In today’s blog post we are going to continue our investigation on Trade Management, which builds on the basic notions laid fourth last week. This week we will take a step forward by understanding how trade management decisions are formulated, based on the following considerations:
- Trading System Style (Trend/Momentum/Counter-trend);
- Time Availability (less time availability usually requires longer term systems, but we will also show an aggressive alternative );
- Risk Appetite (how much confirmation is necessary and what kind of moves you feel comfortable tackling).
Together, these considerations will dictate the objectives you can aspire to reach for your trades, and how you will act based on what the market throws at you. We would love to set & forget our trades, having precise multiple-R values in place…but the market just doesn’t work that way.
Trading System Style
The first thing to address is what your trading style is. Do you like breakout trading? Do you like trend trading? Do you like counter-trend trading? Each one of these styles has a “logic” to it and the trade management should follow that logic.
It should be noted that the most useful option for people that are trading around a day job is a trend-following model because in principle it doesn’t require as much active babysitting as other models do. Also, most retail traders try to fade trends. Since 70% of retail traders tendentially lose money, let’s stick to the trend-following models for now.
Finally, know this: we will be doing our best to illustrate real-world examples of trade management and solid principles but there is no perfect fit, nor is there a management style that works equally well all the time. Volatility conditions are constantly changing in the markets, as well as fundamental influences. This means that the markets accelerate, decelerate, stall on irregular intervals and your trade management should be seen as a “most confortable fit” given:
- your objectives for the trade;
- your time availability;
- your risk appetite.
And this means that you will need to research, backtest and forward test (on demo) until you have a meaningful group of statistics that helps you understand what to expect and helps you establish your management style.
Before going into any detail on the different expectations for each strategy, let’s establish common ground first. Since all trading styles are attempts at “timing” the market, our efforts should be rewarded by swift moves away from our entry as often as possible, independently from the style utilized.
Immediate gratification is a principle that should accompany ANY trading system because if price hovers around entry, without doing much for a certain amount of time, surely it’s not worth holding onto the position because the market simply isn’t following through.
Bottom line: the principle of immediate gratification can assist in deciding when to scratch a trade that hasn’t gone anywhere after a reasonable amount of time. Cut unprofitable trades or situations that are not performing as expected, and spare your risk capital for other opportunities. Don’t sit and hope something will happen.
Now onto trading system styles.
Low-Volatility Breakouts: this kind of setup is based on an acceleration of price after a period of “dormant action”. The first setup on AUDUSD highlighted above is a low-volatility breakout. Logically, you would expect price to exhibit a strong push after the signal candle (momentum) before slowing down into a normal trending market phase.
So trades like these can actually be broken down into 2 components: the momentum phase and the trend phase. Ideally the market pushes away from entry enough to offer a potential scale-out before retracing. In the example above, the market does in fact push towards a previous resistance before retracing. You could perhaps attempt to book some profit at this point OR trail your stop to breakeven.
This leads us to a few considerations. The chart above is a 1H chart of the initial Low-Volatility Breakout on AUDUSD on which we have highlighted the Marabuzo Line (a tool much used by our colleagues Alan & Steve, and that you can learn how to use here).
Since we are executing off of the daily chart, we need to view the chart logically and see what the first area of technical resistance will be. Ideally the area is at least 1R away from entry (but it would be nice to have more than 1R between our entry and the target). However, in this particular occasion, the breakout day is quite long! Placing a “lazy” stop below the breakout day’s low is quite a wide stop and it requires an equally strong push just to reach 1R!
So this leads us to the first part of investigation: if you want to play low-volatility breakouts, start by placing the stop loss below the breakout candle low (if buying) or above the breakout candle high (if selling). Then take note of the
- Maximum Favourable Excursion (MFE)/ (Entry – Stop Loss)
- Maximum Adverse Excursion (MAE)/ (Entry – Stop Loss)
of both the initial momentum phase and the subsequent trend phase. Based on your results, you may find that tightening the initial stop loss is required in order to obtain multiple-R returns, or to maximize the momentum phase. In our example, we have offered one way to go about this: using the Marabuzo of the Breakout day. This cuts the stop loss in half, so automatically it skews the risk:reward slightly more in your favour.
