday equity positions are likely to reverse in lockstep behavior. In addition, these small patterns yield instant trade setups because we can place stops just outside the buying or selling spike, and capture a low risk entry into the morning trend. Once positioned, price should “snap back” through support/resistance by the close of the next 15-minute bar. If it holds the new high or low any longer than that, the countertrend can attract momentum players and yield a secondary spike that cuts through the stop loss.
You might not locate second scenario events until they show up in your end-of-day research. You can find these patterns with the 7-Bells Finger Finder scan, outlined in The Master Swing Trader, because they’ll often print daily-scale hammer or doji candlesticks. This rinse job generates ideal conditions for the instrument to trend sharply out of the opposite side of the trading range because the event cleans out one side of the supply-demand equation, setting up an imbalance between buyers and sellers. It then takes just a little pressure in that direction to have a magnified effect on price movement. No, it isn’t a pleasant experience if you’re caught holding the bag during these rinse job reversals, but it does mark a great opportunity if you’re coming off the sidelines. Just keep in mind the market dynamics triggered by these events are time-sensitive. Realistically, the buy-sell imbalance will persist for just three to five sessions before new money comes in and equalizes the equation.
Rinse jobs often unfold when price tests a rangebound high or low. Cavium Networks sets up a trading range (1,2) between 16 and 17.50. The stock sells off toward range support on July 7th and closes (3) near 16.30. It breaks down in the first hour of the following session, dropping 50-cents and then shooting higher (4), closing above 16 in a daily-scale bull hammer reversal. Price continues higher for the next three sessions and then breaks out strongly (5).
Rinse jobs can evolve over a few days, rather than showing perfect alignment with a single intraday session. In a classic example, a stock sells off for several days, finally reaching a major support level, like the 50-day EMA. It breaks down in the following session and closes poorly. Price then pops back above support and traps late sellers, or hovers just under the moving average for up to a week and then shoots higher, having the same effect over a longer time period. In both cases, rinse job mechanics have worked perfectly to shake out weak hands and set up a notable reversal.
In: Market Mechanics, TA
Algos: Observations & Strategies
Organizations running computer algorithms are highly secretive, which means we’ll have to wait for a tattletale book before learning the dark mysteries of the quant universe. However, traders have a powerful tool at their disposal that let’s them deconstruct these black boxes and formulate sympathetic strategies. It’s called tape reading. Indeed, in the market’s long history, nothing has ever come along to bypass, undermine or denigrate this near legendary skill set.
So, in no particular order, here are a few things we know about trading bots and their considerable influence on intraday price action:
The market often prints the highs or lows of the day near the lunch hour.
- Directional programs are more numerous in the first hour, near 2:15pm and in the last thirty minutes of the session.
- Up: down volume higher than 80:20 or lower than 20:80 predict trend days that show persistent channeling behavior.
- Support and resistance levels are vulnerable to repeated traps, characterized by gaps in the opposite direction of the prior day’s closing momentum.
- Open-to-close daily program strategies are prevalent, with early themes persisting through the entire session, but then disappearing overnight.
- As a result of open-to-close strategies, rotation is now a daily event, which is nearly unpredictable through routine technical analysis
- As a result of open-to-close strategies, intraday trend reversals are less likely than they were five, ten, or fifteen years ago.
These observations take us into new territory as traders because they go against the grain of common market wisdom. For example, we expect that a strong close in a trending market will yield a strong open (followthrough) the next day, but this popular strategy has been a complete loser’s game in our modern electronic environment. On the flip side, since first hour price action, whether strong, weak or choppy, tends to persist through the entire session, we can take advantage of this expectation with sympathetic strategies. These include building positions during intraday countertrends, buying/selling 15-minute breakouts or breakdowns, and simply standing aside because the chop favors no risk at all.
Rinse Jobs
The rinse job denotes a sudden dislocation within a trading range, in which price thrusts above or below support/resistance and then reverses, closing back within the boundaries of the sideways pattern. These spikes shake out stops and trigger all sorts of contrary entry signals. Rinse jobs can unfold in many ways, but two manifestations are most common in our modern markets:
- Bull or Bear Trap – The instrument gaps out of a 15-minute or 60-minute range at the opening bell, draws in breakout or breakdown traders, and then reverses hard, filling the gap.
- Stop-Gunning Exercise – The instrument grinds sideways for a few hours, attracting the continuation trade. Price suddenly jumps out of the quiet range, thrusts a few ticks and then reverses hard.
