Tuesday, October 03, 2006

When Do I Get Out of a Trade?

Yesterday, in my Webinar session (which will be archived in the next couple of days on the Teach Me Futures site), I introduced an idea that I called "transitional structures" in the market. These are shifts that occur at turning points, in which bearish sentiment gradually becomes bullish and vice versa. For a nice example of a transitional structure, take a look at this post. Thinking in structural ways is important, because it provides a framework for thinking about how markets are behaving--and why.

A question came up in the Webinar that went something like this, "How many ticks (or points) away from my entry should I place my stop?"

If you're thinking in structural market terms, that's not the risk management question to be asking. All too often, it's easy to select price-based stops based on one's pain threshold--not on objective market action--and thereby limit opportunity.

Rather, the question to ask is, "What market action would convince me that the rationale for my trade is incorrect?"

Let's take the very simple example above. We have a candidate transitional structure, labeled with the downside momentum extreme, the price extreme (bottom) on reduced volume and reduced volume at the bid, and then we get a couple of bars of exhaustion. During those exhaustion bars, we have some net selling (volume at bid) around 1337.75, but the volume is drying up (when compared to the previous bars) and we're unable to make new price lows. You would want to enter the market on the long side as close to those exhaustion points as possible, with the expectation that you will return to the mean trading price of the previous bars that encompassed the market decline.

Now the question is: What would get me out of the trade?

Do I set a stop several ticks below the market's low point to decide I'm wrong? Not at all. If my trade idea is based on the notion of exhaustion, then any expansion of volume at the bid at that 1337.75 region takes me out of the trade. Why? That tells me fresh selling is entering the market. I don't want to go there; it invalidates my trade idea.

It's not a maximum tick or point loss that should get you out. It's being wrong that gets you out. When a market structure gets you into a trade, a violation of that structure should be what gets you out. Not fear. Not loss. Not pain.

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