Today I am going to consider my approach to exits and to do that, I need to explain my approach to setups and entries.
Whenever I think I found a robust setup (i.e. a setup that is likely to produce predictable results in the future), I ask myself two questions:
- Under what circumstances did the setup make money (work)?
- Under what circumstances did the setup lose money (fail)?
My aim in doing this is to see if I can define a set of parameters that will be followed by a setup that works. For example in the Nature of Trends, I describe a number of setups I call Negative Development. The principle behind Negative Development is straight forward enough: they are setups that have shown a robustness in the past i.e. they work (head and shoulders top, for example). But on this occasion, after triggering the trade, the market instead of following through, resumes its original trend.
For example: we have an 18-day H&S topping pattern triggered by a close below its neckline. But instead of heading South, the market closes above the neckline and resumes the uptrend. Now imagine the situation. You have a ton of people that will have gone short on the close below the neckline. Their stops will be above the neckline. What happens when those stops are triggered? They provide profit for the traders who took the Negative Development Trade.
The next question I ask myself is under what conditions do these false signals generally occur? They tend to occur when the first higher timeframe is trending and corrects. The correction causes the next lower timeframe to attempt to change its trend but when the correction is complete, the higher timeframe resumes its trend and in so doing commences a new trend in the lower timeframe.
So, in the example above, the 18-day H&S is triggered when the 13-week corrects and the 18-day pattern fails when the 13-week resumes the uptrend.
Taking all these factors into consideration for uptrends we can say that in the appropriate circumstances:
- If the First Higher Timeframe is trending and then corrects,
- And if the next lower timeframe provides a breach of support but then turns up, we have a Negative Development buy signal.
- And because this Negative Development Pattern counts on election of stops stimulating the market to move in our direction, I can set a time limit for the market to move ‘x’ points after entry or else I exit the trade.
In this way a setup and entry strategy defines the conditions I will stay in a trade; it also defines the conditions under which I will exit a trade before my initial stop is hit. The stops I place in every trade are stops beyond the swing extremes (with an allowance for a filter).
I find that this approach provides the safety I need with the flexibility that leads to increasing the difference between the ‘avg$win’ and ‘avg$loss’.