Traps are most common in the latter phases of established trends, in which one side is controlling the tape. As a rule, complacency runs high in uptrends, setting up abnormally low put/call readings. Flip over this tendency in downtrends, when fear yields equally high put/call readings. Both scenarios present ideal conditions for gaps against the prevailing trend, shaking out weak hands and reestablishing a balance between positive and negative sentiment.
Traps are also set when one side of the market gets overcrowded because news is so bullish or bearish that traders overreact and chase one strategy too aggressively. The capture of Saddam Hussein in 2003 and the London bombing in 2005 both yielded this type of extreme reaction, with massive gaps that filled immediately, trapping bulls after the first event and bears after the second event. These contrary dynamics play out all the time, to a lesser degree, after economic or earnings releases that shock the prevailing wisdom.
The Nasdaq-100 Trust closes at high tick (1) on May 4th and pulls back the following day. It closes just under the high and breaks out on May 6th, in a healthy gap. Sellers enter the market immediately, knocking the fund back under the two-day high (2) in a rinse job that yields a vertical selloff. The decline breaks the low of the prior day (3) and then recovers strongly, closing about 35-cents under the opening high. The ETF gaps above the prior day’s recovery high (4) the next morning and sells off, in yet another rinse job (5). This decline also breaks the low of the prior day (6). Price tests the multiday low (7) in the next session and closes strongly. A third rinse job erupts the following morning, with a down gap (8) that undercuts the multiday low and then zooms higher, trapping early short sellers.
Overnight rinse jobs, especially on the major indices, get most of our attention but midday events are also common, especially in dull or sideways markets. These rinse jobs take on two distinct scenarios.
- A morning trend reverses and pulls into a common support or resistance level. Pullback traders jump in, price cuts sharply through that level, and shakes out those orders. The instrument then reverses and reestablishes the early trend.
- A trading range, lasting days or weeks, is broken suddenly by a vertical rally or selloff, triggering a variety of entry and exit signals. Price takes in these orders and then reverses, closing the session back within the daily or weekly range.
The first scenario has great value when it occurs on the index futures because equity positions are likely to reverse in lockstep behavior. In addition, these small patterns yield instant trade setups because we can place stops just outside the buying or selling spike, and capture a low risk entry into the morning trend. Once positioned, price should “snap back” through support/resistance by the close of the next 15-minute bar.
You might not locate second scenario events until they show up in your end-of-day research because they often print daily-scale hammer or doji candlesticks. This rinse job generates ideal conditions for the instrument to trend sharply out of the opposite side of the trading range because the event cleans out one side of the supply-demand equation, setting up an imbalance between buyers and sellers.
Rinse jobs often unfold when price tests a rangebound high or low. Cavium Networks sets up a trading range (1,2) between 16 and 17.50. The stock sells off toward range support on July 7th and closes (3) near 16.30. It breaks down in the first hour of the following session, dropping 50-cents and then shooting higher (4), closing above 16 in a daily-scale bull hammer reversal. Price continues higher for the next three sessions and then breaks out strongly (5).
Rinse jobs can evolve over a few days, rather than aligning with a single intraday session. In a classic example, a stock sells off for several days, finally reaching a major support level, like the 50-day EMA. It breaks down in the following session and closes poorly. Price then pops back above support and traps late sellers, or hovers just under the moving average for up to a week and then shoots higher, having the same effect over a longer time period.
In: Market Mechanics, TA
1-2-3 Breakouts and Breakdowns
Traders encounter whipsaws, fakeouts and false breakouts throughout their careers. They shouldn’t be surprised though, because all we’re doing is playing an odds game and even a perfect trade setup can fall apart for no reason, and with little warning. This reminds us risk management is not optional if we intend to trade. It’s absolutely required on each open position.
Breakouts and breakdowns occur in zones of conflict. Both sides of the market are very passionate at these turning points, but no one knows how much force will be required to carry price into a sustainable trend, higher or lower. As a result, any position you take near a breakout or breakdown level carries considerable risk, no matter how perfect a pattern looks.
Price can respond in different ways to breakouts. First, it may carry through successfully to higher levels. Second, it may generate whipsaws that force losses on both sides of the market. Third, it may trap buyers in a false move and start a trend in the opposite direction. Each of these outcomes requires careful trade management.
Successful breakouts occur in three phases, which I’ve marked 1, 2 and 3. It begins when price breaks through resistance on increased volume. We’ll call this the action phase (1). Price expands a few points or ticks, and then reverses as soon as buying interest fades. This starts the reaction phase (2). The market sells off and spawns the first pullback, where fresh buyers see a chance to get positioned close to the breakout price. If all systems are “go”, a second rally kicks into gear and carries price above the initial breakout high. This marks the resolution phase (3).
