There are many clichés regarding trading that (on the face of it) appear extremely easy to implement, but in reality are very difficult to put into practice. “Letting your winners run” and it’s equally important correlated phrase; “cutting your losses early” are two of the most widely used clichés we hear in trading discussions.
Yet despite being regarded as trading ‘memes’ both subjects are absolutely critical to our trading development and continual success. If we can come close to mastering these two essential measurements of our trading performance, then we’ll be on our way to trading excellence.
Trying to pick the bottom and top of a market move is a skill none of us will ever perfect. Despite how long we live and prosper as traders we’ll never come close to mastering what is after all an impossible task. “Why won’t we ever be able to pick the exact turning points?” is a simple question to answer.
There will be many times when your perfect set up occurs; the technical and fundamental analysis will align perfectly, the cluster of indicators you favour will line up better than a constellation in the night sky, the price action will be as bold as you’ve seen in an age, but after taking the trade sentiment suddenly reverses leaving you nursing a loss that you didn’t see coming. That’s the market we operate in, we trade on the possibilities that patterns we’ve seen many times before will repeat and in doing so will reward us. But the possibility still remains that the pattern won’t repeat; it’ll begin to look as if it’ll repeat then suddenly it’ll fail. So in agreeing that it’s close on impossible to predict the tops and bottoms of a trade, the best we can do is to take a sizable ‘chunk’ out of a market movement, but we know that we’re highly unlikely to capture all the pips or points.
What past experiences can we relate to when not letting our winners run?
Perhaps one of the most typical scenarios of cutting our winners too early involves trading manually, or ‘freehand’. We’ll enter the trade manually, as our conditions for entry are met perfectly, but we’ll have no pre-determined plan in place for closing the trade in profit other than a loose target based on nothing other than an arbitrary round number target, or a R:R that we’d like to aim for.
For example, in an FX swing trade we could be risking 150 pips in the hope of a 1:2 R:R of 300 pips. The trade develops perfectly, we’re in considerable profit, then suddenly the trade begins to show weakness. We’re not sure if this is a temporary retracement, or could it represent something more significant happening (fundamentally) in the market that we’ve failed to pick up on? Or has price reached a level where many orders; buy, sell, limit and stops are clustered? We take no chances and close the trade for 120 pips profit feeling OK about ourselves, having banked a very decent profit and after evaluating the conditions we’re satisfied that we took the logical decision to close our trade early.
And we know what happens next in this B movie slash, horror. Price pauses for a session or two retraces to the downside momentarily and then it continues its inevitable exponential run up as we look on helplessly. We’re confused, we have rules set out in our trading plan that prevent us from re-entering a trade movement unless conditions reverse, or retraces by a significant amount, to then continue in the original direction. We therefore have no alternative but to sit out the move as we watch over the next few trading sessions price reach a new two month high. And we’re left to lick our wounds as that 120 pips banked could have been 400 or more.
For sure what we’ve outlined there is a universal experience that nearly all of us traders have endured at some stage during our steep learning curve. But before we discuss possible improvements, leading to concrete methods in our trading plan for letting the winners run, let’s concentrate on the extremely positive issues regarding the position we found ourselves in.
Firstly we identified the high probability set up perfectly. We monitored the trade and closed at significant profit, not quite 1:1 R:R, but quite close to it. Moreover we stuck to our plan and didn’t re-enter outside the scope of our trading plan. We still took a sizable chunk of profit and pips out of the move. We only ‘failed’ on the one aspect; faced with plenty of ‘white chart’ to our right we didn’t follow the plan for exits. Or more likely the chapters in our trading plan covering exits just require a little bit more polish and refining. So let’s look at one possibility for trading our exits better.
What gets you in can get you out
Regular readers of our trading blog, who subscribe to our weekly trend predictions newsletter, will be familiar with the method we offer up as a trading strategy. Now it’s not the most sophisticated trading method known to man, but there’s a reason for that; the overall strategy has to appeal to and cover a wide range of experience and ability, it has to be what we term an ‘Everyman’ strategy. We use seven of the most widely used indicators, combined with Heikin Ashi bars and only adjust the stochastic lines from their standard settings.
Despite the fact that indicator based strategies come in for criticism across many trading forums and blogs, they do have one excellent feature above all else; they have the ability to get us in and get us out of trades based on their alignment. They can arguably take away the guessing involved in exiting with profit, allowing traders to effortlessly and seamlessly defer to their trading plan for decision making.
Indicators provide several methods for deciding that the trade has run its course, or more importantly, they provide a method allowing you to exit with reasonably good returns without fretting on what you could have taken out.
An example of an exit strategy letting the winners run based on the most commonly used indicators and taking only what the market offers us
Let’s defer to our usual indicator set in order to thrash out some ideas for taking our trades to the limit of what’s reasonably achievable and what is achievable over a consistent basis. But before we do we need to alter our mind set to accept that we’re not aiming for the tops and bottoms of a trade’s movement now, we’re aiming for reasonable returns based on what the market offers up.
An entry signal for our swing trade could be generated by the following indicators aligning; the PSAR, the MACD, the DMI, with perhaps a lower or higher Bollinger band being breached and the RSI moving above the median 50 line. Let’s surmise that this entry has worked perfectly and that after several days we’re into considerable profit, but crucially we haven’t set a R:R target, instead we’ll accept what the market offers up, as opposed to thinking we can force a profit out of the market.
Suddenly the price action on our Heikin Ashi candles are less affirmative of our direction as the momentum appears to have left the move. We experience a doji on our daily chart and consider exiting at a profit of circa 100 pips. However, there are no indicators that are negative, we’re just nervous that our trade, if not managed carefully, could lose all the profit we’ve developed over recent days. We suddenly remember our plan, in which it determines that we don’t close until the PSAR signals in the opposite direction and appears on the opposite side of price. We weather the intense temptation to then witness price (once again) regain its momentum and we bank more pips and use the PSAR to manage our trailing stop. Days later the PSAR appears on the opposite side of price and we close out our trade.
So what did we do differently in order to let the winner run? Firstly we had a plan that, despite intense persuasion otherwise, we stuck to. Secondly we acknowledged that if we broke this ‘code’ of ours then we’re violating one of the cornerstones of our trading plan. Thirdly we realized that we can’t possibly impose our demands on the market, we take what the market offers, we close our trade and await the next opportunity.
In our next article we’ll cover the equally tricky issue of cutting our losses early.
