One of the golden rules of trading is to cut losses short and let profits run. Anyone that has traded has surely heard this at some point, and on the surface it’s quite simple. However putting it into practice is actually somewhat difficult. The function of cutting losses short implies that a stop is always in place when a trade is placed. The entry plays a vital role in this equation, as the difference between where we get in and where we place the stop is how we measure our risk. In addition, finding where the lowest risk entries in the market are located, (usually at the turning points) can assist us in applying this most important of trading rules.
The second part of this rule involves attaining profits. This can be achieved by having an understanding of how far price can travel before reversing. In other words, if we buy a futures contract in a demand zone, we expect that it will go higher until all the buy orders (demand) are filled and the unfilled sell orders (supply zone) will not only stop prices from rising, but because there are so many of them, price will turn down.
The tricky part for many, is that in order to follow this rule we have to wait for the levels to form, and once they have formed, we then have to wait for price to retrace back to the origin of the imbalance before we can have the smallest risk entry point. Notice that there’s a lot waiting involved in getting entries in the market that are low-risk, high probability, and high profit, and therein lies the challenge. Why? Because, who wants to wait? Everyone wants to be in the market now.
In a class I taught recently I showed a monthly chart of the Dow Jones Industrial Average between 1960 and 1980 (shown below).
In it we can see that a strong demand level formed in late 1962 and that it took until October of 1974 for the Dow to “test” that zone again. Right after showing this chart one of the students incredulously asks, “You mean you had to wait 12 years to buy the lowest risk entry point in the Dow back then?” Apparently, he thought I was being ridiculous. I replied, “Yes, if you were an investor.” Incidentally, that level marked the bottom of the seventies bear market, and as an added bonus for waiting, what ensued was the greatest bull market in US stock market history. For short-term traders, the wait may be hours or perhaps days, as they would be using smaller time frame supply and demand levels as their entry points.
What I was trying to convey with this example is that no matter what time frame, price discovery is a function of finding where the buy and sell orders are most out of balance.
The reality is that most traders in the futures market tend to cut their winners short and let their losers run, and because of the leverage component, this is a losing game simply because of the math. Part of the challenge is that waiting for the right setup does not come naturally to us, because in any other endeavor, we must always be doing something if we are going to be productive. If you’re a lawyer you try cases, if you’re a Doctor you see patients, being idle is unproductive. In trading however, it doesn’t work that way, and many people find that transition very difficult.
So the next time you start feeling antsy about a trade, ask yourself if you’re putting that money you worked so hard for, in a low risk, high probability opportunity. If the answer is no, then ask yourself if it’s worth waiting to do so. The answer of course, should be yes. So now that you’ve decided this, proceed to put your hands on your chair, and sit on them until the right setup comes along.
The lesson here is that people that have self-control (patience) will have a much better chance at trading successfully, than those that don’t.
Until next time, I hope everyone has a great week.