Imagining an entry around 0.7200 and a stop loss just below 0.7150, the initial resistance is almost 2R away (0.7300). So if price were able to reach the initial resistance, you have options:
- scale out 1/2 position and trailing the stop to par;
- trail stop to par.
Scaling out, without moving your stop, books some profit and feels good from a psychological perspective, but it works in this case only because the initial resistance is at 2R from entry. So by scaling out 50% we are already making enough to “pay for the trade”. However, scaling out ahead of 2R makes things much less profitable. Every time you scale out of a winning position, the remainder of the position needs more favourable movement to make up the initial risk and this doesn’t happen often. If, by scaling out, you find yourself getting frequent small winners that are less than 1R, please realize that your strategy is now totally dependant on your hit rate – which isn’t a favourable position to be in. It is possible and sometimes logical to scale out when the market moves aggressively in your favour. So experiment, but just be aware of the drawback.
Trailing the stop to par, after price as reached the initial target, eliminates the risk on the trade and allows for larger wins although you will also suffer more premature stop-outs. This is the main trade-off. But there are benefits to trailing the stop to par also: if you get stopped out, you can re-enter so long as the setup remains valid. You can also hold onto your winner for larger gains. However, if you find that trailing your stop to par cuts your trades prematurely and after your stop-out the market continues to move in the desired direction, you will need to adjust.
We have taken for granted that the initial objective for our trade was the previous resistance level, which is both logical and evident. When thinking about your initial objective for a trade, think about a place that looks logical on the price chart and consider that your goal. We all want trades to push way beyond our initial targets and run to the moon. But to be honest, probably only 30% of them do that. The rest will touch a target, chop around, and then retrace.So your efforts should possibly be directed at squeezing out as much juice as possible from that initial move. That is when you can say “job well done”.
So try to make your initial objective as fruitful as possible, and then defend the remaining position.
Pullback within a Trend
This discussion on maximizing the return as the market approaches our primary objective leads us to our second setup: the pullback within a trend.
In the chart above we have zoomed into the second trade: the pullback entry. If you are confused about pullbacks and when they end, please refer to this post. Obviously, the main objective of any pullback entry is the previous cycle high or low, which in our case is the 0.7300 handle.
Once again, as you study these occurrances, start by placing the stop loss below the signal day low (0.7160 for us). That would be 1R between an entry at 0.7220 and our initial objective. Acceptable, but can we do better? A Marabuzo isn’t feasible this time round because by definition the Marabuzo requires a large range day. Also, keeping a stop randomly within the signal day’s range is not logical and perhaps only using a smaller timeframe entry would be a valid alternative in order to skew the odds more in your favour. Obviously this would only be a consideration if you had the time availability to think about it, and valid setups to adopt on smaller timeframes.
Regarding the trade at hand, it does in fact reach the 0.7300 handle easily. So at that point in time the best course of action would simply be to trail the stop to breakeven because any scale-out would not cover the initial cost of the trade. The trade pushes beyond 7300 and reaches 7330s, offering a 1.5R trade. At this point in time it is possible to scale out 2/3 of the trade and lock in 1R profit, letting the rest to run (with the caveats discussed above) or simply hold onto the trade with the stop at breakeven. The next day, the market comes back down below the prior resistance area, hence starting a pullback and prompting you to close the trade (around 1R) or encash partial profits because you can never know the extent of the pullback. Without taking any action, the trade would have been stopped at par.
More Aggressive Options
Depending on your time availability, you may also try to squeeze the most value out of intraday volatility as well. We placed some good examples of management considerations for intraday (and multiday) objectives at the bottom of this blog post.
Over to You
About the Author
Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.