Wednesday, September 02, 2009

When to Exit a Trade

A few people have asked me why I covered my swing trade (selling S&P 500 Index on Friday and adding to the position Tuesday morning). Three reasons stand out:

1) I had set an initial profit target at the weekly S1 level. We hit that level and, per my discipline, I always take profits on one unit when the first target is hit. (Note: this presumes a system for unit sizing of positions; I will be blogging on this topic shortly. The basic idea is that you divide your capital for a particular idea into several portions or units. This enables you to systematically scale in and out of trades.)

2) When I saw that we were having a labored time hitting the second, S2, target, I took the position off entirely. My concern was that we were seeing significant selling pressure (negative NYSE TICK, volume at bid exceeding offer in the ES futures), but that the pressure was having a difficult time moving stocks meaningfully lower in the afternoon.

3) I knew we had a strong momentum day to the downside. Recall that the proprietary Demand/Supply measure is an index of the number of stocks trading above and below the volatility envelopes surrounding their short-term moving averages. We hit 200 on the Supply side, which means that a very large number of stocks had closed below their short-term bands. This has only occurred 30 times since late 2002 when I first began collecting the data. When this has happened, the S&P 500 Index (SPY) has closed up the next day 20 times, down 10 for an average gain of .60%. That told me that, short-term, I might be able to re-enter my position at better prices. (Note: I update Demand and Supply every day before the market open via Twitter; follow the tweets here).

Everyone has different ways of trading and different disciplines. Mine calls for me to let positions run to their targets, but--once they hit targets--be proactive in harvesting profits when my edge seems to have dwindled. It's a nice illustration of trade management and its role in helping traders maximize gains, but also protect them.