Last Thursday a student said to me: “It’s (the ES) in the zone! Why have a setup? If it goes up buy it!”
She makes sense, doesn’t she? Yet setups are an important part of my approach; and, unless I have one, I’ll bypass the trade. In this post, I’ll look at why I use setups as part of my ‘low risk entry’ requirements. I’ll start by defining what I mean by setups, then consider the reasons for a trade and finally why I consider setups essential to a ‘low risk entry’.
For a buyer of dips in uptrends, setups are chart patterns that say a zone is likely to hold.
To understand why I consider them essential, I first need to consider the nature of trading. Trading is a probability game that begins when we initiate a trade and ends when we end the trade. All the market does is provide a constant stream of opportunities in different timeframes; in so doing it gives us an opportunity to make a profitable, a losing or scratch trade. Our job is to decide when the probabilities favour us (our entry) and when the probabilities no longer do so (our exit).
The Expectancy Formula [(avg$ win x win rate) – (avg$loss x loss rate)] shows that the line of least resistance to profitability is to increase the difference between the win and loss side of the equation. The easiest way of doing this to have a large difference between the avg$win and avg$loss.
The traditional method of managing risk is to place a stop loss at a price point which if reached:
- Says the analysis is wrong (technical stop) or
- At a price that represents a dollar loss beyond which the trader is not prepared to accept (money stop).
There is a vast difference between these two ideas but there is little said in the literature. More important while generally any stop is better than no stop, both methods are an inferior way of defining your stop loss levels.
The money stop is the worst of the choices because the basis of your decision fails to take the market’s nature into consideration. One of Pete Steidlmayer’s early ideas was to describe the function of markets as being one that facilitates trade. In short the market will find a level that will promote the greatest amount of trading. If we place our stops ‘too close’ to the market’s activity, if we fail to provide our trade with a margin of safety, if we need precision to profit, then the probability is we’ll lose money even if the market does eventually move in our direction. The market doesn’t care what our loss constraints are; it will move according to its nature. Thus in a sideways or congestion market, placing our stops within congestion, especially if they are closer than an ATR’s range, means we need to very good or very lucky for our stops not to be hit.
The other method is to place technical stops, usually with some sort of price filter, and not exit a trade until and unless the stops are hit. The rational is since we can’t forecast the future, it’s best to place the initial stop and not move it unless the market moves in our favour.
While this is better than placing our stops according to our loss tolerance, it is rigid and in its very inflexibility lies the seeds of our large losses when we are in drawdown mode.
I could never see the sense of taking care to enter a trade and not exercising care to exit the trade. Pete’s method was to consider the reasons for taking a trade and not exiting until they were no longer present. His approach is echoed by the one taken by the Phantom of the Pits (http://www.webtrading.com/phantom/preface.htm).
The Phantom takes the view that we are in a trade, the trade is wrong until the market proves it correct. The corollary of this idea is that ‘unless the market proves the positions correct’ we will exit or reduce positions.
Today I have considered why I believe that the traditional ideas to trade management are inadequate. In tomorrow’s post, I’ll consider the solutions.