The three phases of a successful breakout are dependent upon certain volume characteristics. Demand must exceed supply during the initial breakout. Volume should “dry up” when it pulls back in the reaction phase. New buyers need to jump in to ensure a successful resolution phase. Whipsaws and false breakouts result when these supply and demand dynamics fall out of balance.
What exactly are whipsaws? Simply stated, they’re choppy price swings back and forth through common support or resistance levels. Natural tug and pull generates most whipsaws. But hidden hands also manipulate price through common stop levels in order to generate volume, and intentionally wash out one side of the market. Whatever the source, whipsaws are responsible for many of the losses in a trader’s yearly performance.
Whipsaws emerge when a breakout can’t generate an efficient reaction phase. This failure may or may not trigger a major reversal. The pullback shakes out weak hands and forces price back to resistance but new buyers keep a floor under the instrument, stepping in repeatedly to support higher prices. A followthrough rally, which confirms the breakout, can begin quickly after a whipsaw fades out. The loss of volatility when a whipsaw dies down triggers a buying signal on many trading screens. This starts a bounce that generates the momentum needed to carry price up and beyond the last high.
Major reversals occur when price action traps one side of the market. Many traders wait to enter their positions at key breakout levels. Once these folks execute their trades, they’re at the mercy of the market. In other words, their profits depend on other traders seeing the same breakout, and jumping in behind them. False breakouts occur when this second crowd fails to appear on schedule.
An overbought market can drop quickly below a breakout level when the second group fails to show up. This throws all the traders who bought the original breakout into losing positions. Without the support of fresh buyers, a stock can fall from its own weight. Each incremental low triggers more stop losses, and increases fear among the trapped crowd.
Momentum builds to the downside while the instrument breaks key support and fresh short sale signals ring, bringing in even greater selling pressure. One trend ends and another begins in the opposite direction.
Avoid The Algos With Longer-Term Trades
Technical analysis works better on long-term charts than short-term charts these days because it’s harder for program algorithms to manipulate price direction over time. The natural forces of supply and demand take control in these broader time frames, letting the chart do the job it was designed to do, namely, identify support/resistance levels and predict trends. As a result, moving out on the time spectrum also aligns perfectly with a survivalist trading mentality.
To get started as a longer-term trader, here are ten useful techniques to play the long-term charts:
- Look back at least ten to fifteen years to find every high and low swing that might affect the outcome of your trade.
- Take small positions and stop using margin. This lowers risk by letting price jump around without shaking you out of good trades.
- Limit your portfolio to slower movers that are less likely to exhibit sudden or violent price movement.
- Trade exchange-traded funds whenever possible because you’ll avoid company news that sends individual issues through the roof, or over a cliff.
- Keep stops loose and out of the way of the current swing, making sure they’ll only get hit if there’s a change in the underlying trend.
- Apply weekly Bollinger Bands, set to 20-week and 2 standard deviations. This tool will expose the most favorable periods to enter and exit positions.
- Trade at the edges of support and resistance, finding the price where weak hands will get shaken out. That’s where you want to place your order.
- Build the position over time with dollar cost averaging, but line up your entries with large-scale support and resistance.
- Use weekly 5-3-3 Stochastics to identify long-cycle buy-sell swings. Try to buy on the upswing and sell on the downswing.
- Do nothing until the market planets come into perfect alignment. It’s easy for remote traders to get bored and lose their discipline.
Choose less volatile stocks and use physical stop losses, unless you’ve established a real time alert system. Beyond that, remote trading with long-term charts can be done with great success. However, there’s a real danger if your reach exceeds your grasp, i.e. you get lucky a few times, forget your limitations and start playing too aggressively. With so many points between major price levels, and so much time to kill, its easy to step into a high-risk situation without realizing it, and then fail to get out of the position when things go haywire.
Aggressive-Defense Cycles
The markets cycle between periods that favor rapid profit production, and periods when it’s hard to put a single dime into your pocket. Low hanging fruit, public participation, and a balance between buyers and sellers characterize the aggressive phase of this cycle. Whipsaws, traps, illiquidity, and an absence of buyers and sellers characterize the defensive phase. The defensive phase tends to last longer than the aggressive phase but there are notable exceptions, like the runaway bull market in the summer of 2003 or the runaway bear market in the late summer and fall of 2008.
Our trading strategies need to shift gears as quickly as possible when the cycle evolves from one phase into the other. Unfortunately, it’s often hard to recognize this atmospheric shift until it’s well underway. You have one major clue, however, that will smack you across the face and tell you “things are different”. Playing one side of the cycle, after the other side has taken control, invariably triggers a string of losses because your market approach stops working. Presumably, traders realize that something has changed after getting hit over the head a few dozen times by these inexplicable losses.
