Have you ever sat down for you nightly analysis and wondered how far a potential trade might go?
Although the market is the final arbitor of how much profit a potential trade can make, we can adjust our thinking and emotions to capture either more or less of that potential profit.
Once you enter a trade, especially if it is related to a reversal or pull-back entry into an established trend, odds are highest for success at the entry point, provided we analyzed the market probabilities correctly. As the trade continues to work in our favor, odds of further continuation (without reversal) decline as the trade moves further in our favor. In dollar terms, a trade entered long at a support zone might have a 75% chance of success, but as the trade moves up $3 or $4 away from that zone (and nearing possible resistance), odds decline to 25% or 10% of further continuation.
So when is the optimal time to exit a profitable trade? Emotions – surprise – help determine the outcome more than probability if we are discretionary traders. At the correct entry point, fear may take over and cause us to do one of the following actions:
- Enter the trade too late (by waiting for confirmation of our intended reversal/shift in supply/demand)
- Pass on the trade (after waiting for confirmation and the ‘proper entry’ is further away now… but there’s still upwards potential)
- Enter the trade properly, but stop out prematurely
On the flipside, Greed may cause us to do the following:
- Enter the trade too early (anticipating a signal)
- Hold on to the trade too long to the downside (when we enter and move our stop downward because “It has to work out!”)
- Hold on to the trade too long to the upside (because it has “just a little more left!”)
Remember that your analysis is clearest BEFORE you enter the trade and cloudiest (by emotion) when you are IN the trade. Typically, your first instinct will be correct, especially if you have been trading for a while and have gathered sufficient experience.
I have found from my trading that I suffered from “Zone Exposure” that stemmed from perfectionism, the need to be right, and fear of loss.
In this example (CTSH, April 2006 – Daily Chart: TradeStation), let me oversimplify analysis to the following:
- Stock in uptrend
- Buy at pullbacks to the 50 period moving average
- Target is slightly above most recent swing high
- Stop is just below 50p MA
Your “perfect entry” is about $56.50.
Assume you find this ‘perfect pullback entry” on your nightly analysis and decide to buy in the morning. The stock gapped up to $58! Are you greedy and do your rush in to buy? Or are you hesitant and fearful, and pass on the trade entirely? What is the correct answer?
A signal, once valid, stays valid until it is invalidated either by the “stop” or the “profit” target (Hint: This is true on higher time-frame analysis). In other words, yes, you missed your perfect entry but odds are higher for more upside continuation than to the downside and you should STILL enter the trade (perhaps with fewer shares, though).
By the way, exit would have been around $62 or $63, depending on your initial parameter (how far above the most recent swing high you desire). Greed could have kept you in all the way to $64… and back down lower. Discretionary trading tests out best when you play for a small, fixed target and not an arbitrary large target. Emotions cloud these targets both at entry (fear keeps you out) AND at exit (greed keeps you in).