Trading the defensive phase effectively is more important to annual profitability and long-term survival than making money during the aggressive phase. To prove my point, look back at a bad year and notice how your losses in losing months far outweighed your profits in winning months because you were trying to outthink the market. Invariably, overtrading is the main culprit on the loss side, as frustration mounts and you feed the market beast, hoping to catch a wave, or a play, or anything else that fills the hole you’re digging for yourself. Defensive phases often correspond with seasonal impulses, like the dog days of August, but they can occur at any time of year. In fact, when a well-telegraphed, seasonally aggressive phase, like the January Effect, fails to materialize on schedule, the defensive phase can kick in with a vengeance.
These periods also follow the natural strength and weakness in our trading plans. Traders are an extremely diverse group, with momentum players, trend followers, fading specialists and scalpers all holding lifetime membership cards. Each of us gravitates naturally toward a customized strategy that matches our intellectual prowess, as well as the realities of our emotional state. That’s why some traders choose to sell short exclusively while the practice sends shivers down the backs of otherwise savvy market players. Each strategy capitalizes upon narrow segments within the pattern cycle structures of individual instruments and the broader indices.
Conversely, the “tweener” periods between these points of perfect alignment trigger defensive phases for that specific trader, which will persist until the next favorable segment arrives. These personalized aggressive-defensive phases can converge or divergence with larger-scale aggressive-defensive phases. With this in mind, you can understand why the greatest periods of profitability come when personal and broad-scale aggressive phases combine in a synergistic impulse. Conversely, the greatest danger arrives when a personal tweener period aligns with a broad-scale defensive phase.
TYPICAL AGGRESSIVE-DEFENSIVE PHASE ALIGNMENT |
||
| PLAYER/PHASE | AGGRESSIVE | DEFENSIVE |
| Momentum | Runaway Market | Price Channel |
| Scalper | High Volatility | Low Volatility |
| Short Seller | Downtrend | Oversold Bounce |
| Day Trader | Trading Range | Trend Day |
In: Market Mechanics, TA
Action-Reaction-Resolution
Massive liquidity across a spectrum of futures, debt, currency and derivative exchanges ensure that crosscurrents outside the realm of ordinary supply and demand impact every aspect of our trading activities, from initial position choice to final profit or loss. Despite this enormous complexity, many technicians still believe that pretty patterns predict everything they need to know about trend direction, extension and duration. Sadly, this is a weak-handed view because convergence-divergence oscillation between equities and numerous world markets exert tremendous power over price movement.
In the real world, cross-market forces can trigger cascading selloffs on the most bullish patterns and parabolic rallies on the most bearish ones. That’s not to say we should just abandon our pattern analysis because it doesn’t work any more. In fact, nothing could be further than the truth. But using triangles, rectangles, and trendlines to make trading decisions in a vacuum, and without consideration of the dominating external forces, is a sure fire way to lose money.
Which brings us back to the concept of pattern failure, a central theme in The Master Swing Trader. When the book was published in 2000, traders were just entering a tough environment in which classic technical analysis had started to lose its historic potency. In the simplest terms, TA stopped working after the bubble burst, because its Internet-trained adherents had became the majority that needed to be punished and, just like every overplayed inefficiency, the profit door was slammed shut.
[ Breakouts and breakdowns evolve through action-reaction-resolution (1-2-3) cycles. Cerner rallies above resistance at 40, after a four-month basing pattern. The breakout sets off the action phase, with a rally that gives way to a series of whipsaws, which are common during the reaction phase. Volatility quiets down for a week and price then surges above the first high, triggering the long-awaited resolution phase. This confirms the initial breakout and initiates a fractal 1-2-3 cycle in a smaller time frame.]
To this day, traders chase around deceptively simple breakouts and breakdowns, without recognition of many ways that pattern failure will undermine their bottom-line results. It’s really a shame because a single addition to their workflows will address this critical issue in an efficient manner. It starts with a deconstruction of the three-step mechanics you’ll observe in the majority of breakouts, breakdowns, whipsaws and pattern failures. I call this the action-reaction-resolution cycle, or simply the 1-2-3 cycle.
Successful breakouts and breakdowns tend to occur in three phases. They begin when price pushes through support or resistance on increased volume. We’ll call this the action phase. Price expands a few ticks or points, and reverses, which initiates the reaction phase. The instrument then shifts into countertrend mode and spawns the first pullback, where sidelined players get a “second chance” opportunity to buy or sell near the support or resistance level. If all systems are working as intended, a second impulse eventually kicks into gear and carries price through the initial swing high or low. This thrust marks the resolution phase, which confirms the breakout or breakdown.
Whipsaws, as well as false breakouts or breakdowns, result when supply-demand dynamics fall out of balance. Whipsaws are defined by choppy swings at or near support or resistance levels. The natural tug and pull between bulls and bears generates most whipsaws, but program algorithms also impact this activity with trend-neutral strategies that target common stop levels in order to generate volume. Whatever the source, whipsaws are responsible for many of the losses in a typical trading portfolio. This remarkably efficient engine of destruction can take control whenever breakouts or breakdowns fail to generate well-organized reaction phases.
The resolution phase can unfold quickly once whipsaws start to die down. Volatility reduction induces price contraction that, in turn, triggers a wave of fresh entry signals. Positive feedback then kicks in and generates the directional surge needed to carry the instrument through the initial high or low swing. Price exceeding the high or low signals successful completion of the breakout or breakdown, and the initiation of a new 1-2-3 cycle in a smaller time frame.
In: Market Mechanics, TA
Exit Strategies
There are three basic reasons we exit our positions, i.e. to book profits, take losses or respond to a change in market character. Each reason demands multiple strategies to manage the unique attributes of that particular scenario. Traders need to play out these exit plans in their heads over and over again, so they take spontaneous action when the time to act arrives. This role-playing exercise is extremely important in developing effective risk management skills.
Taking a loss is the easiest of the three strategies to learn but the hardest to execute in real-time trading. Simply stated, we need to get out when we’re proven wrong. In most cases, this means dumping a long position that breaks a support level you expected to hold when you did your market analysis. Unfortunately, many folks jump into long side trades that show little or no support for many points below their entry prices.
In these cases, placing a stop loss under support can be a very costly activity because you’re forced to manage the added risk by a) placing a percentage stop loss under the entry price, taking the loss at 2%, 5% or 10%, depending on risk tolerance, or b) looking at the chart in the next lower time frame and placing the stop loss under any support found on those smaller scale patterns.
There’s nothing wrong with reentering a losing trade, as long as it fulfills certain risk requirements. In fact, it might be the smartest thing you can to do when the instrument reverses right after you give up and head back to the sidelines. Buying a pullback into support in an uptrend, after you get shaken out of a momentum breakout, offers a perfect example of how reentry dynamic can evolve.
Schlumberger (SLB) charges higher in a strong energy sector rally. The uptick stalls near 100 and gives way to an intermediate pullback that reaches the 50-day EMA in early August. The stock bounces for a few days and then pulls back to test support. The trader buys (1) when price sells off into the moving average, placing a stop loss (3) under the low of the first pullback, expecting a double bottom reversal. However, the stop gets hit the next day, when a down gap surges through the two-week low.
Price drops more three points and then shoots higher, closing in a long legged bull hammer. The stock jumps back above the 50-day EMA just one day later, triggering a failure of a failure buy signal. The trader reenters the position (2), placing a stop loss (4) under the low of the recovery bar. The bounce holds firm this time and the primary trend resumes control, lifting price up and over the July high.
Taking opportune profits can be difficult as well because greed clouds awareness when it’s time to pull the trigger. Simply stated, traders are market timers. This clock sensitivity demands a quick exit when price fulfills the goal visualized in the initial analysis, a.k.a. the profit target. Markets are constantly banging up against old highs, old lows, and piles of debris from past battles between bulls and bears. Prices react quickly to these pivot points, often triggering major spikes and sharp reversals.
Traders gain tremendous discipline by selling blind into a profit target. This survivalist approach lets them take advantage of the crowd’s excitement at the same time the odds are favoring a reversal. It also frees them from the position so they can move on to the next opportunity. Ironically, the next trade often shows up when the instrument just dumped turns tail, retraces to a support or resistance pivot, and then issues a fresh entry signal.
As you gain experience applying your exit tactics, you discover that trends appear drawn to magnetic “hotspots” before they change direction. This pattern structure, once understood, provides a lifetime edge that lets you plan the exit in advance and resist the thrill of the moment. A perfect example is the tendency of trending price to surge into a major support or resistance level, rather than creep into it.
How do you protect profits in case price fails to reach the profit target or reverses ahead of schedule? The best method is to fall back on the trailing stop loss strategy as soon as the position starts to accelerate toward the profit target. You can do this in one of two ways.
- Place the trailing stop ten, fifteen, or twenty cents behind advancing price and keep it in place until it gets hit, or the profit target is reached.
- Set up an exit order behind the current price and watch bid-ask on the market depth screen. Hit the button when price drops ten, fifteen, or twenty cents off the high.
In: Market Mechanics, TA